Wry & Dry

Investment Matters

The markets

Markets 29 1 16

The local market finished the week around 1% higher with fluctuations in the oil price having a major impact on market movements.  Mining and energy stocks were generally higher with commodity prices rallying off recent lows.

In a volatile week, the US market rose more than 1%, despite concerns over the Chinese market, which hit 13 month lows, and a mixed reaction to the Federal Reserve’s decision to keep interest rates on hold. 

New addition

A new investment - Origin Hybrids (ASX Code: ORGHA) have been added to First Samuel clients' equity portfolios.

These notes are subordinated (i.e. in the event of the company failing, they rank behind other creditors, but ahead of common shareholders), cumulative (i.e. any unpaid dividends accumulate as a debt of the company, unlike unpaid ordinary dividends in a company, which if unpaid, are lost) investments in Origin Group.

The notes pay quarterly interest income of 4.0% above the bank bill swap rate (BBSW), and currently yield 6.3%.  We purchased the security at ~$95, a comfortable discount to the face value of $100 (that is, there is a $5 capital gain if the Hybrids are held to maturity).

The first call date for the Origin Hybrids is 22-Dec-16 (i.e. in 328 days).  We expect Origin to redeem the hybrid (i.e. pay us $100 per security + interest), as they will lose equity credit afforded to it by the ratings agency from this date.  The expected return in this scenario is a yield of 6.5% (actually the realised yield will be higher than this because of the timing of interest payments versus when we purchased), plus a 5.3% capital gain (to $100 face).  This gives an annualised return between now and December of 13.2% (assuming the BBSW remains unchanged).

The equity credit is important, as Origin cannot afford to lose this credit, and keep the hybrid outstanding.  It would potentially affect its credit rating negatively, and thus could affect their ability to operate in the National Electricity Market (where a BBB credit rating is required to operate for all players).  Origin currently has $6.5b of undrawn debt facilities (versus a note size of $900m); has hedged its oil price risk until the end of 2017 and has no other debt refinancing due until 2019. The core business is on track to generate $1.5b in free cash flow in 2017 (before APLNG is included).   This provides us the basis of our expectation for redemption.

In the event that we are wrong, we will continue to receive a good income return, and will realise a capital return later than anticipated.

We are comfortable with this position as a short-term boost to income (along with an expected meaningful capital return) for the next 12 months.  Whilst this is shorter than our typical investment horizon, we see the opportunity as compelling in the current market environment.

This investment is not a common equity security, as most of your other equity portfolio investments are.  It is a hybrid security, as is the CML Note investment which is also owned in your equity portfolio.  We have the flexibility to add such securities to your equity portfolio, where we consider them likely to generate equity-like returns.  (A reminder of the characteristics of hybrids is detailed below.)

A note to clients with an income securities' allocation

Those clients with an an income securities' allocation already own the Origin hybrid.  It now appears under the equity allocation in your daily online report (and your other reports).

A reminder: what are Hybrids?

A 'hybrid' is an investment that has both equity and debt characteristics - hence the name hybrid.    They are similar to equity in that they are frequently convertible into equity at a future date. And they are similar to debt in that they pay interest as would a normal income security.  They typically pay interest based on current interest rates (not the profitability of the issuer).

Each hybrid is unique; they have individual terms (for instance time-frame, franking, level of security, distribution payments and redemption method – cash or shares etc).   These terms determine their risk (along with the risk associated with the issuer).  For instance, we have been cautious (which is polite) in relation to recent hybrid issues from the banks, for instance in relation to their mandatory conversion terms.

Company news

ALS released their third quarter update (for the quarter ending 31-Dec-15, FY end is 31-Mar).  Unaudited net profit was within guidance, at $31m.  Strong earnings growth was achieved from the company's Life Sciences (including both food / pharmaceutical and environmental testing), and Industrial divisions.  However, difficult conditions were experienced in the Energy and Minerals divisions, given the difficult demand conditions.  The company continues to right-size its energy operations, whilst looking to grow its Life Sciences division (including via acquisition).

Cardno has continued with its Board changes - two new appointments have been made, including the company's past long-standing CFO Mr Jeff Forbes.  First Samuel supports this renewal, which has been done under the auspices of the company's new major shareholder, Crescent Capital.

-       Fleur Graves