Goodman: good yield or good gain

PORTFOLIO POINT: Goodman PLUS hybrids offer a running yield of about 10%, with the prospect of a 50% capital gain on redemption.

After an eventful start to 2009 things have quietened down at Goodman Group. Since our last look at Goodman (July 8, 2009) the balance sheet of the company has also been bolstered by a small capital raising via the exercise of $40 million of options issued to Macquarie Group.

Overall, our assessment remains the same. The capital raising has substantially reduced the credit and liquidity risk of the company. We also believe investors fears of the property sector and reluctance to purchase property hybrids are largely unfounded due to the substantial capital raisings undertaken and the widespread write-downs that have already been incurred.

In relation to the Goodman PLUS Trust (GMPPA), the security is currently offering a running yield of close to 10% (based on a price of about $66) and should exceed this as the bank bill swap rate (BBSW) rises closer to long-term averages. Also, in the event that the security steps up the coupon will increase by 1%.

Due to the discounted price the leverage impact of any increase in the BBSW (or step up) on the running yield is approximately 1.5 times (100/66). So if the BBSW increases by 1%, the running yield will increase by about 1.5%.

In terms of valuation, we need to consider the security from two perspectives: That it is redeemed at the first call date; and that it steps up and remains a perpetual security.

GMMPA has a step-up date of March 21, 2013. If the security is redeemed on that date investors will receive a capital gain from today’s prices of about 50%, translating to a spread of around 17.5% and yield to maturity of more than 20%.

If this scenario were to eventuate it would be an excellent result for investors and we believe those returns clearly outweigh the risks involved.

On a perpetual basis we would expect GMPPA to deliver a long-term coupon rate of about 8.4% based on the stepped-up margin of 2.9% and long-term BBSW rate of 5.5% (below the 15-year average to reflect potential lower rates in the future).

At current prices this would deliver a perpetual running yield of about 12.7% with a call option for the security to be redeemed at $100.

This still appears to be a reasonable valuation. Assuming equities should return 10–12%, pure listed property trusts could be expected to earn less than this as they are lower risk (although Goodman Group is a part developer and not solely a property trust).

Preference shares and hybrids are lower risk again and we would expect the long-term return on such securities to settle in a range of 8–10%, which seems appropriate for the risk involved. On this basis, GMPPA still looks attractive on a perpetual basis although redemption at the first opportunity is preferred.

Redeem or step up?

The key question is whether Goodman Group will redeem the security at the first call date or step up into a perpetual. The two key considerations in this decision are reputational issues and ongoing funding costs.

Importantly, on a reputational basis Goodman Group has a rating from Standard & Poor’s and Moody’s. While it is not a bank or insurance company (which have very high reputational issues), the group is active in financial markets and this will certainly be a consideration when the step-up date arrives.

Our key concern with GMPPA is the small size of the step-up, of only 1%. This means the security will only offer a stepped-up margin of just 2.9%, which in the current environment is still a cheap form of funding for the issuer.

However, what’s important is not whether this is cheap funding now, but whether it will be at the time of the step up in March 2013. On a long-term basis, a 2.9% margin would seem about right for the subordinated perpetual debt of a property trust, although there is no certainty of where credit spreads will be in three years’ time.

We would expect Goodman Group will assess market conditions closer to the step-up date in determining whether to redeem or step-up the security. If the group could source alternative funding cheaper it will almost certainly redeem.

If refinancing is about, or even slightly higher, than the 2.9% stepped-up margin, we would expect Goodman would still redeem on the basis of the reputational issues. It would only be if Goodman Group would have to pay substantially more for alternative funds (or have liquidity concerns) that it would consider stepping-up the securities. Even if alternative funding was prohibitively expensive at this point in time it still might redeem the securities depending on the importance it places on reputational concerns.

Overall, GMPPA still offers attractive value. Even on a perpetual basis the securities are likely to generate a running yield of well above 10% on a perpetual basis as interest rates rise and the step-up kicks in.

Alternatively, investors will be redeemed at $100 generating a capital gain of about 50% from current levels either at the step-up date or some point in thereafter. Both scenarios are attractive (the latter option more so) and GMPPA is a buy on our summary sheet and is one of our favoured corporate hybrids.

Jim Stening is managing director of FIIG Securities.