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BMO UK High Income reflects on the challenges facing the UK equity income sector

BMO UK High Income (BHI) reported annual results to 31 March 2020, this morning. Performance highlights include:

  • Total distributions increased by 3.4% to 5.21p per share compared to the prior year. Distribution yield of 7.5% on ordinary shares and 7.7% on B shares at 31 March 2020, compared to the yield on the FTSE all-share index of 5.5%.
  • NAV total return per share for the year was (21.4%), compared to the benchmark total return of (18.5%).
  • Ordinary share price total return per share for the year was (22.8%), compared to the benchmark total return of (18.5%).
  • B share price total return per share for the year was (25.0%), compared to the benchmark  total return of (18.5%).

All of the declines in the absolute return numbers took place during the final five weeks of the year accounting year.

Chairman, John M Evans, commented: “In its response to the introduction of severe restrictions on economic and social activity necessary to fight the covid-19 pandemic, the UK Government has made available enormous sums to reimburse companies for the earnings and wages of staff who have been furloughed. It is entirely understandable why companies that are beneficiaries of such public funding and have seen the livelihood of their employees and other stakeholders severely impacted should choose to cancel, delay or significantly reduce the dividend payments that they make to shareholders. In addition, companies have chosen not to pay dividends in the short term to conserve cash at a time when cash flow is severely reduced. Finally, financial regulators in the UK made it clear that they did not expect certain financial companies to be paying dividends under current circumstances.

Possible scenarios for UK dividends in 2020 were recently provided by Link Group and estimations for falls ranged from 27% to 51%. This is a quantum of decline significantly greater than that seen in 2008 and 2009 during the financial crisis. Furthermore, there is an exceptionally low level of visibility as to when companies may be in a position to commence paying dividends once more and also at what level they may reintroduce a payment. The Fund Manager has set out his expectations for dividends from the Company’s investments within his report.

Consequently, the macro background for an Investment Trust with an objective of seeking income and income growth from a predominantly UK equity portfolio could hardly be more hostile or uncertain.

Shareholders should rightly ask “What is the board’s strategy in response to such a background”?

The answer is simple. The board intends to use the benefits of the investment trust structure to ensure that the level of dividend to shareholders is at least maintained for the foreseeable future.

Revenue reserves following the payment of the fourth quarterly interim dividend will be £4.9 million, approximately 5.7p per ordinary share, equivalent to 109% of the total annual dividend of 5.21p per ordinary share paid in respect of the year to 31 March 2020. These reserves can and, if required, will be used to supplement revenue earnings in future periods. Indeed, following the cancellation of previously declared dividends by several companies held in the portfolio just before the company’s year end, £436,000 of revenue reserve will be used to pay the above dividend.

Your directors consider that the manager has placed the portfolio in a strong position and shareholders should be encouraged by the fact that the level of reduced or unpaid dividends for the portfolio to date is lower than that recorded by the FTSE all-share index.”

Risk of dividends from UK companies fundamentally rebasing to a lower level

John adds: “It may well be the case in future that dividends from UK companies are fundamentally rebased to a lower level and such a situation would severely impair the ability to maintain current payment levels over the long term. However, we will make every effort to try and at least maintain the level of payment to shareholders. The Board is aware of the paucity of yield and income available from other asset classes. Interest rates have been reduced to all time low levels. Bond yields are likewise low. Other asset classes which are owned primarily for an income return have encountered significant difficulties in their ability to maintain dividends.”

The fund’s manager, Philip Webster, had this to say: “At the outset of the pandemic the focus was on the ability of companies to survive while government restrictions were in place. We believe our focus on the quality of our holdings has stood us in good stead and given us comfort on both the level of liquidity held to meet obligations, including debt repayments and investees’ margins over bank covenants which indicate the likelihood of them defaulting on their debt. This was all about liquidity, or more simply, having enough cash to survive a collapse in revenue, and for how long? Without this shift we would have been in a tougher position to weather the liquidity squeeze that drove the initial sell-off.

Given the number of unknowns, we have focused our efforts on the knowns, i.e. the liquidity of each company in the portfolio. As a team, we have run due diligence on all of our holdings, speaking with most management teams to assess how they plan to deal with the current environment. Clearly, the dispersion of answers is extremely wide at this juncture and none have all the answers. Like us, they have stress-tested some very extreme scenarios, especially those that will be hit hardest, in some cases, for example Wizz Air, their extreme scenario was zero revenue for the rest of this year.

In summary, and caveated, we are as comfortable as we can be that our holdings have raised additional debt, drawn down on cash facilities and cancelled share buybacks and dividends to give their businesses the best chance of survival. While this is going to be a tough year for dividends, capital preservation and durability of the business into the medium-term are foremost in my thought process, as there will be some incredible opportunities for the stronger businesses when we emerge from this pandemic.

We have undertaken stress-testing on our revenue account and discussed the current best-case and worst-case scenarios with the Board. The latter includes those companies we believe will not pay uncovered dividends, or where management changes may force this upon us.

This year should be the toughest, but we also have to be mindful that this stress could drag on into 2021. As the chairman noted this is very difficult to forecast, but we believe our revenue expectation for the portfolio companies is currently tracking ahead of the market forecasts.

I would also note that out current gearing is also very marginal, 3.4% at the year-end. As you will know we have a fixed rate facility of £7.5m, which we have drawn down, however we held cash of £4m at the year-end. We also have a revolving credit facility of £7.5m, which is currently undrawn. We regularly discuss the appropriate level of gearing to deploy with the board and currently feel with the total lack of visibility, now is not the appropriate time. When we deploy this it is likely to provide an additional boost to revenue which we have not included in our current forecasts.”

Potential once in a decade opportunity to add cyclical names

“Forecasting the direction of economies and markets is not within our skillset, our focus lies elsewhere – a sensible stance given there is very little visibility on anything as we stand. If we consider for example just the practicalities of getting back to normal working life and how that knocks-on to the wider economy in terms of activity one can see how difficult it is to predict outcomes. There is a once in a decade opportunity to add to some of the more cyclical names we hold which have been impacted most, although for now I feel patience is required. The second quarter earnings are going to be very messy indeed as the full effect of the lockdown in the US and Europe comes to the fore. What recovery from that looks like is hard to gauge and rather than indulging in guess work, our near-term focus is on trying to protect capital, monitoring positions and identifying opportunities which we can harness once more clarity emerges.”

BHI/BHIB/BHIU: BMO UK High Income reflects on the challenges facing the UK equity income sector

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