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• January was a weak month as the listed property sector was sold off -3.3%, due to rising bond yields weighing down on income stocks globally.
• The Atlas Fund returned -2.7% in a month where there were few places for investors to hide,  as all trusts were sold down with little regard to the quality of their property assets,  nor their earnings outlook.
• The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income rather than development profits. As the Fund’s distributions are supported by long-term lease agreements with blue-chip industrial companies, and not swinging emotions of the market, we see that the Fund will be well placed to weather current market volatility.Go to  Monthly Newsletters for a more detailed discussion of the listed property market in January and the fund’s strategy going into 2018.

This morning European property company Unibail-Rodamco announced that it had entered into an agreement to acquire Westfield (WFD) to create a global developer and operator of flagship shopping centres in the US, UK, the Netherland and France. This deal values WFD at A$33 billion, or at a price earning multiple of over 22 times future earnings, what appears to be a full price.

Westfield is the largest holding in the Atlas High Income Property Fund, so we were understandably quite pleased with this development. In this note we are going to look at what will likely be the largest takeover in Australian corporate history.

Today’s deal marks the end of an era for Westfield, which was originally listed on the ASX the middle of the 1960-61 recession when unemployment spiked to a post-war high of 3.1%. The above image is from 1959 and is of Westfield’s first shopping centre in Blacktown.

Westfield Development Corp’s initial public offering offered 300,000 shares at five shillings! In recent years, the various corporate changes at Westfield have appeared to be movements of the chess pieces on the Westfield board leading towards this day. Moves such as the separation of the Australian assets (Scentre: SCG) from WFD’s global assets, seemed to be designed to increase the attractiveness of Westfield to a foreign suitor such as Unibail-Rodamco, and allow the Lowy family to exit the company first listed close to sixty years ago. For a deeper dive into the corporate gymnastics that Westfield has engaged in over the years look at our piece Westfield: the Thimble and the Pea.

The Deal
Under the agreement WFD holders will receive a combination of cash (US$2.67) and 0.01844 Unibail-Rodamco shares for every WFD unit owned. This equates to A$10.01 or a 18% premium to the price at the close of trading prior to the deal being announced. It is anticipated that the combined entity will have a primary listing in Paris and Amsterdam, with a secondary listing on the ASX.

Investors in the new combined entity will own a property trust with 104 shopping centres across Europe and the US valued at A$95 billion.

A higher bid?
In our opinion this deal is likely to go ahead with a minimal chance of competing bids, as the Franco-Dutch Unibail-Rodamco revealed that they already own 4.9% of WFD and that the Lowy family which own 9.5% of WFD are supporting the deal. Digging into the detail in the documents, there is also a US$150 million break fee that must be paid to the other party if either Unibail-Rodamco or Westfield were to decide to walk away from this deal.  The details on when this deal is likely to be completed is yet to be fully announced, though the parties expect that this will be consummated around June 2018 if shareholders vote in favour.

Our Take

Looking ahead, this takeover is likely to provide a positive boost in the near term to the Australian Listed Property market, as it raises the prospect of further takeovers. In the medium term, investors that decide to cash in their Westfield holdings are likely to look to deploy some of the proceeds in other Australian Listed Property Trusts which will boost share prices in the next six months.

The Atlas High Income Trust are likely to take the money that the Europeans are offering and reinvest elsewhere, as typically these situations represent a transfer of wealth from the aquiror’s shareholders (Unibail-Rodamco) to those of the takeover target (Westfield). This occurs due to the premium required to consumate the deal ineviatably is higher than the synergies actually achieved.

 

 

Last week it was announced that Slater and Gordon’s former accountant was included in a shareholder class action over its auditing work. This demonstrates the recognition of legal costs as revenue, before the ASX-listed law firm actually won the case. Obviously, this becomes an issue for a company with a business model that is based on “no win no fee”, as their revenue is predominately based on a percentage of the damages awarded when the case is won. In previous years this assumption contributed to the troubled legal firm reporting healthy revenue and profits to investors, although at the same time financial stresses were significantly increasing.

In part one of a two-piece series on financial statement trickery, we are going to look at some measures a company can take to “dress up” their financial results.

 

Why engage in earnings chicanery?

• The S&P/ASX 200 A-REIT index posted a small 0.5% gain over the month of September, slightly ahead of the wider ASX200 which was unchanged, as commodity prices and the AUD were weaker.
• The Fund gained had a solid month gaining +1.6%, outperforming the index as our strategy of preferring recurring rent collectors over developers was successful.
• Additionally, the bulk of the options sold last quarter ultimately expired worthless at the end of September. This strategy added value, as it converted uncertain future gains (which ultimately did not occur) into certain income.

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

A key part of our investment process is meeting with the management teams of companies at least once every six months or when we are in the process of adding a position to get an understanding of the quality of the management team with whom we are entrusting our investors capital. Generally, we seek to meet with management teams just after they have released their semi-annual profit results, and at other times during the year when we have specific issues or concerns that we feel need to be addressed.

As reporting season finished last week, we have been very busy over the month meeting with management teams from various companies and property trusts. In this piece, we are looking to shed some light on the role that these meetings play in the investment process.

The content and tone of management meetings vary widely depending on the nature of the company and how far the results delivered by the management team deviate from our or the market’s expectations. As such, the meetings can vary from being quite convivial discussions running through dividend policy and debt maturities, to downright hostile conversations about poor acquisitions, asset write-offs or recapitalisations.

Why Meet with Management Teams?

The efficient market hypothesis developed by Fama in 1970[1] states that it is impossible to “beat the market” because stock market efficiency causes existing share prices always to incorporate and reflect all relevant information.

If we believed this to be true, investors should simply invest in an index fund, because   it would be a waste of time for anyone in the market to meet with management, as we could learn nothing that was not already incorporated into every company’s current share price.  Whilst this theory sounds elegant, in practice markets are inefficient due to the influence of human emotions and robotic trading algorithms trading off price momentum.  Ironically, the current trend we are seeing of flows into index funds should deliver a long-term benefit to active management, as they cause market inefficiency by directing an increasing proportion of inflows into higher priced over-valued companies.  After almost twenty years in the market it seems to me that the increasingly short-term focus of investors is creating more inefficiencies.

Further, I have previously worked at a fund’s management firm that had a fund with a strategy of deliberately avoiding meeting with management teams. This approach is based on the view that meeting management, cultivating a relationship, and understanding the business would distract from their investment strategy of profiting from the short-term price movements in a large number of companies. In my opinion, the weakness in this approach is that a company is more than a collection of cash flows, assets and liabilities contained in the financial accounts. The future direction of any company and its share price is determined by the skill and motivations of the individuals managing these assets. Also, management teams have incentives to present their financial results in the most favourable light and in some situations, this results in misleading financial accounts.  Fund managers running index and quantitatively managed funds are unlikely to be able to detect these issues.

Selective briefings?

The press sometimes characterises the additional access to management that institutional investors have over casual mum and dad investors as being unfair or bordering on inside information. In practice, these management meetings don’t provide us with inside information, but rather are used by the fund manager as additional pieces to build up a mosaic of information to determine the underlying value of a company and its prospects for the future.

In the past, some of the most useful information on a company has been obtained not from management itself, but rather from meetings with that company’s direct competitors and clients. Often a company may be a little coy when asked the more difficult questions about issues facing their business, but that same company may enthusiastically discuss problems facing their listed competitors. Relevant issues include lost contracts or aggressive accounting measures being used to boost profits (that the company being interviewed inevitably no longer uses).

Two years ago, RIO and BHP were discussing their plans to cut significantly their cost base by reducing their reliance on contractors and indeed renegotiate existing contracts.  At the same results season the contractors were confident that margins and contracts would be maintained despite falling commodity prices hurting their customers. Coming out of these meetings it was clear that there was a disconnect between the guidance being given by the suppliers (Downer, United Group and Leighton) and their customers (BHP and RIO).

See the Colour of their Eyes

Before investing in a company, it is a critical part of the Atlas process to meet with the company’s management team. When meeting with management teams you are also looking to gauge management’s response and interpret body language when they are answering difficult questions. These can range from refinancing debt to achieving stated profit guidance targets which look excessively optimistic.

By purchasing securities listed on the ASX we are effectively entrusting our clients’ capital to the management teams of various companies and must therefore trust that these management teams are going to act in the best interests of our clients.

For example, a number of years ago we met with management of Lihir Gold (now part of Newcrest) to question them about their meagre dividend payout policy, despite ounces of gold finally starting to flow out of the mine on Lihir Island in Papua New Guinea. Management (former engineers) said that returns for shareholders would not increase, but rather they were going to invest the profits in building a new mine in war-torn Côte d’Ivoire, which would require building a 100km rail line through the jungle.  From this meeting, it was clear that management’s primary instincts as former engineers were to build beautiful mines, rather than reward the owners of the company. We took the view that our clients’ interests would be served better by receiving dividends now, rather than vesting that cash flow in a new, quite risky development; hence the position was sold shortly after the meeting.

Similarly, we left a meeting with a company’s CFO last year with the view that there was a disconnect between the profits outlook presented to us and the structural headwinds from deteriorating conditions in the company’s industry. As a result, we sold the position shortly after.  Whilst the stock price had been drifting downwards prior to our selling, it fell sharply 4 months later on a large profit downgrade.

Not a one-way street

It would be wrong to think that these meetings are mostly adversarial competitions for information between fund managers and company management. From the perspective of the company,  these meetings can be a forum for the CEO to gauge large sophisticated investors’ appetite to back potential acquisitions, changes in strategy, or capital management initiatives The advantage of doing this behind closed doors is that a company can avoid the potential embarrassment or loss of goodwill that comes with presenting an acquisition with a dilutive equity raising to a hostile group of institutional shareholders, some of whom may decline to support it.

Over the last month we met with a smaller company that was performing well, yet had only attracted research coverage from two investment banks. As their management’s focus was on running their assets efficiently and bedding down a large acquisition, they were uncertain about how to engage with the research departments of investment banks to encourage them to research their company. As the Fund is invested in this company, we are incentivised to assist the company in this area to increase research coverage that may assist in pushing its share price closer towards our valuation.

Our take

One of the benefits of having your portfolio managed professionally is that it is constructed and managed by individuals whose sole focus is to select and blend listed companies into a portfolio designed to deliver higher returns with lower volatility. To execute this strategy effectively, professionals prioritize meeting with management teams and going through their financial results in detail.  Another advantage for investors of institutional management is that fund manager tends to have access and opportunities to ask questions of senior management in investee companies that are unavailable to most retail investors.  

[1] Malkiel, Burton G., and Eugene F. Fama. “Efficient capital markets: A review of theory and empirical work.” The journal of Finance 25.2 (1970): 383-417.