Author: Hugh Dive

Monthly Performance May 2017

  • May 2017 marked the launch of the Atlas High Income Property Fund into the turbulent Australian equity market.
  • The Australian Listed Property index fell -1.3% over the month, which was ahead of the wider Australian equity market that declined -2.8%.
  • The Fund’s unit price was essentially unchanged as we are maintaining a cautious approach in constructing the portfolio. Losses were balanced off against gains from call options sold.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in May and the fund’s strategy

Party like it is 2007???

Party like it is 2007???

The Australian listed property sector has performed solidly over the past five years, climbing its way out of the depths of despair reached in March 2009. As many investors clearly recall, that the sector fell 70% between September 2007 and March 2009 as many over-geared trusts struggled to refinance debt, jettisoned recently acquired assets and conducted highly dilutive equity issues.

While launching the Atlas High Income Property Fund, one of the questions I am frequently asked is “aren’t we headed towards a collapse in the Listed Property sector like in 2007?” In this week’s piece, we are going to compare May 2017 to May 2007 and see that the Listed Property sector is not partying like it is 2007!

May 2007

Prior to the Global Financial Crisis, Australian listed property trusts appeared to be taking over the world. With the financial press and investors cheering, many trusts hoovered up property assets in Europe and the United States. Arguments were made that trusts should be treated more like shares than boring rent collectors, due to the trading and business income that was being earned. Various trusts such as Centro were dubbed “the Macquarie Bank of Property Trusts” due to their aggressive and innovative use of debt to create global property empires.

 Passports ready? Pack your bags

In the below chart the grey bars indicate the proportion of offshore real estate assets held by the Australian LPT sector. In 2007 over 40% of the assets held by the listed trusts were located outside Australia. The rationale for this empire building was that management would be able to increase earnings per share by buying higher yielding offshore properties using cheap short term debt sourced from the wholesale market. This strategy resulted in Australian LPTs owing a cornucopia of properties ranging from apartments in Tokyo, industrial properties in Düsseldorf, shopping centres in Poland, office towers in Brussels and suburban low rise offices in Seattle.  Whilst this provided shots of shiny new assets in the annual reports and exotic site tours, during the GFC it became clear that management teams paid too much for assets they didn’t really understand and were hard to administer from headquarters in Sydney or Melbourne. Additionally, few Australian investors could accurately judge the changing fundamentals of the real estate markets on the other side of the world.

Current Position

After billions of dollars of real estate was sold off in the period 2009 to 2014, the foreign real estate exposure on the ASX is limited to 21% and is comprised of Westfield (trophy shopping centres in the US and UK) and Goodman (industrial property predominately in Asia and geared towards facilitating e-commerce).  Unlike the property assets bought in 2004-2006, these trusts own assets that are narrowly focused and not owned by the trusts for a short-term boost to earnings per unit.

Distributions

In the short term, a trust like any company can distribute all their profits to shareholders and artificially boost dividends or distributions. Whilst this sugar hit can be sweet for the share price, in the medium term all corporates need to retain earnings to maintain the quality of the assets owned by shareholders. If this doesn’t happen the assets and their earnings power can degrade. Property Trusts need to retain profits to pay for maintenance capital expenditure such as repairs to lifts and escalators, new tiles in reception areas, air-conditioning and – in retail and office – incentives such as fit-outs.  Additionally, if a trust is distributing all of its earnings there is no cushion to protect distributions if market conditions change, such as if a significant tenant goes out of business.

Ten years ago, on average the entire property sector was paying out 95% of earnings, with some trusts paying out over 100%. In that environment, maintenance capital expenditure was financed either by borrowing or issuing more equity; neither of which is desirable for long term shareholders.  Additionally, when market conditions changed, investors saw significant cuts to distributions. For example, Investa Office cut their distribution from 9.7 cents per unit in 2009 to 3.9 cents per unit.

Current Position

Currently the payout ratio is a more modest and stable 82%. This allows trusts to pay for maintenance capital expenditure and incentives out of current earnings and creates a distributions stream for investors that is inherently more stable. Additionally, the listed trusts are more capable of weathering the inevitable changes in market conditions, without immediate and drastic cuts to distributions.

 

Shaky Debt

Ten years ago, the property sector was both highly geared (debt/debt+equity) and paying a much higher rate on their debt. “Innovative” property trusts such as Centro Properties were riding high, delivering earnings and distribution growth by buying assets around the globe. The strategy employed by many of the ASX Listed Property Trusts was to boost earnings by arbitraging the difference between the higher rental yield on acquired properties and the lower rate at which they could borrow on the short-term wholesale money market. Whilst longer term funding was available, it was at much higher rates which would not have delivered the same earnings growth. For example, when Centro Properties acquired a portfolio of 469 small shopping centres across 38 US states for A$3.9 billion in May 2007, the trust upgraded its forecast for 2008 financial year distribution growth to 19%!

The flaw in this strategy is the assumption that current benign credit conditions will continue forever, allowing the mismatch of funding of the “long-term” property asset with “short-term” one year debt. In the case of Centro Properties, the trust faced significant problems in late 2007 in refinancing US$5.5 billion of debt that was due to be rolled over in a very challenging market. Under these conditions trusts were either forced into administration or, like Goodman, were forced to conduct a series of dilutive equity issues, as shareholders forced to dip into their pockets to pay the debt that had become due.

Current Position

Currently the overall gearing is quite low at around 30% and the trusts overall are paying a much lower rate for their debt. Critically in our mind, the quality of the debt is much higher as the chief financial officers of the trusts have a greater diversity in the sources of funding and have lengthened its term. For example, SCA Property has 30% of its debt due in 2029, 35% in 2021 and the residual in 2019/2020. The critical difference between 2017 and 2007 has been the larger property trusts being able to access the US debt markets, which has allowed them to place long term debt at attractive rates swapped back into Australian dollars to avoid currency risks.

One of the questions that I posed to a range of Property Trusts after the recent results season, is: “Given you can access long term debt at attractive rates, why don’t you increase gearing?” The response was that the investor base of grizzled and cautious fund managers won’t support this due to their memories of the GFC!

Our Take

Whilst Property Trusts have performed very well over the last five years, the underlying financials don’t suggest that the management teams are exposing investors to the same risks that were present a decade ago. Over the last quarter, we have seen the ASX-200 A-REIT index fall 5%, which in our mind has taken some of the heat out of the market and is showing some attractive entry points for a range of Listed Property Trusts.

Faded Blue Chips – solid stocks with feet of clay

Blue Chip stocks are the large well-established household names, in the top 50 companies listed on the ASX with a market value in the tens of billions. Stockbrokers recommend these companies to their clients based on the perception that they are safe and stable and following the axiom “Nobody ever got fired for choosing IBM“. They are viewed safe for advisors to recommend even if they fall in value. However, like Ozymandias in the poem by Shelley, strong and financially sound companies are not always permanent and can become buried in the Egyptian desert like the statue of the pharaoh.

“I met a traveller from an antique land, who said— “Two vast and trunkless legs of stone

Stand in the desert.  Near them, on the sand, Half sunk a shattered visage lies, whose frown,

And wrinkled lip, and sneer of cold command, tell that its sculptor well those passions read

Which yet survive, stamped on these lifeless things, the hand that mocked them, and the heart that fed;

And on the pedestal, these words appear: My name is Ozymandias, King of Kings; Look on my Works, ye Mighty, and despair! Nothing beside remains. Round the decay of that colossal Wreck, boundless and bare, the lone and level sands stretch far away.”

Shelley’s Ozymandias 1818

In this week’s piece, we are going to look at blue chips on the ASX over the last quarter century, the factors that caused them to decline and some thoughts on the current crop of “blue chip” companies on the ASX and their permanence.

What is a blue-chip stock?

The term “Blue Chip Stock” was first used by Oliver Gingold of Dow Jones in 1923 and referred to high priced stocks. “Blue” was a poker reference, as in poker sets the highest value chip is traditionally the blue one. Since then the term has come to denote high quality stocks, with consistent revenue growth and dominant market positions in their industry. They typically have a stable debt to equity/interest coverage ratios and generate superior return on equity (ROE).  Over time this translates into a high market capitalisation that places a company in the Top 50 companies listed on the ASX. Currently the smallest stock (BlueScope Steel) in the ASX Top 50 has a market value of almost A$7 billion.

The below table looks at the Top 50 stocks on the ASX by market valuation in four points in time over the last 26 years. There are many familiar names such as BHP and Westpac that were considered blue chips in 1991 and retain that status today, but there are also many that would be unfamiliar to many investors today. Whilst most of these (Cadbury Schweppes, North Broken Hill, PNO, Dairy Farm Holdings) have disappeared from the share market due to being taken over by other companies, in each period there are a number of supposed blue chips that ultimately went into administration or faded away to a small fraction of their previous size. The faded blue chips in the table are coloured in red. We will now examine the factors that contributed to their declines.

Too much debt

In early 2007 shopping centre trust Centro Properties was riding high after making a string of acquisitions in Australia and the USA. It was viewed as highly innovative, dubbed the Macquarie Bank of Property Trusts due to its use of debt to create a global property empire. After acquiring a portfolio of 469 small shopping centres across 38 US states for A$3.9 billion, the trust was managing A$26 billion of property. As a result of the acquisition, Centro Properties upgraded its forecast 2008 financial year distribution growth to 19%. However instead of rising distributions, in December 2007 Centro Properties faced significant problems in refinancing US$5.5 billion of debt that was due in a very challenging market. Additionally, the shopping centre owner faced questions about the accuracy of their financial accounts after billions of dollars in short-term bridging debt was classified as long-term debt. As a result of asset write offs, Centro Properties in June 2009 reported a negative net tangible assets (NTA) of -$2.23 per share (it was trading at $0.16 per share at the time). Ultimately equity holders were essentially wiped out as the mountainous debt burden was converted into equity.

Financial Engineering

In 1998 zinc miner Pasminco was one of the premier global zinc miners after buying the Century project from Rio Tinto. The company developed an audacious hedging strategy to lower debt costs by borrowing in USD and hedged the currency based on the expectation that the AUD would remain between US68c and US65c. Unfortunately, the AUD/USD fell to below 51c in 2001 at the same time that the zinc price crashed. This left the company with limited cash flow and losses on the hedge book that blew out to $850 million when the company went into administration in late 2001.

The combination of too much debt and financial engineering

No discussion of faded blue chips would be complete without looking at investment bank Babcock & Brown. At its peak in June 2007, the investment bank was lauded as a creative user of financial structuring and a fee-generating machine that propelled the company’s share price to $34.63, with a market capitalisation above $9 billion. From meetings that I had with Babcock & Brown management prior to the GFC, they also made no secret of the fact that only a small amount of their earnings could be characterised as “recurring” and that most of the profit (used to pay dividends) was generated by revaluing assets cannily acquired by the company.

Similarly, to Centro, Babcock & Brown both entered the GFC with too much debt and – more importantly – too much short-term debt that needed to be refinanced in a challenging market. In June 2007, the Babcock & Brown group had amassed $80 billion in assets, supported by $77 billion in debt, much of this held off balance sheet or characterised as “non-recourse” and held by satellite funds.  The company collapsed in 2009 after a falling share price triggered debt covenants and the company was unable to refinance the debt due. Ultimately, in very complex liquidation proceedings the noteholders ended up receiving 2c in dollar for bonds held, with equity holders receiving nothing.

Technology that did not work as expected

The orbital engine was invented by Ralph Sarich in 1972and at one time was expected to revolutionise combustion engines, with fewer moving parts and greater efficiency.  In 1991, the future for Orbital – a company that owned the technology for orbital engines – looked bright and BHP took a 25% stake in the company. Despite this promise, a range of technical problems with cooling and lubricating the engine proved unsolvable and both the founder and BHP ran for the exits. Orbital still exists selling fuel injection technology and propulsion systems for drones, but with a share price of $0.59 which is a long way from its peak at $24.

ERG’s future looked bright 17 years ago and was a glamour tech stock listed on the ASX offering smartcards for mass transit systems from Moscow to Manila. Whilst the technology itself was sound the company was effectively sunk, not by the offshore moves but by difficulties in implementing the ERG’s T-Card in Sydney and issues with the NSW State Government which led to the project being scrapped.  Ultimately this resulted in lawsuits and the company was delisted in 2009.

The above table shows the ASX Top 50 as of April 2017 ranked by market capitalisation.  Whilst it is usually hard to identify at the time which strong companies will falter in the future, history strongly suggests that amongst this list there are one or two companies, currently considered blue chips that will either go into administration or slide back into insignificance. Below we identify some considerations that might influence the future fates of current blue chips.

High Debt

In 2013 Fortescue looked like a candidate for a blue chip that might blow up, with 70% gearing resulting from $10.5 billion in net debt. However, a period of sustained high iron ore prices has allowed the company to pay off $6.5 billion in debt and reduce gearing to a more manageable 30%.

Amongst the blue-chip stocks in the table above, the companies with the highest debt burden as measured by gearing (net debt divided by total equity) are Sydney Airport (770%), APA Group (242%), Transurban (225%) and Ramsay Healthcare (135%). The key characteristic of these heavily geared companies is the view that the stable returns from airports, pipelines, toll roads and hospital procedures affords the ability to service high levels of debt.

Whilst these companies own wonderful assets and point to both the spread of debt maturities and their interest rate hedges (which lock in a portion of the company’s debt at a fixed rate), these hedges will expire and debt currently attracting low rates will almost certainly have to be refinanced at higher rates. For example, in the five-year period 2020 to 2024, Sydney Airport will have to refinance on average $806 million in debt per year.

Technology does not work as expected

Whilst we do not consider this likely and believe that the company has instituted many safeguards, blood therapy company CSL does face the risk of product recalls through contamination. In 2008, CSL’s rival Baxter faced a product recall after 81 deaths were linked to tainted blood thinning drugs produced under contract in China, but sold in the US under Baxter’s name.

 Left Field

Political factors could potentially derail BHP spin-off S32, which has climbed into the ASX Top 50 courtesy of higher coal and manganese prices. In February S32 reported that 35% of their profits were earned from the company’s coal and manganese mines and aluminium smelters in South Africa and Mozambique. Significant political unrest, power disruption from Eskom or amendments to South Africa’s 2002 mining charter requiring higher percentages of black ownership could result in significant falls in S32’s share price.

Our Take

We see that investors spend far too much time trying to pick the next Apple or CSL and not enough time thinking about whether there is a Pasminco lurking in their portfolio. Rather than chasing high return and higher risk investments, Atlas observes that superior performance and lower volatility of returns are best delivered by concentrating on avoiding mistakes or “performance torpedoes”.  Looking at the current list of blue chip stocks, we consider that the most probable candidate to become a fallen angel is likely to come from the list of highly geared utilities.

 

What is going on in Listed Property

In this note we will look at what is going on in listed property,  the key themes to emerge over the past month from the profit results and how we expect listed property to perform over the next year. Given the name of our firm it would be remiss not to mention that this week marked the 60th anniversary of the publication of the Ayn Rand novel Atlas Shrugged. This novel provides an examination of whether the pursuit of profit is a noble enterprise or the root of all evil and the conflict in society between thinkers relying on facts and those defying reason, supporting their arguments on feelings.

Since 2012, listed property has been one of the top performing sectors on the ASX 200. During this time, other sectors in the equity market have faced concerns about a rising and then falling AUD, volatility in commodity prices that saw BHP abandon their cherished progressive dividend policy, Eurozone issues, near zero interest rates, and bank capital raisings. Listed property meanwhile seemed to be immune to these destabilising forces.
This all changed in the second half of 2016, when “safe” stocks such as Listed Property Trusts and infrastructure stocks, considered to be alternatives to bonds or term deposits, fell heavily on expectations that global interest rates will start to rise in the future. In the February 2017 results reporting season the management teams of the listed property sector addressed investor concerns about the impact of higher interest rates and their ability to grow distributions in a higher inflation environment. This increased investor confidence and accordingly saw the Listed Property sector gain 7% from the lows reached in November 2016.
As real estate is not a homogeneous asset, it is useful to break down the real estate held by the Listed Property Trusts into four distinct groups: shopping centres (retail), office towers (office), housing and apartment developers (residential), and manufacturing or distribution centres (industrial).
Retail
Discretionary retail continues to face the challenges of on-line competition to bricks and mortar, a higher AUD, and slower inbound tourism which has reduced profit margins, particularly in clothing and footwear. Weaker retail sales limit the ability of shopping centre operators such as Scentre and Vicinity to raise rents and typically a rental contract will include a percentage of store sales. New clothing retailers Zara continue to take sales away from department stores like Myer, which is important given department stores are typically the largest rent payer in a shopping centre. Additionally, over the last year shopping centre landlords faced a few tenants closing stores due to insolvency such as Payless Shoes, Howards Storage and Pumpkin Patch.

Whilst the outlook for retail looks difficult, we do not see that shopping centres will become redundant, but they will need to evolve by favouring tenants that offer services that can’t be delivered on-line such as personal grooming and dining.

Office                                     
In contrast to shopping centres, the Australian CBD office market looks pretty healthy for owners of office towers such as Dexus and Investa Office. Vacancy is the best measure of the health of the office sector, as empty floors in an office tower don’t earn rental income for the owners of office property trusts. Overall the market looks stable, but the picture across Australia is quite divergent with vacancy at a 23-year high in Perth being offset by very low vacancies in the Sydney and Melbourne markets.  Sydney and Melbourne have benefited from the conversion of office towers into apartment buildings, which reduces supply, whilst Brisbane and Perth face excess supply from towers built towards the end of the mining boom.

Residential                                     
Unsurprisingly the buoyant residential market in Sydney and Melbourne boosted the results of major residential developers Mirvac, Lend Lease and Stockland. Going into the profit results we were concerned that these developers could face defaults from buyers that have paid deposits for apartments (particularly in Melbourne). A buyer may refuse to complete a sale (thus forfeiting their deposit) if after completion the value of the property has declined or the buyer has had trouble obtaining finance. Our concerns were allayed in February with the developers reporting minimal defaults and healthy forward sales.

Industrial                              
Although the industrial assets continue to be priced higher, the underlying fundamentals have deteriorated with vacancies rising across the sector. Unlike office towers which are relatively homogeneous assets – which means, for example, that an accounting firm can take over space vacated by a financial planner – industrial sites are often configured for a particular tenant. A great example of this is the challenges the BWP face in filling sites vacated by key tenant Bunnings. The industrial trusts have continued to generate profits from re-zoning industrial property to residential. In October Goodman sold an industrial park in Sydney’s north west for $200 million to apartment developer Meriton Group.

One Year Outlook                                   
The total return (capital growth plus distributions) that investors can expect from Listed Property based on four financial components. These are; 1) distributions, 2) movement in asset values as measured by the capitalisation rate which is the rate of return on a real estate investment property based on the income that the property is expected to generate3) expansions or contractions in the market price to earnings ratio and 4) movement in the number of shares on issue (current buy backs or equity issues).

Over the next year, we see a small increase in the average distribution yield and a slight increase in asset values. However, due to concerns about interest rates it is hard to see an expansion in the market price earnings ratio above its current long term average and there are no significant buy backs currently in operation.  Consequently, it is hard to make the case that the bulk of returns that investors can expect from listed property will not come from distributions.

Our Take

The Property Trust sector as a whole appears to be trading at a premium to fair value. We see that catalysts which propelled the sector up over the last three years have largely been played out and the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings. The sector currently trades at a +26% premium to net tangible assets (14.2x forward PE and 5.2% yield).  The portfolio strategy of the Atlas High Income Fund of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should outperform in this market. Further, the focus on trusts that are delivering recurring yield should result in a higher distribution yield and lower earnings volatility for our investors.

Hugh Dive CFA
Chief Investment Officer

Themes emerging from reporting season

This week saw the end of reporting season for 180 of the S&P/ASX200 companies and around 2,000 of the companies listed on the ASX. Over the past month these companies revealed their profit results for the last six months and provided guidance as to how they expect their businesses to perform in the upcoming year. Whilst we regularly meet with companies between reporting periods to gauge how their businesses are performing, during semi-annual reporting season companies fully open up their car bonnets to let investors have a detailed look at the their financials. Until this happens, investors don’t know for certain whether they are going to find burning oil and hissing pythons or see that the company’s growth engine is running to expectations.

We previously looked at what happens behind the scenes in reporting season and in this week’s piece we are going to run through the key themes that have emerged over the last four weeks.

Surprising strength

The February 2017 reporting season was on average benign for investors was generally better than expected due to strong earnings growth from the miners (BHP and Rio Tinto), banks (Commonwealth and ANZ) and healthcare (CSL). Earnings growth in these sectors offset weakness in profit in the industrial sector.  Overall we have seen approximately 18% growth in earnings over the 2016 financial year, though the bulk of this is due to the resource companies enjoying the benefit of resurgent commodity prices. Excluding the resources companies, earnings per share from Australian companies in aggregate climbed by +6% over the past year.

Rock diggers looking good
The market was expecting the miners to do well as commodity prices – namely coal and iron ore –  had received a boost. This was largely due to a Chinese stimulus plan in 2016 based on rapid rise in fixed asset investment in infrastructure, reducing real estate taxes and loosening lending standards. What surprised us was the commitment among the miners to controlling production costs, reducing debt and keeping a lid on capital expenditure. This allowed BHP to report a 65% increase in profits and a 150% increase in the dividend (that had been savagely cut in February 2016).  Rio Tinto paid off US$4.2 billion of debt and announced a share buy-back.

On the conference calls to investors, management teams promised to maintain capital discipline and not waste the windfall of temporarily higher commodity prices. I am hopeful that before I retire from the funds management industry sometime around 2050, I will have seen a commodities boom where shareholders capital in mining companies was not frittered away on questionable acquisitions and marginal projects at the top of the market!

Banks squeezing their pound of flesh

Whilst the banks and financials stocks performed well in the last quarter of 2016, January saw a significant sell off in their share prices of around -5% as investors became concerned about the impact of rising interest rates.  Commonwealth Bank reported cash profits of $4.9 billion, which was higher than expected due to cost controls and keeping loan impairment expense flat at 0.17%. Similarly ANZ reported that revenues were up +7% and there were minimal loan losses.  NAB reported a 1% fall in quarterly profits but echoed the other banks’ views on low loan losses.  We see that the banks are well placed to have a good 2017 as the repricing of their loan books will drive revenue growth.

Give me my money back!

Capital management was a feature of the recent reporting season and was understandably popular with investors. Rio Tinto, CSL, Coca-Cola and even QBE Insurance announced share buy-back plans. In the case of QBE Insurance we found it hard to get excited about their A$500 million buy-back given that they conducted a A$780 million capital raising 2.5 years ago at a price that was a 15% discount to the current share price.

At a dividend level AGL Energy, Transurban, Rio Tinto, GPT and Bluescope Steel all increased dividends to shareholders that were above market expectations. Across the market the dividend pay-out ratio remains high and is now approaching 80%. Increasing dividends and buying back stock boosts share prices in the short term  and plays to the current “search for yield” investment theme. However, in the longer term companies do need to retain cash to reinvest in their operations in order to grow.

Best and worst results

Over the month, the best results were delivered by Transurban, Rio Tinto, QBE Insurance, CSL, Boral, ANZ Bank, Invocare, Treasury Wine Estates and AGL Energy. The common theme amongst these companies was a solid control of costs and a profit result that did not rely on an improvement in the domestic Australian economy. Woolworths’ share price performed well after they announced sales growth that was ahead of Coles for the first time since 2009. However, shareholders paid for this market-share gain in the form of lower prices, which caused profits in food business to fall by $131 million to $811 million.

On the negative side of the ledger Blackmores, Genworth, James Hardie, Brambles, Domino’s Pizza and Primary Healthcare all reported disappointing results compared with other companies. The common themes among this group was high price-to-earnings rated companies not delivering on high expectations, or companies that had downgraded expectations and hence delivered results that were worse than expected. Telstra had a particularly tough reporting season with profits down -14%, but what concerned the market was the fall in mobile revenue and evidence of more intense competition.

Our take

In contrast to other reporting seasons, this one was relatively benevolent for quality-style investors avoiding both high priced growth stocks and companies with issues. After overall market earnings declines in 2015 and 2016, this reporting season provided evidence that company profits are rising again and that profit margins (ex financials and resources) are rebuilding. This positive view of the Australian economy was confirmed by the ABS GDP data released yesterday that revealed the Australian economy grew by +1.1% in the December quarter and by +2.4% in 2016, which was well above consensus forecasts and the strongest growth in four years. Whilst we expect the banking sector to have a solid 2017, commodity prices (which we expect to weaken) should dampen earnings for the remainder of the year.