Thursday, August 10th, 2017
Industria REIT (IDR)
On 27 July we initiated a 2% position in IDR for the StocksInValue Model Portfolio, by buying 5,428 securities at $2.26. The investment was funded from cash and the sale of 161 units in the BetaShares Australian High Interest Cash ETF (AAA) that day at $50.15. IDR is an ASX 300 Real Estate Investment Trust (REIT) with a portfolio of 21 office and industrial properties in most major Australian cities including Brisbane, Sydney, Melbourne, Adelaide and Newcastle. The stock listed on the ASX in late 2013 as a $250m office and industrial REIT formed by stapling two trusts that previously comprised the Australand Wholesale Fund No. 6 with Industria Co and two unlisted trusts that were previously managed by APN Property Group (APD). Today APD manages IDR and we like the strategy to steadily and sensibly grow the asset base, for example the purchase of a large industrial property in the first half of 2017. Assets under management now total $588m.
IDR trades at NTA and key portfolio metrics are sound. The yield is attractive and distributions are paid quarterly. The probability of a takeover bid from Growthpoint increases downside protection and potential upside. Our thesis is:
- IDR has a good quality portfolio with reasonable diversity by geography, sector and tenant
- Modestly priced in line with $2.26 NTA, which in our view is marginally understated versus ‘market’ values
- Key portfolio metrics are robust: occupancy is relatively high at 96.0%; the weighted average lease expiry period is 7.8 years, which underwrites the payment of a consistent, long term income stream; and gearing is relatively low at 32%
- Yield is attractive at 7.3% and distributions are paid quarterly
- Management has navigated tougher micro markets, such as Brisbane fringe metro office markets, to drive solid leasing outcomes
- Probability of a takeover, with Growthpoint (GOZ) recently taking an 18.2% stake in IDR. GOZ previously acquired a similar listed REIT, GPT Metro Office Fund, and the management has publicly expressed interest in M&A. The GMF transaction is a reasonable template for the likely course of action from here:
- IDR is likely to revalue the whole portfolio to market values, realising further uplift in NTA
- GOZ would be compelled to bid a premium to NTA to give itself a genuine chance of acquiring IDR
- APD, as manager, is strongly positioned to push for a healthy premium given 21% ownership/control of the IDR vehicle
- In summary IDR offers downside protection, a reliable quarterly income stream, a starting yield of 7.3% and the potential for a 7-10% capital return over the coming six to 12 months.
The downside risks for investors are:
- Concentration by geography and tenancy, representing rental income risk
- Brisbane fringe office markets remain subdued with elevated vacancy
- The payout ratio is elevated and there would be risk to the distribution in an economic downturn or if properties couldn’t be re-leased
- Property devaluation risk: though we remain in a low interest rate environment, it is likely that we are towards the end of the property cycle. Over the medium term capitalisation rates will grind higher from current levels. Properties could then be devalued, especially if rents grow more slowly or fall.
Vicinity Centres (VCX)
VCX announced June half revaluations of its properties and an on-market buyback, which supports our thesis when we invested last month. The details were:
- June 2017 valuations: On 30 June 2017, 34 of VCX’s 74 directly held retail properties, which are 52% by value, were independently revalued and VCX reported a net revaluation gain of $345m for the half. This is in addition to the substantial revaluation gains booked in the first half.
- As a result, per security NTA increased by 3.3% during the half to $2.82.
- Gearing is broadly flat at a comfortable 24.7% with non-core asset sales largely offset by development capex and the acquisition of a further 25% interest in DFO South Wharf during the period.
- VCX also announced the on-market buyback of up to 5% of securities on issue. The buyback will start no earlier than 17 August and should be accretive to EPS and NTA, while also preserving capacity to fund other capital commitments
- We forecast 30/06/17 equity and NTA per security of ~$2.96 and ~$2.82 respectively. In our view the stock is worth $2.80-2.90 per security while the forward yield is still solid at 6.5%, at current prices.
SpeedCast International (SDA)
SDA announced the acquisition of UltiSat, a satellite services provider to militaries, governments and NGOs in 130 countries. Initial consideration is US$65m with earn-out payments of up to US$35m in 2018 and 2019. SDA expects the acquisition to be accretive immediately on a proforma full-year basis and double-digit EPS-accretive in 2018 before synergies. Our initial thoughts:
- This makes strategic sense. SDA wanted to diversify into the government sector because government contracts tend to be larger, longer and stickier. UltiSat’s top six contracts account for ~80% of revenues and have an average term of five years (subject to annual review).
- UltiSat will form the basis of SDA’s new Government division, with UltiSat’s current CEO becoming that division’s head. The acquisition is more of a bolt-on than transformational and requires less integration. SDA expects this division to generate ~$200m in revenue within five years, implying a top line CAGR of 15% p.a..
- The synergies target of $3m within two years appears conservative because it does not include revenue synergies from likely upselling to existing customers.
- The timing is earlier than we would have expected, coming less than a year after a very large and complex acquisition (Harris Caprock).
- Caprock integration is ahead of schedule and initial synergy targets are on track to be exceeded – both are positive updates.
- Gearing (pro-forma net debt/EBITDA) will be 2.8-3.0x on 30 June 2017. The medium term target is 2.0-2.5x excluding acquisitions and 2.5-3.0x including acquisitions.
We upgraded adopted NROE from 22% to 24% with the extra two percentage points of return distributed equally across D and RI, but raised RR from 12.5% to 12.8% to reflect the higher gearing. We see FY18 value of $4.82 and given our unchanged conviction in our positive thesis we added 0.5% to our position on 25 July by buying 884 shares at $3.46, funding the investment from cash.
BetaShares US Dollar ETF (USD)
On 20 July we increased our Model Portfolio weighting by 0.5 percentage points, adding 251 units at $12.18. The AUD is looking overbought, with speculative net long positions in the currency at their highest for 15 months:
The reasons for the AUD’s July surge against the USD are well-known:
- The current rally in commodity prices, especially iron ore
- The narrow premium of Australian 10-year government bond yields (2.6%) to 10-year US Treasury yields (2.3%)
- US political risk created by the Trump Administration’s failure to pass any legislation, delays to stimulus, personnel farces in the White House and the looming rise of US federal debt above the debt ceiling
- The RBA’s own goal in flagging a 3.5% neutral cash rate, which compares with the current 1.5% setting, in the minutes of its July monetary policy meeting. This apparently telegraphed a new tightening bias, the AUD broke higher as a result and the central bank has spent the subsequent weeks back-pedalling. We would describe the tone of today’s August monetary policy statement as neutral for longer but the damage has been done.
USD/AUD is a volatile pair and good for trading. At some point the AUD should depreciate as US economic data pivot stronger, so we still expect to eventually exit our position at a profit.
Bank stocks are looking much rosier after a tough June quarter. The best news was APRA’s light-touch definition of “unquestionably strong” capital, which was better than our own best case (and probably was for most bankers as well). Not only will the four majors easily reach the new 10.5% common equity tier 1 ratio by early 2020, there will be no future increases to the target from increasing the risk weights to mortgages. We also expected a 2019 deadline but the 2020 timing gives the banks more time.
Is the worst over and can we expect banks to rally to new year-highs? Our view is banks have further to rally and are not yet trading sells but a structural rally and valuation upgrades would require GDP upgrades we do not yet forecast. On the Economy Tab we forecast 2.50% GDP growth over the year ahead with some upside risk if the labour market improves further and non-mining business investment strengthens. The July surge in the Australian dollar makes these less likely.
The bull and bear points for the banks are:
- There is now no risk APRA will require banks to have rights issues to raise much more capital soon. Given the large amounts of surplus capital banks are generating at this time of slow loan growth, dividends are secure. ANZ will have surplus capital and we forecast a buyback. Further out, the other majors could be in positions to return capital or pay special dividends
- There is no regulatory pressure to reduce bank leverage. This should support ROEs
- The SA bank levy seems unlikely to proceed after the state opposition said it would block the measure in the upper house
- Full-time employment has grown for nine months, hours worked are rising and underemployment has peaked. Surveyed business conditions and confidence are strong. Bad debts expense should remain low at least for the rest of 2017
- Institutional investors are underweight banks and will probably rebuild their weightings
- This year’s repricing of mortgages supports interest margins
- Banks should be able to achieve positive jaws (revenue growing faster than costs) for the half ahead
- The rally has taken earnings multiples to above long-term averages (though not yet to historic highs)
- The Australian economy is growing below trend and likely to do so for another year. Given banks are leveraged plays on the economy, this spells a subdued outlook
- Households have never been more over-leveraged. This creates serious downside risk in a recession. Meanwhile, this year’s mortgage rate rises are pressuring household disposable income. The prices of essentials are rising much faster than the CPI, so lower-income borrowers are under the most pressure and an uptick in mortgage arrears is likely for this reason
- Bad debts expense is near record lows and cannot go lower. There is no more earnings upside from this source and significant downside if bad debts pivot higher
- Dividend reinvestment plans will continue diluting EPS
- More macro-prudential measures are likely if the Sydney and Melbourne housing markets do not slow. Mortgage lending is yet to slow in response to the measures implemented so far
- Banks have repriced their loan books but are also switching customers from interest-only loans to principal and interest loans, which charge lower interest rates – and rates on the latter have fallen as banks compete over the one mortgage category APRA does not want to brake
- The economy’s main growth sector, services, does not require as much capital expenditure and bank debt as the industrial, engineering and mining growth sectors of the past
- The political environment for banks is at its most hostile for years. An increase to the federal bank levy is possible and Labor is in an election-winning position (admittedly two years out from the next election). Labor wants to reduce negative gearing and capital gains tax relief and hold a royal commission into the banks.