Intelligent Investor Equity Income & ASX:INIF - November 2018
Coles spin off, a bid for Trade Me and Clydesdale's falling margins
Spin-Offs have historically delivered outstanding returns, as I discussed in the recent webinar How to find value. Magic can happen when a smart, appropriately incentivised management team, freed from a bureaucratic parent company, can finally make the investments their business needs.
In contrast, the Coles spin-off from Wesfarmers isn’t necessarily poised for outsized returns. First, Wesfarmers’ share price increased instantly following the spin-off announcement, so expectations were high before Coles’ separate listing.
Second, Coles hasn’t been mismanaged or starved of capital, and is well covered by the investing community i.e. it’s unlikely to be mispriced and, due to its large size, large funds won’t be selling due to illiquidity (a common reason why spin-offs become grossly undervalued).
Furthermore, Coles is carrying a healthy amount of debt in addition to its leases, while simultaneously promising large investments and to pay out nearly all profits as dividends. Should profits come under pressure, perhaps due to increased competition from Amazon or other new and existing players, the dividend may come under pressure and debt could increase.
A forecast price-to-earnings ratio (PER) of ~16 doesn’t provide a large margin of safety, nor does Wesfarmers’ PER of closer to 18, given its large retail businesses could suffer severely in a slowing economy.
For now, we’ve kept our small holdings, but prefer our larger holding in rival Woolworths, which has already made similarly large investments in its supply chain and is capable of returning more money to shareholders.
Trade Me recently received a non-binding bid from UK private equity firm Apax Partners priced at NZ$6.40 ($6.05), which was followed by interest from US private equity group Hellman & Friedman. A deal is far from guaranteed, so we reduced our position from 10% to 7% to reduce risk and capture some upside from the increase in the share price since the announcement.
Given the amount of investment the company has made in recent years at the expense of short-term profits, we believe the deal undervalues the company and that it would be a damning admission from the board about its fears of future competition if it agreed to a deal at the suggested price.
In an unusual step, we sold James Hardie Industries at a nominal loss after a very short holding period. The stock fell 15% after announcing a massive increase in costs that impacted a swathe of US companies the same week.
The consensus is that James Hardie can pass these costs on to customers better than most (we agree), and that the cost increases will be temporary as the US economy adjusts to tight labour and product markets.
Our fear is that, in contrast to the official statistics that show negligible inflation growth, higher costs will be more permanent. The US economy is stretched for skilled labour, for example, which can’t be relieved quickly. While we’re still US housing bulls, we decided to sell and invest the proceeds in plumbing supplies company Reece instead.
Reece’s recent US acquisition means it also has a large exposure to US housing. But having also suffered a recent similar fall in its share price, we feel more comfortable with Reece’s management and less cyclical business. We’ll explain the bull case for US housing and Reece in the upcoming quarterly.
As an aside, it’s an important part of investing to admit quickly when you think you’ve made a mistake. While our valuation of James Hardie may prove too conservative, experience says there’s no better time to sell than straight away when you’ve blundered. Changing your investment case to suit the facts usually only compounds the error and you can always buy the stock back if your fears prove unfounded.
The ugly award this month undoubtedly goes to ageing spin-off and UK bank Clydesdale. The share price has almost halved since reaching $6.33 in August, and we’ve topped up our holding on the way down.
The bank’s profit margins are falling more than expected as the industry cuts home loan rates in response to a slowing housing market. At a price-to-tangible equity of just 0.7 for a business that should be capable of producing a double-digit return on tangible equity in the years to come and paying a dividend yield beyond 5%, for now we’re eager to hear the company’s next three-year plan in June.
Management must prove it can do more than cut costs to get the stock out of purgatory, and we believe it can. Unfortunately, a messy Brexit may delay the high returns we believe are possible.
Skin in the Game is a weekly podcast by InvestSMART with Portfolio Managers Nathan Bell and Alex Hughes.
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