Regional Express

Significant win for REX

In my last update for Rex, I noted that I was going to hold my position till I see a trend reversal in passenger numbers.  Recently Rex had their AGM and announced a few interesting developments which I think may reverse the declining passenger numbers, amongst other things.

The important bits worth noting are:

  • Rex has been selected as the preferred tenderer for the Perth-Albany and Perth-Esperence regulated routes.
  • Fuel hedge will bring additional savings of $4.5 million in FY16
  • AAPA reaches agreement to train cadets for Vietnam Airlines commencing FY16
  • Pel-Air’s Fast Jet contract with the Australian Defense Force has ceased.

The WA selection of Rex for the above two regulated routes is significant given the passenger traffic on these 2 routes.  To give relative traffic on these routes, the 23 Queensland routes which were awarded to Rex in total have about 38,000 annual passengers.  Perth-Albany and Perth – Eseperence have about 58,000 and 45,000 pax p.a. respectively.  Aggregate of these routes are about 10% of current passengers flown. These 2 inaugural routes may open up further opportunities in WA.

On the downside, Pel-Air’s Fast Jet contract has ceased.  Based on the information released by the AusTender, I estimated that this will result in a revenue loss of approximately $7.5 million p.a. based on disclosure from AusTender.

Based on the results in FY2015 and factoring in the above developments, I estimate that the recurring NPAT over a 12 month period is potentially $12.5 million as shown below:












Note that this is not a forecast for FY2016 as the WA routes revenues will only commence in February so will at maximum contribute 5 months of incremental revenue in FY2016 notwithstanding the one-off set up costs for commencement of the routes.  The above analysis is really to show the potential run-rate moving forward.  Obviously things can and will change but $12.5 million is not unreasonable given Rex had achieved NPAT of $14.0 million in FY2013.

As mentioned in my previous post, cash generation is still strong as the depreciation of nearly $16 million is non-cash and the level of debt should come down substantially by the end of FY2016.  I estimate by the end of 2016 barring any major capex spend (excluding the $6.2 million for the new catering facility) the company should be debt free (cash > debt).  My view is that dividends will resume at the latest at the end of calendar 2016, triggered by either a turnaround in passenger numbers (downtrend for continuous 7 years) or when company becomes debt free.

The continuation of dividends would be a catalyst for the stock to move higher.  I’ll wait for the half year results to see how passenger numbers are tracking before changing my stand on Rex.

Floating rate notes


Floating Rate Notes

I thought I write a bit about floating rate notes (FRN) as when the price is right, it can be a good investment for those who need a steady income.

So what are floating rate notes? According to Wikipedia:

“Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (a.k.a. quoted margin). The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.”

In the Australian context, LIBOR is replaced by the bank bill swap rate (typically 90 day BBSW).  FRNs are rank below senior debt (subordinated), unsecured with the typical face value being $100.  As these securities pay floating rates, they have less inherent interest rate risk as compared to a fixed coupon debt instrument and are traded on the ASX.

The following table shows the key terms of some of the FRNs traded on the ASX.


Note: The margin on the Crown’s subordinated notes II is actually 4.00%.

Currently, the three FRNs which are trading below par are Crown Notes I & II and Origin Notes.  The closing prices today were $99.4, $90.2 and $94.7 respectively.

Given that these are debt securities, the key risks are as follows:

  1. Default risk. Under a liquidation scenario, senior debt holders have priority over subordinated debt holders
  2. Risk of interest payment being deferred either due to mandatory deferral or at the election of the issuer.  For both the Crown and Origin notes, mandatory deferral is triggered when certain solvency ratios are breached.  The mitigating factor against optional deferral is that interest payments are cumulative and compounding and until all accrued interest have been paid, neither Crown nor Origin is able to pay a dividend or perform a share buyback (i.e. dividend stopper).
  3. Liquidity risks.  In general, the FRNs aren’t massively traded on the ASX but are liquid enough so as not to cause problems for an average retail investor.

Evaluating Crown Resorts Notes I, II and Origin notes

Crown and Origin are both going through somewhat difficult times.  MelcoCrown, an associate company of Crown is experiencing a significant slowdown in its casinos in China whereas Origin is suffering from depressed oil and LNG prices.  Shares of Crown and Origin over a 12 month period have fallen by 29% and 59% respectively.

The current S&P credit rating for Crown is BBB (stable) and for Origin credit rating was downgraded to BBB- in April 2015 and reaffirmed by S&P today.  The solvency ratios over the past 5 years for Crown and Origin are as follows:






Note: (1) Interest coverage ratio = Normalised EBITDA/ net interest paid; (2) Leverage ratio = Gross debt / Normalised EBITDA (Origin: the testing date for the  leverage ratio was amended so that it is not tested and reported from 30 June 2013 to 30 June 2016.

The interest cover and leverage ratios are disclosed by the issuers and I have calculated the debt to capital ratios.  Although the leverage ratio after 2012 has not been disclosed by Origin, the debt to capital ratio has risen significantly over the last 5 years.  One of the reasons for the increase in debt is the development of the Australia Pacific LNG project which is budgeted to cost $25 billion with Origin having a 37.5% stake.

Although not disclosed, I’ve calculated Origin’s FY2015 leverage ratio to be 5.6x (total debt of $11.9 billion and underlying total debt EBITDA $2.1 billion [includes $400 mil from discontinued operations]) which is above the leverage ratio threshold for mandatory interest deferment.  Origin’s debt maturity profile is as follows:FRN3

In addition to its announcement today to raise $2.5 billion rights offer, Origin has announced a few initiatives including cost savings, asset sales and dividend reduction plans.  In FY2016 Origin is expecting to raise $4.1 billion from the above rights offer and sale of the contract energy division. However On the other side, it is also expecting capex of approximately $2.5 billion in FY2016.

Standard & Poor today reaffirmed Origin credit rating of BBB- (stable) which is a good sign and given it has no loans maturing in 2016, it is possible that the proceeds from this rights offer will be used to settle the FRN ($900 million) on its first call date in Dec 2016.  There will be an incentive to settle this at the first call date as the ratings agencies have allowed the 50% of the FRN to be treated as equity (equity credit) for credit rating purposes for the first 5 years only.  The end of the 5 year period coincides with the first call date.

As for Crown, it is currently in a better financial position as compared to Origin but from a capex cycle perspective they are at opposite ends.  Crown is about to start a capex spending spree on new casinos whilst Origin is coming to an end of its capex cycle.  Some analyst have estimated that Crown will need to spend north of $3 billion on new projects (Crown Sydney >$1 billion) over the next 4 years.  The majority of Crown’s earnings are from its Australian assets and normalised net profit after tax (NPAT) is in excess of $500 million in FY2015 whilst net debt is $2.2 billion.  Interest cover and leverage ratios are strong and Crown will have options available to them when it comes to funding the capex.

Crown’s debt maturity profile is as follows:


In assessing the yield or rate of return for the above notes, I have assumed the following:

  1. Settlement of the FRNs at the first call date given the lapse of the equity credit by the rating agencies;
  2. Assumed a constant BBSW of 2.18% up to the first call date (assumed maturity).  Can use the yield curve to estimate the 3 month forward BBSW for each interest payment period but for simplicity I’ve kept it constant; and
  3. Adopted last traded price at 29 September 15.

My valuations results are as follows (workings attached below):




Based on the above results, compared to Crown, I would rather invest in GJT whereby I would get a somewhat similar dividend yield plus potential for capital gain.  In my opinion, the risk reward ratio is more favourable for an investment in GJT.

However, with the rights issue and recent confirmation by S&P on its investment grade ratings, the Origin notes look interesting at a yield of 11.4%.  This assumes maturity in December 2016 and there is a risk of Origin not calling the notes at the first call date.  Hard call this one but worth a closer look.

The yield to maturity workings are as follows:


Regional Express

Flying through the fog …

Regional Express FY2015 results

Rex recently announced its FY2015 results and it was a mixed result with both favourable and unfavourable elements.  Let’s start with the bad news:

  • Passenger numbers were down again. YOY it fell another 2.7% and this is the 7th year of continuous fall in passenger numbers.  I am convinced that the ticket prices are too high as the passenger numbers have fallen in spite of winning so many new routes in Queensland.
  • Salaries continuing to grow at a faster pace than revenues. This may be due to the mobilisation cost for new Queensland operations.
  • Rex fell to 2nd spot from 1st last year on the airline reliability index which measures on-time departures.

There were a few positive developments as well:

  • Significant expansion of the routes in financial year with the Queensland routes increasing the route network to 53 destinations from 36 last year. Rex now has the scale to further expand the route network in Queensland.
  • Fuel for FY2016 hedged which will bring savings of $4.5 million.
  • Cash generation still good. Cash from operations was $23 million, which is very similar to adding back depreciation ($15.8 million) to net profit ($6.7 million)
  • Borrowings were paid down and net debt is now $12 million compared to $22 million last year.
  • WA will call tenders for the provision of RPT services to various regional towns and Rex may tender, which is a good opportunity to further expand the network.

So what does this mean?

I think Rex’s strategy of increasing ticket prices to offset operating cost escalating is not a sustainable strategy as I’m convinced that the high air fares are driving away passengers. Load factors have decreased from the high 60s in 2008/09 to the mid 50s (2013 onwards).

Having said that Rex still has a dominant position in the regional aviation sector and it’s ability to generate cash flow is excellent.  Capital expenditure is lower than depreciation so free cash flow is higher than the reported net profits.  The Saab 340s will operate for at least another 10 years so I expect capital expenditure levels to be broadly flat.

Rex is still trading at a significant discount to the book value which means the down side is low.  However, for the share price to move up, the market must see some growth and the escalating airfares are not helping the passenger numbers to grow. At the current share price ($0.90), I’m holding my position until I see a reversal of the trend in passenger numbers.

Galileo Japan Trust

Land of the rising GJT…

Galileo Japan Trust FY2015 results

GJT announced its FY2015 results last week.  All in all, it was a strong set of results from the Company with a nice surprise from the rental revisions.  The key positive highlights are:

  1. In the recapitalisation memo in late 2013, management forecasted the annualised pro-forma net profit to be A$18.2 million (assuming A$1: ¥88) and the recurring net profit for FY2015 was $17.8 million (average exchange rate A$1: ¥95).  Even with a higher Australian dollar, they managed to perform in-line with the pro-forma.
  1. GJT to pay out dividend of $0.149 in FY2015, also in-line with its expectations and is 42% higher than $0.105 paid in FY2014.
  1. Weighted average cost of debt falls from 2.7% (FY2014) to 1.9% (FY2015) as a result of an early refinance of Eurobonds in Oct 2014. GJT paid $68 million including accrued interest to acquire all the Eurobonds.
  1. Upward rent revisions on nine office tenancies were successfully negotiated resulting in an average increase over previous passing rent of approximately 13.4%.
  1. The buyback of 1,059,250 units at an average price of $1.79 (below NAV) was completed.

An unfavourable result is that occupancy levels have slightly decreased to 96% (FY2015) from 98.8% (FY2014), details are:

  • Office portfolio occupancy rates: 99.1% (FY2014) vs 97.9% (FY2015)
  • Retail/ mixed portfolio occupancy rates: 98.9% (FY2014) vs 98.5% (FY2015)
  • Residential occupancy rates: 97.7% (FY2014) vs 96.4% (FY2015)

This fall in occupancy is mainly due to the lease cancellation of the single tenant (Tesco) at Funabashi Hi Tech industrial property in Oct 2014 and has remained vacant since.

With regards to the dividends in FY2016, the Company has entered into a forward contract to buy $9.166 million at an exchange rate of A$1:¥87.59.  Based on the current units outstanding of 105.4 million units, this shows that management is confident of paying $0.087 for HY2016; this is a 6% increase over the final dividend of $0.082 paid in FY2015.  Extrapolating this 6% increase over the entire year implies a dividend of $0.157 for FY2016, which in turns implies a 9% forward yield based on current unit price of $1.74.

The dividend yield is very attractive (FY2015 dividend yield – 8.6% and forecast FY2016 – 9%) in the current low interest environment.  Given twin pressures of low commodity prices and record low interest rates, it is unlikely that the Australian dollar will see a material appreciation.  However, although the Yen also has depreciated due to Abenomics, the current low energy and commodity prices should give its economy and currency a tailwind to move higher.

Net asset value has increased from my last post of $2.15 due to slight revision in property values and a fall in the Australian dollar. Nonetheless, using the old net asset value still provides a reasonable margin of safety at current share prices.

Overall, a strong result from GJT.


Ultimate contrarian trade (Part 2)


Greek regulators are finally taking steps to reopen the Athens stock exchange.  After a month of closure, it will be interesting to see how volatile the market will be during the first few days of trading.  Will investors run for the exit or has prospects of a European bailout managed to calmed nerves?

This is a chart of the Athens Stock Exchange index from 1 Jan 2007 to 26 Jun 2015 (last day of trading before closure).  Over this period, the index hit a high on 5334 points in Oct 2007 and fell to a low of 476 points in Jun 2012.  This drop represents a fall of 91%, greater than the fall experienced in the Great Depression.  The index value as at 26 Jun 2015 was 797 points, whilst 60% up from the lows in Jun 2012, it is still 85% below the highs reached in Oct 2007.











A good way for foreign investors to get exposure to the Athens Stock Exchange is by investing in an ETF listed on the New York Stock Exchange called Grek (The Global X FTSE Greece 20 ETF).  This ETF is designed to reflect the performance of the twenty largest securities listed on the Athens Stock Exchange.  The top 10 holdings are as follows:



This ETF has continued to trade throughout the Athens Stock Exchange closure period and its currently trading at $9.75 whilst its net asset value (NAV) of $9.95.  This NAV is however dated, as it is based on stock prices which are a month old (with the exception of the fund’s largest holding Coca-Cola HBC AG which is dual listed in Greece and London).  It appears that the ETF investors are currently not pricing in much movement in NAV once trading re-starts on the Athens Stock Exchange.

Yes, the immediate crisis will be averted by the €86 billion bailout but with this third round of bailout and with even more austerity measures, haven’t we seen the ending to this movie? Einstein once said that the definition of insanity is doing the same thing over and over again and expecting a different result.  It will be interesting to see how investors react to this “insanity” once the market re-opens.

PS: I’m pleased that I’ve wrote about a security which is relevant to visitors from the US … 


Ultimate contrarian trade (Part 1)…

Financial crisis

The current unfolding crisis in Europe intrigued my curiosity about investing in Greek shares during this very uncertain period.  I know that investors tend to overreact and that the best time to invest is when everyone throws in the towel (capitulation), which is typically associated when fear is at it’s highest (be fearful when others are greedy and greedy when others are fearful).  I don’t know a whole lot about the current crisis but I’m quite certain that the 10 million Greeks will still need goods and services and that Greek companies will provide those goods and services regardless of whether Greece stays or leaves the Euro zone. Whether or not these goods and services are exchanged for Euro or new Drachma is not of vital importance in the long term.

To get a sense of potential returns from investing at the capitulation point in a crisis, I have looked at 5 major financial crisis which I think all bear some similarity to what is happening in Greece today.  The similarities are one or a combination of the following: sovereign default, systematic banking failures, drop in GDP and economic activity, asset price contraction, bailouts from either the IMF or ECB, high unemployment rate from jobs losses, political turmoil etc.  For each of the crisis, I have charted the main stock market index from a high before the crisis to a 5 period after a capitulation point was reached. In chronological order:

  • The Great Depression (1929 – 1939) – arguable the worse economic crisis of the 20th century.

US great depression





  • Asian Financial Crisis (1997) – this crisis resulted in massive currency depreciation, bank failures, IMF bailouts and regime change for countries below.

Indonesia (AFC) Korea (AFC) Thailand (AFC)







  • Russian Rubble Crisis (1998) – Default on Russian debt resulted in 66% devaluation of the Rubble with inflation reaching 83%.

Russia crisis





  • Argentinian Great Depression (1998 – 2002) – This depression saw Argentina default on its debt, unemployment of 25%, 80% depreciation of the Peso and fall of the government.

Argentina (crisis)





  • Global financial crisis (2008) – For the countries below, this resulted in massive banking failures and effective nationalisation of the banking sector.  Ireland received an ECB bailout and Iceland’s banking collapse was arguable the largest ever experienced by any country.

Ireland (crisis) Iceland (crisis(





Summary of the extent of the stock market decline for each crisis and the subsequent 1 year, 3 year and 5 year returns are as follows:

Summary capitulation






Note that Russia experience a rapid recovery from higher oil prices. 

The data above shows that the range of stock market falls is between 65% – 95% with the average fall in stock market of about 80% from the high to the low.  In terms of the current Greek stock market falls; from a high point reached in October 2007 of 5334.5 points to the current period (end June 2015) of 797.5 points, the stock market has loss 85% of its value.  Comparing with the above crisis, this fall would rank as the 3rd worse drop in stock market performance.

In my next post I’ll write about how to invest in Greece as a foreign investor (even though the stock market is still currently closed).

Ohh, before I forget … check out this letter penned by Mr. Friedman in 1997 on the Euro.



Galileo Japan Trust

Probably the cheapest REIT in town …

Galileo Japan Trust

Back in 1990, Japanese wealth was being supercharged by one of the greatest asset bubbles in financial history.  Land prices in Tokyo reached such astronomical levels that it was famously said that the imperial palace in Tokyo was worth more than all the real estate in California! What goes up must come down and the real estate bubble popped in 1991. By 2004 residential property in Tokyo was worth less than 15% of their 1991 peak. Here is a graph of commercial real estate values for Japan’s six largest cities from 1971 to 2014 which illustrates the size of the bubble.

Japan land prices

After the bubble popped, Japanese commercial property values fell rapidly to a low in 2004 and have gone nowhere in last 10 years.  However, there have been some recent reports that suggest that the property market is slowly recovering thanks to higher housing demand and the reflationary policies of Prime Minister Shinzo Abe. For an Australian investor, an easy way to get exposure to the Japanese property market is by investing in a Japan focused property group. Two such groups exist on the ASX: Galileo Japan Trust (GJT) and Astro Japan Property (AJP).  I like GJT better.

GJT owns the property portfolio through the Tokumei Kumiai (TK) investment structure.  The TK structure is similar to a silent partnership structure.  Under Japanese law this is a contractual relationship between an investor(s) and a TK Operator where the investor(s) provides capital to the TK Operator who acquires the assets and manages the business venture.  The investor(s) have neither control over the TK Operator nor the business venture but instead has a contractual claim against the business income and assets.

These schemes are set up for tax purposes and the net effect is that GJT will be entitled to 98.5% of the equity (TK Operator provided 1.5% of equity from its own account) and 97% of the profit/ loss of the TK business (TK Operator is entitled to the remaining profit/ loss).

  • Portfolio

GJT controls a mix property portfolio made up of offices, residential, retail and mixed use properties located mostly in the Tokyo and Greater Tokyo area along with a few properties in Osaka.  A snapshot of its properties from HY2015 shareholder’s presentation:

Property portfolio

As shown in the table below, properties values have been falling from 2010 to 2013 whilst gross property yield have been rising.  Occupancy levels have been steady over the last 4 years and close to 100% occupied.

1st table

In 2014, GJT sold two non-core properties:

  1. Doshoumachi in Osaka for ¥800 million which is 14% above its carrying value; and
  2. Lion Square in greater Tokyo for ¥2.385 billion which is a whopping 32.5% above its carrying value.

The results of these transactions may suggest that GJT’s valuation is on the conservative side or a result of them selling their best properties.

  • Financials

I’ve re-calculated the earnings to the unit holders from the reported income statements and removed some of the one-off and non-cash items to give sense of the recurring cash profits attributable to the unit holders.  The pro-forma FY2014 earnings were previously provided by management during the re-capitalisation exercise in the 1st half of FY2014. The recapitalisation exercise significantly reduced debt levels and this enabled GJT to revert back to its focus of managing its portfolio and paying distributions.

2nd table

A few observations I would like to point out:

  1. Management fees as a percentage of average portfolio value are broadly in-line with the fee schedule (0.65% management fee and 0.1% responsible entity fee –reinstated after the re-capitalisation).
  2. One of the reasons why rental income in Australian dollars has fallen from FY2012 – FY2014 is due to the Australian dollar appreciating against the Yen.
  3. One of the key reasons why EBIT has been declining from 2010 was due to the previous strategy of selling off properties to repay debt. As costs did not fall in tandem with the loss rental revenue, earnings declined.
  4. Interest rate on the outstanding debt has also been falling. Based on the HY2015 presentation, the current effective rate is 3.3% p.a. (the above 3.5% was calculated based on finance cost and average debt balance).
  5. Moving forward, without any significant changes to the portfolio, I expect the cash earnings to be in line with management’s pro-forma guidance. Based on the results in  HY2015, GLT is on track to meet this guidance.

Financial Position

3rd table

As at 31 December 2014, GJT had $350.4 million in outstanding debt made up of senior debt (83%) and mezzanine debt (junior and senior) making up the remainder of the debt.  The loans are all due to mature in October 2018 and interest rates are mostly fixed from a fixed for floating interest rate swap facility.  As at HY2015, gearing (debt/ portfolio value) is 62.5% and interest coverage ratio (net profit before interest/ interest) is about 2.5x.  In my opinion, the gearing level is not excessive for a REIT with stable cash flows.

As at 31 December 2014, the book value per unit is $2.15 (which I consider to be its current intrinsic value).

  • Dividend yield and price to book value relative to other REITS

After the recapitalisation exercise, GJT was able to pay distributions and have paid the following distributions:

  • FY2014: 10.5 cents per share
  • FY2015: 14.9 cents per share (estimated)

To get a sense of the recurring level of dividend based on the current portfolio, I estimate that the recurring earnings (assuming exchange rate remains at these levels) to be $17.2 million based on the pro-forma earnings adjusted for the loss of income from the sale of the two properties in FY2014 (they contributed to approximately 6% of the portfolio).  I understand that capital expenditure for maintenance and additions are circa $2 million a year, which leaves free cash for distributions around $15 million or 14 cents per share.  So I believe the current distribution level is sustainable (assuming no major drop in the ¥).

Comparison to other REITS (constituents of the REIT index) on the ASX:

4th table

Based on the above metrics (dividend yield and price to book value) it appears that GJT is the cheapest of this group.  There are 40 plus property groups trading on the ASX and some have a higher dividend yield GJT but I couldn’t find one that had both a superior yield and a lower price to book value than GJT.  In August 2014 GJT announced a share buyback program (maximum buyback lesser of $5.0 million or 10% of its capital).  So far it has bought back about $1.8 million worth of units at prices below the book value per share – great for existing shareholders.

  • Margin of safety

I purchased the shares last year at $1.55 which provided a margin of safety of around 28%.  The margin of safety today (calculated based on the book value per share and current share price) has reduced to about 17%. Whether or not a margin of safety of 17% is adequate depends on your risk adverseness but for me personally, I would probably wait for another 5% pull back from current levels before taking the plunge.  I think with the current Greek problems, there is a real possibility of a drop to that level.

  • Risk Factors

 An investment in GJT is not without risks and the key risks I see with GJT is:

  1. A decline in the ¥ (GJT doesn’t hedge against movements in A$:¥)
    The chart below shows the A$:¥ over a 20 year period.  The average rate over the period is $1:¥81 and the A$ is current trading at the ¥94 level.  So the A$ is trading above its average historical level. I don’t know where the currency is heading to but I believe currency movements are cyclical and mean reverting. The quantitative easing (“QE”) policies in Japan which started in December 2012 have driven the Yen down by 2.3% and 19.3% against the Australian dollar and US dollar respectively.  If recent US experience is anything to go by, then the Yen should spike when the Bank of Japan starts to signal a taper in the QE program. 5th table
  2. Continued deflation in the Japanese economy
    I have no idea whether a deflation environment will further drive down property prices but land price data shows that commercial property prices in major urban areas have grown by 0.1% and 3.6% in 2013 and 2014 respectively. Obviously, a risk exists that deflation may take hold and drive prices down again.  However, intuitively speaking, if Japan’s inflation rate is persistently lower than Australia’s inflation then all things being equal, Purchase Price Parity theory states that over the long run, the Yen should appreciate against the Australian dollar.
  3. Increasing maintenance expenditure (Capex)
    All of the properties in the portfolio were completed between the periods 1986 to 2005 with the majority built from the late 80s to the mid 90s.  So the buildings are not too old and average capital expenditure from FY2009 to FY2013 has been around $3 million a year. This is somewhat less tangible but I believe the Japanese culture of “taking pride and respecting their work place” should mean on average buildings in Japan are better maintained.
  4. Natural disasters
    Japan sits at the meeting point of three tectonic plates and is therefore very prone to earthquakes.  There have been 69 earthquakes greater than a 7.0 magnitude that have occurred over the last 4oo years in Japan.  As a consequence, Japan has one of the strictest building codes in the world and after the 1978 Miyagi earthquake, comprehensive seismic requirements in building standards were introduced in 1981.  All of the properties in the portfolio have been constructed after 1981 and none of properties in the portfolio is currently insured for earthquake damage.  GJT’s policy is to procure earthquake disaster insurance for properties only where the PML is in excess of 15% (none at the moment).  I understand that this is due to the cost of earthquake insurance.
    Earthquakes are nearly impossible to predict and the probability of losses on the portfolio is beyond my capability to assess. So my strategy is too not put all my eggs into one basket and to exit the investment when the share price reaches its intrinsic value (this is not a hold forever type investment).
  • Summary – Key reasons to like GJT

    1. The current dividend yield is attractive (dividends are tax deferred as well) and sustainable (if ¥ holds up). So my strategy is to collect a nice dividend while waiting for the share price to align with the intrinsic value.
    2. Recent properties sales may potentially indicate that the portfolio’s carrying value is below market value.
    3. It provides a hedge (not perfect) in the event the Australian dollar declines. Falling commodity prices and the RBA intent to drive the dollar down worries me.
    4. Tokyo will host the 2020 Olympic games.  This could be a catalyst for a boom in property prices as experience by many past host cities.

So why is the market pricing GJT at a discount to its peers? The most obvious answer to me is due to size, liquidity, GJT not being a constituent of the S&P ASX200 A-REIT index and market’s expectation of a continued decline in the Yen (which I’ve covered in the risk para).

  • Size – GJT’s market capitalisation is less than $200 million compared with most of the REITS mentioned above which have market capitalisation in excess of $1 billion (National Storage market cap is about $500 million).
  • Liquidity – GJT shares are not actively traded so liquidity is low. For example, 11,700 shares was traded today and I hardly see more than 100,000 shares a day being traded.
  • S&P ASX200 A-REIT index – GJT is not a constituent of this index probably due to the size and liquidity issues and therefore unlikely to get the attention of the large institutional fund managers.



Regional Express

Good things come in small packages…

Regional Express Holdings
As a general rule, I stay away from investing in the aviation sector given its tough and volatile business conditions.  But on rare occasions like this one, I bend the rules. Regional Express is Australia’s largest regional airline based in Mascot, NSW.  It was formed by merging the old Hazelton and Kendell businesses, which was sold by the administrators of Ansett in 2001.

Here are 4 key reasons why I like Rex:

  • Sole operator in a substantial number of routes it services – monopoly.
  • Secured key landing slots at Sydney airport – competitive advantage.
  • Good conservative management whose interest is aligned to the other shareholders as majority shareholder is also the executive chairman.
  • Currently cheap, low debt levels and running a share buyback program.

RPT routes
Whilst Rex offers charter services, the bulk of its revenue (approximately 80%) comes from regular passenger transportation (RPT); which will be the focus of this analysis.  Rex is the sole operator on a very high number of RPT routes it services; as shown in table below:

Rex - table 1




Rex route

In terms of regulated/ licensed routes, nearly all of the Rex’s routes in Queensland are regulated whereas slightly more than half of its New South Wales routes are regulated. Notwithstanding the regulated routes, Rex is still the sole operator of many competitive routes in South Australia, Victoria and New South Wales.

Given that these routes are competitive, it begs the question why haven’t Rex’s main competitor (Qantaslink) stepped into the ring?

The answer lies in the type of aircraft and the annual route patronage of these rural communities.  Rex operates a uniform fleet of Saab 340s, a 36 seater turbo prop aircraft which was mostly purchased off lease for approximately $2 million each whereas Qantaslink operates a variety of aircraft with the 74 seater, $30 million Bombadier Dash 8-Q400 making up the largest portion of the fleet.  Given the low annual patronage of some of these smaller routes (sub 50,000p.a) and the competitive pricing by Rex, the economics simply isn’t attractive enough for a company the size of Qantas.  In NSW, I’ve observed that Qantaslink stays away from unregulated routes where the annual patronage is less than 100,000.

Rex has in excess of 540 weekly slots at Sydney airport of which approximately 45% are for peak periods between 7.30am to 9.00am and 5.30pm to 7.00pm.  Rex is the largest holder of NSW regional slots at Sydney airport.  These slots are vital for regional carriers trying to get passengers in and out during peak hours at Sydney airport.  Without primetime slot ownership, it makes it extremely difficult for a new entrant to compete in New South Wales due to the high volume of business travellers on regional routes. This slot system is currently only practised in Sydney airport to alleviate congestion.

Summary of the income statement over the past 5 fiscal years is as follows:

Rex - table 2

Revenue has increased by 11% over the past 5 years in spite of an overall decrease of 15% in passengers over the same period.  This has been achieved to a large extent by fare increases, average fares have increased from $155.90 (2010) to $192.10 (2014), as shown in the chart below.

Rex - chart 1

Costs on the other hand have jumped by 20% over the same period. The main driver of increased cost is salaries and wages (which also happen to be the largest expense item).  The enterprise bargaining agreements (EBAs) currently in place allows for a 2% real growth in wages.  As a result of revenue not keeping up with costs, net profit has decreased.

A summary of its financial position at the end of fiscal year 2014 and half year 2015 is as follows:

Rex - table 3

The majority of asset value lies in the PPE, specifically aircraft, rotable assets and buildings.   Rex operates a total of 96 aircraft, most of which are owned outright.  Based on its annual report, carrying value for its aircraft and other rotable assets is $214.5 million (FY2014).  A high level sense check below suggests that the risk of a material overstatement of the PPE is low.

Rex - table 4

The other thing I would like to point out on the balance sheet is a liability called “unearned revenue”.  In reality this is not a really a liability as it is fares paid in advance (common in the airline industry) which are not likely to be refunded.  Although the accounting standards deem this a liability, it is actually more like an asset as the company can earn interest on this float.  Therefore, the net asset on the balance sheet is somewhat understated.

The market capitalisation of Rex is approximately $107 million.

Based on FY2014 results, it is currently trading on a price earnings multiple of 13.8x ($107m/$7.7m) and a net tangible asset multiple of 0.57x ($189m/$107m).  This appears to suggest that the company is cheap when looking through the asset lens but not as cheap when looking through an earnings lens.  This is simply because Rex is currently not earning an adequate return on its capital.

The return on equity (ROE) based on the book value of equity (FY2014) is 4% ($7.7m/ $189.1m). As a result, the market has discounted the value of equity (market capitalisation) so that a purchaser buying in at the current share price would get a more reasonable ROE or yield of 7.2% ($7.7m/ $107m).

Generally speaking low growth companies have historically been priced on yields of 8% – 10% (price earnings ratio of 10x – 12x).  Based on this general rule, this suggests that the market is pricing in only marginal growth for Rex. The airline industry is a cyclical business and Rex’s passenger numbers have been falling since the GFC.  The drop in passenger numbers have slowed in FY2014 and at some future point in time will eventually reverse.  Given its high operational leverage (mostly fixed costs), any turnaround (increase in revenue) would mostly flow down to the bottom line.

Given the above, I believe the LTM price earnings ratio of 13.8x is undemanding as:

  • Management has disclosed that the decrease in oil price will lead to a $2mil savings for FY2015. Although I am unable to predict with any degree of certainty that oil prices will stay low, some media reports have reported that the world currently has surplus oil production.
  • In FY2015, Rex bagged the Queensland Western 1,2 and Gulf routes greatly increasing its exposure to the Queensland market. This win should help slow down or reverse the drop in passengers.
  • The reintroduction of the enroute rebate scheme. Although this scheme is less generous than its predecessor, it is certainly better than nothing.
  • Savings from leasing charges as Rex currently owns all of the Saab 340s. These savings will kick in when the current bank loans are all fully repaid.

Given the cyclicality of its earnings, it is difficult to predict what earnings will be next year. However, the combination of the above factors has created a “tail wind” behind earnings in FY2015.  Whilst there is of course a possibility of earnings deteriorating further in FY2015, I think there is a higher chance of them being better than FY2014 given this “tail wind”.  Moreover the HY2015 earnings were better than the corresponding HY2014 earnings.

In the long run, I believe Rex will be able to earn an adequate return on equity given its monopoly position on most of its routes. Therefore, the book value of its assets should provide an indication of its intrinsic value (based on the replication method).  Its net tangible book value (HY2015) suggests an intrinsic value of $184.6 million. Compared to the market capitalisation, it implies a margin of safety of 42%, which is pretty good.

An investment in Rex is of course not without any risks. In my mind the potential downside risk for an investment in Rex are:

  • Rex’s fares have reached a point where any further increase will result in a greater fall in passenger numbers,  in which case it would be challenging for revenue to keep pace with growth in costs.
  • Regional councils spending to upgrade their airports and passing on cost increases to passengers which will further increase fares and lower passenger numbers.
  • Government implementing more stringent new safety or security guidelines which may lead to increase costs for regional airlines.
  • In the longer term, the Saab 340s will eventually need to be replaced (in 10 – 15 years time) and large capital expenditure will be required.

Overall, I believe the market has already priced in some of these risks (market believes there will be little or no growth) and that passengers are falling mainly due to a pull back in business and government spending.  So I believe an investment in Rex at current levels (around $1 a share) has limited downside risk but a greater upside potential.  However, this upside will probably take some time to materialise given the downward trend in passenger numbers; but if you wait for conditions to improve then as Buffet says “if you wait for the Robins, spring will be over”.



Good old checklists…

I believe it is important to have a checklist before making an investment.  Very much like buying a pre-owned vehicle, a used car buying checklist can help us avoid buying a “lemon” by reminding us of specific checks or to be aware of certain faults.  Therefore, given the risk inherent risks in investing, an investment checklist can help improve our chances of successful investing.

Obviously not all investors would have the same checklist, the checklist would depend on the investor’s investing strategy and the types of securities he/ she is looking to purchase.  For myself, my investment strategy is build around minimising risks by purchasing securities which are selling at prices lower than their intrinsic value (commonly called value investing). Considering the breath of the investment universe, I believe a principle based checklist which I believe will have broader use than a prescriptive one.  I have developed a simple checklist over time from learning from the great investors, reading books on investing and personal experience. My checklist, in no particular order is:

  1. Know what I am buying.
    This fundamental principle sounds simple but there are few subtle points.  Do I know enough about the industry and the company’s business activities? Are there any potential technological advancements which have the potential to disrupt the industry? Is it within my circle of competence?  Warren Buffet once remarked: “You have to stick within what I call your circle of competence. You have to know what you understand and what you don’t understand. It’s not terribly important how big the circle is. But it’s terribly important that you know where the perimeter is.”
  2. Am I able to value the security with a reasonable degree of confidence?
    The value of a company is the present value of its future distributions so it is important to be able to predict the company’s future cash flows with some degree of certainty.  So I would be more confident in making forecast for a company like Woolworth (with its stable cash flows) compared to a company such as Fortescue Metals (whose cash flows are very much tied to volatile iron ore prices).
  1. Avoid highly geared securities
    I stay away from companies which are highly leveraged.  Although leverage has the potential to greatly magnify returns, it also increases the risk exponentially and since my core strategy is risk minimisation, I prefer companies with low or no debt.  To assess whether a company is highly geared I look at the ability of the company to service its debt obligations (interest coverage ratio) and the overall quantum of debt in the capital structure (debt to equity ratio).  In general, I like companies to have a interest coverage ratio (EBITDA – capex/ interest) of at least 5x and a net debt to equity ratio not more than 30%.
    Warren Buffet has this great saying on debt “If you’re smart you don’t need it, and if you’re dumb, you got no business using it”.
  1. Avoid companies whose management doesn’t act in the shareholder’s interest
    Sometimes it is hard to identify good management just by reading the annual reports and other public documents.  Compounded with that, the general trend these days is to change top management (CEO) every few years so it is hard to gauge how “good” the incoming CEO is. So I think one solution whether a culture of acting in the shareholder’s best interest exists.  I avoid companies whose management puts its needs before the shareholders needs.  Examples of these are overpaying for acquisitions with little or no strategic benefit, unnecessary risk taking by management (maybe due to misaligned incentive system which rewards management for taking huge risks), constant issuance of shares (placements) which dilutes the shareholder’s interest etc.
    Identifying good management can be challenging but avoiding companies with a culture of bad management is an easier way to avoid the landmines.
  1. Understand why the market is valuing the security at the current price
    This is what Howard Marks calls second level thinking.  In general I believe the market is fairly efficient most of the time; so if I do find an undervalued security, I am coming to a pretty bold and arrogant conclusion.  Basically I ‘m saying I’m right and that the entire market with all of its participants is wrong with regards to the pricing of the security.  To achieve that second level thinking, we must invert and understand why the market is pricing the security as such.  Once I understand the reasons for the market pricing, I am then in a better position to assess whether I think the market has overpriced or underpriced the security and this is  typically related to the probability of some future event occurring.  My default position is that the market is fairly efficient most of the time in pricing securities.
  1. Buy the security when it’s price is lower than it’s value (margin of safety exists).
    The margin of safety concept is a concept articulated by Benjamin Graham as the central concept of investing in his book The Intelligent Investor.  Valuing a business is difficult and precise assessment of its intrinsic value is not possible.  The best we can do is to make an approximation of a company’s intrinsic value (say within a range).  Therefore, we should only invest when there is clear bargain and when a clear margin of safety exists.  The principle is similar to say building a bridge, where the daily maximum load is expected to be 100 tons, engineers would always build the bridge so that it can support a load greater than this, e.g. 130 tons.  I wouldn’t want to cross a bridge where the current load is a 100 tons and whose capacity is also 100 tons!
  2. Diversify
    Investing is about the future and since the future is uncertain; there can be no certainty in investing.  All we can do is to invest in securities which have a greater probability of making a profit than a loss.  We may perform the best analysis and invest in a company with say a 90% chance of success and a 10% chance of failure but the failure scenario can prevail (bad luck) which will cause us to lose money on the investment. However, this does not mean our decision to invest was flawed, it was simply bad luck.  So to avoid bad luck wiping out all of my capital and forcing me out of the game, diversification is important.  The age old adage; don’t put all your eggs in old basket is acutely meaningful in investing.  I diversify by trying to invest in securities which are not highly correlated (different sectors).  Diversify but don’t over-diversify, most fortunes are made by owning a single company (most billionaires tend to have the bulk wealth in one entity) and not by owning all 200 companies in the ASX 200.  How many companies to hold in a portfolio to achieve a satisfactory level of diversification? This is personal choice but for me seven to fifteen securities in my portfolio is a good balance in terms of portfolio concentration, diversification and ability to follow these companies closely.

This is my checklist to buying a security.  All feedback/ comments are much appreciated….


Hedging inflation ….

For my first post (which has been a long time coming!), I thought I touch on the Australian stock market returns. We’ll look at whether returns from the ASX keep up with inflation (inflation adjusted returns – which are not frequently cited) and what portion of returns is made up by dividends. I’ve used the ASX All Ordinaries index as a proxy for stock market returns.

Investment returns can be measured in many ways but the ones I like are CAGR (compounded average growth rate) and IRR (internal rate of return). As these returns are calculated on an annualised basis, it makes relative comparisons a whole lot easier. CAGR is good for measuring returns when the investment transaction is a straight forward buy and sell with no interim transactions during the holding period; whereas the IRR is more flexible as it can accommodate other interim transactions during the holding period such as dividends, rights issue etc.

I have charted the long term returns for the ASX All Ordinaries index over a 79 year period from December 1935 to December 2014 on an inflation adjusted basis (real basis – index based on December 2014 dollars).

ASX long runThe CAGR for the above period on a real basis is 0.9%. Before you say that can’t be right, bear in mind that this is just the returns solely based on the price action. To give a sense of the returns based on a nominal basis (i.e. not adjusted for inflation), the nominal returns over the same period was 5.9%. Although inflation eroded approximately 5% of returns, returns from stock prices alone was able to keep up with inflation and produce a real return of close to 1%.

The next natural question would be what if we included dividends, how much more would it add to the returns? This can easily be done by looking at the All Ordinary accumulation index, which is a total shareholder return index assuming that all dividends are reinvested. However, data only exist for the All Ordinaries Accumulation index from 1979.  The chart below compares the price return and the total return indices on a real basis.

ASX AccumulationAs seen above, dividends make up a large portion of returns, how much you ask? Well without dividends the real returns over the above period were 2.7% (price index), whilst the total return including dividends was 7.0% (accumulation index). Based on the above period, dividends accounted for a whopping 4.3% of the overall returns.

So the takeaways from this analysis are:

  • Solely based on the price action alone, returns from the stock market over a 79 year period to December 2014 was able to produce a 1% real return and over a shorter period (35 years to December 2014), the real return based on movement in stock prices was 2.7%.
  • Dividends (reinvested) make up a significant portion of returns. Over a 35 year period to 2014, dividends (reinvested) made up 4.3% of real returns out of the total returns of 7.0%.
  • This suggests that in the long run the stock market is a good hedge for inflation and don’t forget to reinvest those dividends !