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Bond of the Week: 29 September 2015
REA Holdings PLC 9% pref
    

I have been asked to comment on a rather obscure issue, the REA 9% preference share, as it has recently come down in price. In the absence of any imminent new issues for the ORB I thought I would do so. REA Holdings is listed in London with a small market cap of £93.5 million.

I have been aware of this issue for some time and have occasionally considered a purchase but each time I have rejected it. Although I am a glutton for yield (my starting point is you need yield to pay for the inevitable mistakes that will occur, eg VW) I have always rejected REA on a relative value basis. For instance 3 years ago the Lloyds 9.25% pref yielded 9.54% and the REA only 8.24%. REA has now, however, substantially cheapened. Here are the terms of the preference share.

Issuer:         Rea Holdings PLC
Issued:        July 2004
Issue size:   £63,641,232
Maturity:    Irredeemable (no issuer’s call)
Dividend:    9% payable semi-annually Nov and May
Type:           Cumulative
Denominations £1
Price:          96
Yield:         9.6% (allowing for the accreted dividend)

As a preference share, as with ordinary shares, there is a preferential tax treatment on the dividend (now somewhat reduced by Osborne). However, as shares, not bonds, they are not QCBs so tax is liable on capital gains.

What do they do? Rea owns a palm oil plantation (and produces palm oil) in East Kalimantan, Indonesia (Borneo). [Around 80% of the world’s palm oil is produced by Malaysia and Indonesia]. Total land held is 250,000 acres of which 85,000 is planted and 70,000 is mature. The land is held on 30 year leases from the government which can be extended by payment of, in effect, a stamp tax. There are various stages as land leased goes from untitled to titled, during which they budget some ownership will be lost as local villagers (mainly the Dayaks) claim rights. 

The history of REA.  The website of REA sets out the long and interesting history of the company, which has not been without its trials and tribulations. Here is a synopsis. The firm was founded in 1906 as The Rubber Estate Agency (hence REA) running rubber plantations in South East Asia on behalf of London investors. Rubber peaked at 12s 10½d per lb (136p per kg) in 1910 making the company very profitable but then did not reach this peak again for over 90 years (let that be a warning to commodity bulls!). Nevertheless the company traded profitably until the great depression of the 1930s when the rubber price fell so far that many plantations stopped harvesting and estates were reduced to care and maintenance only.

Prices had just started to recover when the Second World War started and Japan invaded and occupied Malaya and the Dutch East Indies. The estates were lost. After 1945 the Malaysian Estates were rapidly returned but, owing to the Indonesian fight for independence, it was not until 1950 that owners there got their estates back. Business then improved (with rubber prices helped along by the Korean war) and estates under management increased to 250,000 acres. This was despite difficulties operating in Indonesia with regular shortages, highly restrictive exchange controls and constant security issues under President Sukarno and the threat of becoming a communist terrorist target during the Malayan emergency.

Then it all turned around again in 1964 when all the Indonesian estates were nationalized and although there was the opportunity to resume control of them again in 1968, none of REA’s clients took the opportunity up (quelle surprise). Meanwhile the Malaysian agency business entered a period of attrition which became terminal as estate owners, doubtless with an eye on what had happened over the border in Indonesia, sold their holdings to local interests . It then becomes a bit complicated with various re-organisations, and the ownership of other interests including Ceylonese tea plantations which were nationalized.

In 1982 under the Tasik project REA moved into palm oil plantations after receiving a concession of 15,000 acres in Sumatra from Anglo Indonesian Ltd. This new plan nearly never got off the ground after the Indonesian government suddenly decided to transfer ownership of the concession from Anglo Indonesia to an Indonesian state company. It was only because President Suharto happened to be visiting Mrs. Thatcher at the time that he was persuaded, over lunch at no. 10, to allow the 15,000 acres concession to go ahead. (He agreed to sign a scrap of paper over the lunch table). From then onwards, via various purchases and sales REA ended up with its major plantation in East Kalimantan, although not without severe financing problems during the late 1990s Asian crisis and mistaken investments in local coal mines. From 2005 development was financed in part via the 9% preference share and also various equity raisings and the planted area increased.

From 1906 until today, buffeted by the vicissitudes of fate blowing them first one way and then another, REA Holdings has survived. I salute their indefatigability. However, I give this rather long winded history not only because it is a curious affair but also in order to illustrate the unknowable and indeed perhaps somewhat random additional risks that a company bears when it is investing in a far-away developing country where we may not fully understand what is afoot.

 

A caveat.

It would be fair to say palm oil plantations have a dubious environmental reputation as they turn this

 into this


 which means no


I have to say I have a soft spot for Orangutans ever since watching my wife, many years ago, sharing a breakfast of bananas, papaya and pineapple with an Orangutan at Singapore zoo. I did question Richard Robinow, Chairman of REA Holdings, on the effect of mono culture palm oil plantations on the rain forest. He assured me that while it could not be denied that the plantations were mono culture, they were aware of their environmental responsibility and had areas zoned for conservation (50,000 acres) and wildlife corridors that ran between them. He also pointed out, quite reasonably, that regulation was continually tightening up and only going in one direction so it made commercial sense to be ahead of the game. Rea Holdings also has the picture of an Orangutan on their website under the word sustainability so they know they are potentially under the spotlight!

From the conservation perspective I would also think, although this may just be my prejudice, that if you are to have palm oil plantations it is better to have one run by a public UK company with investors and environmental organisations looking over their shoulders, than by a less accountable local private company. However, the question still remains; do we want rain forest or palm oil plantations. I think enough has been said on this caveat and it is up to each investor to decide whether this has any relevance.

Price action on the convertible and share. Below, courtesy of Bloomberg, are charts of the share price and 9% preference share going back to 2005 when the convertible was launched.





As you can see the ordinary shares are trading virtually at the low and in the case of the preference share actually at the low.  This compares with other non call prefs such as Lloyds 9.25%, Ecclesiastical Insurance 8.625% or General Accident 8.875% which are trading very much off their lows even if you exclude the nightmare period of end 2008/2009.

It is not difficult to find the explanation for the low prices of REA Holdings. Here is a chart of the price of Crude Palm Oil (unfortunately I could only find one going back to 2008).



From a peak of $1,307 per tonne at the beginning of 2011 the price has sold off continuously to hit a recent low of $423 (prices were in the range $400 to $500 in 2005 when the convertible was sold).. However the price in September has bounced by $100 off the low to $525.

What drive the price of palm oil and what are its future prospects? 86% of palm oil is consumed in food stuffs/ soaps etc and 14% as biodiesel. The biodiesel element has been under price pressure as it competes with alternatives such as crude oil, although Richard Robinow explained most biodiesel was consumed in power stations and the recent VW/ diesel scandal was not relevant.

The Palm oil that is used for food production competes with vegetable and rape seed oil. Here as the world gets wealthier consumption of fats steadily increases. In Europe we consume 60 Kilos of vegetable fat per annum, in India and China it is nearer to 20 kilos. We in Europe consume palm oil in ready-made foodstuffs (eg biscuits) and soaps and cosmetics although little in the way of fat for frying. In the developing world palm oil is used more widely for frying (it has the advantage of a longer shelf life in hot weather).

A positive is that palm plantations produce the highest production of vegetable oil per acre planted compared with the alternative sources of vegetable oil and farmers of annual crop alternatives such as soya bean and rape seed will stop planting before palm oil plantations become unviable. In addition new hybridised trees give a yield of around 10 times more than semi wild seedlings (20 to 30 tonnes of fresh fruit bunches per hectare as opposed to 2.5 to 5).

According to the Chairman of REA Holdings, the prospects for palm oil prices are good. Firstly world consumption has steadily been increasing (I think he said by 2 to 3% per annum) and there is no reason to expect this trend to change. Secondly we are about to have an El Nino weather event which historically has led to a dryer climate, lower yields and higher palm oil prices (The 1997/98 El Nino event led to a then spike in the palm oil price to $705.). REA expects prices to get to $550 in the next 6 to 9 months and in the medium term to $750. I asked what their breakeven price was. I was told that after interest it was around $400, but I think that figure excluded depreciation costs. The marginal costs of production is $255 so it would only be if the price fell below that that REA would put the plantations on care and maintenance. But of course a price sustained at that level for any time might mean there was no longer an REA Holdings Ltd.

P&L and the balance sheet. In the half year to June 2015 versus the same period in the previous year, revenue fell from $66million to $46million but costs were cut by $7.5 million. There was a nominal profit of $1.7million v the previous $17.1million, before the dividend on the preference share was paid, and a small loss attributable to shareholders after the dividend was taken into account. Back in 2011 the company produced an annual before tax profit of $64 million so you can see what the effect of a more than halving of the price of crude palm oil has had on profitability.

The substantial assets on the balance sheet are property, plant and equipment at $320 million and biological assets (trees) of $150 million.

Gearing is in the region of 66% ($197million debt to $300million equity) although I would point out that the preference share is classified as equity not debt. Given it pays cumulatively, even if from an accounting perspective it is correct to include it as equity, it still remains a burden on the balance sheet. If you were to re-designate the pref as debt that would take gearing to a pretty unhealthy level of 142%! However, you can partially mitigate this figure because there is a deferred tax liability of $80 million on the balance sheet which I am told will never be payable since it is the capital gains tax liability that would arise on the sale of (property) assets. If they were to sell they would sell the company not the assets so the tax should not become due.

I asked what their intentions were with regard to debt and I was told that they do not intend to take on any more debt ( that is assuming they can help it) and they may sell minority equity stakes in subsidiaries on local markets. This would be both to reduce debt and also to tap other sources of equity.

I think the major issue away from the price of palm oil is the level of debt. It does appear to me to be uncomfortably high. As a market maker commented, although they have never threatened not to pay the dividend on the preference share, they do have a track record of steadily taping their pref issue and you should always be wary of a company that is paying you your interest out of the money you keep lending them. After the initial placing of the pref in 2005, there were additional reopenings of 1.09mil in 2007, 1.3mil in 2008, 1.49 million in 2009, 1.67 million in 2010 and 15 million in 2011. In July of this year they had a placing of 4.2million additional preference shares (at 120p). Some of these placings may have been scrip issues but even so it is still more debt compounding up at 9%.

Finally they have recently sold £40 million of REA 8.75% 2020 notes. These bonds of course will rank ahead of the pref. The bonds do replace a previous issue but there has been a net debt increase of £5.5million. There is no price available on the 8.75% notes but if you assume par (it was only issued in August so that is not an unreasonable assumption) then is the 1% additional yield on a lower ranking irredeemable 9% preference share enough? I suspect not.

Potential change of domicile. There was a discussion a few years ago as to whether the domicile of the company should be moved to Indonesia as that is where all the business occurs. I have been told that that is no longer likely, although a partial float of subsidiaries in Indonesia is still on the cards, as “ pref shareholders wouldn’t like it”; quite right, I am sure they wouldn’t.

Conclusion. I have occasionally looked at this pref share over the last 5 years but it has never seemed a buy in part because there were so much better pickings elsewhere. At today’s price, it has fallen by 25% since the last placement of additional pref shares at 120p, it does give a substantial pick up over other irredeemable preference shares and bonds in the small denomination Sterling sphere. However, it does do so for a reason; a weak palm oil price against a backdrop of worry about global commodity prices. And also a rather too high level of debt.

My initial thought when looking at the preference share was that you should avoid it and indeed the tone of the market in this pref feels pretty weak so further prices falls would not surprise me. Having spoken to the chairman I think I now have a more nuanced attitude. There was reassurance on the outlook for the palm oil price and the strengths of palm oil plantations as low cost producers of vegetable oil.  Also having placed some recent further debt (the 8.75% bond and some additional preference shares) I take it there is no looming liquidity issue.


However, I shall not be making a purchase. The high coupons (and they having willing offered scrip dividends on the pref for some years) illustrate the basic risk of the operation even when everything is going well. This is a small cap stock operation in the developing world even if it is controlled from the UK where the price of risk capital should be priced quite high. And also even if a good intellectual case can be made out for the future price of palm oil, you are up against the old adage of the trend is your friend and the trend in this commodity is no different to that of most commodities. Yileds abound in this sector. I have just been offered some Glencore bonds with a 16% yield.

I shall finish on a marginally positive note. Because of its yield it is one to keep your eye on. One of three things unrelated to the specific performance of the company might turn me into a buyer of the preference share. The palm oil price could show a sustained turn around, the company could pay down some debt via an equity placing or the price of the pref could get substantially cheaper. I might then throw some chips onto the green baize.

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

Update: 1/10/15

Following yesterday's Bond of the Week I was rung up by someone I know well who has been involved in placing REA bonds and prefs. He thought my piece was balanced and fair but pointed out a couple of errata. I am very happy therefore to make the following corrections:

1) Dividends on the preference share have not been available in scrip form. However, the dividend on the ordinary share has been compulsorily paid 50% in cash and 50% in 9% preference shares (at par). Where investors have not wanted the preference share they have been placed in the market and the proceeds have been given to the shareholder.

2) Provision was made for issuance of £40 million of the new REA Senior 8.75% 2020 bond and it was offered in exchange for the £34.5 million 9.5% 2017 bond. What happened is that only £26 million was exchanged and no additional amount was sold. Therefore the outstanding amounts are approximately £26 million 8.75% and £9 million 9.5% and there has been no net increase of senior debt bonds.

 

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