Who's your counterparty?

Anthony Kavanagh

Chester Asset Management

Amazon, Google, Woolworths, Tesla. No this isn’t an Ari Gold sales pitch(1) but rather a list of recent contract announcements by ASX companies we’ve seen greeted with enthusiastic share price reactions. Yet the reaction to government contract announcements is generally much more muted. Maybe comparing Government to Amazon as a counterparty is akin to the big value vs growth argument we’re currently witnessing but we do believe despite markets seemingly pricing in a recovery, (v, u or otherwise) in many parts of the economy, the heightened degree of certainty that comes from having government backing is being underappreciated. With the FY2021 federal budget this month drawing focus on government spending we thought it opportune to bring forward this thought piece we have been considering for some time. It is in some ways a follow-up to our April 2020 paper discussing the Defence sector(2) wherein we proposed that one of the key attractions of the sector in this uncertain environment is the strength of their key counterparty being in many cases a government department.

Sugar Rush Hit or Complex Carbohydrates

One thing that sticks with this writer from physical education classes at school is the lesson around simple vs complex carbohydrates. Complex carbohydrates contain longer chains of sugar molecules than simple carbohydrates which the body takes time to break down. They hence provide longer lasting energy than simple carbohydrates. We make this point because we believe there are analogies to the current level of fiscal spending and the much discussed “fiscal cliff”. In Australia; JobKeeper, JobSeeker, income support payments, early super withdrawals and other government programs have provided support during the pandemic, to the extent household incomes have actually been up over Q2 and Q3 but drop materially in Q4 (~AUD70bn) as programs are withdrawn. Many consumer discretionary names have benefited from this and experienced a sugar rush revenue surge with big jumps in like-for-like sales(3) i.e. HVN +30%, JBH +40%, SUL +30%, KGN+110%. Some of these rises are unsustainable and in some cases, like the data we have seen for gambling totes, are simply alarming.

With the wisdom of hindsight, this tailwind appears obvious, but was less apparent to us in the 2Q. We have been focusing on businesses with a more sustainable benefit from fiscal spending. For example, approximately two months after our Defence paper was released the Australian Government, announced an AUD270bn 10-year package, an increase of AUD70bn (35%) from previous projections.

Debt Investors price government deals differently

Credit rating agencies assess the creditworthiness of corporations, i.e. their riskiness as a counterparty compared to the government. This transpires in what is called a credit spread, the difference between the yield of a corporate and treasury bond with the same maturity. Below we have included a table showing the current yields to maturity (YTM) of a handful of 10-year bonds in Australia.

Source: Chester Asset Management, Bond Adviser daily rates sheet, bond rates as at 21/9/2020

The table highlights that debt investors require a return over and above that of a government bond, to be compensated for the risk of investing with that counterparty.

Recently we heard the anecdote from a company that was securing debt and had jumped through hoops during previous bank diligence rounds. On this occasion that company had experienced a change in circumstances whereby they were managing assets backed by government contracts. The anecdote reminded us of the quote from the movie WogBoy “did you say government car?” whereby the bank that provided the debt didn’t even physically inspect the assets and provided a much lower rate under the knowledge they were secured against government backed assets.

So, if debt investors who claim to be more stringent in their assessment of companies before allocating capital see government counterparties as less risky why doesn’t the same apply to equities? We consider this below with particular regard to ASX exposed equities and A-REITs.

Equities with Government Counterparties

We have performed an exercise filtering down the ASX300 to a list of companies with higher government counterparty exposure and attempted to demonstrate an earnings yield, comparable to a capitalisation (cap) rate, across the group. As we detail below, this cap rate is a function of risk, opportunity cost of capital and growth, hence we have tried to highlight some of these metrics by showing an average across the group (4).

Source: Chester Asset Management, with data from IRESS, September 2020 – Noting some items here like debt cost and % of government revenue are not easily observable so are estimated by Chester

A summary of some thoughts on these companies is presented below.



Aged Care: EHE, JHC, REG

The Aged Care sector consists of: Estia Health (EHE), Japara HealthCare (JHC) and Regis Healthcare (REG). The sector is funded via the Government’s Aged Care Funding Instrument (ACFI) and while we see Government counterparty (~70% of revenues) as an attractive feature there are a number of trends which provide cause for concern regarding their business models.

· Declining occupancy rates contributing to significant de-leverage through the businesses.

· Slower occupancy of new developments which has coincided with higher gearing levels as brownfield & greenfield growth has been pursued

· Cost growth (staff are ~70% of op. expenses) historically exceeding revenue growth across average residential beds over the last few years

· Slight reversal of the trends towards more residents funding their occupancy via payment of the bulk ‘Refundable Accommodation Deposit’ (RAD) towards the combination RAD/DAP arrangements, or DAP only

Hence we have completed the work on the space but don’t hold any of these names.


One of the attractions of ALS Ltd is its Life Sciences division which is currently ~50% of revenue. Life Sciences is a mixture of Environmental Services (~70%, 18-22% margins), Food (~20%, 8-12% margins) and Pharmacy (~10%, 12-14% margins). ALQ are the global leader in Environmental Services (with ~50% market share) which is delivering 3-4% organic growth per annum. ~70% of Environmental Services is Government contracts with the top contracts being 3-year type contracts.

Building Materials and Contractors – ABC, BLD, CIM

The building material space (and CIM) have long been touted as beneficiaries of long-term government spending but possibly in a more cyclical nature than some of the other names in this table. Each needs to be considered on their own merit, particularly given the diversified nature of revenue streams for each, beyond just work related to Government roads and infrastructure projects.


Recent bad press aside CWY has had a reputation of strong operational and financial performance. Management has contributed to that as well as the diversified nature of their business providing an essential service in waste management. Among its customers CWY services 95+ local (municipal) governments and ~100,000 commercial and industrial parties. Despite the attractiveness of the business we feel at ~20x EBIT these features aren’t necessarily being underappreciated by the market.

Defence – ASB, (CDA) & EOS

As noted, we released a paper discussing the Defence names in April (Have you got your Bunker in Order) so refer readers to the earlier work for greater detail.

However, we thought we would highlight one particular aspect of these names being the Support / Maintenance earnings. Take Austal (ASB) for example the market is currently concerned about the future of their Alabama shipyard post the completion of the current LCS and EPF programs. Hence it currently trades on a forward earnings yield >7%. But we believe the market is underappreciating the support revenue ASB are set to earn on completed ships. ASB is currently targeting AUD500m p.a. of revenue from support contracts over the next few years. They built the ship so are almost guaranteed the contract to maintain it over its 20+ year life. At 8% EBIT margins that’s AUD40m of sustainable long-term EBIT which we believe could attract an EBIT multiple more akin to an industrial like CWY or SLK I.e. 20x =AUD800m capitalized value.


One name we highlight in the above table that we recently added is Downer EDI.

Despite the table indicating our belief revenue is currently 70% with a Government counterparty the company is in the process of “creating a stronger Downer” by achieving full ownership of Spotless, exiting non-core operations and right sizing the cost base. Once non-core businesses (Mining, Laundries, Hospitalities) are exited, and Construction wound down, DOW will be left with a core “Urban Services business”. On our estimates Government will be a counterparty to ~85% of revenue.

The other attraction to the stronger Downer is the benefit to free cash flow generation from this restructure. With ~65% of FY20 capex of AUD305m being from Mining and Laundries, a divestment of these business would see capex drop to ~AUD100m p.a.

On our numbers Downer could effectively be trading on an FCF yield(5) of 12%, or 8x EBIT.

We believe if the turnaround is executed appropriately the business could trade on 12-14x EBIT which would equate to a share price of AUD6.50-AUD8.00/share.

IT Service providers – DTL and TNE

IT service providers to government have potentially experienced a structural change from COVID-19 that may provide lasting benefits for years to come but at a headline level with both of these names on circa ~40x earnings it’s hard to argue that change is being underappreciated by the market


Although PET has a high portion of revenue underpinned by Government contracts, these contracts are often with emerging market governments so their strength as a counterparty needs to be considered on a contract by contract basis. The company is also having a few other issues at the moment including a forensic accounting investigation.


Prior to the August 2020 results we believed the market may have been underappreciating the essential service nature of Transit Systems within the SeaLink Group given 85% of revenue is derived from Government contracts. Given the >30% rise since early August we feel this is no longer the case but suggest defensive earnings and upside from material tenders makes it worthy of consideration.


Service Stream is another contractor name that is worthy of consideration. They have clearly benefited from the roll-out of NBN and are now diversifying away from the design and construction (D&C) phase of the NBN build out to more operations and maintenance type work, as well as utilities (gas, water and electricity) work through their acquisition of Comdain. Given the earnings yield of the business as it transitions to a higher proportion of long-term maintenance contracts there is potentially a similar argument to be made to that of ASB. Notwithstanding that we would suggest these contracts are likely more competitive and shorter duration than a support contract servicing a ship built by the contractor.

Source: Chester Asset Management, September 2020


We aren’t specialist property investors but do consider REITs(6) as part of our investment universe, An obvious but important point is that COVID-19 has certainly shined a light on counterparty risk. Among other things the pandemic seems to have accelerated the decline for Retail REITs(7) and created some uncertainty for the Office space, at a time when interest rates remain near record lows and there is a desire for steady income streams.

Below, similar to the equities list above, we have filtered down the ASX300 REITs to some key metrics which we have averaged below. Astute readers might notice this doesn’t include retirement living(8) REITs, which we address later down the page.

Source: Chester Asset Management, Company Presentation Material, IRESS, September 2020

What we note is that on a simple arithmetic mean basis Retail, Office and Industrial asset classes average out at a similar cap rate of ~5.7%, with an average debt cost of ~3.1%, WALE of 6.8 years and 96.5% occupancy for 1.2% LFL growth. Government as a counterparty represents ~9% of tenancies.

We have chosen to focus on the cap rate for REITs because it is the key determinant in what these properties are worth, the inverse being the multiple at which net income is capitalised to calculate the net asset value of the properties. I.e. capitalisation rate = annual net operating income / value. There are a number of factors that can affect the cap rate of a property but simplistically these factors are: risk, opportunity cost of capital and growth expectations. We address each of these in detail below with particular regard to the retirement living operators.


Two key risks to assess when investing in REITs is the collectability of rent (a function of counterparty risk) and vacancy. On collectability we think the following image is very interesting, showing rent collections in the June Quarter 2020.

Source: Ingenia FY20 results presentation

Regarding retirement living operations rent is in most cases effectively underwritten by a government counterparty. What do we mean by this? Tenants within these communities generally receive fortnightly pension payments from the Australian Government. Upon the pension being received it is automatically debited to the accounts of the village operator (before being touched by the tenants). Additionally, particularly in the case of villages the pension is also coupled with a rental assistance rebate paid directly by the Government to the retirement living operator. I.e. the ultimate counterparty of retirement living operators is the Federal Government, hence the risk of the operator not receiving rent is potentially much lower than office, industrial and retail operators.

On vacancy risk, our understanding is that lockdowns have resulted in increased demand for the vulnerable and the isolated seeking support and community. This has transpired to a material step up in inquiries within communities/villages and is also reflected in record occupancy levels of retirement villages. We further note expected tenure of tenants is ~10 years with tenants agreeing to long-term leases vs AREITs WALE average of 6.8 years. In the case of LIC tenants agree to a 90-year lease over the land their property is situated on.

Opportunity Cost of Capital

One company we spoke to during reporting season suggested there is material demand for quality property assets but there was a heightened focus on “beds and sheds” given the uncertainty around retail and office. Sheds refers to Industrial REITs, where cap rates for quality assets are in the 4s. We believe the conversation around beds was clearly referring to ‘Build to Rent’ as an asset class but can also extend to the retirement living space.


It’s hard to argue that the e-commerce trend driving the attraction of Industrial REITs isn’t a powerful thematic, but the demographic trend of an ageing baby boomer population is also quite appealing. Industrial REITs aside is the trend of an ageing population and the escalators built into leases (3.5% p.a. in LIC’s case) a potentially more attractive growth opportunity than Retail, Office or other REIT classes? We think it’s worth considering.

Below we have tabled the ASX pure play retirement living providers, noting the list was longer prior to corporate activity in Aveo and Gateway Communities(9).

Source: Chester Asset Management, Company Presentation Material, IRESS

With potentially less risk, appealing characteristics(10) vs other REITs and attractive growth we suspect there is room for cap rate compression. At premiums to NTA this may be somewhat priced in, particularly for LIC, but we believe provides for valuation upside in the likes of EGH and INA.


The point of this exercise was not to say that every company that has government contracts will necessarily outperform those that don’t, but it does provide food for thought. I.e. it’s worth thinking about avoiding the sugar crash and considering whether it’s time to load up on carbs.

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(1) As seen in the TV Show Entourage, episode the Script and the Sherpa

(3) I.e. FY21 YTD sales

(4) Which can be further compared to the entire market and a FY22 growth rate

(5) (Operating Cash Flow after tax excluding interest – capex)/ Enterprise Value

(6) Real Estate Investment Trust

(7) We don’t have space in this article to get into a debate around Retail REITs so will leave the comment at that

(8) We have collectively considered land lease communities and retirement village operators

(9) EGH is notably not an ASX300 company but has been considered by Chester as a company with exposure to this thematic

(10) Including potential further industry consolidation

Past performance is not a reliable indicator of future performance. Positive returns, which the Chester High Conviction Fund (the Fund) is designed to provide, are different regarding risk and investment profile to index returns. This document is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any specific individual. As such, before acting on any information contained in this document, individuals should consider whether the information is suitable for their needs. This may involve seeking advice from a qualified financial adviser. Copia Investment Partners Ltd (AFSL 229316, ABN 22 092 872 056) (Copia) is the issuer of the Chester High Conviction Fund. A current PDS is available from Copia located at Level 25, 360 Collins Street, Melbourne Vic 3000, by visiting chesteram.com.au or by calling 1800 442 129 (free call). A person should consider the PDS before deciding whether to acquire or continue to hold an interest in the Fund. Any opinions or recommendations contained in this document are subject to change without notice and Copia is under no obligation to update or keep any information contained in this document current

Anthony Kavanagh
Portfolio Manager
Chester Asset Management

Chester Asset Management is a high conviction equities fund manager co-founded in 2017 by Rob Tucker and Anthony Kavanagh, with a 25-40 stock benchmark unaware strategy comprised of predominantly broadcap (ASX300) stocks.

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