LMI: Duxton Water (D2O)
Investing Recommendation: Long-term buy. Secular trends toward lower growth, high debt and central bank-supressed interest rates mean that opportunities for worthwhile, lower-risk returns are much more limited. Duxton Water offers one of the few ASX-listed pure, real asset diversification opportunities with profits (thus dividends) based on agricultural demand for limited water. The shadow of government and regulator inquiries into the Murray Darling Basin water market present buying opportunities absent any malfeasance (of which there is no evidence with D2O) or misleading information about the reliability of profits. Understanding the Duxton Water reports (monthly, annual, presentations) and underlying risk and return is critical to timing entry (and exit when necessary).
30 June 2019: NTA after realised tax: $1.69 NTA after realised and unrealised tax: $1.54
1 Aug 2019 Share Price: $1.36
1 Aug 2019 After Realised Tax NTA Discount: -19.5%
1 Aug 2019 After Realised and Unrealised Tax NTA Discount: -11.7%
I recommend accumulating at After Realised Tax discounts of greater than 15%. If trading after having accumulated, then trim exposure whenever the price temporarily jumps over 10% for no reason so you can re-buy at lower levels.
Disclosure: As at 27 Aug 2019 less than 5% of my listed investments are in D2O.
Selected brief insights
- Some investors may interpret the quarterly cashflow reports that often show negative cashflows to conclude D2O sometimes operates at a loss. Negative overall quarterly cashflows are usually due to purchasing more water assets and operating cashflows ultimately need to be considered on an annual basis to avoid timing issues with lease and other water allocation payments, and also account for the net impact of the trading of entitlements. Duxton's earnings per share are positive, being based almost solely on leasing and selling water allocations in a water market with increasing prices. Its 16/05/2019 AGM presentation lists EPS of 3.4c for the first 4 months of 2019. Its weighted average EPS for 2018 was 8.5c. If its 2019 EPS was ~12c that gives a P/E ratio as of 1 Aug 2019 (SP: $1.36) of 16. Alternatively, an earnings yield of 8.8%.
- However, in its half-yearly report, published 27 Aug 2019, half-year EPS is only 2.3c due to impairments in the value of general security entitlements that will receive no or minimal current allocations due to low storage levels. This has to be weighed against the increase in the value of high security entitlements and of temporary allocations. This impairment issue and tradeoff of owning a proportion of general security entitlements (which do pay off in wet conditions) needs to be assessed closely.
From Half Year Report ended 30 June 2019:
<<
Water asset revaluation uplift is reflected as part of the fair market value comparison information within this report. However water assets are classified as intangible assets for statutory reporting purposes, the Company’s water portfolio is measured at cost less any accumulated impairment. For the period ended 30 June 2019, a $2.367 million impairment expense has been recognised. This has had a material impact on the Statement of Profit or Loss and Other Comprehensive Income. The drivers behind this statutory impairment is reflective of the pull back in fair market value of NSW general security entitlements. Murray and Murrumbidgee general security licences experienced an 11% and 7% reduction in asset value across the period respectively, reflective of the continuing drought conditions being experienced across NSW. These assets form a critical balancing role within the Company’s entitlement portfolio composition and will support yield through the wetter part of the climatic cycle. The Company has formed a strategic general security holding and expects to see general security asset prices recover as we move back into more normalised climatic conditions.
>>
- In a low-growth, low-interest rate world, a relatively reliable earnings yield over 6% from agriculture products should be highly-prized. As the returns keep coming, if they prove reliable and growing, more investors will become aware, and it would be unsurprising to see the share price bid up till D2O's earnings yield is closer to comparable investments.
- As of June 2019 D2O has published its headline monthly NTA using its After Realised and Unrealised Tax NTA. But then noted a higher NAV when not including unrealised gains: "The NAV excluding tax provisions for unrealised capital gain is $1.69." However, all other ASX-listed LICs report the Realised Tax NTA as their headline figure. Consistent NTA reporting may produce a quick elimination of part of the discount.
- Duxton Water has recently come under fire for profiting from water speculation while farmers get exploited by artificially-high prices. (E.g. Link1, Link2) In reality, D2O is acting as intended in a market for a scarce resource (directing water to its highest and best use) and even in a worst case scenario where the government forced out non-farming entities from the market it would have to be compensated at market prices for its assets. In practice, these markets need specialist firms providing market-making (ever-present demand, supply, prices) and professional market services (advice, leasing, forward contracts, etc). The truth is that elevated water prices are due to long-term factors like climate change trends and higher value permanent plantations not any short-term speculative activities of firms like Duxton Water.
- In my view, Duxton Water's lease proportion and income should be more important in its valuation than changes in the market value of its water entitlements especially given this doesn't appear to fully factor the complexities of how much of its unleased entitlements are actually allocated by basin authorities (which depends on total storage levels). So take less note of NAV changes (which relate directly to Duxton fee income) and more note of leasing proportions and income. In its monthly reports it notes: "Aither Pty Ltd values the Duxton Water Ltd portfolio on a monthly basis on a dry (without allocation) equivalent basis" - this needs to be better understood by investors.
- Rural Funds Group (RFF) has been attacked by a short seller for overstating assets, fabricating non-cash gains, and paying much higher dividends than its actual cash earnings. This may cast some short-term shade on Duxton Water for being an agriculture-related equity with some similar assets but, unless Duxton Water is a fraud or deceptive about earnings, this would be a buying opportunity.
Understanding diversification with real assets
Meb Faber advises: "Diversification has been called the only free lunch in investing. This free lunch, so to speak, is the benefit an investor receives from diversifying his investing capital into two assets that are not perfectly correlated. The idea is when one asset falls, the negative impact on the overall portfolio is softened and the second asset won’t fall to the same degree or may even rise since there is not perfect correlation. In essence, by investing in uncorrelated assets, one plus one equals three."
Ray Dalio advises that adding uncorrelated assets with worthwhile future return expectations is the key to low drawdown, outperforming portfolios. (See video below).
Real assets are one of the few areas where exchange-listed return streams can be found that are uncorrelated with equities. In my view, the key to reliable, lower-risk real asset investments is whether they have a reliable, worthwhile profit stream. Agricultural demand for water certainly ticks this box better than real assets without income streams (e.g. gold, commodities) but the specifics of the water market and investment manager approach need to be assessed.
See:
> Ray Dalio - Uncorrelated return streams (video)
> Real Assets 101: Key Characteristics Investors Need to Know
Key Risks:
Excerpted from the IPO Prospectus:
Government Water Buy-Back Programs
The Commonwealth Government Murray-Darling Basin (MDB) Plan provides for a AUD $3.1 billion water buy-back program in order to address the environmental sustainability of the MDB. This buy-back program involves the Commonwealth Government purchasing Water Entitlements from willing sellers in the MDB and directing this purchased water to environmental flows. As at 30 April 2016, 1,960 gigalitres of Water Entitlements had been purchased as part of the buy-back plan with 791 gigalitres still available to be purchased. Although the majority of buy-backs are complete, any further buy-backs by the Commonwealth Government (including as a result of any change to the MDB Plan) will result in less Water Entitlements on issue, increasing the scarcity of such assets and impacting their price. The participation of the Commonwealth Government in the market may also distort market fundamentals temporarily and reduce opportunities for the Company to acquire Water Entitlements at acceptable values.
Annual Water Allocation Risk
Water Allocations are determined by a relevant water authority. As a result of water availability in any given region and for any given security class, annual Water Allocations may be negligible or zero. This would impact the Company’s ability to derive income from unleased Water Entitlements.
Weather
The market price of Water Entitlements and Water Allocations is subject to market fluctuations due to weather. For example too much rain and flooding would significantly increase the supply of water, driving down prices. As such, negative price movements may adversely impact the ability to generate revenue from new leases for the Company’s Water Entitlement portfolio or the portfolio value itself.
Market Size and Liquidity Risk
The turnover of Australian Water Entitlements is relatively small when compared to the aggregate Australian Water Entitlement market, with an average annual turnover of approximately 311 gigalitres (approximately 4% of the entire Entitlements market) valued close to $400 million, during the 2014-15 season. Average annual turnover in Water Allocations over the same period was 5,550 gigalitres. With limited market activity, the small market size poses a liquidity risk for the Company, creating pricing and capacity considerations.
Risk of being unable to deploy funds
The ability of the Company to generate attractive yields for investors is dependent on its capacity to deploy funds in the water market. For example, if at a certain point in time the Investment Manager did not believe that the purchase of any Water Entitlements in the market would provide attractive yields to investors, the Investment Manager would not invest.
Key Lessee and Other Lessee Risk
From Completion of the Offer until further leases are entered into, the Company will have approximately 86% of its lease revenue being paid by one lessee, Duxton Viticulture. If that lessee defaults, this could adversely affect the revenue generated by the Company. The Company also anticipates that many of its Water Entitlements will be subject to long-term lease arrangements. If the leaseholder were to default on its obligations, this could result in a loss of revenue for the Company.
Water Price Drivers:
Excerpted from the IPO Prospectus:
Weather
Weather is one of the most significant drivers of price movement in agriculture. Significant adverse weather patterns impact the availability of water. For example, droughts reduce the amount of water available for trade which drives up the price of water in the market.
Environmental Programs
The Murray-Darling Basin (MDB) Plan involves an AUD $3.1 billion water buy-back program in order to address the environmental sustainability of the MDB. This buy-back program involves the Commonwealth Government purchasing Water Entitlements from willing sellers in the MDB and directing this purchased water to environmental flows. Further buy-backs by the Government would result in less Water Entitlements on issue, increasing the scarcity of such assets and impacting their price.
Ongoing Investments in Higher Value Irrigated Agriculture
Investment in exotic nuts (almonds, hazelnuts) and olive production is expected to rise. Furthermore, the Australian cotton industry has shifted production south. It is expected that these shifts will increase water use for these sectors, over the next five years by 18% and 65% respectively. If there is another severe drought, such as the millennium drought in 1997 - 2009, these shifts in production could result in extremely high water prices.
Government Programs
In line with environmental programs, the Government is prioritizing water infrastructure programs in order to reach water sustainability targets. Through increased infrastructure investment, funding can be provided to deliver new on-farm infrastructure and water efficiency programmes to farms. Commonwealth activity in the market can impact prices.
Investment in Greenfield Projects
Investment in Australian agriculture has been growing. As investment increases, the demand for water will also rise in order to meet rising farm production. Water prices may respond by climbing higher.
Commodity Prices
Water prices are influenced by product market factors such as agricultural commodity prices. For example, when commodity prices are high, farmers may decide to produce more of a certain crop, as their opportunity cost of water is higher. As a result, irrigators increase their demand for water, with the effect of pushing up the price of water in the market.
Media:
The Guardian
> Murray Darling Basin
ABC News
> Murray Darling Basin
Suzanna Sheed MP
> Media Releases
ABC - Victorian Country Hour
> What is going on with the value of water in the Murray-Darling?
Investing Recommendation: Long-term buy. Secular trends toward lower growth, high debt and central bank-supressed interest rates mean that opportunities for worthwhile, lower-risk returns are much more limited. Duxton Water offers one of the few ASX-listed pure, real asset diversification opportunities with profits (thus dividends) based on agricultural demand for limited water. The shadow of government and regulator inquiries into the Murray Darling Basin water market present buying opportunities absent any malfeasance (of which there is no evidence with D2O) or misleading information about the reliability of profits. Understanding the Duxton Water reports (monthly, annual, presentations) and underlying risk and return is critical to timing entry (and exit when necessary).
30 June 2019: NTA after realised tax: $1.69 NTA after realised and unrealised tax: $1.54
1 Aug 2019 Share Price: $1.36
1 Aug 2019 After Realised Tax NTA Discount: -19.5%
1 Aug 2019 After Realised and Unrealised Tax NTA Discount: -11.7%
I recommend accumulating at After Realised Tax discounts of greater than 15%. If trading after having accumulated, then trim exposure whenever the price temporarily jumps over 10% for no reason so you can re-buy at lower levels.
Disclosure: As at 27 Aug 2019 less than 5% of my listed investments are in D2O.
Selected brief insights
- Some investors may interpret the quarterly cashflow reports that often show negative cashflows to conclude D2O sometimes operates at a loss. Negative overall quarterly cashflows are usually due to purchasing more water assets and operating cashflows ultimately need to be considered on an annual basis to avoid timing issues with lease and other water allocation payments, and also account for the net impact of the trading of entitlements. Duxton's earnings per share are positive, being based almost solely on leasing and selling water allocations in a water market with increasing prices. Its 16/05/2019 AGM presentation lists EPS of 3.4c for the first 4 months of 2019. Its weighted average EPS for 2018 was 8.5c. If its 2019 EPS was ~12c that gives a P/E ratio as of 1 Aug 2019 (SP: $1.36) of 16. Alternatively, an earnings yield of 8.8%.
- However, in its half-yearly report, published 27 Aug 2019, half-year EPS is only 2.3c due to impairments in the value of general security entitlements that will receive no or minimal current allocations due to low storage levels. This has to be weighed against the increase in the value of high security entitlements and of temporary allocations. This impairment issue and tradeoff of owning a proportion of general security entitlements (which do pay off in wet conditions) needs to be assessed closely.
From Half Year Report ended 30 June 2019:
<<
Water asset revaluation uplift is reflected as part of the fair market value comparison information within this report. However water assets are classified as intangible assets for statutory reporting purposes, the Company’s water portfolio is measured at cost less any accumulated impairment. For the period ended 30 June 2019, a $2.367 million impairment expense has been recognised. This has had a material impact on the Statement of Profit or Loss and Other Comprehensive Income. The drivers behind this statutory impairment is reflective of the pull back in fair market value of NSW general security entitlements. Murray and Murrumbidgee general security licences experienced an 11% and 7% reduction in asset value across the period respectively, reflective of the continuing drought conditions being experienced across NSW. These assets form a critical balancing role within the Company’s entitlement portfolio composition and will support yield through the wetter part of the climatic cycle. The Company has formed a strategic general security holding and expects to see general security asset prices recover as we move back into more normalised climatic conditions.
>>
- In a low-growth, low-interest rate world, a relatively reliable earnings yield over 6% from agriculture products should be highly-prized. As the returns keep coming, if they prove reliable and growing, more investors will become aware, and it would be unsurprising to see the share price bid up till D2O's earnings yield is closer to comparable investments.
- As of June 2019 D2O has published its headline monthly NTA using its After Realised and Unrealised Tax NTA. But then noted a higher NAV when not including unrealised gains: "The NAV excluding tax provisions for unrealised capital gain is $1.69." However, all other ASX-listed LICs report the Realised Tax NTA as their headline figure. Consistent NTA reporting may produce a quick elimination of part of the discount.
- Duxton Water has recently come under fire for profiting from water speculation while farmers get exploited by artificially-high prices. (E.g. Link1, Link2) In reality, D2O is acting as intended in a market for a scarce resource (directing water to its highest and best use) and even in a worst case scenario where the government forced out non-farming entities from the market it would have to be compensated at market prices for its assets. In practice, these markets need specialist firms providing market-making (ever-present demand, supply, prices) and professional market services (advice, leasing, forward contracts, etc). The truth is that elevated water prices are due to long-term factors like climate change trends and higher value permanent plantations not any short-term speculative activities of firms like Duxton Water.
- In my view, Duxton Water's lease proportion and income should be more important in its valuation than changes in the market value of its water entitlements especially given this doesn't appear to fully factor the complexities of how much of its unleased entitlements are actually allocated by basin authorities (which depends on total storage levels). So take less note of NAV changes (which relate directly to Duxton fee income) and more note of leasing proportions and income. In its monthly reports it notes: "Aither Pty Ltd values the Duxton Water Ltd portfolio on a monthly basis on a dry (without allocation) equivalent basis" - this needs to be better understood by investors.
- Rural Funds Group (RFF) has been attacked by a short seller for overstating assets, fabricating non-cash gains, and paying much higher dividends than its actual cash earnings. This may cast some short-term shade on Duxton Water for being an agriculture-related equity with some similar assets but, unless Duxton Water is a fraud or deceptive about earnings, this would be a buying opportunity.
Understanding diversification with real assets
Meb Faber advises: "Diversification has been called the only free lunch in investing. This free lunch, so to speak, is the benefit an investor receives from diversifying his investing capital into two assets that are not perfectly correlated. The idea is when one asset falls, the negative impact on the overall portfolio is softened and the second asset won’t fall to the same degree or may even rise since there is not perfect correlation. In essence, by investing in uncorrelated assets, one plus one equals three."
Ray Dalio advises that adding uncorrelated assets with worthwhile future return expectations is the key to low drawdown, outperforming portfolios. (See video below).
Real assets are one of the few areas where exchange-listed return streams can be found that are uncorrelated with equities. In my view, the key to reliable, lower-risk real asset investments is whether they have a reliable, worthwhile profit stream. Agricultural demand for water certainly ticks this box better than real assets without income streams (e.g. gold, commodities) but the specifics of the water market and investment manager approach need to be assessed.
See:
> Ray Dalio - Uncorrelated return streams (video)
> Real Assets 101: Key Characteristics Investors Need to Know
Key Risks:
Excerpted from the IPO Prospectus:
Government Water Buy-Back Programs
The Commonwealth Government Murray-Darling Basin (MDB) Plan provides for a AUD $3.1 billion water buy-back program in order to address the environmental sustainability of the MDB. This buy-back program involves the Commonwealth Government purchasing Water Entitlements from willing sellers in the MDB and directing this purchased water to environmental flows. As at 30 April 2016, 1,960 gigalitres of Water Entitlements had been purchased as part of the buy-back plan with 791 gigalitres still available to be purchased. Although the majority of buy-backs are complete, any further buy-backs by the Commonwealth Government (including as a result of any change to the MDB Plan) will result in less Water Entitlements on issue, increasing the scarcity of such assets and impacting their price. The participation of the Commonwealth Government in the market may also distort market fundamentals temporarily and reduce opportunities for the Company to acquire Water Entitlements at acceptable values.
Annual Water Allocation Risk
Water Allocations are determined by a relevant water authority. As a result of water availability in any given region and for any given security class, annual Water Allocations may be negligible or zero. This would impact the Company’s ability to derive income from unleased Water Entitlements.
Weather
The market price of Water Entitlements and Water Allocations is subject to market fluctuations due to weather. For example too much rain and flooding would significantly increase the supply of water, driving down prices. As such, negative price movements may adversely impact the ability to generate revenue from new leases for the Company’s Water Entitlement portfolio or the portfolio value itself.
Market Size and Liquidity Risk
The turnover of Australian Water Entitlements is relatively small when compared to the aggregate Australian Water Entitlement market, with an average annual turnover of approximately 311 gigalitres (approximately 4% of the entire Entitlements market) valued close to $400 million, during the 2014-15 season. Average annual turnover in Water Allocations over the same period was 5,550 gigalitres. With limited market activity, the small market size poses a liquidity risk for the Company, creating pricing and capacity considerations.
Risk of being unable to deploy funds
The ability of the Company to generate attractive yields for investors is dependent on its capacity to deploy funds in the water market. For example, if at a certain point in time the Investment Manager did not believe that the purchase of any Water Entitlements in the market would provide attractive yields to investors, the Investment Manager would not invest.
Key Lessee and Other Lessee Risk
From Completion of the Offer until further leases are entered into, the Company will have approximately 86% of its lease revenue being paid by one lessee, Duxton Viticulture. If that lessee defaults, this could adversely affect the revenue generated by the Company. The Company also anticipates that many of its Water Entitlements will be subject to long-term lease arrangements. If the leaseholder were to default on its obligations, this could result in a loss of revenue for the Company.
Water Price Drivers:
Excerpted from the IPO Prospectus:
Weather
Weather is one of the most significant drivers of price movement in agriculture. Significant adverse weather patterns impact the availability of water. For example, droughts reduce the amount of water available for trade which drives up the price of water in the market.
Environmental Programs
The Murray-Darling Basin (MDB) Plan involves an AUD $3.1 billion water buy-back program in order to address the environmental sustainability of the MDB. This buy-back program involves the Commonwealth Government purchasing Water Entitlements from willing sellers in the MDB and directing this purchased water to environmental flows. Further buy-backs by the Government would result in less Water Entitlements on issue, increasing the scarcity of such assets and impacting their price.
Ongoing Investments in Higher Value Irrigated Agriculture
Investment in exotic nuts (almonds, hazelnuts) and olive production is expected to rise. Furthermore, the Australian cotton industry has shifted production south. It is expected that these shifts will increase water use for these sectors, over the next five years by 18% and 65% respectively. If there is another severe drought, such as the millennium drought in 1997 - 2009, these shifts in production could result in extremely high water prices.
Government Programs
In line with environmental programs, the Government is prioritizing water infrastructure programs in order to reach water sustainability targets. Through increased infrastructure investment, funding can be provided to deliver new on-farm infrastructure and water efficiency programmes to farms. Commonwealth activity in the market can impact prices.
Investment in Greenfield Projects
Investment in Australian agriculture has been growing. As investment increases, the demand for water will also rise in order to meet rising farm production. Water prices may respond by climbing higher.
Commodity Prices
Water prices are influenced by product market factors such as agricultural commodity prices. For example, when commodity prices are high, farmers may decide to produce more of a certain crop, as their opportunity cost of water is higher. As a result, irrigators increase their demand for water, with the effect of pushing up the price of water in the market.
Media:
The Guardian
> Murray Darling Basin
ABC News
> Murray Darling Basin
Suzanna Sheed MP
> Media Releases
ABC - Victorian Country Hour
> What is going on with the value of water in the Murray-Darling?
It includes a note 1:
