Time to Seek a higher return

PORTFOLIO POINT: Online jobs advertiser Seek is issuing notes offering an annualised yield well above current government bond returns.

Last Friday was a historic moment in the history of government-issued debt: Australian 10-year bond yields closed at a record low of just 2.8%, having averaged over 6% for the better part of 40 years.

Chart 1: Australian 10-year bonds

Over in Britain, bond yields (UK gilts) are at 300-year lows! The low bond yields are informative in several ways.

First, they suggest that a recession – as well as more cuts in the RBA cash rate (currently at 3.5%) – is expected. Anyone who has followed our two-speed economy (I have long referred to it as the “one-cylinder” economy) over the past few years or operates a business outside of the resources sector would argue that Australia is already in a recession.

More worrying is that bonds are no longer safe. Ask yourself, what is safe about being 100% guaranteed to lose purchasing power?

With utility prices such as gas and electricity rising significantly, anyone buying bonds presently is guaranteed a negative return after inflation and tax, considering the average inflation rate since 1990 has been 2.9%, and we all know the official inflation rate is bunkum, because nobody buys a plasma TV every year.

To watch this unfold is frustrating. Baby boomers who have saved hard and worked hard for years and are now reaching their retirement years are seeing their income streams decimated at the expense of those who have geared themselves to speculate on assets. The sensible are now subsidising the profligate.

Savers are literally being forced to switch into other asset classes in order to generate a real income return. And surprise, surprise – the wizards in the structured product departments of our major banks and brokerages have just the thing for you!

Corporate debt, hybrids and high-dividend yielding stocks are all the rage. But these are asset classes which at best are volatile and at worst run the risk of permanent capital loss.

Those seeking a real return are therefore now forced into believing the promise of a Holy Grail – assets that will not only protect capital, but also boost declining incomes.

Warren Buffett once said: "Wall Street will sell what Wall Street can sell", and this week Wall Street is offering Seek Subordinated Notes. Do they fit the bill?

When Seek listed, less than 20% of employment classifieds had migrated online. By 2011, that percentage was 50% and earnings per share had grown 22% p.a., from 7 cents to 29 cents.

As I have said many times before, if the business does well, the shares eventually follow. Seek’s excellent underlying fundamentals have been reflected in a healthy aggregate increase in Skaffold’s intrinsic value. As Figure 1 reveals, this in turn is reflected in a healthy net share price appreciation.

Figure 1: Seek Limited
Source: www.skaffold.com

As an aside, contrast this performance with Fairfax. I believe that if you know how to correctly calculate intrinsic value – and no, BHP was not cheap at $38! – you will quickly discover that price tends to follow value. As you can see from Figure 1, the share price got ahead of intrinsic value in 2007 and again in 2010. Further capital gains cannot be sustained. After seven years, however, the price and intrinsic value have converged. The same is true of Fairfax in Figure 2, but the story couldn’t be more different.

Fairfax is a business that has arguably suffered the full impact of Seek’s meteoric growth. And Fairfax’s positioning in traditional print media/advertising continues to be battered by structural shifts in the advertising industry.

Figure: Fairfax Media Limited
Source: www.skaffold.com

When Seek listed, its market capitalisation was around $300 million. Fairfax’s was around $3.8 billion. Today Seek is capitalised at $2.1 billion and Fairfax $1.4 billion. Fairfax shareholders have endured a value and share price decline that corresponds roughly with Seek’s rise. And note the powerful information that is the intrinsic value graph – once again, the share price has followed intrinsic value over the long term.

At four times the size of the sector’s number two competitor, CareerOne, Seek is the clear market leader in domestic online job advertising. Seek attracts the largest number of job seekers to its website, and, in a self-reinforcing cycle known as the 'Network Effect’, this attracts job advertisers who want to reach them.

The network effect is a resilient and sustainable (but perhaps not permanent) source of competitive advantage. Despite CareerOne being backed by US-based Monster Worldwide, a business which operates in 55 countries and which has $US1 billion in revenues, no meaningful inroads into Seek’s market leadership has occurred. On the contrary, all points lead to the conclusion that the gap between one and two is widening.

Following a dip in 2009 and 2010, returns on equity are back at their high 2008 levels. Additionally, capital requirements are low and cash generation is very strong.

Online businesses have the potential to realise increasing productivity from a relatively small asset base and a market-leading position means that Seek can continue to slowly increase its classified prices over time. This leads to very attractive returns on investment. The only downside is an inability to sustain these high rates of return on incremental equity forever. Once the company achieves a certain size, growth becomes hostage to the limits of structural and macroeconomic conditions.

Fortunately, these conditions appear positive. While Seek is adversely exposed to Australian unemployment levels, which may increase in an environment of economic uncertainty, it is also favourably exposed to the continuing structural migration of advertising revenues from print to online.

The former is uncertain and temporary, while the latter is virtually certain, and more enduring. This migration may have run its course in about five years’ time, but in the meantime Seek seems assured of well-above GDP growth.

Conversely, Fairfax is facing structural difficulties (putting aside the 'rivers of gold’ 70% stake in Trade Me) and I would not be interested in owning a piece of this business, whether that was equity or senior notes.

Seek, on the other hand, has been one of the Montgomery [Private] Fund’s larger holdings and with the tailwinds mentioned above, I would be much more comfortable considering its recent subordinated notes issue (ASX: SEKG).

Through an issue of $125 million, management is looking to fund top-up acquisitions in majority-controlled Brazilian and Mexican online employment classified joint ventures. The notes give the businesses perpetual debt with no maturity risk, and the notes would rank ahead of equity shareholders in the event of Seek ever becoming insolvent.

While the exact yield on offer is an unknown until the book build is over, the notes will likely offer a margin (a fixed rate) of either 5% or 5.5% above the 180-day Bank Bill Swap Rate (BBSW). BBSW is currently 3.0933%. The SEKGs are expected to initially offer investors an annualised yield of between 8.09 - 8.59% (including franking credits). That’s attractive, given alternative investments in what are arguably lower-quality assets and businesses.

There are risks, of course: the notes are non-cumulative and semi-annual coupon payments are to be made solely at the discretion of management. It would take a material deterioration in the business before coupon payments were suspended.

Another key risk lies with the BBSW reference rate which could fall in line with bond rates, should economic conditions deteriorate further. This would have the effect of reducing the coupon payments. The market price of the securities may trade at a discount to their face value of $100 and if sold, a capital loss would transpire.

Personally, I reckon hybrids and notes are marginal propositions at $100. The best time to buy them is when they are trading like junk bonds, and you generally need a financial crisis for that! By way of example, I remember when the Australand prefs (ASX: AAZPB) fell from $105 to $31 and the Multiplex SITES (ASX: MXUPA) fell from $100 to $17.80. The rest of the time, Wall Street will sell what Wall Street can sell.

Further, given the small size of the offering, it is likely that the secondary market would suffer liquidity issues, making it harder to sell if you needed to.

In assessing all the risks – and I insist you read the prospectus in full and speak to your adviser before making a decision – ask yourself this question: would you like to own Seek or lend them money?

I reckon these are an attractive but illiquid alternative to cash, and recent ructions suggest very attractive equity opportunities will require liquidity.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.