The yield trap of 2018

Daniel Mueller

In each of the previous 5 years, there have been several obvious candidates from which to ‘award’ the yield trap of the year. 2018 was harder. One could easily pick on AMP. But a combination of a lofty starting share price and lack of asset sales, due to management overhaul and the Royal Commission, made it more of a value trap than a yield trap. This was notwithstanding a 31% interim dividend cut.

And the yield trap of 2018 is...

So Vertium had to look beyond large caps into the small cap index to find the yield trap of 2018, Asaleo Care. At its 1H18 result in August, Asaleo’s interim dividend wasn’t just reduced, there was no dividend declared.

Asaleo listed in June 2014, promoted as a dependable (some would say boring) manufacturer/distributor of personal care and tissue products. It had a portfolio of well-known brands with high margins and high returns (FY15 EBITDA/revenue and ROE were both 23%). It sounded like a conservative investor’s dream.

Industry overcapacity and a powerful customer

It was just a matter of time before competitors and customers took notice of Asaleo’s profitability. Indeed, one could sum up the Australian supermarket's relationship with its suppliers by quoting Jeff Bezos: your margin is my opportunity.

"Indeed, one could sum up the Australian supermarket's relationship with its suppliers by quoting Jeff Bezos: your margin is my opportunity"

In 2015, the seeds were sown for Asaleo’s downfall, after its competitor, ABC Tissue, announced that it was tripling its manufacturing capacity, equivalent to approximately 50% of Australia’s toilet paper demand. To ensure its factories kept running at capacity, ABC Tissue struck a deal with Coles in 2016 to increase shelf space and promote its ‘Quilton’ branded toilet paper. Consequently, shelf space for other toilet paper brands was reduced significantly. Asaleo responded by reducing prices (moving from promotional pricing to “Every Day Pricing”), leading to a 15% earnings downgrade for 2016. But this strategy was supposed to make Asaleo’s products more competitive and reset sales growth.

Input costs

Unfortunately, 2016 saw lows in two of its major input costs, pulp and energy. In 2017, these input costs began to rise while market share losses continued. “Every Day Pricing” was abandoned in favour of the original promotional pricing strategy, with Asaleo achieving price increases to pass through higher input costs. However, competitors continued discounting and market share losses continued. 2017 headwinds continued into 2018, culminating in a 45% earnings downgrade in July 2018.

"2017 headwinds continued into 2018, culminating in a 45% earnings downgrade in July 2018"

Outlook

Meanwhile, operational performance was starting to impact the balance sheet. At the end of 2015, Asaleo sat comfortably within its target leverage range of between 1.5 to 2.5 times net debt to EBITDA at 1.8 times. It even executed a $99.5 million on market share buy-back from October 2015 to May 2017. However, by the end of June 2018, the leverage ratio had moved above the upper end of the range to 2.82 times and was inevitably followed by the dividend cut in August. Management entered balance sheet repair mode and will look to conserve cash. As we head into 2019, high input costs and competitive pressures appear unlikely to abate. We don’t expect dividends to resume in the near-term.

An updated view on 2017's yield trap: Telstra

The market has gradually come to the realisation that Telstra will cut its dividend again to protect its balance sheet. It needs to sure up balance sheet capacity to bid for 5G spectrum at this November’s auction and to maintain gearing within its target of between 1.3 to 1.8 times net debt to EBITDA.

Valuation

From an investor’s perspective, the issue remains one of valuation, in light of ongoing uncertainty. Consensus forecasts (per FactSet) have Telstra’s dividend dropping to 16 cents per share in FY21 (FY18: 22 cents per share). That represents a 5% dividend yield at the current share price – not terrible, but hardly juicy. Consensus earnings for FY21 is 19 cents per share (FY18: 30 cents per share), which is worse than even our bearish view of a year ago. Yet this puts Telstra on a PE of 16.8 times, which is higher than a year ago. So the market has actually re-rated Telstra.

Why did Telstra re-rate?

To answer why Telstra has re-rated, one has to look no further than the main surprise of the year, which was the Vodafone / TPG merger. Labelling it a “surprise” might be a bit strong as pundits had speculated on the merger for several years now, so one could say it was inevitable. Nonetheless, the market is looking favourably on the Vodafone / TPG merger. The consensus view seems to be that a 4-player highly competitive mobile industry has now become a 3-player rational market. However, it is important to note that Vodafone’s parents have extinguished $2 billion of debt as part of the merger, leaving the new entity with a lot of balance sheet firepower to gain market share. And the strategies of both Vodafone and TPG as stand-alone entities was to be a low cost, lowest price provider, fighting hard for market share. So it seems less obvious to us that the Vodafone / TPG merger is a positive for Telstra.


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