Aegon Asset Management: The Dividend Signal

The big tech payers are expected to pay out $53bn in dividends over the next year. This figure is close to the $60bn expected from the FTSE 100 index in aggregate - a remarkable statistic given the FTSE’s historic reputation for income. 

Nevertheless, the dividend figure is dwarfed by the level of buybacks. The group is authorized to repurchase $315bn of stock this year, almost five times the dividend payout. Clearly, the preference for buybacks remains. However, the trend towards dividends still serves as an important signal for investors.

Maturity hypothesis

Classic theory proposes that dividends convey positive news on a company’s future cash flows. The theory is supported by the positive long-run relationship between dividend growth and share price performance.

Similarly, academia supports the “maturity hypothesis”. The premise is that dividends are a signal of a company’s maturing financial profile, evidenced by a decline in the level of risk and increasing free cashflow generation. The perception of lower risk is positive for the firm’s cost of capital, and the stock is typically rewarded with a higher earnings multiple.

With the tech sector, media attention suggests it is more likely the latter. The headlines of Meta’s ‘coming of age moment’ come after a period of streamlined operations, tight expense control and new focus on shareholder-friendly returns. The dividend initiation is a signal that this discipline is here to stay, and that Meta, like others in the tech space, is entering a new stage in its corporate life.

Maturing financial profiles bring scope for equity retiral and the ability to substantially raise payout ratios. In the Aegon Global Equity Income fund, part of our tactical allocation is to look for these stories which we group into “De-equitiser” and “Hoarder” buckets*.

United Rentals

United Rentals is a recent example of this dynamic. The company is the largest equipment rental firm in the US. Its business model is simple: buy construction equipment, rent it out and later sell it on. Drive past any plant hire yard and you will likely be underwhelmed, but these businesses generate impressive returns when run at scale. United Rentals is the largest player in the industry with 1,600 branch locations and $21bn of fleet.

The equipment rental industry is cyclical. In the great financial crisis (GFC), US non-residential construction activity fell around 30% and as rental demand slowed, intense price competition emerged. Falling rental pricing damaged industry earnings, and United Rentals’ profit margin fell sharply in this period.

The industry has changed since then, with the top ten companies commanding 44% of the market, double the share held in the GFC. United Rentals has consolidated the market aggressively through M&A, branching out into new categories as the ‘single-source provider’ to the jobsite. Revenues have grown at a 14% (compound annual growth rate), while margins have improved from the 25% in 2009 to closer to 48% today.

With the industry consolidated, the largest players have structural advantage in terms of fleet purchasing power and scope of rental offering. The industry has also embraced third-party data provider Rouse, which gives insight into rental rates and utilization levels at local level. In turn, this encourages pricing discipline and enables rental companies to better allocate and plan purchases of fleet.

The years of United Rentals’ supercharged growth is likely behind it. However, structural changes have driven an evolution in the business model which supports higher through-cycle margins and cashflow generation. The company began paying dividends in 2023, a key signal of management’s confidence in the resiliency of earnings and free cashflow. In turn, this supports a higher through-cycle multiple, and the stock has rerated accordingly.

United Rentals is held in Aegon Global Equity Income Fund as at 21 May 2024

*”Hoarders” have the operating success and balance sheet strength to materially increase shareholder remunerations. “De-equitisers” have capital structures that offer scope for equity retiral through M&A or share buy-backs.

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Exp date: 27 November 2024