A still-tempting ALE

We’ve explained the case for an investment in this pub landlord in past reviews, most fully in ALE Property: Down in one on 2 May 12 (Buy for Yield – $2.08). That review is a must-read for interested investors.

Condensing the argument, ALE offers a high starting yield, rare inflation protection and good prospects for modest capital growth. We believe the stock would be at home in most income portfolios.

This review offers a recap of the investment case, and also discusses some important changes to the group’s hedging strategy, a related institutional equity placement and a share purchase plan that retail securityholders will need to mull over soon. Firstly, let’s quickly revisit the investment case.

Inflation protection

ALE Property Group owns but doesn’t operate 87 pubs across Australia, with about half the portfolio in Victoria. On the whole, these pubs are in suburban locations but the portfolio also has a few marquee properties, including the Young & Jackson in the heart of Melbourne.

The pubs are all on long-term leases to Australian Leisure & Hospitality (75% owned by Woolworths). The rent paid by ALH to ALE isn’t dependent on the operating profits of each pub – it’s based on an amount that was set years ago and which will grow each quarter in line with official inflation rates, until a full independent review in 2028 (with a smaller review in 2018).

This means that distributions from ALE have a strong element of inflation-protection, in contrast with many traditional income investments, such as fixed interest securities, which suffer in an inflationary environment.

Another point of difference for ALE is the ‘triple net’ lease structure that applies to 84 of its 87 pubs. The tenant, not the landlord, is responsible for just about every expense related to the property – from rates and insurance through to maintaining the buildings at a high standard. So the cash flowing through to securityholders is genuinely net rent; there’s no chewing through the capital base going on here.

Growth potential

But ALE also offers growth potential ahead of inflation. With ALE’s permission, the tenant has been using its own money to expand and improve many of the pubs in the portfolio, and also adding Dan Murphy outlets to the grounds of 20 of ALE’s pubs. Over the past five years, ALH has spent about $250m on such developments (a large amount compared with ALE’s current market capitalisation of $400m).

For the past few years, the group’s debts have also been inflation-linked, through the use of a hedge based on the consumer price index. We outlined the fairly complex hedging strategy in our initial review, and the strategy made sense from an inflation-linking perspective – when revenue inflows and interest outflows are both growing in line with inflation, the remaining free cash flow, used to pay distributions, should also grow roughly in line with official inflation numbers.

Where the strategy caused us some concern was in terms of refinancing risk. Whereas conventional debt either holds steady in nominal terms or amortises down with principal repayments, the ALE debts were effectively ballooning in nominal terms (although holding steady in ‘real’, after-inflation, terms) due to the hedge. Recent announcements from the group highlight a significant change on this issue.

New hedge strategy

Though the CPI hedge was scheduled to last until 2023, the bank counterparty on the other side of that derivatives transaction has the right to break the hedge in December 2012 (ALE has the right to break any time). Management recently concluded that the hedge was likely to be broken in December by the other counterparty and has taken the opportunity to reassess its whole hedging strategy.

ALE has been in discussions with banks on new and simpler hedging strategies, including a replacement CPI hedge and more conventional nominal hedges. Last week the group said it was in the process of locking down a nominal hedge that, while not explained in detail, we’ve taken to mean a more conventional fixed rate hedge.

According to management, the new hedges will have maturity dates of 2020 or later, with limited, if any, rights for the bank counterparty to break. Low long-dated interest rates mean now is a good time to lock in a low fixed rate while retaining most of the protection benefits of a CPI hedge.

The benefit of the changed structure is that ALE’s debts will no longer ‘balloon’ with inflation. So distributions, previously destined to grow roughly in line with reported inflation, are now likely to grow at a faster clip. Whereas ALE securityholders should previously have been ambivalent about inflation (being roughly ‘hedged’), they should now be hoping for inflation. The stock now offers a high starting yield with inflation-plus growth characteristics.

No free lunch

But of course, there is rarely a free lunch. In this case, we had anticipated the cost would be in the form of lower immediate distributions (management had previously forewarned as much). So it was pleasing to see that management provided distribution guidance for 2012/13 of ‘at least 16 cents per security’ (in line with 2011/12 distributions).

Instead, the costs will be paid in dilution. Last week, the group announced an equity placement to institutional investors to raise $40m (at $2.13 per security) and a further $40m institutional issue of new ALE Notes 2 income securities (increasing debt for the group).

This raising is needed to cover the gap caused by the hedge unwinding – as well as an escalation balance of $36m (representing the ‘ballooning’ since the hedge was implemented in 2007) there are also break payments related to movements in interest rates, partly offset by mark to market gains of $23m on some opposing hedges. The uncomplicated explanation is that the group needs cash now to fund the change.

This institutional raising will be followed by a non-underwritten Share Purchase Plan to retail investors, allowing them to apply for up to $15,000 worth of shares at the lower of $2.13 or a 2.25% discount to the volume weighted average price over the five days prior to close on 26 November. Note, the closing date for eligibility was prior to the raising announcement: buying stock on the market today will not confer an entitlement to participate.

The raising allows ALE to go from an inflation-linked to inflation-plus distribution profile with no change in immediate distributions. The cost will be paid in terms of the potential future capital gains – the benefit of all that money ALH has been spending on expansion in recent years will now be shared among a larger securityholder base. On the whole, we think it’s an acceptable price to pay but just wanted to note it’s not all upside and no downside.

Attractive risk/reward

We also recommend existing securityholders carefully consider the share purchase plan. There may well be a scale back, but if you’re entitled to participate and don’t yet have a full weighting in the stock, it’s something of a no-brainer. The opportunity to buy more stock on a 7.5% starting yield with inflation-plus growth characteristics and decent prospects for further modest capital growth almost sells itself. While the investment is far from risk-free, given ALE’s fairly significant but not inappropriate debts, we think the risk/reward ratio is attractive.

If you’re already butting up against our suggested 5% portfolio weighting or whatever weighting you’ve deemed appropriate, it doesn’t mean you should necessarily ignore the offer. It’s worth considering arbitrage, as outlined in How to profit from a share purchase plan on 17 March 2009.

The stock is currently trading at a 6% premium to the offer price and, if that holds up, it might make sense to apply for some new stock closer to the 26 November closing date and sell an offsetting amount of your existing holding before or after the SPP closes, the latter making an allowance for a potential scale back. If you do plan to invest through the SPP, make sure you’ve got your application in before the closing date of 26 November.

As for those income investors who don’t currently own the stock, we suggest at least putting it on your watch list. The price might weaken a bit if the new institutional buyers decide to sell some of their stock in the coming days. But we’re fairly comfortable with the current price already, and have marked up our recommendation guide to reflect that. At today’s price of $2.25, the stock offers a 7.1% starting yield and the same inflation-plus characteristics and capital gains potential outlined earlier. BUY FOR YIELD.

Note: The model Income portfolio own ALE Property Group.