Franking Credits.

This discussion follows on from our earlier discussions about dividends.

The Company have previously stated that it is their intention to pay fully franked dividends. Now, we don't know if they will continue that policy into the future. There may come a time where the level of foreign profits are such that it is not practical to continue to limit the dividend to that which can be fully franked. However, just for the moment, maybe we can assume that this policy remains in place. We might even go further out on a limb and project that the Company sees no benefit in accumulating large amounts of franking credits and therefore may well pay a dividend that exactly matches that which can be fully franked.

Given the above, I thought it would be interesting to try to establish exactly what the franking credit situation may be at the moment. It actually turns out to be quite hard to do - not the least because franking credits are accumulated on a cash basis.

A couple of basic facts.

Franked Dividend. A franked dividend is simply a dividend that the company has already paid the Australian Income Tax on. A fully franked dividend will have had tax paid at the 30% Company tax rate. Companies do not have to pay fully franked dividends, they may pay unfranked or partially franked dividends. The Australian Taxation Office (ATO) will give us (the dividend recipient) a credit on our tax for the tax that has already been paid on the dividend. For simplicity, I will restrict this discussion to fully franked dividends. It is easiest to understand by an example. If we receive a $.70c fully franked dividend then we will receive a tax credit of 30c. That is because the company would have needed to earn and pay tax on $1.00 to produce a post tax amount of $.70. In essence, when we do our own tax, we record an income of the dividend plus the franking credit ($1.00) and then subtract 30c from our final tax amount to be paid. Thus, if our marginal tax rate is 30% then we will have effectively no tax to pay on the cash dividend received. If our marginal tax rate is higher than 30% then we end up paying the difference between our tax rate and the 30%. If our marginal tax rate is less than 30% then we end up with a credit that will be offset against any other income tax that we have to pay - or if there is none then we receive a nice cheque from the ATO. The best situation is that when we hold the shares in a Superannuation account that is in pension mode. There is no tax to pay and the entire franking credit (30c) is paid to us by the ATO.

Often, it is easiest to examine our dividends as a "grossed up" amount. In the example above (a fully franked dividend), the grossed up dividend is the cash dividend divided by 7 and multiplied by 10 (therefore a 70c ff dividend grosses up to $1.00). This is convenient as it allows us to compare the yield directly with the yield that we might get from alternate investments (eg Bank Deposit, Bond). It is very common to apply the same methodology to dividend yield %. That is, a dividend yield of 7% ff grosses up to 10%. The current Telstra dividend yield, for example, is 8.5% ff which grosses up to a touch over 12% (hint, hint).

Foreign Tax. For companies that earn some of their income through overseas subsidiaries there is another little complexity. Such subsidiaries will likely have to pay tax in the country in which the subsidiary operates. (Generally) Any tax paid overseas will be allowed as a credit by the ATO against the tax that would be paid in Australia. However, such tax will not provide any franking credits. In a "worst case" situation this means that a company that earns all of its income overseas may not earn any franking credits and will not be able to pay franked dividends. More usually, the Company will pay some tax overseas and some in Australia. This means that not all of the earnings of the company can be paid out as fully franked dividends. Either the company will pay only as much dividend as they have franking credits available to make the dividend fully franked, or they will pay unfranked or partially franked dividends.

Cellestis have expressed a desire to pay fully franked dividends. Whilst most of our sales are made overseas, we are in the fortunate situation of having an essential part of the manufacturing process in Australia. This means that a judicious setting of the price that we charge our overseas subsidiaries for the product enables a respectable amount of the profits to be booked in Australia where they will be taxed by the ATO and thereby attract franking credits. The fact that we have extensive expenses (Sales and Marketing) based overseas helps with this also.

I'm guessing that you knew all that.

Now, to specifics. It would be interesting if we can establish what the tax situation of Cellestis is, particularly how much tax they are paying in Australia to provide franking credits.

As I mentioned above, it is actually quite difficult to reconcile the franking credits account - largely due to the fact that it is run on a cash basis. However, if we look at the 2009 Annual Report we find this.

This tells us that in 2009, 93% of the company earnings were recorded in Australia. Consequently, we would have to presume that the vast majority of the income tax paid has been paid in Australia and will therefore have attracted franking credits. This would imply that there is absolutely no reason that the Company could not pay a very high percentage of earnings as fully franked credits, if the Company so wishes.

Now, the reason that such a high percentage of the profits were booked in Australia is due to two factors; firstly that a very high part of operating expenses are incurred overseas; and secondly that a large amount of the profit is recorded because of the price that the Australian operation is able to charge its foreign operations for the supply of product. It would follow that, whilst the second factor should remain reasonably constant in the future, the overseas expenses as a proportion of actual sales will reduce. Ultimately it will mean that the 93% will progressively reduce but not by enough to reduce the ability of the company to pay large fully franked dividends.

It is worthwhile noting that retaining franking credits in the Company provides no real benefit to anyone. I do note that it would appear that the 1.5c ff dividend paid for 2010H1 would not have used up all of the franking credits available. I can only guess as to why the Company might have decided to limit the dividend in that case. It may be that it was felt at that point that it was important to assure the stability of the company by retaining cash. That consideration, at that time, may have outweighed the desire to provide a higher immediate cash reward to shareholders. 

Ultimately, the upcoming financial results will go a long way towards clarifying this situation.

Dividends (a little more).

I note that my previous post regarding the upcoming dividend has stimulated some interesting conversations "around the traps". 


It could be that my post has been misinterpreted by some as a mild complaint about the dividend policy of Cellestis. It is not. I believe that the dividend policy of Cellestis to date has been both reasonable and sensible - it has provided investors with a taste of the rewards to come while ensuring the ongoing strength of the Company balance sheet. 


What I have tried to do is to approach the matter of the dividend policy of Cellestis, "going forward :)", in a dispassionate and logical manner. Hopefully, my logic, accounting and understanding of financial and investing matters is reasonable enough that my conclusions are realistic.


In the end, I guess I am making a statement about what I believe will happen. I believe that the Company will either increase the dividend payout percentage or they will tell us why they haven't done so. Of course I have no more knowledge regarding this than any other pundit, it is just that there is no reason to believe that the Company won't do this. 


Just for interest, if we were to assume a NPAT of $10m for the year and a dividend of 5c for the half then we would have an annualised current PE of around 27 and an annualised dividend return of 3.7% which grosses up to 5.8% - not too bad at all, given the growth prospects of Cellestis.




One other non-consequential little matter. I have received a number of communications from people pointing out that my previous post on dividends has been reposted in another place. That was done with my permission. It was my suggestion that the post not be accredited to me, only because that particular forum has a policy that precludes that. As I have always said, I maintain no copyright over anything that I say - if anybody finds any of it of interest then I am quite happy for it to be reposted anywhere.

Dividends.

The entries so far in my guessing competition (thanks for the entries and comments so far) has started me thinking about the upcoming dividend.


We know that Cellestis had around $20m in cash as at 31st December 2009. The CEO of Cellestis has previously indicated that something around $20m is an adequate cash holding for the company.


Why do companies hold back some of their cash profits into a cash reserve?

• as a buffer against temporary future misfortunes
• to cover the cycle of operating cash requirements (inventory, salaries etc)
• to reinvest cash back into the business (purchase/build physical assets, R&D etc etc)
• to build a war chest for potential corporate action (takeovers)

Let's look at these reasons as they relate to Cellestis.

It is fairly unlikely that there is any severe future misfortune that a cash reserve could solve. Let's think of the worst possible misfortune. How about if somebody released a competing diagnostic that is better, cheaper and faster? (it's not going to happen). In reality, no practical amount of cash on hand would save Cellestis in that situation.

It seems that the $20m cash on hand is more than adequate to cover the cycle of operating cash requirements - even if massively increased sales demand an increase in inventory purchases. A modest increase in cash over time, in proportion to sales growth, to maintain this cover may well be justified.

Cellestis' R&D is a relatively low cost item that can easily be financed from ongoing cash flows. It is unlikely that Cellestis is about to build a factory, buy a chrome and glass edifice to somebody's ego or anything similar. The management have demonstrated a commitment to modest and sensible use of capital - there is no reason to expect that this will not continue.

Takeover. There is nothing that we know of on the horizon. It is simply not sensible to hold back large amounts of cash profits on the "off-chance" that a suitable takeover may appear. Cellestis does not really need to get involved in a takeover at this point. Maybe at some future time it will become a useful action - at that time a takeover can be financed by the cashflow at that time and debt. There is no need to husband cash for that eventuality.

We could expand on all of those points quite extensively. However, the basic point is clearly evident - Cellestis would need a justification for increasing its cash holdings. Now, there may be some great justifications. If there are, then we would expect and be entitled to have those justifications explained to us in the upcoming accounts.

Looking at it the other way round - I can see no reason why the Company would NOT increase it's dividend payout ratio significantly from the current 45%.

Now, I don't know what the NPAT figure for 2010 FY will be. Just for this exercise, let's guess that it is $10m. Given that we have already received 1.5c dividend this year then I can see no reason why the dividend for the second half should not be 5c or 6c - giving a dividend payout ratio of 65% or 75% (annualised) or 71% to 85% (on a current half basis).

We can look at this from another angle. In general, the Cellestis share registry is predominately populated with investors, rather than traders. In a pure sense, investors achieve a return on their investment through the receipt of their fair share of the profits that are made by their company - not by selling their shares. The investors in Cellestis have been wise (or lucky) - we have invested in a startup biotech that has succeeded in reaching profitability. It is only reasonable that we, the investors, should now start receiving a return on our investment (without selling the investment that we have made).

Anybody else have thoughts on this?