The Case for Paying Dividends

By the time RHG’s loan book has been repaid to the point where it is no longer profitable – management have indicated this will be some time in 2011 – we expect the company will have approximately $1 per share in tangible assets. It could be less if the company loses money on the mortgage assets it’s bought or the credit guarantees it’s provided to the underlying lenders.

Conversely, it could be more if the cost of funding RHG’s mortgage book declines. Encouragingly, there are signs of life in the non-bank lending market; Members Equity Bank recently sold Residential Mortgage-Backed Securities without government support at a cost much lower than RHG’s existing cost of funding. But these factors might only make 10 cents difference either way and, the smaller the loan book gets, the less important they become.

From here, how we realise that value is far more important than how much of it arrives. The cash that RHG’s already banked substantially outweighs what the loan book will provide in future.

The Intelligent Investor’s research director, Greg Hoffman, and I are hoping to get elected to the RHG board at the company’s annual general meeting, on 12 November. If successful, we’ll have significant influence over how this process unfolds. In fact, we’ve already achieved a couple of important concessions.

Chairman John Kinghorn stated in the annual report that if management finds an acquisition, the transaction will be put to a shareholder vote before it proceeds. That’s much better than waking up one morning and finding out we’re the proud new owners of Krispy Kreme Doughnuts.

Kinghorn also said that if an appropriate acquisition isn’t found, capital will be returned to shareholders in the most appropriate manner by 2011. While we’re reasonably confident they’ll find something to spend the money on, at least this puts a time limit on the process.

But if Greg and I are elected, we’ll be pushing very hard for the cash to be returned to shareholders as soon as possible. There’s not much evidence in support of the existing board’s acquisition skills and we believe paying dividends is a vastly superior way of realising the value of this company’s assets.

Value for franking credits

Take my personal shareholding, for example, which includes shares housed in my super fund bought at 16 cents on average. If RHG spends its $1 of cash on an acquisition at a ‘fair’ price, I could presumably sell my shares for $1 each. I’ll then pay 10% capital gains tax on the 84 cents of profit (I’ve held them for more than 12 months) and be left with 91.6 cents of post-tax cash.

On the other hand, if RHG returned the $1 of value as a fully-franked dividend, I’d receive the $1 cash, a $0.21 rebate from the tax office for the franking credits and a capital loss to boot (after paying all the value out as dividends, the shares would be worthless). That $1.21 of cash is 32% more than I’d get selling the shares at ‘fair value’ on the market.

Alternatively, RHG could, for example, offer an optional buyback with a huge fully-franked dividend component. Those shareholders who want out could then exit in a tax effective manner, and those who want to keep their wagon hitched to Kinghorn could leave their cash in the business (although it probably makes more sense to take the franked dividend and reinvest the proceeds at a new, higher, cost base).

RHG has generated a substantial amount of profit in the last couple of years and it has handed a decent chunk of that profit over to the tax office as income tax. If it uses the cash to make an acquisition, those franking credits – $48m as at 30 June and plenty more to come as this year’s $52m tax bill is paid – could be locked in the business forever. That might not make much difference to RHG’s institutional shareholders who are remunerated on the basis of pre-tax returns, but it makes a big difference to us.

Tagged as: RHG, RHG dividends, Steve Johnson