Buy Hold Sell: 6 sustainable dividend stocks

Dividend sustainability has become front-of-mind for investors as Australian companies grapple with the short-term hit to earnings and payouts as a result of COVID-19 and a host of long-term issues such as competition and structural changes in consumer behaviour.

In this episode, Jessica Amir of Bell Direct sits down with Neil Margolis of Merlon Capital Partners and Michael O'Neill from Investors Mutual to discuss six income candidates and whether they can be trusted for sustainable dividends.

They include 1) Fortescue Metals Group - Which is facing questions around how long elevated iron ore prices can last; 2) Telstra - Whose current dividend is under doubt due to earnings and margin pressures; 3) Medibank Private - A business swimming in cash but contending structural issues impacting insurance affordability; and 4) AMP - A company that's been in the news for all the wrong reasons.

Neil and Michael also each bring their one top stock idea for sustainable dividends, trading at an attractive valuation right now.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 23 September 2020.

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Edited transcript

Jessica Amir: Welcome to Buy Hold Sell, brought to you by Livewire Markets. My name's Jessica Amir from Bell Direct. Today we're diving into six dividend stocks. In fact, six stocks that pay above-market dividends. I'm joined by Neil Margolis from Merlon Capital, and Michael O'Neill from Investors Mutual. Let's start with you, Michael. Fortescue Metals, buy, hold or sell?

Fortescue Metals Group (ASX:FMG)

Michael O'Neill (Sell): Fortescue is a sell. Much better company than it was five years ago in terms of balance sheet, cost of production. But iron ore prices are at US$120 per tonne, having been held up by supply disruptions and also stimulus in China. And we see the share prices very much exposed to a correction of that supply and demand in balance.

Jessica Amir: Neil. Fortescue Metals, buy, hold or sell?

Neil Margolis (Sell): I agree, Fortescue is a sell. We think about everything as a range rather than trying to pinpoint one number. If iron ore was to stay at these record labels, maybe there's 20 or 30% upside, but we think there's up to 80% downside if it corrects back to long-term levels. So for us, that risk-reward is tilted to the downside. So notwithstanding the high short-term dividend, it's not sustainable and we don't own it.

Telstra (ASX:TLS)

Jessica Amir: Okay. Staying on you, Neil, Telstra. Their shares are not doing so well of late. Buy, hold or sell?

Neil Margolis (Sell): Telstra's a sell still. We wrote an article last September about this on our website. The cash flow of the company is not that strong. By their own measure, the underlying earnings are around 10 cents a share when you exclude the NBN disconnection payments. That still includes a little bit of a contribution from the fixed-line business, which we ultimately think is going to be a break-even proposition that's re-selling the government NBN. It's going to be hard to make money on that. So you're left with a mobile business, which is a good business, but the margins and prices are high. So we think underlying earnings of say 10 cents, maybe a dividend of 7 cents, the market is still pricing it as if the dividend is 10 to 16 cents, so we think it's a sell.

Jessica Amir: Thanks. Neil. Michael, what do you think? Telstra, pretty tightly held. Buy, hold or sell?

Michael O'Neill (Buy): Telstra is a buy for us. It's on a 5.5% yield. It does have 50% market share in fixed-line and mobile, and fair to say they've been through a very tough period of competition from Optus and Vodafone at unsustainably low returns, and something's got to give. And we see their 5G leadership is underpinning some return to improvement in market share and also margin over time.

Medibank Private (ASX:MPL)

Jessica Amir: All right, let's stay on you. Medibank Private, speaking about something's got to give. Buy, hold or sell?

Michael O'Neill (Hold): Medibank is a hold for us. Now, Medibank has no debt. So if you're going to own a health insurer, it's the one to own. Certainly preferable to owning the hospital operators themselves, but they've seen five years of improvement in margins and coverage has fallen. We're heading into a recession, policyholder participation is going to fall, and so we see it as very much exposed to those dynamics. They've already committed to giving back the savings from elective surgery from COVID.

Jessica Amir: Thanks, Michael. Neil, Medibank Private. Buy, hold or sell?

Neil Margolis (Buy): I think it's a buy, but we prefer NIB holdings or NHF, which is even cheaper than Medibank and broadly similar thematics. They have net cash, they don't have debt, which is a positive. They're sandbagging, they're hiding the results because they don't want to be seen to be gouging consumers. The key concern is about affordability and membership, and that is an issue. NHF also has the travel insurance business, which is loss-making, but will obviously recover and we are long-term investors. Ultimately I think, though, that private health insurance will be around to stay. There might be some reforms, maybe younger people pay less, maybe older people pay more. We think net-net, that'll probably benefit NHF and they'll continue to gain market share. And it's very cheap on a cash yield basis.

AMP (ASX:AMP)

Jessica Amir: All right. Neil, staying on the theme very cheap, AMP. Buy, hold or sell?

Neil Margolis (Buy): AMP is a buy. My beard wasn't grey before we invested in it, so that tells you a little bit about it, but I do think it's very cheap. It's extremely unpopular, following the sale of a life company. They've got similar net tangible assets now, which is really cash backing it as they had when they had the life company. And they don't need much capital now, so we think about 80% of the share price is backed by cash and they don't need much now that the board is holding onto the cash.

Neil Margolis: Fortunately, there've been some positive changes there, we see the new chair as being more shareholder-friendly and more willing to entertain a return of much more capital than they've alluded to. One of the key concerns, once they've returned the capital, one of the key concerns is that advice and platform business, but we've just seen transactions there with MLC and CFS that would price that at several billion dollars for AMP. And they have a funds management business that's quite differentiated as well, so we think there's tremendous upside. A company that's been badly run, but there are some signs of improvement and renewal at the board, which I think would be a welcome change for long-suffering investors.

Jessica Amir: Lots of changes at AMP. Michael, what do you think? AMP, buy, hold or sell?

Michael O'Neill (Hold): AMP is a hold for us. I've probably never spent more time on a company that we don't own. And certainly, it's starting to look interesting, we agree with Neil. Some of the businesses outside of wealth are doing quite well and could be valuable in a breakup scenario. The concern we have is a sum of the parts is not always greater than the whole. There are execution risks, and as we saw with the AMP life transaction, a breakup or separation can involve costs and dis-synergies.

Aurizon Holdings (ASX:AZJ)

Jessica Amir: All right, Michael, let's stay on you. What stock are you really backing at the moment as paying a high sustainable dividend?

Michael O'Neill (Buy): That would be Aurizon. So, Aurizon pays a yield of over 6% fully franked, and they're on about 16 times PE. They're the largest freight operator in Australia. About 60% of their earnings are regulated from the Central Queensland Coal Network, and the other 40% are on 10-year long contracts with some of Australia's most profitable, largest, lowest cost coal producers.

IOOF Holdings (ASX:IFL)

Jessica Amir: All right. Sounds good, Michael. Neil, what about you? Big dividend payer, sustainable dividend, what have you got?

Neil Margolis (Buy): Okay, we're putting out something a bit controversial, which is IOOF. They've recently bitten off a big apple in buying NAB's MLC business shortly after buying ANZ's platform business. The company paid a 45 cent dividend last year, now they've doubled the share count on these two big bank acquisitions. Those are difficult businesses, but the banks are panicking and selling it, so I think it's good to be buying from the banks when they're rushing for the exit. Ultimately, if they can get the earnings of NAB, they can reduce costs in the MLC business. They can get their dividend back to 45 cents or 60 cents franked, and the stock's only on $3. So it'll take a couple of years but part of our process is having a long-term time horizon and investing when expectations are very low, and they're pretty low there at the moment.

Jessica Amir: Definitely low indeed. So plenty of rosy dividends among the thorns.

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