Income Report / Income Report; Wesfarmers, a new Bond & a Hybrid opportunity (WES, AXL, NAB)

By Market Matters 25 July 18

Income Report; Wesfarmers, a new Bond & a Hybrid opportunity (WES, AXL, NAB)

Market Matters Income Report 25th July 2018

A more negative session across the ASX today with the Materials stocks the only area providing some support. The Banks were weak yesterday afternoon and the theme continued today while Wesfarmers (WES) and Woolies (WOW) were both weak. We cover our views on WES in the income report today with a focus on the Coles demerger.

In terms of the MM Income Portfolio, it was up 0.55% over the past week . Since inception (5/7/17), the portfolio is up  7.24% versus its benchmark (RBA + 4%)  which equates to 5.79%.  FY to date the portfolio has added 1.17% versus its benchmark of 0.35%.

Axsesstoday (AXLHA) Listed Bond starts trading

The newest addition to the MM Income Portfolio was the Axsesstoday Simple Corporate Bond which started trading on Monday under code AXLHA. The Income Portfolio has a 5% allocation which increases the defensive positioning of the portfolio overall. We reduced the weighting towards Perpetual (PPT) which is cheap, but a 7% weighting to a stock with direct equity market exposure and a Royal Commission about to focus on Superannuation was too high, so we reduced it back to a more palatable  4%. Overall, the portfolio  is sitting on 47.5% in hybrids / fixed interest which reduces its overall volatility while underpinning strong income.

In terms of the Axsesstoday simple bond, the issue was upsized by $5m to $55m, and will pay a quarterly, floating rate interest set at a margin of 490bps over 3 month BBSW. On current pricing this equities to 6.885%. The bond is unsubordinated and has a term of 5 years, maturing 20 July 2023. At time of writing the bond was trading at $100.50

This is a higher yield bond and is higher risk, however when compared with other listed corporates we think the return compensates for the risk.  

Wesfarmers (WES) - Insight into Coles Demerger

On Monday  we had an update from Wesfarmers – a popular income stock – on the likely timetable and details of the Coles demerger ahead of their full year results due on the 15th August. A few key points worth noting; 

-          They expect the Coles demerger  to be completed in late November 2018,  which is still obviously subject to shareholder and other approvals (Board, regulatory, court etc).

-          WES will retain 15% of Coles and 50% of Flybuys. The leverage to Flybuys is interesting and shows you the value they ascribe to  data, digital and loyalty initiatives – it’s such an important element for retail businesses these days to understand the spending patterns of their customers.

-          Post demerger, Coles will have a very strong balance sheet as you’d expect, but it looks to be set up to given them the ability to make further acquisitions from the outset

-          On dividends, they’ll likely payout 80% to 90% of earnings – with WES dividend policy remaining unchanged following the demerger.

Overall, the update was all pretty reasonable and nothing too surprising. The biggest point from an investment perspective at the moment is around Coles losing ground to a resurgent Woolies, with the later expected to maintain their lead for at least the next two quarters, given Coles’ poor like for like sales momentum.

The other obvious issue for all is increased competition in the Supermarkets segment (from Woolies/Aldi/Costco/renewed IGA, and potentially Amazon, Lidl and Kaufland in time). While this has been talked about for some time , and to date, both Supermarkets have managed it well the competitive landscape will only get tougher.

WES has done exceptionally well in the last quarter, rallying +20% however the stock is expensive with limited earnings growth. It’s also a stock that typically trades in ranges, in term of price but also PE. In the past 5 years it’s traded to a low (P/E) of 15.5 and a high of 20.8 – it currently sits at 18.8, which is about 1 standard deviation ‘expensive’.  We appreciate that the earnings outlook will be different going forward, however separating businesses doesn’t often lead to an immediate uptick in earnings growth that would justify the current multiple.  

If we think of WES post the Coles spin out (Coles currently accounts for about 57% of WES revenue and about 40% of EBITDA), Bunnings will be the primary driver of the new entity with greater than 50% of earnings contribution. There is no doubt that Bunnings is a sublime business however its exposed to housing, and the best times in the domestic housing market seem to be behind it.

Wesfarmers valuation metrics

At MM we are a seller of WES at current levels  

Wesfarmers (WES) Chart

Hybrids are rallying (+1 new income idea)  

During the first quarter of the 2018 Calendar year, the hybrid market was under pressure with the average spread across the financial space blowing out to around 3.60%. Now, that spread has come in implying stronger demand for the asset class – and now sits just above 3%. The differential between the 1.50% cash rate and 3 month bill 1.985% remains around 50bps – this increases funding costs for banks and corporates with 90 day BBSW being the key reference point. For Hybrid and Floating Rate investors generally, the cash to bills spread represents a benefit with the dividend rate being priced at the Hybrid Security Issue Margin + 3 month BBSW (rather than over the cash rate), which means our Hybrids are now generating higher yields.

If we combine that with a lack of new issuance for the rest of the year and the demand for hybrids on market should remain reasonable.  Interestingly enough,  Crown Resorts (CWN) last week announced that it has elected to redeem all the outstanding Subordinated Notes (CWNHA) on the first call date of Friday 14 September 2018 .

1 Opportunity

There is an interesting discussion playing out across the domestic hybrid market at the moment surrounding NABHA – will it continue as a perpetual or will NAB redeem it and in doing so, give holders a strong uplift in capital from the ~$84 price to its  ~$100 face value?

Here’s the case for redemption and why it should be considered as an Income Buy, thanks Cam Duncan, Shaw’s Hybrid guru….

-          The National Income Securities (NABHA) has been well bid recently, driven largely by broker and press commentary pointing to NAB’s disclosure in the HY results to 31 March that stated that NAB expects to frank NABHA distributions after 31 December 2021 after which date NABHA will no longer provide any contribution to NAB’s Regulatory Capital calculation.

-          In simple terms, the possible franking requirement would effectively increase the funding cost to NAB, and may be viewed as a sub optimal streaming of franking to a security that is not classed as regulatory capital.

-          Countering this view, NABHA are a Perpetual Security with no maturity date currently incurring a fairly low cash cost of 1.25% over BBSW to NAB, and pays distributions that are discretionary and non-cumulative, and any view on the relative cost of NABHA is in the context of current bank credit spreads.

-          On balance, Shaw and Partners view the likely franking requirement at end of 2021 increasing the chance of NABHA being bought back or replaced (redeemed) as 2022 approaches.  At last price of $84.10  NABHA still offer a reasonable cash running yield of 3.71%.

-          In contrast to Basel 3 Hybrids, NABHA benefit the investor in containing no non-viability conversion trigger, and have a more onerous dividend stopper that requires 1 year of NABHA distributions be made before any dividend may be paid on NAB shares.



Conclusion (s)

We’ve increased our defensive positioning in the MM Income Portfolio by reducing Perpetual & adding the Axsesstoday Bond
We are negative Wesfarmers (WES) at current levels
The NABHA Perpetual security looks an interesting income opportunity  

Have a great day!

James & the Market Matters Team


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, or after the session when positions are traded.


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