Why Lendlease is a Sell

You may remember us writing about the ‘diversified’ development, construction and property management business Lend Lease. It was sold out of our model at a price of around $15 from memory and has proceeded to fall a further 33% amid the COVID-19 shutdown. Yet walking around the suburbs it seems that the construction sector is the only one that has not really been impacted by these restrictions. 

An article published in the AFR last week piqued our interest, announcing Lend Lease’s intention to securitise, or on-sell the cash flows expected to be received from pre-sold apartments at their major buildings in Sydney. Confused? Well it seems that Lend Lease has a cash flow issue for its $100bn in work in hand, and is attempting to sell the profits or future settlement from apartments yet to be finished onto an external party to provide short-term fund. In theory it makes sense, you bring forward profits to reinvest into anotehr project; yet we arent operating in normal conditions.

Our concerns

Our original concerns around Lend Lease remain but have since been added to by the incredible events and changes occuring due to the pandemic. We suggested selling the business after they announced a substantial writedown on a number of major projects, due primarily to cost and delivery blowouts; our concern being that this issue was more widespread than it appeared. The company subsequently rallied some 30%, before falling 50% to where it is today.

During this time, management announced the sale of their engineering division to Spanish giant Acciona, but this will actually cost Lend Lease at least $500m, if not $1bn based on the views of some research analysts. Not only did it cost money, but they were required to retain a number of troublesome projects including Melbourne’s own Metro Rail Tunnel which is now at a standstill as negotiations with the Government continue over cost blowouts; sounds all too familiar. More recently, management attempted to sell the Services division, which was previously known to have one of the worst NBN installation contracts, but has since improved; yet the primary bidders in ASX-listed Service Stream pulled out late in 2019.

There is little doubt the company has delivered a strong growth profile, with over $30bn in property assets under management through their funds and a pipeline of some $112bn in residential and commercial property projects across the world. Yet is this area where we are becoming concerned. Lend Lease is increasingly looking like Macquarie Group pre-GFC with a substantial amount of its own capital invested into its projects, meaning when markets fall, as they are now, cash flow, gearing and other pressures increase. Consider for instance that they currently have some 37,000 residential units that need to be sold around the world, in what can only be considered an extremely uncertain environment.

Our biggest concern, however, now lies in the combination of residential and commercial property they manage on behalf of primairly institutional investors like pension funds. Recent superannuation changes and market volatility have seen substantial switches between investment options and demands for increasing transparency on asset valuations in properties just like these. The last few week’s has even seen rare redemption requests for Industry Funds Management direct property options as funds like Host Plus cash up to fund drawdowns. What does this look like for Lend Lease? Will they also need to offer redemption requests, will the values of these assets be reduced, effectively reducing the value of the properties still under construction? Or will borrowing from tomorrow be enough to avert disaster?

Whilst their current debt isnt demanding, falls in revenue across every business unit except low margin construction and cash flow conversion of just 5% should be concerning for investors. In an environment where everything is on sale, we think there is better value with less uncertainty elsewhere.

Government Announcements

As we all come to terms with the short-term and unknown longer term implications of the Coronavirus, and what a Stage 3 Lockdown could mean, the Federal and State Governments have been on the front foot announcing a series of measures to assist businesses and individuals during this difficult time.

The swift reaction by hospitality and retail businesses of standing down or sacking workers within just a few days of self-isolation announcements was somewhat unexpected but evidence of the ‘everyone for themselves’ survival instinct that occurs in such uncertain times. A summary of the major policy announcements so far include:

  • The minimum pension drawdowns for 2019-20 and 2020-21 have been cut by 50%, as they were during the GFC. That means if you are under 65, you only need to draw 2% of your 1 July 2019 balance, or 2.5% if between 65-74. The same discount applies for each of the other age brackets.
  • For small businesses, the ATO is offering a Cash Flow Boost, by crediting any business activity (BAS) or PAYG amounts that are payable on a monthly or quarterly basis. Specifically, businesses with turnover of less than $50m will not be required to pay PAYG to the ATO on behalf of their employees where it is less than $50,000. In fact, every business will be afforded a $10,000 credit whether they withhold tax or not.
  • The Federal Government is offering early access to superannuation under a loosening of the hardship provisions. This will allow those who are unemployed, eligible for job seeker payments or have been made redundant or lost working hours of 20% or more since 1 January 2020. It is limited to $10,000 this financial year and next.
  • Closer to home, the Victorian State Revenue Office will be refunding payroll tax paid by businesses thus far in 2019-20 but only for those with payroll below $3.0m. This is a case refund and no further amounts will be payable for 2019-20 or the first quarter of 2020-21.

It’s worth noting this is simply the first round of support measures which come on top of the various actions taken by the Reserve Bank in recent days. Both State and Federal Government’s appear acutely aware of the risk that mass unemployment would have for the future of the Australian economy.

Never sell stocks…

In the latest of our ‘never-sell’ stocks, we take a closer look at Microsoft, one of the few trillion-dollar companies in the world. The foundation story of Microsoft is well known, as both Bill Gates and Paul Allen created the business from their garage in 1975 as they sought to capitalise on the growth in demand for personal computers. As the story has it, both are now among the richest people in the world with $100bn and $20bn between them, along with in Paul’s case an ownership stake in both the Seattle Seahawks NFL team and the Portland Trailblazer’s NBA team.

The company is renowned around the world for its Microsoft Windows, Office and Internet Explorer software but is so much more than that today. The business now develops, manufacturers, supports and sells computer software, consumer electronics and personal computers among other things. Interestingly, Microsoft is one of the most active acquirers of new businesses around the world, which as been a key plank to their success over several decades, making them one of the few pre Dot.Com companies to remain in the top 10 by market cap 20 years on.

The company has been well lead over the last decade, initially by Steve Ballmer, who directed the business down the ‘products and services’ route including the launch of the now popular Surface Pro Tablet and Laptops. More recently, under CEO Satya Nadella the business has pivoted once again moving heavily towards Cloud and Enterprise computing services.

Microsoft is very clear in their mission to ‘empower every person and every organisation on the planet to achieve more’. In fact, there operations are contributing to massive changes in the way all companies do business and leading to more efficient operations around the world. Take for instance my business, Wattle Partners. We moved away from a physical server close to a decade ago and have never looked back. All relevant documents are scanned and stored securely via Microsoft’s Azure Cloud platform, our emails run through Outlook and we are access everything from anywhere in the world. Many businesses would have entered this COVID-19 disruption with great concerns about how they can continue to service their customers to the same level, but by partnering with Microsoft the service has been seamless.

After a record year in 2019, Microsoft, along with almost every business, has been impacted by the supply chain and demand disruptions of COVID 19, seeing its share price fall from $190 to $137 today, a loss of 27%. Yet the company is likely to be one of the bigger beneficiaries of the change in business practices, evidenced by the now 44 million daily active users of their Microsoft Team’s communication platform. Whilst now less relevant, Microsoft’s December quarter earnings results were highly impressive:

  • Total revenue improved over 11% to $36bn;
  • Productivity & Business Division (Office) – Revenue increased 17% to $11.8bn;
  • Intelligent Cloud – Grew 27% to $11.9bn, including 62% growth from Azure storage;
  • Personal Computing – Saw the Surface have a record $1.9bn sales quarter, up 6%;

As you can see, all three business units have a near equal attribution to group revenue and all improved in the quarter; most importantly the company makes money, with Net Profit of $11.6bn. Microsoft were one of the early adopters of the subscription model for their Office software, which was originally questioned by market commentators, but has been an overriding success providing a near annuity stream of earnings for shareholders.

One of the key reasons we view Microsoft as a never sell stock, is there dedication to growth opportunities. They acquired Linked In and 2016 for $26.bn and have successfully monetized a platform that many never saw as being possible. Their business is likely receiving great benefits from the current shutdown from a combination of their online collaboration tools and their ownership of the XBOX gaming platform, which is increasingly popular for those confined to their own homes.  They also purchased Skype for $8.5bn in 2011 and have leveraged this technology to challenge the likes of Zoom Communications as more business become nimble and move to video-conferencing. But most importantly, it’s the growth of their cloud platform, which has seen revenue increases of 62%, 59%, 74%, 73% and 76% over the last five quarters.

Having IPO’s at $21 and undertaken nine share splits, the average cost for Microsoft’s first investors is just 9 cents, compared to today’s price of $137. After recent falls the company trades at a PE of around 25x and warrants a position in the portfolios of all long-term investors. 

Should you be worried about your industry fund?

At this point, daily sharemarket volatility exceeding 5% has become accepted, in fact bond yields are now exhibiting more volatility than shares. One if our biggest concerns actually relates to those who aren’t clients of Wattle Partners, in particular those who don’t have access to professional financial advice at this very difficult time.

Whilst we aren’t blaming the Royal Commission, it has come at an incredibly difficult time for retirees and investors in general. Thousands of advisers are leaving the industry or dealing with additional compliance at a time when they should be 100% focused on guiding clients through this volatile environment. We decided to call Australian Super this week to enquire on our small investment in their balanced fund, which has fallen over 25% in the last three weeks.

After spending several minutes on hold, we were informed that they were no longer able to process changes to investment options over the phone and guided all investors towards their mobile application or website. This is a little concerning given many of their members are 70+ years old and in our experience may struggle in dealing with this type of technology.

We have been inundated with calls and emails from readers of our newsletter who have decided that they need to ‘protect’ what they have left by moving their entire investment options back to cash; at what is most likely to the worst such time to do so.

The chart below from JP Morgan evidences the risk of making this decision, in that it explains why the average investor consistently underperforms the funds and assets they invest; this is solely because they tend to change strategy at the top and bottom of the market. The chart plots each asset class from left to right, with the average investor on the far right, with a return of just 1.9% per annum over 20 years.

This leads us to a secondary concern regarding the industry fund sector, which we believe may be driving the huge amounts of volatility being experienced in Australia and around the world. It’s important to disclose that we are proponents of the traditional balanced fund approach for many younger, smaller balance investors, as we understand they are built for accumulating capital, not drawing it down and carry an inherently higher risk investment philosophy.

What concerns us most, is the many retirees and pensioners who move to Australian Super chasing their returns (which interesting still only show up to 30 June 2019 on their website), but are now in a position without any access to advice and having seen a substantial drop in the value of their life savings. We have attempted to summarise our various concerns succinctly in the following sections:

  • Lack of transparency: We have consistently queried the transparency and reporting capabilities of the likes of Australian Super, based on our long-held concerns that their strong returns were being delivered by taking substantially higher risk than many of their older members expected. In times of volatility, humans value information and knowing exactly what it is that’s driving performance both positively and negatively.  Outside of a generic top 10 holdings list or out of date strategic asset allocation table, these funds offer very little transparency at a time of need.
  • Liquidity concerns: This and the next issue were highlighted very well by Robert Gottliebsen in today’s Australian, where he opined on the issue facing industry funds that offer same or next day investment option switches to their millions of members. This is of course fine when the underlying assets are liquid, like cash and shares, however, a liquidity issue emerges when as much as 30% of the typical Balanced option is now invested in things like private credit, junk bonds, property, infrastructure and venture capital, which simply cannot be sold. The result has seemingly been many industry funds having to sell down the only liquid portion of their portfolios, Australian and overseas shares, in order to fund investment switches and redemptions; leading to mayhem in investment markets. Interestingly, many funds faced a similar liquidity issue during the GFC, as their model of internalising sharemarket investments meant they were required to fund the cost of hedging their portfolios, which spiked dramatically as the AUD fell. 
  • Valuation concerns: This was similarly highlighted by Gottliebsen when he suggested that all industry funds should be spending the weekend undertaking a real valuation of their unlisted asset portfolio or risk the potential for legal action from their members in the coming years. His concern, like ours, is that many unlisted assets are likely to be overvalued in this environment, meaning that those redeeming an investment option, maybe leaving a lesser valued asset and disadvantaging those who stayed put. His specific example focused on the concept that there are two office buildings next to each other, one is listed, the other is unlisted; the listed one has fallen 30% in value over the last 12 months, but the unlisted has not moved at all. If you then transfer the unlisted assets to someone else, you are passing on a capital loss to that person.
  • Reliance on contributions: This is closely related to our liquidity concerns expressed above, with our issue being that the huge capital flows into industry funds, which total several billion dollars per month in the form of Super Guarantee contributions, have been a primary source of liquidity. This constant flow of cash has meant they are able to invest more into unlisted assets with the knowledge that pension payments will be covered by incoming contributions; but what if this stops. Or what if investors become concerned about the performance of their fund and all rush to withdraw their balance at the same time. Does the sector face a bank run type event that would require them to freeze redemption requests?
  • Inability to take targeted action: Another major concern is that investors within these funds have very little scope to make targeted changes to their portfolios. They have very few investment options to choose from and the few options available have vastly different risk profiles. Take for instance Australian Super’s Balanced Option, which has 90% in risky assets, the next closest option, Index Diversified, has a 70% allocation to risky assets. In recent weeks we have been advising clients to consider hedging their overseas shareholdings, introducing allocations to gold bullion or removing long duration bonds, all of which would alter their asset allocation by no more than 5%, but vastly reduce the risk. These small changes are simply not possible via large industry funds. 
  • Lack of access to advice: Our biggest concern was highlighted in the introduction, being that these funds now have many millions of individual members simply do not have the staff, technology, experience or the licensing to provide professional financial advice at the time of greatest need. They can advise on investment switches but are not able to explain the potential implications, loss of benefits and compounding of losses that will occur. 

If we can provide one small piece of advice to investors within industry funds carrying large unlisted asset exposures, it would be to maintain your current ‘market’ exposure, but shift your investments into the Australian Shares and International Shares options. We have serious concerns about the current search for liquidity and its impacts on unlisted, private holdings within Balanced options. We hope this has provided some unique insight into the sector and one of the many reasons that markets appear to be behaving irrationally during this stressful time.

The real costs of running an SMSF

This article has been a few months in waiting as there were more pressing issues to cover, however, we thought it worth retouching on the issue raised by ASIC and numerous industry super funds throughout 2019. The issue was initially raised when ASIC published a fact sheet on the Self Managed Super Fund sector, asking readers to consider are they for you?

 Of course, on its own this can only be a positive for the financial advice and superannuation sector, ensuring all investors really consider if they are willing and capable to control the investment of their own life savings. This is of course a unique structure compared to most parts of the developed world. The concern, however, came from reporting that the average cost to operate an SMSF is $13,900 per year! Not only this, they also suggested that trustees spend at least 100 hours per year running their fund. The  ultimate  conclusion,  being  that funds under

$500,000 were unlikely to be cost effective, makes some sense for us, however, our experience is that the  hurdle  is  substantially  lower  at  closer  to $250,000 following the introduction of a number of new service providers in the sector.

In light of these fact sheets and input from a number of SMSF specialists, we thought it worth putting forward our thoughts on the matter. Specifically, we are focusing on the fee question, as this seems to be driving the discussion. When it comes to SMSF’s its important to note that there are many possible fees, but the majority of these are optional, depending on the investment strategy adopted. To summarise, they are as follows:

  1. Accounting and Administration Fee: This is the only fee that must be paid by an SMSF each year, it represents the cost of meeting the funds taxation reporting and audit requirements. In our experience, the average cost of an SMSF tax return and audit is just $2,200 yet many accountants continue to charge amounts as high as $7,000 for what is today a commoditised The lowest fees for returns are around $1,650.
  2. SMSF Supervisory Levy: This represents the ‘registration’ fee paid to the ATO each year which has increased from $191 a few years ago to $259 today and is now automatically deducted from your tax
  3. Platform Fees: These are the first of many optional fees and represent the cost of employing groups like Hub 24, BT Wrap, MLC or Netwealth to undertake all the paperwork for your investments on your behalf. The average cost of this fee is around 0.25% of the assets held in the SMSF. It means you are not required to complete any paperwork and will receive consolidated tax reporting each year.
  4. Management Fees: These fees are charged by professional fund managers, exchange traded funds (ETF’s) and listed investment companies. They are not an out of pocket expense, but rather deducted from your earnings within the structure. Importantly, they are optional and depend on your individual selection of
  5. Adviser Fees: Again, these fees relate to receiving professional advice to guide the investment of your portfolio and assist with meeting your reporting and other responsibilities. These are completely optional, SMSF’s allow you to make all the decisions yourself, or to make none and outsource this Financial advice fees are not included in the cost structure of industry funds.

Without becoming part of the industry vs. SMSF war it’s important to ensure every option is compared on a equal footing. The structure of most large industry funds is highly opaque meaning it is difficult to understand the many layers of fees you may be charged. Consider for instance that most funds charge an administration fee of 0.60% but does this include payments made to their own associated investment entities? Most funds allocate returns based on a ‘crediting rate’ equal to a day’s worth of estimated earnings, but the calculation of this rate is not transparent, does it include all relevant costs? Returns have no doubt been strong for both options, however, we believe investors will increasingly value the need for transparency.



Transfer Balance Cap

By Annabelle Dickson

The Australian Taxation Office (ATO) is alerting superannuation trustees to plan for a number of changes in regard to the indexation of the general transfer balance cap, which will be particularly important for SMSF trustees.

The transfer balance cap is expected to rise to $1.7 million on 1 July 2020 in line with the consumer price index (CPI), bringing changes to the limits of non-concessional contributions, co-contributions and spouse offset.

The cap is currently $1.6 million of the total amount of accumulated superannuation an individual can transfer into the tax-free retirement phase. Retirees commencing a retirement phase income stream after indexation will have the full increased transfer balance cap of $1.7 million. However, for those who have already commenced a retirement phase income stream, the cap will be proportionally indexed based on the highest ever cap balance.

Peter Hogan, head of technical at SMSF Association says: “It is complex because everyone’s transfer balance cap will be different. You can only index the unused amount of the transfer balance cap.”

The ATO says it will calculate the entitlement to indexation and the personal transfer balance cap after indexation, based on the information reported to and processed by them when indexation occurs.

In the case that the balance in the transfer balance account was $1.6 million or more after 1 July 2017 and between the time of indexation, the cap will not increase. Graeme Colley, executive manager, SMSF technical and private wealth at SuperConcepts, says that these changes will affect all superannuation members in pension phase but may affect SMSFs more due to members having higher non-concessional contributions and larger total superannuation balances.

Hogan agrees and says it is important that SMSF trustees understand how much they have used and apply the indexation to what is unused. Colley says: “What may happen with SMSFs is that members will continue putting in contributions as they always have been and may forget about the rules, so mistakes can arise. The ATO is sensible in getting this information out now for the potential indexation to try and avoid that.”

The total superannuation balance limit which determines if an individual is not allowed to make non-concessional contributions will increase from $1.6 to $1.7 million.

In addition, an individual qualifying for a co-contribution entitlement will cut out when their total superannuation balance reaches $1.7 million and above. The limit that excludes an individual from claiming the tax offset for superannuation contributions they make on behalf of their spouse will rise from $1.6 to $1.7 million.

Despite the limits increasing to the same amount, there is a disparity in the way that the contributions are indexed. Colley says: “The transfer balance cap is indexed at CPI but the concessional and non-concessional contributions are indexed at changes in average ordinary times earnings (AWOTE). AWOTE indexation occurs at a greater rate than CPI in nearly all situations.” Hogan agrees: “CPI is less generous than AWOTE and takes longer to get to the same level.”

If indexation does not occur on 1 July 2020, the ATO anticipates it will occur on 1 July 2021

Annabelle Dickson is a journalist at The Rub and The New Investor.

What is ESG?

As we meet more people around Australia, a common trait and questions continue to be raised around the ability to invest more sustainably and ethically particularly in regards to climate change. This is a theme that has been growing exponentially at the institutional level, but limited coverage or options have been made available for most investors. Given the plethora of acronyms already in the industry, we thought it appropriate to provide a short summary of how people can invest more sustainably through a concept called ESG.  Put simply, ESG stands for Environmental, Social and Governance criteria when it comes to investing. There are many ways to apply ESG principles, which we will discuss in future issues, however, at this point we just wanted to provide an introduction to the sector.

Environmental considerations refer to investing in businesses who are stewards of nature. This may sound a little green, however, in this criteria you are either looking at companies who are aware and managing their energy use, waste, pollution and are actively involved in natural resource conservative in some way within their businesses. Most importantly, businesses must be aware of the environment risks that they are exposed to and have a policy of how to manage those risks including contaminated land, climate change and emissions.

Social considerations are becoming increasingly important in our globalised world, as after years of exporting jobs to access cheaper labour, they are now moving home or into frontier markets. The social considerations refer to relationships with employees, customers, suppliers and communities. The key exposures relate to understanding the supply chain of products being manufactured, avoiding cheap and child labour, donating a portion of profits, allowing employees time to volunteer and offer strong working conditions. A movement called B Corporations is quickly gaining steam in the country, as it requires members to consider all stakeholders in running their business. Wattle Partners has been one of the few financial advisers in the country that is an accredited BCorp.

In recent months, with the likes of Woolworth’s underpayment scandal and Westpac’s Anti Money Laundering issues, Governance has become an increasingly important question. This begins at the top, focusing on the leadership of businesses, appropriateness of executive pay, quality of external audits and internal controls (including whistle-blower policies) and protecting shareholder rights. This extends to maintaining accurate and transparent records, allowing shareholders to vote on important issues and disclosing the conflicts of interest or any board members.

Each of these criteria can be applied on a positive or negative basis, which we will discuss in future issues.