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Paul Rickard
+ About Paul Rickard

Paul Rickard has more than 25 years’ experience in financial services and banking, including 20 years with the Commonwealth Bank Group in senior leadership roles. Paul was the founding Managing Director and CEO of CommSec, and was named Australian ‘Stockbroker of the Year’ in 2005.

In 2012, Paul teamed up with Peter Switzer to launch the Switzer Super Report, a newsletter and website for the trustees of SMSFs. A regular commentator in the media, investment advisor and company director, he is also a Non-Executive Director of Tyro Payments Ltd and Property Exchange Australia Ltd.

Follow Paul on Twitter @PaulRickard17

CSL’s 'exceptional' result fails to inspire market

Thursday, August 17, 2017

By Paul Rickard

CSL must be close to, if not the best, Australian listed company. Shareholders who were lucky enough to participate in the privatisation of the old Commonwealth Serum Laboratories in 1994 paid $2.30 for their CSL shares. Twenty three years later, and following a 3 for 1 share split in 2007, those shares are now worth a touch over $125. A capital return of 16,300%.

CSL Share Price - 1994 to 2017

Source: CommSec

And while CSL chooses to largely re-invest and doesn’t pay high dividends, on a per share basis, dividends have also grown very impressively. In its first full year as a private company in 1995, it paid 12c in dividends. This year, shareholders will receive 175.6c - a factor increase of almost 15 times. A great example of “dividend growth”.

Yesterday, CSL announced its full-year profit result. While CSL exceeded its own profit guidance, it didn’t quite live up to some of the analysts’ expectations about growth going forward, and eased on the market, slipping 1.5% to close at $125.27. That’s what happens sometimes - let’s take a closer look.

The CSL Result

The result was headlined as “CSL delivers exceptional performance”, with net profit of US$1,337m, up 16% on FY16. On a constant currency basis (CSL’s preferred measure), NPAT grew by 24% to US$1,427m, higher than CSL’s guidance in February for profit growth in the range of 18% to 20%.

Total revenue for the group increased on a constant currency basis by 15% to US$7,002m. The CSL Behring business, which contributes the lion’s share of the revenue at US$5,891, grew revenue by 12% on a constant currency basis. Immunoglobulins, where CSL is the global leader, saw revenue growth of 14%.

Revenue from the recently acquired loss making Seqirus influenza business increased by 23%. CSL says that this business is tracking to plan and it should break-even in FY18.

Other highlights included:

  • Strong early demand for CSL’s new haemophilia product, IDELVION;
  • The company is very excited about its specialty product HAEGARDA, which was launched in July. This product prevents HAE (Hereditary Angioedema) attacks, a very rare and potentially life threatening condition; and 
  • The acquisition of a majority stake in Chinese plasma manufacturer Ruide closed on 2 August. CSL expects the plasma market in China to grow over the next 5 years at circa 15% pa, with demand forecasted to outstrip supply.

Looking ahead, CSL has guided to revenue growth in FY18 of 8% on a constant currency basis, and underlying NPAT in the range of $1,480m to $1,550m - an increase of 10.6% to 16% on a constant currency basis. The broker analysts were a little underwhelmed by this guidance, in part because a return to profitability for the Seqirus business implies a slower rate of growth in profit by the CSL Behring business, and some of the bullish discussion on the new products.

CSL says that it is investing to support sales growth, and that capex in FY18 will be US$900m to US$1bn. With this level of capex and net debt to EBITDA at 1.5 times, the higher end of CSL’s target range of 1.0 to 1.5, CSL won’t conduct a further share buyback in FY18 when the current on-market buyback completes.

CSL also pointed to FX headwinds, particularly with the sharp appreciation of the Euro and Swiss Franc against most currencies in the last six weeks of the financial year. While CSL sells in 60 countries, the bulk of its manufacturing is located in Switzerland and Germany. 

The Brokers

Going into yesterday’s financial report, the six major brokers who cover the stock were fairly positive on CSL. According to FNArena, there were 4 buys and 2 neutral recommendations on the stock. The consensus target price was $137.87, a 10.1% upside to the current price. Analysts were forecasting FY18 earnings per share to grow by 18.5%.

With CSL now guiding to a lower rate of profit growth, forecasts are likely to be revised down a touch, although there was a sense at the briefing that Management was being somewhat conservative. This may also lead to a small reduction in the consensus target price.

Bottom Line

CSL is trading on a multiple of around 29 times FY18 earnings, which is not cheap by any standards. That said, there aren’t too many companies that have been able to consistently grow earnings at double digit rates of growth. And arguably, it is Australia’s best company and should be a core stock in growth portfolios. 

Around $125, CSL is no bargain buy, and if the Aussie dollar tracks higher, this will hurt the share price. But don’t expect too much of a sell-off - dips will be keenly bought. If you don’t own any CSL shares, put it on the shopping list.  

Disclosure: The author and his SMSF own shares in CSL.


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Forget AUSTRAC, CBA result is good news for bank shareholders

Thursday, August 10, 2017

By Paul Rickard

Commonwealth Bank’s AUSTRAC fiasco has become a classic media beat-up. Led by the anti-business ABC, supported by some Fairfax cheerleaders, and then the usual cabal of Canberra politicians, this story has been done to death. CBA has been tried, found guilty, and hung by the media before it is yet to even file a defence. This is not the making or breaking of the Australian banking industry.

Sure, CBA deserves a material fine, some Executive heads need to roll, and it is quite proper that the CBA Board has slashed bonuses and set up an independent Board Committee to oversee the remediation programme. Further, the Bank hasn’t handled the incident well, starting from a fumbled response last Friday when the story broke, selective media interviews on Sunday (rather than a full press conference), and the lack of contrition in its response.

It is this lack of contrition that really gets the public mad, and comes after earlier failings with life insurance, financial planning and Storm Financial. Facts such as the CBA making 4,000,000 suspicious transaction reports each year to AUSTRAC -  12,000,000 over the period in question - fail to get a mention because the public is so annoyed with the banks inna general, and CBA in particular. Instead, the media multiply the number of offences (circa 53,000) by the maximum fine to beat the story up and come up with an absurd statement that the fine could be in the “trillions of dollars”. Even claims of “billions” are arrant nonsense.

As an ex CBAer, I am going to be accused of being “part of the family” and having lost perspective on this issue. But unless there has been a cover-up by management or they negligently dismissed advice to fix the problem, I don’t think so. It is possible that overseas regulators such as the US Federal Reserve might show an interest and conduct their own investigations, which may lead to other fines, however I think this is unlikely.

Investors should keep perspective and focus on CBA’s bottom line. Yesterday’s full-year profit result ticked most of the boxes.

CBA’s Profit Result

CBA reported a cash profit of $9.88bn for the full year, up 4.6% on the prior year and about $100m better than market forecasts. For the June half year, the cash profit was $4.97bn, up 7.1% on the corresponding period in 2016.

Highlights of the result included:

  • Stable Net Interest Margin (NIM) in the second half of 2.11% (same as first half);
  • Improved Return on Equity for the half year of 16.1% (16.0% in the first half);
  • Higher than expected final dividend of $2.30 per share (compared with $2.22 in FY16). For the year, total dividend of $4.29 compared with analysts’ forecasts of $4.25;
  • Positive jaws - for the year, operating income grew by 3.8%, while operating expenses grew by 2.4%, for an increase in underlying operating performance of 4.8%;
  • Group’s capital ratio (CET1) rose, largely due to organic growth, to 10.1%;
  • In the Retail Bank, a cost to income ratio of 30.8%;
  • Home loans distributed through proprietary channels rose to 57% (broker channel down to 43%); and
  • Impairment expense remains low at 15bp. For the half year, $496m compared with $599m in the first half.

On the other side of the ledger, weaker parts of the result included:

  • An underwhelming performance from Bank West. Negative jaws and an increase in loan impairment losses led to a fall in cash profit of 9.8%;
  • Disappointing performance from the Wealth Division, although the second half was an improvement on the first half. Increased income protection claims led to a fall in insurance income;
  • Market share falls in most products, although home loans grew a little faster than system; and
  • Interest only loans represent 39% of the home loan book, well above APRA’s target of 30%.

The Bank also announced that it is in discussions with third parties about its life insurance businesses in Australia and New Zealand (operated by CommInsure and Sovereign respectively), which may lead to divestment in due course.

Bottom Line

Looking ahead to the next financial year, CBA faces some financial headwinds:

  • The Federal Government banking levy, which CBA says will cost the bank $369m pre tax, or $258m post tax;
  • The crazy South Australian banking levy. At 6% of the national total, this could be another $22m pre tax ($15m after tax). If WA or other states choose to follow suit, this could yet become material;
  • A fine from AUSTRAC. I reckon that this will be closer to $100m than $1,000m - time will tell. The real cost for the CBA will come in the extra ongoing compliance costs as it beefs up resourcing and systems to prevent breaches happening again.

However, the capital cloud has been lifted, the net interest margin has stabilized (showing the pricing power of the banking majors), interest rates will head higher, which will be a positive for margin, bad debts remain under control, and there is still an enormous opportunity to take out cost.

At $81.11, CBA is not cheap and is trading at a premium to its rivals. However, with the earnings and dividend clouds removed and a reasonable expectation that they can be maintained if not increased in the years’ ahead, a 5.3% fully franked dividend yield (7.5% grossed up) looks tempting. CBA is in buy territory.

CBA trades ex the $2.29 dividend on Wednesday 16 August. A 1.5% discount will apply to shares issued under the dividend re-investment plan. Shareholders can elect to participate in the scheme if they notify the Registry by Friday 18 August.

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Do you want to own a second-tier UK bank?

Thursday, August 03, 2017

By Paul Rickard

Do you want to own a second-tier UK bank? National Australia Bank (NAB) shareholders who were “gifted” shares in CYBG Plc, the holding company for the Clydesdale and Yorkshire Banks, should periodically ask themselves this question for two reasons. Firstly, because the shares are often in the “nuisance” category, and secondly, CYBG is really just a minnow in the UK banking market.

Back in February 2016, NAB decided to exit UK banking and their ownership of the Clydesdale and Yorkshire Banks. NAB shareholders were given one share in CYBG (quoted on the ASX under code: CYB) for every four shares they owned in NAB. For example, if you owned 1,000 shares in NAB which were then worth around $30,000, you received 250 CYB shares worth $1,000 (the exact cost price for each CYB share for CGT purposes was $4.01). In relative terms, the CYB shares were about 3% of their NAB investment - nuisance value for many shareholders.

Despite a share sale facility that saw 140,000 CYB shareholders with less than 100 shares exit in early July and receive $4.76 per CYB share, there are still some 240,000 Australian shareholders who have a holding of less than 5,000 CYB shares. Based on yesterday’s closing price of $4.72, shares worth less than $23,600.

They will be pleased to see that CYB has released an encouraging third-quarter trading update that shows it is on target to meet its FY17 fiscal and strategic objectives. However, the question remains that as CYB is a second-tier player in a foreign banking market, is there any strong reason for Australian shareholders to continue with their investment?

Image: Cash machine at a Clydesdale Bank's Piccadilly branch, London. Source: AAP.

CYB’s targets

CYB is a northern English and Scottish retail and small business bank, with 2.8m customers and £30.7bn in loans. Its strategy is to offer a differentiated customer experience delivered brilliantly through an omni-channel mix (digital, branches, contact centres and third party). Financially, this translates to the following medium term metrics:

By Australian standards, these aren’t particularly exciting or challenging targets. Australian Banks have ROEs (return on equity ratios) of around 14% (CBA is the highest at 16%, ANZ the lowest at 12.5%), while cost to income ratios for our majors are in the low 40’s (CBA’s retail bank is nearing 35%). For CYB, however, these targets are a long way off. In the first half of FY17, CYB had a cost to income ratio of 70% and the RoTE was just 6.3%!

The third-quarter update showed that CYB is nevertheless making solid progress. Mortgage growth of 5.8% with record application volumes in the third quarter, loans to small business up by 4.7%, a small increase in net interest margin (NIM), a CET1 capital ratio of 12.4%, and an efficiency program running ahead of guidance that should see operating costs for the full year of less than £680m compared to previous guidance of £690 - £700m. 

In the medium term, CYB’s strategy to improve shareholder returns involves an aggressive cost out plan which includes branch closures, head count reduction, business simplification, process re-design and organisational design, and digital transformation by leveraging their “market leading banking platform”. In regard to the former, they are running marginally ahead of schedule.

CYB’s “market leading banking platform” is known as iB, a set of microservices and APIs sitting over a core banking platform to manage interactions with customers and staff, and provide access to real time data and insights. While this digitization strategy should be an important enabler to positioning the Bank for future growth, caution is required as residual legacy issues from the core banking platform (which is not being changed) may limit the capability of what is offered. 

In the first half, the Bank reported an underlying profit of £123m, up 15% on the corresponding half in FY16. With the third-quarter results pointing to an improved cost outcome, broadly stable NIM and asset growth in line with the target, the Bank is on track to record an underlying profit of £250-£255m this year. The payment of an inaugural dividend has also been telegraphed.

What do the brokers say?

The major brokers who cover CYB are largely neutral on the stock, with one buy, two neutrals, and two sells. According to FNArena, the consensus target price for the stock is $4.93, a 4.4% premium to the last price. Individual recommendations are as follows:

On a multiple basis, the analysts have CYB earning 19 pence or 32.0 Aussie cents in FY17. This puts it on a multiple of 14.7 times FY17 earnings. Earnings for FY18 are forecast to rise to 37.6c, giving it a multiple of 12.5 times.

Bottom Line

The multiples aren’t cheap, but when a Bank has a RoTE of just 6.3% and a cost to income ratio of 70%, there has to be considerable upside opportunity. Then again, it is a second-tier bank operating largely in regional markets, and it is going to remain a second-tier bank.

If you don’t mind the nuisance value of the investment, hang on for the ride. Otherwise, look at one of the Australian majors.

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Think smart, not big

Thursday, July 27, 2017

By Paul Rickard

If you have been watching commercial television lately, you will probably have seen BHP’s commercials that are branded under the Think Big tag. I really like them as TV - but why a company that is a price taker and sells only to other companies and intermediaries is running a consumer-orientated brand campaign is absolutely beyond me. While it might make the staff at the Melbourne Head Office feel a little better about working for BHP, for shareholders, it is just another example of a lazy $10m being frittered away.

On the theme of “Think Big”, or not, shareholder activist Elliott Associates has launched their latest salvo at BHP. Under the heading “Instead of THINK BIG, BHP needs to THINK SMART”, they argue that change is needed at BHP.

You can read my thoughts on the Elliott proposal here, or visit the website they have created to see their arguments in full.

In brief, Elliott makes four key points.

Firstly, they say that BHP has underperformed. While they provide an apples and oranges comparison by citing the performance of BHP compared to the S&P/ASX 200 index (US$100 invested in the index five years ago would today be worth US$131 compared to just US$72 if it had been invested in BHP), they have previously demonstrated that BHP has underperformed compared to Rio and other comparable stocks.

They argue that BHP’s dual listed structure, which was established following the merger with Billiton in 2001 and sees two companies - BHP Ltd in Australia and BHP Plc in the UK - is obsolete and leads to the destruction of valuable franking credits. Elliott claims that US$853m of franking credits have been wasted on the shareholders of BHP Plc since 2015. Under their model, a unified BHP that was incorporated, headquartered and listed in Australia would be established.

The Elliott team says that US$11 billion of value could be created if the dual listed structure was unified, as this would unlock a significant balance of stranded franking credits. This could then be used to increase returns or conduct off market buybacks.

Elliott makes a particular point about BHP making the most of Australia’s unique and valuable franking credit system, and argues that the expected returns from allocating capital to new projects should be compared with those that can be achieved by buying its stock back at a discount. Previous off-market buybacks have been conducted at a discount of 14% to the then market price, and each time, massively oversubscribed. Elliott says that dedicating more free cash flow to discounted buybacks could lead to significant value accretion and create US$20 billion of value for shareholders.

The third suggestion is for BHP to maximise the value of its US petroleum assets by conducting a full review of alternatives such as a demerger of this business or the sale of the assets to local specialists. Elliott says BHP has destroyed more than US$22bn of value with its investment in shale oil, as that investment of US$29.2bn is now worth around US$6.5bn on consensus valuations.

Labelling the foray into shale oil as “disastrous” and “misguided”, Elliott says that the operation of these assets is so incongruous with a global, bureaucratic resource company that is used to projects with very long lead times and long paybacks. Typically, these wells are developed in months and only operate for relatively short periods, so the culture to develop and operate requires a very different mindset - nimble and entrepreneurial.

Demerging BHP’s existing US petroleum business, comprising US shale oil and offshore Gulf of Mexico assets, could unlock US$15bn in shareholder value.

Finally, Elliott argues that further changes to the BHP Board are required. It has welcomed the appointment of Ken MacKenzie, the former Amcor CEO (and no relation to BHP CEO Andrew Mackenzie) as Chairman to take over from the hapless Jac Nasser, but sees this as just the start of a process to renew the Board and remove some of the cluttered thinkers that signed off on BHP’s disastrous acquisitions.

What does this mean for shareholders? Elliott says that its “think smart” plan could add US$46bn of value - increasing the current value of BHP by approximately 51% from US$90bn to US$134bn!

Bottom line

If Elliott is only 10% correct, the “think smart” plan represents considerable value to BHP shareholders and should be considered. So far, BHP’s response to the plan is unconvincing and Elliott has won considerable support from institutional shareholders. One inevitability is that BHP exits the US oil shale business, another is that there are further changes to the BHP Board. The question is just how long this process takes to play out.

Elliott is maintaining pressure on the BHP Board and is encouraging retail shareholders to sign an on-line petition. You can find this here.

Disclosure: The author and his super fund are BHP shareholders.

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Banks breathe a sigh of relief

Thursday, July 20, 2017

By Paul Rickard

The market’s reaction yesterday to APRA’s announcement about bank capital requirements was telling. The major banks won’t need to conduct dilutive capital raisings to meet the new target. As a result, shares in the major banks rose by between 3% and 3.9%, with ANZ the best up 3.9% to close at $29.41.

Following its review of the “unquestionably strong” benchmark - the target set by David Murray’s Financial Systems Inquiry in 2014 - APRA is raising the minimum Common Equity Tier 1 (CET1) ratio for the major banks to an effective 10.5%. This is achieved by increasing the minimum requirement from 8.0% to 9.5%, plus another 1% for a buffer.

Each of the major banks has been taking steps to increase their capital ratios and currently has a CET1 ratio of around 10%. So between now and January 2020, the major banks will need to increase their capital ratios by between .5% and 1%.

Banks CET1 Ratios

ANZ’s, NAB’s and Westpac’s CET 1 ratios have reduced a little in net terms since March following the payment of their dividend in early July, offset by organic capital generated since the end of March. For ANZ, it says that on a pro-forma basis (which takes into account previously announced asset sales including stakes in Shanghai Rural Commercial Bank and UDC) its CET1 ratio on 31 March was already at 10.5%.

APRA says that the increase in capital required can be done in an “orderly fashion”, without equity raisings and without significant changes to dividend policies.

“The average capital growth rate needed through to January 2020 is now in the order of 25-30 basis points per annum. APRA estimates that the major banks should be able to generate this level of additional capital from retained earnings, without significant change to business growth plans or dividend policies, and without consideration of other capital management initiatives such as asset sales or equity raisings. On this basis, APRA considers that the CET1 capital ratio benchmark of 10.5 per cent can reasonably be met by the four major banks in an orderly fashion.”

But any capital increase still means some pain for shareholders through a lower return on equity. ROE’s have been falling for some time as the capital ask has been increasing and revenue growth has been static. Commonwealth Bank has come down from the very high teens to 16.0% in the latest half year, Westpac and NAB both reported 14.0%, while ANZ came in bottom place at 12.5%. Going forward, ROEs of 13% to 15% will become the norm.

Interestingly, APRA has estimated the “customer impact” if the Banks chose to pass on the cost of extra capital by increasing their margins, rather than letting shareholders bare the burden. It says:

“APRA estimates that an instantaneous 100 basis points increase in the CET1 capital ratios of the four major banks would, if entirely passed on through repricing of loans and deposits, require an increase in margins of approximately 10 basis points.”

For the minor banks such as BOQ and Bendigo & Adelaide, APRA is increasing the minimum capital requirement by 0.5%.

But some of the banks are not totally off the hook

While the banks in aggregrate should be able to meet this new target quite comfortably, APRA has yet to finalise the framework that will underpin banks having “unquestionably strong” capital ratios. This framework will take into account global regulatory initiatives from the Basel III accord and other changes to address mortgage concentration risk.

APRA says that changes to the framework should be able to be incorporated within the overall CET1 ratio of 10.5%, however as there may be changes to the risk weights that apply for higher loan-to-valuation ratio loans and for investor lending, the capital impact could  vary from bank to bank.

APRA says that it hopes to release the new draft prudential standards later this year, with consultation to follow in 2018 and the final standards to be determined in 2019.

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Vocus remains in play

Thursday, July 13, 2017

By Paul Rickard

Vocus shareholders will be breathing a sigh of relief that a second private equity firm has joined the bidding war. But many of those same shareholders will be wondering how a company that was trading at $9.40 just a little over a year ago could be the subject of a fire sale now at $3.50 per share.

On Monday, Affinity Equity Partners lobbed an indicative and non-binding proposal to acquire all of the shares in junior telco Vocus at $3.50 per share via a scheme of arrangement, matching an earlier non-binding proposal from Kohlberg Kravis Roberts (KKR). The Vocus Board announced that both parties would be provided access to conduct due diligence, potentially setting up a bidding war.

While the indicative bid of $3.50 is a long way short of $9.40 and less than half the $7.55 paid by shareholders in a $652m entitlement issue last June to fund Vocus’s acquisition of Nextgen, it still represents a premium of 50% to the low point of $2.33 hit seven weeks ago.

Source: CommSec

And as the Board of Fairfax discovered, just because two private equity firms make indicative offers to purchase the company, there is no guarantee that they will come to fruition. TPG and Hellman & Friedman bid $1.20 for Fairfax, only to withdraw after commencing due diligence. Fairfax is now trading around $0.95.

So, what is the future for Vocus? First, a bit of a re-cap on how Vocus got into this position.

Acquisition Indigestion

The collapse in Vocus’s share price can largely be put down to indigestion from too many poorly executed transactions. As a result, the market losing confidence in the management team, and slashing the multiple it was prepared to pay for what on paper appeared to be a high flying growth company.

The catalyst might have been the purchase of Nextgen announced in June last year, but the foundations were the purchase of Amcom in July 15 and the merger with the M2 Group in February 16. Three big deals all within the space of 12 months.

On the share market, investors felt the impacts of these transactions as follows:

  • 23 August 16 - Vocus announces full year profit. At the bottom end of previously announced guidance. Provides update on the integration with Amcom and merger with M2, but details disappoint the market. As investors peer more into the numbers, the share price drops under $8.00 in the days following;
  • 21 September 16 - shock resignation of CFO Rick Correll. Vocus offers no explanation. Shares plunge to $6.09;
  • 29 November 16 - Annual General Meeting. Trading update provided underwhelms market - total revenue for FY17 of $1.9bn, underlying EBITDA of $430m to $450m, underlying NPAT of $205m to $215m, says it expects to report material below the line expense of $105m. Highlights weak first half, acquisition and integration challenges. Shares crash from $5.76 to $4.35;
  • 22 February 17 - first half result. Reconfirms full year guidance, shares rally from $4.40 to $4.81;
  • 2 May 17- trading update. Revenue now guided to be $1.8bn in part due to accounting issues, EBITDA from $365m to $375m, NPAT from $160m to $165m. Below the line items now $113m. Shares plunge from $3.35 to $2.44;
  • 7 June 17 - KKR lodges indicative proposal to buy Vocus at $3.50 per share. The shares rally from $2.86 to $3.48.

Vocus remains committed to its strategy which is to be a vertically integrated, challenger telco providing services across Australia and New Zealand to all key market segments. With a market share of 3.5% of the Australian telecommunications market and 6.7% in New Zealand, it sees significant growth opportunities as it leverages its 30,000km fibre network and infrastructure footprint. This involves Australian mass market consumer brands Dodo and iPrimus, Commander for the SME market, New Zealand mass market and a wholesale division providing focused telecommunication services to Australian corporates. It is also investing in a 4,600km submarine cable linking Australia to Singapore via Indonesia, which is on track for service in mid 2018.   

The Brokers

Each of the eight major brokers that cover the stock has a ‘neutral’ or ‘hold’ rating on the stock. Like the market, the analysts have been very badly caught out by the performance of Vocus - it wasn’t that long ago that the broker consensus target price was over $9.00. Today, it sits (according to FNArena) at $3.29, with UBS the highest at $3.65 and Morgan Stanley the lowest at $2.55.

In regard to forecasts, the brokers have Vocus trading at a multiple of 14.3 times FY17 earnings and 16.2 times FY18 earnings. Notwithstanding the current interest from private equity, a couple of the brokers see Vocus as “high risk” and haven’t ruled out asset sales or a capital raising.

My view

I am not really into junior telco risk and hence Vocus is not on my radar as a buyer.

However, if I owned Vocus and had worn all the pain of a stock trading from above $9.00 down to $2.33 and now back to $3.50, I think I would be inclined to hang on and see if a cash bid from one of the suitors is forthcoming. It is hard to reconcile the huge change in valuation in such a very, very short period of time. It makes me think that there must be some upside.

My guess is that Vocus will prove to be different to Fairfax, and that shareholders will have the opportunity to consider a formal takeover offer at $3.50 or higher. Hold.

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Share investors need to watch the bond markets

Thursday, July 06, 2017

By Paul Rickard

Don’t be fooled by reports that the Reserve Bank has gone soft on the idea of future interest rate increases. As Governor Philip Lowe makes clear in his statement, the Bank is worried about the current strength of the Australian dollar.

“The outlook continues to be supported by the low level of interest rates. The depreciation of the exchange rate since 2013 has also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment.”

With the currency over 76 US cents, the Bank couldn’t afford to give any hints that it is contemplating an increase in interest rates - yet. But in an environment where the rest of the world has commenced a tightening cycle - the US has now had four rate increases and higher rates are seriously on the agenda in Canada and the UK - it is inevitable that Australia will follow suit. It may not happen until 2018, but it will happen.

Moreover, the bond markets are telling us that it is going to happen. Over the last week and a bit, 10 year US Treasury Bonds have jumped from a yield of 2.13% to 2.33%. In Australia, our 10 year Government Bond has risen from a yield 2.35% to 2.62%.

US 10 Year Government Bond Yield

Source: Bloomberg

Australian 10 Year Government Bond Yield

Source: Bloomberg

The yield on the two year US Government bond has reached its highest level in many years at 1.41%, while the yield on the two year Australian Government bond has risen from 1.65% to 1.79%.

Importantly for share investors, bond markets appear to have resumed an uptrend in yield. Recovering from a multi-decade low, the uptrend accelerated with a frenzy following the election of President Trump in November. This led to a major shakeout in the equities markets, and while global markets in aggregate rose, there were a number of losers as investors switched out of interest rate defensive stocks. Yields subsequently retreated and prices on the defensive stocks rallied, but already, a similar pattern is starting to emerge following this latest uptick in bond yields.

Winners from higher bond rates

In theory, increasing interest rates should be bad for stocks. Higher interest rates means that the cost of servicing borrowings by companies increases and as result, profits decrease. Further, consumers delay or put off discretionary spending, leading to lower economic growth. Historically, rising interest rates have been accompanied by bear equity markets.

This time, the markets believe it is different (at least initially), because interest rates are still essentially at emergency levels. They can go up a couple of percent or so to “normal” levels without having too much impact on the economy. Moreover, they signal in the short term that economic growth is picking up and that a little bit of inflation is coming into the system.

Winners include the cyclicals that benefit from higher economic growth, and potentially even resource companies like BHP and Rio who stand to gain from increased demand for hard commodities. The other major beneficiaries have been the financials (banks and insurance companies).

While in the long term higher interest rates will be bad for banks due to an inevitable increase in loan losses and bad debts, in the short to medium term, it is a positive because they should be able to increase their net interest margin. Most banks have a large volume of 0% or near 0% deposits (for example, cheque accounts) that they can’t or rarely change the deposit interest rate paid. If benchmark interest rates go up, they can pass on the higher charge to their borrowers, but don’t need to pay a higher rate to these 0% depositors. Consequently, the net interest margin for the bank improves. The converse occurs when rates fall - bank margins are squeezed.

For insurance companies such as QBE, it is about the investment return on their reserves, which goes up if bond yields increase.

Losers from higher rates

Losers from higher interest rates are companies that are highly-geared. Interest costs will go up, so profits will decrease.

The other major category is the so-called “interest rate” defensive stocks. These companies have annuity style characteristics with predictable (and often regulated) income returns, and are sometimes viewed as “bond substitutes”. When interest rates fell to near 0%, the prices of these stocks were bid sky high as investors chased their very predictable and relatively high distribution yields. With interest rates rising, they are relatively less attractive, so prices fall. Examples include the property trusts, utilities, and companies such as Transurban and Sydney Airport.

Interestingly, these stocks have already started to move. As a sector, property trusts were down 4.4% in June (income and capital), while utilities dropped by 2.7%. Transurban has dropped 10.4% since 20 June, from a high of $12.945 to yesterday’s $11.60. At the peak of the frenzy last November when 10 year US bond rates hit 2.60%, Transurban fell to a low of $9.45. Another bond proxy, Sydney Airport, is down 8.5% since 26 June.

Gold is also a loser, as the zero income return becomes relatively less attractive (more expensive to hold). Where gold goes, the gold miners such as Newcrest and Northern Star follow.

How to position

Because the US leads and the rest of the world follows, US treasury bonds hold the key to how components of the market will perform. My guess is that we will see further weakness in the interest rate defensives in the short term.

Back in November, US treasury yields topped out at around 2.60% - so this will be a key level that the market will watch. If this level holds, then the equities markets will switch their attention to other matters, such as the upcoming earnings seasons (in the UA and in Australia). If it breaks, then we could be in for a whole different ball game.

Fixed income investors are probably best advised to keep their duration short, while term deposit investors may want to keep rollovers to less than nine months.

Bottom line - watch the bond market.

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Link’s big punt on the UK

Thursday, June 29, 2017

By Paul Rickard

Perhaps it is the allure of the UK summer, with Wimbledon, Royal Ascot, The Henley Royal Regatta, the British Open, a test at Lords, or a Pimm’s or two in the late afternoon sunshine ... but for some reason, Australian companies are very favourably disposed to making big UK acquisitions. And perhaps for an entirely different set of reasons, these acquisitions have been a graveyard for Australian companies.

In fact, it is quite hard to think of a really successful acquisition in the UK by an Australian-listed company. Going back to the John Elliott inspired bid by Elders for Courage Brewery to “fosterise” the world, AMP’s purchase of Pearl Insurance and what would later become Hendersons, NAB’s purchase of the Clydesdale and Yorkshire Banks and Slater & Gordon’s purchase of Quindell, the list of failures is long. More recently, we have seen Wesfarmers lash out for the Homebase hardware business (too early to say how this is going). On Monday, Link Market Services announced the purchase of Capita Asset Services for a lazy £888m or approximately $1.5bn.

If there is one company that you would back to make a go of an acquisition, then that would be Link because John McMurtrie and his team have successfully integrated more than 40 businesses to make Link the leading funds administration and share registry business in Australasia, with a market capitalisation (pre-acquisition) of $2.8bn. But this is a game changer for Link, as the Capita business will deliver 41% of Link’s revenue and take offshore revenue to 45%. Net debt will rise from $283m to $923m, with the gearing ratio moving out to 39%. Strategically, it represents somewhat of a departure from Link’s expected growth trajectory of increasing share in the Australian superannuation administration business.   

Capita Asset Services

Capita Asset Services is being sold by Capita Plc. Deemed to be a “non-core asset” by Capita Plc, the Asset Services Business provides administration and registry services to fund managers, debt issuers and companies in the UK and Ireland. It comprises four divisions, which each contribute between 20% to 30% of total revenue.

  • Fund Solutions - which provides administration services to fund managers and has about 60% market share in the UK;
  • Shareholder Solutions - the largest division by revenue, which provides share registry services to UK companies. It is the third ranked registrar;
  • Banking & Debt Solutions - which provides loan servicing and admin services, as well as recovery of non-performing loans, to debt funds, investment banks and pension funds. 76% of the revenue is sourced from Ireland; and
  • Corporate and Private Client Solutions - which provides trustee/directorship services, trust administration, company secretariat and finance and accounting to major corporates, family offices and high net worth individuals. 

Revenue has grown from £284m in CY14 to £316m in CY16, a growth rate of 5.5% pa. EBITDA has largely remained flat, from £70m in CY14 to £72m in CY16.

Link says that the deal has attractive acquisition metrics in that it is EPS (earnings per share) accretive by around 17%. The implied acquisition multiple of approximately 12.4 times enterprise value reduces to 10.3 times once expected run-rate efficiency benefits of at least £15m are factored in.

Strategically, Link says that the acquisition: 

  • Has a strong strategic fit, and is aligned with Link’s growth strategy (for example, exposure to the outsourcing trend in an environment of increasing regulatory complexity);
  • Is an extension and diversification of Link’s business profile and geographic exposure (non-Australasian revenue will rise from 7% to 45%);
  • Provides immediate scale and leadership in the UK and a growth platform for Europe;
  • Link can drive significant growth and efficiencies post acquisition through the application of technology and investment, a shared services model, property optimisation, and enhancing products and services to drive revenue; and 
  • The Capita business has a resilient and defensive financial profile with growth opportunities.

Interestingly, the seller (Capita Plc), describes their rationale for the sale as to “simplify and streamline Capita Plc by repositioning the Group and refocusing on delivering technology-enabled business and customer management solutions that make business processes smarter and deliver better customer service”. In other words, they didn’t see this as much of a technology enabled business - or certainly one that warranted much further investment.

It takes two to tango - I guess that's what makes a market.

Funding

The acquisition is being funded by a 4 for 11 pro rata renounceable entitlement offer to raise $883m, with the balance of $664m coming from existing cash and available debt facilities.

The entitlement offer is set at $6.75 per share, a 13.8% discount to the closing price on Friday 23 June and a 10.5% discount to the theoretical ex-rights price of $7.54. The first part of the offer, to institutional investors, was completed on Wednesday. The offer to retail investors will open on Wednesday 5 July and close on Monday 17 July. Retail entitlements can be traded from today on the ASX and will trade under stock code LNKR.

Retail investors can elect to take up their entitlements by buying new shares at $6.75, sell their entitlements on the ASX (trading ceases 10 July), or do nothing. If they take no action, their entitlements will be auctioned in a book-build.

The Brokers

The Brokers have given the deal an initial tick of approval. Noting the forecast accretion in EPS, each of the major brokers has upgraded their target price:

  • Citi - from $8.25 to $9.20, upgrade to buy from neutral
  • Deutsche Bank - from $8.70 to $9.50, buy retained
  • Macquarie - from $9.20 to $9.50, outperform retained
  • Morgans - from $8.16 to $8.29, hold retained
  • UBS - from $8.10 to $8.55, neutral retained.

According to FNArena, the consensus target price is now $9.01, well above the theoretical ex-rights price of $7.54. Not surprisingly, the institutions have also supported the entitlement offer, with a very high percentage of eligible entitlements being taken up.

Jury will be out for some time

This is a transformative deal for Link and the market’s initial assessment is positive. However, because it won’t be complete until November/December, it will be many, many months before the market gets a good read on how the acquisition is progressing.  

And notwithstanding Link’s tremendous track record with acquisitions, history is against it in making a UK acquisition like this work. Being EPS accretive is a positive, but the strategic rationale is sound rather than compelling. The market will thus be cautious in passing judgement.

My sense is that Link is likely to experience a period of share market underperformance as the jury waits to assess the acquisition and the market absorbs the stock from the entitlement issue. It may not underperform in weak markets, but if the market rallies, Link could lag. Some contraction in the PE multiple is likely. Hold.

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A B-grade Budget

Thursday, June 22, 2017

By Paul Rickard

Labelling a budget that forecasts a surplus of $2.7bn and an average of $2.0bn over each of the next four years as “B Grade” is a tough call. But once the hype about the extra spending on infrastructure fades, the NSW Budget handed down on Tuesday will go down as a missed opportunity.

A little like the last term of the Howard/Costello government from 2004 to 2007, which is now judged by many to be both “wasted” and “wasteful” and led to middle class spending initiatives such as the baby bonus, the Berejiklian Government is following the same playbook. More than six years into office and facing an election in March 2019, Gladys and her team are putting electoral cycle considerations ahead of planning for the long-term challenges that NSW faces. The introduction of an ’active kids rebate’, which pays families $100 for each child who enrolls in sport or swimming lessons, is the classic example of mindless, short-term populism. 

NSW Premier Gladys Berejiklian. Source: AAP

This is not to say that the Liberal Government hasn’t already done a lot of heavy lifting. It has, and through the combined efforts of O’Farrell/Baird/Berejiklian, has run the most fiscally responsible strategy of any of the states. But NSW’s ongoing good fortune depends very much on the housing boom and employment growth, and it can’t afford to rest on its laurels.

As the biggest state and accounting for more than a third of the nation’s economic output, the health of the NSW economy is vital to the nation’s well-being. Moreover, because the states play follow the leader, where NSW goes, others will follow. 

So, missed opportunities need to be called out, risks highlighted, and Governments encouraged to focus on the long-term challenges.

A river of gold from stamp duty drives budget surpluses

The NSW budget forecasts a surplus of $2.7bn in FY17/18, down from the expected $4.47bn projected for the current year ending next Friday, but up $1.37bn from the estimate in last year’s budget. And this comes despite an increase in expenses of 5.0%, as the Government hires more front-line staff such as nurses and allied health professionals, cuts stamp duty for first home owners and implements new programs such as the active kids rebate.

NSW Budget - Key Outcomes

Headline revenue growth of 2.4% in 17/18 masks a largely unchanged GST and Commonwealth grants revenue, and is underpinned by taxation revenue, chiefly stamp duty and payroll tax, increasing by 3.7%. In fact, over the forward estimates, GST revenue is expected to fall in nominal terms to be only $31.6bn in 2020/21.

To make up this slack, taxation revenue grows at a compound rate of 4.0% pa over this period. Payroll tax increases at a compound rate of 4.8% pa, land tax at 7.6% pa and transfer duty on properties and land (stamp duty) by 2.8%. And this is despite the new stamp duty concessions for first-home buyers, a slowing home market and a record take in 2016/17 of $9.6bn (projected), up some 10.6% on the amount collected in 2015/16.

In fact, NSW’s surplus for 16/17 of $4.47bn, which compares to the original budget forecast of $3.71bn, is largely due to higher stamp duty receipts - the river of gold from a booming property market.     

NSW - Revenue Sources

Not only has NSW been enjoying a booming property market, economic output (as measured by real gross state product) has been rising at a faster rate than the rest of the nation. This has been supported by population growth of 1.5% pa and the nation’s lowest unemployment rate of just 4.8% (May, seasonally adjusted).

The good news, according to the Budget, is that the good times are set to continue. As shown in the table below, real gross state product is expected to increase by around 2.75% to 3.0% pa over the forecast period, the unemployment rate is forecast to stay at, or below, 5.0%, wages growth should start to pick up and drive an increase in payroll tax and immigration will continue to lead to population growth of 1.5% pa.

NSW - Key Economic Forecasts 

Risks

Expecting the rosy economic outlook to continue and potentially improve, and the river of gold to keep flowing, are interesting assumptions. Not without foundation, but also not without considerable risk.

The NSW Budget statement summarises the risks as follows: 

“While the risks to the economic outlook appear broadly balanced, uncertainties remain, particularly around the housing market and wages growth. The largest risk to the forecasts, both to the upside and the downside, is the outlook for the housing market given its highly cyclical nature and large flow-on effects. A significant slowdown in dwelling approvals could see the pipeline exhausted and activity decline by more than expected in 2018-19. Higher than expected interest rates or a sharp decline in dwelling prices could also bring an end to the cycle. On the upside, strong population growth or supportive government policies could boost demand and drive higher-than-expected activity.”

What NSW should be doing

Many observers would suggest that the risk of a slowing housing market, including dwelling approvals, is real and very likely. Further, if interest rates in Australia rise, which is probable in the medium term given the move by the US Federal Reserve Bank to raise US rates, mortgage stress could cause a sharp decline in dwelling prices. Further, unemployment could well be on the rise.

A prudent “A” grade Government would be planning for this very real scenario. Rather than waste money on non-mean tested middle-class welfare like the active kids rebate, or however well intentioned, hire an additional 4,500 health professionals, 1,000 teachers and other recurrent spending initiatives, the Government should be far more focused on supporting an environment for businesses to invest, prosper, and employ. The obvious thing to address is payroll tax - that insidious tax on jobs. 

Ensuring that NSW has the lowest rate of payroll tax, and potentially even abolishing it altogether, would be a strategy to deliver NSW a competitive advantage over the other states, promote employment growth and investment, and in an economic downturn, assist business. That’s what the river of gold should be applied to.  

This budget is a missed opportunity. A bare pass with a “B”.

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Pressure on BHP builds

Thursday, June 15, 2017

By Paul Rickard

In the next few days, BHP is expected to announce the appointment of a new chairman to take over from Jac Nasser. For many investors, this transition can’t come soon enough because Nasser has presided over some of the most value-destructive acquisitions in BHP history. He also championed the hopelessly flawed progressive dividend policy - now since abandoned.

Ken MacKenzie, the former Amcor CEO (and no relation to BHP CEO, Andrew Mackenzie) is emerging as the favourite. Other candidates are said to include ex-KPMG head and chairman of Westpac and Transurban, Lindsay Maxsted and the former CEO and now chairman of Orica, Malcolm Broomhead.

MacKenzie is the cleanskin on the Board, having joined it last September. Broomhead has been on the Board since March 2010, while Maxsted joined in March 2011. Both are somewhat tainted with BHP’s disastrous US shale oil acquisitions (which occurred in February and August 2011), and the progressive dividend policy that misled so many shareholders.

Shareholder activist Elliott Associates will also welcome the announcement of a new chairman, as this may open up the lines of communication between the Board and a growing band of aggrieved shareholders. Interestingly, Elliott issued another press release yesterday, calling on the new chairman to “address the company’s poor capital allocation and underperformance, nominate diverse and qualified directors, and review the executive management team”.

Elliott cited the support their campaign has achieved from shareholders, including AMP Capital (one of BHP’s largest shareholders), which in a note to investors called on BHP to conduct an “independent assessment” of Elliott’s proposal and “to prove the worth of its US onshore (oil) business and why it is compatible in the BHP portfolio”. 

Other investors cited by Elliott include Schroders Investment Management, Tribeca Global Natural Resources, Aberdeen Asset Management and BT Investment Management.

The Elliott proposal 

Elliott’s open letter to the BHP Board on 16 May and the accompanying presentation is available here. It starts by outlining BHP’s chronic share price underperformance, which is detailed in the table below. This shows that compared to a broad range of comparators (Rio Tinto, comparable portfolio, comparable pure-play mining portfolio, ASX 200, etc.), it has underperformed over pretty well every time period. For example, over the last eight years, BHP’s total shareholder return is only 46% of Rio’s.  

BHP total shareholder return relative to comparable peers

Graphically, this is represented by the following chart which shows total shareholder return since 2008 using a common base, with BHP in brown, Rio in black and the comparable portfolio in grey.

BHP total shareholder return vs Rio vs comparable portfolio, 2008 to 2017

In regard to BHP’s Achilles heel, its onshore US petroleum, Elliott says that BHP has “destroyed” US$22.7bn or 78% of its value. A total investment of US$29.1bn through US$19.9bn of acquisition costs and US$9.4bn of negative cashflow is now worth around US$6.5bn on consensus broker estimates.

US onshore petroleum - value destruction

According to Elliott, BHP is not the right custodian of the US onshore assets, petroleum offers no real operational synergies or risk diversification, BHP does not operate the vast majority of its petroleum assets and the value of these assets is obscured. Elliott concludes that “the intrinsic value of BHP’s US petroleum business is obscured by bundling it with BHP’s other assets within an overly complex group structure while managed from a great distance, with insufficient focus”.

Elliott proposes that the value of the US petroleum business should be unlocked via a full or partial demerger. They cite the demerger of South32 as clear precedent for success, noting that South32 has outperformed BHP by 47% since the demerger. They say that “a more nimble and focused independent petroleum business, with a more disciplined approach to capital management, would have avoided significantly overpaying for BHP’s US onshore portfolio.”

In regards to capital returns, Elliott says that there is strong shareholder support for BHP to return excess capital to shareholders. This won’t disrupt the balance sheet or put future growth at risk, will help ensure disciplined and optimal capital allocation, and will stop excess capital being wasted on value-destructive acquisitions and other pet projects. They say that there is a very strong case for regular buybacks, arguing that BHP needs to lift its game on buybacks as its track record has been “abysmal” (it has done these infrequently, and paid way too much relative to book value when it has).

They continue to push for a single unified entity (rather than two separate companies listed on different exchanges), and accept that this new entity would be headquartered in Australia, be an Australian tax resident, and have its primary listing on the ASX. A secondary listing would be in the UK. 

They refute BHP’s counter claim that this would cost US$1.3bn to implement, saying that the costs should only be around US$200m. The benefits of unification are less clear, however. Elliott contends (though doesn’t substantiate) that it will enhance BHP’s market value by US$5bn. They say that BHP will be able to monetise franking credits more quickly and more efficiently (current reserve US$9.8bn), and that having a single unified structure and share capital will give BHP an “acquisition currency” (other than cash) that could be used in future acquisitions.

Bottom line

Elliott and the BHP Board may not be ready yet to sit down and smoke the peace pipe, but because BHP has such a lousy record and Elliott shows no signs of going away, BHP will inevitably cede major ground on this proposal. A new chairman will make this easier. The US petroleum assets will either be put up for sale or demerged, and expect BHP to be far more focused on returning excess capital through off market buybacks.

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