Income Report / Income Report; Staring down the Bear – BUY Harvey Norman

By Market Matters 26 July 17

Income Report; Staring down the Bear – BUY Harvey Norman

Income Portfolio 26/07/17

The income portfolio lost -0.41% over the course of the week (to Tuesdays close) versus the ASX 200 which was up by +0.68% or +39pts. The market overall has been range bound and as we’ve written recently, this very tight range looks primed to break. We turned more short term bearish at the start of the week given the Australian markets inability to rally on good news, however it now seems that call was premature given a strong performance yesterday, and buying in the market again today.

Stocks that are lagging in the income portfolio are Suncorp (SUN) and Alumina (AWC), down between 2/3% a piece while the stocks that are flying are AP Eagers (+9.51%) and HFA Group (+6.67%). The expected yield on the portfolio jumps to 5.94% grossed for franking following the purchase of HVN.

Since APRAs announcement last week of “unquestionably strong” capital benchmarks for banks which requires the major banks to have CET1 ratios (Tier 1 Capital) of at least 10.5%, we have seen bank CDS spreads contract – or in other words, the perceived risk of bank credit has reduced, which is understandable given higher capital makes banks safer even if it is a drag on earnings. Safer banks with more capital are a positive for Hybrid holders, yet over the past week we have seen hybrid margins widen an average of ~10bps across financial hybrid complex . A widening margin essentially means prices have declined which is counterintuitive to what has actually occurred. Tier 1 hybrids are dominated by retail investors who like reading the AFR and the ASIC Chair’s comments last week may have prompted some selling. Although we don’t have any ‘Tier 2’ subordinated debt or senior debt in the portfolio at this stage, this is a market with more institutional activity / interest and spreads contracted over the past week – which is the correct reaction.

In terms of ‘high yielding stock’ below is a quick snapshot of some names to consider

This is a simple list looking at yield and a reasonable valuation. The names highlighted are stocks we think are worth considering – 1 of which we added to the portfolio today.

Following on from our AM report this morning, Amazon is coming…in case you haven’t heard and Australian retailers are in the firing line. Stocks have dropped sharply and Gerry Harvey has made more television appearances than Alex Malley. Is it all as doom and gloom as the market is anticipating? Firstly, getting an understanding of Amazon is difficult, and it’s  impossible to sum up the Amazon business, and the potential impact on Australia in a short note today (or even a long one), so we’ll make a couple of broad observations instead.

Firstly  we see the “death” of good quality, well located bricks and mortar retail as unlikely simply because of the arrival of Amazon. The experience in other countries, like Canada for example where Amazon has been operating for the past 6 years demonstrates this. Canada is a very similar market to Australia, in terms of demographics and geography. We both have relatively low population densities, 2 or 3 dominant large cities that are geographically dispersed, economies that are heavily driven by commodities/resources, online penetration as a percentage of total retail sales is low (but growing), and lower retail space per capita relative to the USA. All up, it seems to be the best guide as to what Amazon might mean for Australia (when it eventually arrives) – and in short, it has had an impact but not to the magnitude that many thought it would.

Overlaying the concern of Amazon is the concern around a slowing housing market and weak retail sales. These are legitimate concerns particularly as interest rates rise. If house prices come back that will likely depress like-for-like sales growth for Australian retailers, however for some, the renovation cycle would likely remain strong. All in all, the trends in retail are weak, the market hates uncertainty which Amazon is delivering in spades and the majority of investors simply think, it’s all too hard. Clearly the retail sector now is high risk, however in our view, a combination of valuation, yield, and the current markets completely bearish positioning (shown through short interest) is enough to get is interested in 2 more retail names.

Harvey Norman (HVN) – Forecast P/E of 11x Yield of 7.4% FF

Despite the negative headlines, HVN have actually been growing the top line consistently and in the most recent update in April, they showed like-for-like sales growth of 4.8% in Australia, which was weaker than markets had thought, but OK in its own right.  The real threat as we see it from Amazon is more focussed on consumer electronics which are a part of HVN’s business, however the more bulky products like furniture and TVs, or higher value products like computers, or products that customers like to look and feel before purchasing are more in the defensive category, and HVN has a lot of them. Also worth noting that HVN is a property play, with around $2.30 per share underpinned by its property assets – which provides some good downside protection in the event we’ve underestimated the impact of Amazon. Clearly, this is a higher risk proposition however we think the risks are being overstated by the market. We will add Harvey Norman (HVN) ~$4.07 to the Market Matters Income portfolio today with a 4% allocation

Harvey Norman (HVN)  Weekly Chart

Some other interesting stocks to consider in the table above;

Centuria Metropolitan REIT (CMA) Forecast P/E of 8x Yield of 7.25%  unfranked

We already have Centuria Capital Group (CNI) in the MM Income Portfolio and CMA is a Real Estate Investment Trust run by Centuria Capital Group. CMA invests in office and industrial space in metropolitan areas within Australia.  CNI (which is already in the portfolio) also run CIP, an industrial REIT that invests in industrial space across Australia. CMA has recently acquired 3 new properties, two in Perth and one property under development in Melbourne, for a total of $150mil. CMA have recently raised funds to pay for this at $2.35 per share. They now trade at $2.40 which puts them on a +7% yield with some growth, and importantly, they have bought these 3 above mentioned properties well. Although we are unlikely to add this to the portfolio given our exposure to CNI, we like this company for yield.

Centuria Metropolitan  (CMA) Weekly Chart

Mortgage Choice (MOC) Forecast P/E of 14.5x Yield of 6.3% FF

MOC is a mortgage broker that looks attractive from an historical valuation perspective trading on a discount of ~15% to its long term PE – currently around 14.5x. with a yield of 6.3%, paying a forecasted half year dividend of 7.5c FF. Mortgage Choice would seemingly be a great choice for the income portfolio, however the company is facing considerable headwinds. The mortgage broking industry has been facing scrutiny around unethical practices and many are pushing for reform that would shake up the commission based fees. Even the most basic of reforms, such as a push to pivot commissions where broker compensation is increased as the LVR falls, would significantly hit Mortgage Choice’s profits and valuation. Clearly this is an income opportunity that carries too high a risk to capital for the income portfolio.

Mortgage Choice (MOC) Daily Chart

Conclusion (s)

We have been very anti-retail over recent years which has saved us considerable money but perhaps there now exists a few cheeky but high-risk opportunities.

Today we are adding Harvey Norman (HVN) to the income portfolio

We considered Mortgage Choice however there is simply too much regulatory uncertainly around this stock, which makes it a more binary outcome


Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday.


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