Another round of ALE?

The first recorded use of that confounding idiom ‘you can’t have your cake and eat it too’ is said to have been by Thomas Howard, 3rd Duke of Norfolk, in a letter to Thomas Cromwell. The Duke might have had three castles, but he obviously never owned a bakery.

It’s also unlikely he successfully invested in stocks, where a stock offering potential growth – the cake – and generous dividends – the eating of it – is what income investors thirst after. Pub owner ALE Property Group, offering a generous starting yield of 6.4% and capital growth potential might just slake that thirst.

Since first introducing the company in ALE Property: Down in one from 2 May 12 (Buy for Yield – $2.08), the security price has risen 20%. But, for reasons we’ll explain, it’s still cheap enough to re-enter the Buy list.

Let’s get the boring bits out of the way first. ALE owns 87 Australian pubs, mainly in Queensland and Victoria (see Chart 1). These are leased to Australian Leisure and Hospitality (ALH), which is 75% owned by Woolworths and 25% by Bruce Mathieson. ALH’s leases on these properties run until 2028, with four 10-year extension options.

Collectively, these assets are valued at $785m on capitalisation rates (cap rates) of around 6.8%, financed roughly half by debt ($385m) and half by equity. A debt-to-asset ratio of 50% appears high – and it is – but in the context of the leases and tenants, both of which are first class, it’s much less of a concern.

Potential for rent increases

After unwinding a series of complex hedges in 2012, debt levels should fall as CPI-linked rent increases increase the value of ALE’s properties. Taking advantage of the low interest rates, the company has locked in a 10-year, 3.8% interest rate over its bank debt (around two-thirds of total debt) with no major refinancing due until 2016. The message is: don’t sweat the debt.

To the more interesting stuff. In one sense, ALE Property Group is a typical property portfolio delivering low risk, stable income. But a review of the lease arrangements reveals a few special conditions that turn ALE from potentially interesting to quite compelling.

First, the leases are ‘triple net’. This means all expenses relating to the properties – electricity, water, taxes (except land tax in QLD), rates and, most importantly, maintenance spending – are borne by the tenant. If a pub needs repainting or a roof replaced, ALH foots the bill.

This means that after paying management fees, interest and land tax in Queensland, what’s left is paid out to ALE owners. Bet you can’t say that about your investment property?

Second, ALE has built-in inflation protection because rents automatically rise with the rate of inflation.

Understand, though, that profits in the pub businesses are growing much faster than the rate of inflation. In fact, we estimate that between 2004 and 2012 ALH grew pub profits at around 5% a year, well clear of the 2.8% inflation rate.

That might not sound like much but compounded year after year it adds up. And it has a major impact on ALE because, as each year passes, the gap between the rent received by ALE from ALH and market rent, based on a percentage of pub profits, widens.

Chart 2 demonstrates this nicely. Assuming pub profits keep growing at a pace greater than CPI, the rent paid to ALE becomes a smaller and smaller portion of ALH’s overall profits.

That makes ALE’s current income even less risky. But the real kicker is in the potential this offers for significant rent increases. The first rent review is in 2018 and is limited to a 10% change. We estimate ALE will receive close to a 10% increase but, by 2028, when the portfolio has a full market rent review, it could rise far more. What’s that about cake and eating Thomas?

But it gets even better. ALH, with permission from ALE, can expand or build new stores (such as Dan Murphy’s) on ALE sites. This spending, which has totaled around $250m so far, is paid for by ALH but is owned by ALE at the end of the lease. Twenty Dan Murphy’s have been built so far and, according to management, there’s scope to add another 20 or so.

What’s ALE worth?

Let’s see how this might play out over the next 15 years and what it might mean for returns

There are a few key assumptions that will dictate how much ALE is worth. Table 1 contains nine values, each adjusted for different scenarios and return expectations.

The key assumption relates to pub profit growth and CPI over the next 15 years.

In the base and bull case we’ve assumed CPI rises at 2.5% a year over the next 15 years – a tad below the long run average. The bear case assumes it drops to 1.5% as the overall economy slows, perhaps due to a downturn in China.

The next key assumption relates to pub profit growth. In the base case we’ve assumed that after a decade of prosperity pubs face a tougher 15 years and only generate real growth of 0.5%. The bull case assumes real growth of 2% – still less than historical rates – while in the bear case we assume it also falls to 0.5% (in a lower CPI environment).

These assumptions are conservative. ALH is the best pub operator in the country with vast experience and the buying power of Woolworths behind it. These pubs should generate higher profits than industry averages and be resilient to recessions. But we don’t want to invest on the basis that the most rosy scenario must play out for the case to stack up, hence the risk-averse approach.

By combining our expectations for CPI and pub profit growth we can estimate market rent in 2028. Even in the bearish scenario rent could jump at least 10% in 2028, and multiples of that aren’t out of the question.

Now we need to turn that future income into a capital value via a capitalisation rate. Pub profit growth and how much the market is willing to pay for pubs is linked. Both move in tandem. When profits are rising cap rates are likely to fall (lower cap rates lift property values) and visa versa.

In the base case we’ve assumed pub cap rates rise from their 2013 level of less than 7% to 8%. In the bull case they’re unchanged at 7% and in the bear case they blow out to 10%. But even in the bear case, the significant under-renting should help insulate current investors against any sharp distribution falls.

To one last kicker: remember all those Dan Murphy’s? Until 2028 ALH doesn’t have to pay any rent on those stores. Having spent an estimated $60m-$100m on sites so far, with scope to spend the same again, they may add another $5m-$15m to rent in 2028.

Finally, we must estimate the interest rate on ALE’s debt. We’ve assumed a rate of 6% (well above the recent long term hedge of 3.8%, which expires in 2022) for the base and bull case and a lower rate of 4% for the bear case, predicated on lower economic growth and therefore interest rates.

Perfect income stock?

So, that’s the entrails of our model laid out before you. Let’s pull it all together. Even in the bearish scenario on an aggressive 12% required return ALE is worth around $1.70 – or 30% less than today’s price. With limited downside, a decent running yield and potential for growth via rent rises, that makes it the perfect stock for risk averse and income focused investors.

The base case delivers an annual return of just over 10% – better still if a few things fall in our favour.

Of course, it all depends on the rate of return you’re aiming for. If you’re a younger investor with years of work ahead, or you’re willing to wait for the ‘fat pitch’, you may demand higher returns and wait for a lower price, accepting that you may not get one.

But if you want respectable returns from a stable, inflation-linked income source with upside potential, ALE is a perfectly baked cake that you can own and eat right now. We've increased the 'Buy' price to $2.70 and are upgrading ALE Property to a BUY for up to 6% of your portfolio.

ALE Notes 2

ALE Notes 2 are a listed debt security issued by ALE due to be redeemed in August 2014 (although ALE has the option to extend repayment for up to two years). They pay a quarterly coupon equal to the bank bill swap rate (currently 2.8%) plus 4% on their face value of $100, which equals to a current yield to maturity of around 6.5%. They’re an attractive alternative to a term deposit where returns are currently half that. Still, they’re not a replacement for an equity investment.

In this regard we favour owning the ordinary equity, although the official Notes 2 recommendation remains a HOLD.

As such we’re selling the 60 ALE Notes 2 from our model Income Portfolio for $101.15, banking $6,069. We’re using a portion of proceeds to top up our holding in ALE, buying 400 securities for $2.50, for a total of $1,000. The remainder will be kept as cash, our preferred low-risk investment. On-call cash is immediately available when it’s needed, granting us the flexibility to pick up bargains swiftly as they arise – something that can’t be said of a term deposit or an illiquid income security.

Note: Our Income Portfolio owns securities in ALE Property Group.