Saturday, November 18, 2017

Bank Dividends: Go Ahead and Drink The Kool Aid

Dividends are no longer sexy. So says Rob Isbitts, a Forbes contributor in a recent article that he penned. Not sure they ever were sexy, but he has a point. Read the article, make your own judgement.

Or read on. Today I had another debate with my colleagues about discount rates. You know, those rates you learned in Finance class, CAP-M, or Ibbotson Build-up? Yeah, text book stuff. Don't hear much about either on CNBC these days.

I view things simplistically. If you are going to project out into the future, say in strategic plan projections, then you should discount back to present day to determine if your strategy is adding or eroding value. A key component to the calculation is the discount rate.

So here is my simple definition of what your discount rate should be: The annual capital appreciation rate expected by your investors. That differs based on business model, in my opinion. If you are executing a fast-growth strategy in a slow-growth market, you may be taking larger risks. Therefore, your investors should expect greater capital appreciation, and therefore a greater discount rate.

If you grow more slowly, and closer to your market growth, you would likely be executing a less risky strategy, and you should consider a smaller discount rate. But your investors would still expect equity-like returns. Common stock remains the lowest rung on the capital hierarchy, regardless of strategy employed. 

Absent a change in your market multiples, your stock's capital appreciation should move in tandem with your earnings growth, or possibly your book value growth, or some combination of the two. That is typically how banks are valued. So what if in executing your strategy, you're projecting 6% earnings compound annual growth? I doubt your investors would be happy with 6% annual returns. How do you deliver the returns they are expecting?

How about the dividend?

Let's look at Territorial Bancorp in Honolulu, the holding company for Territorial Savings Bank. Why Territorial? Aside from my affinity for Hawaii because I lived, worked, and went to college there, they are a highly capitalized thrift that converted from mutual to stock form in 2009. Their capital ratios are not an issue.

Territorial had an inconvenient truth in their 2016 10k, or annual report for those that don't speak in SEC forms. See the below chart.

They have under-performed bank stocks and the wider market over the past five years. They are not a poor performer though, having a year-to-date ROA of 0.89% and Efficiency Ratio of 56.5%. The challenge may be their balance sheet growth, only 4.1% per year, on average, since 2011 (see table). The Hawaii population is projected to grow 3.46% over the next five years.

One way Territorial is trying to improve shareholder returns is through dividends. Their dividend has grown at a CAGR of 22% since 2011, even though their EPS has grown at a CAGR of 8.5% over the same period. In 2016, that resulted in a dividend payout ratio of 52.3%, up from 29.1% in 2011. Quite a commitment to the dividend. An 8.5% annual EPS growth, combined with a 2.8% dividend yield, should result in a total annual return of 11.3%. That assumes no change in Territorial's price/earnings multiple. Not too shabby. 

So why don't others deliver higher dividends to stoke shareholder returns, especially if their balance sheet is growing slowly, and their EPS growth is not enough to meet shareholder expectations? Why maximize profitability only to accumulate capital?

Territorial is working their capital position down from a very lofty perch post-conversion. Clearly dividends are one part of their strategy, as well as share buybacks. The buybacks are typical for a converted thrift. Although don't get me started on the logic of issuing shares at $10 only to immediately start buying them back at a higher price.

What if, as Territorial "normalizes" their capital position as per their capital plan, they have to cut the dividend? This is a common objection I hear from bankers for not increasing their dividend and payout ratio. They don't want to cut it. And suffer the consequences. Like GE recently did.

The Board and executive management of Territorial have this covered, in my opinion, in the form of a special dividend. In 2016, their regular quarterly dividend was $0.18/share. In December, they declared a special dividend of $0.20/share, in addition to their regular dividend. They recently declared a special dividend this year of $0.30/share, payable in December. Once their capital levels return to "normal", if the special dividend reduces capital ratios, they can reduce it or eliminate it altogether, without impacting the regular dividend.

But no, bankers object because their shareholders will grow to "expect" the special dividend. As if active shareholder relations programs can't mitigate this risk. 

As a result, many keep banging the growth drum to stoke EPS and therefore shareholder returns. As if growing faster than the bank's markets can continue ad infinitum. If it doesn't pan out, we turn first to cost cutting (largely within our control). Then to buy-side M&A (less within our control). And if we fail to deliver shareholder returns by these methods... then sell-side M&A (within our control). 

And, alas, we have fewer than 6,000 banks.

Are you drinking my dividend Kool Aid?

~ Jeff

No comments:

Post a Comment