As the sage of Ohama says, be fearful when others are greedy, be greedy when others are fearful. So is the case with the ASX listed Virgin bond. Virgin raised $325m (versus initial expected size of $150m) via the issuance of an ASX listed bond on 26 November 2019. Since listing, the bond has briefly traded at par, which largely owes to printing to demand.

Compounding the woes of the Issuer overprinting, is the coronavirus. Clearly this a negative for aviation stocks, the education sector and the economy as a whole. However, fear creates opportunity. As is the case for the Virgin ASX listed bond.

As is typical with the market, fear and emotion take the front seat, and fundamentals take the back. But the facts are, Virgin operates in a duopoly market, has a young fleet of aircrafts (8.7 years) and has around $1.35bn of cash. Furthermore, the Velocity business, which the debt was raised to purchase the 35% Virgin did not own, de-risks the business profile of the Group, as this business is not exposed to the vagaries of the aviation industry. Favorably for the credit for FY19, Velocity contributed 29% of the Group’s EBITDA.

Virgin bought this business on an implied equity value of $2.0bn (EBITDA multiple ~16x). While it can be argued that Virgin may have overpaid because it may be worth more in their hands than an unrelated third party, it is nevertheless a source of equity if Virgin were to have capital issues. This event is not our base case. The Velocity group is likely to be well received by the market if it were spun off and listed on the ASX, acknowledging the symbiotic relationship between the businesses i.e. you need a viable Virgin to have a viable Velocity business.

Problem of ASX listed bonds vis a vis OTC

The principal difference and deficiency between trading ASX listed bonds versus OTC is the accrued interest. When trading an OTC bond, the clean price or discount margin is agreed, and the accrued interest is paid. While with ASX listed bonds, the price paid includes accrued interest which many retail bond investors may not know the quantum.

Virgin currently has $1.69 of accrued interest, which at yesterday’s closing price implies a clean price $93.81 and a yield to maturity of ~9.65%. With the price largely not reflecting the accrued interest at this juncture, come 13th May when the bond goes ex, it is likely to carry most of its $4.0 cash coupon creating a potential arbitrage opportunity.

Relative Value

The most comparable bonds to the ASX listed Virgin is outlined in the table below. As the table illustrates, the ASX listed bond provides superior relative value to the most comparable bond, the Virgin November 2024. Putting the technical’s aside on where both bonds trade on an asset swap basis, the ASX listed bonds provides an annual yield pick up of 0.75% for 11 days longer maturity.

Conclusion

A time when an ASX listed bond became unloved and represented tremendous value and rewarded those that conducted credit work and took a contrarian view, was the Crown subordinated notes. As a credit house we focus on the cash generation of the business and less on the profit and loss. Cash is fact, earnings are an opinion. There is around a $300m difference between EBITDA and EBIT, hence Virgin’s P&L looks more challenged than its cashflow generative capacity. Further with the group having $1.35bn cash and maintenance capex funded from the operating activities, the business has ample liquidity to meet challenged operating conditions. Another positive is that many of the shareholders are defacto government owned enterprises and have provided equity support when required, shareholders include Etihad (20.97%) and Singapore airlines (20.03%). 



Jason Dukes

Thankyou Dean for your insights. Is there any chance of getting an update on your view of VAHHA notes now that Virgin has released its half year results and the coronavirus seems to have developed further since your article on 12th Feb. Seems concerning that half year was a loss before impact of the virus and new BNE-Tokyo route must be creating come challenges. Also seems that free cash which you have highlighted at 1.3bn has dropped to 1.0bn Am I being overly pessimistic ? Thanks.

Dean Italia

Morning Jason, happy to have a chat. You can email me on dean.italia@mutualltd.com.au