The Experts

John Abernethy
Australian Equities
+ About John Abernethy
John Abernethy is Clime Investment Management's Executive Director and Chief Investment Officer.
With over 25 years experience in funds management and corporate advisory services, Abernethy's common-sense approach to investing and forthright opinion has earned him a loyal following of investors.
As CIO of Clime Investment Management (Clime), Abernethy has consistently delivered outstanding results for the company. Clime has two different investment vehicles, the Clime Australian Value Fund (CAVF) and Clime Capital Limited. Both funds have consistently outperformed the market over the past five years, resulting in CAVF recently being recognised by Morningstar for its superior performance with a five-star rating. Clime’s investment committee utilises MyClime, an online stock valuation service  to determine their stock selections. 
Prior to establishing Clime, Abernethy's roles included 10 years at NRMA Investments as the head of equities, where he successfully managed investment portfolios of approximately $2 billion.
Abernethy is a regular contributor to CNBC: Market News and The Eureka Report. He is also a regular commentator in the AFR, The Australian and The Sydney Morning Herald.
You can trial MyClime for free @

Small stocks sizzle in share rally

Thursday, May 03, 2012

Smaller companies are leading the way in the recent market resurgence. Today, we identify some smaller capped standouts, however buying small doesn’t necessarily equate to outperformance if you’re buying without reference to value.


McMillan Shakespeare Limited (ASX:MMS) Engaged the provision of remuneration, asset management and finance services to public and private organisations throughout Australia. The business has displayed impressive profitability over time and the growth profile is something to be desired. The group recently announced a 6 year sole provider contract for salary packaging and novated leasing services to the South Australian Government.

Thorn Group Limited (ASX:TGA)

Best known for the “Rent, Try, Buy” offering of its Radio Rentals brand, TGA displays the business characteristics we like. It is a low debt, strong operating cash flow business with a track record of consistent profitability and the ability to thrive in a soft economic environment.

OrotonGroup Limited (ASX:ORL)

In contrast to the majority of ailing discretionary retailers in Australia at present, ORL is an example of how a brand owner with a clear online strategy can still perform in soft markets. Having recently reported like for like sales up 9% and NPAT up 4% on the previous corresponding period, ORL stands out in the retail world. The business is highly profitable with strong cash flows.

Mortgage Choice Limited (ASX:MOC)

Despite the perceived softening in the Australian housing market, we see mortgage broker MOC to be a ‘higher risk’ yield play. The groups’ loan book continues to grow and stood at $42.4B as at 31 December 2011. As competition heats up between the lenders, MOC looks to be a beneficiary.


Matrix Composites and Engineering Limited (ASX:MCE) MCE is involved in the manufacture and sale of syntactic foam buoyancy, polyurethane products and fabricated metal products predominately for offshore oil rigs. Poor cash flows have necessitated the need to raise capital via both equity and debt.

This has led to reduced profitability and increased risk to owners. We find MCE to be expensive at current prices.

Jetset Travelworld Limited (ASX:JET)

Despite a strong Australian dollar, JET, a business which should see some benefit is failing to perform. Having raised in excess of $270M over the past 3 years, profitability has suffered. Going forward value is not forecast to grow substantially and at current prices it is expensive.

Vocus Communications Limited (ASX:VOC)

Despite strong price performance to mid-2011, wholesale telecommunications services provider, VOC, is not a standout from a fundamental perspective. Profitability has been trending lower over the past three years primarily as a function of the doubling of their equity base via capital raisings in FY10 & FY11. Net debt to equity is relatively high, and the business is yet to pay a dividend. Most importantly the business is priced 29% above value.

PMP Limited (ASX:PMP)

Media and marketing services company PMP Limited are involved in commercial printing, digital premedia, letterbox delivery and magazine distribution services.

It can be seen that the soft retail environment, internet advertising and online magazine subscriptions are taking a toll on the business as it continues to undertake cost cutting measures. Profitability is poor with losses in 2 of the last 5 years. 

Copy prepared by Matthew Koroi


Finding ‘safety’ in the market

Thursday, April 19, 2012

The following questions were recently posed to John Abernethy, Chief Investment Officer at Clime, and the answers make important reading for people trying to account for risk in their portfolios.

Is there such a thing as a ‘safe’ investment? Don’t all investments come with some sort of risk?

The safest investment is obviously cash subject to inflation. An investor needs to ensure that the interest earned or the returning yield is above the inflation rate. Tax needs to be considered as well. We are fortunate in Australia that cash investments generate a reasonable return. In the US, Europe and Japan cash interest rates are below the inflation rate.

All investments do come with risks. The risk that shares may decline quickly in price was starkly shown during the GFC. Remember the maxim – "the higher the risk then the higher the potential return".

The maxim is true and the aim of investment is to achieve a return which will be better than the perceived risk. To do this, a valuation methodology that both correctly identifies and considers risk, is important.

When it comes to the share market, which investments are safer than others? 

Across the listed securities market, the least risky investments are generally debt securities and particularly those issued by major corporations. Those issued by the banks and Woolworths come to mind. These debt issues are supported by strong businesses that have a strong stable cash flow. The primary risk for an investor is that they purchase these securities at the wrong price.

An investor in listed debt securities is deciding to limit and cap their return. The debt investment in say Woolworths is an alternative to investing in Woolworths shares. Right now Woolworths shares actually offer a higher yield (including franking credits) than their listed debt. However, the shares are volatile and may fall in price.

All listed investments (debt, hybrids, shares and units) must be risk assessed based on the quality of the underlying business, their financial history and the size of their operations. They must also be value assessed to ensure an adequate return is achieved commensurate with their individual risk.

Price and value are different concepts and often investors buy quality investments at the wrong price and therefore defeat their investment goals.

How can people minimise the risks of a volatile market?

A short-term investment focus will actually increase investment risk unless an investor is outstanding at picking market trends, investor sentiment and have an acute understanding of the risk and value. Very few people have this capacity. Thus, an investor can mitigate risk in two ways.

First, take a longer-term investment view (be patient) and focus on five-year returns where returns from investments are compounded. That is, invest for longer and re-invest income back into good businesses if the price on offer is in value.

Second, an investor must have a sound basis for assessing the value of a business. Without a view on value then investing in the share market becomes a high risk undertaking.

What should they be doing to protect their share market nest eggs?

Regularly review the reasons why they own individual stocks or securities. Ensure that there is a reasonable spread of investments (say 15-20 securities) and do not use margin loans to invest.

Investors should review the businesses that they own. They should think like an owner and ask:

  • Do they understand what their investments do and what their outlook for growth is?
  • Do they appear to be run by honest and ethical people?
  • Most importantly, do they have a basis for assessing the value of the businesses and to determine if this value will grow into the future?

If the answer to the final question is no then they actually have no way of protecting themselves from potential capital loss.

When is the best time to divest from the share market (that is, how long should you wait for things to get better)?

The divestment of a total portfolio of listed investments is a significant asset class decision. To come to this conclusion, independent of personal circumstances, it is a very difficult decision to make. Further, over many years there are only short periods in which it is appropriate to hold no shares at all.

Indeed, the greatest investment returns are made from a period when things look bad. By the time things start to look better, the market prices have generally risen.

From a valuation perspective, there are two broad reasons to sell out of the market.

First, the investor having a sound basis for assessing value determines that market prices in general are well above an assessment of value. Remember that the value of good companies will rise into the future. Therefore, for quality companies a small over-valuation is not a reason to sell.

Second, an investor should have a watching brief on the world economic situation. This can be difficult and more so because there is so much conflicting commentary at present. Be careful to assess the world situation in context. Find trusted advisors or writers who have a track record of reading the international events. Those people who correctly foresaw the subprime crisis in the USA in 2008 saved significant capital by divesting from the market.

What’s the best strategy if time’s not on your side (you may be ready to retire and not be able to hold onto investments until the market improves)?

At present the best strategy is to blend your listed investments between solid yielding investments (debt and shares) and companies which have shown growth over the last 5 years. If you have limited capital or it is required to meet retirement then ensure that your “growth” investments do not require you to continually invest more.

Once you have settled your portfolio, try to keep as much capital in investments as is possible. The affect of compounding investment returns is actually one of the most powerful forces that generate superior returns for an investor.

Gain further insight to today's markets. Identify the value of a stock (company) and access weekly research written by John and our team of analysts with MyClime - our online stock valuation and research service. Register for a free trial to MyClime.

For advice you can trust book a complimentary first appointment with Switzer Financial Planning today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Looking into the future

Tuesday, April 17, 2012

“... to our mind it is more sensible to focus on that which is more predictable – the likely changes to the economic environment over the next three to five years. From this we can focus on what is important to do now to position portfolios.”

The confusing daily commentary of unfolding events across the economic world surely test market confidence. Naturally investors' perceptions about the investment outlook are at best wary, at worst panicky. However, much of this is focused on the short term. We have commented in the past that while the short-term outlook is clouded, the longer term is much more certain.

To summarise our longer-term view, it is clear that Australia (we) will continue to grow due to our strong trade engagement with China and our predictable population growth. In the last five years, Australia has grown by about 13 per cent (economic growth), our terms of trade have reached record highs, our export volumes have grown to record levels and our population grown by over one million people. The outlook for the next five years is for more of the same. However, we are constantly confronted with questions such as:

  • What will Europe look like following the sovereign debt crisis?
  • How long will it take for the US to recover?
  • Is Japan in terminal decline, and will China fall into some sort of recession?

These questions and their ultimate answers do matter and to answer them at this point is really difficult. Thus, to our mind it is more sensible to focus on that which is more predictable – the likely changes to the economic environment over the next three to five years. From this we can focus on what is important to do now to position portfolios.

Therefore, in this week's article, we make some predictions of the more distant future. In particular, we outline what we think are the more obvious likely economic or market events. In doing so we suggest that you ask yourself – are you prepared?

Prediction 1

Bond markets generally and the US bond market in particular will correct heavily in the next three years.

There are many reasons to predict this but it appears overpoweringly logical to suggest that a three per cent yield on a 30-year US Government bond represents irrational stupidity. Further, across the US bond curve we observe that five-year yields are below one per cent and 10-year yields are below two per cent. The logic of investors accepting negative real yields (that is, below inflation) for prolonged periods does require much analysis. Indeed, a proper explanation may only be possible many years after the correction. Does anyone actually know why the Nasdaq Index went above 5000 points (today 3040) in the year 2000?

Bubbles eventually burst and the US bond market is a bubble. People may point to Japanese bond yields to draw comfort and suggest the sustainability of US rates. However, the US has nearly 40 per cent of its bonds (loans) owed to China, Japan and OPEC countries. In comparison, the Japanese have only raised about five per cent of their debt from foreign investors. The Japanese have not, to this point, had the international market properly assess its true risk.

Our prediction is simple. US bond rates will correct. So too will Australian bonds and thus investment portfolios should be positioned to withstand this risk. Investment in debt securities should be floating rate and bond exposure kept minimal and very short in duration. The pricing of long-term infrastructure assets from the long-term bond yield is highly dangerous at present. We maintain that required returns for equity investments should not be based on current bond yields.

Another factor sure to affect bond values is emerging inflation from China – see below. A rising bond yield, when it comes, will mean lower PERs and lower equity multiples for intrinsic valuations. High double-digit PERs are simply not acceptable given this outlook. Further, companies with ROE at about current bond rates will be disasters – of course, they already are but no one wants to admit it!

Prediction 2

The Australian dollar stays stronger for longer.

We make this prediction based on a simple observation. The US, European Union, United Kingdom and Japan are engaging in quantitative easing and we aren't. If they print currency and we don't then it is likely that our currency remains strong. Indeed this is reinforced by a trade surplus and a strong fiscal position.

Further, the provision by Central Banks in these regions of massive low-cost loan facilities, will take many years to repay. The repayment will come from economic growth. Policies that maintain weak currencies will be paramount in stimulating growth.

Against this view we note that there are always economic stabilisers at work. Thus, it appears to us that the Australian dollar will rise further against the US dollar but it will go higher against the euro, pound and particularly the yen. As most of our international trade and finance is US dollar-based, it is apparent to us that the Australian economy is severely affected when our currency approaches 110 US cents. We suspect the RBA knows this and so intervention will likely occur from the RBA if our currency pushes aggressively upwards against the US dollar.

As for the cross rates against the pound and yen, we suspect the Australian dollar will rise further. The current economic numbers from the UK are very poor (despite its devaluation) and our view on Japan is rapidly becoming one of concern – see below.

Prediction 3

China will revalue the Yuan more aggressively following the US election and worldwide inflation becomes an issue.

China has pegged its currency very tightly to the US dollar for many years. Indeed, it is perverse to realise that the Australian dollar has actually appreciated by around 10 per cent against the Yuan over the last five years.

However, this policy is surely tested by rising oil and commodity prices. China has successfully developed manufacturing export industries through an undervalued currency. It has thus created tens of millions of jobs for a burgeoning middle class. To maintain growth of the internal economy, inflation must be checked on imported goods, services and inputs. A rising Yuan will achieve this.

The checking of inflation in China through a rising Yuan will reverse the deflation that previously flowed to its trading partners (Australia benefited here). A lift in imported inflation in the US and a rising oil price (subject to gas alternatives) suggests inflation (possibly stagflation) could occur in the US. Indeed, maybe the Fed and the US Government would regard inflation as a means to deflate the US debt? If that is so then that is another reason to move out of bonds as an investment.

But a rising Yuan also benefits Australia. Inbound tourism is increasing from China and a rising Yuan will help this. The wealthy Chinese middle class is developing rapidly. James Packer has worked this out and explains his sudden desire to position himself in Sydney casino and hotel assets.

Thus, one investment theme to consider is the potential of quality Australian tourism assets that are attractive destinations for inbound Asian tourists.

Prediction 4

Japan will be seen as in terminal decline and the yen devalues at an extraordinary rate.

The following chart suggests what everybody knows but is afraid to discuss.

Figure. Japanese Population (1870 - 2100)

The declining Japanese population, its ageing profile and its extraordinary level of government debt are serious concerns.

But it is the recent trend developments in the Japanese trade account (moving to a deficit) that suggest to us that the Yen is about to commence a major downward adjustment. Indeed, it may have already occurred if not for the decline in US dollar and euro.

A declining yen in the next five years will have ramifications for Japanese inflation. As a large energy importer, the effect on the yield of Japanese bonds will be significant. Devaluation may induce Japanese investors to repatriate funds and investments from overseas markets. From an Australian perspective it suggests that the Japanese will be continual sellers of Australian property in coming years. The question is whether Chinese investors will replace them.

Prediction 5

China's growth is secure for the next five years because of its ability to stimulate growth through fiscal measures if required.

The changing pattern of China's current account surplus (consisting mainly of exports minus imports) in the next three to five years will be a key determinant for the global economy. China's highly competitive manufacturing sector will continue to power ahead, to expand exports and to gain global market share. At the same time, China's domestic economy should continue to grow fairly rapidly, thereby drawing in imports. However, how this plays out will largely depend on how much progress is made with re-balancing the economy, from the single-minded focus on exports of previous years to growing internal consumption.

The International Monetary Fund's latest assessment on the Chinese economy (December) reflected the worsening external environment and accordingly it suggested that China's economic growth for 2012 be revised down from nine per cent to 8.25 per cent. But this is short term and it is more sensible to consider longer-term trends and the relative size of the Chinese economy.

So let's put expectations of future growth in perspective. China's economy expanded 10.4 per cent annually in the past 10 years, about five times the pace in the US, as the government boosted spending on roads and rail, ports and bridges and manufacturers exported everything from toys to trains to the rest of the world. The economy grew at 9.2 per cent in 2011.

Even assuming a significant moderation in Chinese growth, over the next three years China is likely to grow from around 46 per cent the size of the US economy (China at $6.9T compared with the US at $15T) to 52 per cent by 2015 (China up to $8.5T, the US up to $16.2T). That assumes a growth rate in China of 7.2 per cent (with below six per cent regarded as a hard landing) and growth in the US of 2.6 per cent.

China still needs to rebalance its economy away from building up productive capacity and towards growing internal consumption. Figures assessing the level of internal consumption are notoriously rubbery, but a best guess is that consumption in China accounts for about 40 per cent of GDP, a bit more than half the ratio in the US. Recent growth in China has been built upon the surge in investment, rising from 42 per cent of GDP in 2007 to 48 per cent in 2011. This raises sustainability questions. China is exposed to Europe and other countries through trade (the eurozone is the largest destination for China's exports): its global exposure has risen, with its share of global exports in 2011 rising to 10.5 per cent, up from 8.8 per cent in 2007.

Like the last decade, a key driver of economic growth over the next decade will remain urbanisation as millions more people move to the cities in search of higher-paying jobs. China recently announced that people living in its towns and cities now outnumber those in the countryside, making it a predominantly urban nation for the first time in Chinese history.

City dwellers represented just 11 per cent of China's population in 1949, when the Communist Party took power, and 19 per cent in 1979, when Deng Xiaoping launched market reforms. Today, urban dwellers account for 51.3 per cent of China's entire population of 1.3 billion – or a total of 690 million people.

We expect the trend to endure for some time. McKinsey, the consulting firm, forecast last year that the country would have one billion urban residents by 2030 –its urban population growing by more than that of the entire US in just two decades.

Unfortunately, there is a downside to the urbanisation thematic. Mass migration places an increasing strain on urban housing, transport and welfare, and fuels pollution, social unrest and demands for political reform. Finding a balance between GDP growth, urbanisation and farmers' rights will be one of the main challenges facing a new generation of party leaders.

Moreover, urbanisation is hardly the only demographic trend sweeping over China. At the same time as more workers are moving into the cities, the size of the Chinese work force – those aged 15 to 64 – is peaking as the work force ages. More than 30 per cent of the population is expected to be older than 60 by 2050, producing an increasingly heavy economic burden on those in the work force.

Unlike most other countries, however, China has the policy space to contain the negative spillover should such risks materialise. A fiscal stimulus package in the order of three per cent of GDP could hold growth up above seven per cent, much as China's pre-emptive policy action in 2008 eased domestic vulnerabilities.

China could use any significant slowdown in the coming year or two as an opportunity to boost consumption, including through helping the most vulnerable, strengthening household income and social services. This would also help reduce China's reliance on investment and support a more sustainable internally balanced economy.

Gain further insight in today's markets. The following report is a summary of "The View" written by John Abernethy. The View is a weekly macroeconomic report provided by MyClime – an online stock valuation and research service. For a free two-week membership, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Planning today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Dividend stocks for 2012

Thursday, March 22, 2012

The investment focus of many Australians is shifting. With the market below where it was five years ago, investors are now focusing on the need to achieve yield as opposed to capital growth and this has prompted many to simply deposit their savings into the bank. It should, however, be remembered that the return on your deposits are subject to the actions of the RBA and any decision to reduce rates will result in lower cash flows for savers.

Unfortunately, much of the growth of the past decade was debt fuelled and the continuation of growth was reliant upon buoyant levels of confidence. Investor confidence was shattered by the GFC and the increasingly conservative behaviour which followed has resulted in a growing desire by most to save and to deleverage.

Accordingly, we are now wading through a period of stagnant growth. Nevertheless, investors with a rational view on valuing businesses will have the opportunity to be rewarded over time. As such we look to what 2012 may bring and where to look for quality companies, which at current prices also display attractive yields.

Our picks for 2012

We acknowledge that as investors reach for ‘low risk’, high-yielding securities, prices can be bid up to unsustainable levels. However, we remain confident in our ability to achieve yield by maintaining the discipline to invest in sound operating businesses only when they are offered at a discount to their intrinsic value. In our view, the following companies are worth following in 2012 if they can be acquired below their intrinsic value.

1. Telstra Corporation Limited (ASX: TLS)

Price: $3.20

Yield: 8.74 per cent (Fully franked)

2. Spark Infrastructure Group (ASX: SKI)

Price: $1.44

Yield: 4.86 per cent (Unfranked)

3. Ethane Pipeline Income Fund (ASX: EPX)

Price: $2.03

Yield: 5.5 per cent (Unfranked) in 2012

4. Woolworths Limited (ASX: WOW)

Price: $25.07

Yield: 4.87 per cent (Fully franked)

5. ANZ Banking Group (ASX: ANZ)

Price: $22.48

Yield: 6.23 per cent (Fully franked) 

6. Commonwealth Bank of Australia (ASX: CBA)

Price: $48.72

Yield: 6.67 per cent (Fully franked) 

7. Growthpoint Properties Australia (ASX: GOZ)

Price: $2

Yield: 7.37 per cent (Unfranked)

8. Mortgage Choice Limited (ASX: MOC)

Price: $1.29

Yield: 10.04 per cent (Fully franked)

9. Platinum Asset Management Limited (ASX: PTM)

Price: $3.97

Yield: 5.79 per cent (Fully franked) 

Written by Matthew Koroi, analyst at Clime Investment Management.

The following report was originally published in MyClime – the online stock valuation and research service powered by Clime Investment Management in January 2012. For a free two-week membership, click here (

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Buffett and IBM? The case for pairing two icons

Saturday, November 26, 2011

It certainly was a surprise to be confronted with a morning headline containing the words ‘Buffett’, ‘Buy’ and ‘IBM’ all in the same sentence. During the first three quarters of 2011, Berkshire Hathaway acquired 64 million shares in IBM, equating to $10.7 billion or 5.4 per cent of the company.

Long-standing followers will note that technology companies have long been outside Buffett’s ‘circle of competence’. Buffett has long preferred companies selling stable products in stable industries. The high speed of change within the technology industry places greater reliance on management to innovate in order to defend a competitive position. Those who cannot innovate are destined for poor economic returns. This is not lost on IBM, which once dominated the personal computer market only to later completely exit the business.

In regards to innovation IBM are well placed, with a century’s worth of R&D under its belt, illustrating they can adapt over a long-time horizon. For the last 18 years, IBM has been granted more patents per year than any other company, receiving over 38,000 patents during this period. This is a direct result of approximately $5 billion per year invested in research, development and engineering since 1996.

Buffett commented that after reading IBM’s recent annual report, he viewed the business through a different lens. This prompted him to visit many of his Berkshire Hathaway subsidiaries to see how their IT departments functioned and why they made the decisions they had. He came away with an enhanced perception of the position IBM holds and was impressed by the ‘stickiness’ of their customer proposition. For further insights, he read IBM’s former chairman and CEO Lou Gerstner’s book, Who Says Elephants Can’t Dance? about IBM’s historic turnaround for the second time.

IBM does possess some characteristics of a classic Buffett buy. Their long history has allowed Buffett to read the annual reports for over 50 years and analyse their performance across a range of business cycles. In addition, Buffett has competed directly with IBM as Chairman of Mid Continent Tab Card Company over 50 years ago as well as testifying on IBM’s behalf in an antitrust case in 1980. It’s a reasonable conclusion to say Buffett has a fair idea as to what makes this business tick.

Furthermore, a key filter for a Buffett investment is finding managers who think like owners. Management appears to have the interest of shareholders at the front of their minds and is taking action to ensure increasing value, including sound capital management and transparent performance targets. Buffett was impressed by how management has been treating their stock with ‘reverence’.

In addition, IBM is an iconic American business boasting impressive brand recognition. Buffett, the perpetual bull of America, has invested in other classic American companies such as General Electric and Bank of America in what appears to be a strong vote of confidence in the future of America.

The business

IBM has refocused their operations to the higher margin and higher growth industries of software and services, which contributed 83 per cent of revenue (up from 65 per cent in 2000). Most of the more commodity-like businesses (personal computers, disc drives and printers) have been divested. This is notable in an improving NPAT margin over time. This also highlights the need to revisit companies periodically to keep up to date with any developments.

To give clarity on the future strategic direction, IBM publish five-year roadmaps, which give quantitative benchmarks in which management performance can be measured. (For those interested, I recommend reading IBM Chairman and CEO Sam Palmisano’s recent addresses.) This is a stark contrast to shooting the performance arrow and drawing a bullseye around where it lands.

EPS growth is the ultimate objective with a defined target of $20 per share by 2015. IBM surpassed the previous five-year goal of $10-11 EPS in 2010. Management has outlined three key drivers of EPS:

Operating leverage

IBM aims to improve operating leverage by shifting to higher margin business and improving enterprise productivity. Management is targeting $8 billion in productivity improvements over five years, with part flowing to the bottom line and the remainder invested to improve its competitive position.

Capital management

IBM expects to generate $100 billion in cash from operations over the next five years. With this cash they aim to return $70 billion to shareholders, comprising $50 billion in buybacks and $20 billion in dividends. While it is hard to model the effectiveness of future buybacks (as price paid is indeterminable), what is certain is Berkshires stake in IBM will be larger in 2015.


Below are IBM’s 2015 revenue targets:
  • Cloud computing, $7 billion. IBM are well placed to engage themselves in the growing use of cloud computing.
  • Smarter Planet Solutions, $10 billion, a division which aims to provide solutions to cities, municipalities and businesses to become more efficient in their operations.
  • Business Analytics, $16 billion. IBM spotted an emerging trend early and built a world leading analytics business, which employs 7800 consultants.

In addition, the growth markets of China, Brazil and India are targeted to contribute 30 per cent of total sales, up from 21 per cent in 2010.


Over the five-year view, IBM has grown profits from $10.4 billion to $16.2 billion without needing incremental equity to do so. Analysis of standard ROE over the longer term provides an equally encouraging trend.

Over the preceding 10 years, cumulative NPAT of $97.4 has been exceeded by cash flow of $171.6 billion. This strong cash generation is a boon for IBM, as cash can be reinvested to maintain and grow the business as well as be returned to shareholders in the form of buybacks and dividends.

Over the last 10 years, IBM has paid $18.8 billion in dividends and repurchased $86.8 billion of its own shares. This has been notably beneficial to profitability as well as increasing each continuing shareholder’s stake in the business. The guidance of $50 billion of buybacks in the next five years was likely an attractive proposition for Berkshire, which will watch their ownership stake grow over time.

If we assume an average price of $300 per share, $50 billion will buy back 166.7 million shares. If this were to occur, Berkshire’s holding in 2015 would have grown to 6.3 per cent of the company without adding any additional capital. In addition to receiving $1 billion in dividends, this provides a reasonable return for a large amount of invested capital.

IBM’s size is also attractive for Berkshire. In his early days, Buffett had more ideas than capital. Now the reverse is true and this plays a huge factor in which companies Buffett can look at buying. In 2010, Berkshire had free cash flow of nearly $12 billion, which equates to $230 million per week ($23,000 per minute) for which Buffett needs to find a sensible home. For an investor who likes to be reasonably concentrated, allocating such a quantum of capital takes big ideas. To put that into perspective, if Berkshires bought ARB Corp (ARP) and it doubled it would provide a gain in book value of 0.3 per cent. Berkshire may have a reasonable ‘elephant gun’, however suitable big game is increasingly becoming an endangered species.

Indeed, the size of a Berkshire investment requires an extended buying period. The doom and gloom that has persisted throughout 2011 has provided a sufficient window in which Berkshire could accumulate at decent prices. During the nine months in which Berkshire was buying, the price fluctuated within $146-$190, averaging out at $170 per share, a sliver below our assessed value of $173.

Indeed, at $170 per share, IBM is not a screaming bargain. However, it appears Buffett seized the opportunity to deploy a substantial amount of capital into a wonderful company at a fair price. Time will tell whether this will be worthwhile for Berkshire shareholders.

Alex Hughes is an analyst at Clime Group. The following report is part of reports/research written by John Abernethy and his team of analysts each week and distributed to members of MyClime – Clime's online stock valuation and research service. Register for a free two-week trial to MyClime.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.


Remuneration of Australian executives

Wednesday, November 23, 2011

A notable feature of the recent trading on the Australian stock market has been the dramatic drop in daily turnover. Whether this is important or not for the market or for us as investors, is subject to much debate. The turnover is low compared to what? Were previous periods normal? Does mindless turnover really matter and if you are not a seller should you care?

Obviously for those businesses and individuals that rely on turnover to generate commission or revenue, the drop in volumes is confronting. A recent report in the Sydney Morning Herald noted suburban pockets of rising unemployment. These job losses appeared to be flowing from the financial services industry with commercial and investment banks reducing staff. The rise in unemployment was observed to be dampening down the prices of residences in high-income areas. The effects of the GFC and the European debt crisis were hitting home.

It is our observation that the effects of a poorly performing equity market is affecting the ability of many advisors to generate an adequate return for their clients. This should have had an effect long before now but time and poor performance are now converging. So what is causing this and how bad is it?

To answer these questions we note the following observations drawn from the ASX website:

  1. The ASX 200 Index is currently 4350 points with a total market capitalisation of $1.26 trillion.
  2. The ASX 200 Index was also 4412 at the end of October 2005 with a then market capitalisation of $1.026 trillion.
  3. Net new equity raised in the market (that is, primary issues) over the six years approximates $230 billion.
  4. New floats over six years amount to about $66 billion.

While we note that there have been some companies taken from the market, it is observable that the market capitalisation today approximates the market capitalisation of October 2005 after new capital raisings are added. All this has occurred in an economy which over six years has grown from $1.16 trillion (GDP 2004/05) to $1.31 trillion (2010/11) or about 13 per cent.

From the above we can see that:

  • The Australian Equity market as a whole has generated no capital gain for index investors in six years.
  • Worse still the market has achieved no gain or revaluation from the capital raised or from the new companies that have been floated.
  • Importantly, the suppliers of capital or the gate keepers (the fund managers) have supplied capital to companies who have not converted it to value creation.
  • Finally and crucially the managers of the capital, the CEOs and their teams, have been paid huge salaries and bonuses to achieve incredibly mediocre returns.

The whole of Australia has grown at about 2.2 per cent per annum compound over the last six years but this economic growth barely matches inflation. With population growth of 1.5 per cent per annum, the low GDP growth suggests an anaemic level of improvement in productivity.

Worse still – when the economic growth from the resources sector is subtracted, it leads us to conclude that the rest of Australia’s productivity must actually be going backwards. So what is the rest of Australia? Well ignoring the production generated by agriculture it is dominated by service industries such as financial, tourism, health, education and public service. The fastest growing sector of the last ten years has been the financial sector.

Clearly something is wrong and frankly the rewards being received by our top executives are not being translated into wealth creation for the broader population. There is no dramatic productivity improvement under their management and the returns on employed equity are not rising. So on what basis are these people being remunerated and is there any evidence to suggest that extra pay actually translates into a higher level of performance?

Thus, questions must be asked as to why we as a community are paying so much for such mediocre results. Further, are not the actions of these people directly responsible for the poor returns of equity markets in a period of sustained economic growth? Why have the returns on the over $300 billion of new equity that has been invested in companies not produced an adequate return to justify a lift in value of the market? Are we actually sure that the new capital that is invested into companies is going to those that can achieve the best returns on equity?

As an aside, what the above does show is that the investment phenomena known as indexing, has turned into an economic disaster. Have we allowed consultants and experts to stupefy our capital markets (through pushing indexing) to the point where the markets are no longer proxies for growth? Individual companies are growing (and that is Clime’s focus) but indices aren't and so maybe we are observing the downfall of indexing as a legitimate investment process – if indeed it ever was! Investment managers who do think and can value companies will add value for their investors so long as they are not stopped from plying their trade.

Thus, the observation that so many financial service employees are losing their jobs may not be solely because turnover is falling. Rather it is a symptom of poor business leadership at the very top of Australia’s management tree. If companies are not improving their economic performance then ultimately the market will reassess their value. Those advisors who cannot properly value companies cannot foresee the likely ramifications on the investment returns of their client portfolios. Possibly clients on mass are realising that their advisors and brokers cannot offer value in a market where the ability to value a company is paramount.

So much for advisors, but the above analysis shows why shareholders are rightly looking at highly paid executives. Importantly they should focus on of five- and 10-year returns and if they do they will conclude that very few executives have added value and thus they are excessively remunerated.

John Abernethy is the Chief Investment Officer at Clime Group. The following report is a summary of 'The View', a weekly report written by John and distributed to members of MyClime – Clime's online stock valuation and research service. For a free two-week trial to MyClime, click here.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.


Italy in perspective (and why a macro view is important)

Saturday, November 12, 2011

The recent economic developments in Europe are not unlike those that confronted investors in late 2007 and early 2008. With investment banks collapsing in the US, the substantial interest rate cuts by the Federal Reserve and the pending resetting of teaser rate subprime mortgages, there was enough evidence to suggest that investors should have been concerned about developments.

How these developments would then translate into pricing movements on the Australian share market was a little more obtuse. However, none of those developments could possibly be interpreted as positive. Thus, those investors that did lift cash levels or maintained cash were well positioned to benefit from the substantial price falls of 2008/09. Those who didn’t raise cash and maintained exposures are to this day still attempting to recoup their losses.

Thus, it is incumbent upon investors to maintain a close watch and understanding of the economic developments in Europe as they do have the potential to send markets into a tailspin.

Specifically, there have been some substantial moves in the yields of European bonds and this is a situation that deserves close attention. Over the last six months, the bonds of Greece, Ireland and Portugal have all devalued against the German bond despite them being issued and traded in Euros. But these are small countries. In the last two weeks, the bonds of Italy (a member of the G8) have slumped with their yields lifting to five per cent above that of a German bond. This is clearly a more significant situation.

Understanding and noting bond yields is important as the bond yield is the so-called ‘risk free rate of return’. If risk free rates rise then it is a confronting development for the assessment of value of other assets.

Remarkably, Italy has had a substantial debt to GDP ratio for many years and debt markets ignored the risk that this presented to lenders. A high debt to GDP ratio exposes lenders when there is an economic downturn and that is exactly what presents itself in Europe right now.

Italy’s 10-year notes traded above 5.5 per cent for 40 days before breaching the six per cent mark on 28 Oct and closed just below seven per cent. Greece, Ireland and Portugal followed a similar trajectory, consistently averaging above six per cent for about a month before crossing the 6.5 per cent barrier. After that, it took an average of 16 days for yields to pass the unsustainable seven per cent level. Portugal and Ireland had to seek bailouts after their yields rose to over seven per cent.

The following simple example gives us an insight into the immense problems confronting Italy.

Figure 1. Public Debt

Source: Economist Intelligence Unit

Let’s assume that we translate Italy’s economy to the following. It has GDP of $100 and net sovereign debt of $120. That is it has a debt-to-GDP ratio of 120 per cent. (That is where Italy stands today).

A review of the tax collection to GDP of most developed economies suggests it could sit at around 40 per cent for a fully employed economy. Australia has a legislated cap on revenue of about 23 per cent of GDP (and we think we are highly taxed!) but let’s assume Italy sustains its government revenue at 40 per cent of GDP.

Figure 2: Government Revenue to GDP

Source: OECD Charts 2009/10

Despite its level of debt, Italy paid (on average) only about three per cent interest on its debt of $120 in the year 2010. Therefore, across its debt maturities (one month to say 10 years) it was paying $3.60 of interest. Thus, the revenue collected exceeded interest by over 10 times and this is akin to an interest cover ratio. Further, the interest bill approximated Italy’s fiscal deficit of four per cent of GDP. In other words, Italy was borrowing to pay interest. This is why its debt has lifted by over 10 per cent (against GDP) in the last three years.

Following the troubles in Ireland, Portugal and the collapse of Greece the credit markets are being forced to reassess risk. With 120 per cent debt to GDP, the assessed risk of an Italian default has lifted. This in itself has lifted interest costs to Italy from about three per cent to well above six per cent. Over time, Italy’s cost of funding its debt will rise as it issues new debt and rolls maturing debt. Last night the yield on new issue one year Italian paper rose to above seven per cent. Italy clearly has no capacity to redeem debt.

Based on the above, we see that the cost of servicing Italian debt has risen to over $7 per annum. On the assumption that tax revenue is maintained at 40 per cent of GDP (or $40) then the revenue to interest ratio drops to under six times. The increase in interest cost is $3 per annum and unless expenditure is cut then the Italian fiscal deficit will rise to seven per cent of GDP. This deficit is funded by more borrowings and debt will increase again.

As you can see, the country could enter a debt spiral due to rising interest rates and costs. Once it commences, it becomes difficult to stop. If say interest rates rise above 10 per cent (as in Greece) then default becomes probable rather than possible and the Government will be forced to substantially cut expenditure. This in itself causes more economic hardship and stymies economic growth.

Italy now sits at the precipice. Its debt to GDP is over 120 per cent, its unemployment is eight per cent and its fiscal deficit is rising in the face of austerity promises. With the market reassessing the required yield on its bonds, it has become the first G8 country to face rapidly rising costs of sovereign debt.

What does this mean for countries such as France, the United Kingdom, Germany and the United States? Each of these countries have sovereign debt to GDP over 80 per cent and each has its ten-year bonds trading at yields between two to 2.5 per cent.

Clearly Greece is a sideshow compared to the risks associated with the Italian economy and the economic response of European Leaders will have to be swift and significant. One obvious response is for Germany to consent to the European Central bank to print Euros. This quantitative easing would steady bond markets and give European governments time to implement much needed policy changes. It may even give Europeans time to dismiss and replace their leaders with people who can meet the difficulties through a capacity to “think anew and act anew” (quote from Abraham Lincoln, December 1862).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.


Why investors need to put market fears into perspective

Friday, September 30, 2011

Over my morning coffee on Saturday, I was confronted by the following front-page headlines of two of Australia’s major newspapers:

  • “World on the brink”... The Sydney Morning Herald (SMH)
  • “Now it’s getting scary”... The Australian Financial Review (AFR)

Both headlines obviously reflected the editor’s perception of their readers’ concerns for the European sovereign debt crisis and the declining equity market. Both headlines and the numerous accompanying reports expressed no real insights into the future (uncertainty was clear). The plethora of expert writers proposed no suggestions or solutions for the economic mess, except for Nouriel Roubini on page 62 of the AFR.

Having read these reports and headlines, my immediate thought was to try to put these headlines into context. They expressed a view that there was no hope. They suggested an imminent impending disaster which I could neither see nor describe. I could see that people could well be scared by these headlines, but in the café it was business as usual and I noted that most of the people weren’t reading the papers!

My initial reaction was to conceive of a real disaster headline so that I could put these ‘real’ headlines into a proper context. So I designed the following and tried to imagine the scene as if there was a real disaster coming.


“The world readies for imminent destruction as massive meteors are just a week away from impact. There is no hope”.

The SMH reported that all trading on the world’s equity markets ceased yesterday after the dramatic market declines of recent weeks. NASA made a final declaration of the impending unavoidable collision. All world banks were closed as people prepared themselves for the inevitable. “There was no point in trading or investing” said Australia’s Treasurer, a recent and now the last recipient of EuroMoney’s Best Finance Minister Award. “There is no future and people should stay at home with family to focus on that which is important to all of us as humans”. Finally, the editor and staff wish everyone peace in these final days.

Now that is a headline. It is clear and unambiguous. It puts the future into context. There is clearly no solution to that impending disaster. Suddenly and importantly, the real value of investments is defined by the observation that there is no tomorrow. Suddenly even cash has no value and there is no price for gold!

Coming back to the present, we can immediately see that there is a future. While the short-term future is unclear, the farther out in time we look, the future actually becomes clearer. Thus, while there may be a recession in Europe or the US in the next six months, Greece may default and some more banks collapse, it is clear that the world will achieve economic growth over the next five years. It seems clear that China in five years will be substantially larger than it is today. Indeed China could grow at half its current growth rate and still be 20 per cent bigger in five years. Australia will have over one million more people in five years’ time and will be supported by China’s growth. When you look to the next ten years, all of the above forecasts of growth are likely to be compounded. While the short-term future is unclear, the longer-term economic growth outlook is certain. That is why we invest and our aim is to capture this growth.

What is even clearer is the cause of the current market decline. The world is undertaking a massive restructure of its economic and social framework. Excessive debt is now seen as an unsustainable stimulant to economic growth. It brought forward consumption, it created excesses, degraded moral behaviour, stimulated greed and actually destabilised long-term economic growth. In some respects the GFC of 2008 was the “economic collapse we had to have”.

The future is now clear. Debt is going to be repaid. Consumption has slowed and speculation will be curtailed. Importantly the perceived value of all investment assets will be reassessed. Some assets will be worth more and many less. Those assets that rely on debt or speculation will fall in perceived value. A rationale and conservative assessment of sustainable returns will result.

As investors with capital with a longer-term focus, the market will present to you an abundance of growth opportunities.

For many months now we have been advising and managing clients’ capital on the basis of:

  1. There is no hurry to invest. Markets will generally be weaker over the short term. We have maintained relatively high cash levels to be ready when market opportunities present themselves and sentiment is irrationally negative.
  2. We suggested that there is no logical basis for index investing. We are not buying markets but we are purchasing parts of businesses on clients’ behalf. Stock selection and a focus on yield are vitally important. Companies that can produce high levels of profitability and convert current profit into future growth are our targets.
  3. We were hopeful that our selected stocks would be offered at attractive prices due to market volatility. We use the market volatility to acquire targeted stocks at prices below our assessment of value. We will continue to buy slowly and average down wherever possible.
  4. We have a rationale assessment of the world’s economic problems and we have put them into context in assessing investment risk. We do see solutions and have no doubt that decisions will be made by those in power to alleviate the situation.

In recent weeks, our clients would have noticed that our buying activities on their behalf have stepped up a notch. Their individual stock weightings and their time with us will to an extent determine the level of activity.

Right now it is our investment team’s belief that the Australian share market is approximately 15 per cent undervalued as a whole. Individual stocks are being presented at greater or lower discounts and we are building portfolios along the lines that we have consistently outlined in our recent briefings.

In our view, the market will remain at these discounted levels for at least the next six months. We will use this weakness to improve the cost of acquisition of client portfolio as we can see that the world, in particular China and Australia, will grow over the next five to ten years. The medium-term future is certain and starkly different to the weekend headlines.

John Abernethy is the Chief Investment Officer of Clime Group. Clime’s investment committee utilises MyClime, Clime's online stock valuation and research service to determine their stock selections. For a free two-week membership, click here

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Our top picks of attractive dividend stocks

Tuesday, September 06, 2011

Written by Matthew Koroi, Analyst at Clime

Total returns from investments in listed companies come from two sources: capital appreciation and the distribution of profits through dividends. Capital gains were almost taken for granted before the global financial crisis, but volatility in financial markets in the past few years has changed that.

Investors now need to identify profitable companies that reward shareholders with consistent and sustainable dividends if they are to maintain a steady source of income from the sharemarket during the current global uncertainty.

Research indicates that around 70 per cent of the market (excluding resources) total return has come from dividends, which shows just how important identifying high-yielding dividend shares have become for many investors.

Dividends represent an investor's share of a company's profits. Management can either choose to reinvest profits back into the business to pursue opportunities for growth, or give some of them back to shareholders.

Average dividend yields in the past few years have been more or less steady, ranging from four to five per cent. We believe this will continue in the mid-term but will depend on the speed of the global economic recovery.

Nevertheless, by identifying well-run companies that have continued to perform despite the adverse macro-economic environment of late, and investing in companies trading at a discount to their intrinsic value, investors will be well placed to benefit when confidence returns to the market and business conditions start to improve.

The right characteristics

We should first define what a company with attractive investment characteristics looks like, because they are the companies that will reward shareholders with consistent and reliable returns. These characteristics include:

  • High and sustainable return on equity driven by a competitive advantage.
  • Little or no debt and strong cash flows.
  • Sound management with (preferably) equity in the business.
  • A history of sensible capital management.
  • Positive industry outlook in which business can grow.
  • Available at a discount to its intrinsic value (the company's true value).

Examples of companies that Clime believes show many of these characteristics include Woolworths, Blackmores, CSL, ARB Corporation, Iress Market Technology, and Cochlear.

Although these are the characteristics of an attractive business, not all attractive businesses provide investors with attractive dividends and yield. In analysing companies when searching for yield, we tend to find the best ones display the following aspects:

  • Dividends are consistent and sustainable.
  • Dividends are franked.
  • Dividends are paid from the business earnings and supported by real cash flows, not recent capital raisings.
  • Yield is in excess of six per cent.
  • The business displays a record of growth in dividends per share.

In a general sense, mining companies tend not to make great investments for those seeking yield, because they often prefer to use profits to pursue new mining opportunities, as seen by BHP Billiton's recent acquisition of Petrohawk.

It should also be noted that the absolute dividend figure is not necessarily of uppermost importance, but rather the percentage-based yield figure. In BHP Billiton's case, although it paid annual dividends of roughly $1 a share, it is yielding only 2.3 per cent, which is quite low considering you can place your money on deposit with a bank, risk free, and earn six per cent or more.

Clime takes a conservative stance in the construction of portfolios and over the past few years has put increasing emphasis on the need for yield. With this in mind, here are some high-yielding shares that Climefavours (they show the attractive investment characteristics noted above):

Company Current yield Franking
Adelaide Brighton Limited 7.3% 100%
ANZ Banking Group 6.4% 100%
Commonwealth Bank of Australia 6.1% 100%
Ethane Pipeline Income Fund 10.1% 0%
Mortgage Choice Limited 9.4% 100%
OrotonGroup Limited 6.6% 100%
Spark Infrastructure Group 7.1% 0%
Telstra Corporation Limited 9.1% 100%
Westpac Banking Corporation 7.1% 100%
Woolworths Limited 4.4% 100%
Fleetwood Corporation Limited 5.9% 100%
Perpetual Limited 7.8% 100%

Source: MyClime Valuations. Yields current as at market close, 29 July 2011

Don't overlook risk

When searching for high-yield investments, investors often focus solely on the potential returns with little or no regard for the risks involved an important consideration that is often overlooked.

Although small-cap companies should not necessarily be avoided, investors should take their investment timeframe into consideration and allocate a lower percentage of their portfolio to higher-risk shares.

For example, you could buy Oroton shares at current prices on a yield of seven per cent, while Woolworths only offers 4.8 per cent. However, Oroton has a much smaller capitalisation and operates in the discretionary spending sector. It would be wise to factor in these risks despite both companies being attractive and Oroton displaying a higher yield.

To quote Warren Buffett, “More people have lost money stretching for yield than at the point of a gun”, and this is a lesson lost on many investors who disregard the risk side of the investing equation. For example, despite the attractive yields available on Greek bonds, the risk of capital loss is quite high given uncertainty surrounding European sovereign debt problems. We would argue that much more sustainable and less risky opportunities are available to prudent investors in the Australian share market.

Another aspect many people tend to disregard is that in investing, and more importantly investing with the aim of capitalising on the benefits of dividends, they need to take a long-term view of the market. Investors can then avoid the unnecessary worry associated with short-term fluctuations in market price levels driven by sentiment. For people with shorter investment horizons, such as those nearing retirement, knowing how to identify quality, high-yielding businesses is essential.

Given the uncertainty surrounding global financial markets and the problems this brings to investing in the share market, you could be forgiven for fleeing to more worry-free investments. However, by investing in attractive listed businesses that reward shareholders with dividends, at a discount to their intrinsic value, it is possible to secure returns that beat property or fixed interest. Also, it gives exposure to the future growth of the economy.

Written by Matthew Koroi, analyst at Clime Asset Management. Clime Asset Management and MyClime are part of Clime Investment Management (CIW). Using MyClime, our asset portfolio is ranked #1 of 87 in the Australian Open End Equity Large Value Peer Group – Morningstar™, 30 June 2011. For a free two-week membership, click here.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Reporting Season Wrap #2 – volatility is not risk; it is opportunity

Saturday, August 13, 2011

While difficult at the time, appreciating that volatility simply represents opportunities to the prepared investor is one of the most powerful concepts in the investing world. As investors, we need to train ourselves to resist running with the herd and often go against it.

This is exactly what we did this week, rationally reducing cash levels and buying parts of sound businesses for our clients and shareholders, not for next week or next month but for the next three years at large discounts. This is the DNA of Clime and the essence of our MyClime product. While we cannot identify the exact moment when prices are at their nadir, we can identify a sound estimate of value as an anchor point and observe to wave of price action that provides opportunities to transact.

Equities have been sold off without reference to value or fundamentals this week, an old fashioned panic. Irrational sellers and margin calls have pushed share prices down to compelling levels. Looking over our investment universe, we cannot find many businesses trading for prices above our estimate of value, which is a rather rare occurrence.

To us, the concept of value and the notion of margin of safety are at the heart of our investment process. We cannot emphasise enough that price expectations are at the centre of speculation.

It is times like this that test our conviction and forge our will to stick to our process. As shareholders we are part owners in businesses. Over time, the value of a sound business will increase, driving returns that are augmented by dividends.

The market today (12 August) is pricing in a significant chance of a recession in Australia. However, the RBA only a week ago forecast GDP growth of between three per cent and four per cent in each of the next two years. Either the market or the RBA will be wrong. We think the market is wrong, the outlook for the Australian economy and Australian businesses has not changed that much.

At this point, the aggregate analysts’ earnings growth projections for the market are 16 per cent in 2012 and 20 per cent in 2013. We know that broking analysts are renowned for being optimistic (it helps generate commissions), but if earnings growth turns out to be half of what is currently expected, this will still be more than the 6.6 per cent average earnings growth over the last 20 years. Dividends have consistently been around 60 to 70 per cent of earnings in aggregate.

The case for holding capital available for investment in cash (that is not needed for living expenses in the next few years) is weak at current market levels. We believe that interest rate cuts before Christmas are likely and a number of banks have already reduced three-year loan rates. Take a bank account earning the current cash rate of 4.75 per cent for a taxpayer on the 30 per cent tax rate. In this case, one would earn 4.75 per cent and pay 1.43 per cent of as tax and be left with a real return of 3.32 per cent. The current inflation rate is 3.6 per cent. In this case, the investor is left with a negative real return. At current market prices, there is a plethora of good companies that offer 10+ per cent pre-tax yields.

While equities carry more risk than a bank deposit and prices may get cheaper, just remember that no one rings a bell at the bottom of the market – but they certainly ring it loudly in a panic attack!

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it,” says Warren Buffett.

Prominent companies that have reported this week

JB Hi-Fi Limited (JBH)

JB Hi-Fi Limited (JBH) announced revenue decreased 8.35 per cent to $2.96 billion and NPAT decreased 7.55 per cent to $109.7 million for 2011.

“While we anticipate the market will remain challenging, we will continue to focus on driving market share growth through our core strengths of everyday low prices, great people and our low cost of doing business. When combined with the opening of 16 stores, the maturing of recently opened stores and our continued online focus, we are well positioned to maximise growth through the next 12 months,” said CEO Terry Smart.

During the year, JBH took a restructuring charge of $24.7 million relating to its Clive Anthony's business following a detailed review.

Cost of doing business was flat during the year at 15.4 per cent. NPAT margin was weak, decreasing from 4.34 per cent to 3.71 per cent in 2011. Stock turns decreased from 8.29 times to 7.98 times in 2011. Like-for-like sales were negative 1.2 per cent over the year. Average profit per store fell from $841,000 in 2010 to $698,000 in 2011 indicating a tough retailing environment.

One concerning metric was the change in sales versus changes in inventory. Sales increased eight per cent over the year however inventory increased 22 per cent over the year. This is likely due to the store opening program but it could also be a sign of poor inventory management. We will be paying close attention to this at the half-year results.

The number of stores at end of the year was 157, the business opened 18 stores and converted four Clive Anthony’s stores. Management noted the intention to open 16 new stores in 2012. Management have a target of 214 stores.

JBH noted that online sales represent one per cent of total sales. JBH has announced its intention to launch an online music streaming business late this calendar year, the intent is to leverage off the companies music heritage. The subscription-based service is set to offer unlimited streaming to a PC or Mac with mobile devices added later.

As a result of the buyback, net debt to equity increased from six per cent to 135 per cent in 2011. While we expect this to decrease over the next few years as equity grows and absolute debt levels decline, this does add risk to the business.

Cash flow was weaker that past periods however still sound, marginally exceeding NPAT for the year. JBH announced a 29 cent fully franked dividend.

We maintain NROE and marginally increase our RR to reflect the structural challenges in the industry. NROE is currently forecast to be 116 per cent in 2012 and 94.9 per cent in 2013 and 80 per cent in 2014.

Coca-Cola Amatil Limited (CCL)

Coca-Cola Amatil Limited (CCL) announced revenue increased 3.3 per cent to $2.2 billion and NPAT decreased 27.8 per cent to $153.6 million for the half. Profit was impacted by a restructuring charge against the SPC business unit.

“I believe that the operating performance in the first half has been solid given the business has had to manage external headwinds, as well as the cycling of a very strong first half result in 2010. The combination of devastating natural disasters in Australia and New Zealand, rapid increases in resin costs and the impact of translation on offshore earnings from the stronger Australian dollar reduced our net profit growth by around five per cent for the half,” said CEO Terry Davis.

Positively CCA noted that the Indonesian and PNG business increased EBIT by over 20 per cent as CCA’s market share continues to grow strongly.

SPC Ardmona recorded an earnings decline as the business continued to exit a number of unprofitable export and domestic private label lines. The stronger Australian dollar continues to impact SPCAs competitiveness against cheap imported brands and private label categories in Australia and its earnings from international operations with export sales declining.

The Pacific Beverages JV has continued to grow volumes with Peroni and Bluetongue performing ahead of market growth primarily as a result of the successful scale up of draught beer capacity at the new Bluetongue brewery in NSW.

Net debt to equity decreased from 86.35 per cent to 82.16 per cent in first half 2011. We expect this to decrease over the next few years as equity grows and absolute debt levels decline marginally.

Cash flow was strong over the half exceeding NPAT for the half-year, although NPAT was impacted by the restructuring charge. CCL announced a 22 cent fully franked dividend.

We maintain NROE and marginally decrease our RR. NROE is currently forecast to be 38.6 per cent in 2012 and 38.06 per cent in 2013.

Commonwealth Bank of Australia (CBA)

Commonwealth Bank of Australia (CBA) announced revenue increased 11 per cent to $46.2 billion and NPAT increased 13 per cent to $6394 million for the year.

“This is a good, solid result in what has been a difficult year. All of our businesses have performed well during a period characterised by subdued credit growth and intense competition. We have maintained our conservative business and financial settings which has enabled us to support our customers in an uncertain economic environment which remains challenging for many,” said CEO Ralph Norris.

Positively deposits have grown faster than loans over the year allowing CBA to fund new loans from deposits and reducing its need to access offshore funding.

Bad debt expense fell 47 per cent and impaired assets remained flat over the year. System credit growth was subdued and CBA grew its assets less than system, assets grew 3.34 per cent over the year. CBA noted they are focusing on profitable growth and pleasingly EPS grew 16 per cent over the year outperforming equity per share growth of 4.3 per cent over the year. Positively CBA increased dividends per share 29 per cent over the year.

Net interest margin increased over the year and was 2.19 per cent at year-end. CBA announced Tier 1 capital of 10.01 per cent, CBA is well capitalised. The last time Tier 1 capital was above 10 per cent was in 1996. CBA announced a $1.88 fully franked dividend for the full year.

Broadly this is a good result in a challenging environment. We maintain NROE and our RR. NROE is currently forecast to be 26.4 per cent in 2012 and 26.8 per cent in 2013.

Advanced Share Registry Limited (ASW)

Advanced Share Registry Limited (ASW) announced a 21 per cent increase in revenue to $5.39 million and a 22 per cent increase in profit to $1.77 million for 2011.

Management made the following brief comment: “The Company continues to focus on a value proposition for its client base by improving its service and service offerings to a wide range of clients. The directors are confident of the future growth and profitability of the company.”

In the first half, operating costs increased mainly due to the advent of full operations in their Sydney branch office, and an increase in Perth staff levels.

The balance sheet remains sound with no debt and cash on hand of $4.13 million. Operating cash flow was again strong at $1.96 million for the year.

ASW declared a fully franked dividend of two cents per share. NROE continues to improve as scale increases.

Despite the recent sell off in equity markets, ASW still remains fundamentally sound yet expensive. We retain forecast NROE at the level achieved in 2011 and have slightly reduced our RR to 15.3 per cent.

Cochlear Limited (COH)

Cochlear Limited (COH) announced revenue increased 10 per cent to $809 million and NPAT increased 16 per cent to $180.1 million for the year. Cochlear implant unit sales were up 17 per cent to 24,661 units.

“This is an excellent financial result with record revenue, profit and a net cash position at year end. Importantly, the business was strengthened and readied for ongoing growth from the areas of technological innovation, further improvements in manufacturing and supply chain processes and advancement of online digital strategies,” said CEO Dr Chris Roberts.

Positively earnings and dividends grew at double digit rates over the year. However, EPS growth is expected to slow in the next two years.

COH noted that they expect future growth to be driven by bi-lateral implants and adults in developed economies, and children in developing economies. COH announced a $1.20, 70 per cent franked dividend for the full year.

We maintain NROE and marginally reduce our RR. NROE is currently forecast to be 46.5 per cent in 2012.

Telstra Corporation Limited (TLS)

Telstra Corporation Limited (TLS) announced revenue increased 0.7 per cent to $809 million and NPAT decreased 16.8 per cent to $3231 million for the year, ahead of consensus expectations. Operating cash flow was strong at $8018 million for the year.

  • PSTN: -7.8 per cent on previous period to $5205 million, in line with eight per cent decline in 2010.

  • Mobiles services: 7.4 per cent on previous period to $6940 million.

  • Internet: -2.4 per cent on previous period to $2091 million.

  • IP & Data Access: -0.1 per cent on previous period to $1771 million.

  • Sensis: -11.8 per cent on previous period to $1909 million, this business unit is continuing to struggle with structural changes. Yellow Pages print saw a 15.8 per cent decline in revenue.

Positively, mobile revenue growth was strong for the year especially against peers where Optus achieved around 4.5 per cent growth Vodafone experienced declines. This reflects the strong customer growth for TLS over the past 12 months; TLS noted they added two million mobile customers.

Over the past year, TLS has recorded a turnaround in operational results, generated customer growth, reduced customer churn, driven revenue growth and higher market share in fixed broadband and mobile. There are a number of challenges ahead, the business has submitted its structural separation plan to the ACCC and is toward gaining acceptance before its AGM so a shareholder vote can be taken on the NBN proposal.

TLS announced a $0.14 franked dividend for the full year. TLS announced its intention to maintain its $0.28 dividend for 2012. TLS this year paid more in dividends than it declared in profit, although well covered by operating cash flow. As such, equity per share has marginally declined. This is expected to continue in 2012 before stabilising in 2013.

We maintain NROE and our RR. NROE is currently forecast to be 40 per cent in 2012 and 41 per cent in 2013.

Next week...

Week three of reporting season will see a large number of businesses telling us how they fared in 2011 including:

Monday: LEI, UGL

Tuesday: OST, GWA

Wednesday: ARP, CSL, TRS

Thursday: ASX, PTM, WES


Composed by analysts at Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). Using MyClime, our asset portfolio is ranked the #1 Best Performing Fund byMorningstar – Equity Australia Large Cap, 30 June 2011. For a free two-week membership, click here

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


The Big Short 2

Thursday, August 11, 2011

“From a value-based investment perspective, the sharp falls are opportunities to invest at very attractive prices. The major banks offer excellent examples. Interim results show continued strength, yet at a point on Tuesday, CBA was trading at $43.50, offering investors a grossed up dividend yield of 9.9 per cent. We believe that we will get more opportunities in coming months…”

Maybe we should wait for the release of ‘The Big Short 2’ on internet book portals in 2013 to explain the recent collapse of equity markets around the world. However, by then we may have missed out on some wonderful investment opportunities which are being presented in the current mayhem. So let’s have a look at what is actually happening in the world and see if there are any connections that we can piece together.

At the outset, let’s pose a confronting question – is there any connection between the outbreak of coordinated attacks by youths in the United Kingdom and the coordinated attacks on equity markets around the world? We would suggest that there is, in a perverse and disturbing sense.

Over in the equity markets of the world, there appears to have been a similar coordinated attack. The equity market itself has very weak defences because it is characterised by excessive leverage and its flows are dominated by withdrawable funds and not by permanent or committed long-term capital. Even more disturbing is the proliferation of derivatives, exotic Exchange Traded Funds (ETFs) and shadow trading activities. These trading products are promoted by investment banks and supported by stock exchanges. Indeed it is likely that in coming weeks, the ASX will reveal that it has achieved stunning growth in revenue from clearing derivative trades as opposed to tepid growth in fees from stock trades.

An attack on the equity market is in a sense self-fulfilling. With the recent GFC so fresh in people’s memories, there is a real temptation for many people to head for the exits at the first sign of trouble. The psychology of the market is now so fragile that shorting attacks have every chance of being successful; and the more investor skepticism rises, the more successful the strategy will be.

It has been our view in recent months that world growth was stalling (again) and that equity market upside was limited. Active funds invariably have some commercial relationships with the large investment banks of the world. Indeed it is a universal fact that investment banks themselves have massive proprietary trading desks that are constantly active across markets. While they are proffering their public views on market directions, simultaneously they employ covert and biased views of value in the hunt for trading profits.

While there was a rational liquidity argument for speculative rallies from the quantitative easing campaigns of central banks, it soon became apparent that there was little possibility of a sustainable market recovery in the short term. Investment banks and their associated broking houses have continued to recommend stock purchases to their clients right up until recent weeks. They continued to do this despite a rapidly deteriorating outlook in Europe and slowing growth in the US. In Australia, the investment bank economists unanimously forecast interest rate increases in early June given the strength of the Australian economy! None of them (apparently) looked outside of Australia to the growing mess of international economies. Only one commercial bank economist (Bill Evans from Westpac) questioned the logic of the majority of economists. The question is, why did so many economists get it so wrong?

Having exhausted the rhetoric to their clients of the potentially strong equity price performance due to world growth, the investment banks came to the realisation that their serious clients (the institutions) were becoming increasingly skeptical. What a beautiful trading position to be in when your clients are telling you that your forecasts are rubbish. Even better when your investment bank peers are hearing the same stuff; proprietary trading desks sniffing blood probably started devising their short trading strategies.

Having numbed the general market with ‘pie in the sky’ price and stock indices targets, the settings were perfect for a massive attack on sentiment. Thus, we suspect that the large trading books of the investment banks and their related parties went to the short side. Indeed it now seems obvious that the Australian market was a prime candidate for an equity and currency attack. The reason for this is because our market is dominated by major resource companies and banks. The Australian institutions are ‘full to the gills’ with these stocks and are not natural buyers other than meeting index flows. Thus, price falls are unlikely to be countered by equivalent buying and less so when the bank bill futures are forecasting interest rate increases.

To understand why the Australian market can easily be destabilised and cause massive gyrations of stock prices, remember that:

  1. We continue to offer investment leverage through margin loans.
  2. We have shadow-trading products such as CFDs and options.
  3. We have withdraw-able equity trust funds where managers are meeting redemptions when they should be buying.
  4. We have index funds that lend stock to hedge funds for shorting.
  5. We have a stock exchange that supports volatility as a business case.
  6. We have broking houses that are hopelessly conflicted with their owners.
  7. We have debased the formation of permanent capital in this country with the destruction of mutual institutions.

The recent gyrations in world equity markets are disturbing. The volatility and the intraday moves demand an international enquiry. However, there will be none and the true facts will only become apparent after private investigation. The sharp rally last night in the US equity market of five per cent in just 90 minutes was a rerun of Australian and German markets. It was clearly a short covering rally much like those UK thugs running from the scene of the crime.

But there is some good news. From a value-based investment perspective, the sharp falls are opportunities to invest at attractive prices. In recent days, we have bought stocks slowly at excellent entry prices. The major banks offer some outstanding examples. Interim results and trading updates from both the Commonwealth Bank and NAB released this week show continued balance sheet strength, improving net interest margins, and declining bad debts. In the words of retiring CBA CEO Ralph Norris, “a good, solid result in what has been a difficult year”.

Yet at a point on Tuesday 9 August, the CBA was trading at under $43.50, thus offering investors a grossed up dividend yield of 9.9 per cent. On our assessment, CBA also offers a sustainable return on equity in the mid 20 per cent range, and a required return at 12 per cent. We regard that as a wonderful combination and were actively buying CBA at prices around $44 for client portfolios. We believe that we will get more opportunities in coming months because the wolves of the world are active and unregulated.

Who was throwing away their Commonwealth Bank shares at $44? Like the alienated young thugs torching parts of London, distressed and fearful retirees and baby-boomers contemplating a dismal retirement and mistrustful of their politicians probably decided they couldn’t face any more pain and capitulated. They have lost confidence in the rational functioning of the capital markets and in the traditional sources of advice: who wouldn’t when we see bond markets and share markets behaving in seemingly random and irrational fashion, and when large institutions like the investment banks appear to manipulate markets for their own short term trading profits?

Finally, a quick comment on interest rates. The decision by Westpac and CBA to lower fixed rate home loans, the influx of retail deposits into banks and the sharp declines in rates in the US, suggest to us that deposit interest rates will fall. Those investors who were spooked out of equities in the last few days will see their deposit rates fall sharply in coming months. The only thing stopping rates from falling now is the tightness in European markets. We suspect that by Christmas the Australian deposit rates will be between half and one percent lower then current rates. Then Australian bank shares will become even more attractive from a yield perspective.

With so much excitement in markets at present and so many unanswered questions we cannot wait for The Big Short 2 to become available on Kindle!

Some interesting charts

The following explains why Standard and Poor’s downgraded the US last week from AAA to AA+. The US has gross public debt equivalent to 100 per cent of GDP and proposes to lift this level to about 115 per cent in the next year. This is because the debt limit has been lifted by $2 trillion, while over the same period the economy is likely to grow only by $200 billion. Hence the debt to GDP ratio gets worse.

At that point, the US joins Japan, Ireland, Italy, Greece and Iceland as countries that have extraordinary high government debt.

In the meantime, the bond markets of the US are oblivious to credit risk but focused on slowing growth. The yields on ten-year bonds touched 2.14 per cent last night and have staged a dramatic rally since the end of QE2 on 30 June. One wonders if the Federal Reserve is unloading its $600 billion of bond purchases into a spooked market. We suspect that it is and is sanitising purchases which will allow it to re-enter markets in coming months. Indeed it may enter equity markets at some point if stability is required.

For a larger image, click here.

The following table show who owns the US debt. Other countries are dominated by OPEC nations and China is now the single largest foreign owner. In recent weeks China has been a more vocal critic of the US Administration debt policy and it would be extraordinary if China is a continuing buyer of US debt. In coming months, it will be interesting to monitor the purchases of US bonds and we suspect that the US public, through US banks, has been the major buyer. The funds are the repatriated flows back to the US from foreign markets (like Australia) and is indicated by the rise in the US dollar.

For a larger image, click here.

The following is the debt maturity profile of the European economies. The next two years sees over one trillion Euros of maturities and we suspect another one trillion Euros of new debt. The emergence of the ECB with a quantitative easing programme to buy Spanish and Italian bonds was essential. In essence, the ECB will buy bonds held by European banks and eventually reissue a form of ECB bond at a lower yield and higher rating.

The chart does show the massive bond-raising task and suggests continuing strain in the European debt market. Australian banks continue to rely on this market for offshore wholesale funding but the credit rating of our banks are superior to some European countries and there is the omnipresent support from the AAA rated Australian Government.

For a larger image, click here.

We note the exposure of large German banks to Greek government debt. The proposed private owner loss on the Greek debt restructure does expose some German banks to capital ratio problems. Generally, the largest exposures to Greek sovereign debt reside in those banks with the lowest capital ratio. This suggests that there are large capital raisings likely in Europe in coming months and this will keep a lid on the affected equity markets.

Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). Using MyClime, our asset portfolio is ranked the #1 Best Performing Fund by Morningstar – Equity Australia Large Cap, 30 June 2011. For a free two-week membership, click here

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Reporting Season Wrap # 1 – sound fundamentals, but a tough start to reporting season for markets

Saturday, August 06, 2011

As we headed into reporting season, the market remains concerned by the well known macro issues such as US/European growth and debt concerns, Chinese inflation and the Government’s response, the strength of the Australian dollar and its effect on varying sectors of the economy, and fears over a soft domestic economy.

Will Australian property prices come back? Will the consumer continue to be cautious? Will the savings rate continue to remain at 20-year highs? Recent APRA data indicates for the year to June credit growth of around five per cent and deposit growth around 12 per cent.

Uncertainty, always present, is at elevated levels at the moment. If there is one thing the market dislikes, it is uncertainty. It saps confidence and leads to pressure on businesses, consumers and share prices. A calm head and a steady hand are what are needed, particularly in this market. This is not the time to be listening to your emotions.

These are some of the challenges facing the market and as a result it is hard to see the market running strongly in the short term. Looking through sentiment to fundamentals we see the All Ordinaries Index value at around 4700, yes on a longer-term view the market is cheap.

Value is now evident in most sectors. When we look back in a few years, we will quite likely realise that we are currently in a window of one of the rare great buying opportunities.

A challenge is in the short term that the market could get cheaper, should one or more of the macro issues unfold worse than currently expected, remembering that markets in a panic ignore fundamentals! To break the domestic deadlock we need to see interest rates and/or the $A come down. The high Australian dollar and uncertain government policy is leading many overseas investors (rationally) to repatriate capital at present, increasing pressure on share prices. Margin lending today (12 August) is at around half the level it was in 2007 and as such we do not see too much forced selling influencing prices at present although we believe there was some margin selling late this week.

Broadly broking analysts are (still) expecting 15 per cent earnings growth for the market in FY2012, we think this is unrealistically too high and will be corrected toward single digits over the next month or two. We see rising cost pressures from the likes of labour, fuel and utilities contributing along with poor productivity growth to margin pressures.

When combined with slow top line growth in many sectors due to consumer’s preference to save and resistance to borrow, it makes us think many businesses will need to continue to focus on cost cutting programs to drive/maintain profits and profitability. Some sectors such as retail are facing structural changes while some sectors such as mining are enjoying cyclical tailwinds. Overall in Australia, GDP, aggregate profits and dividends are set to increase however we think at a slower pace than many expect.

Pessimism and poor sentiment is pervasive at the moment – just the environment that rational investors with conviction relish, as it creates depressed prices and buying opportunities. The absolute and relative outperformance of tomorrow is earned in tough markets like this. One needs to focus on value and use price as an indicator of opportunity. We have our watch list of companies we would like to own at the right price and will be updating our thinking around many of them and their outlooks over the next few weeks.

Prominent companies that have reported week ending 5 August, 2011

Rio Tinto Limited

Rio Tinto Limited (RIO) announced a record first half profit of US$7.8 billion supported by US$12.2 billion of operating cash flow. This is a very good result however marginally below consensus expectations, impacted by poor weather in parts.

Commenting on the result CEO Tom Albanese said, “In a period of rapid investment across the industry we are experiencing high cost inflation in certain mining hotspots. Coupled with the increasing strength of the Australian and Canadian dollars, this has put pressure on our cost base. Nevertheless, through our industry-leading investment in technology and innovation and our track record of superior operational performance, we expect to mitigate some of these cost increases.” This cost pressure has lead to marginally weaker performance and marginal earnings downgrades (FY11 -7 per cent, FY12 -3 per cent).

RIO is continuing to invest in capacity across its businesses. RIO has US$26 billion in approved projects and over US$40 billion in the advanced study stage. If approved, these could be in production from 2015. This is clearly evident as volumes have increased four per cent over the year. However, capital expenditure has increased 236 per cent over the year. Growth in capacity is geared more toward 2015 with Pilbara iron ore expansions and Oyu Tolgoi not operational until 2013. From 2015, capacity meaningfully increases with Pilbara Iron Ore expanding to 300+ million tons per year. Earnings estimates are flattening out over the period to 2015 due to expectations of moderating commodity prices. NROE is estimated to fall over the period toward our assumption due to the quantum of retained earnings diluting NROE.

Strong commodity prices have meaningfully contributed to the record result, to the tune of $5 billion. Copper prices were up 31 per cent, molybdenum prices were up 13 per cent, gold prices were up 26 per cent and aluminium prices were 20 per cent higher than 2010 first half.

Volumes were marginally lower driven by lower iron ore sales driven by poor weather.

Net debt to equity has increased over the period as a result of the Riversdale acquisition and investment in the Ivanhoe operations from around seven per cent at the full year to around 25 per cent (5 August). Debt appears quite manageable at the moment.

RIO declared a $0.50 dividend for the period that will be franked for Australian shareholders.

RIO has announced that it is increasing its buyback program by $2 billion to $7 billion and intends to complete this by early 2012. We note that RIO has completed around $3 billion of this to date and will likely focus the buyback on its UK listed PLC shares.

NROE is forecast to be 41 per cent in 2011, 30 per cent in 2012 and 24.5 per cent in 2013. We marginally reduce our NROE.

Navitas Limited

Navitas Limited (NVT) announced a 16 per cent increase in total group revenue to $643.8 million, while NPAT was up 20 per cent to $77.4 million.

Management noted operational highlights during the year to be:

  • The acquisition of SAE for $294.3 million less $22 million of cash acquired
  • Commencement of operations for six new University Program colleges
  • The securing of Commonwealth contracts to deliver Adult Migrant English Program in NSW, said to be worth $200 million over three years.

Following the acquisition of SAE, NVT has moved from a net cash position in 2010 to a net debt position of $102.8 million in 2011. Thus the net debt to equity ratio now exceeds 40 per cent. Intangible assets have increased substantially as a result, which now constitute a very large portion of total assets. A further result of this acquisition is a negative impact on profitability and thus our valuation. From 2010 to 2011, equity increased by 131 per cent, while NPAT only increased 20 per cent. Ultimately, time will tell but the above suggests NVT may well have overpaid for this acquisition.

Further commentary from management provided some insight into various headwinds being faced by the company at this stage; a strong Australian dollar, a changing Visa regime and a slower-than-expected US rollout.

Operating cash flow was reasonable for the year at $69.46 million. NVT declared a fully franked dividend of 12 cents per share.

NROE is currently forecast to be 50.6 per cent in 2012 and 57.7 per cent in 2013. We have thus lowered our forecast NROE, and have increased the payout ratio to reflect these forecasts. As a result of balance sheet movements, our RR has been slightly increased to 14.6 per cent.

Coal & Allied Industries Limited (CNA)

Coal & Allied Industries Limited (CNA) reported a 25 per cent increase in first half revenue to $1.165 billion, while profit after tax excluding divestments was up 41 per cent to $227 million.

When reviewing CNA, it is important to understand that there are a number of moving parts to consider – all of which make forward-looking valuations quite challenging. Fluctuations relating to commodity prices, weather impacts, currency and production could all have a meaningful impact on future profitability for the commodity business. Despite this, it would appear CNA is delivering quite reasonable value growth after the actual 2010 valuation was rolled out to a forecast 2011 valuation.

Management noted that performance in the first half was solid, driven by an increase in production despite weather impacts. Revenue grew strongly following recent investment in heavy mobile equipment, ultimately driven by higher sales volumes and significant increases in both thermal and semi soft coking coal prices. CNA’s Bill Champion commented that “these strong market conditions are expected to continue for the remainder of the year and we will increasingly see these higher prices flow into revenue as contracts are renewed”. A factor that somewhat offsets strong production growth is the ongoing strength of the Australian dollar, which impacts the international competitiveness of Australian producers.

Operating costs increased during the half mainly due to higher stripping ratios, increased overburden removal and workforce growth. Project expansions remain underway at each of CNA's existing mine sites. The development decision regarding the Mount Pleasant project is due in late 2011.

The balance sheet remains sound, with net cash of $126.6 million. Operating cash flow was strong for the half at $301.3 million. CNA declared a fully franked dividend of $1.20 per share.

NROE is currently forecast to be 55.6 per cent in 2012 and 44 per cent in 2013. This is obviously subject to factors (alluded to above) that may well fluctuate such as coal pricing, weather, production and infrastructure capacity. We have slightly lowered our payout ratio to reflect forecasts for the next three years. The RR has been increased moderately to 14.2 per cent.

Reporting season will heat up in Week 2 with a number of prominent businesses telling us how they fared in 2011 including;

Monday: JBH

Tuesday: CCL, COH, RKN, BKN and NAB with a quarterly result. 

Wednesday: CBA, CPU, FXL and DMP

Thursday: TLS

It is challenging to focus on the long term when the short term looks so clouded. However, owning parts of sound operating businesses has outperformed every other asset class over the long term and there is no credible reason why this will not continue. Sensible investors stay the course, stick to their strategies and focus on value. Investing is simple however it is not easy.

For a larger image, click here.

Composed by analysts at Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). Using MyClime, our asset portfolio is ranked the #1 Best Performing Fund byMorningstar – Equity Australia Large Cap, 30 June 2011. For a free two-week membership, click here


Part II – The risk-side approach to long-term investing

Tuesday, June 21, 2011

In Part I of this report, we mentioned there were a number of ways one could use the ‘risk-side’ of the MyClime Equation to identify core investment stocks.

In Part I, the stock candidates were determined by aggregating external and internal factors, which we called the risk number. For companies with a risk number lower than one standard deviation from the average, the company was included in the portfolio (Portfolio 1).

Today, we bring you Part II of our analysis. The portfolio selection is based on a separate assessment of each company’s external and internal factors (see below for process).

Selection process

Using the same stocks in the Clime Fund Management stock universe (approximately 100 stocks), we have determined the external and internal factors separately. From this population, we can determine the average external and internal factors as well as the standard deviations respectively.

In this selection process, the following selection criteria are used:

  1. Companies which present as having both the internal and external factors at one standard deviation better than the average on the low risk-side (very attractive) are automatically chosen to be included in the portfolio.
  2. Companies which have very attractive external factors (lower risk-side), but unattractive internal factors have been removed.
  3. Companies with very attractive internal risks (lower risk end), but unattractive external factors have also been removed.

In the first selection process, we found eight stocks. Using the second and third selection process, a further nine stocks were found which met the criteria, giving a total of 17 stocks for this portfolio (named Portfolio 2).

We believe Portfolio 2 is sufficiently well diversified such that the unsystematic risk is close to 85 to 90 per cent diversified away although 20 stocks would be preferable.

Portfolio 2 consists of the following stocks (in alphabetical order):

  1. AGK
  2. ANN
  3. ANZ
  4. ASX
  5. BKL
  6. CBA
  7. COH
  8. CSL
  9. IRE
  10. QUB
  11. ORG
  12. ORL
  13. RHC
  14. RKN
  15. SAI
  16. TLS
  17. WOW

We note Portfolio 2 is essentially similar to Portfolio 1 with the exception of three stocks. They are NAB and WBC and IVC.

In Part I, the poorer internal factors for NAB, WBC and IVC were masked or compensated by very attractive external factors.

We also see the only stock that has been added to this portfolio which was not in Portfolio 1, is RKN. In this case, it has attractive internal factors and reasonably attractive external factors. Thus, RKN has been included based on selection process #3.


Once again, we have back-tested the performance for Portfolio 2 to 31 December 2010. The one-, three-, five-, and 10-year total return for the individual and average total return with equal weights are shown in Figure 1 below.

We then compare the performance of Portfolio 2 against All Ordinaries Accumulation (XAOAI), the ASX 200 Accumulation (XJOAI ) and ASX 200 All Industrial Accumulation Indices (XJIAI).

Figure 1. The one-, three-, five- and 10-year total returns for Portfolio 2 (to 31 December 2010)

Source: Calculated using data sourced from IRESS

It is clear that Portfolio 2 has outperformed the market significantly and not surprising that the performance of this portfolio is superior to Portfolio 1 (Part I) due to the segregation of the external and internal factors.

The consistent outperformance of Portfolio 2 can be clearly shown in Figure 2 below. We would also like to highlight the outperformance of this portfolio in the negative market during the GFC, and its ability to maintain a positive absolute return over this period.

In the stronger market over the past 12 to 18 months, Portfolio 2 has also leaped well ahead of the market. On the five to 10 years’ timeframe, the performance is consistently more than 15 per cent per annum.

Figure 2. Performance of Portfolio 2 against the market

All stocks within Portfolio 2 are industrial stocks, and do not include any resource stocks. However, we need to note that the resource sector has outperformed the general market significantly over the past decade, suggesting that the above portfolio has performed in a remarkable fashion.

It highlights the power of investing in lower risk stocks over the long-term so long as you have a robust measure of external and internal risk.

Our conclusion is that investing in stocks with lower required returns with an extra filter for the internal and external risk factors appears to offer a powerful investment approach.

Having identified the candidates for the portfolio on this basis, then the object (as always) is to properly assess their valuation and seek to purchase them with a margin of safety.

Vincent Chin is a senior analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Telstra Corporation Limited and NBN Limited

Wednesday, June 15, 2011

Being a widely held business, there is no shortage of commentary on Telstra Corporation Limited (TLS). When this commentary is combined with a decade or more of unrelenting share price declines, often the discussions become emotive.

For a larger image, click here.

Figure 1. TLS: Value & Price

People have been communicating via traditional POTS (plain old telephone service) since 1876 when Alexander Graham Bell received his patent for the device. Observing the business of telephone calls over time would indicate that for the majority of TLS’s life, which began in 1901 as a government body, it has had a monopoly on voice calls. This monopoly allowed it to control pricing, maximise margins and reinvest the profits in expanding its network infrastructure as the country grew – indeed a wonderful competitive position.

A snapshot 15 years ago would have seen the slow proliferation of mobile telephones, some landline, competition and the growing popularity of the internet. In the mid 1990s, everyone would have likely had the view that they needed a landline and TLS had a strong competitive position, but the monopoly had gone.

For a larger image, click here.

Figure 2. Proportion of subscribers by connection type

Source: Australian Bureau of Statistics

Looking at the industry today, mobile phone and broadband penetration is high, substitutes to POTS calls is high with Skype, Facebook, GoogleTalk and Apples FaceTime on the growing list of fixed and mobile substitutes.

Today, more people are questioning the need for a landline and the proliferation of wireless-only households in Australia is increasing. At the first half results, CEO David Thodey estimated that 12 per cent of Australian homes have now become wireless only, a number we think will rise in the coming years following overseas trends. As a result, TLS’s competitive position is much weaker today than at any time in the past.

Looking forward, it appears that the slow slide in the price of voice calls will result inevitably in voice calls being universally free when attached to a VOIP (voice over internet protocol) broadband plan or an uncapped mobile plan. There are participants providing both today.

Maybe the smartest participant was the government selling T1 ($3.30), T2 ($7.40) and T3 ($3.60) to the public markets for a price higher than value (amazingly so with T2 in 1999) on the eve of real competition and availability of real substitutes in the industry.

What do we know about NBN Co Limited (NBNCo)?

The current government wants to build a wholesale fibre to the premises network to replace TLS’s monopoly copper network with estimated fibre connections to 93 per cent of premises nationwide. To this end, it has formed a company called NBNCo to facilitate the project which will offer entry level speeds of 12Mbps and speeds of up to 100Mbps initially. It is hoped construction will be complete by 2020. However, we think this will slip somewhat.

TLS and NBNCo have signed a non-binding agreement and are in the process of agreeing to terms to access the passive infrastructure such as pipes, ducts, exchange space and backhaul fibre optic connections.

NBNCo is forecasting a seven per cent return on around a $35.9 billion capital investment. This is clearly an inadequate equity market return and quite marginal even for a government borrowing at around 5.5 per cent. There appears little room for cost overruns or lower than expected take up.

We believe the cost will blow out as evidenced recently by NBNCo suspending the tender process because none of the 14 tender proposals had acceptable terms and pricing. NBNCo suggested all 14 were price gouging and attempted to use rising labour costs fuelled by the resources boom as an excuse, one or two colluding maybe but 14 appears highly unlikely.

Of course the government needs TLS’s involvement in the NBN. It was ridiculous to exclude TLS from negotiations in 2008. One can only wonder how the government thought it could complete the project without access to a century’s worth of nationwide pipe, duct and exchange investment owned by TLS. Of course, politics is rarely a place for rational economic thought.

We look forward to further details on how the NBN will work with a definitive agreement with TLS, which can go to the ACCC for approval and then TLS shareholders.

Where are the opportunities?

Looking forward, it appears that mobiles are a key to success. TLS has a network meaningfully ahead of competitors. TLS operates around 30 per cent more base stations than its nearest competitor, provides 42Mbps while competitors offer 7.2Mbps and has a significantly faster backhaul network that any competitor.

TLS has announced it will upgrade its mobile network to 4G by the end of 2011 in major cities. With 4G wireless, we can expect up to 100Mbps when moving in a car or train and theoretically 1Gbps for fixed wireless. If TLS decides to offer this product cheaper than the NBN and supports this with reasonable customer service, it could materially undermine the NBN by attracting customers to wireless-only solutions.

Interestingly, within the NBNCo Business Plan, it assumes 70 to 80 per cent take up and that wireless-only residences will only grow by three per cent to 16.4 per cent by 2040. In the US, wireless households already represent around 25 per cent of the market. This is a structural shift and we think this substitution is a meaningful risk to the NBN business case and an opportunity for TLS.

TLS knows this and thus is refocusing on the mobile space with some recent success driven by lower prices and a stumbling competitor in Vodafone. The question remains as to whether mobile subscriber growth can be translated to profitability growth.

For a larger image, click here.

Figure 3. Australian Fixed Line Market - Wireless only households (click image for full view)
Source: Roy Morgan, NBN Co, CDC Wireless Substitution Study

Customer base is arguably TLS’s greatest asset. TLS has over 10 million fixed phone/internet customers and over 11 million mobile phone/internet customers. This vast reach can be a very powerful area for cross-selling and bundling of services.

In an NBN environment, TLS will no longer enjoy the wide margins it currently derives from its infrastructure, wholesale and retail margins. Fixed phone and internet delivered over an open-access NBN fibre will attract minimal margins and meaningfully lower barriers to entry for competitors. Competitors from unusual places are likely to emerge that could offer multiple services bundled on the one bill.

In NSW for example, consider the recently privatised energy retailers (now profit driven) that offer electricity and gas. What would stop them from offering fixed phone and internet services on the same bill bundled with a discount? Could TLS offer fixed and mobile phone/internet, electricity and gas on the same bill? We know that nimble competitors (notably MTU) are already considering exactly this and developing IT systems to leverage these opportunities that are just around the corner.

For over a century, TLS has invested in the pits, pipes and exchanges that house the cables currently providing services to Australians. It will retain ownership of these in a post-NBN environment and therefore TLS will derive ongoing rental income.

TLS values plant, property and equipment (PP&E) in its accounts at $22.89 billion or $1.84 per share. Some of these assets are likely to be more than fifty years old at depreciated book values. Replacement cost in today’s dollars is likely to be many multiples.

What is the replacement value of all the pits, pipes and exchanges in Australia? Could TLS spin out a listed infrastructure trust that houses its pits, pipes and exchanges with revenue derived from the rentals from NBNCo? A simple bond like discounted cash flow could provide a reasonable estimate of net present value. This appears quite an opportunity, however a catalyst could be years away.

New technology and content is a growing feature of TLS. Products like the T-Box and T-Hub have enjoyed good success in the short time since launch. The T-Box, which has sold over 280,000 in less than a year, looks particularly appealing to a broad market. The product offers an array of TLS IPTV content (music, NRL, AFL, V8, 24hr news and TVN racing), alongside traditional free-to-air TV and soon Foxtel. An interesting feature is the Bigpond Movies component that allows users to download a movie or TV show that is unmetered (if they have a TLS broadband connection), and stays on the T-Box for a couple of days. The service is similar to the popular US Netflix product and looks to be a sound strategy with meaningful opportunity to differentiate TLS’s offering – a particular risk of video rental stores around the country.

Where are the risks for TLS?

Uncertainty around the definitive agreement with NBNCo is a meaningful risk. There is speculation negotiations are coming to a close. The longer it takes for a definitive agreement with NBNCo, the closer it gets to the next election. If the government loses office, the opposition have noted they will scale back the NBN project. This places reasonable uncertainty on the compensation payable to TLS.

Customer retention is a considerable risk once the NBN is operational either partial or at completion, especially in fixed line services.

Nimble and lean competitors with fair and equal access to the NBN that may be willing to accept a lower margin for business have the potential to be quite a headwind for TLS over time. This scenario could be very similar to the competitive utilities of gas and electricity.

Churn rates are high and margins are low. When offering an undifferentiated service to succeed, companies need to focus on customer service and keeping overheads low. This will likely be a challenge for TLS. However, a positive is that the current CEO is taking steps in the right direction.

The TLS business has been listed for over a decade and there still are signs that the culture is skewed toward network engineering and infrastructure, although slowly changing toward a sales and customer focus.

Sensis advertising and directories revenue was down by 6.8 per cent in the recent half year. Directories revenues fell by 7.2 per cent during the half, with Yellow Pages revenue down 10.6 per cent. In Australia, the Yellow Pages has fared remarkably well relative to many overseas locations where declines of greater than 10 per cent have been common for a number of years. This is a structural shift as consumers embrace other methods of looking up details online, mobile devices and search engines like Google, businesses recognise this and divert marketing spend towards other mediums such as websites, social media and online advertising.

A real risk is that telecommunication services become undifferentiated commodities simply providing the ‘pipe’ we use to communicate. Smartphone penetration is driving innovative apps that are disrupting traditional phone and messaging revenue. The way we communicate has likely changed as much in the last decade as it had done the century before.

Fast-changing industries are difficult for investors to get right. TLS currently has an edge in its fixed and wireless networks. However, with the fixed network being replaced by fibre and competitors spending billions to bridge the wireless gap, TLS’s network advantages are contracting. In this environment, low costs and service are critical. Time will tell if the business can refocus to a customer-orientated sales organisation.

Investment case

For a larger image, click here.

Figure 4. MyClime Valuation: Telstra Corporation Limited

Since listing, equity per share has fluctuated between $0.80 and $1.20 – today, equity per share is around $1. NROE has oscillated between 28 to 45 per cent. The business has paid out approximately $41.8 billion in dividends, while declared profits have been $45.9 billion and returned more than $800 million to owners via buybacks.

TLS has employed meaningful amounts of debt to finance its operations and net debt to equity has been over 100 per cent since 2005. Operating cash flow has been strong and exceeded NPAT every year since listing. High debt levels increase risk. When debt levels are supported by cash flows derived from regulated monopoly assets, risk is somewhat mitigated. However, moving to a NBN environment where TLS does not enjoy monopoly assets, cash flows may become more volatile. Thus, we would expect TLS to utilise some of its NBN compensation to reduce debt levels.

TLS does have a high level of intangible assets (63 per cent of equity). However, many commentators miss that TLS’s fixed assets such as pipes, ducts and exchanges are in the books at cost less depreciation. The replacement costs today are likely many multiples of book value. TLS is prone to capitalise software costs and then amortise them over their useful life rather than expense via the P&L.

TLS is a technology company – however, this is somewhat aggressive accounting and together with depreciation of hard assets, explains the difference between cash flow and profits over time.

For a larger image, click here.

Figure 5. TLS: Cash flow, earnings and dividends per share

Deriving a value for a business with a high payout ratio is an interesting thought process which is similar to deriving the value of a bond investment. If you have a business with $1 per share of equity deriving around 36 per cent NROE and you want a 12 per cent return for holding shares in the business, a sensible valuation is around three times equity when it pays out all earnings as dividends.

Business value can only grow strongly if the business can retain and compound capital at attractive rates. This maxim is no more evident than with TLS. If TLS could retain and compound half of its profits at the current NROE, our valuation would increase to around six times equity. This does, however, appear unlikely.


From the above analysis, you can see that TLS has both business opportunity and risks in the future. Thus, the valuation of the company is somewhat hamstrung by lots of unknowns. However, rationale management decision making by the current executive and board of TLS should see it focus on the opportunities and defend the business against the risks.

In summary, the business of TLS will transform dramatically in the next few years, assuming a deal is done with NBN. At this point, one can conclude that TLS is fair value at current prices based on historical performance and its very high payout ratio. The valuation will then change quite quickly into the future as debt is reduced, margins decline, capital expenditure falls, new products are developed and competition intensifies.

If you have yield focus for your portfolio, then TLS may just fit the bill. But remember that dividends are discretionary and with a high payout ratio there is little dividend cushion if the business stumbles in the transition to an NBN environment.

As always, price follows value over time and TLS has been no exception. Could QR National display a similar price and value graph if we look at it in 2020? Rational investing is not about following the latest fad or commentator suggestion; it is about understanding the outlook for an industry, focusing on businesses that generate attractive returns on capital and demanding a margin of safety in the price you pay.

At $3, TLS does not offer a significant margin of safety to justify a purchase. For owners of the stock, it is delivering a high pre-tax yield which exceeds the overall expected return from the market. As time passes, we will gather a better understanding of the business and industry outlook for TLS and we could well lift the valuation of the company should the executive define its plans to lever off its strong market shares and high access to Australian households.

It is likely TLS will announce their deal with NBN this week.

George Whitehouse is an analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week membership, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Demystifying required return

Thursday, May 26, 2011

The required return for an investment is closely associated with the risk of the investment. The base return from which other returns are derived is the so-called ‘risk-free’ return, which is derived from the government bond yield. All other investment assets must deliver a higher return than government bonds. This is because all other investment assets implicitly have a higher risk profile than a government bond.

Investment assets should produce a higher return proportionate with their individual risk, that is, a bank bill should produce a higher return than a bond. Equity should produce a higher return then a bank bill.

An investment in a company's shares is a high-risk proposition. This risk is measured or described as the equity risk premium. Equity risk may be expressed as the required return above the risk-free return. There is significant research suggesting the average equity risk premium for the whole market is seven per cent. Thus, if a 10-year bond yields five per cent then the average required return for an investment in a listed company is 12 per cent. But this is an average and some companies may have a higher or lower required return.

So what should the required return be for an individual company? 

At MyClime, we have undertaken extensive research, to identify the factors or ‘attributes’ that determine the required return for an investment in a listed company.

These attributes are both external and internal to all companies. However, by consistently reviewing and applying these attributes across the MyClime universe, we can derive a structured required return for individual companies. That is, companies with similar weighted average attributes will have a similar required return.

The required return will thus be the risk-free return (+) the equity premium required return (+/-) the relative attributes of a company. 

For those who prefer a more analytical approach the ‘required return’ can be presented algebraically as:

The market equity required return (RRm) is based on the risk free rate, rf, equity risk premium (ERPm) in the market. Both can be measured and are observable.

The required return for the individual company (RRi) is a function of the discount or premium to the required equity risk return of the equity market. This can be expressed in a generic form as:

… where "±" represents the discount or premium of all the external, internal parameters and the market capitalisation factor is relative to the market’s required return.

Factors used to calculate ri 

The required return for individual stocks is dependant on three major factors. They are: 

  1. External factors (or attributes) that will influence the profit or profitability of a company. These factors are generally beyond the control company management, such as the exchange rate.
  2. Internal factors (or attributes) that will influence the profit or profitability of company management, such as gearing of a company.
  3. Market capitalisation is related to the size and liquidity of the company. In general, the market assesses a lower required return for larger companies.

1. External factors

These may include:
  • The barrier to entry to the particular market in which the business operates.
  • The pricing power of the company against suppliers and/or clients.
  • The competitive landscape observed in the market considered in the context of its rivals.
  • The cyclicality of the business.
  • The susceptibility to technological changes or to currency or commodity values.

For every factor, we assign a degree of negativity or positivity. We then sum the influence of all these factors. At MyClime, we have a total of 12 external parameters, which we believe are sufficiently important to be included in our analytical model.

2. Internal factors

Internal forces that will influence the operational efficiency include:

  • Competency of the management
  • Gearing in the balance sheet
  • Interest cover
  • Dividend (franked and unfranked)
  • The basis of the NTA or equity per share and particularly the level of intangibles.

For every internal factor, we again assign a degree of negativity or positivity. We then sum all of these factors together. MyClime has a total of 11 internal factors, which we believe are sufficiently important to be included in our analytical model.

3. Market capitalisation

Market liquidity or market capitalisation plays an important role in the market. Analytical research of historical market data has consistently shown that the market is willing to pay a premium for larger capitalisation stocks, while pricing smaller stocks (say) outside the ASX 200 at a discount. We consistently research in this area and have applied an appropriate discount/premium for individual stock depending on their inclusion into different indices in the market.

Putting it all together

The numerical value for the external, internal and market capitalisation factors are weighted and summed. The end result is a numerical number for rwhich represents the discount or premium to be used in equation two to calculate the required return for the individual company.

If the final calculated ri is negative, it implies that the company is more attractive than the market average and thus more attractive than its peer companies on the ASX. Alternatively, if it is a positive (that is, higher premium) then it is a relatively less attractive company than the market average.

In general, the required return will only change when the circumstances that govern these factors are altered. Normally, the specific or total required return of a company should only vary slowly and/or slightly over time. However, this is impacted by the bond market or risk free rate of return. As bonds are freely tradable and observable, it is likely that the risk free return will vary more frequently and could impact more regularly on the total required return of a company.

We are confident in our required return model because:

  • It is fundamentally based on observable factors.
  • The required return determined for each company is consistently applied.
  • The model is reasonably flexible and additional factors may be added or the weightings of existing factors adjusted based on observation or changes in economic climate.

Thus, one of our key tasks is not only to maintain the relativity, relevance and varying degree of emphasis for each of these parameters at all times, but also to be on a constant lookout for new structural shifts, or any precipitating factors in the local and global economy that may eventually show up to influence the required return.

Vincent Chin is a senior analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX: CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Which ASX-listed companies will suffer most from a carbon tax?

Tuesday, May 24, 2011

In anticipation of a possible carbon tax proposed by the Gillard Government, we have collected carbon footprint data for a number of ASX-listed companies.

Not surprisingly, the disclosing companies are either larger capitalisation companies and/or those companies that have been leaders in environmental and/or socially responsible areas.

It is our view that these companies are a good representation of the indicative trends of the effect of carbon tax on Australian companies and thus the Australian equity market.

The following represents a preliminary view of the affects of the carbon tax on profits. Clearly, there are major negotiations to take place before the tax is implemented and there will be many offsets.

Having noted the above, we believe the following outcomes are the most salient points for investors to understand:

  1. Mining, building material, steel manufacturers, utilities, energy producers and airlines are the greatest carbon emitters.
  2. While the major miners (that is, BHP Billiton and Rio Tinto) are the largest carbon emitters for the ASX-listed companies, the amount of tax payable (at $20/tonne) is actually very small compared to their forecast net profit after tax (NPAT). For example, it is less than 1.5 per cent of both their NPAT in financial year 2013.
  3. On the NPAT basis (based on FY13 forecast), the companies which are most impacted are Bluescope Steel Limited (BSL), Virgin Blue Holdings (VBA), Adelaide Brighton Limited (ABC), Envestra Limited (ENV), AGL Energy Limited (AGK), Alumina Limited (AWC), Boral Limited (BLD), Brickworks Limited (BKW), OneSteel Limited (OST), and Qantas (QAN) as the carbon tax is more than 15 per cent of their market consensus FY13 NPAT.
  4. On the other hand, the least impacted companies are the financials, particularly the major banks in term of the percentage of NPAT. Ironically, we also note that it is the banking sector, (particularly Westpac) which are the most environmentally conscious even though they are barely impacted by the carbon tax.
  5. It is likely that some of these companies will be able to pass on most of the tax to their customers. It is likely that airlines and utilities companies will find it easier to pass on most of the carbon tax to their clients compared to steel and building materials companies.
  6. At a $20/tonnes tax basis, the total amount of tax to be collected from reviewed companies is about $2.2 billion. This is equivalent to about 2.4 per cent of the total forecast NPAT of these companies in FY13.
  7. Assuming that these companies represent about 70 per cent by market capitalisation of the listed market, and that the entire listed market is about 35 to 50 per cent of the total Australian corporate Sector by value/size, it is probable that the carbon tax for the Australian Economy would be between $6 and $9 billion in FY13. This implies that it represents a tax of about 0.5 per cent of the Australian GDP.
  8. Some companies have already taken initiatives to offset their carbon emissions and developed a timeline to be carbon neutral. Thus, it is possible that the amount of ‘carbon tax’ that is projected above may be reduced and that the ultimate after-tax profit affect will be less pronounced.

Which companies are most at risk by a carbon tax?

The total carbon emission in term of tonnes as well as the percentage of the FY13 NPAT at $20/tonnes for carbon is shown in the below table. We highlight those companies in which the proportion of the carbon tax to their net profit after tax is greater than 10 per cent in red and more than 25 per cent in red bold font.

For a larger image, click here.

Table: Carbon emission figures for top companies (representing approximately 70 per cent of the ASX300 and the proportion of their NPAT if carbon is tax at $20/tonnes.)

Source: IRESS, Company's latest sustainability and annual report and Broker Research (JPM and GSJBW).

We will be updating the required return to take into account this most recent information and continue to monitor for further fine-tuning if required should this carbon tax materialise in the future.

Vincent Chin is a senior analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Is a share in the banks suitable for you?

Thursday, May 05, 2011

With a combined market capitalisation of approximately $280 billion, it is not surprising the Big Four is part of many investors’ portfolios. With reporting season fast approaching for three of the Big Four – ANZ, NAB and Westpac (WBC) – we take the opportunity to review the sector.

Banking, as we know it, has been carried out for centuries – operating since 1472, the oldest bank, Italy’s Banca Monte dei Paschi di Siena is still in operation today.

For Australian banks, it all started in 1817 when the Bank of New South Wales (now Westpac) opened for business followed by what is now ANZ in 1835 and NAB 1858. The Commonwealth Bank (CBA) is a relative newcomer to Australian banking, opening in 1912 and operating as Australia’s central bank between 1924 and 1959. It was listed in 1991 via a sell down by the CBA at $3.40 a share.

Broadly commercial banks are quite simple businesses, however a little unusual as they make money from the business of moving money. Their operations comprise of:

  1. Raising equity capital to support their business.
  2. Borrowing money by accepting funds deposited on account, term deposits and by issuing debt securities such as bank bills and bonds. These reside on the balance sheet as liabilities.
  3. Lending money by making advances to customers, by making loans and by investing in marketable debt securities and other forms of money lending. These reside on the balance sheet as assets.
  4. Charging fees for almost all payment services, a bank account is indispensable by businesses, individuals and governments.
  5. More obscurely undertaking trading activities across financial markets in an attempt to hedge their exposures.

While banks generate revenue in a number of ways, the main income is lending money at a higher rate than they pay for use of that money. This is referred to as the net interest margin. However, over the last fifteen years, it is observable that banks have placed more emphasis on non-interest income to grow their profits. Today, non-interest income represents around 30 per cent for ANZ, NAB and WBC and around 40 per cent for CBA.


Banks are exposed to a number of different risks, which have from time to time been the catalysts for the occasional systemic crises, and some of the more exciting times in Australia’s financial history. These include liquidity risk, credit risk and interest rate risk.

Liquidity risk is where many depositors request withdrawals in excess of a bank’s available cash. As banks often borrow money for short periods and lend money for longer periods (think of your cash account and a home loan), this has the potential to cause what is known as a bank run. There isn’t a bank in the world that could pay all depositors if they asked all at once.

While we haven’t seen a classic bank run in Australia for many decades, we did witness one with the UK’s Northern Rock during the peak of the GFC. There are a number of systemic features of regulation that reduce the possibility of a bank run in Australia including an implicit federal government deposit guarantee and the operations of the RBA as the lender of last resort. Nevertheless, banking is a business where depositor confidence is very important.

Credit risk is the chance that those who owe money to the bank will not repay it. The key thing to try to understand is whether a meaningful portion of a bank’s borrowers are likely to default. If just 10 per cent of a bank’s loans were not repaid, the entire equity base would be wiped out for each of the Big Four banks. The banks know this and employ their own complex credit scoring techniques to assess a customer’s credit worthiness.

The last time credit risk really caused a problem for one of the Big Four was in the early 1990s when Westpac got into trouble and wrote off some $6.3 billion. It only survived by undertaking a large discounted rights issue of which 30 per cent was taken up by its shareholders. The balance was underwritten and allowed Kerry Packer to enter the register. Without the underwriting, Westpac may have failed and more likely become nationalised. This risk hasn’t caused much level of concern for a while in Australia. However, this is something equity owners need to be aware of. This risk needs to be offset by an adequate return to a bank shareholder through dividends and capital gain.

Interest rate risk is when a bank will become unprofitable should rising interest rates force it to pay more on its deposits than it receives on its loans. This is the so-called margin squeeze. Modern banks have many tools at their disposal. For instance, they mitigate interest risk by utilising swaps, floating rate instruments and the conservative pricing of fixed loans based on the expectations of future reference rate moves.

The derivative books and proprietary trading of the major banks are another potential risk area. This was exhibited in 2003 when NAB lost some $360 million in a foreign exchange ‘rouge trading’ incident. Unfortunately, a keen shareholder is not likely to quantify this risk by looking at the accounts. Directors themselves commonly find out after the fact and this is a small but inherent risk of owning equity in a modern bank.

A great read on some of the times when bank risks have come to the fore is Two Centuries of Panic by Trevor Sykes.

Key metrics we look for

There are five financial metrics that we use to analyse banks.

Return on Equity (ROE)

As a fund manager and long-term investor, we like to see a bank achieving a standard return on equity of about 20 per cent for its shareholders. In a good year, this should be exceeded, in an economic downturn it will fall short as we saw recently in the GFC, and in a recession it could well be negative.

The banks have displayed mixed profitability over time with all but NAB exceeding our 20 per cent ROE metric at various points over the last 15 years. CBA is forecast to have the best ROE for the next few years partly as the result of buying Bankwest at a discount to its equity in the depths of the GFC. However, they subsequently did find a few unexpected ‘surprises’ in the loan book.

Return on Assets (ROA)

We like to see a bank achieving a ROA of approximately one per cent.


In the diagram above, we can see the impact of the GFC and the return to more normal ROA performances in 2010, especially with Westpac. Again, we can see that NAB has performed poorly against our benchmark and relatively with its peers. WBC has been a good performer over time and has performed the best recently.

Cost to Income Ratio

We can see that over the review period (1995+) the major banks have all enjoyed good success in reducing costs as a percentage of income, especially ANZ. This ratio is a good measure of efficiency and is impacted by the scale achieved by a bank.

When offering largely commodity products in a competitive space, to be successful a business must have low costs and good customer service. Major banks have certainly reduced costs and have arguably improved service delivery by use of technology.

As in many industries, the use of technology has had a significant impact on the cost of doing business. Using technology better than a competitor provides a temporary competitive advantage and the major banks have been busy trying to find and refine their use of it.

WBC scores top marks on this measure. Although CBA recently held an investor briefing outlining its Core Banking Modernization Plan, CBA’s initiative is now past the halfway mark in a four-year project. CBA has noted they now have the ability to allow product managers to roll out specific targeted campaigns more efficiently. CBA have also reconfirmed a cost to income ratio target of 35 per cent for its retail division by 2013 and expect cost savings of around $300 million a year after completion, a nice but likely temporary competitive advantage. With credit growth subdued, it makes particular sense for CBA to seek out cost savings by strategic investment.

Net Interest Margin (NIM)

As a result of deregulation, major bank’s NIM has been under pressure for many years from increased competition from smaller banks and non-bank institutions. More recently NIMs have been under pressure from higher costs of wholesale and retail funding. This has particularly affected the smaller banks with lower credit ratings. Going forward, recently announced covered bonds would likely relieve some pressure on margins and help banks meet their Basel III requirements.

ANZ scores top marks here and NAB rates well. Overall, banks have been able to maintain ROE in the face of NIM pressure by reducing costs through effective use of technology. We expect NIMs to remain around current levels for the foreseeable future.

Asset growth and impaired assets

When credit demand is strong and banks write more loans, this drives net income and, all else being equal, flows through to ROE and ROA. When system credit growth is slow, as it is now with consumers choosing to repay debt, banks need to look to other areas to increase profits. More sustainable credit growth is likely a positive for bank shareholders. Recently, we have seen banks write back provisions for bad debts. We view these write backs as nearly complete. As such, the banks are now focusing on stronger competition for loans and looking for cost reductions to grow the bottom line.

Both CBA and WBC undertook acquisitions during the GFC that resulted in significant asset growth. However, when these are backed out we can observe that the underlying growth of all the majors has recently become quite subdued. Indeed system credit growth is lower than it has been for many years with businesses and consumers continuing to deleverage.


Currently, housing credit growth is reasonable but at lower levels than it has been historically. Consumers and businesses will eventually regain their appetite for credit but this may be a few years off.


Impairments and provisioning have been a challenge facing all banks over the last couple of years.

They had been heading down as banks recovered from the recession in the early 1990s to historically low levels in 2007. The relatively mild downturn in Australia did expose a range of sectors which were too highly geared. This resulted in an uptick in impairments and provisions in 08/09. We note that both currently and historically NAB rates well on this metric.

A key economic indicator to watch going forward is unemployment. If unemployment stays at the low levels we enjoy today, bad debts are likely to remain around current levels. The time of real pain for bank owners is when unemployment rises sharply causing pressure on residential borrowers and businesses in general. This is often flagged as a concern in Australia with our relatively high housing prices. However, the recent deleveraging across both businesses and consumers is dampening this risk somewhat. There are strong correlations between GDP growth, unemployment and bad debt losses by banks. Currently, local GDP growth is expected to be sound and unemployment is expected to be marginally lower heading into 2012.

Capital management and equity growth

Banks have been thirsty for capital over time often exercising dividend reinvestment plans and underwritten dividends that boost equity and capital ratios. Generally, we prefer businesses that can self fund growth. The major banks, however, have been able to deploy the new equity at sounds rates.

Over the review period from 1995, ANZ has grown EPS faster than equity per share in eight to 16 years, CBA nine to 16 years, NAB seven to 16 years and WBC 10 to 16 years.

Going forward, we estimate banks will be obliged by the regulators to hold more capital to support their asset growth. The additional capital can be seen in the capital adequacy ratios which for all major banks which are currently at or near their highest levels. This has the impact of reducing NROE, but provides regulators and customers more certainty that banks can meet their obligations. In times of uncertainty, this is important. We do not see Basel III requirements being overly onerous on Australia’s major banks, as they appear to already comply. 


We have derived marginally different required returns for the banks that we believe take into consideration the risks of investing in this business – ANZ 12 per cent, NAB 12.5 per cent, CBA 12 per cent, and WBC 12.3 per cent.

MyClime produces the following values:

We currently see the major banks at varying discounts to valuations that are set to grow at reasonable rates over the next few years. Add to this the sound grossed up dividend yields on offer and it is not difficult to expect total returns greater than 12 per cent over the next few years for the major banks.

Our favoured banks are ANZ due to its Asian growth strategy – Asia offers the best economic growth profile globally at present (although not without higher risk and potential capital raising/s for acquisitions) – and CBA which has strong metrics, a clear strategy and is the best performing locally focused bank.

WBC is interesting and may surprise with increasing synergies from the St George acquisition driving further cost reductions, a multi-branded strategy with a high-quality lending book, and wealth management leverage should equity markets remain sound. Longer term, we feel NAB's ROE and other key metrics will fall short of peers due to its exposure to UK assets with fundamentals likely to drive a lower total return for owners.

Today, banks are out of favour largely due to a number of cyclical factors and this is consistent with history. Banks go in and out of favour based on economic events. Back in 1995, a couple of years after Australia’s last official recession, it would have been easy to be wary of the banking sector. However, from that point, an investor would have achieved stellar gains over the next 15 years that included events such as the Asian financial crisis, the Dotcom bubble, a number of wars and natural disasters and the worst financial crisis in a generation.

There will certainly be setbacks in future years. Will banks have similar profitability in five, 10, 15 and 20 years from now? The answer is almost certainly yes. One cannot have the same certainty about some of today’s hot sectors such as mining services.

There are always reasons not to invest in equity, the real challenge for investors is to value a business, focus on fundamentals and think long term because that is where the real money is made.

George Whitehouse is an analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week membership, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Spending on mining projects set to soar

Monday, April 18, 2011

The above headline typifies the enthusiasm currently surrounding the Australian resource sector. The surge in committed and proposed minerals and energy project spending is unprecedented and will have significant flow on effects for many industries across Australia.

In this research report, the current and forecast level of mining capital expenditure will be discussed along with some potential beneficiaries of such spending – mining services companies.

The Australian Bureau of Agricultural & Resource Economics (ABARE) routinely releases projection updates for the resource industry. The most recent information related to mining capital expenditure is titled “Minerals and Energy. Major Development Projects – October 2010 Listing”.

The key points to glean from the ABARE report are:

  • At the end of October 2010, there were 72 projects at an advanced stage of development, with a record level of capital expenditure of $132.9 billion. This represents a 21 per cent increase from April 2010.
  • ABS data indicates capital expenditure in the mining sector in 2010-11 is estimated to be around $54.8 billion. If this expenditure is to be realised, it would represent a 58 per cent increase on 2009-10 expenditure.

Figure 1. New Capital Expenditure

Source: Minerals & Energy: Major Development Projects, Australian Bureau of Agricultural Resource Economics, 2010

  • There were 38 newly listed projects in the six months to October 2010, with 12 either committed or currently under construction. According to ABARE, “the relatively high number of new projects reflects an increase in prices over the past 18 months, with an improved outlook for minerals, and increased investment in exploration expenditure in recent years”.

Figure 2. Projects added to list

Source: Minerals & Energy: Major Development Projects, Australian Bureau of Agricultural & Resource Economics, 2010

The recent announcement by BHP Billiton Limited (BHP) regarding approvals for capital investments indicates approximately US$12 billion of capital expenditure (inclusive of pre-approval funding) for BHP alone. This investment across iron ore and coal focuses on upgrading both operations in WA and QLD.

Research and forecasting specialists BIS Shrapnel also provide an interesting insight into the proposed level of capital expenditure in resources, energy and infrastructure over the next five years. This was presented in the recent half year presentation provided by Monadelphous Group Limited (MND).

Figure 3. Market Conditions

Source: Monadelphous Limited - 2011 Interim Results Presentation

For a larger image, click here.

Generally such bullish long-term forecasts should be treated with caution, but it nonetheless indicates a perceived area of strong growth in the years to come. Only after reviewing ABARE's list of major minerals and energy projects can one begin to truly grasp the gravity of what is currently happening with mining related expenditure. Figure 4 below illustrates the geographical spread of projects across Australia.

Figure 4. Advanced minerals and energy projects

Source: Minerals & Energy: Major Development Projects, Australian Bureau of Agricultural & Resource Economics, 2010

For a larger image, click here.

Reviewing the value of advanced projects by commodity and state/territory, however, paints a significantly more detailed picture.

Figure 5. Value of advanced projects - Commodity vs State & Territory

Source: Minerals & Energy: Major Development Projects, Australian Bureau of Agricultural & Resource Economics, 2010

For a larger image, click here.

A number of highlights and investment themes can be deduced from the above. Capital expenditure is clearly skewed towards petroleum (predominantly LNG projects), iron ore, coal, alumina and gold projects. Further, it is also clear that Western Australia and Queensland are the overwhelming beneficiaries in terms of the absolute dollar value of expenditure. Together, WA and QLD account for 91 per cent of the total value of advanced projects.

The above information has some very interesting investment implications. The mining services companies most likely to benefit would logically have a strong presence in WA, and to a lesser extent QLD. They would also have a capability to deliver projects primarily for the commodities listed above.

There are a handful of ASX-listed companies in Australia that meet the above criteria in that they are based in WA and have appropriate delivery capabilities.

Figure 6. ASX companies capable of delivering projects primarily in commodities

For a larger image, click here.

The shortlisted companies all currently meet a solid general fundamental criteria including:

  • Reasonably sound balance sheet
  • Net debt to equity less than 25 per cent
  • Net return on equity in excess of 25 per cent
  • Pay 100 per cent franked dividends
  • Historically strong operating cash flow
  • Projected intrinsic value growth in 2012.

Of the companies listed above, however, only one is appearing in value at this point in time – the newly-listed MACA Limited (MLD).

MACA Limited (MLD) was founded in 2002 and listed on the ASX in November 2010. MLD is a leading supplier of mining and civil services to clients in the mining and construction sector primarily in Western Australia. Services include contract mining, loading, hauling, drilling, blasting, crushing, screening and civil infrastructure requirements. MLD has a workforce in excess of 550 employees and subcontractors.

MLD specialises in providing mining services to predominantly mid-size mining projects for open pit mining. The business is primarily comprised of four distinct but complementary operating divisions.

Contract mining

Approximately 87 per cent of current revenues (as at 3/11/2010), this division provides mine to mill solutions for open pit mining. MLD aims to customise its offering to meet the project needs and ultimately deliver the required outcomes for a project. MLD currently offers contract-mining solutions in the following areas:

  • Complete load and haul mining contracts
  • Selective mining
  • Bulk overburden removal
  • Bulk earthworks
  • Dry and wet hire of plant.

MLD also delivers drilling and blasting solutions in the following areas:

  • Production drilling and blasting for surface mining and quarries
  • Pre-split drilling and final wall blasting
  • Contour drilling and pioneering
  • Blast hole sample drilling
  • Probe drilling and controlled blasting.

Crushing and screening

Approximately 13 per cent of current revenues (as at 3/11/2010), MLD has a fleet of crushing and screening equipment to deliver tailored screening and sizing solutions. MLD’s crushing and screening equipment includes:

  • Primary jaw crushers
  • Secondary cone crushers
  • Tertiary cone crushers
  • Scalping screens
  • Vibrating and fixed screens
  • Single-, double- and triple-deck screens.

This division currently provides crushing and screening solutions for four DSO iron ore operations.

Civil earthworks

Revenue is derived from civil works that are part of a longer term mining contract and revenue is accounted for in Contract Mining above. The Civil Works division is operated by its recently formed 60% owned joint venture entity MACA Civil Pty Ltd. The Civil Works division provides professional expertise and machinery to build infrastructure for mining and civil infrastructure projects including:

  • Private roads
  • Dams
  • Rail embankments
  • Airport runway construction
  • Complete mine infrastructure works.

The joint venture is currently managed by Andrew Sarich and Darren Erikssen. They hold the other 40 per cent interest in the joint venture and have significant experience in the civil works sector.

Material haulage

The Material haulage division provides haulage of raw materials for the process and earthworks elements of resource operations. MLD provides solutions in the following areas:

  • Complete haulage contracts
  • Ore haulage
  • Bulk earthworks
  • Loader feed contracts. 

Business model and outlook

As outlined above, MLD is essentially a contractor for the mining and resources industry. Its business model revolves around tendering for projects relating to contract mining, crushing and screening, infrastructure development and materials handling. Both historical numbers and current forecasts indicate MLD typically makes a profit margin of between 10 to 13 per cent on total revenue. This margin bracket currently appears to be holding firm despite the larger scale of projects MLD is starting to undertake.

Figure 7. MLD Project Commodity Exposure

Source: Investor Presentation, MACA Limited - 2011 Half-Year Report

Based on the economic data presented at the beginning of this report, we would suggest the short to medium term outlook for MLD is positive. MLD has enjoyed a number of recent tender wins, which have added a greater degree of certainty to its forward order book. Further to this, many contracts extend over a number of years and typically include potential extension options. Currently, the average contract length is 33 months. As at 6 April, 2011, the work in hand position of MLD stands in excess of $800 million.

Figure 8. Work in hand - Tenure & Value

Source: Investor Presentation, MACA Limited - 2011 Half-Year Report

For a larger image, click here.

Since the above tables were published, MLD has subsequently been awarded a further contract for the Peculiar Knob Direct Shipping Ore Project. This contract is for the provision of crushing, screening and train loading operations and is estimated to generate $127 million in revenue over a five-year period from Q1 2012. 


The PDS released last year for the listing of MLD dealt quite specifically with the significant number of risks associated with a potential investment in a mining services company. Closely reviewing and understanding this list would suggest that MLD is higher up the risk reward curve, and underlines why we have derived a required return (RR) of 16 per cent for the company. Key risks include:

  • Reliance on the mining industry – in a recent company meeting with a related mining services company, management then noted “form a view on the longevity of China’s growth and you will form a view on this company”. A slowdown in China would undoubtedly have a flow on effect for the price of commodities and thus the appetite for the development of new mining operations.
  • Ability to win new contracts – unlike many other industries that typically have more recurring revenue streams, MLD is a company that needs to continually win new contracts in order to maintain/increase future revenues. Failure to do so would severely hamper the future value of the company.
  • Contractual Risk – early termination of any MLD contracts would clearly adversely impact the future profitability of MLD.
  • Disruption or discontinuance of operations – the recent disruptions to the operations of Magellan Metals and Crosslands Resources highlight the potential negative impact on profitability.
  • Lack of listed operating history – MLD has only recently listed. It lacks the long-term track record of performance that top quality investment grade businesses typically display. 

Investment case

Figure 9. MyClime Valuation: MACA Limited (ASX:MLD)


For a larger image, click here.

The balance sheet of MLD suggests the company is currently in a sound financial position. As at 31 December 2010, MLD had no intangible assets, cash on hand of $54.2 million and total debt of $44.6 million. Given the cyclicality of the industry in which MLD operates, this is a good position to be in. Companies with high debt levels, coupled with a high proportion of plant and equipment as a percentage of total assets generally have a higher investment risk.

Profit has grown strongly over the previous five years and profitability has been exceptional. Investors should note MLD has grown from a very small equity base and will find it almost impossible to maintain previous levels of NROE in the years to come. This is especially apparent after the IPO, as the new equity raised combined with the large amount of retained profits equate to both a meaningful increase in equity and a subsequent reduction in forecast profitability.

To put the above in perspective, MLD is currently forecast to achieve NROE of 84 per cent in 2011, 51 per cent in 2012 and 50 per cent in 2013. These forecasts are subject to the many risks outlined previously, and as such we have currently utilised a more conservative forecast NROE of 43 per cent. Operating cash flow has historically been strong and has exceeded reported profits in each of the last four financial years. The 2011 first half result again showed MLD to be producing significant cash flow from operations.

The capital raised through the recent IPO represents the only capital raising in recent years. This will allow the company to execute a greater scale of projects in the years to come. As a condition upon listing, 60 per cent of shares are currently held in escrow (that is, these shares cannot be sold) by the original shareholders until November 2011. Directors of MLD currently hold 21 per cent of the company. This provides a good level of vested interest for management to continue to act in the best interests of all investors. It may, however, result in a supply of stock into the market later this year.

We have selected 43 per cent as our Normalised Return on Equity (NROE). We have derived a Required Return (RR) of 16 per cent which takes into consideration the risks of investing in this business.

Using the above inputs and the equity per share, MyClime produces the following values:

The following valuations are based on analysts’ forecasts and are subject to change.

Figure 10. Value & Price

The value and price chart above reveals MLD has been meaningfully growing intrinsic value both pre and post listing on the ASX. The current market price is currently trading at a reasonable discount to the estimated FY2011 value.

Figure 11. Earnings and Dividends


At this juncture, it is worthwhile to remind ourselves of the cyclical nature of such enterprises. The urbanisation and development of China has brought with it a massive upswing in the commodity cycle. This cycle appears to have prolonged strength and has positively impacted the prospects of many companies including MLD.

Prudent investors pay this investment theme its due attention but also realise that the cycle won’t last forever. Investment decisions in the coming years should be made accordingly.

Extrapolating current profitability out into the distant future (as many commentators and brokers do) could prove to be a perilous exercise for long-term investors. In such a scenario, paying a rational price for a company that is inherently riskier becomes even more critical. Investors need to consider not only their risk tolerance but also their time frame for investment and overall capital allocation carefully. With this in mind, we would suggest only considering an investment in MLD at a good discount to the estimated 2011 value of $2.82.

Adrian Ezquerro is an analyst with Clime. Clime Asset Management and MyClime are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


The risk-side approach to long-term investing

Tuesday, April 12, 2011

As investors we tend to search for stocks by focusing upon the ‘normalised return on equity’ filter. Our focus is on companies which have a high or rising return on equity (ROE) in coming years. While there is nothing wrong with this, we believe that searching for stocks solely from the return side can sometimes be misleading and especially so if one is not considering the risks, the volatility and cyclical nature of the business. Further, high ROE is difficult to maintain for long periods and an approach solely based on ROE will eventually lead to high portfolio turnover as ROEs of some companies inevitably slow or are affected by normal economic cycles.

However, we believe that the risks to a specific business do not vary significantly over a period and thus a ‘required return’ approach may identify stocks with consistently high total returns over time. This ‘risk side’ approach for an investor focuses upon stocks which can and do justify a lower required return when compared to the market as a whole. 

The ‘risk’ approach to investing (selection criteria)

You may recall that we have a quantitative approach to determine the required return of all stocks we cover in MyClime. In calculating the required return for each stock, we have used more than 20 attributes/factors. Half are external and half are internal factors. In this analysis, the market capitalisation of a company is excluded as an input. Each factor will impact on the measure of risk of a business. From all of these factors, we derive the required return of each individual stock without considering its size or market liquidity.

In order to select stocks using the risk side of the equation, we have looked at more than 100 profitable companies. We then calculated the effect (represented by a value) of the internal and external factors for each company. We then aggregate these into just one number, called the risk number. As there are more than 100 profitable companies spanning over large and small capitalised stocks, we can then calculate the average risk number for this population.

So how do we identify the more ‘attractive businesses’ from the ‘average businesses’? Fortunately, mathematics has taught us how to do that. There is a term used in statistics, known as the standard deviation. The standard deviation is a widely used measurement of variability or diversity used in statistics and probability theory. It shows how much variation or ‘dispersion’ there is from the ‘average’.

Thus, the idea is that in addition to the calculation of the ‘average business’ risk number, we also calculate the standard deviation of this risk number from this population of more than 100 profitable companies. Thus, to identify the best companies, we choose those in which the risk number is at least one standard deviation from the average risk number on the lower risk side. In other words, we pick attractive businesses which stand out from the average ones.

Under this approach, there are only 19 stocks out of the more than 100 stocks which satisfy these selection criteria. We list the 19 stocks below.

Candidates based on risk factors


An immediate observation of this list is that there is no resource or resource-related stocks. This is because resource stocks are much leveraged to global growth. As we know, resource booms come and go and have been doing so for more than 200 years. Thus, it is not possible to gauge with great confidence how long this cycle may last. Thus, the required returns for holding resources companies are much higher and none of them made it into the list of ‘attractive business’ over a long timeframe. (more than10 years, for example).

It should also be emphasised that the above is not the only possible selection process using the risk or required return. For example, one may decide to segregate the external and internal factors and seek out stocks with good external and/or internal attributes separately and any other combinations to suit one’s strategy.

We should emphasise that we have not paid attention to the valuation or price here, but have merely tried to identifying good quality companies based on risk factors in our quantitative required return model (QRRM). To prove this is a good strategy for the long term (more than 10 years), we now turn to back testing of the performance of these stocks over the past decade. To our surprise, they also have proven to be very strong performers in the short term – a one-year timeframe!

Back testing

The one-, three-, five- and 10-year performance return for these 19 stocks are tabulated in Figure 1. Also shown is the average total return for the whole portfolio of 19 stocks with equal weighting as well as three other accumulative indices; the All Ordinaries Accumulative (XAOAI); ASX200 Accumulative (XJOAI) and ASX200 Industrial Accumulative (XJIAI) indices.

Figure 1. Annualised Performance Return (including dividend) to 31 Dec 2010 for selective 19 stocks

Source: Calculated using data from IRESS

*All Outperformances are annualised

We see that the one-, three-, five- and 10-years’ performance has consistently outperformed the market as shown in Figure 1 and 2.

For example, in Figure 2 below, we see that these 19 stocks have outperformed the All Ordinaries Accumulative Index by 13.15 per cent per annum; 11.29 per cent per annum; 8.07 per cent per annum and 4.63 per cent per annum respectively and even better for the other listed indices.

Figure 2. Outperformance by strong and investment grade stocks against market indices.  
Source: Calculated using data from IRESS

Figure 3. The performance to 31 Dec 2010 of the 19 attractive stocks compared to XAOAI, XJOAI and XJIAI.

Even without the strong performing resource stocks, it is clear the list of 19 attractive stocks based on a risk filter have consistently outperformed three common benchmarks for the one-year, three-year, five-year and 10-year.

What have we learnt from this exercise? 

Using the risk filter we can identify a portfolio of stocks that not only consistently outperform the market significantly in the short term (one-year to three-year) but also for the long term (five-year to 10-year).

The price performance of these stocks pre and post-global banking crisis is consistently good. While it is clear that some of these stocks are trading at a premium to or at our MyClime valuation, a portfolio of these stocks still managed to generate an absolute positive return against a negative market. This provides strong evidence that they are:

  1. Resilient in a negative market
  2. Sufficiently well diversified to provide a positive return.

Post-GFC, when the market took off again, we note that these investment grade stocks outperformed a rising market.


While it is important to identify companies that are consistently profitable, it is also important to identify companies who over the longer term have a lower risk profile than the broader market. Many commentators and advisors fail to understand risk and fail to understand how it is calculated.

In essence, a portfolio which has a healthy exposure to both highly profitable and low risk companies will outperform over the long term.

Written by Vincent Chin, Senior Analyst. MyClime and Clime Asset Management are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Will the US see QE3?

Monday, April 11, 2011

Recent reports regarding the economic settings in the US seem to suggest that the age-old cliché that ‘all good things must eventually come to end’ may well be true. In this context, the good things are the extraordinary debt binge being undertaken by the US Government and the beneficiaries are market traders.

But will the current economic policies of the US Government and the Federal Reserve (FED) really come to an end in the next three months? We somehow doubt it.

The US government is racing towards its legislated debt ceiling of about $14 trillion and the FED supposedly has just three more months of quantitative easing (QE) to undertake. After that, commentators are debating whether the US Government will run out of money and whether it will affect the normal functionality of the US capital markets – whatever normal is!

In our view, some form of QE will continue throughout the rest of the year in the US, just as it will throughout Europe and Japan. Whether it is called a QE2 extension, QE3 or something else, it will not matter. We may not even be told that there is a QE being undertaken, although that would defeat one of its stated purposes – to promote positive sentiment.

Further, our view is that the US government will get its money from the Republican-controlled Congress. Life will go on and the good times for the wealthy in the US will continue until the next debt ceiling is reached or the QE clock passes through another cycle. The Republicans will ensure that those most able to contribute to the refinancing of the US government debt will not be asked. The US dollar will continue to devalue, and US corporations will continue to be profitable without increasing employment.

Thus, the slow grind of mounting US government debt continues. Think about it this way – if the US economy grows by three per cent for the next five years and the government maintains a $1 trillion annual budget deficit (which is the projection), then US government gross debt will rise to about $20 trillion. Further still, the US bonds on issue will grow to about $14 trillion. In this scenario, government debt will always grow at a faster rate than the GDP, and therefore debt as a percentage of GDP will grow – just like it did in Ireland and Greece before they imploded. Thus, does anyone think that government debt can continue to grow at this rate without the Fed supporting the US bond market? Well, actually yes, and many of these are the economists who reside inside major investment banks. These intellects seem to have lost their capacity for a rationale thought process and they certainly do not delve into the future, past their next bonus cycle.

As one notable scribe noted recently, “No one has convinced him that QE is supporting equity markets and thus when it finishes there will not be any affect other than to note that QE2 has finished”. This view is based on the observation that QE has not resulted in credit creation in the US and therefore it has not directly supported US economic growth or company profitability. Thus, he suggests that take QE away and nothing will change!

We beg to differ. QE was not introduced to placate doomsayers. It was absolutely needed to help the US government finance its massive fiscal deficit. The deficit, which represents over 10 per cent of GDP, must be funded. It is funded by the issuance of government bonds and if too many government bonds are issued into a market then their price must fall. When bond prices fall, the yield or interest cost rises. When interest rates rise, the government interest bill will also rise and interest rates across the economy rise. Everyone who has debt will pay more for it. This is the first benefit of QE for share markets. It keeps the general level of interest rates below their normal level.

Second, by funding a massive government deficit, the stimulation to the economy from the deficit can continue. It is truly amazing that economists don’t acknowledge that a 10 per cent government deficit must positively affect GDP. The fact that the US is only growing at 2.5 per cent per annum with such stimulation suggests that it would be in recession without it. Thus, QE funds a deficit to help GDP grow and that helps corporate profitability and thus the equity market. Our conclusion is thus, that QE is absolutely supporting the US equity market and possibly every other market through the support of market sentiment.

So what is too much government debt and when will it affect the general level of interest rates? This is difficult to answer, but here is an attempt.

We can start by considering the normal level of debt in an economy and we can glean this from the size of bank assets operating in a normal economy. The normal size of the assets of domestic and foreign banks operating in an economy is about 250 per cent of GDP. That is where Australia is at present. The government does not borrow from the banks, but it competes with the banks for funding. However, banks do invest in government bonds for liquidity and capital requirements. Thus, domestic banks are actually large financiers of government bonds. The rest of the government funding (excluding QE) comes from pension funds, insurance offices, domestic investors and foreign investors. These are the same investors who provide the funding (liabilities) to domestic banks. So if a government grows its debt to in excess of (say) 100 per cent of GDP, then it naturally will crowd out other borrowers trying to access debt funding. If the banks need to fund 250 per cent of GDP and the government is seeking 100 per cent of GDP for its funding then there will be massive competition for funding in an economy. But the analysis is complicated by the demand for currencies and the internal workings of an economy.

Indeed, a complication for the analysis results from the ability of a government to access foreign debt and therefore avoid the rigors of the local debt market. The US government can access substantial offshore funding because it issues bonds in the world’s de facto currency. Thus, it can access massive non-US sourced borrowings so long as there is confidence in the US dollar and the government’s ability to service and repay debt. Other countries such as Greece, Portugal and Ireland were not so fortunate. They were lucky that they could for a while trade off the euro which was regarded a de facto Deutsche Mark. But this façade has ended over the last 12 months.

Finally, it is possible that a country can have massive government borrowings and fund the same from totally internal sources. The Japanese government has the highest level of debt of any country and the world’s lowest bond yields. It has achieved this by imposing on its citizens 15 years of stagnation. Extremely low growth and a high savings ratio are a symptom of economic distress. It is a terminal strategy and time is running out for this policy. The recent earthquake has suddenly brought back to the world’s attention the precarious position of Japan.

So the answer to the dilemma of what is too much government debt and when will it cause a major correction in bond prices is a difficult one. The answer is certainly different in every economy. However, it seems clear to us that the US government will be able to borrow to very excessive levels (in excess of 100 per cent of GDP) before there is real concern from markets. However, this view is tempered by developments in other countries and the onset of default contagion in Europe or Japan.


We maintain that the US will navigate itself through the current pending debt issues and put back the day of reckoning for a while yet. There will be some form of QE post 30 June because the funding of government debt is a massive problem.

This ensures that the ‘good things’ in economic life for the US economy are not quite over just yet, but it would be folly for any investor to dismiss the current US economic policies as anything other than a massive bandage. Open the bandage and withdraw QE and you may be shocked by the wound that you unveil.

Written by John Abernethy. MyClime and Clime Asset Management are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.


The world economy – a closer look at macroeconomics

Tuesday, April 05, 2011

The April FED Meeting will be crucial for world markets. Will they or won’t they relaunch quantitative easing?

The downgrade of Greek and Portugal government bonds to junk status last night is a timely reminder of the slippery slope that is the current outlook for the world economy.

The omnipresent risk of a severe bond market correction around the world is something that all investors must be acutely aware. The following table is a snapshot of the present state of affairs.

For a larger image, click here.

Figure 1. Fiscal situation and prospects

Source: IMF, World Economic Outlook and OECD

The above table highlights the extreme fiscal pressures that are testing the major economies of the world. A cursory glance notes that the measures of government debt and fiscal deficiency in the US, UK, France and Japan are arguably as bad as those of Portugal, Greece and Ireland. So why are the ratings agencies picking on the weak?

The following table (from 2008) highlights the massive build up of debt across the world. The debt loads of the UK, Japan and Spain were truly staggering in the GFC. Each of these countries is still struggling to achieve sustainable economic growth. The debt growth in China, Brazil, India and Russia is justified by the emergence of those countries as economic growth regions. The existence of so much debt raises the question how much debt is normal?

Figure 2. Debt by country

Source: Haver Analytics, McKinsey Global Institute

In our view, the current levels of debt are neither normal nor sustainable. The observation that central banks in the US, Japan and Europe are printing currency to fund the fiscal deficits of their countries seems to be justified by the adolescent notion – “that guy over there is doing it so why can’t I?”

There is so little debate by our world leaders and indeed our leading economists as to how these economic policies can be withdrawn, that one is led to the ominous conclusion that no one actually knows! As for Australia’s politicians and leaders we should work on the basis that they just don’t care.

The following table shows the state of play in Europe. The massive expansion of the European Central Bank’s (ECB) assets in May 2010, resulted from the collapse of Greece. The decline of Ireland has been a more orderly process. The pending collapse of Portugal is clearly manageable. However, if Spain or Italy falters then we are into another game altogether. We note that the combined economies of Greece, Ireland and Portugal, are half the size of Spain.

The QE2 of the US would look like a ferry if Spain or Italy needed a bailout.

Figure 3. ECB bond purchases under Securities Markets Programme (SMP)

Source: European Central Bank

The following is an estimate (by Royal Bank of Scotland or RBS) of the bailout costs required for dealing with Portugal (estimated 80 billion euros). While the numbers are large, they are clearly manageable for the ECB.

Figure 4. Portugal IMF and EFSF bailout cost metric

Source: Royal Bank of Scotland 

Of course RBS has some form when analysing European debt. The following table highlighted the huge exposure of RBS to Irish government bonds as the Irish economy began to falter.


Figure 5. European bank’s holdings of Irish sovereign debt in trading books

Source: Peterson Institute

In our view, it remains essential for the ECB to intervene in the European bond market as the European banks need to exit their bond holdings in an orderly fashion to protect their capital bases. Even last night, there were reports of a German bank seeking more capital support and the following table shows why.

Figure 6. Portugal vs Ireland – yield curve comparison

Source: Royal Bank of Scotland

The deterioration in the Irish and Portuguese bond markets has directly led to the capital depletion of European banks. Thus, we continue to recommend that investors monitor the interest yields in bond markets. In recent days, the US ten-year bond has seen its yields lift towards 3.5 per cent. At this level, we remain relaxed with equity markets and suggest that there is no overvaluation issue. However, we note that bond markets are under the control of central banks and markets are reliant on this continuing. Thus, the US Federal Reserve (FED) meeting in April will be crucial for markets. Should the FED intimate a withdrawal from its quantitative easing programme in June, then markets will become very skittish.

The US

Economic news overnight suggested that home prices fell by 3.1 per cent over the year to January 2011 (Case Shiller Home Price Index). On top of this, consumer confidence has fallen throughout March despite the fact that consumer sales rose in February. Market analysts suggested that most of the growth was due to higher food and petrol prices.

There was a revision up in the December quarter GDP to an annualised three per cent (previously 2.8 per cent). Most of the revision resulted from a marked reassessment of inventories across the US economy.

At 5.96 per cent, the ratio of cash to total company assets is nearing a 45-year peak for the US equity market. Stock buybacks have swelled to a three-year high of $139.1 billion. It is clear that credit growth in the US is low and the corporate sector is in excellent shape.

Companies, however, are still not hiring. The 201,000 new hires expected in March will barely offset the number of new entrants to the labour force, and the unemployment rate is expected to hold at 8.9 per cent when the government releases its monthly job numbers on Friday. Personal disposable income increased 0.3 per cent in February, but fell 0.1 per cent after adjusting for inflation.


Ten-year Portuguese bond yields surged to 7.80 per cent (after touching eight per cent) after S&P joined Fitch Ratings in cutting the nation’s credit worthiness. The extra yield investors demand to hold the 10-year debt versus benchmark German bunds rose to 4.5 per cent.

Portugal is bracing for its first bond maturities of the year. The country faces redemptions worth about nine billion euros in total on April and June 15, and intends to sell as much as 20 billion euros of bonds this year to finance its budget and cover maturing debt.

A bailout for Portugal may total as much as 70 billion euros. Portugal continued to rule out a rescue, a day after the parliament’s rejection of budget cuts led Prime Minister Jose Socrates to quit. Elections will be held by June and a budgetary austerity programme will be the major election issue.

Greece’s unemployment rate surged to a record 14.8 per cent in December, making it the second highest after Spain in the 17-member euro region. The government has been forced to toughen spending cuts and raise taxes in exchange for last year’s 110 billion euro bailout from the European Union and the International Monetary Fund as the nation grapples with its third year of recession.

Inflation in eurozone accelerated to 2.4 per cent in February, well above the ECB’s target of close to, but below two per cent. It has been above two per cent since December.

Irish Bank stress tests are expected to show a further capital hole at the lenders of between €18 billion and €23 billion. This could push the Irish Government injections into the banks from €46 billion to between €64 billion and €69 billion.

Angela Merkel, the German chancellor, convinced her European counterparts to restructure a new €500B euro zone bailout fund so that members will not have to pay cash into the system quickly. The new fund, which goes into place in 2013, will require €80B in paid-in cash as well as €620B in guarantees and callable capital. Given that European countries all have massive deficits this proposal was warmly supported.


China’s real estate sector is facing an increase in its housing inventory this year that could lead to further price declines. Only 30 per cent, or 931 metre square metres, of China’s total housing under construction was sold last year, meaning that there is a large inventory of housing in the country. Adding to the glut is Beijing’s plan to implement 10 million units of affordable housing this year on top of commercial housing stock. China could overtake the United States as the world’s largest economy if it maintains annual growth of eight per cent over the next 20 years, according to the World Bank.

Chinese inflation will probably rise more than five per cent in the year to March. Although the government has made progress in taming price pressures, the combination of a low-base effect, high global commodity prices and rising service costs will push inflation towards three-year highs.


If it smells like a mess and tastes like a mess …

Monday, March 28, 2011

Last week, the coordinated intervention by the world’s central banks into currency markets was yet another example of how much intervention exists in financial markets at present.

All the major economic powers moved in unison to bring down the rising yen. They did so to offset the effects of the repatriation of Japanese investments around the world. The flood of capital back to Japan threatened to make Japanese exports highly unattractive on world markets. A rising yen would have thrown Japan further into economic crisis and may have spelt danger for those countries reliant on Japanese investments.

While Japan has stagnated for the last fifteen years, it has still been able to generate a massive foreign reserve base from its trade surpluses and foreign investment earnings. Japan holds in excess of $850 billion of US government bonds and is the second largest foreign owner after China ($1.1 trillion). This holding represents approximately 10 per cent of the US government debt. Thus, you can immediately see why the US Federal Reserve (FED) would be keen to stop the rising yen, which could cause an avalanche of selling in US bonds as stressed Japanese investors sought to protect themselves against further currency losses.

Thus, having protected the US bond market from Japanese selling, the next problem becomes – who will replace these same Japanese investors as the buyers each month of 10 per cent of the newly issued US bonds? As the US Treasury issues about $120 billion new bonds each month, of which the FED is currently buying $100 billion per month in the secondary market (quantitative easing), the Japanese were quite important for the balance. Maybe a covert arrangement has to be done with the Chinese or even OPEC. Maybe that is why the US had slow to move aggressively in the Libyan conflict. Ultimately, it could of course lead to QE3 after QE2 sinks in June.

As for quantitative easing, the world appears to have entered a higher level of this unprecedented economic policy experiment. The Japanese Central Bank was forced to accelerate its printing presses following its devastating earthquake. This follows the decisions of the European Central Bank to bail out Ireland and Greece with pristine currency. These actions are good news for the US who certainly would not want to go alone with its quantitative easing experiment. At this point, it appears that the coordinated printing across the world is supporting a higher level of speculative capital flows. Speculative capital is flying all over the world, with most of it borrowed at historically low interest rates. However, the printing by the major Central Banks is offsetting each other and has resulted in the relative resilience of the Australian dollar. The Aussie dollar remains above parity, despite the constant calls of economic pundits for its demise.

The world just gets more complicated by the week and it is fascinating to speculate on the side the deals that must constantly be undertaken by our world leaders and their trusty advisors. The good news is that there is ample evidence that everybody is focused on getting the world through this mess, no matter what so-called ‘black swan’ events arise and no matter what the cost to future generations in terms of debt.

In this context and at this moment, it is unclear as to what the Australian Government is doing in proposing a unilateral carbon tax. Both sides of Australian politics appear to agree on some form of carbon offset trading scheme and this would be consistent with the schemes that are developing in Europe. Further, the introduction of a short-term carbon tax regime with compensatory tax cuts to low-income families creates just another complication in our diabolical tax system. Why is it necessary for an international trading scheme to be approached through a short-term taxation regime? Maybe all will be revealed when the Green-controlled Senate supports Government legislative agenda later in the year. Maybe that is what a true offset scheme is!

Who are the biggest carbon polluters? Well, our coal fired power stations, which were previously owned by our State Governments. What a wonderful government policy regime we are witnessing. Sell your largest polluters to the private sector and tax it because it produces carbon. As prices rise for power, blame private enterprise for not having created clean energy – what a very convenient untruth!

But the hypocrisy occurring in Canberra does not stop there. Just last year, the Government proposed a Resource Rent Tax as a public benefit to capture the excess profits of our resources sector. Now that same Government is about to sanction a $2 billion tax deduction for BHP shareholders. The proposed buyback clearly allows for the tax paid by BHP to be offset via a mechanism which maximises franking credits and capital losses to low paying tax entities who are shareholders in BHP. All of us should be confused – do we want to collect tax from BHP or not?

Rest assured, we will be accessing the tax breaks for our clients who can utilise the sizeable tax benefits of this buyback. However, that doesn’t make it right. It is just plain dumb policy and every time this is done, it just results in an offsetting dumb tax policy somewhere else. The basis of economics is that for our social services to function properly and fairly, tax must be paid by those who are profitable and can afford to pay it. The contribution must come from that one big pot called GDP. If someone avoids tax, then someone else will have to make up the difference. Commonly, the avoiders are individuals and the offset is made by the rest of society.

An alternative to fair and rational economic policy is the one adopted in the US at present. There they continue to ignore economic reality and have created an economy where tax is not fairly levied or paid. The result is the necessity to offset the low collection of tax with the printing of currency – what a mess!


Value at the core exposed

Monday, March 21, 2011

For a little while, the ‘core’ to our market was exposed and it actually revealed reasonable value in a range of large cap stocks. However, the selling will continue for a few more weeks as the amounts to be liquidated will be immense.

Therefore, an accumulation strategy of our favoured stocks should be undertaken in a slow methodical fashion. We absolutely suggest that investors adopt a dollar averaging down process when investing and use the likely market falls and volatility as an opportunity. We outline our favoured stocks below.

BHP Billiton Limited (BHP) and Rio Tinto Limited (RIO)

Both these stocks have suffered at the hands of extensive overseas index selling. We see the Japanese disaster and ultimate reconstruction as being positive for Australia’s major mining companies. Both stocks have drifted further into value and they are high on our list for accumulation.

The negative issues remain around tax. The Resource Rent Tax is still to be resolved and the introduction of a carbon tax is a substantial unknown. At this point, we see the introduction of a carbon tax as being a means to appease the Greens and we suspect it is part of ‘trade off’ to allow the government to pass legislation in coming months (see Telstra below).

Mineral Resources Limited (MIN)

The sharp pullback in the price of MIN has pushed this stock well into value. The growth outlook is excellent and just yesterday the company announced record manganese shipments to China. Prior to this, it announced a four million ton haulage agreement with QRN. Thus, we see MIN as generating strong cash flows from an ungeared balance sheet.

Further out (June 2012), we see a substantial lift in the value of MIN should it achieve the forecasts currently being projected by its house stockbrokers.

Banks – Commonwealth Bank of Australia (CBA) and ANZ Banking Group (ANZ)

We note that all the banks are sharply in value and we perceive that forecast gross yields are approaching levels which are extremely attractive (about nine per cent gross in 2012). At these dividend yields, we have normally seen sharp rallies in bank stocks.

The negative issue for the banks remains the constant struggle to grow assets. The rising savings ratio and low credit growth means that banks must focus on cost ratios as a means of generating profit growth. This is difficult in a low growth environment when inflation pressures are building. 

Telstra Corporation Limited (TLS)

Clearly TLS has suffered from large offshore index selling following the constant stock supply from the Future Fund. We suspect that the proposal to introduce a carbon tax will mean that the Greens will support the $12 billion TLS compensation package attached to the NBN rollout.

We remain positive for the outlook for TLS when the compensation is paid and the fixed wire network is transferred to NBN. This transaction results in a substantial reduction in TLS debt ($0.5 billion lower interest) and a substantial reduction in TLS capital expenditure (over $1 billion per annum). The massive increase in mobile customers noted in the half year will see cash flow continue to rise in the future. The risk, of course, remains that the NBN compensation does not receive parliamentary approval. 

Brickworks Limited (BKW)

Rarely have we seen a company of this quality trade at below its equity value. The recent market decline has pushed this stock below its stated NTA and well below our valuation of approximately $12. The company will generate towards $1 billion in cash flow from property releases in the next ten years. Further, the extensive upgrades to its manufacturing operations will see productivity gains, which will flow to profits and profitability. 

Coca-Cola Amatil Limited (CCL)

This is a high quality company with an unquestionable franchise. The extension of its brewing capacity is a logical fit with its powerful distribution base. We note that despite the headwinds of the last year, the company was able to lift profits and we see no reason why growth will not continue into 2011.

The rollout into Indonesia of its Coke franchise is a long-term project, which promises a substantial reward on success. 

Our yield plays

As always, we maintain a focus on yield as a critical supplement to generate our targeted returns. It is worth remembering that in calendar 2010, the Australian share market produced a return of just three per cent which was totally from yield.

We continue to favour AAZPB (Australand Assets Trust notes) and MXUPA (Multiplex Sites Trust). Both these securities offer floating rate yields over the 90-day bank bill. At current prices, which are full of accrued income, the yields are about 11 per cent. Given the turmoil in Japan, it is now likely that interest rates in Australia will not rise in the next six months and deposit rates offered by banks will fall as the savings ratio increases. Thus, these yields are attractive.

Ethane Pipeline Trust (EPX) is a high-yielding pipe owner. Recently the supplier of the ethane (Santos) and the renter of the pipeline (Quinos) agreed to an extension of their supply agreement through to 2014. This extension should be extended again in the future, but it does result in a substantial lift in the yield of EPX in 2012 (17 cents per unit), 2013 (25 cents) and 2014 (25 cents). This lift results from the full repayment in debt by December 2012. 

Other stocks

We continue to see substantial upside in McMillan Shakespeare Limited (ASXMMS) as we expect a major expansion into NSW in the next 12 months.

The Reject Shop Limited (TRS) should be well through its troubles by September 2011 and Oroton Group Limited (ORL) whose result tomorrow will be telling. Conformation of its Asian rollout and the maintenance of its impressive return on equity will be critical.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Japan’s impact on the market

Monday, March 21, 2011

The significance of the catastrophe in Japan is subject to much conjecture at present.

From an investment perspective, an immediate impact has been seen in substantial moves in investment asset prices. However, it is important to understand that the bulk of these moves are the result of short-term flows emanating from the disaster, rather than a predictor of a future disaster.

It has been clearly observable over the last few days that the bulk of selling has been in large index stocks rather than mid cap stocks. The selling has been irrational and it followed large selling in the prior week from large offshore funds. The offshore index funds, however, can only sell what they own. Thus, yesterday they sold the top 50 stocks bar QRN National Limited (QRN).

This observation shows how ridiculous it would be to draw any conclusion about the future from the selling. The institutions who sold just had to sell and they didn’t own QRN. This is what we think has happened to the Australian market in recent times:

  1. Observations regarding a slowdown in China based on tightening of bank credit.
  2. Proposed introduction of a carbon tax in Australia.
  3. Offshore selling based on a view that $A will correct due to the above two issues.
  4. Shorting of Australian equity market based on view that selling above will accelerate.
  5. Tsunami and nuclear meltdown in Japan leads to massive Japanese institutional selling of Australian equities and swamps the market.

All of the above led to a partial meltdown of the Australian market. For a little while yesterday, the ‘core’ to our market was exposed and it actually revealed reasonable value in a range of large cap stocks. However, the selling will continue for a few weeks more as the amounts to be liquidated will be immense. Therefore, an accumulation strategy of our favoured stocks should be undertaken in a slow methodical fashion. We absolutely suggest that investors adopt a dollar averaging down process when investing and use the likely market falls and volatility as an opportunity.

Is Japan a significant issue for markets and Australia?

Key Japanese economic data shows a country suffering from deflation for many years as it has been increasingly moving into dangerous levels of government debt. However, it does generate substantial income from trade and foreign investments. The crisis however will see some of these foreign investments become liquidated.

  • GDP $5.5 trillion
  • CPI negative 1.3 per cent over 2010
  • Unemployment 4.9 per cent
  • Trade surplus $85 billion (2010)
  • Current account surplus $191 billion (2010)
  • Budget deficit minus 6.9 per cent of GDP
  • Ten-year bond yield 1.2 per cent

It is true that Japan is Australia’s second largest destination for exports. However, its significance has been swamped by the rapid emergence of China. Indeed, we recently noted that China surpassed Japan in 2010 as the world’s second largest economy. Japan’s contribution to world GDP has been declining steadily from 17 per cent in 1995 to less than seven per cent in 2011 and the trend is just one way down!

Figure 1. Contribution to World GDP

Figure 2. China and Japan’s GDP

Source: World Bank, China’s National Bureau of Statistics, Japan Cabinet Office, China Daily

In nominal GDP terms Japan’s economy has stagnated for 15 years and the growth seen from 2002 to 2008 has been wiped out in the last two years.

Figure 3. Japan Nominal GDP

Source: World Bank, China’s National Bureau of Statistics, Japan Cabinet Office, China Daily

From a share market perspective, the Nikkei Index has been a disaster for the last 17 years and its recent plunge takes it 10 per cent below the levels of 12 months ago.

Figure 4. Dow vs Japan’s Nikkei

Japan’s government has massive debt with issued bond securities now representing about $8 trillion (160 per cent of Japan’s GDP). As can be seen from the following tables, the Bank of Japan actually owns about eight per cent of government issued paper (in the US, the FED owns nine per cent of its government’s debt) with foreigners owning less than five per cent. The holdings by the Central Bank of Japan are likely to increase substantially in coming months. In the meantime, Japan has benefitted from an extremely low cost of debt, which has allowed it to service its massive debt. We question as to how long this can be sustained.

Figure 5. Holders of US Treasury Securities & Japanese Government Bonds

Source: Japan Ministry of Finance

Time is, however, running out on this policy. The reliance on government deficits to stimulate the economy has resulted in a substantial increase in the diversion of government revenue to service debt. It has also resulted in Japan having the highest corporate tax rates in the world, which is a negative for corporate profitability and the Japanese stock market.

Figure 6. Statutory Corporate Income Tax Rate (%)
Source: OECD and Goldman Sachs Global ECS Research
So what is the outlook for Japan from here?
  1. Japanese institutions will continue to repatriate funds from offshore markets to meet the liabilities created by the tsunami. Clearly, the first assets sold will be offshore equities and then they will reduce holdings in foreign debt and bond markets.
  2. This will result in a lift in the value of the Yen at a most inappropriate time.
  3. The Japanese economy, which has been stagnant for so many years, will receive a major stimulatory boost from the reconstruction and result in a higher level of economic growth.
  4. The Japanese Central Bank will support the government through an aggressive programme of asset purchasing (quantitative easing).

Ultimately, the positive aspects of the above will outweigh the negatives for Australia. Clearly, growth from Japan as a trading partner and a purchaser of our raw materials will help sustain our major commodity markets. Any decision to divert power away from nuclear to coal fired or LNG sources will be positive for Australia. The reconstruction will require steel and thus increased demand for iron ore and coking coal.

Japan has suffered a cruel blow and we all hope there is no more to come. Hopefully, they will undertake a major reconstruction and rebuild sustainable communities from their devastated areas.

We should, however, not forget that the Japanese economy has been in a terrible predicament for many years with a dislocated political system. The anticipated repatriation of funds to Japan will continue for many months and will throw up investment opportunities for value investors.


And the Oscar goes to... indifference

Monday, March 07, 2011

It was fascinating to watch the 83rd Academy Awards last week. Only in America, and more specifically Hollywood, could a society openly acknowledge fraud by awarding an Oscar for an exposé on the recent criminal activities of investment bankers. The American society knows that massive amounts of money have been diverted from the broader community to a select few. They read about it and now they see it at their local theatre or on the internet – but what do they do about it and do they care?

To his credit, the producer of Inside Job noted in his acceptance speech “that not one banker is in jail” for the frauds committed in the subprime crisis. In a way he was lamenting the indifference of the American society to fix the serious problems of its financial industry.

It is this continuing ‘indifference’ that we can now witness as it permeates through investment markets. Indifference is exhibited by people who know something is wrong but who choose to go about their lives without doing anything to correct the wrong. In an investment sense, indifference is a widely practiced investment activity maintained by large fund managers and in particular index funds. They acknowledge that companies are overpriced but they continue to hold them. They acknowledge that executives are overpaid, but do nothing to stop the diversion of capital. They acknowledge that economies are built on mountains of debt, but do not adjust their portfolios.

In our view, it is indifference that has and will continue to undermine investment returns. Indeed, it may well be the one critical factor that has resulted in stock indices returning less than bonds in the US over the last ten years. It could explain why the US economy is stuck in a debt trap, which it cannot acknowledge.

Mr Bernanke goes to Washington

Last week, the head of the Federal Reserve (Fed) presented his bi-annual review of the economic outlook for the US. Commenting on inflation issues he stated, "The most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in US consumer price inflation".

However, he warned that, if expectations of future inflation were to build, the Fed may need to act. "We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability".

Bernanke said buoyant financial markets suggest the policy of quantitative easing was working, but the labour market still has a long way to go. He refrained from offering detailed advice on fiscal matters, but urged lawmakers to get the deficit under control. "The long-term imbalances are not just a long-term risk," Bernanke said. "They're a near and present danger".

What do we make of all this? Well, we think the US is in a ‘suck-it-and-see mode’. There is no way the head of the Fed is going to suggest that inflation is a problem because the US government is living off low interest rates and the whole economy is deep in debt. The fear of inflation would undermine the bond market. Thus, it is better to acknowledge inflation, but downplay its risks.

The Chinese ownership of US bonds

Meanwhile, the US Treasury has dramatically revised data on foreign holdings of US government debt. It now estimates that China owns more treasuries than previously thought, while the UK holds much less. Of the now $8 trillion of tradable US government debt, there is an estimated $1.1 trillion held by Chinese investors. US bonds could thus represent over 30 per cent of Chinese foreign reserves.

Such a dramatic reappraisal of China’s holdings puts into question the leverage that the US has over trade and currency negotiations with China. For months, the US Treasury has claimed that China has been reducing their purchases of US bonds when in fact they have done the opposite.

For how much longer will the US be indifferent to how they fund their fiscal deficits? While we believe the Chinese Administration will continue to revalue their currency, they will be reticent to do it quickly given their burgeoning US dollar exposure. Further, they appear happy that US interest rates remain low because they would suffer massive bond losses should interest rates rise in the US.

Up goes the oil price

In the last few weeks, the Middle East, the epicentre of the world’s oil production, has sparked up into a contagion of political unrest.

Is this important for markets? It most certainly is. The recovery of the world economy and thus its markets is built upon a most unstable base. That base has at its core the concoction of unproven and experimental economic policies. These include the maintenance of massive fiscal stimulation (huge government deficits), burgeoning government debt, unsustainably low interest rates and a multi-continental quantitative easing regime (colloquially known as money printing).

All of these stimuli have been operating for so long, almost two years, that one may think this is the norm for world economic management. Indeed these economic stimuli have begun to create an environment that has induced ‘indifferent’ investors to drift into another false state of exuberance. If you think this is a fanciful statement then recall that a mere four years ago investors on masse believed that the provision of excessive amounts of credit to poor people to buy houses created a sustainable economic environment in the US!

Having made this point, we must not forget that the world is growing and it is projected to grow or recover for the next few years. Economic growth is positive for equity markets but sustainable growth is even better. As Bernanke said last week, "Until we see a sustained period of job creation, we cannot consider the recovery to be truly established".

We would contend that the growth in the developed world is currently propped up by unsustainable economic policies. Thus, unless growth occurs, concurrent with the withdrawal of these economic stimuli, then the growth in the developed world could be short-lived. The emergence of a rapidly rising oil price is an unwelcome event for the world. It really has the potential to upset the outlook seen in the chart below.

Figure 1. World GDP Growth* (Year Average)

Source: IMF

The world’s growth is not even. The developing world, which is dominated by China, Brazil, India and Russia, is growing at a great rate. The developed world dominated by US, Germany and Japan is recovering but the growth is very modest when these countries are combined with the economic calamities unfolding in Southern and Western Europe.

Figure 2. Industrial Production (January 2005 = 100)

Source: CEIC; RBA; Thomson Reuters; United Nations

A spike in oil prices, emanating from an upheaval in the Middle East has an immediate effect on the outlook for the world economy. Should oil prices find a higher plateau and average over US$100 a barrel, then the cost imposts for China would be immense. Further, the inflationary pressures on the US would occur at a most undesirable point in their recovery.

China has been supporting the economic recovery settings by buying US bonds and exporting deflation to the world  – this has helped to hold US interest rates down. With oil spiking (following huge lifts in bulk commodity prices) and with China importing 55 per cent of its rapidly growing oil consumption, then it may well now begin to export inflation to the world. Add this to direct energy inflation in the US, then you see a real risk that US bond markets may tumble and yields begin to rise. That turn of events would not be good for the US economic recovery and would require more quantitative easing.

Up until these recent events, the outlook appeared to be reasonable for overseas equity markets with Ben Bernanke’s economic settings highly supportive of rising equity prices. Think about it this way – if all you can get in the bank is 0.5 per cent per annum or all you can get from the government is two per cent per annum (for five years) then investment capital will be forced into the equity market. Thus, speculative capital moves into the market, prices rise, sentiment improves and the outlook appears good. That is where we were a few short weeks ago.

Where to now?

As always the immediate outlook is hard to predict. We would maintain that it is prudent at this point for investors to be realistic in their assessment of likely stock market returns over the next year.

In our view, a total return of towards 10 per cent should be regarded good, but to achieve this result it will require judicious stock selection and a focus on yield. Why do we think this? Well, have a close look at the following chart that measures the savings ratio of Australian households. It points to a difficult outlook for many Australian industrial companies and explains why the recent interim results were generally disappointing.

Figure 3. Household Saving Ratio* (Per cent of household disposable income)

Source: Australian Bureau of Statistics

It is clearly apparent that Australian households have reigned in consumption and increased debt repayment since the GFC. Those households with high levels of debt prior to the GFC were most likely the people who were consuming above their means. Australian households amassed over $1 trillion of debt prior to 2008 and this swamped household income of $700 billion. The ratio of debt to income of 150 per cent was virtually the highest in the world. In Australia, we created an “aspirational society” who consumed beyond their means. This led to excessive credit growth and the requirement for our banks to borrow offshore to fund household credit growth.

While not all households are in debt, there is a large group who are and they have been shocked by the GFC into paying debt back. Looking at the above chart it is arguable that a savings ratio of 10 per cent of household income could be the norm. Thus, it highlights a difficult outlook for the following sectors:

  • Discretionary retailers who are already affected by the competition from growing internet sales.
  • Retail landlords who will struggle to lift rents.
  • Banks and credit suppliers who will struggle to grow assets.
  • The government who will struggle to balance budgets without the introduction of new taxes – is that the real reason for a carbon tax and RRT?

From a share market perspective, this suggests that some sectors of the Australian market will see profit growth slow despite a booming economy. It thus becomes an absolute requirement for an investor to have a realistic approach to valuing companies. While the outlook is difficult, it does not mean that the sectors noted above are overpriced if the market has already adjusted for the outlook.

It is apparent, however, that investors may need to focus upon the resource sectors of the market for real solid and strong growth. History suggests that resource stocks are highly cyclical and have rarely sustained rallies for longer than say a few years. However, this Chinese growth cycle appears unique in history and it certainly looks to be a long resource boom for Australia. This was confirmed last week by forecasts from ABARE who note that export income has lifted by over $50 billion per annum and will continue to grow in the next five years.

Thus, our recommended focus remains with the major resource companies and we retain a judicious watch on suppliers and services to the resource cycle.

The Australian market remains hostage to overseas sentiment shifts. The high currency level, high relative interest rates and an uneven two speed economy mean that the Australian market will not bound ahead as suggested by some commentators. A focus on sustainable yield will be rewarded and investors should keep an eye on market corrections, which throw up buying opportunities.


Rebuilding Queensland

Saturday, March 05, 2011

Seymour Whyte Limited (SWL) is a mid-tier infrastructure development company whose customer list includes the Queensland Government. With the recent widespread flooding in Queensland, we take a look at the effect it has on the business.

Seymour Whyte Limited (SWL) was established in 1987 by directors John Seymour and Garry Whyte and listed on the ASX in May 2010. SWL is now a mid-tier infrastructure development company whose operations primarily focus on servicing QLD, NSW and the ACT.

With a proven 23-year track record in civil engineering and construction, SWL has become a company of preference for government authorities and joint ventures delivering major and complex infrastructure projects. SWL has also been developing a presence in the commercial construction sector in QLD and NSW.

SWL provides strategic solutions to civil infrastructure projects across transport, resources, water, community infrastructure and building.

Business model

Independent projects

Discussions with management lead us to the view SWL focuses on non-traditional alliance tenders and contracts. This typically results in greater margins for SWL and generally greater rewards when client objectives are met. Put simply, if SWL were to deliver a project on time and of high quality, they are then rewarded with a performance bonus on top of their standard project compensation. Given their experience and technical expertise, SWL are able to favour these types of projects to receive the good returns on resources employed.

Joint ventures

Joint venture arrangements began in 2003 and has been a successful part of the business. It offers SWL access to significantly larger and longer-term contracts, in time securing greater forward revenue and certainty for the business. Due to this, it has enabled SWL to tender for, and deliver, some of Australia’s largest and most complex infrastructure projects.

Without a doubt, the basis for the current business model of SWL is dependent on strong relationships with their key clients – state governments. Management noted that SWL will seek to continue to “attract value seeking customers who place a premium on quality and certainty in outcomes for their projects”. When asked why the respective governments would keep choosing SWL for infrastructure projects, SWL management reiterated the desire for project quality, delivery efficiency and general reliability as key drivers. Such a relationship takes time to build, and having successfully delivered a range of high-quality projects over a long period of time, it could be strongly argued that this is indeed a growing competitive advantage for SWL.

Principal customers of SWL:
  • Department of Transport and Main Roads, QLD
  • Roads and Traffic Authority, NSW
  • Brisbane, Townsville and Gold Coast City Councils
  • Queensland Rail
  • Councils, port authorities, transport infrastructure bodies and selected private clients

After discussions with SWL management, it has also become apparent that the company values its people. Such a reference would typically draw scepticism. However, according to BRW, SWL has consistently been recognised as one of Australia’s best places to work. SWL management believe their focus on the recruitment, and retention of, quality people is a further competitive advantage. In a post-flood employment market where skilled workers will be in significant demand, such a workforce is a valuable asset for SWL.

Outlook and risks

It could be strongly argued that macro-economic forces and long term investment trends support the industry within which SWL operates. ABS statistics reveal the total engineering construction activity (in Australian dollar terms) on an annual basis has more than doubled since 2002. The Construction Forecasting Council estimates long-term civil engineering works in NSW and QLD will trend upwards over the next three years. Forecasts also project road and bridge expenditure to trend above $13 billion per year over the same period.

The underlying demand for the building of roads, bridges and buildings is a long-term trend that is worthy of consideration and will certainly benefit the better quality contractors such as SWL.

SWL highlighted recent project wins have further augmented their already strong forward order book. Contracted work in hand now totals $399 million, spread over the balance of the next three years. This is a good situation – however, the risk then shifts from tendering to execution. Maintaining margins and executing projects well is what turns revenue into profit for companies such as SWL. Getting this part of the job is critical and management failings in project execution can be painful – just ask recent shareholders of Nomad building Solutions (NOD) and Downer EDI (DOW).

Given their strong forward order book, a further positive for SWL is that they can now focus on tendering for higher margin projects (in the near term). This coupled with the potential accrual of further performance bonuses augers well for the financial performance of SWL in financial year 2012 and financial year 2013.

The recent widespread flooding in Queensland will likely have a two-stage effect on SWL. Long periods of heavy rain and inundation may well lead to short term project delays for SWL, the most notable of which being the Ipswich Motorway Upgrade. Management have subsequently noted they expect a deferral of some revenue from financial year 2011 and financial year 2012. There is a longer-term silver lining for SWL – one cannot imagine a better time to be a preferred civil engineer and construction company for the Queensland Government. Thus, it appears some short-term pain for SWL may well be compensated with longer-term opportunity.

A further risk that may arise relates to capacity constraints – too much work and not enough skilled labour. Being an employer of choice will help, but this is no doubt a factor all companies in the sector will need to be cognisant of.

Longer-term geographic growth for SWL will be facilitated by the impending ‘National Prequalification Harmonisation’ policy to be introduced in 2011. This will essentially make it easier for SWL to roll out their business beyond their current eastern state footprint.


In analysing the company financials and meeting with management, it would appear SWL is a well-managed company. A focus on profitability, margins and balance sheet strength is matched by their desire for a good quality workforce and exceptional project outcomes.

Management ownership is high with directors owning a total of 63 per cent of SWL. This provides a high level of vested interest for management to continue to act in the best interests of long-term investors.

It is important to note that at this point in time 77 per cent of shares in SWL are held in escrow until 1 April 2011. While there may be no fundamental reason for a sell off at that point, investors should be aware that this may well be the case. Those who took part in the IPO would have already realised an impressive gain and may be tempted to lock in some profit. The flipside of this, however, is that it may provide an atmosphere where astute long-term investors can take advantage of a price that is trading below our estimate of value.


The current financial position of SWL is very sound, with the key fundamentals all instilling confidence for the fundamental investor. The balance sheet is very strong, with no intangibles and net cash of over $30 million. The high level of cash is somewhat necessary and allows SWL to fund larger projects over the coming years. It also provides a useful buffer in case the company is met by tougher future market conditions.

Profit has grown strongly year-on-year over the previous five years, and profitability has been exceptional. Recent commentary from SWL confirmed forecast profit for financial year 2011 will largely be in line with financial year 2010, with profit growth projected to return in the years thereafter.

We currently project normalised return on equity (NROE) to level off at approximately 48 per cent over the next three years. Operational cash flow has been lumpy over the review period. According to CFO Craig Galvin, this is mainly due to project-related timing differences.

Capital management has thus far been of good quality. Despite their recent IPO, SWL have raised minimal new capital and have paid an increasing level of fully franked dividends over time. Management stated their intention to continue growing organically, and it certainly seems they have adequate capital to self-fund this strategy.

Figure 1. SWL: Value and price

The value and price chart reveals SWL has been strongly growing intrinsic value both pre- and post-listing on the ASX. The current market price is currently trading at a meaningful discount to the estimated values of financial year 2011 and beyond.

Figure 2. SWL: Earnings and dividends

The strong financial performance, bright future prospects and high owner-manager quality all paint an impressive picture regarding the investment grade of SWL. The recent flooding and cyclone disasters in Queensland will negatively impact the operations of SWL in the current financial year. Looking through the shorter-term haze though, reveals medium- to long-term trends and macro-economic conditions that could well support the ongoing growth of SWL.

Shorter-term headwinds have recently created some volatility in the price of SWL. Such short-term volatility may be accentuated by the impending April release of 77 per cent of shares from escrow. This may well create an opportunity for longer-term investors to purchase a part share of SWL at a significant discount to intrinsic value.


Another reporting season wrap-up

Thursday, March 03, 2011

Reporting season is slowly coming to a close and we are seeing a number of great results.

Today, we review a number of prominent business including WOW, CCL and CSL. Your analysts also take a look at how the property sector has fared this period.

ARB Corporation Limited (ARP)

ARP announced a 17.2 per cent increase in revenue and net profit after tax (NPAT) increase of 18.1 per cent over the half.

A strong result with 4WD sales growth – driving strong performances in the domestic and non-US export markets despite the absence of a stimulus in Australia.

Manufacturing facilities continue to operate to near-full capacity, with store expansions in Queensland and Western Australia taking retail stores to 41 with 16 company-owned. Management's longer-term target is approximately 50 stores.

The Australian aftermarket remains a key part of ARP's success with a 17 per cent increase in sales – propelled by demand in the Australian aftermarket space and a continuing pick up in OEM work.

Operating cash flows was lower than NPAT at $9.1 million for the half. Key contributors to the decline was a $6 million increase in inventory and a rise in tax payments, resulting from lower tax offsets in Thailand. We understand that around 50 per cent of the inventory increase represents seasonal stockpiling, while the other half reflects surplus stock which is expected to clear over the coming months.

The business has no debt and announced a 10-cent franked interim dividend.

We maintain our normalised return on equity (NROE) (33 per cent) which is currently forecast to be 36 per cent in 2012 and 34.5 per cent in 2013. Value is estimated to grow at 14 per cent compound annual growth rate (CAGR) between 2011E to 2013E. The business, however is not in value at the moment.

CSL Limited (CSL)

CSL announced a seven per cent increase in revenue and NPAT increase of three per cent to $500 million for the half.

The result was negatively impacted by the stronger Australian currency ($47 million), positively impacted by stronger margins and the recall of competitor products.

Dr McNamee said, “Our underlying business has continued to grow. We have reached a number of important milestones in the development of our existing portfolio that will support continued growth. These include licensing into new geographic and patient markets.”

The business has no net debt and has declared a 35-cent partially franked interim dividend. CSL is partway through a $900 million buyback.

We maintain our NROE (27 per cent) which is currently forecast to be 27.5 per cent in 2012 and 28 per cent in 2013. We note that the value of this business has not grown meaningfully this year and the equity base is likely to contract due to the buyback exceeding the retained profits generated. Value is estimated to grow at 11 per cent CAGR between 2011E to 2013E. 

Woolworths Limited (WOW)

WOW announced a four per cent increase in revenue and NPAT increase of six per cent to approximately $1.2 billion for the half. It is well supported by an operating cashflow of $1.8 billion. Earnings per share increased 6.9 per cent over the period due to the buyback.

CEO Michael Luscombe said, “This is a sound result given the macro economic and market challenges. In Australia, consumer spending tightened, with increased individual savings levels, interest rate increases and sharp rises in household utility costs.

“Consumers have benefited from deflation in average food and liquor prices as well as key categories of general merchandise. The deflation effect has been intensified by a sustained strong Australian dollar and high levels of price competition. Overlaying these economic conditions is unseasonably poor weather in Australia in the last quarter curtailing summer spending in December.”

The business is continuing to focus on improving their range of product, store formats (with the 2015 format receiving strong customer response) while investing in price by leveraging their business model. WOW noted they increased their market share over the period and noted that project Quantum has reduced the cost of doing business (CODB) over the period. Continuing improvements in the supply chain have been achieved such as a 50 per cent increase in direct buying and progressive distribution centre improvements.

WOW also has noted that the home improvement division is progressing well and is on track to be operating in the first half of financial year 2012.

WOW also today announced the acquisition of Cellarmasters from private equity for $340 million to bolster its liquor division. Cellarmasters is a direct marketing wine business that also provides contract bottling and wine services. This bolt-on acquisition will no doubt support the new Dan Murphy’s online offering that was recently launched.

  • Australian Food & Liquor, earnings before interest and tax (EBIT) 8.1 per cent. A strong result illustrating more intense price competition has not eroded profitability.
  • NZ Supermarkets, EBIT 15.2 per cent.
  • Petrol, EBIT 23 per cent.
  • Big W, EBIT -17.1 per cent. Disappointing driven by subdued consumers and deflation.
  • Consumer Electronics, EBIT -35.9 per cent.
  • Hotels, EBIT -2.4 per cent.

The small Indian consumer electronics venture with TATA is progressing well with EBIT increasing more than tenfold.

Positively gross margins for the group increased 16 basis points (bps) on increased sales and customers reflecting the impact of moving from a direct to store delivery model to distribution centres in liquor, the benefits of global buying, improved shrinkage rates, increasing sales of exclusive brand products.

WOW announced a 57-cent franked final dividend, an increase of 7.5 per cent.

With WOW and WES (Coles) fighting over sales and market share, we think it must be extremely difficult for smaller independents in this space. The retail market is tough with consumers who are spending less whilst having a greater propensity to save. This combined with the uncertainty around the level of inflation going forward, the risks of future interest rate rises, and a continuing strong dollar suggests a subdued trading environment especially in the discretionary sectors.

WOW reiterated guidance of NPAT growth of five to eight per cent for the full year to June. Our assumption is for a little over six per cent.

We maintain our NROE (37 per cent), NROE which is currently forecast to be 38.4 per cent in 2012 and 37.5 per cent in 2013. Value is estimated to grow at around 10 per cent CAGR between 2011E to 2013E, skewed to 2012 and 2013 as the buyback will influence equity levels in 2011.

Coca-Cola Amatil Limited (CCL)

CCL announced a 1.2 per cent increase in revenue and NPAT increase of 10.8 per cent supported by strong cash flow for the year to December.

CCL exceeded expectations and led to consensus upgrades for 2011 and 2012.

CCL’s Terry Davis said, “Cycling the very strong result in 2009 was always going to be challenging. To deliver full-year EBIT growth of 7.3 per cent was a very good outcome given the cooler and wetter weather conditions experienced across the eastern seaboard of Australia and the weaker consumer demand in the second half. The strength of our business model is in effectively balancing pricing, volume growth and market share has again provided the platform to improve our profitability and market position.”

Profits grew faster than revenue in the period due to the success of Project Zero at reducing costs, the new ‘blowfill’ lines are delivering reductions in PET resin usage, elimination of empty bottle storage and are reducing handling and transport costs. The investment will continue in 2011 with three new blowfill lines to be commissioned in Australia and New Zealand.

The successful deployment of the IT platform project, OAISYS is further reducing the cost of doing business. This was seen in the NPAT margin increasing 88bps over the year to its highest level in a decade. Positively, net debt to equity fell over the year from 99.4 per cent to 86.3 per cent, stock turns increased.

CCL noted the Bluetounge Brewery is now fully commissioned with local production of packaged beer leading to material increase in draught beer capacity.

Indonesian growth is key to CCL’s growth and is expected to be 10 to 15 per cent per annum for the next five years.

CCL has a number of headwinds due to the rising commodity prices of sugar, aluminium and PET resin. CCL hedges however should these commodity prices remain high for longer, increased costs will be incurred. CCL has been successful in passing costs through to consumers.

CCL announced a 28-cent franked dividend.

We maintain our NROE which is currently forecast to be 38.5 per cent in 2011 and 37.88 per cent in 2012. Value is estimated to grow at 10.7 per cent.

CAGR between 2011E to 2013E.

Monadelphous Group Limited (MND)

MND announced a 13 per cent increase in revenue and NPAT increase of 12.2 per cent to $45.5 million for the half. This is well supported by $61.5 million of operating cash flow. An excellent result that exceeded market expectations and lead to consensus upgrades.

Revenue growth was achieved across MND’s three operating divisions with a high level of demand and significant scope growth on existing engineering construction projects. The acquisition of KT Pipeline Services and the successful establishment of the Infrastructure division last July delivered increased exposure to the infrastructure sector and broadened the company’s revenue base.

MND continued to invest in plant and equipment during the period. The commissioning of a number of new cranes and the development of a specialist heavy lift team, have expanded the company’s heavy lift capability to provide on site installation of large preassembled modules.

Following the acquisition and integration of KT Pipeline Services, MND has invested in specialised pipeline equipment to enable future growth. KT Pipeline Services specialises in high-pressure gas pipeline and facilities construction.

Engineering and construction prospects in the short- to medium-term remain positive with a healthy forward workload and the resources and energy project pipelines continuing to strengthen, creating ongoing high levels of tendering activity.

Management noted while the recent Queensland floods and cyclone have affected many people, there was no significant impact on MND’s Queensland operations and these events are not expected to have a material impact on the second half earnings.

During the half, MND raised some $17 million of new capital as the result of options being exercised. This has increased the equity base and reduced the NROE closer towards our adopted NROE. The increased equity base and maintenance of our NROE, D & RI and RR have caused the valuation to lift meaningfully. The challenge for this business is to maintain profitability on a larger equity base. A dominant market share and great reputation for completing projects support this as long as the work is available.

NROE is currently forecast to be 77.4 per cent in 2012 and 74.8 per cent in 2013. Value is estimated to grow at 11.3 per cent CAGR between 2011E to 2013E. 

Billabong International Limited (BBG)

BBG announced a 15.7 per cent increase in revenue. However, NPAT declined 18 per cent. The result was again impacted by the appreciating Australian dollar.

The half-year accounts reflect the acquisitions of retailers West 49, SDS/Jetty Surf and Rush Surf, resulting in debt levels and goodwill increasing.

The West 49 acquisition appears expensive. At the time of purchase, West 49 had negative equity. Billabong paid $94 million for the business, which contributed NPAT of $1.7 million for the half year. The purchase price represents a very large multiple of both earnings and equity.

This result confirms our view that management is destroying shareholder value by pursuing expensive acquisitions.

Following the result, our valuation fell from $5.76 to $5.52 due to the reduced NROE expectations over the next few years. 

Global Construction Limited (GCS)

GCS reported a stronger than expected first half with profits up 85 per cent and revenue up 82 per cent. This is supported by strong cash flow.

Positively, the company has continued to reduce its debt. A fully franked interim dividend of 3.75cps was declared, payable on 31 March 2011.

GCS is confident in achieving its full year earnings guidance in excess of $17 million as stated in previous announcements which, given the stronger than expected first half, may suggest the company is more comfortable in providing a conservative guidance.

It was noted that 70 per cent of the $24-million City Square project and 50 per cent of the $79-million Fiona Stanley Hospital Project are now complete. No new contracts have been announced.

We have maintained our NROE (25 per cent) following the results with NROE currently forecast to be 27 per cent in 2011 and 24.5 per cent in 2012. 

Mineral Resources Limited (MIN)

MIN announced a 216 per cent increase in first-half revenue and a 121 per cent increase in NPAT for the half. MIN benefitted from strong performance from contracting operations and strong iron ore prices. After meeting with management post the release of their first-half results, we can shed some more light on what has been a very strong performer of late.

Management noted the half-year result was largely underpinned by a strong increase in iron ore volume exports – 1.3 million tonnes in the half versus a full-year volume of 1.3 million tonnes for the 2010 full year.

Construction of MIN's 19-million tonnes per annum (MTPA) crushing and processing plant at Christmas Creek Mine is progressing inline with the project timetable.

Completion of the construction phase is due this quarter, along with commissioning and ramp-up.

MIN commenced full operations of their manganese operation in the first half with initial shipments from Port Hedland.

The mine is noted to be producing to plan in both grades and tonnages although the short-term sales plan of MIN reflects perceived softness in the manganese market price.

During the first half, MIN announced the sale of its assets in the Windimurra Vanadium project to its consortium partner, Atlantic Limited. This sale is due to be finalised in April for a figure of approximately $73 million. This, coupled with the likely approximate $60 million exercise of options by Hancock, will add further cash to the balance sheet. This may be offset by a reasonably large amount of capital expenditure in the second half.

Subsequent to 31 December, MIN has agreed to substitute its 40 per cent profit share for a 30 per cent equity stake in the Mt. Marion lithium project, a joint venture with Reed Resources Limited (RDR). MIN is targeting a production for late CY2011.

The balance sheet remains strong, with good levels of cash and no net debt.

MIN announced a fully franked dividend of 15 cents per share.

MIN is currently forecast to achieve 32.8 per cent in 2011, 37.5 per cent in 2012 and 39.8 per cent in 2013. The key sensitivities for these forecasts would include prices of iron ore and manganese, and to a lesser extent currency fluctuations.

When asked about their view on iron ore pricing, management indicated that they expect prices to top out this year, before falling back a touch to more sustainable levels over the next few years. This is a point investors should be cognisant of when assessing companies with high leverage to iron ore pricing. 

Property sector

REITs that have reported have been generally in line with expectations, a few marginally exceeding expectations.

Stockland (SGP), Mirvac Group (MGR), Dexus Property Group (DXS), CFS Retail Property Trust (CFX) and Bunnings Warehouse Property Trust (BWP) all reported inline or on the higher end or have upgraded their distributions guidance to the upper range of their guidance.

SGP has announced a better than expected distribution for first-half 2011 (estimated in December 2010). DXS has increased their earning guidance, while CFX has increased their full-year distribution to the higher end of their guidance.

CPA’s results are in line, however NTA decreased slightly even though their average capitalisation rate dropped. This is due to heavily discounted capital raising during the course of this financial year to part fund three A-grade offices in Melbourne. They are now pondering a buyback which we would question their strategy/motive after having raised money at a big discount to NTA in the first place. MRG has also reported better underlying profit, although headline profit was a net loss due to the provision of inventory loss of which was pre-announced. MRG has also upgraded their EPS for financial year 2011.

Westfield Group's (WDC) result was in line with expectations. They are now a ‘lighter beast’ having spun off 50 per cent of their Australian and New Zealand assets into a new entity, Westfield Retail Trust (WRT). In addition, they have announced a major project in the US – a first major development project in four years which may indicate a sign of confidence in the future of US shopping malls.

The stand out result is Ardent Leisure Group (AAD) who has reported strong top line revenue growth in most of its divisions, including their theme parks in Queensland, despite the flood and heavy rain over the December 2010 holiday season.

Overall, the capitalisation rates of the property assets continued to improve, mainly due to a combination of slight tightening of the capitalisation rates as well as income rental growth. Gearing has also continued to fall which is also a positive.

Other than WDC, most of the REITs that have reported are still trading well below its published NTA, again another positive in term of value conscious investors. This gap between NTA and price is probably due to a combination of reasons but mainly we are of the view that the distribution yield of the REITs must recover a little more prior to the narrowing between the NTA and its share price.

You may recall that most of the REITs raised capital and cut their distributions significantly shortly after the GFC. Since distribution growth from REITs would mainly be gradual and in line with rental growth, unlike specialist property investors, as value investors with a larger choice of investment ideas, it is prudent to be patient and only invest in good quality REITs with lower than average gearing when:

  • A minimum forward-looking distribution yield is achieved.
  • There is a weakness in the property sectors.
  • There is reasonable discount between price and NTA of the particular REITs shares.

Written by MyClime Analysts. MyClime and  Clime Asset Management  are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Reporting season wrap-up

Thursday, February 24, 2011

We are currently halfway into reporting season, and we take this opportunity to discuss our thoughts on a number of prominent and interesting businesses that have reported so far.

We look at the implications the results have had on the valuations and raise a few questions you may like to consider.

Profits are important but a longer-term view on profitability and risk is what drives our valuations.

JB Hi-Fi Limited (JBH)

JBH was early to report, announcing revenue increased 8.3 per cent to $1.68 billion, largely as a result of the continuing store rollout program.

Profit increased 15.6 per cent to $87.86 million for the half, largely in line with expectations. Like-for-like sales were -1.5 per cent over the half and the business is still experiencing losses in its NZ stores.

Positively, JBH managed to increase margins as a result of increased rebates received from suppliers and were able to keep the cost of doing business (CODB) flat over the half.

Cash flow continues to be strong allowing the business to repay debt and for the first time since listing, the business has no net debt. The strong cash flow and low debt position has prompted management to consider capital management initiatives.

JBH has sufficient franking credits to fund a number of special dividends or a buy back consisting of a capital and franked dividend component. JBH noted they will inform the market of any capital management decision by the end of May.

JBH opened 13 new stores in the half and is planning another five more in the second half. JBH now has 158 stores and management have indicated they are aiming for 210. This suggests the business has another few years to go with the store roll out. A lingering question is, “will the last 50 store roll out be as profitable as the first 150? Have all the best locations been secured already?”

JBH announced a revised dividend policy of 60 per cent of the earnings for the preceding half. This increases the normalised payout ratio to approximately 68 per cent and is reflected in a marginally lower equity multiple for our MyClime valuation.

We marginally increased our RR as the result of our view that there are underlying structural changes occurring in parts of the business. Like-for-like sales of music, movies and games was down 10 per cent. Games sales were particularly concerning with a decline of 18 per cent. These categories are increasingly tested by the growth in online sales.

The business is showing signs of maturing. Perhaps one of the clearer signs is the falling return on incremental equity:

  • 2006 to 2010: 53.7 per cent
  • 2011E to 2013E: 36 per cent

JBH is a sound investment grade business. We expect the value to grow by approximately 12 per cent per annum to 2013. This is a significant slowing from wonderful rates achieved in the last five years, 36.6 per cent compound annual growth rate (CAGR).

Cochlear Limited (COH)

COH announced NPAT increased 16 per cent to $87.2 million for the half. The result was marginally ahead of consensus expectations.

Pleasingly sales increased 20 per cent in the half and good progress is being made with the Nucleus 5 product.

The building of COH's new global headquarters was successfully completed in the first half of 2011 and all functions except manufacturing have now moved into the Macquarie office.

Manufacturing will transfer to the new building as regulatory approvals are obtained. On practical completion, Macquarie University paid COH $130.3 million and then leased the building to COH on commercial terms.

As the business continues to derive more profits offshore, it has reduced the level of franking of its dividends to 60 per cent. This impacts our normalised earnings which takes franking credits into consideration and thus our net return on equity (NROE). As a result, we marginally reduced our NROE.

Value is set to increase by around 8.7 per cent CAGR to 2013.

Rio Tinto Limited (RIO)

RIO announced a record profit of US$14.3 billion supported by US$18.2 billion of operating cash flow. Simply an amazing result that has enabled the business to reduce its net debt to equity ratio to a very low level at year end and announce its intention to buy back $5 billion of shares.

Commenting on the result, CEO Tom Albanese said, “Rio Tinto is reinvigorated, running strongly and benefiting from favourable markets. GDP growth in emerging markets and supply constraints mean the general market and pricing outlook for commodities remain positive, albeit with elevated risk. In particular, the timing and speed at which post-global financial crisis stimulus packages are removed, have the potential to generate both volatility and substantial swings in commodity prices.”

Sensibly, RIO is taking full advantage of very strong commodity prices to reduce debt. Average iron ore prices were 80 per cent, copper prices 47 per cent, molybdenum prices 45 per cent, gold prices 26 per cent and aluminium prices 31 per cent higher than 2009.

Production was more mixed:
  • Iron ore – nine per cent
  • Bauxite – nine per cent
  • Alumina – three per cent
  • Copper – -16 per cent
  • Gold – -30 per cent
  • Molybdenum – 14 per cent

RIO is investing large amounts of capital back into its business to boost production in future years.

RIO’s current market capitalisation is around $170 billion and could RIO be capped at $300 billion in 2013? This will depend on NROE and the resultant equity multiple.

If RIO achieves what is expected over the next three years, it will have closing equity of slightly more than $100 billion in 2013. Today our equity multiple is 3.26.

BHP Billiton Limited (BHP)

BHP announced revenue increased 39 per cent to US$34.2 billion and net profit after tax (NPAT) increased 71.5 per cent to US$10.5 billion, supported by operating cash flows of $12.2 billion over the half. BHP exceeded consensus expectations leading marginal earnings upgrades. Things have never been better.

BHP has expanded buyback program by US$5.8 billion to US$10 billion. During the half-year, 6.8 million BHP Plc shares were repurchased on market. BHP will continue to consider both on- and off-market execution for the US$10 billion program and subject to market conditions, expects to be largely complete by the end of the 2011 calendar year. At discounts to value, it is sensible for BHP to buy back its shares. At around $1 billion a month of buyback, it should also provide support for the share price.

BHP noted its intention to invest US$80 billion within the business over the next five years to the end of the 2015. This should broadly support increased production of 5 to 10 per cent per year.

BHP noted stronger commodity prices increased earnings before interest and tax (EBIT) by US$8.5 billion to US$14.8 billion. That is quite a swing and is outside of management's control. Similar to RIO, essentially all of the additional profit was derived from increases in commodity prices.

BHP noted that “prices will ultimately be determined by the marginal cost of supply, with the quality of our tier one assets well positioned to sustainably deliver strong margins and investment returns through the cycle”. This highlights BHP's key competitive advantage, low costs of production and long mine life and key risk, commodity prices.

These were the following:
  • Iron ore prices – 80 per cent
  • Copper prices – 47 per cent
  • Oil prices – 24 per cent
  • Aluminium prices – 31 per cent
  • Lead prices – 40 per cent
  • Zinc prices – 28 per cent
  • Uranium – 52 per cent
  • Thermal coal – 39 per cent

Production experienced more muted increases:

  • Iron ore – five per cent
  • Copper – seven per cent
  • Oil – zero per cent
  • Natural gas – negative one per cent
  • Alumina – 14 per cent 
  • Aluminium – zero per cent
  • Lead – eight per cent
  • Zinc – 27 per cent
  • Silver – six per cent
  • Uranium – 33 per cent
  • Diamonds – -10 per cent
  • Nickel – negative three per cent
  • Metallurgical coal – negative one per cent
  • Thermal coal – zero per cent

Positively, the business for the first time in a decade has a net cash position. BHP announced an increased fully franked final dividend of US$0.46 for the half year, a 10 per cent increase.

When prices of commodities are high (as they are now), economic and market theory suggests that new competition and capital will flow into these markets. New production will lead to additional supply (not quite here yet). However, both RIO and BHP have high quality resources at present whose quality and grades would be difficult to match.

What global supply is forecast to come online in the next few years? What is likely to drive demand in the next few years? Are there meaningful risks to this demand? Is China’s growth sustainable? What are commodity prices likely to be the next few years? (Iron ore, the most significant to RIO, BHP is more diversified). What is the AU/US exchange rate likely to be in the next few years? These are very important questions for investors in these businesses to ponder as they have large implications for profitability, value and ultimately an investor's return. We must not forget that commodities are cyclical and commodity businesses are not safe, reliable utility type investments. We are enjoying the strong part of the cycle at present.

Investing is a forward-looking discipline – to be successful, investors need to watch businesses and the drivers of profitability.

Commonwealth Bank Limited (CBA)

CBA announced NPAT increased five per cent to $3052 million for the half. A quality result, CBA beat market expectations, which encouraged consensus upgrades for the full year.

Positively, return on assets (ROA) is increasing towards one per cent and 'standard' return on equity (ROE) is increasing towards 20 per cent. The cost to income ratio decreased over the half by 70bps to 45.4 per cent. These are key metrics for a bank's performance.

Including an allowance for recent floods, impairment expenses to gross loans is back to pre-GFC levels. For the foreseeable future, it is credit growth that will be the driver of future profit growth.

CBA noted it is cautiously optimistic for the full year noting subdued system credit growth, elevated funding costs and competitive pressures. CBA increased the interim dividend by 10 per cent to $1.32.

NROE is currently forecast to be 26.3 per cent in 2012 and 26.32 per cent in 2013. As a result, we marginally increased our sustainable NROE to 24.5 per cent (from 24 per cent). The grossed up dividend yield is currently 7.8 per cent and we expect value to grow at around seven per cent CAGR out to 2013.

CBA is the only major bank with a June yearend – positive quarterly updates from the NAB and WBC recently suggest profitability is increasing marginally across the sector. 

Telstra Corporation Limited (TLS)

TLS announced revenue decreased 0.5 per cent to $12.26 billion and NPAT decreased 35.6 per cent to $1.19 billion for the first half of 2011. TLS maintained its fully franked interim dividend at $0.14.

TLS has not yet concluded the definitive agreement on the NBN. However, it noted that it remains on track for the NBN EGM by 1 July 2011.

Positively, over the half, TLS was successful in turning around the mobile phone segment and recorded sound growth of 221,000 net new customers. The new T-Box offering is showing strong growth from a low base with 4000 new customers a week. However, the additional customers did come at the cost of margin and profitability pressure.

With the eventual exit from owning fixed-line services, mobile services will be an important part of the business in a post-NBN future. It is pleasing to see TLS becoming more aggressive in this area. Interestingly, David Thodey estimated that 12 per cent of Australian homes have now become wireless only, a number we think will rise meaningfully in the coming years.

TLS know the importance of securing 4G spectrum when it is auctioned in the next year or so. Announced this week, TLS will be launching 4G services in all capital cities and some regional areas this year, much sooner than we expected using its current spectrum. This will further differentiate the TLS Next G network on speed and quality compared to competitors. This also raises more questions on the viability of the NBN. The speed of developments in the wireless space is staggering – to us, the NBN is looking more like a white elephant every day.

Within the key divisions:
  • PSTN revenue declined by 8.4 per cent largely driven by ongoing phone line losses of around two per cent. The key item was double-digit declines in calling revenues due to falling pricing, fixed to mobile substitution and at the margin increased take up of VoIP platforms.
  • Broadband revenue declined by 2.8 per cent. Retail broadband revenue was flat. - Mobile service revenue grew by 6.5 per cent. This was driven by growth across all major categories, including post-paid handset revenue 2.8 per cent, pre-paid handset revenue 9.3 per cent and wireless broadband revenue 24.5 per cent.
  • Sensis advertising and directories revenues were down by 6.8 per cent. Directories revenues fell by 7.2 per cent during the half, with Yellow Pages revenue down 10.6 per cent. This appears to be a structural shift as consumers embrace other methods of looking up details online from web and mobile devices. TLS did not provide commentary for the decline of the Sensis unit.

TLS continues to enjoy strong cash flow (operating, $3435 million) significantly exceeding declared profits ($1194 million) for the half.

NROE is currently forecast to be 38.6 per cent in 2012 and 41.3 per cent in 2013. We marginally reduced our sustainable NROE to 38 per cent (from 39 per cent). We do not see the value of TLS growing in the next few years as the business pays out all earnings leaving equity per share flat. TLS does offer strong dividends and currently a 13.7 per cent grossed up dividend yield would exceed out targeted total market return.

FlexiGroup Limited (FXL)

FXL announced NPAT of $24.5 million. This represented a 31 per cent increase in NPAT on the previous corresponding period. FXL noted a quite significant 27 per cent volume growth.

FXL management further upgraded full-year NPAT guidance to a range of $50 to $52 million. Our estimate is at the upper end of the range, $51.7 million. The result was underpinned by particularly strong growth (23 per cent to $179 million) in the Certegy Interest Free business and was complemented by more moderate growth in Flexirent, Flexi Commercial and Mobile Broadband.

After meeting with management post the release of their results, it is clear they will focus on organically growing their current business units. They further noted this strategy may be complemented if an appropriate acquisition opportunity were to arise in the future.

The balance sheet looks to be in reasonable order and operating cash flow for the half was strong at $51.47 million. We see profitability levelling off closer to 25 per cent over the next few years. NROE is currently forecast to be approximately 30.4 per cent in 2011, 26.7 per cent in 2012 and 25.7 per cent in 2013. FXL are currently offering a reasonable grossed up yield of approximately seven per cent.

FXL appear to be benefiting primarily from increased volumes and lower loss rates, resulting in a good quality result for the first half. This has seen our estimate of intrinsic value increase from $1.80 to $1.97 as we introduce our 2011 valuation. The recent run-up in price, however, means there is no meaningful discount to value at this point.

K2 Asset Management Holdings Limited (KAM)

KAM announced NPAT for the first half of $13.68 million on revenue of $32.85 million. Revenue from management and performance fees was $6.93 million and $25.37 million respectively. All figures represented a very significant increase on the previous corresponding period and highlighted a strong first half performance.

KAM have been beneficiaries of strong funds under management (FUM) inflows during the first half. This, coupled with strong portfolio performance, has provided strong impetus for the growth in both management and performance fees. KAM is well rewarded for outperformance in excess of their six per cent hurdle and collecting 20 per cent fees on such outperformance. However, from year to year, this performance fee is somewhat erratic and generally leads to less consistent (albeit generally very high) profitability.

It is also important to note that given KAM’s stated intention to pay $24.18 million of dividends in FY2011, it is likely the equity base of KAM will meaningfully decrease. Thus, while profitability will increase, equity per share will decrease substantially to approximately $0.06 at the end of FY2011. This negatively impacted the valuation, which fell to $0.58.

KAM currently have a strong balance sheet, very high management ownership and good levels of NROE. Given the shift in value coupled with the recent run-up in price, however, it would appear that KAM shares are not cheap.

McMillan Shakespeare Limited (MMS)

MMS has announced an 83 per cent increase in NPAT to $20.53 million for 1H11. While a marked increase, the result includes the new Interleasing business which was not present in the previous period.

However, expenses increased quicker than revenue as a result of depreciation, vehicle expenses and finance costs having come onto the P&L due to the new asset management business.

Operating cash flow was also impacted due to expenses relating to the new business improving by only 8.74 per cent.

However, as the new leasing business is integrated, the traditional Group Remuneration Services business is still performing with a 35 per cent increase in NPAT and 24 per cent revenue growth.

We have maintained our NROE (47 per cent), as we prefer to take a conservative approach to the consensus estimates for MMS. NROE is forecast to be 57 per cent in FY11 and 53 per cent in FY12.

We have also increased our payout ratio to approximately 67 per cent. We hold the view that as the business matures, the payout ratio will increase. This reduces our equity multiple and valuation.

Investors should note the likely exercise of executive options in by end 2012. These seven million options will increase issued capital by over 10 per cent and generate $30 million in new capital. The result – the holding company will then be debt free with no particular need for retained equity and thus payouts will increase dramatically. After meeting with MMS management, we can see net profit rising to $50 million in 2011/12 on increased capital.

Statistics released on Wednesday show that new motor vehicle sales have also remained steady for the third consecutive month and the Australian unemployment rate remains low at 5.1 per cent (January 2011).

The Reject Shop Limited (TRS)

TRS announced revenue increased 10.2 per cent to $275.9 million and NPAT decreased 16 per cent to $15.9 million for the half. This was supported by $18.7 million of operating cash flow.

Gross margins fell from 45.2 per cent to 43.6 per cent over the period, driven by a number of factors including price deflation, poor seasonal sales and additional costs of stock management.

Although sales increased, profits fell due to increased costs associated with interest expenses, depreciation on stores opened over the last couple of years and costs associated with the Ipswich Distribution Centre (DC).

The recent flooding in QLD has caused significant disruption to the business, damage to the Ipswich DC and loss of 80 per cent of the stock in the DC.

Management met with us at our offices this week to discuss the business and described the effect of the floods. The loss of a DC is just about the worst thing that could happen to TRS.

Fortunately, the business considered this risk and a number of years ago sort to insure this risk, described by current management as a stroke of genius. The insurance policy covers all stock, the automated equipment at the DC, clean up costs, labour and lost profits. We estimate this would otherwise have cost the business $15 to $20 million.

TRS has already received $5 million for lost stock from insurance. Management expects partial operation of the DC to be available in March with full operation to be achieved early in FY12 due to the lead-time of replacement components. While the costs are recoverable, the immediate need to fund working capital has meant the business has had to access debt facilities.

Remarkably, management noted they made a profit in January, albeit a small one. As a result, the business has declared a lower interim dividend, 23 cents. Indeed, it's been a tough year for the business.

TRS opened 17 new stores in the half and plan seven new stores in the second half. Total stores at the half was 211. Management noted the ideal location of a store is between a supermarket and a post office, as a TRS store feeds off the foot traffic generated. TRS have secured 15 sites for new stores so far for 2012. The largest growth area for the business is likely to be QLD and NT. This growth will leverage the Ipswich DC. At 20 to 25 new stores per year, it is likely the business has five or more years of the rollout strategy to go that should see the cost of the DC’s spread over larger sales volumes vindicating the investment decisions made recently.

Net debt to equity fell over the half from 52 per cent to 42 per cent. However, this likely increased in January and February as the business funds restocking and repair of the Ipswich DC. This should moderate as the proceeds from the insurance claim arrive.

It is easy to become negative when looking at a business that has had a challenging year. However, rational thought on questions about the likely future of the business is likely to be more profitable. Is Big W & Kmart (and other competitors) likely to make a meaningful impact on the competitive landscape going forward? Is deflation a permanent part of retailing? Is management up to the task? Are 400+ (profitable) stores achievable?

We maintain our NROE (53 per cent). NROE is currently forecast to be 50.6 per cent in 2012 and 53.5 per cent in 2013.

Index View

In aggregate, we have seen brokers trim earnings growth estimates for the index as a whole for the year to June from 20.4 per cent prior to reporting season to 19 per cent at the moment. Much of the expected earnings growth has been pushed out a little and we have seen earnings growth estimates for FY2012 move up from 16.4 per cent prior to reporting season to 18 per cent now.

The All Ordinaries Index NROE is very close to its 20 years’ average and we see fair value at the moment around 4600 points.

Written by MyClime Analysts. MyClime and  Clime Asset Management  are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Evaluating Global Construction Services Limited

Wednesday, February 16, 2011

Global Construction Services Limited (GCS) was listed on 14 August 2007 at $1 and offers a range of products and services to the commercial, residential, resource and industrial sectors of the Western Australian economy.

GCS was established in July 2003 following the acquisition of Security Scaffolding, the operators of which had been servicing the WA market for 25 years. Since establishment, GCS has undertaken a growth strategy aimed at diversifying the group’s geographic exposure, product and service offering via a combination of acquisition and organic growth.

Of interest to investors is that a number of GCS staff (including the MD) were involved in the establishment and development of Perth Construction Hire Group (PCH), a company which has grown from a WA-based construction business (similar to GCS) to a provider of scaffolding and other construction equipment and services internationally. Thus, some of the current management team have a history of success in another listed company.

The group’s stated objectives is to “further establish its position in the Western Australian market and develop a presence in new sectors through a mix of organic and acquisitive growth”. It is rapidly pursuing this objective, having acquired a range of businesses and established a presence in a number of new areas since listing.

The group has a clearly stated growth strategy comprised of both acquisitive and organic growth. It aims to grow via expanding its products and service range to create an enhanced offering to its customer base and allow for cross-selling of new and existing products and services. The group also aims to broaden is customer base in both new sectors and geographically. They have done this since establishment by branching into the commercial and industrials sectors, also establishing facilities in areas to the north and southwest of the Perth CBD.

Other possible growth areas include the provision of equipment for maintenance services and the provision of temporary seating that can be used for public events. Both of these represent small divisions of the current group.

GCS has made a number of acquisitions since listing as part of its growth strategy. These purchases have been made primarily via existing cash and debt facilities. A small $500K equity raising was utilised in the purchase of the concreting businesses (Newave and Blueline). An equity raising in financial year 2009, however, was made in order to increase working capital and strengthen the balance sheet.

Net debt to equity is towards the upper end of our desired level, reaching a high at 65.4 per cent in financial year 2009. At the end of financial year 2010, net debt to equity was 44.9 per cent.

Despite the number of acquisitions made since listing, intangibles as a percentage of equity has fallen steadily. Goodwill represents 100 per cent of intangibles ($16.29 million commercial, $7.81 million residential – financial year 2010).

A quick glance at the balance sheet does reveal a strong cash position at $11.63 million or 15 per cent of equity (30 June 2010). We suspect a portion of this is to support performance guarantees for contracted work. The group has the capacity to acquire more businesses and to utilise some of this cash and debt facilities as opposed to raising equity. We await the financial year 2011 results to re-analyse this cash position.

Net operating cash flow has outpaced NPAT in all years since listing except for 2008 which is positive. It is desirable to see such figures and it provides confidence that the business is running well. It should always be remembered that in companies’ financial statements, NPAT figures can easily be manipulated and particularly so by contracting companies through recognition of income.

The declining NROE is noted and needs reviewing. Annual growth in both revenue and NPAT since listing has been at a declining rate. As the group retains equity, the slowing growth has affected profitability.

Concurrently, the businesses cost of good sold (COGS) figure has risen consistently as a percentage of sales revenue and this factor also is affecting profitability. Higher capital employed, as a company grows and which generate lower margins is indicative of diseconomies of scale. These exist in most small companies.

Further, when we consider the number of acquisitions made over the past few years we can begin to develop an understanding as to the context of the declining NROE. By acquiring these businesses, the consolidated GCS entity has increased its equity base by taking on goodwill and large amounts of new plant and equipment to its balance sheet.

While EBIT margins are quite high at 18.8 per cent of revenue, these have declined as the company has grown and acquired businesses.

The falling NROE highlights the fact that these additional businesses have not as yet enhanced the value of the group. Earnings have risen but not profitability. Rising year-on-year revenues and NPAT are excellent selling points for management, but these should not necessarily impress a value-based investor. Thus, while GCS has managed to consistently increase profits, profitability is declining.

The payout ratio is forecast to be 50 per cent over the next two years and both EPS and DPS (based on company guidance) are forecast to rise.

Figure 10. GCS: Value and Price

Global Construction Services appears attractive as its price is well below our MyClime valuation. It is pursuing growth with board members who have successfully grown a similar business internationally. The business has focused its operations within the growing West Australian economy. With exposure to the state’s buoyant mining industry being only a small percentage of the groups’ revenue, there is the possibility for growth in the area.

However, of concern is the declining NROE which is a result of its growth strategies. The increased levels of plant and equipment which the company has acquired has boosted equity but has not resulted in a proportionate growth in profitability. However, these acquisitions have been made as part of a strategy to increase the group’s geographical exposure and product range in order to better service its clients. One would hope that eventually some synergies flow through and lead to an improving NROE.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Have some stocks been pushed too hard?

Wednesday, February 16, 2011

Following some massive rises in certain mid-capitalisation stocks, there is a rule of thumb that can sometimes help an investor realise that the likely return from a very good company may well be already fully factored into the share price. This rule of thumb is as simple as asking yourself, “How long would it take for the company (that I am about to invest in), to pay me a 10 per cent yield (through dividends) on my cost base?”

Why is this relevant? Well in our view, if you were contemplating the acquisition of a private business, which is growing rapidly or promises to grow rapidly, then one logical analysis you would undertake is to determine how quickly it will return capital back to you. As there is no market for your company’s shares, you will look for an income return from the excess profits that are generated by the business.

Thus, on this analysis, let’s have a quick look at Matrix Composites & Engineering Limited (MCE), Forge Group Limited (FGE) and Data#3 Limited (DTL). These are all high-quality companies exhibiting or promising exceptional returns on equity. However, we know that companies will all eventually suffer diseconomies of scale. Very few small companies are really successful and even fewer can evolve into major enterprises. They will simply slow in their growth or they will be taken over by larger companies who themselves are struggling to grow.

1. Matrix Composites & Engineering Limited (MCE)

Last week, MCE reached an all time high of $8 having been listed on the market for a mere 15 months. The market capitalisation reached about $560 million and it is expected to make about $35 million in profits this year, with a closing equity base of $90 million. Last year it paid $2.3 million in dividends on earnings of $18 million. Thus, is it reasonable to forecast that this company will pay $56 million in dividends in one year in say five years’ time? To achieve the growth forecast the company has to retain substantial equity (retained profits) and it has to maintain the return on equity on a much large equity base. This will be very hard to do without introducing financial leverage to the business (that is, debt). We should not forget that in the year prior to float (2008/09) the company made a mere $3.1 million.

2. Forge Group Limited (FGE)

FGE also raced through $500 million in market capitalisation. Its profit is forecast to be $35 million this year, dividends paid should approximate $12 million and its closing equity base of $90 million. Is it likely or possible that FGE could pay a $50 million dividend in the foreseeable future on its rapidly increasing equity base?

3. Data#3 Limited (DTL)

DTL jumped above $210 million in capitalisation. It will make a profit of $13.5 million this year and return about $10 million to shareholders. In contrast to the above companies, it is retaining very little equity. It does, however, convert retained equity into profit at a highly attractive rate. But is it possible for it to grow over the next five years and pay $21 million in dividends in a single year?

In our view, the most likely company to achieve the growth to justify the current share price is DTL. That is because it converts retained earnings into profit at a high rate. Further, it retains little equity and thus has measured, consistent growth. Also, it is not exposed to commodity price moves or currency moves. However, the current price of DTL does not offer any margin of safety.

The above questions are not designed to denigrate any of the above companies. However, the market appears to be pricing these companies in the expectation of exceptional and unhindered growth for the next few years. Further, the market prices do not appear to factor in any possibility of disappointment – akin to a “priced for perfection” scenario. When prices in small- or mid-sized companies rally in excess of the broader market we can draw the conclusion that some fund managers in the small capitalisation space have been allocated funds (by consultants and trustees) that are in excess of their ability to invest. There are simply not enough investment grade opportunities in the middle market. Those stocks that are quality are bid up and as prices rise then the momentum traders follow and prices are further bid up well above intrinsic value.

Thus, while it is always hard to take profits in highly attractive companies, it may be prudent to do so and especially more so when larger capitalisation stocks are being presented in the market at better relative value.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Which ASX-listed businesses would Warren Buffett be interested in?

Thursday, February 10, 2011

The key characteristics that Warren Buffett has displayed over decades has been his ability to identify excellent businesses, estimate their value, exercise patience and opportunistically purchase them when they are available at attractive prices.

Excellent businesses have an ability to grow over time through the reinvestment of profits (retained capital) to produce even higher profits. They rarely acquire other businesses and even more rarely seek to raise capital from shareholders.

Further, Buffet is focused on commonsense investing and the following are a few of his key considerations:

  1. The businesses need to be simple and understandable, driven by strong competitive positions.
  2. While a monopoly would be great, they are rarely available, so a strongly branded business that can pass on higher costs to customers via price increases is desirable.
  3. The business needs to produce high sustainable returns on equity with little or no debt.
  4. The businesses have to have a proven operating history and possess favourable long-term economics and prospects.
  5. Management needs to be rational with capital and resist the institutional imperative to grow at all costs. Management has to honest.
  6. Finally, after calculating intrinsic value, an investor needs to seek a large margin of safety (a price on offer below value) before allocating capital.

The companies we feature below are some of the stand outs in the Australian market. They may not be compelling value at present but investors must be alert to opportunities to acquire them should their market price fall into value. 

ARB Corporation

Renowned for designing and manufacturing high quality 4WD accessories, ARB derives its competitive advantage from its expertise in product innovation, marketing, exporting and distribution capabilities. Turning commodity inputs into branded products is ARB’s strength. The quality products as necessities for the 4WD enthusiast, you would not want to be 150km along the Birdsville Track and a bit of your kit breaks, leaving you stranded thinking about the few dollars you saved by purchasing a cheaper bull bar. Serious 4WD enthusiasts know this very well and this provides ARB pricing power.  

10-year total shareholder return: 24.2 per cent

Average owner return on equity last five years: 36.6 per cent

MyClime Valuation:

2010: $5.66

2011E: $6.52

Blackmores Limited

Blackmores develops, manufactures and distributes branded vitamins and supplements in Australia and Southeast Asia. The competitive advantage stems from quality branded products that people trust. Management depth is strong, Marcus Blackmore has been on the board of directors since 1973, led the business for 33 years and owns close to 30 per cent of the business.

10-year total shareholder return: 21.5 per cent

Average owner return on equity last five years: 57.4 per cent

MyClime Valuation:

2010: $26.37

2011E: $27.33


Cochlear offers the gold standard in implantable hearing devices. The competitive advantage is based on continual and successful research and development expenditure that leads to the quality products and a worldwide market share of around 70 per cent. Countries are realising the benefits of rectifying deafness from an early age. There remains a large untapped market in both the developed and developing markets for implantable devices.  

10-year total shareholder return: 11.2 per cent

Average owner return on equity last five years: 59.5 per cent

MyClime Valuation:

2010: $65.88

2011E: $73.03  


REH sells bathroom and plumbing products to the retail market (~30 per cent of sales) and trade customers (~70 per cent of sales). Pipes, taps and toilets may not be exciting but they don’t go out of fashion and have little risk of substitution. A growing population over time will drive continued and increasing demand for these types of products as the need for housing increases.

Reece derives its competitive advantage from the network effects that come from scale allowing it to negotiate cheaper prices on product and managements disciplined business focus on specialised plumbing and bathroom products.

10-year total shareholder return: 22.4 per cent

Average owner return on equity last five years: 29.2 per cent

MyClime Valuation:

2010: $18.49

2011E: $21.21  


Woolworths is Australia’s largest retailer with operations across food and grocery, liquor and hotels, petrol, general merchandise, consumer electronics and financial services serving more than 24 million customers weekly across Australia and New Zealand. The competitive advantage stems from an efficient supply chain, a low-cost culture developed over the best part of a century of trading and the network effects that come with scale. 

10-year total shareholder return: 17.2 per cent

Average owner return on equity last five years: 39.9 per cent

MyClime Valuation:

2010: $32.75

2011E: $34.85  

George Whitehouse is an analyst with MyClime. MyClime and Clime Asset Management are part of Clime Investment Management (ASX:CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


The Japanese sovereign debt downgrade a warning shot for the US bond market

Tuesday, February 08, 2011

Following last week’s surge on foreign equity markets, the world market indices have risen between two to three per cent since 1 January. Just like last year, the Australian index continues to lag and had barely moved before today’s rally. The Australian dollar once again poked above parity, US bonds weakened slightly and copper reached an all-time high. Sounds like Groundhog Day in world markets.

What stoked markets was manufacturing data that suggested industrial production throughout Europe, US and China is accelerating. This is occurring despite a report that the Eurozone unemployment rate is still above 10 per cent. We can only surmise that labour productivity is surging across the world as people with jobs are focused on keeping them by working harder.

This is all good news, however obviously confusing. These figures were recorded during a diabolically cold northern winter. Further, despite the fact that the consumers of the developed world are repaying debt, at a great rate, the industrial sector is increasing output. Presumably this must be going to the growing consumption base of the developing world. It will be interesting to monitor the coming month’s trade accounts of countries to see if world trade is picking up and that the developed world is balancing its trade account.

The following table explains why Japan received a sovereign debt downgrade last week. The bland numbers are that the Japanese Government has about $10 trillion of issued debt (205 per cent of GDP) and total government receipts (mainly taxation) of approximately $900 billion per annum. We can deduce that interest payable by the government is about $100 billion per annum, maturing debt approximately $500 billion per annum and over $400 billion of new debt is being created this year. The result – Japan’s total gross debt servicing commitment (including rollover debt) will exceed its total revenue collections for the first time since 1946.

Figure 1. Japanese debt service as a percentage of tax revenues

Up to this point, the Japanese Government has managed to fund its debt from the local economy. Indeed, 95 per cent of its bonds are held by local citizens, banks and corporations. However, the ability of the economy to fund this largesse is approaching its ceiling. Thus, our view is that Japan will from now have to increasingly seek foreign capital and this will expose it to the rigours of international debt markets. Just how this will occur will make for exciting reading in the next year. It would be quite amazing if the great lender of the world, the Chinese Government, offered financial support to its long time nemesis – Japan.

Of course, we must reflect that international bond markets have not been too rigorous in recent years, as they have been increasingly infected by central bank intervention. Maybe this explains why markets took the Japanese news in its stride. It was as if markets had either fully anticipated the news or chose to ignore it. The first view suggests that debt and credit markets are operating well ahead of the ratings agencies prognosis. The second view suggests that markets continue to be awash with liquidity and pay scant regard to warning shots. We favour a combination of both views and point to the confirmation by the US Federal Reserve that it will buy $600 billion of US government bonds by June as evidence that the world is awash with liquidity.

However, there was a mild reaction in the Japanese bond market but it was akin to a grade one cyclone, which will quickly pass. Ten-year yields moved to 1.4 per cent with the recent low in yields (peak in bond prices) being 0.8 per cent in October last year. That certainly doesn't look like the bond market is predicting a default by the Japanese Government any time soon.

The following table shows the widening fiscal deficits of Japan over the last twenty years.

Figure 2. Trends in general account tax revenues, total expenditures and government bond issue

Source: Japanese Ministry of Finance; Japanese Budget Office

There is one clear and absolute effect of widening fiscal deficits. That is, the countries that have them are increasing their tax rates. The following table highlights the high gross corporate tax rates in Japan and the US. Countries like Iceland and Ireland, which have blown their economies, had artificially low corporate rates, which will quickly reverse in coming years.

Figure 3. Statutory corporate tax rates, OECD countries

Source: OECD Tax Database and Goldman Sachs ECS Research

All of this supports our view that the recovery of the world economy will at some point be met with a substantial lift in taxation rates by governments who are deep in debt. The fact that markets are currently so blasé with the debt situation is consistent with our observation that Central Banks are flushing the world economy with liquidity. The world’s banking system is not recycling this liquidity into credit creation but is rather recycling it into government bonds or into financial asset trading.

While there is some financial basis (liquidity) for equity markets to rally, it is hard to see a case for a major upsurge from this point. Investors must be aware that central bank intervention has a positive effect on equity market liquidity and thus will positively move the whole market.

However, the fundamentals of individual stocks will ultimately determine those companies which will be the real performers in the coming year and those that will ultimately withstand the taxation headwinds that await unsuspecting markets.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


The negotiation of debt will continue to be the theme of 2011

Monday, January 31, 2011

"... the good news for value-based investors is that many investors don’t have a methodology, therefore you will be able to continually unearth possible investment opportunities."

The World Economic Forum (WEF) recently released a “Report on Sustainable Credit”. In it, the WEF has created an impressive database on debt levels in 79 countries, with debt disaggregated into three sectors:

  1. Retail credit – all household credit stock (loans outstanding), including mortgages and other personal loans such as credit cards, auto loans and other unsecured loans.
  2. Wholesale credit – all corporate and SMB credit stock (loans and bonds outstanding).
  3. Government credit – all public sector credit stock (including loans and bonds outstanding).

Figure 1. Potential Credit Hotspots

Source: World Economic Forum

In the table above, the red boxes are regarded as of concern to the WEF. The more red boxes that a country has, the more concerned we should be regarding the sustainability of its credit ratios.

By doing this, an analyst can review the world's economies on a consistent debt basis. The report proposes a number of ‘rules of thumb’ to indicate whether credit levels and credit growth are sustainable or not.

In summary, the key measures or ratios identified by the WEF are:

Personal or household debt to GDP (greater than 75 per cent is of concern) and interest plus average principal repayment burden as a percentage of disposable household income (higher than 20 per cent).

Corporate debt to GDP (greater than 80 per cent) and corporate interest plus average principal repayment burden to GDP (greater than 25 per cent).

Outstanding government debt to GDP (greater than 90 per cent) and government interest plus principal repayment burden to GDP (greater than 30 per cent).

Based on 2010 figures, the countries with the highest household debt to GDP and largest burden of interest and repayment were Portugal, Denmark, Ireland, Netherlands, United Kingdom, US, Australia and New Zealand.

The largest corporate debt ratios and repayment burdens were Portugal, Spain, Italy, Korea, Hong Kong and Malaysia.

The largest government debt and interest plus repayment burdens were Japan, Portugal, Greece, Italy, Belgium and US.

On aggregation of all ratios, the highest indebted countries of the world (that is, greater than 250 per cent of GDP) are:

  • Japan (330 per cent)
  • Portugal (300 per cent)
  • Spain (290 per cent)
  • Greece (290 per cent)
  • Denmark (250 per cent)
  • Ireland (250 per cent)
  • Italy (250 per cent)

The governments with the highest repayment and interest burdens as a percentage of GDP are:

  • Japan (42 per cent)
  • Greece (56 per cent)
  • US (37 per cent)

The conclusion from above is that both Portugal and Spain will be in a debt workout in 2011.

More concerning, however, are the debt servicing and repayment schedules of the Japan and the US. Quite simply, neither country could withstand a concerted rise in government debt yields, and this is why we must diligently watch bond markets in 2011. The downgrading of Japan’s sovereign debt to AA minus last week is the first warning shot for bond markets in 2011.

Where to now?

We currently see no change from the market trends set in 2010. While the United States is clearly in some sort of economic recovery, the question remains as to whether it will be a fair recovery (that is, where the broader population benefits) or indeed a sustainable one. At present, the quadrella of low interest rates, a devalued currency, quantitative easing and a huge fiscal deficit suggest that the recovery has a very poor foundation. Time will tell, but we can at least take heart from President Obama’s ‘State of the Union’ address, which has set a ceiling on government expenditure and an intention to develop clean energy as a new growth industry.

Meanwhile, the key US housing sector remains weak. Housing starts fell 4.3 per cent in December to a 529,000 annual pace – a one-year low, and are still hovering around the all-time record low of 477,000 recorded in April 2009. Existing home sales rose 12.3 per cent to 5.28 million (annualised) in December. However, a huge backlog of housing stock remains. More positively, manufacturing remains solid and it appears that the devalued US dollar is helping. Of course, it is also helping the Chinese economy who maintains their currency peg to the US and exhibits no urgent intention to change. This fact was confirmed again during the recent visit to the US by the Chinese Premier.

We are strong believers that the US, like Europe, cannot merely consume their way out of their economic and debt problems. They must become more productive and grow their economies through the creation of new dynamic industries and through trade.


Market timing or real view risk?

Monday, January 24, 2011

"... if you are investing in a generally overpriced market then be honest enough to acknowledge this and adopt an appropriate trading strategy."

The ‘one-in-a-hundred-year flood’ that struck Brisbane last week is a stark metaphor of the risks of investing. While market commentators are assessing the effects on the economy, the government’s (state and federal) fiscal position and the stock market, we believe there are other effects that have so far been glossed over.

For instance, what is the effect of the flood disaster upon the value of property that now sits in a flood zone? Significant parts of Brisbane inner city that housed commerce, retail and residences have been affected. For the foreseeable future, a purchaser of these properties will enquire as to whether the property is in a flood zone? The market price will adjust and it will adjust down! It is just a question of by how much?

Why is this important to us as investors? In our view, it is a stark reminder of what can go wrong – that is, the ‘right out of left field event’ that no one can predict that devalues an investment through no fault of its own. It is interesting to reflect that the Brisbane flood was not a ‘one-in-a-hundred-year flood’ event. Indeed it is the second time in 35 years that the Brisbane River has flooded. We can now confidently predict that it will happen again and the governments of Queensland and the Commonwealth are planning on this basis. The costs of the clean up are significant but will only be a portion of the expenditure required to flood proof the city – if that is indeed possible.

In a world sense, the 2008 meltdown of financial markets has been described as a ‘once in a generation’ event. Unfortunately it is not. In recent memory, we have had a market crash of 1987, the Asian financial crisis of 1997, the internet bubble of 2000 and the tragedy of September 11. Each of these events jolted markets and confidence. Each of them gave investors the opportunity to acquire good quality companies at a bargain. Yes, markets recovered, but not all companies recovered and certainly recovery was not consistent across company’s stock prices.

The above leads us to the conclusion that investors need to understand risk. Indeed they need to calculate risk and they need to understand how risk absolutely affects the required return from an asset. They need to understand that risk can be mitigated in the share market by prudent stock selection, the spreading of risk by portfolio construction and by the discipline of reducing equities that are wildly over priced in the market.

Market timing is important but the definition of market timing is often confused. While it does refer to the effects on markets of observable events and facts, it also refers to observations that markets are mispricing risk. In other words, the price of an asset in a market does not offer a return that justifies the risk of investing in it. This observation is never better illustrated then by the famous John Maynard Keynes declaration that “the market can stay irrational longer than you can stay solvent”. Thus, it is sensible market timing to withdraw from an equity or indeed the market if the prices on offer are well above a logical assessment of value. Further, if you are investing in a generally overpriced market then be honest enough to acknowledge this and adopt an appropriate trading strategy because that is what you are doing – namely trading.

In our view, the outlook for 2011 is clouded by the mispricing of risk in the world’s bond markets. This is a vitally important observation because the so-called “risk free rate of return” is the yield of a sovereign bond. For an equity investor, the risk free rate of return is sensibly regarded as the long-term rate or the ten-year bond. An equity investor should and must require a higher return from investing in shares then an investment in bonds.

The Queensland flood had a very mild effect on bond prices but it had, or should have had, a significant effect on some share prices. The effect on a company’s share price is not merely because of short-term profit issues but ultimately because the market had mispriced the risk of a flood and the effect of that flood. Go back to our Brisbane property example – the chances of a flood in Brisbane city was not considered an issue in property markets for at least the last twenty years. Now it is and the required returns increase just as the cost of insurance for protection against a flood will also increase.

So why are the world’s bond markets mispriced? How can MyClime make this observation in stark contrast to the pricing in the largest markets in the world? Why would we be right and the markets wrong? Are not the bond markets the most efficient calculators of risk?

The answer to these questions has been addressed in our musings over the last few years. The world’s bond markets are constantly being manipulated by quantitative easing, government bailouts, bank bailouts and fiscal deficit policy settings. Even last night in Europe the European Central Committee made it clear that there will be enough support to ensure that no European nation will default.

This pronouncement does not surprise us as we forecast a year ago that no European country would default, but that there would be compromises made (read "A way Europe can survive"). Further we suggested that compromises would have to be made because default by a European nation would have dire consequences for the German banking system.

However we consider that there are questions surrounding this pronouncement that there will be no defaults and these are as follows:

  1. Is it true and can it be believed?
  2. How long can the Central Bank of Europe print Euros and buy sub-standard European bonds?
  3. If Ireland or Greece cannot default then what should their bond yields be?
  4. Could there be some unforeseeable event (not a flood) that could occur that makes the proclamation of the European Union impossible?
  5. Who is going to pay for the repayment of debt across Europe?
  6. Should it have any effect on the prices of equities and what should it be?
Quite simply, the above questions are not easily answered. However, there is one powerful way in which we can mitigate against the risks inherent in blindly believing statements by politicians or bureaucrats and investing in equity markets. That is, through a comprehensive and disciplined method for assessing the risk of investing in equity, which MyClime defines as the ‘required return’ of an investment.

The required return is powerful as it is one of the two most important inputs that determine value. The other is sustainable return on employed equity. However, the derivation of required return is not something that can be plucked from mid air. It should not be manipulated to derive a valuation that suits the market price. Further, its derivation should be cognisant of the possibility of the mispricing of the ‘risk free’ rate of return in bond markets. Thus it cannot be blindly evaluated from an inappropriate risk free base.

Fortunately, in our view, Australia has a fairly priced bond market. Thus, we have confidence that our assessment of value in the Australian market is based on a reasonable assessment of risk. We do not have the same view of the US, Europe or Japanese bond markets. However, we are not going to move their bond markets, nor are we going to influence their equity markets. All we can do is bring to your attention our perceptions of mispricing of risk which if correct will ultimately lead to a correction in overpriced markets.

Thus, our conclusion is that 2011 will be as volatile as 2010. Indeed we expect the Australian equity market to continue to be affected by offshore market moves, shifts in sentiment and a continued lift in the value of the Australian dollar. However, by maintaining a realistic approach to deriving required return and being cognisant of overseas events we believe that we will, once again, navigate through 2011 with success.


Evaluating Coca-Cola Amatil Limited

Monday, January 17, 2011

Coca-Cola products were first introduced into Australia in the 1930’s. Coca-Cola Amatil Limited (ASX: CCL) was originally part of the British Tobacco Company (formed in 1904), before buying a controlling interest in Coca-Cola Bottlers in the mid 1960s. In the late 1980s, The Coca-Cola Company (NYSE: KO) became a major shareholder (30 per cent) and remains so today.

In 2005, CCL acquired SPC Ardmona and entered the ready-to-eat fruit and vegetable market. This division contributed 12 per cent of EBIT in 2009. At the time of acquisition, management noted the opportunity to accelerate innovation in health and wellbeing products across SPC Ardmona’s leading brands of Goulburn Valley, SPC and IXL. Today, CCL is deriving the full benefits of acquiring SPC Ardmona via stronger NPAT margins and some product diversification.

Later, in 2006, CCL entered a joint venture with SABMiller called Pacific Beverages, which manufactures and markets a range of premium beers in Australia and New Zealand. It also sells and distributes the premium spirits portfolio of Beam Global Spirits & Wines.

Today, CCL operates in five countries:

  • Australia (69.9 per cent EBIT)
  • New Zealand (10.5 per cent EBIT)
  • Fiji (10.5 per cent EBIT)
  • Indonesia (7.9 per cent EBIT)
  • Papua New Guinea (7.9 per cent EBIT)

It manufactures and distributes a diversified product portfolio of beverages including carbonated soft drinks, water, sports and energy drinks, fruit juice, flavoured milk, coffee and packaged ready-to-eat fruit and vegetable products.

CCL’s key product Coca-Cola was developed in 1886 in Atlanta by a pharmacist, where it sold for five cents a glass and sales averaged nine glasses a day. Shortly after, in 1891, the business was acquired by Asa Griggs Candler for a total of about $2300. Today, The Coca-Cola Company has a market capitalisation of around US$150 billion and has grown to one of the world’s most ubiquitous brands, with more than 1.6 billion beverage servings sold each day in over 200 countries.

CCL’s key competitive advantage is the Coca-Cola brand. Importantly, the brand power allows price increases over time. The brand has stood the test of time and is estimated to have a value of US$56 billion for the parent company. Other competitive advantages include a strong distribution network and significant local scale, the drive to keep innovating with new products and packaging as well as the influence from The Coca-Cola Company board members. This allows CCL to keep local market leadership while managing costs better.

While CCL has many commodity inputs, it does need to purchase the syrup from The Coca-Cola Company, which has been successful in raising prices over time. This detracts somewhat from the margins and the NROE achievable. The business hedges for aluminium and sugar. PET resin however, is unhedged and CCL has exposure to sharp movements in this commodity price.

CCL faces short-term pressures when commodity prices surge for inputs. Like all manufacturing businesses, increased raw material costs are initially challenging to pass on to customers. This has the potential to reduce margins and NROE. While food inflation is not on anyone’s mind at the moment (although Woolworths no doubt is hoping for some), this is a risk over time. The acquisitions of SPC Ardmona and Grinders Coffee provide further leverage to food inflation, which could become more prominent over the next decade.

The main risk is if CCL loses its brand power in the key portfolio products and innovative edge within Australia. This would likely prevent CCL from raising prices.

Expansion into Indonesia

CCL's involvement with Indonesia began in 1992, when it took a joint venture interest in seven of the 11 Indonesian Coca-Cola territories. By 1995, CCL had consolidated all of the Coca-Cola Bottling franchises into a single operation. Since that time, market penetration has improved in per capita terms (1992 – four serves per capita per annum to 2009 – 13 serves per capita per annum) but is still a long way behind other markets. CCL is obviously hopeful of increasing per capita consumption levels towards that of Thailand and the Philippines.

Indonesia offers a sound growth opportunity based on volume growth. Currently it represents around eight per cent of group EBIT. There is longer-term profit upside, if CCL can execute successfully. Indonesia’s population is around 240 million, with half under the age of 30 and enjoying increasing disposable income per capita. The typical CCL target market is aged 12 to 30 years old and this accounts for 30 per cent of Indonesia’s population, which is still very low per capita when compared to other countries.

CCL is targeting EBIT growth rates of 10 to 15 per cent per annum for the next five years. For the Indonesian business, we are more inclined to consider the lower end of the range of 10 per cent EBIT growth over the next few years, as reference over the last 15 years volume growth has been in the vicinity of eight per cent CAGR. As such, it is likely that the Indonesian business will contribute a growing part of group EBIT over the next few years and possibly 30 to 50 per cent of group EBIT in a decade’s time. To facilitate this growth CCL plans to invest $100 million per annum in production and distribution capacity as well as a fleet of drink coolers.

Counteracting this, CCL has not had the best record of overseas expansion having divested a number of overseas bottlers over the past decade.

CCL strategy

Along with the Indonesia strategy, CCL has some significant capital expenditure ($500 million) plans under a project it calls ‘Project Zero’. This project is running from 2010 to 2014 and is aimed at reducing the cost of doing business. The project includes a new SAP IT system, automated distribution centres and PET self manufacture systems. The most significant of these is the increased spend on PET self manufacture, which is estimated to be around 80 per cent of the investment. This follows successful commissioning of two new lines installed at the Northmead facility in early 2010. CCL now intends to install these PET facilities so that essentially all PET bottling needs are carried out at the start of the fill lines. While aiming to reduce manufacturing costs, this will bring back in house the PET bottles outsourced currently to Visy. CCL believe they can reduce the PET resin used in the bottles by 15 per cent by producing the bottles just prior to filling, as the fluid provides support rather than being produced offsite and needing to have thicker walls. The PET bottle represents around 50 per cent of the packaging cost and the business expects to eliminate 50,000 truck movements as a result. CCL is targeting 20 per cent return on this investment.

The board is incentivised to act in shareholder interests with two members of the board from The Coca-Cola Company and the board owning around $11 million worth of shares. However, the CEO Terry Davis has sold over $8 million worth of stock this year. Whilst not always a red flag, it is never a positive when a MD decides to sell a large block of shares.

While the company will benefit from a sustained stronger Australian dollar over the medium-term as a result of the lower cost of US dollar denominated inputs, there is an earnings impact from the translation of offshore earnings into Australian dollars and from reduced export earnings by the SPC Ardmona division. CCL notes that it hedges its currency exposure and a ±10 per cent change in the currency has around a one per cent impact on NPAT and a more pronounced impact on the cash flow hedging reserve.


CCL has a market capitalisation of around $8.4 billion. CCL has provided shareholders with a total return of 13.5 per cent per annum over the last 10 years, higher than the 8.6 per cent per annum achieved by the All Ordinaries Accumulation index over the same time period.

In 2005, with the adoption of AIFRS, reported equity fell by over 50 per cent due to the company reversing a previous (1999) revaluation of intangible assets ascribed to ‘Investments in bottler’s agreements’ under the previous AGAAP. This was the director’s view of the value on the CCL’s exclusive licence to produce, market and distribute Coca-Cola in the markets CCL operates within. While this did not have any meaningful effect on earnings, and no effect on cash flows, it does distort some ratio analysis over the period as debt levels represented by the net debt to equity ratio increased dramatically and NROE increased significantly. A similar reduction in intangible assets (although for very different reasons) has had a similar effect on Fosters recently. Over time, CCL’s net debt-to-equity ratio has headed down as the absolute level of debt remained constant and the equity in the balance sheet increased. This is forecast to continue with 2013 net debt to equity estimated to be around 65 per cent. Interest cover is sound at around 5.3 times.

CCL derives significant leverage from the use of debt, significantly boosting ROE. Positively, return on capital employed (ROCE) has been improving in recent years. While CCL has very sound cash flows, as has been highlighted over the last few years’, debt is never a problem until it is. At that point, diluting discounted capital raisings are a real possibility.

It is positive to note that over time the business has managed to improve the NPAT margin as scale increases, each additional dollar of sales revenue translates more potently to bottom line growth. The NPAT margin has grown over the last decade from 4.95 per cent to 10.2 per cent. However, CCL is not as profitable as The Coca-Cola Company that boasts an NPAT margin close to 20 per cent.

Interestingly, CCL is noted to generate 40 per cent of its second half Australian EBIT in the last six weeks of the calendar year. There has been some reported softness in this period from retailers (BBG and TRS) both noting cooler than normal weather. This seasonal short-term event may provide a longer term opportunity for investors.

Over the last decade, CCL has generated around $1 billion more cash flow than it has declared in profits highlighting the strength of its cash-generating ability.

Buying CCL is akin to entering into a partnership with The Coca-Cola Company, which owns around one third of CCL. Today CCL’s share price is essentially equal to our December year-end valuation. CCL does tick many of the boxes for successful long-term investment, including a strong NROE driven by branded products, a significant competitive advantage, growing earnings, sound management with significant experience and a bright future. The debt level is something to be aware of (reducing financial strength) and factored into an investors margin of safety requirement.

CCL is an investment grade business with a sound outlook. However, investors should always demand a margin of safety in the price they pay. There, unfortunately, is no margin of safety in today’s price.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


The outlook for 2011

Monday, January 17, 2011

"... equity markets are more likely to rise moderately than to fall in 2011."

At this point, all economic forecasters, including the IMF, forecast that the world will grow in 2011. It is likely that the developing world, which is dominated by China, Brazil and India, will grow at a rate of at least six per cent. The developed world of the US, Europe and Japan will grow at a more subdued rate of just two per cent. Australia is likely to grow at a faster rate than the major developed economies of the world.

These observations lead us to the view that equity markets are more likely to rise moderately than to fall in 2011. We do not expect a strong rise, because the economic problems confronting the developed world are immense. They range from excessively high levels of sovereign debt, severely crippled economies (the latest being Portugal), unstable banking systems, to looming unfunded crises created by an ageing population in the developed world.

The magnitude of the problems propose that government responses must also be immense when they are finally implemented. Indeed, we suggest that there will be one very predictable response by governments around the world – new and higher taxes. Whatever growth there is, and from wherever it comes, it will attract tax. The taxation response may not be until 2012, but markets will begin to price in the effects of new taxes at some point in the next 12 months. The effect of new and higher taxes will be to lower the expectation of profit growth in future years.

Quite simply, the governments of the world will be forced to repair their highly indebted balance sheets in preparation for the forecast dramatic lift in pensions, social security and health payments that will arise throughout the next decade.

Although Australia's sovereign debt is low, like the rest of the developed world we are confronted with the looming problem of an ageing population. The baby boomers, born between 1945 and 1960, are rapidly reaching retirement. Although they are the controllers of immense wealth, they will still burden society with increasing claims on health care before they move into retirement and then aged care.

They are moving from a consumption stage to a savings stage of their lives. The combination of increased taxes (whether in the form of direct tax charges or a lift in utility or services charges) and the dramatic change in consumption patterns of the aged, will surely slow economic growth. In Australia, we are also confronted by our excessive household debt. This burden falls most directly on the generation of 30 to 45 year olds who have borrowed excessively to enter the residential market and who have to, or will be required to adjust their consumption patterns.

Despite the above, we in Australia are relatively well off compared to our peers. We benefit from our direct trade engagement with China. Further, our propensity to attract, house and provide for immigrants supports our population growth. The rest of the developed world is not so fortunate, and consequently the depressing impact of offshore economic sentiment will weigh negatively on our equity market throughout 2011.

Currently, we have a positive view on Australia’s equity market, which offsets our concerns about the outlook for the US and in particular, the European economies.

Therefore, 2011 could well be a rerun of 2010. Indeed we would suggest that the investment experiences of the first decade of the twenty-first century should be reflected upon by all of us. This past decade has seen Australian equities return about eight per cent per annum to investors in Australian dollar terms.

It is interesting to reflect that approximately 60 per cent of this return has emanated from income or dividends – so less than 40 per cent of the total return is from capital gain. Further, while the first seven years of this century produced astronomical gains, they were subsequently decimated by the severe market contraction of 2008. The early economic and market gains were overstated by the burgeoning credit creation in the US, Europe and even Australia through to 2007. Then as debt and credit markets crunched the excess gains were quickly taken away. The result was that Australian share market returns (of eight per cent per annum) over the past decade were marginally above the long-term norm or average. Returns in the US were more sobering and barely matched inflation. With this recent history, it would be extraordinary to expect a resurgent recovery in equity markets built upon excessive consumption and the reopening of easy credit. It is not going to happen, and the demographic pressures plus excessive government debt will simply cap any excessive market exuberance. Further, the strict requirement for banks to lift their capital ratios will in itself slow credit growth in future years.

In the meantime, the growth in China and India should continue. There is much speculation among commentators who somehow predict that there will be strong equity market rallies in 2011 despite a slowdown in the Chinese economy. We do not expect China to slow, but if it did it would severely test the very sober world economic outlook and it would derail equity markets.

In summary, we believe the outlook for world and in particular Australian markets in 2011 is as follows:

  • Australian equity market return of approximately five to eight per cent with the return dominated by income.
  • Only minor upward adjustment in cash rates by the RBA as it becomes increasingly obvious that Australian households are in debt distress.
  • Continued strength of the Australian dollar to levels well above parity with the US dollar and towards 80 eurocents.
  • Continued weakening of long-term bond markets as the market becomes concerned with the credit ratings of the major economies of the world.
  • Continued market volatility as Europe aggressively ramps up its own form of quantitative easing in response to the contagion of economic calamity across its region.

Therefore, 2011 will be a stock picker’s market and if you are a member of MyClime, you will have an advantage over investors who rely on index type equity investments. Similar to what was seen in 2010, we are optimistic that there will be good buying opportunities, especially in the mid cap space. Last year, MyClime highlighted to its members a number of great companies that have subsequently significantly outperformed the market including McMillan Shakespeare Limited (ASX: MMS), itX Group Limited (ASX: ITX), Matrix Composites & Engineering Limited (ASX: MCE) and Mortgage Choice Limited (ASX: MOC). From an asset allocation perspective, we would caution against a portfolio that is overexposed to long-term bonds, non-Australian dollar assets and low-yielding property assets (such as retail) for we expect that these assets will have another disappointing year.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


Has the great bond market bubble burst?

Tuesday, December 28, 2010

The US bond market has been one the great financial asset bubbles of all time and it now appears to be coming to an end. So why is it happening and what could it mean for investors and borrowers?

One of the biggest corrections in bond markets in decades is transpiring in the US with little discussion over the possible ramifications. The US 10 year bond has retreated from a yield of just 2.2% in September and this week shot up to 3.5%. This will result in substantial losses to banks and institutions who had been piling into these bonds as a means of generating a yield at distant points along the bond duration curve. The US bond market has been one the great financial asset bubbles of all time and it now appears to be coming to an end. So why is it happening and what could it mean for investors and borrowers?

Figure 1. Australian and US 10 year bond yield 
Source: Data from IRESS
In our view the increase in bond yields is a function of two causes. First, the forecast of growth in the US has led to the possibility of inflation emerging.This is hard to comprehend at present as massive productive overcapacity still exists in the US. This can be seen with the high level of unemployment which suggests that an inflationary wages push is unlikely anytime soon. However, there is the omnipresent risk of imported inflation. This results from a weak dollar and a large trade deficit. Simply put the US could soon begin to import inflation and it will come from its trade gap with China (where inflation has risen 5% over the last 12 months) and from the rising price of oil. We note that the US has an oil deficit of about $300B and the oil price has lifted by about 10% in recent months. This is leading the market to see that inflation is possible and thus bonds are weakening.

Second, the US Government continues to rack up substantial amounts of debt. The recent capitulation by President Obama to the Republican demands for the maintenance of tax cuts for the wealthy has led to a forecast deficit of $1.5T in 2011. The increase in US government debt is leading to speculation that the US AAA credit rating could be downgraded in a few years time. Thus, yields at the long end of the bond curve will price in the risk of a credit downgrade.

The US Government raises bonds with maturities of less than a year and out to 30 years in duration. A bond is the mechanism whereby the government borrows money to fund fiscal deficits. The bond has an implicit government guarantee of interest payments per annum and the repayment of it's face value at expiry.
Over the last 5 years the US Government has been able to borrow and fund it's massive deficits at very low interest rates. To some extent it has benefitted from uncertainty, risk aversion, it's status as the worlds largest economy and sheer market complacency. It appears to us that it has benefitted from the naive view of international investors that US bonds were not subject to exchange risk.

The current rise in interest rates for US bonds will slowly affect the actual cost of funds for the US government and it could ultimately drive the government into a deeper deficit. This is because the government only pays the market rate of interest on new issue bonds. So the effect of rising rates will be on the $1.5T of new debt issued this year and the $1T of rolling debt from bond maturities. It will not affect the cost of the other $7T of previously issued bonds until they are rolled over.
However, a more immediate effect of rising bond yields is that it will quickly lead to a lift in the interest charged to corporate borrowers and consumers through the debt markets. These rates are priced off bond rates with a margin for risk. Indeed long term mortgage rates in the US are already beginning to lift from the all time lows reached just 6 months ago. Thus whilst quantitative easing is designed to keep bond rates low, it is actually having no such effect and is rather causing a depreciation of the $US, inflation and thus higher interest rates for the general community.

This leads to our view that bond yields in Australia are likely to rise as well in coming months. The Australian 10 year bond has historically traded at a margin above the the US 10 year bond of between 2% and 3%. Right now the differential is just 2.1% and this margin could easily blow out and mean Australian long term yields move to over 6%. If this occurs then it could put downward price pressure on property trusts and infrastructure investments because they become much less attractive in a relative yield sense. We simply would not consider investing in property trusts or infrastructure assets with yields of less than 6%. Further, we do not see growth by these types of assets in the next few years which could possibly offset these yields.

Figure 2. Difference between the Australian and US 10 year bond yield
Source: Data from IRESS

It is worth noting that bond yields are also beginning to rise all round the world. Some observers are suggesting that this is in response to a new era of world growth following GFC. To our mind this is rubbish. Yields fell far too low and this was the ultimate result of the loose monetary settings that followed the sub prime financial crisis. These yields are not normal and this is not a normal economic era and it has no historical precedents.

We continue to see much too much bullish analysis and forecasts for stock markets which has no recognition of the financial stress being felt by and awaiting developed world governments. The advisors, brokers and investment bankers who forecast rising stock markets are doing so to scare their clients into investing. They neither give scant consideration to rising bond yields nor do they comprehend the dangers of quantitative easings.

It would be far more factual and correct if they suggested to their clients that they should position their portfolios for the rapid escalation of currency printing which will result in the potential for speculative bubbles in equity markets. Of course this does not sound as compelling as the suggestion that markets will rise from now because the US is moving into a growth cycle. Much better for intermediaries to talk about growth cycles then speculative cycles.


The Australian economy and The Reject Shop downgrade

Wednesday, December 15, 2010

The dramatic lift in employment reported by the Australian Bureau of Statistics certainly defies the GDP slowdown in the September. We noted last week that the economic figures are not making sense and these job numbers confirm this. A higher population and the acceleration in employment growth should result in a lift in retail sales. Yet all retailers are confirming weak retail sales in November and The Reject Shop Limited (TRS), who downgraded profits recently, even suggested that the number of actual shoppers through their stores declined.

The conclusion we have is that the RBA certainly overstepped the mark when it lifted rates in early November. The decision by the banks to maintain their margins and lift their lending rates compounded the problem. The average Australian household is highly in debt and the real cost of living is rising faster than the RBA inflation numbers. The combination of higher mortgage rates, school fees, medical insurance, utility charges and road tolls is having a stifling effect on those householders with young families.

In 2008/09, the government-housing grant encouraged ‘first-time’ house buyers to acquire residential property and banks obliged with excessive levels of debt support. The result was that average mortgages lifted from about $230,000 to over $300,000 now. Thus one year on, we now see the unfair effect of RBA interest rate moves on young households.

The TRS downgrade is also a wakeup call to the RBA that a more rational approach to debt containment needs to be adopted. As for TRS, we also suspect that management has made some significant mistakes in stock ordering and inventory management. Poor retail sales have compounded the problem. At this point, we are willing to accept that the issues are short term and we acknowledge that the store rollout seems in place for a few years to come. In any case, our view is that the current valuation is towards $13 and it will rise towards $15 next year if the business is stabilised and growth re-established.

However, as always, we recommend a cautious response following a profit downgrade and our overriding view remains that there remains no imperative to buy any stock aggressively at present.

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Let us focus on the big picture

Tuesday, December 07, 2010

“… our view that a rally in equity prices in the US is being driven by massive liquidity produced by unsustainable economic policies.”

We are now advised by the ABS that the Australian economy barely grew at the slow rate of one per cent per annum in the September quarter. This is quite surprising given the surge in our terms of trade, our $40 billion budget deficit and our low unemployment. It is even more surprising when you consider that the Reserve Bank lifted interest rates in November to deflate an overheating economy!

Something does not make sense. We suspect that the June quarter growth was overstated and thus that an adjustment has occurred in the September quarter. However, these are just economic numbers and it is far better to look at growth over a year. On this basis, we see that Australia grew by about 2.7 per cent over the 12 months to September. This growth rate was superior to most of Europe, Japan and parts of the USA.

Also worth noting is that the September quarter contained a drawn out federal election. Economic activity always slows whilst elections are held and this year’s version was drawn out past the finish line by two weeks.

However, there is one disturbing feature developing on reviewing our National Accounts. It appears that whilst we are creating many jobs (and have a substantially better employment position then elsewhere in the world) we have a less productive work force. Productivity in Australia has fallen in the last five years and the numbers are actually declining quite rapidly more recently. To our eye, the growth in resources production is actually hiding the real extent of the productivity decline. Australia has closed manufacturing and created masses of services jobs, which actually don't produce or do much.

Another interesting point that we noted in the September quarter is that India, which has a similar size GDP to that of Australia ($1.2 trillion), grew by an annualised eight per cent in the quarter. At this rate, India will double its GDP in just nine years. Fair enough too given it has 70 times Australia's population.

Australia, like India, has a democracy and ours has been working overtime for the last two weeks as our leaders legislated for the structural separation of Telstra.

This was not an approval for the National Broadband Network and this awaits parliamentary consideration sometime in March. By March, hundreds of kilometres of cable will be laid and millions spent as Telstra shareholders await the farce being played out in Canberra. At some point before June next year, Telstra shareholders will be offered $11 billion to transfer its wholesale network to the NBN. The deal will be done and Telstra will become a substantially un-geared retailer. Its current $25 billion of revenue will decline, but so will its operating costs. Both its depreciation and its interest bill will also decline substantially in the future.

The company has already scaled back on capital expenditure to well below depreciation and this is producing a solid cash flow for the company. Its strong cash flow has allowed Telstra to announce at last week’s AGM that it expects to maintain a 28-cent dividend in each of the next two years.

Further, the company is beginning to grow the subscriber base to its mobile network, which appears to be the best in Australia. Competitive pricing exists. However, Telstra is dragging itself forward and in our view may be purposely coy about its cash flow until the shareholder and parliamentary vote has passed.

Despite this information, the Australian Future Fund (AFF) has now sold about 280 million shares in the last two months at an average price of $2.70. They still retain a billion shares, and to our mind this is likely to be their best returning investment in the next few years, if they can manage to hold it. As for the AFF's recent vote against the Board at the AGM, it appears that they forgot to nominate replacements. All of this suggests that they don't care, they don't have a plan and they are on the way out! Imagine how clever they would be if they had nominated some of Australia's great entrepreneurs to the Telstra Board? Maybe the AFF sees better value in Queensland Rail Network (QRN) and is undertaking a switch.

As for QRN, one could be mistaken to feel that rational investors everywhere have got this terribly wrong. We maintain our view that it is seriously overpriced in the market. Further, we suspect that the process of bringing it to market has been arranged to create a false market. For instance, the stock has traded on 20-day deferred delivery since its listing. This means that purchasers of QRN shares from day one have not had to pay or settle their trades. On the first day and in the first 15 minutes, millions of shares traded at $2.55. The QLD Government had a buy back facility for hundreds of millions of shares at this price but did not purchase any. Those who did received a free put option and a 20-day call option at $2.55. Now that's a deal that doesn't appear every day! Since then, we suspect that those who did buy the stock in the float have withdrawn their offers because they don’t receive the proceeds of sales for a few weeks. Why sell a call option for nothing?

However, all good things come to an end and on 7 December, trades will be a normal three-day settlement. At that point, we will see where the real buyers are and the probable massive unloading of speculative positions by hedge funds.

In our view, the QRN float concoction is symptomatic of our recent chaotic times. The investment banks are the great financial engineers in history who created the subprime debt that led to the GFC. Today they still go unchecked. Governments threaten regulation but then turn around and use these engineers to sell overpriced assets to the public. Unfortunately, this behaviour has been observable all over the developed world and no more so than in the decimated Eurozone periphery and in the financial system of the US.

For instance, how did Greece hide from the financial markets for so long that it was heading for financial demise? It was advised by investment banks. What has brought down both Iceland and Ireland? The lending practices and financial products of investment banks. Who has provided the key staff the Federal Reserve of America and designed QE2? They are mainly ex-investment bankers. Who does QE2 actually benefit through the purchase of US bonds? Well the investment banks or hedge funds that buy bonds in tenders and sell them to the Federal Reserve for a profit. It is this practice that has an eerie similarity to the QRN float!

Finally, the great bailout of Ireland has been undertaken. The question now is will this solve the Irish economic problem? Sadly the answer is no. To explain this more clearly let us take Ireland’s economic fundamentals and superimpose them on Australia to understand the predicament. If Australia was Ireland, what would we be presented with at present?

Well our government would have about $1.3 trillion of debt (100 per cent of GDP) of which about $900 billion was held by foreigners. Our budget deficit this year following the bailout of our four major banks would be about $350 billion. Our deficit is thus 30 per cent of GDP. We have unemployment of 1.25 million people representing 14 per cent of our workforce. We have just received $500 billion of bailout money from our friends in China (APEC) and we have just raided the Australian Future Fund (AFF) for everything they had and told public servants that their pensions are halved – that’s if they actually get them. Our hospitals have reduced service levels by 40 per cent and we are encouraging people to leave the country.

However, the real clanger is that our interest rates or cost of debt has just begun to rise substantially. For some reason, the people who lent us money three months ago at four per cent now want at least seven per cent per annum. Thus, our treasurer Mr. Wayne Swan has sought the help of investment bank advisers and unveiled a budget which he hopes will reduce our deficit by $250 billion to just $100 billion next year to comply with international debt standards. He forecasts this with some trepidation as he hopes that no one realises that tax revenue has already declined from $300 billion per annum to $250 billion per annum and our interest bill is about to rise from $50 billion per annum to over $100 billion per annum. In other words, interest bill of the government will now represent 40 per cent of government revenue.

As you can see, the above outlook is not sustainable and the Irish situation is playing out in Spain, Portugal, Greece, Italy and even the United Kingdom. Further, a close look at the economic fundamentals in the US shows a similar situation.

Thus, the recent rally in world markets has nothing to do with economic fundamentals. Indeed Australia’s fundamentals are somewhat understated and those of the US somewhat overstated. We are reiterating our view that a rally in equity prices in the US is being driven by massive liquidity produced by unsustainable economic policies. We note the constant buying by the Federal Reserve of US bonds in the open market this week. We see the printing pressures being stoked up in Europe and Japan.

Thus, the coming weeks could be a good opportunity to clean out your speculative positions and position your portfolios in cash, yield and those quality industrials which have shown consistent growth in recent years, with a high rate of profitability (that is, return on equity) and which have bright prospects.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Evaluating Blackmores

Tuesday, December 07, 2010

Blackmores Limited (ASX:BKL) was founded in the 1930s by pioneering naturopath, Maurice Blackmore. The company listed on the ASX in February 1985.

BKL develops, manufactures and distributes branded vitamins and supplements in Australia and Southeast Asia. In Australia, BKL holds around 20 per cent market share. Today it has approximately 7500 points of distribution in Australia across pharmacy, grocery and health food stores.

BKL products are positioned toward the premium end of the natural healthcare market. Vitamins and complementary medicines are gaining popularity as adjuncts to traditional medicines. Key drivers of the business are a growing and ageing population and increasing social awareness of the benefits of a healthy lifestyle.

BKL sells products primarily in Australia with international operations in New Zealand, Malaysia, Thailand, Taiwan, Singapore and Hong Kong. Recently BKL announced entry into the Korean market via a partnership with CJO, a major Korean home shopping network that will enable TV, online and catalogue sales direct to consumers.

The primary focus of the company is its Australian operations. However, Asian operations account for nearly 15 per cent of sales and are likely to be a key area of growth in the future. Asian sales were responsible for over 50 per cent of the 2010 NPAT growth. Thailand and Malaysia, which comprise approximately 90 per cent of Asian sales, grew 37 per cent and 17 per cent respectively in constant currency. This was achieved even with several months of civil unrest in Thailand.

In the recent annual report, management also noted a new partnership with Eu Yan Sang, a company that manufactures and retails specialist Chinese medicine. BKL products are now stocked in some of Eu Yan Sang’s retail outlets in Malaysia and Singapore with further product launches and expanded distribution planned. Eu Yan Sang and BKL will also share their expertise in Western and Eastern medicine. This appears to be an early stage partnership, but a good opportunity.

Worth noting, in 2003 BKL experienced a significant market share gain after the Therapeutic Goods Administration suspended the license held by Pan Pharmaceuticals Limited to manufacture medicines.

The business potentially faces the following risks:
  • Customers questioning the merit of complementary medicines;
  • Sovereign and political risk in Asian markets which may pose short term problems;
  • There are ample supply of remedies and alternative medicines in the companies new Asian markets which may make it difficult for BKL to gain market share;
  • Product quality issues that tarnish the brand. Whilst BKL has an impeccable record with product quality one error could be disastrous for sales and profitability.

BKL is also currently facing currency headwinds as the $A appreciates against a range of foreign currencies. BKL enters into forward exchange contracts to buy or sell nominated amounts of foreign currencies at future dates, in an attempt to match contracts with the committed future cash flows of the business. A ±10 per cent change in the $A against the Thai Baht, Malaysian Ringgitt, Hong Kong Dollar, Taiwan Dollar and Singapore dollar is estimated to have a two per cent impact on NPAT. This is not significant today. However, with growing sales within Asia, currency is likely to have a more significant impact on BKL over time.


Figure 4. MyClime Valuation: Blackmores Limited (ASX:BKL)

BKL has a market capitalisation of around $480 million. BKL has provided shareholders with a total return of 22.2 per cent per annum over the last 10 years, higher than the 7.9 per cent per annum achieved by the All Ordinaries Accumulation index over the same time period. 

Between 2000 and 2010, sales have increased by a compound annual growth rate (CAGR) of 10.4 per cent. NPAT has increased by 16.3 per cent CAGR, dividends have increased by 9.8 per cent while equity has increased by 15.22 per cent CAGR – all signs of a strong operating business. It is positive to note that over time the business has managed to improve the NPAT margin. As such, each additional dollar of sales revenue translates more potently to bottom-line growth. This business has been successful in deriving tangible benefits from the scale it has achieved over time and via the more recent consolidation of activities at the Warriwood facility. We expect that as volume grows locally and particularly via growth in Asian sales, each dollar of revenue will translate to a larger impact on the bottom line.

This can be seen in a comparison of the NPAT margin over time.

BKL today has manageable debt with net debt to equity of 36 per cent and an interest cover of around 19 times. The debt is largely due to the construction of the new facility at Warriewood. Over time, the business has utilised debt responsibly.

The business gets paid rather slowly with average receivable days a little over two months. Shareholders are funding significant working capital which accounts for around 65 per cent of equity. It is likely the large grocery retailers exert some power over payment terms for BKL.

Over the last decade BKL has generated more cash flow than it has declared in profits. This has allowed BKL to pay a growing stream of dividends and finance its own growth rather than returning to shareholders for additional capital.

We have selected 50 per cent as our Normalised Return on Equity (NROE). In the period of 2000 to 2013, NROE is estimated to average 50.1 per cent. We have chosen a Required Return (RR) of 13.5 per cent that we believe takes into consideration the risks of investing in this business.

Using the above inputs and the equity per share, MyClime produces the following values:

The following valuations are based on analysts’ forecasts and are subject to change.

Between 2000 and 2010, value has grown at a compound annual rate of 14.3 per cent and is forecast to grow at a sound rate in the next few of years.

Figure 7. BKL: Value and Price

Looking at the value and price graph above and the business's performance, the market appears to have broadly priced BKL appropriately over time. Good opportunities to accumulate shares have clearly been early in the last decade and throughout the GFC. Intrinsic value has grown strongly reflecting the positive business performance.

Today BKL's share price is marginally ahead of our 2011 value estimate. BKL manages to tick nearly all of the boxes required to make it an ideal business investment: it has a strong sustainable NROE driven by branded products, a significant competitive advantage, demonstrated earnings power, growing earnings, manageable debt, sound management with significant experience and a bright future. The only missing component is a compelling price.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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WDC or WRT – which is better?

Tuesday, November 30, 2010

On 3 November 2010, Westfield Group Limited (WDC) announced a proposed restructure of Westfield Group Limited by spinning off 50 per cent of the Australian and New Zealand shopping centres to be known as Westfield Retail Trust (WRT). The new spin off will create a real-estate investment trust with gross assets of over $12 billion and debt likely to be below 20 per cent of assets. The trust will comprise of 54 shopping centre interests of which 42 are in Australia and the remainder in New Zealand.

The proposal has been touted by WDC as a direct response to significant market demand for a domestic trust, focused on investing in high quality retail real estate, with conservative gearing and income sourced primarily in Australian dollars.

The proposal will be effected through a pro-rata distribution of units in the new trust to Westfield Group security holders. Eligible WDC security holders will be distributed one WRT for each WDC share that they own and this equates to a capital distribution of $7.3 billion.

Then the Westfield Retail Trust will undertake a $3.5 billion capital raising of new units to eligible investors at 42.75 per unit. The offer comprises:

  1. A public offer, which seeks to raise gross proceeds of up to $2 billion.
  2. A Westfield security holder offer, available to eligible Westfield Group security holders, which seeks to raise gross proceeds of up to $1.5 billion. Eligible WDC security holders are entitled to subscript to one new unit WRT for every 4.23 units in WDC.

The Trust will have a separate board and management team, led by Richard Warburton AO as Chairman and Domenic Panaccio as Managing Director. The Westfield Group will act as the responsible entity for which it will not charge fees.

Under the proposal, Westfield Group and Westfield Retail Trust will be separately listed entities, but will maintain a close ongoing relationship. Westfield Group will continue to act as the property and development manager for the joint venture on terms materially consistent with those already in place with Westfield Group’s other third party joint venture partners. The two entities will also cooperate on future retail property acquisition and growth opportunities.


We have carried out the valuations of the separation of the new Westfield Group and Westfield Retail Trust respectively.

1. New Westfield Group (WDC)

Using a post-restructure equity per share of $8.19, a return of equity of 12.5 per cent and required return of 12.8 per cent, and a proposed payout ratio of 65 per cent of earning, we have calculated the new Westfield Group would have a valuation of $7.93.

We have increased our required return for the new Westfield Group slightly. This is a result of the perceived higher risk from losing the stable earnings flowing from the Australian and New Zealand shopping centre rental income. Furthermore, in the near to mid-term we believe the bulk of the new Westfield’s shopping mall assets in the US and UK will suffer from slower growth and a relatively higher exposure to foreign currency movements.

While the near to mid-term could be quite challenging for the new WDC, there may be upside to the valuation in the long run when and if development profits emerge. Also, the new WDC will be distributing franking dividends as well as the distribution from the retail assets. The distribution of franked income will enhance the NROE and the valuation, but at this point the level of franking is not certain.

2. Westfield Retail Trust (WRT)

Using a post-restructure equity per share of $3.03, a return of equity of 11 per cent and required return of 12.1 per cent, and a proposed payout ratio of 90 per cent of earning, we have calculated that WRT would have a valuation of $2.73. We have lowered the required return for the newly formed WRT due to the fact that it will have a lower gearing, pure passive rental collecting REITs and no foreign currency risk.

3. Combined valuation

When the two groups are combined together, we note that the combine valuation is $10.66. Based on these parameters, the sum of the two parts is indeed slightly higher than our single entity valuation of low $10. Thus in our view, the proposed structure has ‘created’ small value for the existing WDC security holders. However, we have not formed a view as to whether more long-term (+10 years) sustainable value will be achieved under the new structure. We are therefore neutral on the new proposed structure.


The new WDC business model should deliver higher profitability, growth and, therefore, higher returns to investors, while WRT should deliver lower growth but more predictable and less volatile returns.

An investment in the new WDC is basically a decision to follow the existing management and the Lowy family. Given that the Lowys have been proven to be very capable managers, it is likely that they will create shareholder return above the market over the long term (+10 years).

This week, the Westfield Group announced an agreement to sell 50 per cent interest in retail component of the Westfield Stratford City in London for $1425 million to a new joint venture comprising APG of the Netherlands and Canada Pension Plan Investment Board. This is an indication of how the new WDC will be actively managing their assets to increase profitability. This transaction values the retail component of the retail asset at $2850 million and as a result, WDC will achieve a development profit of approximately $490 million.

However, in the near to midterm, we believe the new WDC will have significant challenges to overcome and therefore suggest that investors remain patient to determine an entry point at a discount to our valuation.

WRT attracts us as a high quality retail trust, offering a six to seven per cent per annum income return and three to four per cent per annum capital return averaged over the long term. Thus, we see WRT as a good addition to a diversified property trust portfolio. However, we once again suggest investors wait for a discounted entry to our valuation.

MyClime and Clime Asset Management are part of Clime Investment Management (ASX: CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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McMillan Shakespeare Limited – a quality buy?

Wednesday, November 24, 2010

McMillan Shakespeare Limited (ASX: MMS) listed on the ASX in March 2004 and provides a suite of vehicle leasing (operating and novated) and salary packaging administration services in Australia. The company services a variety of state and federal government agencies, hospitals, charities and large private sector organisations.

About the company

Salary packaging allows employees to increase their disposable income by using their pre-tax salary to pay for goods and services. Known as fringe benefits, items that are commonly included are living expenses, additional super, mortgage/rent, membership or school fees and car leases.

Under Australian taxation laws, significant Fringe Benefits Tax (FBT) concessions are available to people working in industries, such as charities, government agencies, trade unions and public hospitals. Certain benefits these organisations provide to their employees are exempt from FBT provided the total grossed up value during the relevant period is equal to or less than the ‘capping threshold’ as determined by FBT guidelines.

MMS comes into play by assisting employees to maximise their disposable incomes by identifying and organising these salary-packaging opportunities. With two capping thresholds at $17,000 and $30,000, there is a clear incentive for these employees to seek the services of a salary-packaging expert like MMS.

As the only integrated provider of salary packaging and company car solutions in Australia, MMS clearly has a competitive advantage over its competitors who can only provide single (salary packaging, novated leasing or operating leasing) services. Effectively, MMS is a one-stop shop and offers their customers the convenience to deal with just the one supplier.

MMS also conducts information sessions for employees of the company’s they service, informing them of the benefits of salary packaging.


When studying a business, it’s important to be aware of the market in which it operates in to anticipate changes in the company’s fortunes.

You could say MMS’s continued success is, at a macro level, dependant upon two broad marketplaces:

1. The labour market figure (Unemployment rate)


While we can’t assert a direct correlation between “declining unemployment levels to increased business for MMS”, one could imagine that as employers continue to draw from a labour market that is becoming increasingly tight, the use of fringe benefits may become more common and participation rates amongst employees may increase. Generally speaking however, a strong labour market and economy in general is good for MMS.

2. Motor vehicle market

The motor vehicle leasing and fleet management market is also important. Based on AFLA statistics (PDF) we can see that overall, the growth in novated and operating leasing has been steady over the past decade which is encouraging for the MMS business.

Figure 2. New motor vehicle sales, total vehicles – long term


This is another consideration, especially in regards to their Interleasing business for the second-hand vehicle market. As mentioned earlier, Interleasing sells their cars via retail and wholesale markets. However, as noted by the company, prices in the second-hand car market can be quite unpredictable and new car sales have yet to reach its 2007 highs.


Figure 3. MyClime valuation: McMillan Shakespeare Limited (ASX:MMS)


MMS has a current market cap of roughly $470 million. The company has managed to maintain its return on equity over time without the need to raise additional equity or debt, which is positive. We have selected 47 per cent as our Normalised Return on Equity (NROE). We have chosen a Required Return (RR) of 14 per cent, which we believe, takes into consideration the risks of investing in this business.

Using the above inputs and the equity per share, MyClime produces the following values:

The following valuations are based on analysts’ forecasts and are subject to change.

Figure 5. MMS: value and price

As a general rule of thumb, we prefer to see a debt-to-equity ratio below 50 per cent. However, MMS has quite a high debt to equity ratio of 140 per cent. Part of the Interleasing purchase was funded by debt and as such a $215 million borrowing facility was established, of which $72.3 million remains undrawn. This being said, the debt-to-equity ratio is not excessive for this type of business. However, it should be monitored and any growth in the lease book should be supported by a growing level of retained equity.


Currently priced at a small discount to equity, opportunities for growth remain strong with a vast market which MMS is yet to tap and a unique service offering. It has averaged 50 per cent NROE over the past five years without the need to issue vast amounts of capital and with minimal debt (disregarding 2010 as discussed earlier).

For a company such as MMS, a strong economy is crucial to its success. Where economic conditions deteriorate people are less inclined to buy motor vehicles and there a less people working. Looking at the MMS performance over the past five years, one would find it hard to believe that there even was a financial crisis.

MMS is currently trading at a 7.7 per cent discount to value.

MyClime and Clime Asset Management are part of Clime Investment Management (ASX: CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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QE2 has left the port, but it won't be bringing back happy passengers

Monday, November 15, 2010

It has been 20 months since the G20 Meeting in March 2009, where the leaders’ communiqué led to the surge in US equity markets following the presumption that the worst of the GFC was over. The surge was a direct consequence of the direction to governments to do “whatever was necessary” to create economic growth and stabilise the financial system.

As the leaders headed to Seoul for the weekend’s G20 Meeting, the main concern seems to be that that the US has taken the March 2009 direction far too literally. Well advertised by pre-release promotions, the announcement of the new round of Quantitative Easing (QE2) was expected by everyone. Now that it is here, it rather looks like an overhyped Hollywood movie that will be quickly withdrawn from major theatres to be endlessly repeated on free-to-air TV. In our view, the policy is one that could only come out of the minds of former investment bankers, whom unfortunately dominate the strategic positions on the US Federal Reserve and US Treasury.

The thought process behind the QE2 experiment was clearly explained this week by Federal Chairman Bernanke who suggested that QE2 would lift the equity market and, therefore, household wealth. This will then encourage households to spend to stir the US economy back into growth. However, we question whether this will actually occur.

The basis of Bernanke’s argument is shown by the following table of household wealth and debt. The table compares the US household balance sheets to those of Australian households at June 2010. It can be clearly seen that more of US household wealth is related to the US equity market (financial assets) and that Australian household wealth is related to houses.

Figure 1. Household Wealth and Debt
Source: Australian Bureau of Statistics

The problem for the Bernanke argument is that the above table does not show the distribution of wealth and debt. If the wealth and debt of the US householders were evenly distributed then a general rise in equity prices would lift the wealth evenly across the economy. However, this is not the case. Further, following the sub-prime experiment of 2000 to 2006, the debt of US households is not evenly distributed. In truth, the wealthy have too much wealth and income and the poor have too little wealth and too much debt.

The effect of QE2 is thus to make things worse. As stock prices rise driven by excessive liquidity and low interest rates, the assets of the wealthy rise. As QE2 debases the value of the US dollar, the prices of commodities and oil rises. The average cost of living for US households will rise faster than the cost of debt will fall. Indeed if inflation becomes an issue, then the cost of debt will rise and cause increased pain for borrowers and increased joy for the wealthy. In our view, this is exactly what lays ahead for the US.

Compare this to Australia where our household wealth is tied up in residential property. Our wealth that is exposed to the equity market is mainly in the form of long term superannuation which we cannot access quickly. Thus, Australia’s consumer sentiment is more affected by house prices. However, like the US, the wealth and debt in Australia is not evenly or fairly distributed. Australia has a massive residential wealth but approximately 40 per cent of our households have excessive mortgage debt against this asset. Australia’s reading of household debt at 150 per cent of household income is just about the worst in the world and indicates that when mortgage rates rise they have a substantial impact on a sector of our households who have too much debt. The recent interest rate increases will have a serious effect on the highly geared in our household sector.

In our view, the US has embarked upon an economic policy that could stimulate speculative rallies in equity and commodity markets. However, it will do little to improve the outlook for average Americans.

The creation of money and the maintenance of low interest rates by the FED will clearly benefit large US multinational corporations, investment banks, hedge funds and commodity traders. But, at this stage there is no indication that credit is flowing into the mid-sized corporate sector in the US and there is evidence that middle-American households are actually repaying debt. Thus, we are not hopeful of the creation of a sustained economic recovery in the US. Further, we would suggest that a further rally in equity prices in Australia (say 5000+ on our index) driven by US equity market sentiment, is an opportunity to direct more capital into cash and yield investments. At least in Australia, unlike the US and Europe, we have sensible interest rate settings that reward savers and give investors a legitimate choice for their investment capital.

Thus, the results of the weekend’s meeting in Seoul will be most interesting. We don’t expect anything positive for world equity markets and banks in particular, to come out of this meeting. Indeed, if the European and Chinese leaders are allowed to publicly declare their views on the US economic policy, the meeting has the potential to derail investor sentiment. Further, the continued tightening of bank regulation seems a given, subject to the observation that major European banks with exposures to insolvent European countries probably could not cope with tighter capital rules at present.

In Australia, clearly, all eyes have been on the big four banks and their announcements on an interest rate rise. With Commonwealth Bank of Australia (ASX:CBA) and Australia and New Zealand Banking Group (ASX:ANZ) adding 20 and 14 basis points respectively to the RBA interest rate lift of 25 basis points, we await NAB and WBC’s response to the lift.

In our view, it is difficult to understand as to why the CBA and ANZ have waited until after the RBA rate move to increase their rates. Margins are margins and the CBA and ANZ should be adjusting its rates as required. Its decision effectively took the heat off the RBA who, in our view, have overreacted. Further, we are left with the impression that the RBA does not talk to our banks for how else can you explain the RBA and the CBA moving on the same day?

Finally, the recently reported results of the banks show some developing issues for Westpac Banking Corporation (ASX:WBC) which suggest to us that it deserves its low rating compared to the other three majors. Essentially, all the banks are exhibiting slow asset growth as debt is repaid by customers and the asset growth that has occurred appears focused on mortgage lending. We note that in the last six months, WBC had a lower pre-provision profit in the September half compared to the March half year. Both Australia and New Zealand Banking Group (ASX:ANZ) and National Australia Bank Limited (ASX:NAB) produced higher pre-provision earnings. Whereas Westpac Banking Corporation (ASX:WBC) picked up profit through a sharp reduction in provisions. Despite being Australia’s biggest bank as measured by assets, it curiously had the lowest impairment charge of the majors in the last six months. Also, WBC has attained the status as the most cost efficient bank of recent times. However, all the banks are now under pressure to improve service levels and the likelihood is that that WBC will see an increase in its cost ratios, which are more pronounced than the other major banks.

While all the banks are in value, our current preference is NAB. However, due to the political uproar, the recent price decline of CBA is currently presenting a buying opportunity at a reasonable discount and attractive yield.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Related articles

Abernethy discusses the effect of the rising dollar on Australian shares.

And, are you shopping for a bargain in the share market? Abernethy shares his tips.


Shopping for a bargain

Tuesday, November 09, 2010

Some of the great success stories of the Australian stock market in recent years have come through well-managed retail rollouts. The prime example of this is JB Hi-Fi Limited. 

JB Hi-Fi was established in 1975 to provide specialist hi-fi and recorded music at low prices. Its product range has now expanded to include televisions, computers, games and consoles. Through its rollout programme it now operates 141 stores (131 in Australia and 10 in New Zealand), of which 106 are JB Hi-Fi branded stores. It aims to have 210 JB Hi-Fi branded stores in the long-term and the company plans to open 18 new stores in financial year 2011. This successful rollout has seen the companies share price go from $1.55 at its IPO in 2003 to over $19 today and has rocketed the company into the ASX100.

With this in mind we have decided to cast our eye over a number of the smaller players in the sector to see how they are progressing and what the future holds for them.

By comparing these companies on the basis of a ‘revenue to market capitalisation multiple’ we can see that two groupings emerge. The speciality retailers of Oroton Group Limited (ASX: ORL) and Kathmandu Holdings Limited (ASX: KMD) trade a premium to the rest of the sector. If we cast our eye to the profit margins of these businesses, we see why. Oroton and Kathmandu are able to achieve profit margins well in excess of the other retailers due to their premium brands.

If we then turn our attention to the return on equity (ROE or profitability), we get a slightly different picture. By considering profitability (including the distribution of franking credits), we can see that retail companies trade in a wide range of ratios of market capitalisation to shareholders equity. On this measure, two companies standout with one of them being Oroton (again) while the other is The Reject Shop (ASX: TRS). Both trade at equity multiples of over eight times and well in excess of the other four companies. The high market rating for Oroton and Reject Shop is justified by their superior profitability. It is sustainable high profitability which over the long term drives the value of a business.

The Reject Shop has been a great success story in recent years. They opened their first store in South Yarra, Victoria in 1981 with five staff selling ‘seconds’ and discontinued lines. Since then, it has grown to 192 stores located within shopping centres and shopping precincts throughout Australia. Today, they no longer sell just seconds and discontinued lines. They have adopted a new formula for success by targeting low prices and bargains on the everyday items people use most in their life.

If we look at The Reject Shop’s historical profitability, the trend is positive. Management has been able to generate profits, pay growing franked dividends and retain some profits which have been reinvested into the business at higher and higher rates of return.

This has been done through their continuing roll out programme and through increasing brand awareness. So what does this mean for our valuation?

We have assumed the company will achieve an ROE of 60.9 per cent for the next three years. This represents a fall from their financial year 2010 ROE of 78.3 per cent. When we combine this with our required return of 13.5 per cent, we derive a valuation of $16.96. Unfortunately, the share price has raced away from this for the time being.

Oroton is a retailer of luxury fashion brands in Australia and New Zealand. Apart from the Oroton brand, it also has the Australian distribution rights for Polo Ralph Lauren.

Oroton underwent a significant restructure in 2006 when the newly appointed CEO Sally Macdonald, divested the underperforming Aldo, Marcs and Morrissey brands. From that point they focused on ‘high margin’ and ‘upmarket’ products. Their main focus is the design and retailing of a wide range of Oroton products including bags, small leather accessories, jewellery, ties, umbrellas, knitwear, lingerie, men's underwear and shoes. Products are sold through 38 own retail stores, two David Jones concession stores and six factory outlets. Products are also sold online.

Oroton has been the Polo Ralph Lauren license owner for the Australia and New Zealand territory for over 20 years. Merchandise is sold through eight own retail stores (one of which is in New Zealand), nine Myer concession stores, five David Jones concession stores and five factory outlets.

Similar to The Reject Shop, we see a history of sustained profit and growing profitability from financial year 2007 to financial year 2010, a key characteristic of a strong performing business. This coincides with the change in CEO in 2006.

The growth in profit from 2007, prior to the economic downturn, through to 2009/10 is impressive. More impressive is that this was achieved with there being no new capital raised from shareholders. Capital increased solely from retained earnings of approximately $8 million. Over this period, earnings growth was approximately $7 million which shows a high capital retained to profit conversion ratio. Simply stated, ORL is a highly profitable business.

We have adopted a forecast profitability level of 110 per cent which we regard as achievable over the next few years given the Oroton business has demonstrated strong like-for-like sales growth and excellent margins. However, we note that the maintenance of this level of profitability will be a challenge for management in coming years.

We believe the stock is in value at current market levels but investors should note that the current share price and the MyClime valuation represent a high multiple of equity. Thus, in this case investors should seek to acquire the shares with a significant margin of safety or a discount to the valuation of at least 10 per cent.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Related articles

Abernethy discusses the effect of the rising dollar on Australian shares.

Plus, he looks at recent bids for PPT and ASX and what they mean for shareholders.


Recent bids for PPT and ASX look good for shareholders

Tuesday, November 02, 2010

Recently in Australia, we have seen two major corporate announcements. First was the proposal by the US private equity firm Kohlberg Kravis & Roberts (KKR) to acquire Perpetual Limited (PPT) and the second was the proposed merger by the Singapore Exchange Limited (SGX) to acquire the Australian Securities Exchange Limited (ASX).

Our views are fundamentally based on our valuation methodology and our reflection on the recent financial history of both companies.

Our analysis of PPT suggests that a cash bid in excess of $40 per share is highly attractive to PPT shareholders. For the PPT directors to reject the bid price they must be confident that PPT will lift its return on equity to over 60 per cent and have the ability maintain it at this level.

Figure 2. MyClime Valuation: Perpetual Limited (ASX:PPT). Click here to enlarge

We do not predict that this will happen for two reasons:

The Board in recent times has over compensated the funds management team for their services. This is not to dispute that the fund managers are not some of the best in Australia. However, it does show the risk that a funds management company has when the employees become absolutely paramount to the success of that business and are paid accordingly. This is similar to the issues at Macquarie Bank where remuneration is not linked to returns to the shareholders. It results in a company which favours key employees over shareholders; and

There is clear evidence that there are diseconomies of scale in funds management businesses. This diseconomy is more pronounced in the returns generated for managed fund investors than the returns for shareholders. However, over time the diseconomies will affect investment performance, slow FUM growth, lead to indexing strategies and lower percentage fees. A good fund manager becomes mediocre through weight of FUM, but the costs of the operatives are never adjusted. Thus, in time the ROE of the business will fall unless excess capital is returned or gearing introduced and that is exactly what private equity will do.

In regards to the ASX, we also see compelling value for shareholders to sell their shares for cash at prices above $40.

Figure 2. MyClime Valuation: Australian Securities Limited (ASX). Click here to enlarge. Source:

The financial history of ASX shows that, prior to its acquisition of the Sydney Futures Exchange, it generated a return on equity in excess of 60 per cent on equity that was substantially cash. The acquisition resulted in equity increasing by 800 per cent and profits by 250 per cent. The result is a declining return on equity to levels well below 20 per cent. The proposed merger terms suggests a price for ASX, which can only be justified by achieving a 25 per cent return on its equity in the next few years and that effectively means that profit must rise by over 30 per cent. Given the rapidly developing competitive landscape in securities trading platforms, we would suggest that significant profit growth is a fair way away.

Thus, the ASX Board has done the correct thing in supporting the merger subject to their strong belief that:

  • The SGX shares are fairly priced.
  • The synergies of the merger are real and can support the level of the proposed merged share price.

On these points we don’t have any real insight and thus merely point out that sometimes an exit for cash is better than waiting for a merged entity’s shares to be issued based on future uncertain earnings.

As for the appropriateness of the current political discussion regarding the national interest of the transaction, we would suggest that the ASX is a valuable asset of Australia. The control of the capital market transactions of a country is of vital national interest. While we believe that the internationalisation of securities exchanges will occur in time, we are not sure that it should be facilitated with companies who are part owned by their governments. The financial crisis, which is still rolling around the world, has many 'work out' years left. The legal changes to debt and capital markets will be immense.

Australia has a strong financial system that withstood the crisis and just maybe we underestimate the strength of our system and our independent securities exchange.

MyClime and Clime Asset Management are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.


The effect of a rising AUD on Australian shares

Tuesday, October 26, 2010

September 2010 represented one of the strongest months for the US equity markets. A surge in stock prices of over eight per cent in one month normally indicates the onset of a period of strong economic growth, or at least a period of sustained economic recovery. This market surge however, appears to have been the result of and the promise of more excessive liquidity created by the US Federal Reserve (The Fed). We know this because the US bond market continues to rally to extraordinary levels as represented by ever decreasing interest rate yields.

As equities rose, the US bond market saw yields on ten-year bonds fall to 2.4 per cent. We continue to view these yields as predictive of an ongoing recession in the US. Indeed we would regard further falls in US bond yields as deeply concerning.

Over in Europe, we continue to note the deteriorating fortunes of Ireland and Greece. Protests in European streets over government austerity measures are a warning of the political consequences flowing from the GFC. The responsibility for the repayment of government debt and the reduction in bloated government deficits will need to be shared amongst the wealthy and the poor. Unless this is achieved and seen to be achieved then the emergence of radical political elements will be seen. This is just another risk for equity markets in Europe, which is yet to be discussed.

Back to the US, and the certain result of its weak economy is that the Greenback will continue to depreciate against the Aussie dollar. Our engagement with China, our strong terms of trade, the widening trade surplus, near full employment and the low relative Commonwealth debt suggests to us that the Australian dollar will continue to appreciate. Indeed the fundamentals of Australia continue to be far superior to those of the US, Europe and Japan.

However, the question we must now seriously consider is whether a stronger Australian dollar, at parity or higher to the US dollar is positive for Australian equities?

There is no easy answer to this question, but what follows is our view of the effect of the rising Australian dollar on various sectors and companies in the Australian market. At the outset we can now confidently predict that index investing in Australian stocks will produce poor returns compared to active stock selection. This is not a bold prediction when you reflect on the last twelve months of the Australian market. For instance, we have witnessed massive outperformance of companies with high ROE who are not directly exposed to the affects of a weakening US dollar or US economy.

First, a critical part of the Australian market is our major resource companies. At this point we note that the rising Aussie dollar is beginning to negatively affect the valuations of BHP Billiton Limited (BHP) and Rio Tinto Limited (RIO). Both companies have benefited from record commodity prices and record volumes. At this point, this has more than offset the currency affect. Nevertheless, a move above parity to the US dollar will begin to negatively affect profits and profitability of both companies.

Further, it is likely that a revamped resource rent tax will be introduced at some point and will lift the rate of tax paid by these companies. It is also worth remembering that resource companies ferociously re-invest capital and they will struggle to achieve high rates of return on reinvested equity as the Aussie dollar rises. While we are opposed to recommend the sale of our major resource companies, we can see difficulties ahead based on the currency.

Reported profitability and profits of resource companies will be affected by the currency. However, they will not suffer a fall in the level of Chinese demand for our commodities. Continued volume growth, mine expansion and infrastructure spend, does support the outlook for mining servicing companies and engineering groups. These companies are not directly affected by the rising dollar. Whilst we do prefer mining servicing companies to engineering groups due to a lower need to reinvest capital, we note that we have already seen a substantial lift in stock prices in these companies [e.g. Monadelphous Group Limited (MND) and Fleetwood Corporation Limited FWD)]. There are pockets of value here, but they tend to be in smaller emerging service companies who do have to prove that they can manage growth from their low base [for example, Forge Group Limited (FGE) and Matrix Composites and Engineering Limited (MCE)].

The currency will have little effect on our banks whose biggest short term issue appears to be achieving asset growth and margin improvement as their offshore funding lines are tightened. We have read commentary suggesting a higher Aussie dollar will lower the offshore liabilities of our banks, but this is incorrect as banks must fully hedge their offshore funding to protect their capital. We remain comfortable with our banks, but we suggest that the ROE achieved three to four years ago of over 20 per cent will not be achievable over the next few years. Our banks are well capitalised, but offer limited growth and should be acquired on pullbacks of at least five per cent from current levels.

The big beneficiaries of the rising currency are definitely our importers and particularly our retailers of clothing or electrical goods etc. While gross margins will increase with a rising dollar, we should note the effects of heavy price discounting. To this end consumer sentiment is important and the recent comments of the RBA intimating higher interest rates are not positive. A business's supply arrangements also need to be understood. For instance a retailer like JB Hi-Fi Limited (JBH) does not get the full benefit of the currency as its suppliers deliver in Australian dollars. Other retailers have different hedge strategies and generally will not immediately benefit from a rising dollar if (say) currency is hedged six months in advance. Ultimately a sustained rise in the dollar will benefit retailers, so long as consumption and retail sentiment remain positive.

Our property companies are a mixed bag and do not offer compelling value at present. However, they are generally sheltered from the Australian dollar. The major property group that is affected is Westfield Group Limited (WDC) who has a substantial US exposure. Thus in the case of WDC, we do see how a powerful Australian business model can be affected by a very poor US retail outlook.

The Australian building supplies sector is generally one that is sheltered from the effects of changes in currency.  Despite this, both James Hardie Industries (JHX) and Boral Limited (BLD) have ventured into the US and will suffer from a very weak US building cycle and currency. It is easy to avoid these companies and focus on the pure Australian building supply companies such as Brickworks Limited (BKW) and Adelaide Brighton Limited (ABC) should they fall into value. We do note however that building supplies companies are cyclical, require significant reinvestment of capital and do not maintain high returns on equity.

Other major Australian companies which are negatively exposed to a rising Aussie dollar include CSL Limited (CSL), Computershare Limited (CPU), Billabong International Limited (BBG), QBE Insurance Group Limited (QBE), News Corporation (NWS) and Cochlear Limited (COH). These are all major companies which attract a constant flow of index funds, which buy shares based on market capitalisation rather than valuation. In other words they will always attract fund flows, but this will not translate into share price performance over time because they will struggle to lift profitability in this current climate. Indeed they could significantly disappoint the market with some trading updates later in the year which reflect the sustained appreciation in the Aussie dollar.

Other beneficiaries include companies who pay international prices for raw materials of fuel. Both Qantas and Virgin  have pointed to a substantial fall in their fuel costs and a potential reduction in the capital/leasing costs of aircraft. In spite of this, we do not like these businesses because they commonly overstate their profits by utilising off balance sheet financing practices. Also capital reinvestment often exceeds their depreciation rates.

In the main, we do not believe that a rising Australian dollar to levels above parity is a positive for the Australian equity market. Indeed the rising dollar is one reason as to why the Australian market has underperformed most other developed country markets this year in constant dollar terms. It is interesting to reflect that since late May, the Australian dollar has revalued by 20 per cent against the US dollar and thus a US based investor has achieved a substantial lift in the value of Aussie dollar equities during this relatively short period. At some point, this will lead to selling by these offshore holders as they lock in profits.

In terms of MyClime valuations, please note that we have taken into account the rising Australian dollar in our two inputs of valuation.

First, the required return of a company has been adjusted should it be exposed positively or negatively to currency moves. In our derivation of required return the sensitivity to currency moves will mean that a high return is required.

Secondly, the assumed Normalised Return on Equity (NROE) will also have been adjusted so long as market forecasts have noted the assumptions in the forecast for currency. If market forecasts have not done so, then our analysts have made an adjustment where required.

Our Disclaimer

The information provided by MyClime and is intended for general use only. The information presented does not take into account the investment objectives, financial situation and advisory needs of any particular person nor does the information provided constitute investment advice. Under no circumstances should investments be based solely on the information herein. is intended to provide educational information only. Please be aware that investing involves the risk of capital loss.

MyClime and Clime Asset Management are part of Clime Investment Management (CIW). MyClime is Australia’s premier online share valuation service. For a free two-week trial, click here.