WALL-E; Industrial S-REIT's dirty little secret

An S-REIT is a REIT listed on the Singaporean stock exchange. This article concerns industrial and logistic REITs listed in Singapore and also owning properties there. Most of such properties are built on land leased from the Singaporean government. These land leases are relatively short, 30 to 60 years, and part of that time has already passed. The remaining time is expressed as the Weighted Average Land Lease Expiry, which I will shorten as WALL-E, like in the namesake movie. 

When the land lease of a particular property has expired, the REIT owning that property has to demolish it and return the land to the government. The REIT may also manage to extend the land lease, but it must pay a large lease payment. It is really a lose-lose dilemma for the REIT. This WALL-E issue does not get much exposure in the media. This may be because the weighted expiry is still 30 years or more in the future, which is an eternity for most of us.

Still, it is the elephant in the room for me. Imagine the worst-case scenario where a REIT can not extend any of its land leases after 30 years. The impact on the REIT valuation is like a discounted cash flow calculation without a terminal value. If you are unfamiliar with these calculations, let me assure you that it dramatically decreases the value. Another way to think about it: you should at least get a 3.33% dividend yield per year just to be compensated for the fact that a year of the properties' earnings potential has been lost. Only the yield above 3.33% is what you truly earn. 

The best Singaporean finance blogger Kyith Ng wrote about this issue in 2011  and concluded:

"It will be prudent to value a REIT as if this is a non-perpetual asset with a finite lifespan and calculate the internal rate of return as accordingly."

As Kyith Ng mentions in this article, the JTC Corporation is responsible for either extending a land lease or terminating it on behalf of the Singaporean government. Looking at historical cases, it seems that JTC will usually renew a land lease, but it might not do so when there are redevelopment plans for the area where an industrial property is located. Thus, JTC's decisions seem to be driven by urban planning motives rather than attempts to maximize profits. It may not be as bad as it looks for the REITs. 

Even so, I am annoyed by the WALL-E issue. I do not feel I really own an asset if it must be returned within 30 years. Funny enough, I don't have this concern when a lease expires in 60 years or more. The expiring land lease issue could get increasing media attention as we get closer to the expiry dates of more and more properties. In a few years, the threat might be felt as more pressing and could influence the share prices of REITs. At least one S-REIT manager seems to share this concern...

5. Rebalancing of portfolio to freehold assets, whilst not compromising on growth:

a. With our Singapore properties, accounting for 60.5% of our portfolio by valuation, held through Jurong Town Corporation (JTC) on a leasehold basis, it is prudent that we progressively rebalance AA REIT’s portfolio to longer tenure or freehold properties to minimise the future impact of a shortening land tenure.

(AIMS APAC REIT, Annual Report 2022, page 8)

The WALL-E issue affects S-REITs with industrial properties in Singapore, like ESR-LOGOS REIT, AIMS APAC REIT, and Sabana REIT. It is much lesser an issue for S-REITS with offices, hotels, and malls, which are sectors where land leases tend to be much longer. It is also not an issue for industrial S-REITs like Daiwa House Logistics (Japan) and Frasers L&C (Australia, Europe), which, although listed in Singapore, are active in countries where land lease expiry is very long or properties are typically on freehold land. That said,  there are other countries, such as Vietnam and China, where land leases are also relatively short. S-REITs like CapitaLand China Trust and EC World REIT may be impacted in these cases. 

In my portfolio, the WALL-E issue concerns ESR-LOGOS REIT, AIMS APAC REIT, Sabana REIT, CapitaLand China Trust and China Merchants REIT in Hong Kong. I sold all of these.

Sold out: Able Global Berhad (KLS:7167)

Able Global Berhad sells milk under the brand names Able Farm and Tarik Tarik. I had purchased a 0.5% position to feel out this stock. My rule is to double the starting position or sell it off when I don't feel confident about the company's prospects. The company has low debt, a good ROE, and a decent dividend yield. The stock price seems low compared to these fundamentals. So, why do I not feel confident?

Able Global is expanding its dairy business into Mexico. Analysts applaud their spirit of entrepreneurship, but I am confused about the reason for choosing this particular country. I have reviewed the company's publications but did not find any rationale for this choice. When a company expands its operations, it is typically done at the edge of its circle of competence. It would, for example, expand into a neighbouring country or a product line that supplements the current products. It is unclear why a company would jump from Malaysia into Mexico. Able Global increased its debt burden to support this effort, raising the stakes even higher.  

My second area of doubt concerns Able Global's digital brand strategy. There is no active presence of Able Farm on Instagram, TikTok, Twitter, or Facebook. But even worse, a search on Shopee does not even yield 25 listings of their products. You may argue that offering milk on a trading platform makes no sense because it would get spoilt during shipping. Let's clarify here that Able Farm offers condensed, evaporated and UHT milk variations, which you don't have to refrigerate. F&N and Dutch Lady provide similar products in the Malaysian market. Searching these brand names lists hundreds of results on both Shopee and Lazada. Where are the Able Farm products? Let me be clear that the products do exist. I have seen those used in various street food hawker stalls for which Malaysia is famous. There is likely a long-time functioning supply chain behind these products, possibly with third-party wholesalers. They might not see the need to advertise to the ultimate consumer. 

For my portfolio, I am looking for consumer staples where the brand name is the moat. Brand names must be supported by modern advertisements and other marketing efforts. The absence of modern marketing efforts for Able Farm and my reservations about the future Mexican operation made me conclude that the stock does not fit my requirements. I should have caught these objections because both already existed when I bought the stock. My lack of research and reflection was a mistake. By the way, selling the stock may also be a mistake when the Mexican operations take off successfully. I will be keeping an eye on the developments. Sold Able Global at 1.29 RM.

Disclosure: Long Fraser and Neave (F99 in Singapore)

Sold out: DFI Retail Group Holdings Ltd aka Dairy Farm

I regard Alibaba as one of the biggest mistakes I ever made. In thinking about Alibaba, I got charmed by their position in the Chinese internet and didn’t stop to realize, 'they’re still a gawd-damned retailer.'

(Charlie Munger, Daily Journal annual shareholder meeting, 15 February 2023)

Charlie Munger is unhappy about his Alibaba purchase. I can relate to that; I sold off mine last January already. But let’s notice his dim view of retailers in general here. Is retail such a lousy business? 

Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? 

[...] in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day. [...]

We would rather look for easier things to do.

(Buffett, Student Visit 2005)

Buffett is also pessimistic about the prospects of retailers. He seems to suggest that investors try to identify the smartest player in the sector, such as Wal-Mart, which is one of the success stories within Berkshire’s investing track record. 

Value investor Pat Dorsey is more specific in his book The Five Rules for Successful Stock Investing. 

Not surprisingly, we generally don’t find a ton of great long-term stock ideas in retail and consumer services because most economic moats for the sector are extremely narrow, if they exist at all. The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors’. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever. It’s rare to find a retailer or consumer service firm that maintains any kind of economic moat for more than a few years.

Retail is generally a very low-return business with low or no barriers to entry. [...] The primary way a firm can build an economic moat in the sector is to be the low-cost leader. 

Let’s start our survey of DFI Retail Group here. Is it a low-cost leader, or does it offer something unique to survive the retail battlefield in the long term? I think neither. DFI has been struggling for several years, starting years before the Covid pandemic. It recently sold its supermarket operations in Malaysia and wrote down its investment in The Philipines.

An excellent introduction to DFI was written by Global Stock Picking. This blogger bought the stock in December 2017, traded in and out a few times, but sold it off in 2022. The blogger’s quote about DFI’s parent company Jardine Group drew my attention.

In a city like Hong Kong there are many examples of businesses that are protected due to vested interests from business owners, who are allowed to influence politics.

Globalstockpicking argues that DFI built its retail business in Hong Kong under the protection of a duopoly with Hutchison. We could theorize that DFI’s operations outside Hong Kong enjoy less success because they lack such a moat. In the latest FY2022 report, the Chairman remarks about DFIs’ future: “The Group’s overall results will largely depend on the recovery in Hong Kong of its Health and Beauty and Restaurants businesses, and an improved performance by its associate Yonghui on the Chinese mainland.” 

DFI’s focus is still on Hong Kong. However, I hesitate to rely on a strong economic come-back of Hong Kong for any investment success in the foreseeable future. Besides Hong Kong’s economic prospects, we can question whether DFI’s moat there is still intact, considering the political developments. The retail duopoly might be disrupted by new players entering the market.

A more pressing concern is DFI's debt which fails my criteria. In its FY2022 report, DFI discloses its interest cover at 3. However, there are several ways to calculate Interest Cover Rates. RHB Research sets it at 2 in their latest report, which is also my estimation. Moreover, 60% of the debt consists of floating-rate borrowings instead of fixed-rate agreements. DFI associate Yonghui, which runs supermarkets in mainland China looks quite leveraged too. Yonghui’s FY2022 financials have not been published yet, but its operating profits have been negative for a while. Considering the Chinese 2022 lockdowns, we can expect Yonghui’s 2022 performance to be poor again. On the bright side, China re-opened in 2023. From now on, earnings and operating cashflows for both DFI and Yonghui will recover at least somewhat. In that light, although leverage looks worrying it is not an immediate threat to the continuity of either company.

DFI was already a turnaround story before the Covid pandemic. In early 2020, Blogger CS Jacky pointed out the challenges and warned us, “The transformation plan to reshape DFI is a long-term endeavour”. Fast forward to 2023, and we can ask whether the turnaround is ongoing or has failed. To quote Warren Buffett again, “turnarounds seldom turn” (1979). Hence, I dislike relying on a business turnaround for my investment returns.

DFI reported its FY2022 financials in the same week as Haleon and Reckitt. I couldn’t help noticing how much easier their challenges seem compared to DFI. Why make an uncertain bet on DFI when more straightforward choices are around? KISS = Keep It Simple, Stupid. DFI also fails several of my checklist items. I am taking my loss at about -15% (including dividends), sold at 3.14 USD. Admittedly, at this price, DFI looks cheap on the surface, yet I am more confident making back my loss with another stock. To echo Buffett's quote from 2005 again... 

We would rather look for easier things to do. 

Disclosure: Sold out DFI and Alibaba. Currently long CK Hutchison, Haleon, and Reckitt.