Rolls Royce Update

Rolls Royce has been my worst investment, still down since I bought it 4 years ago:

Time to review this position.  If I was not holding it, would I buy it now?

The Story and the Numbers

Rolls' story is that they are slowly building up a large customer base, which will provide them with a continuous stream of payments from maintenance when flying their engines.  Do the numbers reflect this story?

Start with their cashflows.  Working capital swings wildly from year to year, so exclude it.

For the last few years, CFO (ex WC) is ~1.5bn.  With 1bn of CFI, they have 500m of cash to spare.  We can't tell how much of the CFI is sustaining, and how much is new investments.

Looking at the CFO in more detail:

For the last 2 1/2 years, operating profit is near zero.  CFO is much higher, the difference being D&A (orange) and Net Contract Assets (yellow).  The latter are the regular payments made to Rolls under Long Term Service Agreements.  Rolls charges by Engine Flying Hours (EFH).  These items have been paid for, but not recognised as revenue/income, as they are considered to be pre-payments for a 5-year scheduled shop visits (major refurb).

For the last few years we are starting to see EFH pre-payments make up a significant portion of Rolls' cashflows.

Engine Problems

Rolls has had some engine problems with its Trent 1000 (dreamliner).

• Still causing significant customer disruption.  Fixed blades for the C variant (~50% of the fleet) may be successfully rolled (to target < 10 planes grounded) end of year.  New blades are being designed for the B variant.  New problems were found with the Trent TEN (about 1/3rd of the fleet), currently redesigning the blades, work will continue through next year. (pp5-6)

• Cash cost for the B/C variants is expected to be ~500m in 2019, reducing to 100m next year.  
• Cash cost for all Trent variants is 219m in 1H19 (p14).  Cash costs are included in the CFO charts above (as part of Operating Profit), so we will get a boost from their absence in future.

Valuation

Rolls has long had a target of 1bn FCF by 2020.  This includes 2-300m of inventory reductions in 2020 (p18), so lets make it 750m recurring FCF.  That is 39p per share.  At a current price of 712p, its trading at 18x FCF - not cheap.

Rolls has a 'mid-term ambition' of 1 pound FCF per share (around 2bn in total).  There are 3 ways they'll achieve this (pp9-10):

• Reducing their manufacturing (OE) cash loss per engine.  They reduced it from 1.7m to 1.3m in 1H19.  They may be aiming for 400K by 2023.  They aim to manufacture 500 engines per year (p17) over the next few years.  If they hit 1m/engine, thats an additional 150m per year (over 1H19 numbers).
• Improving their aftermarket cash margin.  Mostly from an increased installed base of engines (more EFHs) - this is the bulk of CFO that we saw in above charts.  They expect an additional 150-200m from this.

Service Visits (SV's above) are unscheduled smaller visits, which are recognised when they take place.  Margins for SVs vary be engine type: Trent 700s have higher margin, Trent 900/1000s are lower (p10).

• Reducing fixed costs: R&D, (Commercial & Administrative) C&A, and capex

It looks like their largest 'improvement' comes from cost-cutting.  They give the projected savings as a percentage of sales, but I think this is too fuzzy and far away to look at now.

Conclusion

Would I buy this stock today?  Its a question of valuation.

• Right now, I think they can reach 1.7bn FCF (88.5p per share) in a few years.  Based on their 1H19 cashflows (920m, annualised), with continual OE margin improvements (plus 150m), increased EFH (plus 200m), and a removal of Trent 1000 costs (plus 438m).  Check 2019 Cashflows again when full year results are out - capex (CFI) will probably be higher in 2H.   
• At 15X FCF of 88.5p, this would be 1327p, almost double its current price.  Roughly USD 17 per ADR.  Even if we cut FCF to 1.5bn, there's 50% upside.
• Rolls story is plausible, and backed up by cashflows.  The new management looks like they will deliver the 1bn FCF/year they promised, though I think they were caught off guard by the scale of the Trent 1000 problems.

The risks are a recession (reducing EFH), or more engine faults.  A recession would invalidate all the above numbers.

If I wasn't holding now, I would buy into this.  Though I'd probably only buy half, this late in the cycle.

Manulife US Reit acquisition of 400 Capitol

The recent announcement seems OK.  Not good, not bad. just OK.

It is a Class A office building in Sacremto downtown (CBD), possibly a "trophy", being the "tallest building in Sacramento...forming an integral part of the city’s skyline. The Property is widely considered the premier building in the market and is downtown Sacramento’s address of choice for premier law, financial service, accounting, and professional service firms."

Average of 2.3% rental escalations per annum.

Committed occupancy is 94.9%, though the small print says that excludes one tenant that has exited since then.

Manulife says that rentals have space to move up:

The 2019 Q2 Cushmand and Wakefield report that I found gives Downtown Sacremto's asking rent as  $3.18 (p3), which would be $38.16 per year.  Maybe the newer report has higher rent.

One of their major tenants is a bit dodgy:

WeWork signed the lease in 2019 Q2 (See p3).  I do not know if the lease length is a long one, adding to the 5.9 year WALE.

The property had a lower occupancy rate of 84% in 2018 - this was before the WeWork lease.  Manulife gave a proforma calculation of how it this acquisition would have affected their results if it had been done in 2018:

Almost no change.  So if WeWork stopped paying rent tomorrow, it is likely that DPU after the acquisition would be unchanged from before it.

Longer term, I think its a good property and I'm surprised they were able to buy another CBD property, rather than suburban.  Shorter term, I don't think its as good as they make it out to be. Vacancies were higher last year, and with WeWork as a tennant, the numbers might not reflect reality.   Perhaps the seller leased to WeWork to increase the valuation before selling.  And perhaps Manulife rushed a bit in order to grow to be included in the Nareit:

Its a valid business strategy to grow bigger to be included in the Index.  Size matters for REITs, and inclusion in the index will boot their valuation, reduce their cost of capital, allowing them to acquire more.

I think Manulife REIT is still decent and, and one of the few SGX-listed REITS not overvalued.  I will be subscribing for the preferential shares, and will continue acquiring it.

Bought Wharf Reic (HK.1997)

Bought 2000 shares of this company last week, on news of the extradition bill being cancelled.  This action decreases the chance of bloodshed (Tiannamen 2.0) - there's a chance both sides can talk now.

Wharf REIC derives 2/3rds of its profits from Harbour City.  It's a massive shopping complex, with separate buildings for luxury, children, sportswear and dining.   They account for 10% of HK retail sales (excluding F&B).

Their numbers are excellent.  Gearing is below 20%.  Their property's lease is for 800 years.  Its a very simple business where the rental just flows through to the profits.  Its trading at a trailing PE of 7 to 8.  Thats at a payout ratio of 65% (its not a REIT).

This is a cyclical stock.  Leases are short: 1-2 years, which is good in a rising markets, but bad when things go south.  Management is projecting a "high single digit and even "double digit decrease" in retails sales in the second half, which may affect rents that are based on tenants' sales.  This stock can be taken as a proxy for Hong Kong tourism, and Mainland Chinese luxury goods spending.

Why is it so cheap?

• The global slowdown, and slowdown in China specifically.
• HK protests

I am buying this stock, hoping that, in one to two years time the protests are forgotten.  Tourism and shopping returns.  Maybe China will stimulate its economy more  stimulus (they have been surprisingly cautions so far), so that more people can travel and buy LVs.

The main risks to this story are:

• The downturn continues and we get a recession, despite best efforts of the Chinese government.
• Political risk.  Harbour city avoided a protest, but this may have made mainland Chinese angry.

This is not a buy-and-hold forever stock.  It only forms 2% of my portfolio, and thats as much as I'll buy.  Long term, HK is not a place to park my money.  Unless the government can improve the lives of its citizens (primarily by decreasing property prices), it will remain a powder keg.  And after 2047, the Chinese government does not have to honour any 800-year property lease.

I got this idea from Kyith at Investment Moats.

My Macro View

I think of macro as a way to explain what can happen, not what will happen.  To see all the possibilities in the future, and make sure you will be OK either way.


The US economy is in a slowdown.  This may or may not turn into a recession.  Previous slowdowns in 2012 and 2015 and did not turn onto a recession and proved to be buying opportunities.

The cyclical downturn started before the trade war in both the US and China.  The trade war is not the cause, just the icing on the cake.  We can get a cyclical upturn without a resolution to the trade war.

Both the US and China will do everything possible to avoid a recession.  Trump to avoid losing the election.  And Xi to avoid a revolution.  Whether the Fed's cutting rates and China's stimulus (for the n-th time) is enough remains to be seen.

No resolution to the trade war.  The differences between China and the US are too big and cannot be negotiated.  This is a cold war.  Longer term, US companies will disengage from China, and there will be two parallel, seperate supply chains.

Long term:

• I think China's economy will not implode, but will drift downwards as they restructure.  Whenever it looks like it is about to collapse, they will pause restructuring and stimulate.  Stop-start, stop-start.  A glide slope.
• The Eurozone will a probably break up.  Countries so different should not have a common currency.
• Theres a small chance of the USD shooting up due to their shortage.  Probably accompanied by emerging market crisis.

Things I think the market is not pricing in now:

• Oil price recovery
• For HK/China stocks, a cyclical upturn due to Chinese stimulus.
• Bank stocks (both SG and US) are low, due to the expectations of low rates foreverrrr.....  If this changes, lets say 6-18 months out, like it did in 2016 after Trump's election, bank shares are worth a look.
• A crash, due to the market being too high combined with political risk, maybe exacerbated by systematic traders.

In general, markets are high now, I would not buy into "the market" (the indexes).

I am looking at REITS and dividend stocks, but there's not much out there thats reasonably priced.

Stopped the Systematic Strategies

Last week I stopped following these strategies, both the momentum and The Acquirer's multiple.

Returns have been quite bad since starting in February:

• 2% for the momentum strategy.  Its been a choppy market.
• -28% for The Acquirers Multiple.  Value investing has done badly compared to momentum, since 2009 (1) (2).  I'm sure it will come back, I just don't know when.

On a daily basis, both strategies are high beta, and follow/magnify the movement of the Russel 3000 index.  If the index is up 1%, they're usually up 2-3%.  Same for down.  Holding 'value' - at least this kind of 'deep value' - meaning companies that are nearly dead - does not protect you.  On down days, they do worse than the market.

The reasons for stopping:

• Its hard to stick with when it goes wrong for long periods.  When you manually analyse and select own value stocks one-by-one, if a stock goes down, you can try to see why.  Has something changed with the fundamentals, or the macro environment?  Or have perceptions changed?  Has the whole market dropped?  Did you make a mistake?  You can (at least) try to look at the stock with a level head and see if you should cut losses or hold.  With a portfolio of non-discretionary stocks, theres nothing to do except to have blind faith,
• Manually analysing stocks takes more time and effort, but I can choose when to do it.  In most cases my long term investments won't be affected by missing a few weeks of work.  The exceptions are if results are unexpectedly bad, or for sudden crises (eg: HK protests) - though even these take weeks or months to play out.
• It was a pain in the ass to stay up trading 9:30-10:30 Monday nights.  I found Interactive Brokers pretty hard to use, sometimes I sold the wrong amount and accidentally ended up short.  It was only one hour a week, but it was a chore, and I didn't like doing it at nights.

I think the main advantage of the non-discretionary strategies is that it keeps you in the market, so you avoid FOMO.  However they get whipsawed in a trendless market, and will not protect you agains a 1987 style crash.

In the end, I decided hold cash, while building up a dividend portfolio.  I think this suite my personality better, and I can measure progress by dividends collected, instead basing it on stock price fluctuations.

Right now I'm 2/3rds in cash.

Like a diet, the best investment strategy is one you can stick with.

Netlink Trust AGM

I attended the AGM today, there was some Q&A on 5G, the competitive landscape, and capex. 

Here are the points I took.  Things I am not sure, or did not hear well, have a question mark (?):

• Revenue/profit review.  Monthly recurring revenue per-user for Residential is $13.80, and Business is $25 (?).  Installation and Diversions are the only non-recurring revenue streams.  Diversions is from having to divert underground cables due to construction work.
• Netlink currently has an 88% share of the residential market.
• Regulatory profit targets.  Their profit is regulated and reviewed every 5 years (next review in 3.5 years).  A 7% rate of return is targeted - the target profit number will also depend on other factors such as interest rates, debt and capex.  From the target profit/revenue, the regulator determines fees per user, as the number of uses is known.  In the long run, more capex means they will be allowed more profits.
• They see a lot of potential in Smart Nation.  Have received requests from govt agencies to wire up cameras.  Most current cameras are on 4G platform, which affects picture quality.
• Competition in Business Segment.  There were several questions on SP Telecom as a new competitor.  The answers: 1) SP Telecom only competes in the Business connection area.  2) SP Telecom is both their competitor and customer.  Netlink lays cables for them in some areas.  3) The business connection segment is already competitive, with the three telcos already competing with Netlink.  Netlink has around a 1/3rd market share, Singtel is slightly above that.  4) SP Telecom is a small player in this market  5) The telcos have fibre in some areas, but not others.  M1 does not have any fibre (?)
• There were many questions on if the dividend was sustainable.  The answers: 1) Management took pains to state that dividends were only paid out of Cashflow from Operations, not from Capital.  2) In the 2018 results, the 221m dividends is for FY2018 (126m) as well as FY2019 (95m), that is why it is bigger than the FY2019 FCF (158m).  3) They have a 100% payout ratio, no plans to reduce it to 90%.
• There were many questions on 5G.  They answered may times that 1) 5G requires micro base stations 2) These are expected to increase revenue for Netlink  3) Regarding specifically if the last-mile connection can be serviced by a single access point (servicing 5-6 homes with wireless), thus cannibalising Netlink's Residential revenue, they answered they do not forsee this, as they expect home data usage to keep increasing - so it would make no sense to serve the home with (lower/shared) bandwidth connections.
• Capex.  1) Capex was 212m in FY2018, 71m in FY2019.  Expect FY2020 to be more than FY2019.   2) Generally, most of their capex is for expansion.  Sustaining capex is for their central offices' maintenance and equipment (eg: chillers, vehicles); this varies so they can't give a percentage.
• One question on why Trustee fees are paid in cash, not units like other REITS.  Netlink trust owns the trustee.  The money paid is mostly directors fees.   The trustee does not generate a profit, unlike other REITS.
• A throwaway comment that struck me is that Singtel actually has the technical capacity to service Residential, but they do not do so (or not allowed to do do?)

Non-investment things:

• Most questions and answers were worthwhile, for a beginner to understand the business and competitive landscape.  There were only a few stupid questions ("What is the purpose of this meeting?")
• Only tea and coffee after the meeting, no food.

I found it worthwhile to attend, may attend next year.

US Prime REIT

Kyith at investmentmoats has already covered this IPO's buildings and basic metrics.  No need to repeat it here.  They seem decent, except for the leverage.

But he thought they may need to raise money for expansion after listing.  I want to look further at their growth potential.

Growth Potential

Their leverage upon listing will be 37%, limiting their ability to borrow more money.

Is there scope to grow by increasing occupancy?  Not much.  In their 2020 projections that the 7.4% yield (@ 100% payout) are based on, they already assume a high occupancy rate:

Is there scope for rent increases?  Summarising the Property Market Report (Section F) of the prospectus:

Not much here either.  Note that this 3% increase is in gross rent, the percent increase in Net Property Income may be different.  In absolute terms, either all of most of the gross rent increase will be passed through to NPI.  In percentage terms, NPI may increase by more or less than 3%.

Are their buildings' markets expected to improve long term?  From the Property Market Report, we can derive an estimate for how vacancy rates will change in each building's submarket.  We only have the projected change for all of A/B/C class buildings, they did not give the projected change for A-class alone.

Some submarkets are projected to have higher vacancies (bad - red), some lower (good - blue).  The two largest buildings (by value) are red.  It's a little disappointing that the building with the longest lease is in the bluest market. On average, there is a slight increase in vacancy, more so if you weight by the buildings' values.  So generally OK, with a slight negative bias.

My take on these 5 year projections is that future supply is well known, but future demand is pure guesswork.

Conclusion

Its decent, but I can't see much scope for Prime REIT to grow beyond its average 2.1% rental escalations.

I'd like to compare it with Manulife US REIT next.