Australand: Sold

Progress is cumulative in science and engineering,’ warns Jim Grant, ‘and cyclical in finance’. Again and again, investors refuse to learn this painful lesson.

Sharemarkets are complex systems and inherently unstable. But the more distant the last crisis becomes, the more investors act like goldfish, forgetting history and repeating past mistakes, albeit slightly differently.

In the aftermath of the GFC, stocks carrying high debt were cast aside. Infrastructure stocks like Sydney Airports and Spark Infrastructure, both generating reliable profits to service that debt, were available at bargain prices. Yes, those were the days.

Australand Holdings, boasting a $2.1bn portfolio of fully tenanted commercial and office property, fell into this juicy fruit basket, which is why we upgraded it in Pouncing on downtrodden developers from 22 Jan 10 (Long Term Buy – $2.375*).

Investors, weary after several capital raisings, were steering clear of Australand despite its safer financial position and 8.6% distribution yield. All three stocks have since delivered excellent returns.

Selling out

Australand's total return of 48% (or 16% per year) compares favourably with the measly 6.5% return of the All Ordinaries Accumulation Index. You may have fared even better had you followed more recent recommendations.

The remarkable thing about this high return is that absolutely nothing has changed except investors, previously sceptical of any business with high debt due to painful memories of the GFC, are now desperately bidding up any stock sporting a decent yield with scant regard for the risks.

Australand's recent capital gains and the popularity of the recent batch of hybrid income securities shows that once again investors are falling for the same trap of 'reaching for yield' that caused so much grief when the GFC struck. Like the average holding period of a stock, financial memories are shrinking to unbelievably short periods and it's time to lock in our gains and sell out.

Transformation

Over the past decade, Australand has been transformed from a risky property developer into a more reliable property owner, culminating in its inclusion in the A-REIT Index last year, alongside giants such as Westfield Group and GPT Group. The company now owns a $2.1bn commercial and industry property portfolio, built from largely from scratch over the past decade.

Australand usually only develops buildings for tenants prepared to commit to space prior to breaking ground, which reduces the risk of vacancies. It also means it can bank development profits before enjoying a relatively steady stream of rent that grows with inflation.

Growth will likely slow in future, though. Its properties are almost full so there’s only one direction vacancies can go. Also, Australand’s portfolio is far larger than it used to be, so each development has less of an impact on profits and distributions. Despite the expected completion of the $180m building at 357 Collins Street this year, distributions are expected to remain flat at 21.5 cents.

The company’s residential development division is its problem child. Like battered rivals such as AV Jennings, Devine and Sunland, Australand hasn’t produced satisfactory profits due to lower property prices and demand, miserly credit growth and onerous development costs, a fact the company is keenly aware of.

In 2009, chief executive Bob Johnston outlined a goal of increasing the residential division’s return on capital employed ‘to at least 12%’ by 2012. As 2012 draws to a close, returns remain stubbornly low at 8.4%, below the five year average of 8.8% (see Chart 2).

Profits aren’t expected to increase substantially from here, either. It would be better if the division were sold or wound down and the cash used to reduce debt, expand the portfolio or returned to securityholders.

It doesn’t look as though that’s going to happen. Until profits from this division increase substantially, Australand deserves to trade at a 14% discount to net tangible assets per security of $3.46.

Weak case to Hold

With the security price increasing 25% since the original Long Term Buy recommendation, the yield has fallen from the original 8.6% to 7.0%. Compared with a bank term deposit, that might appear attractive but with a reliance on volatile development profits and relatively short-term bank debt, it comes with plenty of risk.

A more appropriate comparison is Westfield Retail Trust, an altogether safer proposition, which trades on a yield of 6.3%.

The case for holding on is therefore weak. Interest rates would need to continue falling, returns from the residential development business would need to rise and the possibility of further capital raisings would need to be low to warrant a Hold recommendation.

Having lamented missing the opportunity to sell at a similar price around 18 months ago (see The buy and sell strategy), we’re not going to miss the chance this time. Progress in finance is, as Jim Grant says, cyclical. We may get another chance.

If the security price falls back to levels that compensate us for the risks, perhaps at around $2.50, we’ll look to upgrade once again but with the price increasing 8% since 30 Jun 12 (Hold – $2.77), we’re banking our profits. SELL.

Note: The Growth portfolio is selling 2,180 securities at $2.98 each netting the portfolio $6,496.

For more on Australand tune in to our recent Boss Talk interview with Bob Johnson Australand’s managing director.

*Adjusted from the 5 for 1 consolidation in April 2010.