In Brief (MYBG, WESN)

MYOB Unsecured Subordinated Notes (ASX: MYBG)

In my previous role I analysed MYBG when it was sold to investors (November 2012) and decided not to invest despite the attractive terms. The reason being was the amount of debt involved and my lack of understanding of the business - or more accurately - my lack of understanding of the the future of the software industry. MYBG have since dropped from the face value of $100 to $95. While a $5 drop isn't the end of the world, the point to note is that income style investments have been aggressively sold in Australia and not everyone of them will work out. I've learned that the hard way.   

MYBG are issued by MYOB which is a software company (see their website here) and is very popular with small businesses in Australia. MYOB was bought out by Bain Capital last year and loaded it up with debt, which include the MYBG notes. The screen shot below is a summary of the latest financials:

Take a look at the FY12 column. Notice the monstrous gross profit margin and EBITDA margin? Look further down and see the very large Depreciation/Amortisation figure? That represents previous expenditure being amortised and unless the software is absolutely bullet proof and cannot be competed away, it will incur future at least some expenditure to keep the software up to date. Look further down and notice the large interest bill. All of this adds up to negative PBT.

The big X factor here is what figure truly represents future capital expenditure? Is it $63.1m or lower or higher? This figure can dramatically distort true profitability for better or worse. MYOB carries a monster intangible asset of $1.195bn, and most of this is goodwill ($738m) - hence the large amortisation charge. Current capital expenditure is nowhere near as high as $63.1m, and knowing the software, I doubt whether they need to spend this sort of money in the future.

MYBG are being priced in the 'junk' territory: they pay 6.7% above the 90 Day Bank Bill Swap Rate meaning the current yield is 10.3% p.a. and the Yield to Maturity is 11.2% p.a. (they mature December 2017, so there is also a small capital gain on offer). That's a similar yield to the Healthscope Notes I recently discussed (these posts have been by far the most popular since I started writing the blog - I guess reinforcing the point of the popularity of income investments. Or maybe my other articles are mind numbingly boring!). Both have their risks. If I had to choose one, I'd go for Healthscope given the strong fundamentals of healthcare.

MYBG aren't for me, but I can understand the attraction investors have to them.

Wesfarmers Partially Protected Shares (WESN)

WESN has been discussed in previous posts (the last can be found here). At the time I disclosed I was selling a few of my shares given we were getting close to the $43.11 threshold and WES itself was getting expensive. Little did I realise this was the short term high in the stock! I have since sold my remaining shares. Why? After revisiting my numbers, it is obvious WESN doesn't stack up on an IRR perspective as well as other investments I am in. I want to stress this doesn't mean WESN won't keep going up, but as I live on my capital I need to squeeze every drop I can.

Kristian 

Disclosure: no position in MYBG or WESN

Australian Infrastructure Fund (ASX: AIX) - does it pass the smell test?

AIX owns a collection of airports. The fund assets are subject to a contentious takeover. The returns are very high if the deal completes, however there are real risks involved. 

Please note this idea is not original: it belongs to my former place of employment. However I have not bought AIX because a) initially when the deal was announced the return wasn't particularly appealing and b) subsequently, a challenge to the deal appears to have genuine merit. Given the price has since drifted lower AND the proposed closing date is getting nearer, the potential returns on offer are much higher so therefore the situation is getting more interesting and the purpose of this post is to discuss the merits of buying. 

If successful, unit holders will be paid over a few different dates. In addition, franking credits may  be paid or not paid. The table below indicates the potential money to be made:

And this is based on paying 100% cash for AIX shares: taking a leveraged position will magnify the gains/losses even further. While leverage is a dirty word at the moment, I noted the research demonstrating the power of leverage on Berkshire Hathaway's returns in an earlier post (click here) and personally I am on the hunt for situations where I can safely add some leverage in to make more money from the same situation. 

Note the very big difference between the simple return and IRR (which takes all of the cash-flows and reconfigures it to a p.a. return): because a good chunk of the money gets paid back very quickly, the rate of return appears astronomical: and it is.  This is particularly important if leverage is used as it allows ones capital to be recycled quickly. I have assumed the franking credits are returned in cash at a later date when tax returns are completed. Another scenario is the second payment will get paid by no later than 31 December. Assuming this is the case and assuming no franking credits, the simple return remains at 5.9% and the IRR drops to 46.1% p.a. pre-tax. 

Risks? We need to look at the issues that may stop the offer and what might happen if the deal falls over. The first issue is particularly messy and it would be naive of me to think I could offer an edge. In a nutshell: the buyer (Future Fund) and management of AIX (Hastings Funds Management) have been accused of rigging the sales process by over inflating the value of some of the airports to put them out of reach of buyers enacting pre-emptive rights. The Future Fund and Hastings have rebutted this argument. To my simple way of thinking, I have to concede the deal could fall over, or at least be seriously delayed in a legal punch-up. 

But let's not get bogged down in that and instead consider what happens if the deal falls over and whether we have enough margin of safety to bother with further analysis. And this is where my enthusiasm wanes: at $3.03, the distribution yield is a lousy 3.6% p.a. SYD is 6.6% p.a. AIX still has an expensive management structure in place gobbling up performance fees. Asset valuations are difficult to understand and believe in these types of investments and simplistically referencing the accounts could be misleading in understanding the downside risk. AIX after all has until recently traded a massive discount to NTA. It would be far easier and less risky if there were easily valued assets, but they are not. And given the potential legal issues, I am leaving  AIX alone. 

Kristian

Multiplex SITES (ASX: MXUPA)

MXUPA are a hybrid security currently paying a floating rate of 8.2%. They are managed by Brookfield Asset Management which is the subject of a not-so-flattering review. 

1. General Observation of Accounting Practises

Bronte Capital posted a link to an article called The Paper World of Brookfield Asset Management. This was article was interesting for a number of reasons. First, as Bronte Capital note, two Australian listed investment banks Macquarie Group Ltd (ASX: MQG) and the now deceased Babcock & Brown similarly engaged in the practise of taking assets such as infrastructure, leveraging them up, grabbing hefty fees and presenting the remaining 'mutton dressed up as lamb' investments to the public. In my previous role I spent some time analysing the flagship 'satellite' Macquarie fund: the Macquarie Infrastructure Group. That vehicle has now been split into two different entities. I can't recall the exact time period I analysed, however it was in the order of at least eight years and on a cumulative basis it produced roughly zero cashflow. Fees paid to 'mothership' (MQG) helped empty the bank accounts of the various satellite investments. Yet, the accounts showed large profit gains thanks to asset revaluations which have been since questioned following the demis of mark-to-model* accounting.

Before we tut-tut the investment bankers for this practise, many (millions?) engage in a similar practise in Australia: it's called negative gearing investment property. You lose money on a yearly basis (rent minus costs) and get to claim the loss on your tax return. However your property is growing in value so your collective financial position is improving. People from overseas call people who do this nuts. In Australia we call them rich. Providing the right location etc has been selected, the strategy has worked for many, many years.

The above article explains in some detail the opaque nature of Brookfield Asset Management (BAM) itself, and while the execution is a little different and even more opaque, the result is similar: a transfer of wealth from the masses to a few. I'm always fascinated to see how businesses really work and as usual it's presumptuous to judge a book by its cover.

2. MXUPA

The second point is more practical: it involves MXUPA. Please let me connect the dots. Multiplex Group was bought out by Brookfield in 2007. Multiplex ran some managed funds, one of which is now called the Brookfield Australia Property (BAP) Trust. MXUPA sit on BAP's Balance Sheet as  equity. While classified as equity, MXUPA have a debt like structure: MXUPA have a face value of $100 and pay a coupon rate of 3.9% plus the six month bank bill rate. MXUPA currently trade at $85.60 and distributions are non-cumulative. The notes are perpetual.

The current yield on MXUPA is 8.2% p.a. 

Despite the misgivings of BAM itself, the MXUPA structure is actually pretty good, in my opinion. It could be argued that MXUPA are equity like risk for debt like return (= bad) however I think the opposite applies: equity like return for debt like risk (= good). I made a similar argument in a previous post (click here) on Healthscope Notes. Although I  do note MXUPA has run up in price of late and therefore the yield has lowered somewhat: my equity/debt argument is no longer as strong as it was. I do appreciate that MXUPA holders money is being used as leverage for the controlling equity holders benefit. MXUPA holders are getting paid a fat interest payment in return. In addition, the Responsible Entity, Brookfield Funds Management, provide a guarantee to MXUPA. I won't provide a detailed analysis of the recent financials, however they can be accessed from asx.com.au.

MXUPA is another decent income paying security, and as mentioned in a previous note also makes a good parking spot while waiting for other opportunities.

Kristian 

Disclosure: own MXUPA

*Mark-to-model as opposed to mark-to-market accounting allows for a revaluation of assets based on internal model assumptions rather than benchmarked against other market prices. I have not done any analysis on whether the mark-to-model accounting was abused, but it is safe to say the power of monetary incentive must have placed the assumptions used in the model under stress(!)

Healthscope Notes (ASX: HLNG, HLNGA)

Details of new Healthscope Notes (HLNGA) announced 

The new Healthscope Notes (HLNGA) have been priced at 10.25% p.a. The offer has been very popular with investors allowing Healthscope to not only price the yield at the bottom of expectations but also increase the offer size substantially to $300m. Raising the offer size is annoying: more high yield debt = higher interest costs = higher risk. I find this very strange. I can (kind-of) understand switching some senior debt for lower grade debt to alleviate some banking covenants pressure, but expanding the offer from $150m to $300m doesn't pass the smell test. The extra $150m in debt will cost $15.4m p.a. in interest and the interest on the existing debt that is being switched out of is almost certainly much less than that. Healthscope already has a massive interest bill wiping out most of the EBIT so the increased offer will all but wipe out short term profitability altogether. So why do it? Healthscope must improve earnings to justify debt levels and while that is likely, it is not a certainty. Yes, the yield on offer is seductive however I fail to see a margin of safety. 

    

For my money (literally!) I am not convinced by HLNGA. 

Disclosure: sold HLNG, not applying for HLNGA

A General View on Preference/Income/Hybrid securities

Depending on the time frame, the long term return of the Australian share market is anywhere from 9-11%. This includes both capital growth and dividends, however it does not include franking credits. The taxation system favours capital gains over income, so depending on your marginal tax rate or which accounting entity you use will greatly influence long term after tax returns. For retirees with an allocated pension or what is now called an account based pension paying 0% tax there is essentially no difference between receiving income or capital gains, excluding transaction costs and reinvestment opportunities. So, for people paying minimal or no tax, does it make sense to earn a consistent 8-10% from income type securities however make no decent capital gains? My personal opinion is potentially yes*. Growth based investors may want spicier trades, such as RCU (click here for the recent post). Some investors want a combination of growth and income such as WESN (click here for the recent post).  The quality of the income security is obviously paramount. But as a generalisation and depending on your personal goals etc I think there can be a case for these types of securities, even just as a parking spot while waiting for higher performing investments. These income type investments have greatly under-performed the stock market over the last 9 months yet as a group have sailed through very stormy seas in recent years. In short they have provided equity like returns for debt type risk. 

I cover most of the listed income/hybrid type securities in Australia and there are enough quality issues to form a decent portfolio, which form one component of my families superannuation. Over the last four months of my sabbatical I have spent considerable time researching similar overseas issues and have come home empty handed. Hong Kong and Singapore have very few listed income securities. The UK and EU region do actually have quite a few on offer but none really tempting enough to take on the currency or fundamental risk. The USA has lots! They tend not to be as clean as Australian income securities such as having 'maturity dates' that aren't really maturity dates but allow the issuing company to redeem the stock. The conversion price is often linked to the ordinary share price, introducing a degree of equity price risk. As a crude generalisation, USA plain-vanilla preference shares deliver 4-5% returns while issues yielding 8% or more tend to have skeletons in the closet. Therefore, relative to historical long term stock market returns, overseas investors don't appear to have the same opportunity to earn equity like returns from income investments that Australian investors do. It is no wonder these investments are popular in Australia and there is every reason to believe this sector will see more issues. 

Kristian  

*Please note this site is not authorised to provide financial advice (the site disclaimer can be found here).

Real Estate Capital Partners Trust (RCU)

This post is a follow up to recent posts on RCU (the last one can be found here). Admittedly I was doubting myself a little in the last post, however we are now over the line with the redemption facility becoming official. Investors had until 14 March to send in their redemption requests. The redemption price is expected to be A56.85c.  

This is a very good outcome for a few months work. After reviewing my previous notes (the first post can be found here), the investment case has panned out, however the major shareholder did throw a spanner in the works by trying to turn RCU from a cash-box into a listed investment vehicle for other purposes. While I still believe the downside was low, this scenario could have tied our money up for longer than expected and/or we would not have made the money as originally expected. Even nice simple situations can have events thrown at them.

Kristian

Wesfarmers Partially Protected Shares (ASX: WESN)

A detailed analysis of WESN was provided in a previous post (click here for the article). I commented how I loved the structure as it provided some downside protection while providing full upside exposure. I also commented it was starting to look 'pricey': that was early February when the price was $39.62 and the price has just kept marching north and is now $42.40. In my prior role as an analyst, it struck me that sometimes we don't want share prices to move too fast; it just means we have to make more decisions as to whether to sell or hold. More decisions = more chances to make balls-ups. Not to mention the tax problems it also creates. However, we do need to keep an eye on reality and decide if we are to hold or sell. 

The table below shows an updated version of the return pay-off of WESN depending on the final share price of WES: 

Some more columns have been added to cater for further assumed dividend increases at a rate of 7% (adjusted for actual ex-dates of dividends). Some other changes have been made to the table such as showing WES price increments of $5. The column on the far right is our rate of return under the various price assumptions. Please note these returns are all pre-tax figures and are gross franking credits. 

The important point to note is that any price movement above the upper protection threshold of $43.11 does not have any downside protection (if that sounded confusing, it is best to go back over the original article). The current price is $42.58. So not only does WESN become less appealing on a valuation perspective as the price increases, the level of built-in insurance also diminishes. This is discomforting from a risk perspective. The case to hold above $43.11 becomes one of fundamentals and not structure. The table below compares WES with its Australian peers (WOW, MTS) and the big overseas supermarkets players (TSCO, WMT):

There are a few other inferences that can be made out of this basic analysis (why is TSCO so cheap!) however WES certainly remains quite expensive. The analysis is a little misleading as WES has other sources of income than Coles and looking at simple metrics such as PE is dangerous, especially when Coles has arguably more for earnings growth from its turnaround strategy. However the key point is risk: higher valuations mean more risk. 

The problem I have is that WES needs to keep growing its earnings quickly to grow into its valuation, yet it is very likely to do exactly that and of course we have the built-in downside protection which is extremely rare for such a good blue-chip company. From an Internal Rate of Return (IRR) perspective, we need both solid gains in dividend growth and the share price to achieve substantial returns. Ideally, we make as few assumptions as possible and so I am going to play at least a little bit of a safe hand and trim back some my shares. For the time being I am holding the majority of the WESN position. 

Kristian  

Real Estate Capital Partners Trust (RCU)

Gosh, the drama just keeps unfolding! First, there has been judicial approval of the redemption request and second the estimated net assets are 56c to 58c. There are some potential legal claims against the trust which could at the worst case scenario could reduce the payment by 15c. This is highly unlikely. It does look however like my estimate was far too conservative, however it's not over 'til the fat lady sings and I won't be surprised to see some form of counter attack by the major shareholder before this deal is done.

The deadline of 8 March to submit redemption requests is tomorrow, so if you are an eligible unit holder then you need to consider getting your requests in ASAP. As it is now too late to buy units and apply for redemption, it is not surprising to see the unit price wallowing at ~44c.

Kristian 

RCU... Have I stuffed this up?

Okay, further to my now many posts on Real Estate Capital Partners Trust (RCU), there has been more corporate activity. Ideally I would have a final blog to finish up this trade, however that is not to be in this case. Despite the big discount to assets, self-interests of other parties are getting in the way of an otherwise nice easy asset play. 

As you may recall, RCU has now sold the majority of its assets. The original idea was to then simply pay out the proceeds to unit-holders and the trust would be wound-up. Instead, some key unit holders blocked the return of cash as they wanted to keep control of the shell and use it as a corporate vehicle for other purposes. Plenty of unit holders have since requested a 'redemption' of their units, which the management of RCU has tentatively agreed to subject to clarifying some legal issues. This is basically a way to get around the blocking stake of  the unit holders. I am not sure of the exact legal issues and whether the redemption process can be stopped; I actually expect the blocking unit holders to try something on and RCU has just gone back into a trading halt, so I don't know what the next move will be. 

The price will be based on the net asset value of the fund at time of redemption, which has not been determined. The catch is we need to apply for redemption by 8 March, so we need to at least have an idea as to what the value might be. The balance sheet as at 31 December showed net assets of 58c. However, that figure will be lower given the non-performing assets are losing money, the property sale means a hair-cut and there are general corporate costs to allow for. Post the Saban sale, the net asset value was estimated to be 54c, however we need to be realistic and budget for a lower figure; I'm banking on 50c. 

If this is the final figure I will end up making a bit of money, but not much. However it does free up capital for other uses. The original purpose of the trade was to participate in the break-up of an asset and I will stick to that original idea. 

In summary: I am applying for redemption of my RCU units.

Kristian 

Healthscope Notes (ASX: HLNG)

As part of my families superannuation (retirement) fund, we own some notes called HLNG. They are issued by private hospital and pathology operator Healthscope. The notes were issued when Healthscope was taken over by private equity, and I bought in shortly after. The investment has been profitable. The idea of buying this type of stock and others such as AFIG (click here for the article) is to provide our portfolio with some low risk, high income generating ideas as a balance to more volatile trade ideas. I won't go into Healthscope in detail, and as a summary these are the key points: 

• Private hospital and overseas (ex Australia) pathology divisions = good 
• Australian pathology division = bad 
• Private equity owns Healthscope = lots of leverage 

Lots of leverage isn't so bad when a business has very stable cashflows, which Healthscope mostly has. However Australian pathology has been deregulated with a resulting downward pressure on profitability. I've been monitoring this situation for years now, however the most recent results and issuance of more of these notes has me concerned. 

First, let's look at the half year results to December 31: Revenue $1.114bn, EBIT $109.3m, Interest Costs $92.3m and NPAT ($109.1m). Pretty much all of the pre interest and tax (EBIT) profit is swallowed up by interest payments. Profitability is being dragged down by Australian pathology, however it only accounts for a small portion of profits and the dominant business - private hospitals - are growing very nicely thank you very much (and probably will continue to do so). Large impairment costs have been responsible for the large after tax loss for the half. 

Okay, so let's look at the notes themselves and the new offer. HLNG are hybrids: they rank below senior debt but rank ahead of equity holders. They pay a fixed rate of 11.25%, mature for $100 (or maybe a little bit better if Healthscope is re-floated) on 17 June 2016. The current price is $105.50. The overall yield to maturity is 9.2% p.a. That's the most we will make and if business turns sour, we could lose money. I don't think that is likely; but it could happen. What has me worried though is Healthscope is 'voluntarily' offering new notes that will rank equally with HLNG as a way of paying down senior debt.  Does it really make sense that you would swap debt with a lower interest cost for a higher interest cost? I'm not convinced. The new notes will mature 25 March 2018 and will pay between 10.25% to 10.75% depending on a bookbuild. At the very least, it makes sense to sell out of HLNG at current prices and buy into the new notes at the face value of $100, or even a bit above if you don't/can't buy them through the IPO: the choice is hold HLNG and earn a yield of 9.2% or buy the new notes and potentially hold for a few more years and earn at least 10.25%. 

I'm not decided on buying the new notes, however in the meantime I am selling HLNG. 

Kristian 

Disclosure: currently own HLNG (in the process of selling).