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Building Materials Woes: Who pays when things go wrong

The Grenfell tower fire in London in mid-June was very tragic and resulted in 79 deaths. This terrible occurrence has highlighted the extremely negative impact that the choice of building materials can have. There have not been many significant advances in construction materials recently. The Colosseum in Rome was largely built with concrete, terracotta roof tiles were used on the temple of Apollo in Corinth in 700 BC, and plasterboard was invented in 1894.  We see that due to the lack of advances in construction materials, a perception has developed that all building materials and construction techniques are safe and have been tested over centuries.

As a former building products analyst at a large US investment bank I have more than a passing interest in construction materials. In this week’s piece, we are going to look at the impact that plastic-based aluminium composite cladding may have on Australian direct property investors, and who is likely to pay the remediation costs when building materials go wrong. Looking at past examples, the home owner invariably has borne most of the costs for decisions that were not made by them.

 

Aluminium cladding

Cladding is added to a building to prevent rain from entering the building’s structure, to improve sound and thermal insulation, and in many cases to improve the exterior aesthetics of a building. Aluminium cladding consists of two thin aluminium outer layers bonded to a mineral fibre core such as polyethylene or polyurethane. The issue is that not all of the polymers used in the honeycomb core are fire resistant, and indeed some of the cheaper polymers used are actually very flammable.

If the polyethylene core catches alight, the aluminium skin acts as a chimney to accelerate the fire up the outside of the building.  The composite cladding used on the building in London was responsible for the 2014 apartment fire at Melbourne’s Lacrosse building and a number of fires in Dubai. In the Melbourne fire a cigarette left on a balcony table caused a fire to spread up the 13-storey tower in less than 15 minutes.

Australia
In the wake of the Grenfell fire, the Australian Society of Building Consultants estimated last week that there are 2700 buildings in Sydney utilising aluminium composite cladding, and 50% of the high-rise buildings built in Melbourne over the past decade also use it. The aluminium cladding commonly used in Australia and installed in Melbourne’s Lacrosse building is Alucobest which is imported from China and is cheaper than fire-resistant aluminium cladding such as Alucobond.

Whilst not all of the aluminium cladding used in these buildings is of the flammable variety, investors owning apartments with non-compliant cladding may face significant remediation costs, dramatically reducing returns.  In February 2016 the Victorian Building Authority (VBA) found that 51% of the 170 high rise residential and public buildings around the Melbourne CBD had non-compliant external aluminium cladding. Paradoxically the VBA audit concluded that this did not pose a safety risk.

We would suggest that owners of apartments constructed over the past decade investigate whether the cladding used in the construction of their asset is of the fire-resistant variety. In the case of Melbourne’s Lacrosse building, owners of the apartments are still battling through the courts over who is responsible for the $15 million repair bill.  Based on our crude calculations, this represents a bill of $100,00 per apartment, a significant sum for investors in an apartment building where two-bedroom apartments are being sold for between $400k and $500k. Research indicates that apartments were sold off the plan for ~ $300k in 2010, so the remediation costs may eat up most of the capital gains.

Chinese drywall (plasterboard)
Similar to the abovementioned Chinese made aluminium cladding was the contaminated plasterboard used in residential construction in 100,000 homes in the US between 2001 and 2009.  During the homebuilding boom in the US last decade, there was insufficient local production of plasterboard which caused builders to source Chinese-made plasterboard that also happened to be cheaper. The high levels of pyrite in the cheaper Chinese-made plasterboard resulted in the release of sulphur gas into the home, which is bad for respiration of residents and also causes corrosion of copper pipes in the walls. The remediation costs are quite significant with costs being around US$200,000 to remove and replace the plasterboard on an on a four-bedroom home.

Despite major importers of the plasterboard being companies the giant German building materials company Knauf, affected homeowners were eventually limited to claiming only a tax deduction after replacing the plasterboard.

Who pays? Leaky homes in rainy places
In New Zealand and British Columbia, changes to the building codes in the 1990s resulted in the uptake of building materials and construction methods more suited to the sunny Mediterranean, rather than the rainy South Island of New Zealand or Vancouver where it rains on average 160 days per year. The change resulted in buildings with minimal eves to disperse rain and wrapped in a fashionable textured cladding such as stucco or fibre cement. As water gained entry into cracks in the building structure, the timber frames began to rot and mould developed.

 

Despite the cause of these building calamities being changes to government construction policies, the owners of the buildings ended up bearing most of the costs of remediation. In New Zealand after many years of litigation and builders going into administration, a bailout package was put together. This the split the costs with 64% covered by the property owner, 26% local council and 10% Federal Government.  In Canada, the situation was even grimmer for property owners, with the best offer being an interest free loan and tax relief.

Our Take

Whilst many would assume that builders or developers would be responsible for replacing aluminium panels that are susceptible to fire, the above examples strongly suggest that owners of property with this material installed are likely to bear the costs of replacing the problem building materials.

Not all Great Ideas turn into Great Companies

In my experience, most professional fund managers and equity analysts are frequently given unsolicited stock ideas from clients and friends. Generally, these are small companies, with a great idea that is either going to turn them into the next Amazon or revolutionise a particular industry.  Frequently these companies are difficult for investment professionals to value as they are often at a very early stage. They tend to be long on promise, but short on profits and assets that provide the basis of most valuation methodologies. Inevitably the person presenting the idea knows much more about the exciting technology behind the company and is very enthusiastic about its prospects.

In this week’s piece, we are going to look at the processes and questions that investors should ask when looking at early-stage listed companies.  Atlas is not endorsing any of the companies mentioned in this piece, they are only mentioned in the context of the process that we use in evaluating early-stage companies.

1. How much runway do management have?

The first thing that I look at when reviewing one of these speculative companies is how much time or financial runway management has in which to commercialise their idea before running out of cash. Whilst companies can look to raise additional equity to extend this runway, this is almost always done at a discount to the prevailing share price and relies on supportive investors. Few early-stage companies are financed by debt, as the interest rates charged are likely to be high to compensate for the risk of lending to an unprofitable company.

Investors should look at the company’s cash flow statement to gauge how much cash the company has been burning for the past six months. Compare this against how much cash is on hand on the balance sheet. The reason for using the cash flow statement is that this represents actual cash flows and is harder to manipulate than the profit and loss statement. For example, when I looked at cloud call recording software company Dubber in February, the company reported a cash burn of $4M in the previous six months, yet had $5.2M cash on hand. Here unless there is a dramatic change in the company’s fortunes, one could expect another equity raising within the next 9 months.

Conversely, technology company Fastbrick Robotics had no debt and $10M of cash on hand. This is sufficient to fund the company’s development of a bricklaying robot beyond 2019. Without making any judgement as to the relative investment merits of the two companies, the second company has more flexibility to weather delays, without coming to the market to raise more equity to keep afloat. Obviously, the spectre of near-term equity raisings provides a cap on a company’s share price, as outside investors know there will be discounted share issues in the future.

In more extreme circumstances, the lack of a financial runway has seen companies with solid ideas or assets going into administration, with these assets later picked up by competitors.

2. Management’s record and shareholding

The next step is to look at the experience of management and board of the company in question.  Here what I am looking for is not so much experience at large and well-known corporations such as General Electric or Westpac, but rather experiences in guiding small and more financially unstable companies through to an IPO or trade sale. Large companies have little difficulty in getting attention from potential investors or banks and managing cash flows. Additionally, executives from large organisations are unlikely to have had experience of running a number of business areas while also having a laser-like control of costs.  Looking at job management software GeoOp, it was apparent that the chairman and CEO have solid experience in the digital space and in running start-up ventures.

Additionally, investors should look at the percentage of the company owned by management, as a management team with a significant portion of their personal wealth invested in the company are more likely to act as good agents on behalf of the other shareholders. Here investors should look at existing holdings, as well as the share options granted when management hit certain targets such as profitability and specific share prices.

3. Who else is on the share register?

The presence of larger corporations or well-regarded fund managers on a fledgling company’s share register should be viewed as a good sign. This can indicate that others have done the due diligence on the company, and it is often helpful that they have the voting firepower to stand up to management and scrutinise decisions. The presence of competitors or corporations in similar industries could indicate the possibility of a takeover at a later stage. In the Dubber example mentioned above, the presence of small capitalisation manager Thorney on the share register at 6.4% is a positive sign.

However, the presence of well-known fund managers on the register should not by itself be viewed as sufficient grounds for investment.  Most if not all small capitalisation fund managers have positions in their fund that they now regret and may be quite illiquid at the size of their investment. What may seem to be a significant investment for an individual investor may only represent 0.25% of a large fund.

4. Who are the Company’s competition and what is the size of its addressable market?

All successful small companies face the spectre of competition from large industry players. In some cases, large competitors may be watching the target company closely, learning from their mistakes, before launching a competing product or technology drawing on the larger company’s scale and market access.  Whilst “disruptive” financial technology companies or fintechs are very much flavour of the month at the moment, I find it hard to believe that the big banks and insurance companies are not keeping a close watch their activities. A great example of this is mobile payments company Mint Payments which in 2013 went from 2c to 40c per share on expectations that the company’s wireless point of sale would enjoy spectacular growth. The share price has slid back to 6c as the banks and technology companies such Apple launched competing payment products.

When looking at the prospects for a company and its potential growth, it is important to look at the size of the market to which its products can be sold. A small niche market might not attract competition from larger players, but significant share price growth is unlikely to come from dominating a very small market. Additionally, investors should be wary when a company suggests that it has no competitors, often this is a case of no competitors yet.

5. What barriers to entry are there?

A small company’s prospects of enjoying significant share price gains are significantly decreased if there is little in the way of barriers to stop other firms from entering into their industry. The technology sector in particular has been an elephant’s graveyard of large companies laid low by smaller, more nimble competitors that jumped over the low barriers to entry.  Examples of once exciting companies that only had low barriers to entry include AltaVista, Netscape and Myspace.

Recently we looked at social media marketing company VAMP that was planning on listing on the ASX and was backed by high profile Nova Scotian Qantas and Fairfax Media director Todd Sampson. The social media marketing firm had an exciting buzz as it was designed to capitalise on growing demand from advertising agencies and high-profile consumer brands to connect with Instagram ‘influencers’. However, on reflection, this particular antediluvian fund manager thought that the barriers to entry into social media marketing are quite low.

Our Take

Whilst most small companies have an exciting good, technology or concept that is inevitably presented in a form that will result in large gains in the share price, we see that it is helpful for investors to have a five-point checklist to look at when evaluating a small, exciting, yet unprofitable company. Atlas would like to thank our supporters whose ideas helped in writing this article.

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.

Banks Reporting Season Scorecard 2017

Over the last two weeks, investors had a wild ride following bank reporting season. In addition, in last night’s Budget a surprise levy of 0.06% on the liabilities of Australia’s five largest banks was announced. This move sparked a big sell-off in the shares of the four major banks on Tuesday in anticipation that this tax will reduce bank profits. Whilst this may occur, historically banks have been very successful in both passing on additional costs and using public relations muscle to alter government policy.

Prior to the 2013 election, the Gillard government attempted to introduce a 0.05% levy on bank deposits which was shelved in the face of a very impressive campaign from the banks. We expect that this tax will result in increased monthly loan repayments and cuts to term deposit rates, despite claims that shareholders will bear the brunt of this impost.

In this piece, we are going to look at the common themes emerging from the May reporting season, differentiate between them, and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Key theme: profit growth

Across the sector profit growth was stronger than recent reporting seasons with ANZ leading the pack.  ANZ reported headline profit growth of 8% in a complicated set of financial statements, but this reduced to a still respectable 3.8% when backing out the impact of the sale of the bank’s Asian retail businesses, Esanda and property gains.  Across the sector solid profit growth was achieved by robust economic conditions and cutting costs.

Gold star to: 

Key theme: bad debt charges still very low

One of the key themes across the 4 major banks and indeed the biggest driver of earnings growth over the last few years has been the significant decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay, and that the bank will lose money where the outstanding loan amount is greater than the collateral eventually recovered. In 2016, we saw some evidence that bad debts were starting to rise to a normal level of around 0.3% of loans, though 2017 has actually seen another fall in bad debts that can be attributed to a buoyant housing markets and a recovery in commodity prices easing pressure on the mining sector. CBA gets the gold star courtesy of their higher weight to housing loans that historically attracts a low level of loan losses.

Gold star to: 

Key theme: dividend growth stalled

Across the sector, dividend growth has essentially stopped, with CBA providing the only increase of a mere 1c.  With relatively benign profit growth,  a bank can either increase dividends to shareholders or retain profits to build capital protecting a bank against financial shocks; but not both. In the recent set of results the banks have held dividends steady to boost their Tier 1 capital ratios. Whilst dividend growth across the banks is likely to be meagre in the near term, the major Australian banks in aggregate are sitting on a tasty grossed up yield of 8.3%.

Gold star to: 

Key theme: interest margins
Net interest margins in aggregate slightly declined in 2017. This was attributed to higher wholesale funding costs, increased competition for deposits and lower margins in lending to corporations. In May 2017 CBA and Westpac had the highest and most stable net interest margins, whereas NAB and ANZ both delivered lower margins. This reflects the two Melbourne-based banks having greater relative exposures to business banking and CBA/Westpac’s greater weighting to housing.

In late March 2017 the big four banks raised loan rates on average to investors, interest-only owner-occupiers, and businesses, with politically-sensitive principal and interest home loans remaining steady (for now). This followed rate rises that were pushed through in December 2016.

One of the key things we looked at closely during this results season was signs of expanding net interest margin [(Interest Received – Interest Paid) divided by Average Invested Assets], but this was not apparent. At the full year results in October and August (CBA) we may see signs of rising margins, as the full year impact of repricing loans upwards in December and March flows though.

Whilst Australian banks can be viewed as expensive globally, Australia is an attractive banking market which leads to strong and stable profit margins. For example, the major banks reported an average net interest margin of 2%, whereas European banks such as Credit Suisse earned only 1.2%. Small numbers that makes a large difference on a loan book in the hundreds of billions!

Gold star to:  Australian banking oligopoly

Key theme: total returns
In 2017 only NAB has outperformed the S&P ASX 200 total return (capital gain plus dividends) of 4.5%, as investors were concerned about potential new capital issues and a cooling of the housing market. NAB has been rewarded by investors as it has been both the cheapest bank (in price earnings terms) and has jettisoned its UK issues with the spin-off of the Clydesdale Bank and Yorkshire Bank.

Gold star to: