Downgrading VRT and Arena

After strong runs, we’re keeping watch on two key income stocks.

Downgrading Virtus Health (VRT) to a hold

Virtus recently acquired the Canberra Fertility Centre, which controls 35 per cent of the ACT assisted reproduction market. The $3.5 million acquisition is fairly immaterial in the grander scheme of things but it adds to the network across the eastern seaboard.

The company appears well placed to benefit from long term demographic trends such as the increasing number of women in the workforce, the rising number who postpone starting a family as a result, and the increasing incidence of diseases such as chlamydia and obesity that point to increasing demand for assisted reproduction services in coming decades.

The company’s share price has risen seven per cent since our last update (read more here: Why we still like Virtus), taking it past our projected price of $7 – today the stock is trading at $7.13. Now selling on a forward PER of 17 and dividend yield of 3.9 per cent, we’re downgrading it to Hold.

Disclosure: the author owns shares in Virtus Health

Moving Arena REIT (ARF) to a Hold

A-REITs (AKA listed property trusts) such as Arena REIT are viewed as ‘’bond equivalents’’ due to their generally higher yields and lower growth compared to many other companies trading on the ASX. As such, with Australia’s ten year yield bond rate plunging to historically low levels after the RBA recently cut official interest rates to 1.75 per cent, their (generally unfranked) dividends have become even more attractive to investors.

This is merely a continuation of the ‘’search for yield’’ that has played out in recent years both in Australia and overseas and which has helped push up A-REIT share prices as investors are forced to pay more for yield.

For its part, we recently met with Arena REIT’s management and remain comfortable with its outlook. However, with full occupancy, leases averaging around nine years before expiry and rents that generally rise by the greater of inflation or 2.5 per cent each year, most of its growth will come from periodic market rent reviews and development, along with any future acquisitions.

Thirteen per cent of its portfolio is subject to market rent reviews during the second half of 2016, with rental increases limited to between zero and 7.5 per cent. Half of its $60m development pipeline has been invested to date, with five of the six early learning centres that it’s building for and leasing from the state of Victoria at a cost of $15 million due for completion in January 2017. These will be sub-leased to the YMCA on very long-term leases.

Based on conversations with management, it appears the market for childcare centres may be peaking, with supply rising faster than demand. All things equal (i.e. ignoring any further declines in interest rates), this may lead to higher capitalisation rates and hence lower prices for childcare centres, although the fundamentals of each childcare centre and its surrounding market mean the prices of individual centres will continue to vary, in some cases significantly.

Heavily regulated by the government, we also await announcements by both parties during the on-going election campaign and their potential impact on the childcare sector.

Arena REIT shares have risen six per cent since our last review, to $2.00, and are now hovering around our projected price of $2.01. As such, we’re also downgrading it to Hold.