HPI: beer we go again

ALE Group has been one of the most successful investments on the Australian Stock Exchange since listing in 2003, producing a 21% total annual return (capital gains, deferred taxes plus distributions).

We upgraded Australia's largest pub landlord in ALE Property: Down in one on 2 May 12 (Buy for yield – $2.08). With distributions since then of 32 cents and a share price now of $2.85, that's a total return of 52% – an exceptional two-year return for such a safe business offering inflation-protected distributions.

ALE is unquestionably a superior business to its smaller rival Hotel Property Investments (HPI), which listed back in December. But, as we're about to explain, there's only one advantage HPI needs to be a superior investment.

ALE's pubs are operated by Australian Leisure and Hospitality, a joint venture between Woolworths (75%) and Bruce Mathieson (25%), while HPI's pubs are run by the Wesfarmers-owned Coles. But it's the geographic spread and quality of ALE's portfolio of pubs and the structure of their leases that explains why ALE is a superior business to HPI.

ALE's portfolio is more diversified, with 34 pubs in Victoria, 32 in Queensland, 10 in New South Wales, seven in South Australia and four in Western Australia. In stark contrast, 95% of HPI's pubs are located in Queensland, with 5% in South Australia (see Chart 1). That means HPI is more exposed to potential changes in Queensland's liquor laws, which could increase competition and reduce the value of HPI's pubs and bottle shops.

ALE's pubs are also higher quality with a weighted average capitalisation rate almost 1% lower than HPI's (see Table 1) because they are mostly located in capital cities, particularly Melbourne and Brisbane.

While HPI owns more than a dozen pubs in and around Brisbane (see Chart 1), including Queensland's 2013 pub of the year The Regatta Hotel, its pubs are mostly located in regional areas such as Gladstone and Cairns on the North Queensland coast.

As any pom currently living outside of London will tell you, regional areas are often more affected by recessions than major cities. But HPI's leases provide plenty of protection for distributions, as HPI's average lease expires in nine years and Coles has options to roll them over for combined periods totaling up to 20 years.

So even if Banana Benders start drinking less XXXX, in the short to medium term that will be Coles's problem not HPI's. The rent must get paid and Coles is unlikely to want to forfeit a well located property to a rival like ALH looking to expand while it can get a good deal.

Inflation

The vast majority of HPI's leases stipulate annual rent increases of the lower of 4% or two times the five-year average inflation rate (as measured by the rise in the consumer price index). Under normal circumstances that will protect against inflation (the RBA targets a range of 2–3%).

However, if inflation increased substantially beyond 4%, which has happened in the past (see Chart 2) and could happen again, particularly if the Aussie dollar were to fall substantially, then ALE would provide far better protection. The longer CPI stayed above 4% and the further above 4% it went, the more you'd wish you had stuck with ALE Group. That's because ALE's leases provide for annual CPI increases and a potential 10% rent increase in 2018 potentially followed by even larger increases following a market rent review in 2028. That should be a banner year for ALE, as ALH has spent over $200m on renovations so far that aren't fully reflected in ALE's rents or property values.

All things being equal, ALE's leases are also more valuable because ALH, unlike Coles, is largely responsible for all outgoings, upkeep and major improvements under what are known as 'triple-net' leases (see Shoptalk). In contrast, HPI pays for expenses such as maintenance and repairs.

Unlike ALE, HPI also pays for property improvements or major refurbishments, which means HPI will require more money to invest over time (either by increasing debt or raising capital). But with each project that's negotiated with Coles, HPI should earn a return as soon as the projects are finished rather than having to wait for rent reviews well into the future like ALE (albeit ALE doesn't have to fork out any cash). If HPI and Coles can't agree on terms, then HPI doesn't have to invest a dime.

Over time we expect renovations to add plenty of value, but unfortunately we're unable to judge the performance of Coles's pub management skills as Wesfarmers folds the performance of its pub division in with its liquor division.

Half-full

In summary ALE's portfolio is safer, it offers superior protection against high inflation and rents have the potential to increase by 10% in 2018 and a lot more in 2028. HPI's portfolio is lower quality and riskier, but investors don't have to wait to earn a return on renovations, albeit they do have to pay for them.

The most important difference between ALE and HPI for today's investor, however, is price. While ALE offers a yield of 5.7%, after falling 5% from its float price, HPI offers a yield of 8.0%. That's a pretty attractive starting yield for a business that should grow over time with acquisitions and by expanding and refurbishing existing properties, and whose earnings and distributions are protected from recession by long leases and a tenant with very deep pockets.

Note that your personal taxation situation may have a bearing on the attractiveness of HPI compared to ALE. ALE's distributions are mostly tax deferred and should remain that way for several years yet (the figure should be at least 75% in 2014), while HPI's distributions are less than 20% tax deferred. We recommend seeking professional financial advice if you're unsure how this affects you.

As HPI is riskier than ALE we're initiating coverage with a 4% portfolio limit (the limit for ALE is 6%). And while we'd much prefer to buy as far below $2 as possible to increase our margin of safety, we're happy with HPI as a BUY up to $2.10. We recommend patience if the price increases beyond $2.10 as the price you pay for a property trust matters a lot, given the narrower range of potential outcomes compared to most high-quality operating businesses.

Note: We're purchasing 3,000 shares of HPI for our model Income Portfolio at $1.995 for $5,985.