15–21 august 2009 armageddon averted…for now€¦ · such as the ARB fridge/freezer and...

E v E r y p u b l i s h E d a r t i c l E f r o m t h E i n t E l l i g E n t i n v E s t o r w E b s i t E

publishEd this wEEK

It’s only been a few short months since economic comparisons with the Great Depression were given serious airplay. And although stocks never got to the once-in-a-lifetime bargain prices seen in the 1930s and 1970s—especially in blue chips—massive stockmarket falls up until March 2009 certainly lent credibility to the Armageddon scenario.

The reporting season, so far, has painted a different picture. Sure, many companies have reported significant reductions in profits and dividends, but the results we’ve seen so far have fallen well short of Armageddon. This week, big global operators like Brambles (page 10) and QBE (page 9) have reported modest profit falls, although some at the smaller end or with high fixed cost bases, such as STW Communications (page 7), Perpetual (page 3) and BlueScope Steel (page 10), have experienced more savage profit cuts, even losses.

There have also been enough companies bucking the trend though—NIB Holdings (page 10)

and ARB Corporation (page 2), for example, reported increased underlying earnings and dividends—to suggest that March’s mumblings were overblown.

But reporting season is a little like school report card day, when you can bet your last cracker that it won’t be the overachieving kids who are dawdling home. We expect to see some poor result cards before 31 August, the last official day of this reporting season. It won’t be Armageddon, but perhaps the market is catching on to this possibility, with the All Ordinaries Index closing down 3.6% over the week. We’ll keep you posted with daily reporting wraps and twice- weekly special podcasts, and more detailed reviews when appropriate.

thought for the weekA cyclical downturn in profits

is one thing, but a more pressing issue for many income investors is the drastic downturn in dividends this season. For those who rely on a regular dividend flow to cover their living expenses, there is no easy

response. But an explanation of why it happened might be comforting.

Australian companies have gone through a much-needed and very large recapitalisation process this year (we’re referring to those share purchase plans clogging up your mailbox)—a direct result of borrowing too much in the boom years and having that access to debt snapped away in a hurry during the credit crisis. While replacing cheap debt with expensive equity is likely to hobble longer term returns from the stockmarket, many companies will find a firmer financial footing as a result.

The irony is that just as most income investors are coming to the conclusion that company dividends cannot be completely relied upon, those dividends may actually be becoming more reliable. We’re referring to next year and beyond, though. This year will deliver poor dividends to investors and its memory should never completely melt away when one is considering portfolio allocation in the years ahead.

armageddon averted…for now

1 5 – 2 1 a u g u s t 2 0 0 9

Recommendation changesARB Corporation downgraded from Buy to Long Term BuyAustraland ASSETS downgradedfromBuy for Yield toHoldDexus RENTSdowngradedfromBuy for YieldtoHoldGoodman PLUS TrustupgradedfromHoldtoBuy for Yield Perpetual downgraded from Buy to Long Term Buy

FeatuRe aRticLes page

Investors College: The art of reading between the lines 11Bristlemouth: Will the Internet Destroy Flight Centre? 12Ask the Experts 14

detaiLed stock Reviews stock asX code Recommendation page

ARB Corporation ARP LongTermBuy 2Australand ASSETS AAZPB Hold 5Dexus RENTS DXRPA Hold 5Goodman PLUS GMPPA BuyforYield 5Perpetual PPT Hold 3QBE Insurance Group QBE LongTermBuy 9STW Communications SGN Buy 7

updates BlueScope Steel BSL Sell 10Brambles BXB Hold 10NIB Holdings NHF Hold 10

2 the intelligent investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

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arb bumps the crisis

tough times clearly highlight the difference between great companies and everything else.

aRB coRpoRation (aRp) $4.31

19 Aug 2009SECOND LINE INDUSTRIAL

$2.55–$4.34

3 3.5

LONG TERm BUY

INFORMATION CORRECT AT

STOCK CATEGORY

MARKET CAPITALISATION

12-MONTH SHARE PRICE RANGE

BUSINESS RISK out of 5 SHARE PRICE RISK out of 5

OUR VIEW

Anyone who’s been following four wheel drive accessories company ARB Corporation for a decade or more ‘could be forgiven for getting a little blasé about the consistent double-digit growth in sales and earnings’. Those were the words we used in our review on 21 Feb 08 (Long Term Buy—$4.12). The result for the year to 30 June 2009, with sales up 11% to $191.2m and net profit up 15% to $22.5m, may simply cause more shrugging of the shoulders.

The company deserves more ardent support. With earnings per share up 15% to 33.9 cents and a fully franked final dividend of 10 cents declared (ex date not yet known), the yearly total dividend rose to 16.5 cents from 15 cents last year. It was a particularly impressive result in a tough year, continuing more than a decade-long run of record sales and profits. Over the past ten years, sales have grown at an average of 14% per year and net profits at 18%. There aren’t many companies that can boast of such numbers.

Australian aftermarket sales, which make up roughly 60% of total sales, were up an impressive 19% this year, a reflection of the growing number of stores and product additions like the Thule rack business. Offsetting this, USA sales were down 8% in US dollar terms (but up 12% in Australian dollars) and non-USA exports also down 8%. And Original Equipment Manufacturer (vehicle manufacturer) sales, which are lower margin and constitute about 8-10% of ARB’s business, fell 7%.

Partly due to the economic slowdown, partly a result of the higher Australian dollar, which has the effect of reducing the local currency value of US dollar sales,

overall sales growth in the second half was more subdued, only growing 5% compared with the half year ended 30 June 2008.

Management noted pleasing sales of new products such as the ARB fridge/freezer and Nitrocharger Sport shock absorbers, although no numbers were released. Importantly, expenditure on research and development has been maintained, which is, in our view, the key to future growth. Another interesting development was the creation of ARB Off Road Ltd in Thailand to wholesale ARB products in Thailand, Vietnam, Laos and Cambodia. It’s early days and expectations are modest, but Thailand in particular has a huge pickup market and ARB already has a reputation in the region.

debt free and ready to rollAt $28.2m versus net profit of $22.5m, operating cash

flow was impressive. But this is at least partly attributable to a second-half manufacturing slowdown (which had reversed by the end of the half) that saw inventories and receivables grow more slowly than sales. The extra cash, however, has allowed ARB to eliminate its already modest debt.

FinancialsYEAR TO 30 JUN 2007 2008 2009 2010E

Revenue ($m) 146.1 171.6 191.2 200.0

NPAT ($m) 15.8 19.6 22.5 24.0

EPS (c) 23.7 29.5 33.9 36.0

PER (x) 18.2 14.6 12.7 12.0

DPS (c) 13.0 15.0 16.5 17.5

Fkg (%) 100 100 100 100

Yield (%) 3.0 3.5 3.8 4.1

In a related matter, management hinted that a special dividend is under consideration. The company has the franking credits to pay a fully franked 50-cent special dividend in addition to the final dividend, but would need to borrow to do so. If a special dividend is declared, it might be more in the region of 20-25 cent per share.

Reliant as it is on sales of big-ticket items, tough economic conditions may yet cause ARB some damage. But the company is well placed to seal its dominant market


WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary.The Intelligent Investor and associated websites are published by The Intelligent Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288).

DISCLAImER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.COPYRIGHT The Intelligent Investor Publishing Pty Ltd 2009. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only.

DISCLOSURE In-house staff currently hold the following securities or managed investment schemes:AAU, AEA, AHC, ANZ, ARP, AWE, BEPPA, CBA, CDX, CHF, CLS, CND, COH, COS, CRS, CXP, DBS, EFG, FLT, GMPPA, GNC, HVN, IAS, IDT, IFL, IFM, IVC, KRS, LMC, LWB, MFF, MLB, MMA, MNL, MQG, NABHA, NHF, OEQ, PRY, PTM, RHG, ROC, SAKHA, SDI, SFC, SGN, SHV, SIP, SOF, SRV, STO, TGR, TIM, TIMG, TIMHB, TLS, TRG, TRS, TWO, WBC, WDC and WHG. This is not a recommendation.Thanks to IRESS for the charts and price information.

Important information about The Intelligent Investor

3the intelligent investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

The Intelligent Investor 15–21 August 2009

perpetual performance impresses again

position should they do so.The stock is up 51% since our last mention on 18

Feb 09 (Buy—$2.85) and all appears to be travelling to plan. Although the company remains one of the largest holdings in our Growth portfolio, we are downgrading a notch because the stock is not the outright bargain it once was. It’s still quite cheap, though, and remains an attractive LONG TERM BUY.

Postscript: At a recent broker conference, managing

director Roger Brown explained that management intends to fully underwrite any special dividend. So the company wouldn’t need to borrow to pay a special dividend, and could therefore pay 50 cents per share. Of course, it would be no free lunch, with the bigger dividend causing greater dilution. Thanks to Mark W for pointing this out.

Disclosure: The author, Gareth Brown, owns shares in ARB Corporation.

despite another misstep, good fund performance numbers and a stronger sharemarket mean there’s light at the end of the tunnel for perpetual.

peRpetuaL (ppt) $36.17

19 Aug 2009BLUE CHIP INDUSTRIAL

$22.23–$51.45

3 3.5

HOLD


STOCK CATEGORY




OUR VIEW

Roger Burrows, chief financial officer of Perpetual, must hate making company presentations. While his boss, David Deverall, gets to talk about all the fun stuff, Burrows gets lumped with revealing all the problems. After having to talk in depth about the Exact Markets Cash Fund (EMCF) and Perpetual Protected Investments (PPI) debacles in past presentations, Burrows was charged with revealing another stuff-up in the 2009 results presentation—$12.8m worth of rebate and unit pricing errors.

As management admitted, unit pricing of managed funds is a complex area, and mistakes are to be expected. But the magnitude of these errors is significant, and every misstep is a mark against Perpetual’s brand. At least the company is lucky to have plenty of ‘brand equity’ to spare, largely thanks to the continued outperformance of key funds.

This strong performance has been our key reason for recommending Perpetual (you can see details of this outperformance on page 14 of the results presentation, although the numbers would look less impressive if fees were deducted). Management estimated that this outperformance generated $800m of additional funds under management during the 2009 financial year. In other words, investors in Perpetual’s various funds were $800m better off than if they had been invested in the relevant benchmarks.

Keeping activeLike Platinum Asset Management, Perpetual can

claim that its fund managers add value over and above ‘passive’ investing (such as buying an index fund). This should drive future inflows, which we’ve already begun to observe at Platinum recently. Pleasingly, Perpetual won $1bn of new institutional funds during 2009, although this business is lower margin than retail money.

Turning to the result itself, profit was a little weaker than expected due to the pricing errors we’ve highlighted. With the weak sharemarket, revenues fell 24% to $375.1m, while underlying profit fell 51% to $65.7m. Deducting restructuring costs, EMCF losses and writedowns on seed investments saw the bottom line fall 71% to $37.7m. A final dividend of 60 cents fully franked was declared, making 100 cents for the year (down from 330 cents).

FinancialsYEAR TO 30 JUN 2007A 2008A 2009A 2010E

Revenue ($m) 445.2 476.3 375.1 395.0

EBIT ($m) 209.8 193.6 98.2 110.0

NPAT ($m)* 145.3 133.5 65.7 75.0

EPS (c) 353 321 156 176

PER (x) 10.2 11.3 23.2 20.6

DPS (c) 360 330 100 140

Fkg (%) 100 100 100 100

Yield (%) 10.0 9.1 2.8 3.9

* Underlying net profit

There’s also early evidence that Perpetual’s escapades into higher risk products won’t cause too many long term problems, as we proposed back on 2 Mar 09 (Buy—$23.03). In the Exact Markets Cash Fund, management expects to recoup most of the $55m of marked-to-market losses over the next few years. Already there’s been some recovery in the corporate bond market, although not in mortgage-backed securities. Management has promised that any recouped EMCF losses will flow through to shareholders as dividends.

We expressed particular concern about potential


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losses from the Perpetual Protected Investments on 2 Mar 09, but this product seems to be naturally winding down. The poor performance of the PPI means investors have redeemed products and repaid loans worth $109m recently. The current value of the PPI loan book is around $212m (down from $332m) and it should decline further this year.

small acquisitions likelyInstead, growth will come from less risky areas.

Deverall has highlighted that he wants to increase the size of Perpetual’s Private Wealth division. The company currently has about 1.5% of the ‘high net worth’ market and there are opportunities to extend the company’s respected brand in this area. Small acquisitions in the range of $5m-$20m are likely, which partly explains why the company has increased its debt facilities from $45m to $70m. This lower risk growth represents a

discernible—and welcome—shift in Perpetual’s strategy.Perpetual’s profits are very dependent on market

movements, so the recovery in the sharemarket since March bodes well for higher profits in 2010. The company’s managed funds division, Perpetual Investments, saw profits slump 60% in 2009, but is likely to see a reasonable snap back this year. If the ‘natural level’ for the market is around current levels or higher, then our high end valuation for Perpetual Investments from 20 Mar 9 (Long Term Buy—$28.50) of $838m is probably a little undercooked.

But, while there’s still share price upside if the market continues to rise, the margin of safety has reduced significantly. With the share price up 27% since 20 Mar 09, we’re downgrading to HOLD.

Disclosure: The author, James Greenhalgh, owns shares in Platinum Asset Management, as do other staff members.

as ‘bottom up’ investors we tend to focus on the individual cash flows of a business. But pitching three property income securities against each other has resulted in an upgrade.

Owners of Goodman PLUS floating rate securities were buoyed recently when their issuer, Goodman Group, announced a massive $1.8bn recapitalisation. Having fortified the Goodman PLUS securities, we recalibrated our recommendation guide on 11 Aug 09; Buy for Yield up to $60.00.

However, later that night I felt the recommendation was a bit harsh in light of our positive recommendations on fellow property income securities Australand ASSETS and Dexus RENTS. So in this review we’re going to pitch the securities against one another. But first let’s recap how they work.

part equity, part debtAt prevailing prices we’re not interested in the ordinary

securities of the issuers, Dexus, Goodman Group and Australand. We favour the floating rate securities (or ‘hybrids’) because they escape dilution if there are further equity raisings and rank ahead of ordinary security holders when distributions are paid and in a wind up situation—though they’d both likely receive zilch once the creditors had pecked over the carcass.

In that sense, hybrids resemble ordinary equities, but they mimic debt securities by paying quarterly distributions based on the 90-day bank bill rate (which

fluctuates with the official interest rate) plus a margin, as you can see in the table.

The carrot for investors is a potential ‘step up’ in the margin or a potential capital gain if the securities are redeemed at their $100 face value. We highly recommend reading past reviews, which discuss further particulars.

weighing in DExUS RENTS GOODmAN PLUS ASSETS

Price ($) 83.00 59.25 75.52

Securities issued (m) 2.04 3.27 2.69

90-day b’bill (%) 3.275 3.275 3.275

Current margin (%) 1.3 1.9 4.8

Yield (%) 5.5 8.7 10.7

Step-up date 1/7/12 21/3/13 1/10/08

Step-up margin (%) 3.3 2.9 4.8

Conversion discount (%) 2.0 1.0 2.5

From where we sit, higher interest rates will be needed to ward off inflation due to prolific government spending. This will boost distributions, provided higher interest rates don’t impair the issuer’s capacity to pay them. However, if we’re at the beginning of a protracted Japanese-style depression replete with ultralow interest rates, investing at current prices will be a mistake.

With that caveat in mind, let’s analyse the business and financial risks facing the issuers, which will help determine the price we’re prepared to pay for their hybrid offspring.

an each way bet on property income securities



business modelsOur three issuers are listed property trusts, but they

vary in numerous ways. Dexus earns 96% of its profits from rent collection, harking back to the days when income investors coveted dullness and predictability. However, Dexus didn’t practice abstinence in the boom and bought foreign property for which it is currently repenting (foreign occupancy stands at 88.0%, compared to 97.2% in Australia). Dexus RENTS owners are also praying the Sydney office property market doesn’t collapse, as you can see in the chart.

dexus portfolio diversification ($bn)

US industrial

Aust. industrial

Aust. retail

Other Aust. office

Sydney office

European industrial

0.2

1.7

1.5

0.3 1.3

2.7

Management fees from a wholesale fund ($2.9bn), mandates ($2.6bn) and syndicated assets ($0.2bn) constitute the remaining 4%. In stark contrast to Goodman Group, which manages a suite of wholesale and listed funds totalling $14.9bn, Dexus doesn’t invest its own cash in the funds.

plenty to loseGoodman Group has $2.7bn invested across its nine

highly leveraged Asian and European funds. Though lenders can’t seek restitution from Goodman if the funds default on their debt obligations (the debt is non-recourse, like that used in GPT Group’s disastrous European joint venture with Babcock & Brown), Goodman recently set aside $250m to bolster the funds and protect its

investments. Unlike Dexus, a major collapse in Goodman’s funds would threaten its financial position.

Goodman also owns $2.8bn of high quality industrial real estate primarily in Australia ($2.1bn), the remainder is spread across Europe and the UK. However, this relatively staid portfolio is flanked by a risky development arm, which is expected to produce a recessionary $77m of revenue in 2010, compared to $388m in 2008. Goodman’s sprawling and highly leveraged empire makes it a riskier proposition than Dexus, in our view.

Apart from the funds management division, Australand resembles Goodman. However, Australand owns $2bn of mostly smaller and lower quality Australian industrial (53%) and office (42%) property. And because it’s also one of Australia’s largest residential developers, Australand

arguably has the riskiest business model of our three issuers, which brings us to refinancing risk.

refinancing riskIf Goodman’s 75% net debt-to-tangible equity (hybrid

securities are treated as debt but fund debt is netted off against fund assets) ratio smells, then the funds reek to the sky with their own $7.5bn pile of debt. Following the recapitalisation, however, Goodman’s next major debt expiry will move out to May 2012, providing breathing space to sell assets, raise further equity or renegotiate loans (2011 looms as the next major hurdle for the funds).

Dexus’s 55% net debt-to-equity ratio is the lowest of the three (Australand’s is 61%), but its $2.9bn of debt matures progressively from 2010 (negotiations are currently underway) and management’s rekindled desire to acquire assets has us concerned. The majority of Australand’s debt comprises a $950m bank loan, which expires in June 2011; an ill-timed re-emergence of the credit crisis could make refinancing difficult.

white knightsHowever, CapitaLand, which owns 59% of Australand,

has ridden to the developer’s rescue twice within a year and would likely do so again in a crisis; in the same way that Goodman has moved to protect its fund investments.

Though Goodman performed a successful financial Heimlich manoeuvre on China Investment Corporation (CIC) which coughed up $700m (through a $200m loan and $500m of hybrids), CIC has a higher incentive to abandon a sinking HMAS Goodman until it becomes an ordinary securityholder (via a seperate options package or by converting the hybrids), particularly given that the sheer size of Goodman’s empire would make it harder to rescue.

Size often equates to safety in property because large properties occupying prime locations usually perform better than their smaller rivals in a downturn. But when

it comes to debt, it’s often a case of ‘the bigger they are, the harder they fall’.

Deciding who has the riskiest financial structure is therefore somewhat subjective, but Dexus’s lower gearing provides comfort. Forced to choose between Goodman Group and Australand, overall we favour Goodman Group, given the latitude provided by its lenders and its higher quality assets. Now let’s get down to price.

getting down to priceOn safety grounds, Mr Market agrees with our

preference for Dexus over Goodman and Goodman over Australand, judging by their current yields (higher risk

comparative informationCOmPANY ASx CODE PRICE AT REvIEW FUNDAmENTAL RISk SHARE PRICE RISk OUR vIEW

Australand ASSETS AAZPB $75.52 3.5 3.5 Hold

Dexus RENTS DXRPA $83.00 3 3 Hold

Goodman PLUS GMPPA $59.25 3 3 Buy for yield


STOCKS IN DETAIL

is reflected in a higher yield). The question is, how much are we willing to pay for each security?

dexus Rents

Buy for Yield Up to $80

Hold Up to $90

Take Part Profits Up to $100

Sell Above $100

Dexus RENTS are currently trading on a paltry 5.5% yield, which jumps to a more attractive 7.7% on the step up date (assuming interest rates haven’t changed). However if Dexus decides to redeem the securities in cash or ordinary Dexus securities, instead you’ll pick up an additional 6% annual capital gain. All up, an annual return above 11% isn’t too shabby in a low interest rate environment, but given management’s rejuvenated appetite for acquisitions and the 11% increase in the security price since 8 Jul 09 (Buy for Yield—75.00) we’re downgrading to HOLD.

australand assets


Hold Up to $90


Sell Above $95

Australand ASSETS are yielding 10.7%, which reflects its riskier business model and financial position. Our view remains unchanged since we upgraded on 29 Jul 09 (Buy for Yield—67.00) so the higher price has prompted us to downgrade by a whisker to HOLD.

goodman pLus


Hold Up to $75


Sell Above $85

We’ve recalibrated our recommendation guide for the Goodman PLUS securities and judge that an 8.7% yield is adequate compensation while we wait for interest rates to increase, the margin to step up, or a potential 69% capital gain if the securities are redeemed at their $100 face value. BUY FOR YIELD up to $62.00.

summing it upTo recap, if interest rates fall and remain low then our

issuers will be reluctant to redeem the securities as they provide a cheap source of funding. Under this scenario, we’ll be stuck with low distributions and lousy returns. Your own view of the future path of interest rates is a vital consideration.

Tipping our hat to the risk of a property crash triggering another credit crisis, and that one property group might be hit harder than another, we recommend keeping each security to no more than 2% or 3% of your portfolio and as a group they should constitute no more than 8%.

Higher interest rates are toxic to stock values. But perhaps in this case the goldilocks scenario is a 1% or 2% increase in official interest rates, which would boost distributions without threatening the survival of their issuers. With the spring carnival looming, it’s an each way bet worthy of consideration.

Disclosure: The author, Nathan Bell, owns Goodman PLUS securities.



this diversified advertising and marketing group has been back in favour with investors lately. Yet its potential continues to be underestimated.

stw communications (sgn) $0.755


$0.32–$1.38

3 3

BUY


STOCK CATEGORY




OUR VIEW

STW Communications remains one of only half a dozen stocks we currently believe to be more than 30% underpriced (our cut-off for an outright Buy recommendation). That the stock has already risen 72% since 28 Apr 09 (Buy—$0.44) illustrates two points; one relates to the stock price itself and the other to the business’s fundamentals.

Firstly, the stock became far too cheap back in April. ‘We view this as a terrific investment opportunity’ we

remarked at the time, raising our Growth portfolio’s holding in the stock. Secondly, business conditions and expectations have moderated from the abject fear that abounded in April.

latest figuresThe recent half-year results to 30 June reinforced

management’s reputation for running the business ‘by the numbers’, with the group remaining comfortably profitable in a period when large multi-national clients were aggressively cutting their marketing budgets. Revenue from ‘Globally aligned clients’, which account for 43% of STW’s top 50 customers, fell by an average of 15%.

Blue chip domestic clients (the other 57% of the top 50 customers) actually increased their spending by an average of 5%, resulting in overall revenue falling by 10%. Management responded by swiftly cutting the business’s main variable cost; staff. The group shed 271 jobs in the half-year at a cost of $2.3m. The financial benefits of that action should flow through in the second half results as the company moves through the rest of the year with 11.5% less staff.

All up, underlying profit for the half-year fell by 19% to $13.9m and management remains confident of achieving its forecast of $33m in underlying profit for the full year (which would be roughly in keeping with the group’s traditional 40:60 profit split between the first and second

half of the year). A fully franked interim dividend of 1.5 cents per share was declared (ex date 8 Sep), which should place the final dividend at two cents per share or

stw shines in tough times

table 1: key financial projections 08A 1H09A 2H09F FY09F 10F 11F 12F 13F

Underlying EBIT ($m) 85.2 30.1 45.0 75.1 85.0 92.5 100.0 105.0

Finance costs ($m) 20.4 7.3 4.5 11.8 10.0 11.5 12.0 12.0

Tax ($m) 12.9 5.8 11.0 16.8 21.0 22.7 24.6 26.0

NPAT ($m) 28.3 17.0 29.5 46.5 54.0 58.3 63.4 67.0

minority interests ($m) 11.3 4.2 9.5 13.7 16.0 18.0 19.5 20.5

NPAT to STW ($m) 17.0 12.8 20.0 32.8 38.0 40.3 43.9 46.5

Shares on issue (m) 191.5 364.3 365.0 365.0 368.0 371.0 374.0 377.0

Earnings/share (c) 8.9 3.5 5.5 9.0 10.3 10.9 11.7 12.3

Dividends/share (c) 8.0 1.5 2.1 3.6 4.1 4.3 4.7 4.9

PER (x) 8.5 8.4 7.3 6.9 6.4 6.1

Dividend yield 10.6% 4.8% 5.5% 5.8% 6.2% 6.5% CASH FLOW CALCULATIONS

Cash after dividend ($m) 6.3 13.4 19.7 22.8 24.2 26.3 27.9

Earn-outs due ($m) 13.9 9.0 22.9 21.9 37.7 11.7 15.5

Cash surplus/(deficit) ($m) (7.6) 4.4 (3.2) 0.9 (13.5) 14.6 12.4

Reinvestment/acquisitions ($m) (2.4) (8.0) (10.4) (8.0) (8.0) (10.0) (10.0)

Total cash surp./(rqrmt) ($m) (10.0) (3.6) (13.6) (7.1) (21.5) 4.6 2.4

Closing cash ($m) 43.0 33.0 29.4 29.4 32.0 34.0 36.0 38.0

Closing debt ($m) 206.2 107.8 107.8 107.8 117.5 141.0 138.4 138.0

Debt re-financing required ($m) – 119.0 147.5 – 2.2


STOCKS IN DETAIL

Now to the important issue of valuation. You’ve seen some rough estimates for future profit in Table 1. They include a recovery in 2010, back to 2008 levels of around $85m in gross EBIT. From there we’ve projected another two years of solid but not spectacular profit growth followed by a more pedestrian rate in 2013. Again, these numbers are intended to be more illustrative than predictive.

To these gross EBIT numbers we’ve applied a valuation multiple of six. That might seem relatively modest but the low-looking multiple is offset to a degree because not all of the EBIT is attributable to STW shareholders (a portion flows to former vendors of businesses which retain some ownership in their companies as ‘minority interests’).

In the pre-boom years, an EBIT multiple of four was common in the private market for such businesses. We’re comfortable with a higher multiple for STW given its listed

status (one benefit of which was clearly illustrated by this year’s mammoth capital raising) and the—dare we say it—synergy and diversity within its collection of companies.

Table 2 projects out the valuation based on this EBIT multiple of six and then cross-checks it by calculating a PER and yield for each year at the implied value per share.

It seems inappropriate to judge the business’s long-term value based on 2009’s depressed earnings, so we’re inclined to focus more on the 2010 number. That lands us north of $1 per share, which seems a sensible estimate of the group’s intrinsic value and leaves a healthy margin of safety for today’s buyer. Additionally, there could be substantial upside to these numbers if the economy and corporate marketing budgets rebound quickly.

Recommendation guide

Buy Below $0.80

Long Term Buy Up to $0.95

Hold Up to $1.25

Take Part Profits Above $1.25

If you’re a natural contrarian, you may find it difficult to be attracted to a stock which has risen by 72% over the past four months. But it’s crucial to remain focused on the gap between price and value.

Today’s buyer should enjoy a respectable fully franked starting dividend yield of 4.8%, which we expect to grow by more than 8% per annum over the next few years. And, if that happens, decent capital gains

slightly higher. That total dividend of at least 3.5 cents for the year is higher than our previous expectations, due mainly to our earlier conservative forecasting.

bouquets for management

We have to hand it to management. STW’s long-term strategy of diversifying into niche businesses (where profit fell by 12% compared to the traditional advertising agencies which were down 17%) seems to have paid off, financially it is on the front foot following a capital raising earlier this year and tough operational management has softened the blow falling revenue might have otherwise dealt to the bottom line—as promised at the group’s annual meeting.

STW is now in rude financial health after a 7-for-8 entitlement offer earlier in the year which sawed its debt level almost in half. Our extensive financial analysis

indicates that the group should be able to comfortably pay out dividends, finance its outstanding earn-out payments (to the vendors of previously acquired businesses) and make a modest number of additional acquisitions without asking shareholders for more funds. That assumes the banks will roll over its existing debt facilities when they fall due in 2010 and 2011, which shouldn’t be a problem. Even if the group’s earnings don’t rebound sharply from the depressed levels of 2009, interest cover should remain above five times.

longer-term calculationsTable 1 (on the previous page) sets out some relatively

conservative figures for the next five years. We’re typically reticent to reveal such longer-term calculations lest the detail be mistaken for predictive conviction. But with that caveat in mind, this analysis provides a guide as to what the future may look like.

From a dissection of projected earnings, our figures then take accounting profits as a proxy for cash flow (a comfortable assumption given STW’s businesses typically don’t require a lot of capital). After deducting projected dividends and known earn-out payments, an additional amount has been subtracted for future acquisitions and related earn-outs, as well as reinvestment in the business (which is in prospect for this half following the tremendous $36.1m of free cash flow extracted in the first half). We’ve then used our own judgment to apportion any cash surplus or deficit to the cash balance or debt levels.

table 2: valuation and cross-check 2009F 2010F 2011F 2012F 2013F

EBIT (gross) multiple of six—valuation ($m) 450.5 510.0 555.0 600.0 630.0

Equity valuation (after subtracting debt) ($m) 342.7 392.5 414.0 461.6 492.0

valuation per share ($) 0.94 1.07 1.12 1.23 1.31

PER at valuation (x) 10.4 10.3 10.3 10.5 10.6

Dividend yield at valuation 3.8% 3.9% 3.9% 3.8% 3.8%



should also be forthcoming (providing the option of cashing out and moving on to another opportunity). Our recommended portfolio limit of 6% remains, as does our

recommendation. BUY.

Disclosure: Interests associated with the author, Greg Hoffman, own shares in STW Communications, as do other staff members.

it’s been one of the worst years ever for insurance businesses around the globe. meanwhile, QBe has gone from strength to strength.

QBe insuRance gRoup (QBe) $22.06


??’??

2.5 3.5

LONG TERm BUY


STOCK CATEGORY




OUR VIEW

Not much needs to be said about QBE’s half-yearly result; the numbers speak for themselves. Thanks to the GFC, the claims ratio—at 60.8% of all premiums collected—was the highest it’s been since 2005 and the return on invested funds (a crucial source of profit for any insurance company) was a paltry 3.3%. Yet despite these headwinds the company managed a 19% increase in net profit and a 6% increase in earnings per share. The interim dividend was also raised a little to 62 cents per share (only 20% franked).

FinancialsYEAR TO 31 DEC 2006A 2007A 2008A 2009E

Net earned prem. ($bn) 8.1 10.2 11.1 13.3

Claims ratio (%) 55.8 54.3 57.6 60.0

Combined op. ratio (%) 85.3 85.9 88.5 89.0

NPAT ($bn) 1.5 1.9 1.9 2.3

EPS (c) 173 217 206 225

PER (x) 13 10 11 10

DPS (c) 95 122 126 128

Fkg (%) 60 55 20 20

Yield (%) 4.3 5.5 5.7 5.8

This is one of Australia’s best management teams and has again proved its worth over the past six months. The $2.1bn of capital raised in the QBE’s Christmas share purchase plan has been put to work, extremely volatile capital markets have been successfully navigated and recent acquisitions have been profitably integrated.

A deal we questioned at the time, last year’s acquisition of mortgage insurer PMI, for example, has paid extraordinary dividends so far.

Many insurance companies generate a loss on their underwriting operations but make a profit by investing the premiums until they are paid out. QBE, overall, generated an insurance profit of about 10% of its premiums, making it one of the world’s most profitable diversified insurers. The PMI part of the operations returned an astonishing profit of 46% of premiums. This is undoubtedly a lumpy business and when the losses come, they will come in squadrons, but we’re prepared to accept that CEO Frank O’Halloran knows better than us and let him get on with the job.


Buy Below $18

Long Term Buy Up to $25

Hold Up to $40

Take Part Profits Above $40

The share price is up a touch since the final installment of QBE’s quality assurance on 1 May 09 (Long Term Buy—$21.79) but has traded at less than $20 for a substantial part of the last three months. Hopefully you’ve been able to make this high quality blue chip a part of your portfolio at cheaper prices but, if not, it’s not too late. This is a stock we’re happy to hold for a long time and a few dollars here or there won’t make a huge difference to your final returns. LONG TERM BUY.

Steve Johnson

QbE thrives in gfc


management teams stop treating shareholder reports as a Public Relations exercise, the sooner we can stop approaching such reports in the manner of World War II decoders.

The fact that underlying net profit fell by 9% in constant currency terms to USD$534m is nothing to hide from. Brambles’ main business, CHEP, holds a position in the global economy that other companies might kill for. And it’s no secret that the past financial year was a shocker for the world economy, so a fall in profit is not indicative of poor management in this case.

In CHEP’s three geographical areas—Americas, EMEA (Europe, Middle East and Africa), and Asia-Pacific, sales in constant currency terms were flat to up a little. But in the two biggest markets, Americas and EMEA, sales to existing customers were down 4-5% and this was completely offset by new business wins. So the company’s revenues look set to jump when the volumes of its existing customers recover.

Nothing in the results significantly altered our conclusions from The basics of Brambles (issue 268). Capital expenditure at CHEP fell sharply (>20%) for the 2009 financial year, leaving an extra $200m in the bank. Management lauded the increased free cash flow (more spin) but this is a natural result of the slowdown reducing the need for new pallets, not a permanent feature. Our belief that CHEP is an ‘irreplaceable, monopolistic capital sinkhole’ remains unchallenged.

Directors declared a final dividend of 12.5 cents, 20% franked, bringing the yearly total to 30 cents, down 13%. With the share price up 25% since 21 Mar 09 (Hold—$5.71), it’s moved further away from the ‘below $3’ price at which we suggested Brambles would be irresistible. But we’re sticking with HOLD.

Gareth Brown

niB hoLdings (nhF) $1.05


HOLD


STOCK CATEGORY

OUR VIEW

Private health insurer NIB’s 11% drop in full year net profit, to $23.8m, masked a sterling 22% improvement in the company’s insurance profit, to $40.2m. The rift followed a $1.8m investment loss (which contrasts poorly against the $7.5m gain in 2008), propagated by stock market losses at home and abroad. A fully franked dividend of 4.4 cents was declared (ex date not yet known), bringing full-year distributions to 7.4 cents.

Overall, this was an excellent result, in our view. While enduring government meddling with the Medicare Levy Surcharge, the global financial crisis and a scandal at head office, NIB swelled its membership ranks by 5.2%, compared to 3.0% for the industry. Rationalising branches also cut costs, helping lift the insurance margin (which excludes investment returns) to 4.8%, from 4.4%.

BLuescope steeL (BsL) $3.15


SELL


STOCK CATEGORY

OUR VIEW

For years, we made the case that BlueScope Steel was worth no more than its net tangible asset value. For years, as the stock rose to a price in excess of three times NTA, many arguments were mounted—‘China’, ‘India’, ‘one billion new middle class consumers’, ‘globalisation’—that disputed this view.

If history delivers a verdict at all, this is perhaps one case where it falls in our favour. BlueScope and others profited from conditions that were temporary. The cyclicality of this business did not go away; it was merely well disguised.

Vast profits, a result of unexpected and equally huge increases in demand, were eventually eroded by annual demand growth returning to more normal levels, and by massive supply increases, particularly in Asia. The China story failed to trump the cyclical nature of this business, a fact more than adequately revealed in the latest result.

The company today reported a full year net loss after tax of $66m and an underlying NPAT of $56m. Culling the final dividend was responsible practice, as was the capital raising in June. The slowdown has been harsh and, while there may be some scope for a turnaround, we don’t envy management’s task.

With the results media release headlined BlueScope Steel ready for recovery, the board clearly seems more optimistic. The goldilocks economy, it appears, is a seductive, alluring concept, especially for those that have been great beneficiaries of it.

Optimistic or not, one doesn’t need to be a steel industry expert to identify a mediocre business. BlueScope fits the bill pretty well. Despite its share price falling 71% since our last mention on 3 Mar 08 (Sell—$10.88) it still trades in excess of its $2.46 NTA. Better to look for good businesses or dirt-cheap stocks. BlueScope fails to satisfy either of these criteria. SELL.

Gareth Brown

BRamBLes (BXB) $7.15


HOLD


STOCK CATEGORY

OUR VIEW

Brambles’ full year results, which you can download here, were titled ‘Brambles delivers revenue growth and strong cash flow—well placed to accelerate financial performance as economies recover.’ Those who’ve read James Greenhalgh’s recent Investor’s College article, The art of reading between the lines (see page 11), can perhaps already guess what happened to net profit by its absence from that headline; it fell. The sooner

COMPANY UPDATES



the art of reading between the lines

If membership grows between 4% and 6% in 2010, and the insurance margin improves again to between 5.0% and 5.5%, a $45m to $50m insurance profit is forecast; a 12% to 24% improvement over 2009.


Long Term BuyUp to $0.78

HoldUp to $1.14

Take Part ProfitsUp to $1.28

SellAbove $1.28

Though we laud management’s focus on shareholder returns, and the quality of business information that it releases, plans to embrace debt to lift return on equity to 15% makes us uncomfortable; the company’s pristine balance sheet is one of its major attractions. The share price has increased 28% since 5 Jun 09 (Hold—$0.82) and we’re edging closer to the exits. HOLD.

Disclosure: Staff own shares in NIB Holdings, but they don’t include the author, Nathan Bell.

INVESTOR’S COLLEGE

companies rarely say what they mean, but decoding announcements is a skill you can develop.

Nobody likes a critic, so they say. But being critical, we propose, is a big part of the savvy investor’s job. Criticism—or, as we prefer to call it, independent thinking—is vital to successful investing. Today’s sad reality is that most companies feel they must sell a story to their shareholders, their employees, their customers and, most of all, the media. And, with the pressures facing traditional media outlets, journalists frequently fall for these stories hook, line and sinker.

‘Spin’ is everywhere. Too many annual reports have the paw-prints of public relations firms all over them. Even companies that don’t actively go out of their way to disguise bad news (plenty do) still insist on putting their best foot forward.

It’s vital, then, that you learn to read company reports, presentations, announcements and media reports with a critical eye. Like patience, it’s a habit you need to actively cultivate. Let’s refer to a couple of recent company announcements with the intention of ‘reading between the lines’.

hills hoist on its own petardTake security cameras-to-clothing hoists manufacturer

Hills Industries’ recent profit result (head to the recent ‘Preliminary Final Report’ announcement to the ASX if you want to follow along). In the announcement, Hills reiterated that it would no longer pay 100% of profits as dividends, and that it was raising $50m of capital. Then, on page 2 of the announcement, Hills stated: ‘Also today we can advise that we have extended the term of our banking facilities with our principal lender to November 2011’. Our translation of this announcement is:

‘Hills’ debt levels have proven to be too high for the

difficult credit markets that have characterised the 2009 financial year. As a condition of extending our debt facilities, our lender requested that we reduce our dividend payout ratio and conduct a capital raising’.

Hills would not phrase it like that, of course, because it implies management got the company’s capital structure wrong. Like a lot of capital intensive manufacturing businesses, Hills’ free cash flow has been insufficient to pay high dividends for many years (Crane Group is another example). These companies have funded their unsustainably high dividend payout ratios with regular capital raisings and increasing debt levels. But this only works while the economy is buoyant and, now that it isn’t, Hills’ financial position is stretched. We ceased coverage on Hills on 14 Feb 07 (Sell—$5.58) because of its poor free cash flow and unsustainable dividends.

Zoned outThen there was the seemingly innocuous ‘Trading

Update’ by mobile phone and computer retailer Vita Group, which operates the Fone Zone and Next Byte chains, on 24 July. The profit guidance didn’t concern us; rather it was the statement in the last paragraph that ‘Vita Group is in discussion with Telstra regarding the early renewal of the company’s long term dealer arrangement [to sell Telstra products through Fone Zone]’. Vita Group went on to note that ‘finalisation of the discussion has been slightly delayed and it is now expected that the new dealer arrangement will be in place within the next few weeks’.

It’s impossible to know the reasons for the delay, or what the outcome will be. But we do know the context, which is that Vita Group’s financial position is uncomfortable, and that Fone Zone depends on a very


INVESTOR’S COLLEGE

powerful supplier, Telstra, which demands exclusivity and the meeting of sales targets. Reading between the lines, a translation of this announcement might read something like this:

‘Fone Zone’s sole supplier of telecommunications products, Telstra, has been reviewing its arrangements with the company. We have been unable to agree to the contract terms Telstra proposed, and hope to conclude sales targets that are acceptable to the company shortly.’

The reality is that Telstra already holds the power in this relationship, and that Vita Group’s financial situation means it is in a poor bargaining position. We covered Vita Group as one of our Retailers on the brink on 2 Feb 09.

buried treasure?Unfortunately it has become all too common to see

important information buried at the end of company announcements. And the practice isn’t confined to the companies we’ve avoided. In June 2008 Fantastic Holdings announced an acquisition, but the second page contained a profit downgrade. Not only is the market rarely fooled by this chicanery, but it suggests a possible breach of the ASX’s continuous disclosure rules. An acquisition announcement and a profit downgrade falling on the same day seems an unlikely coincidence.

The presentation of numbers in a favourable light is another of our long-time gripes. The quoting of writedowns on an after-tax basis is particularly relevant during reporting season. Fletcher Building, for example, wrote off NZ$399m of assets in its recent results, but it was

the lower after-tax figure (NZ$360m) which appeared in the company’s results presentation. We’ve also criticised Commonwealth Bank for this practice, too.

Reading between the lines:

1. What is the company saying?

2. What is the company not saying?

3. What does the announcement imply about what’s going on behind the scenes?

The reality is that almost all companies engage in ‘creative reporting’ to a greater or lesser degree. Unless you’re extremely comfortable with management, don’t accept their comments at face value, particularly in presentations and marketing-oriented material (and annual reports often fall into this category now).

So ask yourself the following three questions when you’re carefully reviewing a company announcement or presentation:

1. What is the company saying?2. What is the company not saying?3. What does the announcement imply about what’s

going on behind the scenes?With these questions, you’ll be better prepared to

‘read between the lines’. There’s a great deal to be said for healthy scepticism when assessing company announcements. And often it’s what’s left unsaid that matters most.

Disclosure: The author, James Greenhalgh, owns shares in Commonwealth Bank and Telstra. First published online 19 Aug 09.

BRISTLEMOUTH

will the internet destroy flight centre?

A recent Ask the Experts debate raises some interesting questions about the impact of the internet on Flight Centre. It’s something we’ve been having heated arguments about internally for the past five years and, given the response by members, it seems the views among the wider investment community are just as diverse.

Steve G kicked off the debate with this comment about a recent Flight Centre experience:

“Just some feedback on our local flight centre and why we won’t be going back. We went to a local flight centre to book flights based on a newspaper special. Those particular flights had all sold so we then looked at other deals. The service was adequate, not great, from two of their people—I wouldn’t employ either of them. Perhaps they weren’t trained adequately. The price for comparable

flights were much more expensive—we declined and ended up using Jetstar direct via the internet. We saved enough from the flights compared to the flight centre to pay for our accommodation, which we also booked online direct via the accommodation site (we could have booked via Jetstar but the same accommodation was dearer via Jetstar’s site). I think more people will gradually move online for travel themselves. Jetstar online service was great/ will definitely re use in future.”

I’ve included the responses below, but what do you think? Does Graham Turner have his head stuck in the sand? There’s no doubt the internet is stealing market share but is there room for both? When I told a friend of mine who runs a Flight Centre store (and historically booked all of my holidays for me) that I’d organised



want to book a $30,000 family holiday in Europe without lifting a finger … I’m like a glorified sectretary, and there’s no way the internet can dispose of me’.

Is he right?Steve Johnson

my entire Japan holiday over the internet this year, he shrugged and told me I only used to waste his time anyway. ‘You only ever wanted to book a flight and then organise the rest of the trip on the run, yourself’ he said. ‘I make 90% of my profit from the rich customers who

a sElEction of onlinE commEntscomments are unedited and appear as they do online.

matthew c: My wife and I recently went on a trip to Nth Qld that my wife organised through our local Flight Centre. In contrast to Steve’s experience the amount we saved on accommodation by using FC rather than booking direct almost completely covered the cost of our flights. They also reorganised our itinerary including transfers when Virgin Blue changed the flight schedule, which made it no hassle for us. We did have one incident on the trip where the resort did not have our booking in their system when we turned up. They blamed it on either their head office or FC but further investigation revealed this not to be FC’s fault, so I can only say we had a good experience as far as FC was concerned. We also used FC in Canada a couple of years ago to organise a trip to Florida and had no issues. The other point I would make is that my wife and I have both done a fair bit of travel in our lives and while initially were inclined to book it all ourselves we are now tending to consider a travel agent as our starting point. I imagine when we retire this may reverse but that is a good 20 years away (barring exceptional investment performance from my II inspired portfolio).

simon R: FLT I have had two experience with flt, one to thailand where the net was hugely cheaper and easier to organise, and one recently to germany where the opposite was correct. In addition the trip to Germany I needed to arrange a bassinet, and it was much easier dealer with FLT then trying to do it online. I think for some destinations or simple trips the net is better, but anything slightly more complex then FLT is the way to go. I would hope that FLT are working on improving their website which is in my opinion pretty old in terms of usability, though perhaps this is delibrate in order to get you in the door?

gareth Brown (tii) Reply: Thanks Simon. In response to your last sentence, this is one of the key issues I’m mulling right now. From the outside, it appears that Flight Centre wants less and less to do with the internet, and this must be a deliberate strategy on their part although it’s one we disagree with.

Brendan: I have not used FLT since my first major overseas trip 9 years ago. Since then, I have organised most of my own extensive travels with the aide of the internet and guide books. I get a thrill out of looking around different websites and putting together a trip. The one time I have used a travel agent since was while I was living in Germany and I wanted to book a stopover on a trip back. I do this in the web form of the airline. So from that perspective, travel agents still have more flexibility for more complex trips and packaging.

Hence, this is where travel agents need to focus on their value adding ability, because the advent of flight price aggregators has eroded margin on flight-only bookings (which may explain FLT’s reluctance to go down this path).

So, despite not using them personally, I do own FLT shares because I know there are a lot of people who don’t have the time, confidence or inclination to sort of the details of travel.

I’ll also probably never travel first class, but I appreciate that people do and they subsidise my Qantas economy class flights.

colin I’ve only used FC once, 3 years ago. The FC employee was lazy and sloppy. She had to be prompted to finalise important aspects of the trip. The final itinerary referenced flights we weren’t even booked on. At the destination the transport had not been pre-booked. The hotel room she had recommended and booked was disgusting. That ruined the whole holiday. I’m sure most FC employees are very good and we were just unlucky to deal with one that wasn’t. It shows though that you can’t rely on just 1 or 2 customer’s comments to form a view of the entire company.

Justin o’kane: A couple of years ago Turner made a comment that it would be 20 years before the internet would seriously hurt FLT. At the very same time he was seriously growing its corporate business until it now represents 35% of TTV and one of the top five corporate travel agents in the world. At the time I thought it was just to boost volumes but now it looks more and more like a defense against the internet. After all, in corporate travel the price/cost isn’t the key determinant so the threat of the internet is less prevalent. Not only that but what sectary is going to book their boss a flight, transfers and accommodation directly on the net and risk a stuff up when it can be done more efficiently (and cheaper) by the company designated travel agent. With this strategy I don’t think Turner has his head in the sand but is fully aware of the internet risk.

FLT’s leisure travel business is only at risk long term if airlines, hotels etc want to compete directly and openly on price alone and customers only care about price alone – both unlikely. In the meantime 85% of Australian outbound flights and holiday travel continue to be booked through a travel agent which all gives support to Turner’s 20 year comment.


ASK THE EXPERTS

be tiddlers today, not $30bn companies like Woolies. We would count on a much lower average EPS growth rate for Woolworths over the next few decades, and wouldn’t even be comfortable using a number of 8%, let alone 18%. And it’s the future growth rate, rather than the historical one, that counts. Obviously, this is something we try to weigh up in our research and, looking at possible future growth rates we’re not confident it’s cheap, despite the obviously impressive past growth rates. Hope that clears things up for you.

transpacific

good day, what do you think about transpacific industries tpi, which i do now own, but kind of thinking. the share price is the lowest ever at present, but used to be a very very expensive $14 only two years ago. they are in the process to raise capital. what is your assessment of this company? inna B

James Greenhalgh: Hi Inna. We haven’t spent any more time on Transpacific since the concerns about debt we highlighted three years ago. Perhaps there’s something in it now, but we’re naturally averse to companies which had aggressive management, where the chickens have come home to roost and which might have failed but for a highly dilutive capital raising.

the worst call in our history?

Your bank sell call must rate as one of your worst in your analyst history. since the sell recommendation, all the banks have rallied 30 or 40%. while not wanting to hit you over the head—i am wondering, at what point will you admit you are wrong? will it be based on the level of outperformance of the banks over the market or will it be a time thing—so say after 6 months—you come back out with a hold recommendation—much the same as most in the analyst community do. aaron R

James Greenhalgh: Hi Aaron. It won’t be a price OR a time thing—it will be based on the performance of the banks’ businesses over the next few years. That means we think it’s a bit early to call it a mistake—we don’t judge our performance over a few months, but over a period of years. We often ‘get it wrong’ in the short term, but our longer term record on calls is pretty good—we were negative on property trusts for years (and saw property trust prices rise sharply afterwards) but were ultimately correct.

I keep mentioning this point about the banks, but I think it’s worth reiterating. There’s a big lag between recessions/property downturns (the latter of which we haven’t really seen yet) and bank profit performance. In other words, it takes time for the bad debts and writeoffs to show up in bank profits. This is what happened in 1992/93 when Westpac almost failed—years after the actual recession.

Finally, we’re often criticised for being too negative.

please note that the member questions below have undergone minimal or no editing and appear essentially as they do online.

woolies’ growth rates—trees can’t grow to the sky

Firstly i want to add my compliments for your “australia’s 10 best businesses” special report; it’s just the sort of thing i subscribe for. i also enjoy your investor’s college articles. i’ve been reading your investor’s college article dated 25/04/2006 titled “how to value stocks & shares” and am trying to relate it to woolworths as discussed in the “aussie best 10’ feature. my question is what to do when the growth rate exceeds the discount rate. in the i.c article the example uses a discount rate of 8% and a growth rate of 4%. the wow dps growth rate over the past 10 & 20 years is about 18%. if i subtract growth from discount in the wow example as was done in the ic article i get a negative number which can’t be right. the ic article goes on to say that if the growth rate matches the discount rate then the value of the security is infinite, it follows then that if the growth rate exceeds the discount rate that’s obviously even better. in the wow example; with a share price of say $28, a dividend yield of about 4%, a payout ratio of about 70%, a dps growth rate of 18% and a return on incremental capital of 32%; then even with a discount rate of 10% wow looks a great buy now. i feel like i must be missing something but i can’t quite see what it is. often when i write questions like this the working through answers my own question but it hasn’t worked this time. mary s

Gareth Brown: Great question Mary! And good on you for trying to work it out yourself first, it’s always the most effective way to learn. I hope I can clear it up for you. You’ll note that the subheading above the relevant paragraph in that Investor’s College article you’ve referred to was ‘Paradox’, and it’s not without reason (others can find that article here). You cannot use that formula for valuing a company whose earnings are growing at faster than the discount rate, but by deduction we can see that its value is ‘more than infinite’—which is ridiculous.

But that result is not without some reasoning. Woolworths may have grown earnings at more than 18% per year over the past 10 and 20 years, but it will not do so indefinitely. I can say so confidently because with the Australian economy likely to grow at 2-4% a year, if Woolies were to grow earnings at 18% then at some stage a few decades from now Woolworths would be bigger than the Australian economy, which is also ridiculous. So unless Australia is going to start growing at 15%+ per annum (which is not going to happen) or Woolworths is going to dominate the entire global retailing sector by 2029, then this historic growth rate is not going to be repeated.

There may be one or two Aussie companies that end up growing at 18% over the next few decades, but they’ll



And it may be that Australia’s shallow recession means the very negative scenario for our banks was way too pessimistic. But you only need look at what has happened to the global banking sector over the past year to realise bank shares are not low risk. If we’ve managed to highlight those risks to our members, some of which have had 50% or more of their portfolios in banks stocks (a very risky weighting), then we think we’ve done our job.

the major banks

major Banks now have the capital markets open to them and can raise tier 1 capital in a number of different ways other than issuing more shares, as evidenced by cBa with peRLs v. the issue i am debating is how much more current shareholders are likely to be diluted and with capital markets open again it may be no more is most likely. You have covered the downside well in your coverage however on the upside if bad debts return to more normal levels in 12-18months, and shareholders are not further diluted, then the current share price does not look expensive to me i.e. i am a hold on the banks, not a sell, as i dont expect more dilution from here. thoughts? Jonathan h

James Greenhalgh: Hi Jono, my personal view is probably closer to yours than that of the ‘house’, as I believe the consumer segment is healthier than TII believes (I’m the holder of the bank shares in the staff portfolio and have only marginally reduced my weighting to the sector). But where I agree with the house view is that the commercial property segment of the economy could have more pain ahead.

Also, I suspect that the bad debt levels we saw 2 years ago weren’t actually normal, at all, but way too low. So the average level of bad debts over the cycle would be considerably above where it was then. These two factors suggest to me that bank shares aren’t particularly cheap now.

So I’m expecting my holding of bank shares to underperform the market a little over the next few years for those reasons. But I’m happy to hold the sector for diversification purposes and, even with the capital raisings and dividend cuts, the yields are reasonable.

the issue of debt at hills

regarding your reference to hills industries and concern re debt by way of example from the ‘spin’ , i am interested to see how you came to that conclusion as from what i saw in a cursory way, they logged their debt to equity at 36% which did not seem that high to me. what have i missed. also i was wondering where you got the info on the cash flow, as i have a hard time finding or deciphering it. thanks and i do not have any hills ind shares. Jennifer h

Gareth Brown: I don’t think our issue with the debt at Hills has been with the absolute level of debt, the debt to equity ratio on its own can be misleading. Our

concern was that, with its high payout ratio and capital intensive nature, Hills wasn’t generating enough cash to provide for its dividends. It made up for the difference by issuing shares or borrowing. In today’s environment, the unsustainability of borrowing to pay dividends would cause concern for bankers, even if only a modest amount of debt was involved.

For a better picture of the situation at Hills, look at page 11 of the 30-page investor presentation from 5 August, titled net debt movement. Gross cash flow of $86m wasn’t enough to provide for tax, capex, dividends and interest, and that situation was more acute in previous years.

the first word on derivatives

what’s a derivative? andrew sGareth Brown: Great question! Truth is that you

could read several textbooks on derivatives, or do a full university finance course, and still not understand everything. But that’s ok, you don’t need to understand everything.

The simple definition, according to investordictionary.com, is this:

A tradable financial instrument whose value is dependent on the value of an underlying financial asset or a combination of assets. For instance, an option is a derivative because the value of the option changes in relation to the performance of an underlying stock. Other examples would include futures contracts and mortgage-backed securities. Investors often use derivatives to hedge a portfolio or improve overall returns.

They’re called derivatives because their value is derived from something else, the underlying asset. That may be a stock, bond, commodity or something else. Hopefully that’s enough to get you started. If words like ‘option’ or ‘futures’ get your head spinning, I’d always recommending starting with an online source like investordictionary.com or investopedia.com.

stw calculations

the calculations shown in ‘stw shines in tough times’ are thorough, though i’d like to add that: (i) the cash after dividend cash flow figure for 1h09 is $1m too low and conversely $1m too high for 2h09; (ii) may need to reduce the closing cash levels for FY09 by

~$10m to reflect a normal level of on-going client cash. that’s because closing cash of $33m for 1h09 included $25m of client cash (2008 $15m; though admittedly the number is fluid and from memory it hit ~$40m in the boom years). in the mgmt presentation it says “(c)irca 50% of working capital improvement [$23.8m] purely timing and may reverse 2h 09.” therefore, a large part of the boast the operating cash flow may be short-lived. (iii) should adjust the valuation for debt net of company cash rather than gross debt as shown; (iv) would have thought there’s a more fitting way to


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handle minority interests rather than apply a low-ball multiple to ‘gross’ eBit. perhaps subtract the value of minority interests (as shown in the recent balance sheet—though i accept that a market value rather than accounting carrying value may be more appropriate) from the enterprise value initially based on gross eBit. so for FY09, the equity value per share comes in a tad higher at 95 cps [that’s gross eBit of $75.1m x multiple of 6 (though arguably a tad higher using this revised method), less $107.8m debt, plus stated closing cash of $29.4m, less $25m client cash (deliberately left the client cash figure intact for simplicity), less $34m in minorities = $313m or 95 cps)]. while the valuation is much the same using an identical gross eBit multiple, this approach is arguably sounder. mark w

Greg Hoffman: Thanks for the comments, Mark. I’d agree with you on most of those points and people running their own numbers may want to make the appropriate adjustments.

On point (ii) I had allowed for $8m in the second half (in reinvestment/acquisitions—I don’t think they’ll be making $8m of acquisitions in the second half). Regarding point (iii), I’d used the gross cash number for consistency with the printed statements and thought about the subtraction of gross (rather than net) debt in the valuation. My reasoning was it added another slight layer of protection (or, to put it a different way, was another balance to the minority interests’ share of the EBIT on the other side).

On point (iv), I take your general point (about there probably being a better way to handle the minorities), though I’m not necessarily comfortable with taking the balance sheet number. The accounting rules (impairments for duds but no write-ups for stellar performers) mean that the balance sheet number is likely to be substantially understated. Thank you, again, for taking the time to convey your own views and suggestions. I’m sure many others will find them helpful in their own analysis.

not attracted to industrea, but not experts either

is it time to review idL (industrea) again.? check the last few announcements. they certainly seem to be hitting a few runs, and generating lots of revenue. seems to be a healthy business, and mgmt seem to have the debt (mainly for the huddy’s purchase) under control. good market share in australua (se QLd and nsw) and also in china. malcolm c

Gareth Brown: No change of thoughts since your query a few years back and no plans to cover Industrea at this stage, it is currently outside our circle of competance. If someone can make a compelling case as to why the company should be worth $400m or more, despite negative reported NTA (and book equity of $142m), we may reconsider. But there are only so many hours in the day and we think there are better places to spend our time at the moment.

net debt to equity ratio doesn’t tell the full story

i am attracted to tLs on the basis of yield and what looks like a fairly constant dividend stream in the future. i’m concerned about its debt to equity ratio of 150%. should i be concerned? is there any good reason as to why it is so high? greg e

Gareth Brown: Firstly I’d recommend the three-part Investor’s College series we did on debt back in 2004 (here are links to Part one, Part two and Part three). Looking at the debt to equity ratio alone provides a one-dimensional view of debt that can be misleading. I’m not the analyst on Telstra, but I’d imagine that the copper wire network has been largely depreciated over the years, meaning its book value is probably significantly lower than its true economic value, which is the more important matter when it comes to supporting debt. According to the company’s recent results presentation, interest coverage (discussed in part two of that Investor’s College series) was in excess of nine times, which suggests a company that can pay its interest bill comfortably. Debt is not the top of our concerns for Telstra, but I will point out that the yield isn’t enough to tempt us into buying—we reviewed the company last week (see here) and our recommendation is Hold.

nab spp arbitrage

in your opinion do you think the small investors should sell their holding in naB for small profit and take up the offer of the new share issue right? Roxanna L

Gareth Brown: We can’t provide individual financial advice but, generally-speaking, the opportunity to sell an existing holding at today’s price of about $27 and subscribe for an identical amount of new SPP shares at $21.50 looks like money for jam. I’m not sure what the prospects of a scaleback are, though, which is the one potential upset (NAB said they’ll scale back applications if they receive more than $750m from shareholders, and this target is quite likely to be surpassed). Over the past few months, we’ve tried to give members all the knowledge they need to assess such offers—starting with the Investor’s College article Your guide to retail share offers and folliwong through with practical examples such as How to profit from a share purchase plan (about Westfield) and this review of ANZ’s SPP. The same mathematics will apply to the NAB SPP. If you want to particpate, don’t forget that you’ll need to send your money in 21 August (Friday).

feedback on daily reporting wrap and big bank recommendations

hi a couple of opinions. Firstly i love your reporting wrap, it is so much more useful than the financial press which just regurgitates managements commentary. i didnt know that this is a new feature, but i strongly



recommend your organisation does this at each reporting season. its a very ‘value added’ feature in my opinion. secondly i just want to congratulate you on your stance on the banks. whilst i dont agree with them (i place a lot of value on the intrinsic value of the australian big 4 banks due to their oligopoly situation) i have to say that i respect your views (it also serves to temper my natural enthusiasm to this sector). mr market in the short term can move in either direction depending on current investor psychology, but over the longer term the market generally isnt fooled (hence the term weighing machine). too many retail investors just think about upside potential(as reflected by the share price), when in my opinion, intelligent investing is about comparing future returns against risk. mac d

Gareth Brown: Thanks Mac, we really appreciate this feedback. Two rational investors can come to vastly different conclusions when looking at any stock, and we genuinely appeciate your approach to this difference of opinion. Every member is going to disagree with us at some stage. Even though everyone won’t agree with our big bank call (and it would scare us if everyone did), hopefully bank bulls can use our research to see the other side of the argument and strengthen their understanding as a result. Thanks also for your feedback on the daily reporting wrap.

currencies unavoidably influence infomedia

with the recent research conducted by hsBc, which shows the australian dollar has become the mirror image of chinese economic activity, and forecasts, that this is to remain likely so, does this influence your profit expectations of iFm, or does iFm have adequate financial risk measures in place to counter the perhaps rising australian dollar? chris s

Gareth Brown: I haven’t looked at the HSBC research you’re referring to, but I’m unlikely to put more trust in it than the weighted average of the market’s opinion, which is basically what the current foreign exchange rates are. We discussed some of Infomedia’s hedging in Infomedia disappointing but cheap in issue 264. At the time, we were disappointed to learn that the company had hedged for a few more years, but with the Aussie dollar up significantly since we’re obviously not so disappointed anymore.

Infomedia earns its revenues in various currencies, and pays most of its expenses in Aussie dollars. Moving currencies are an unavoidable fact of life with this one. A conservative policy might see it hedge, say, half its expected profit for the next fie years, or some percentage of its expected revenues. But whatever its policy, people are likely to be disappointed—disappointed for not hedging enough if it goes in your favour, or too much if it doesn’t. We try to focus on the wisdom of the hedging policy, rather than the immediate outcome—here, though, we’ve expressed concerns in the past.

The rising currency will put a dent in Infomedia’s expected earnings, for sure. But we think it’s cheap enough to compensate. I expect Greg will provide further

guidance on the effects of the currency when we review the results due out in a week or two.

commonwealth bank vs westfield

i’m a bit puzzled by the contrary positions you’ve taken with cBa and westfield. Your current article on cBa and your 7th august article on wdc say almost exactly comparable things about the risks of the two businesses except that one’s in property and one’s in finance. actually, you even point out that a major concern of your cBa analyst is its property loans while with wdc you say the same thing differently when discussing wdc’s imprudently low cap rates. Your cBa conclusion is seLL, however, while with wdc it’s Long teRm BuY! You place a lot of faith in wdc’s management. You seem to give absolutely no credence though to cBa’s management who i would have thought could have claimed to be the westfield of the banking sector. since privatisation nearly 20 years ago , cBa has shown a clean pair of heels to the other three, has been at least as opportunistic and nimble (Bankwest) as any other and while they’re certainly facing risky times, has a track record of prospering during adversity, and best of all, management has shown they can accept they’ve made mistakes and skilfully rectify them in such basic areas as the hollowing of their branches. in the end you give a tick to westfield only because of your faith in its management’s ability. what are the management errors of cBa which make you see them so differently? we were ipo investors in cBa (but neither employee nor customer) and one of the few consistent and unchanging features of the market since then has been that cBa’s performance has continually been underrated, under-predicted and underestimated by most analysts. isn’t it time a world-class performance is given its due? graeme and Rosemary c

James Greenhalgh: Hi Graeme. Goodness, you’re a member of the CBA fan club! (I’ll disclose my family has also owned CBA for a long time, so i understand your enthusiasm). You’ve made an interesting point here, but the short answer is that themes aren’t stocks, and we don’t want to confuse history with the future.

CBA is highly leveraged (all banks are), so failures of commercial property owners (which is still a big risk) could cause another huge surge in bad debts, for example, and therefore require big capital raisings. None of this would be good for shareholders. And it’s important to note that bank profits often get hit by recessions with a long lag. The fallout from the late 1980s property boom didn’t hit Westpac’s profits until 1992/93, for example, when it needed an emergency rights issue. Westfield, because it’s not a bank, is subject to completely different risks, which do include the low cap rates as you mention. But it’s not going to suffer the same problems as CBA if office property owners fail, for example.

Then there’s the issue of price. The same themes


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spin and reporting post-tax numbers on writedowns (instead of the larger pre-tax expenses), but that’s pretty common behaviour. Banking is a confidence game, and they don’t want to appear too rattled by anything. In the end, you’re very right to be questioning this sort of stuff, and it will be interesting to see whether the ROA figure makes it into the annual report.

an op-ed piece by warren buffett in today’s ny times

For the weB watchers out there: http://www.nytimes.com/2009/08/19/opinion/19buffett.html?_r=2&ref=opinionalexander c

Gareth Brown: Thanks Alex. And Steve wonders if Buffett has lost his marbles? This op-ed piece is typically sensible stuff.

amcor

hi, i am pretty sure you guys are maxed out with reporting wrap. i was just wondering if you would be doing an update review on amcor (amc) anytime soon. this company has been on my watch list for a while (more than 4 years) now. cheers shak. sakthi n

James Greenhalgh: Hi Shak. It’s unlikely. These old style manufacturers are rarely the best companies to own, with high capital requirements and powerful customers. I just had another glance at Amcor’s free cash flow over 2007 and 2008 and it was what I expected—not great (although there did seem to be some signs that management was driving the business a little harder with working capital improvements). Perhaps Amcor will get a bargain with Rio’s Alcan assets, but it’s not near the top of the list to spend much time on.

might have relevance for each company, but they are reflected in the price in different ways. We judge Wesfield to be cheaper (ie the market is more negative towards to it) than CBA, where the market seems to have gained a renewed enthusiasm.

Finally, we’re not really about ‘giving companies their due’. Rather, we try to weigh up whether they’re cheap or not based on their prospects. We think the market is not seeing some big risks for CBA, but seeing too many for Westfield.

commonwealth bank management

i would like to know your opinion of the candidness of cBa management. i was unable to locate the Roa statistic for cBa in the 2009 annual Report. i checked back, and in 2007 and 2008 the Return on average total assets figure was given in the Five Year Financial summary. the Roa has declined from 1.2% (2007) to 1%(2008) to approx 0.7% (if i calculated correctly for 2009). warren Buffett identifies the Roa as the most important statistic for a bank, as do many valuation texts. what reason, do you think, could be given for this apart from my suspicion that cBa management desired to focus on more positive figures? Like you said in your report, a Roe of 15% is still respectable. wells Fargo did not fail to report its Roa of 0.44% down from 1.55%. aiden d

James Greenhalgh: Hi Aiden. I don’t think CBA’s annual report is due out until September so, to give them the benefit of the doubt, perhaps we shouldn’t be too critical yet (recent announcements are only the preliminary final releases). But most bank managements could be marked ‘could do better’ on being upfront with the market. We’ve criticised CBA in the past for positive

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