I love this type of structure.
I own WESN and just wish I could find more investments like it. I've looked all over the world and so far come up empty handed. WESN aren't particularly cheap anymore, but nevertheless the structure of the issue itself is superb; it provides 100% upside exposure just like an ordinary share, but has built-in partial downside protection.
Let me explain.
WESN are issued by Wesfarmers Ltd (ASX: WES). As a very loose analogy, WES might be thought of as a mini Berkshire Hathaway or conglomerate. WES has a great long term track record of identifying opportunities across various industries: mining, insurance, agriculture, investment banking, home improvement and supermarkets. The vast bulk of WES earnings are now made up of Coles supermarkets and I have long been a backer of the their change strategy. Many analysts thumbed their noses at Coles chances of the turnaround given Woolworths Ltd (WOW) had for more than 10 years ruled supreme in the Australian grocery scene. But the solution was fairly simple: get the right products on the shelves and make the prices competitive!
As part of the Coles takeover, WES issued another class of equity: WESN. WESN rank equally with WES shares and receive exactly the same dividend and franking credits. WESN will mature, at which each WESN share will convert into one WES share. In addition, depending on the WES share price, WESN shareholders may receive more than one WES share.
Okay, let's break that down a little further. The latest maturity date is November 2015. Maturity can occur on early November anniversaries, however the S&P ASX200 Industrials Index needs to close above 6,500. It is currently 3,781. So its safe assuming the later maturity date. If WES closes below $34.49 at maturity, an additional 0.25 WES shares will be issued to WSN holders on top of their one WES share. If WES closes above $43.11, no additional shares will be issued and if the price closes in between those two price points, additional shares are issued on a sliding scale basis.
WES and WESN have had a terrific share price run of late. WES trades at $38.63 and WESN trades at $39.62. The historic dividend is $1.65 or $2.36 including franking credits and I fully expect the dividend to increase over time. The current grossed up yield of WESN is therefore 5.9%; almost double that of the RBA cash rate. However, that yield isn't particularly fantastic relative to Telstra Ltd (TLS), the banks and plenty of other stocks. Buying WESN at these prices does mean making a degree of trade off between income and some downside protection. In the following analysis I have modelled some different scenarios as to the assumed closing price of WES in November 2015. I have assumed no dividend growth, which I believe is conservative:
| Final WES Share Price ($) (A) | Additional Shares (no.) | Additional Shares ($) (B) | Value of Shares (A+B) | Dividends p.a. * | Yield p.a. |
| 15.00 | 0.25 | 3.75 | 18.75 | 2.36 | -15.9% |
| 16.00 | 0.25 | 4.00 | 20.00 | 2.36 | -14.3% |
| 17.00 | 0.25 | 4.25 | 21.25 | 2.36 | -12.7% |
| 18.00 | 0.25 | 4.50 | 22.50 | 2.36 | -11.2% |
| 19.00 | 0.25 | 4.75 | 23.75 | 2.36 | -9.8% |
| 20.00 | 0.25 | 5.00 | 25.00 | 2.36 | -8.3% |
| 21.00 | 0.25 | 5.25 | 26.25 | 2.36 | -6.9% |
| 22.00 | 0.25 | 5.50 | 27.50 | 2.36 | -5.6% |
| 23.00 | 0.25 | 5.75 | 28.75 | 2.36 | -4.3% |
| 24.00 | 0.25 | 6.00 | 30.00 | 2.36 | -3.0% |
| 25.00 | 0.25 | 6.25 | 31.25 | 2.36 | -1.8% |
| 26.00 | 0.25 | 6.50 | 32.50 | 2.36 | -0.5% |
| 27.00 | 0.25 | 6.75 | 33.75 | 2.36 | 0.7% |
| 28.00 | 0.25 | 7.00 | 35.00 | 2.36 | 1.8% |
| 29.00 | 0.25 | 7.25 | 36.25 | 2.36 | 3.0% |
| 30.00 | 0.25 | 7.50 | 37.50 | 2.36 | 4.1% |
| 31.00 | 0.25 | 7.75 | 38.75 | 2.36 | 5.2% |
| 32.00 | 0.25 | 8.00 | 40.00 | 2.36 | 6.3% |
| 33.00 | 0.25 | 8.25 | 41.25 | 2.36 | 7.3% |
| 34.00 | 0.25 | 8.50 | 42.50 | 2.36 | 8.4% |
| 35.00 | 0.23 | 8.11 | 43.11 | 2.36 | 8.9% |
| 36.00 | 0.20 | 7.11 | 43.11 | 2.36 | 8.9% |
| 37.00 | 0.17 | 6.11 | 43.11 | 2.36 | 8.9% |
| 38.00 | 0.13 | 5.11 | 43.11 | 2.36 | 8.9% |
| 39.00 | 0.11 | 4.11 | 43.11 | 2.36 | 8.9% |
| 40.00 | 0.08 | 3.11 | 43.11 | 2.36 | 8.9% |
| 41.00 | 0.05 | 2.11 | 43.11 | 2.36 | 8.9% |
| 42.00 | 0.03 | 1.11 | 43.11 | 2.36 | 8.9% |
| 43.00 | 0.00 | 0.11 | 43.11 | 2.36 | 8.9% |
| 44.00 | 0.00 | 0.00 | 44.00 | 2.36 | 9.6% |
| 45.00 | 0.00 | 0.00 | 45.00 | 2.36 | 10.4% |
| 46.00 | 0.00 | 0.00 | 46.00 | 2.36 | 11.2% |
| 47.00 | 0.00 | 0.00 | 47.00 | 2.36 | 12.0% |
| 48.00 | 0.00 | 0.00 | 48.00 | 2.36 | 12.7% |
| 49.00 | 0.00 | 0.00 | 49.00 | 2.36 | 13.5% |
| 50.00 | 0.00 | 0.00 | 50.00 | 2.36 | 14.3% |
A couple of observations:
- If WES maintains its current price, the pre-tax return will be 8.9% p.a.
- If WES drops to ~$26, we lose money
WES itself isn't particularly cheap these days: it trades on 19 forecast earnings. WOW trades on 17. I have been comfortable holding on at expensive multiples given the quality of the underlying business, however I have been potentially suffering a case of myopia given that overseas equivalents such as Tesco Plc (LN: TSCO) has been trading at a much less demanding multiple of 11 following profit downgrades last year. Even supermarkets aren't guaranteed of permanently trading on big multiples.
My conclusion: the structure of WESN is superb, however the valuation of WES is starting to get pricey. I am sitting on good gains in my portfolio and if anything I will trim a few back. I bought at levels less than the floor price, so the level of built-in protection I have is higher than current prices. Ideally I would like to see a good market pullback in order to pick some more up a bit more cheaply.
Kristian
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