Your Money Weekly | Issue 37, 2016 · 2 Your Money Weekly 29 September 2016 3 Chris Douglas...

Peter WarnesHead of Equities Research

29 September 2016 | Issue 37

Your Money Weekly

Early in the week the eyes and ears of a record number of Americans were captive to the first debate between Hillary Clinton and Donald Trump. But ultimately the larger question is: What will U.S. financial markets do if Donald Trump wins the Presidential election on 8 November? Some believe if he wins, markets will go into a tailspin. Others believe economics is more important and the result is unlikely to have a major bearing on the behaviour of financial markets. I am not so sure.

Donald Trump is not a politician. Yet he is running for the highest political post in the world. Only in America could this happen. To get to debate Hillary Clinton, Trump beat five senators and 11 governors, all career politicians--he is a winner. This election is unlike any previous Presidential election. It pits the first female candidate against the first opponent from a non-political background, at least since 1900. This election is probably the most emotionally charged in US history, has divided the country, and is therefore completely unpredictable.

The electorate is increasingly frustrated by politicians continuing to tell them what is good for them. Main Street has been forgotten while Wall Street gets a disproportionate share of the bikkies. Despite central banks flooding the world with liquidity, the U.S. and others have experienced eight years of below-trend economic growth and subdued wages growth. Voting in the U.S. is not compulsory, so expect the unexpected. Remember Brexit and markets can overact when surprised.

With most giving a win to Clinton in the first debate, U.S. markets reacted positively, but enthusiasm was muted. Gold sold off. Trump did better than was generally expected. He is not a polished debater but will be much better prepared for round two. A close friend in the U.S. made an interesting observation--Trump supporters take him seriously, but not literally.

The liberal press and progressives (the latté-sipping set) take him literally, but not seriously. Trump could be classified as a typical New Yorker--loud and frequently verbally offensive but not necessarily intentionally mean-spirited in what he says. The polls didn’t move much after round one.

Of greater importance to the U.S. will be the management of monetary policy by Janet Yellen and her Federal Open Market Committee (FOMC) over the next few years. What would happen if Trump was successful on 8 November and volatility returned to financial markets? Not another deferment of an overdue hike rate at the 13-14 December meeting!

Over the past two weeks the bond market bull has had a transfusion and is giving the picadors merry hell. German bunds seem to be leading the way with the 10-year yield negative 0.15% after a very brief time in positive territory. U.S. 10-year and 30-year yields have retraced the earlier spike to 1.73% and 2.47% respectively and are now at 1.57% and 2.29% respectively.

More volatile financial markets are likely in the final quarter of 2016. I remain cautious, quite happy with higher cash levels and would also look for a small exposure to gold as insurance. Should equities markets come under pressure, I believe the A$ could also weaken.

Banks 101The chief executives of the four major banks will be in Canberra next week to be grilled by politicians. Labor’s Pat Conroy will ask why Australian banks have higher returns on equity than banks in other countries; is it a function of market concentration? Why aren’t more international entrants attracted by these high returns? And so on.

These are all fair questions. They come at a time when the banks have a surprise supporter in Paul Howes, former Australian Workers Union boss and now head of wealth management advisory at major accounting firm KPMG. Howes is criticising Labor’s call for a Royal Commission into the banking sector. This is quite an about turn, perhaps driven by a change in paymaster.

Has Hillary got a no Trump hand? Banks 101

Continued on page 2

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Special Reports

Morningstar Qualitative 3 Manager Research

Australian Foundation InvesCo 5 Ord AFI

Small Cap Focus: AWE 6

The big picture for the major 9 banks is playing out as expected, but CBD apartment risk is increasing

Hybrid Corner

ANZ Capital Notes 4 12

Company Reports

AGL Energy 14

ANZ Bank 13

Brickworks 16

Challenger 17

CSL 14

Flight Centre Travel 18

Graincorp 19

Insurance Aust. Grp. 15

IRESS 20

Premier Investments 21

SAI Global 24

Vocus Communications 23

Washington H. Soul Pat 22

Australia’s Leading Independent Investment Newsletter Since 1973

2 Your Money Weekly 29 September 2016 3

I am not a bank apologist but here’s my 101 for Pat Conroy on Australian banks. The Australian major banks do have higher returns on equity than most overseas counterparts. While it obviously reflects the level of profitability--the return on equity is the ratio between cash earnings and equity capital--it possibly says more about operational efficiency and the more efficient use of capital than the cry they must be screwing customers.

Australian banks have cleaner and more transparent operational structures than U.S. counterparts, many of which are investment banks with a traditional banking tail. The retail banking arms in part finance extensive investment banking activities--at times more akin to high-stakes gambling. Wells Fargo is the closest U.S. bank to Australian majors. Efficiency or productivity is measured by the cost-to-income ratio and on this metric Australian major banks leave most in their respective wakes. Wells Fargo’s cost-to-income or efficiency ratio sits at mid-50% compared to our majors between 42% and 45%. This means Australian majors spend $42-$45 to generate $100 of income while Wells Fargo spends $55 to generate $100 of income. The difference is a major driver of profitability and return on equity. It does not mean customers are being screwed.

The highest quality component of a bank’s income is net interest income (NII). NII is the difference between interest received from borrowers and interest paid to lenders, whether depositors or bond holders. NNI is then transformed into a net interest margin when spread over the average loans outstanding. The four major banks have a net interest margin around 2%. Wells Fargo's stood at 2.86% in the June quarter. Are Wells Fargo customers being screwed?

Are higher returns on equity or profitability due to concentration? One will find the smaller the market, the higher the level of concentration. The Australian corporate scene is littered with oligopolies. Australia’s population of 24 million is small compared to the U.S., Europe or Japan. Australia has attracted many overseas banks but most have left after short, unsuccessful and loss-making stints. Poor timing of entry is often a factor and aggressively competing for lower-quality loans in a bull cycle sows the seeds of future bad debts. Don’t blame the Australian banks for the perceived lack of competition. Competitive pressures are as intense as anywhere in the world.

Australia’s profitable and well-regulated banks helped keep the Australian economy from recession during the global financial crisis. While the government lent support by guaranteeing deposits

it did not have to use taxpayers’ funds to bail out any bank, unlike the massive bailouts in the U.S., the U.K. and across the Eurozone.

The Australian major banks contribute more tax revenue than any other group in the Australian economy. Governments should be focused on growing their revenue via taxation and supporting and encouraging profitable enterprises rather than making it increasingly difficult to grow, employ, become more profitable and pay taxes.

Beware of high-yielding debenturesWhile the focus remains on major bank lending risk, are we neglecting the smaller end of town, the non-traditional lenders? History has shown a tendency for these lenders to facilitate high-risk borrowers the major banks have refused to accommodate, such as relatively risky property developers. They offer high-yielding debentures to unsuspecting retail investors, passing on the higher interest rates they charge borrowers.

High-yielding debentures generally reflect high-risk lending, often in the form of apartment borrowers looking to commence, continue or complete outstanding projects. This might be fine while property prices appreciate. However, in times where price stagnate or fall, as is the case across many apartments in Australia, these high-risk borrowers are increasingly likely to default. This can put the debenture income stream at risk, and more importantly, the capital base. Do not be attracted by elevated yield.

Passive investment vehiclesLast week I mentioned we will introduce regular research on passive investment alternatives. As a forerunner, on page three, there is a two-page explanation of the ratings methodology and process undertaken by the Manager Research team in providing the research and recommendations on our passive investment vehicles.

Morningstar Individual Investors Conference: 14 OctoberThe conference, with its focus on Balancing Risk and Reward in a New Investment World, is fast approaching. The strong speaker line-up includes Platinum’s Kerr Neilson, Investors Mutual’s Anton Tagliaferro, respected commentator and owner of The Constant Investor Alan Kohler, and Morningstar Inc’s head of behavioural science from Chicago Stephen Wendel. There are several SMSF-dedicated sessions. Those who cannot attend in person should consider viewing the event in real-time via the cost-effective live-streaming option. K

Overview continued from Page 1

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Contact DetailsTel: 1800 03 44 55Email: [email protected]

Key TermsBuy: Significantly undervalued;Accumulate: Modestly undervalued;Hold: Fairly valued;Reduce: Modestly overvalued;Sell: Significantly overvalued.

Any feedback on this week’s Overview is always welcome. Send your comments to

[email protected]. We’d love to hear from you.

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Chris DouglasDirector of Manager Research Ratings, APAC

Tim Murphy, CFA, CAIA

Director of Manager Research, APAC

Morningstar Qualitative Manager Research

Morningstar is a leading global provider of independent investment research, with more than 110 manager research analysts based across North America, Europe, Australia, New Zealand and Asia. The 14 member Australasian manager research team has 10 years of average experience and has been producing qualitative manager research and ratings since 1999.

Morningstar’s qualitative manager research aims to determine which investments deserve the attention of investors and which do not.

Morningstar assesses investment managers based on how we believe they will perform in the future over an economic cycle, against both peers and accepted benchmarks. Our model rewards managers that are open and transparent, have a well-run investment process and, importantly, are good fiduciaries of investors’ monies.

Morningstar operates an independent manager research model. This means that we determine our own coverage universe. Our coverage is organised across 19 sectors that span all major asset classes. We had full coverage on 500 flagship strategies which mapped to about 4,500 underlying funds, ETFs and LICs.

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ŒThese funds are our highest conviction recommendations and stand out as best of breed for their investment mandate. To earn a Gold rating, a fund must distinguish itself across the five pillars that form the basis of our analysis. That is, a Gold-rated fund should have a seasoned, talented and successful manager or management team; a sound, thoughtful process that has been executed skilfully and consistently; a portfolio that’s in harmony with the stated process and that’s capable of delivering a reward that compensates investors for the risks it takes; reasonable expenses; and a strong parent organisation that is focused on responsible stewardship of investor assets.

Manager ResearchAs a Morningstar Premium subscriber, you have full access to our qualitative research and ratings on Managed Funds, Exchange-Traded Funds and Listed Investment Companies.

http://www.morningstar.com.au/Funds/ResearchReportsAll

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•Funds in this category are high-conviction recommendations. They have notable advantages across several, but perhaps not all, of the five pillars. With those fundamental strengths, we expect these funds to beat their relevant performance benchmarks and/or peers on a risk-adjusted basis over the long term (defined as a full market cycle of at least five years). While these are worthy funds with many positive features, they don’t necessarily rise to the standard of best in breed. Funds rated Silver may be working their way up our list of recommended picks as we gain more familiarity and conviction in key pillars or working their way down on the basis of a degradation within specific pillars.

´These funds have advantages that clearly outweigh any disadvantages across the pillars, giving us the conviction to award them a positive rating. As is the case with any fund receiving a positive rating, we expect these funds to beat their relevant performance benchmarks and/or peers on a risk-adjusted basis over a full market cycle (defined as a full market cycle of at least five years). Funds rated Bronze may be working their way up our list of recommended picks as we gain more familiarity and conviction in key pillars or working their way down on the basis of a degradation within specific pillars

‰These are funds in which we do not have a strong positive or negative conviction. In our judgment, they are not likely to deliver standout returns but

are not likely to seriously underperform either. A fund that is overly benchmarkconscious could receive this rating so long as its fees are reasonable enough to give it a chance of keeping up with the average fund in the category or a competing index fund. Promising but unproven funds may also feature here until we see further evidence that the fund has the potential to outperform.

ÁThese funds possess at least one flaw that we believe is likely to significantly hamper future performance, such as high fees or an unstable management team. Because of these faults, we believe these funds are inferior to most competitors and will likely underperform their median peers and benchmark on a risk-adjusted basis in the long term. For example, a fund that combines an overly benchmarkconscious strategy with high fees is likely to get this rating because its strategy lends itself to underperformance.

Morningstar may also use two other designations in place of a rating:

ˆThis designation means that a change at a rated fund requires further review to determine the impact on the rating.

∏This designation is used only where we are providing a report on a new strategy or on a strategy where there are no relevant comparators, but where investors require information as to suitability. K

ResearchUniverse

ManagerReview

RatingsCommittee

Pre-meetingAnalysis

Post Review

Analysis & Draft Report

Final Report

& Sector Wrap

Morningstar Fund Review Process

(Must be in the Morningstar database);

Three broad factors for inclusion:

3 Investment Merit;

3 Client Demand;

3 Strategy Size.

Review material:

3 Performance attribution;

3 Portfolio composition;

3 Manager reports;

3 Morningstar reports (incl. offshore analysis);

3 Morningstar® Direct™;

3 Morningstar® Adviser Research Centre™;

3 Industry experts.

1.5–3 hour meeting;

Typically with portfolio

manager/analysts;

Focus:

3 People;

3 Process;

3 Parent;

3 Price;

3 Performance.

Internal discussion and debate;

Ratings note is written by lead analyst;

Focus on peer group relativities.

Lead analyst presents their findings to the ratings committee for discussion and review.

Analyst Rating:

Œ

•

´

‰

Á

Report written and Report released;

Sector wrap released.


Morningstar TakeAustralian Foundation Investment Company (AFI) is an excellent vehicle through which to obtain well-diversified Australian equities exposure at a low cost. AFI has a well-resourced setup composed of experienced investors and a long track record dating back to 1936. Its sizable asset base of $6.58bn as at 31 July 2016 makes it Australia’s largest listed investment company.

The team uses a value-based approach, seeking quality names trading below fair value, with a heavy focus on sustainable dividends that can be passed on to shareholders. A combination of in-house and broker research is used to identify investment opportunities through in-depth fundamental analysis as well as industry analysis. The team adheres to the long-term buy-and-hold philosophy we've come to expect from this favoured offering, as evidenced by the portfolio’s low average turnover. However, up to 10% of the portfolio can be used for shorter-term opportunities.

Seasoned investors Mark Freeman and Ross Barker capably manage the strategy and are supported by five experienced analysts. A key advantage over some of its peers is the team’s access to an impressive and sizable board providing valuable insights into a plethora of industries.

AFI has proved its ability to add value over the long term, though its short- to medium-term performance has trailed its benchmark in part because of its structural underweighting to REITs. Despite this, the strategy has outperformed the S&P/ASX 200 Index over the 10 years to 31 July 2016 on a pretax net tangible assets basis. This is partially attributed to its low fee of 0.16%, which minimises the drag on returns relative to its active unlisted peers.

AFI qualifies for the listed investment company tax concession, which means pretax NTA is a more appropriate figure to use when assessing premiums or discounts. All in all, AFI offers a standout option for cost-effective Australian equities exposure. K

Listed Investment Company

Australian Foundation InvesCo Ord AFIMorningstar Analyst Rating™ Morningstar Category Market Index Net Assets $m 31/08/16 Listing Date Analyst

• Equity Australia Large Blend S&P/ASX 200 TR AUD 6,353.4 30/06/1962 Wilson Wong

Growth of $10,000 ■ Market Price ■ Market Index ■ Category

Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Aug-16

18,000

14,400

10,800

7,200

3,600

0

NTA Information 31/08/16 Trading Information 28/09/16

NTA (Pre-Tax) $

5.59Premium/Discount (Pre-Tax)

1.07

NTA (Post-Tax) $

4.82Premium/Discount (Post-Tax)

17.22

Closing Market Price $

5.68Avg Daily Shares Traded (1 Yr)

289,345

52-Week Range $

5.32–5.99Shares Outstanding 26/09/16

1,137,536,474

Top 10 Holdings Ticker Portfolio Weighting %

Commonwealth Bank of Australia CBA 9.47

Westpac Banking Corp WBC 7.31

Telstra Corp TLS 4.66

Wesfarmers WES 4.31

BHP Billiton BHP 4.17

National Australia Bank NAB 4.06

Transurban Group TCL 3.52

Australia and New Zealand Banking Group ANZ 3.27

CSL Limited CSL 2.96

Amcor AMC 2.94

Top 5 World Regions % Cat Avg

Australasia 96.07

Asia Emerging 1.81

North America 1.81

United Kingdom 0.19

Europe Developed 0.08

Top 5 by Stock Sector % Cat Avg

y Financial Services 33.49

r Basic Materials 12.12

p Industrials 11.11

d Healthcare 10.83

s Consumer Defensive 9.16

http://www.morningstar.com.au/LICs/NewsAndQuotes/AFI


Executive summaryThe market underestimates Ande Ande Lumut's (AAL) value and is likely to be caught short. We estimate the net present value of AWE Limited's (AWE) 50% stake at $105m after tax, equivalent to 20 cents per share, or 20% of our total $1.00 fair value estimate. At 60 cents per share, we think the market credits less than zero for AAL.

A more bullish oil price and project cost improvements underpin our disagreement with the market. AWE is undervalued, with our $1.00 fair value estimate 67% above the share price.

Following a poor run in the mid-2000s, AWE has demonstrated a solid run of acquisitions which have been value-accretive, in keeping with our Standard stewardship rating. The now decade-long track record means the chance for capital misallocation is reduced. We think the market misses this and is likely too bearish on the outlook for the oil price as U.S. shale drilling declines. Our mid-cycle US$60 per barrel oil price is at a 25% premium to spot and in line with the US$60 hurdle we see necessary for AAL's approval by operator Santos, now targeted for the second half of 2017.

Key takeaways 33 Given its pre-investment decision status, our 20

cents per share AAL valuation for AWE discounts forecast cash flows at a strident 16% per annum, well above the 11% weighted average cost of capital (WACC) we employ for the rest of the company. This reduces by 20% the value for AAL that would otherwise be recognised--we think sufficiently prudent conservatism. But even with this conservative approach, it must be recognised there is a wide range of potential valuation outcomes for AWE. This and AAL being at predevelopment stage elevates risk and contributes to our very high uncertainty rating. AWE's net debt neutral status is only a partial offset.33 We expect a final investment decision for AAL

requires joint venture evaluation of resubmitted contractor bids, a three- to six-month process, and for those bids hopefully to confirm a project

Small Cap FocusAWE: Shares underplay Ande Ande Lumut project

that is at least free cash flow breakeven at US$35–40 per barrel oil price (Santos' strategic priority). Our thesis is these objectives can be met and consider a US$60 per barrel oil price, in line with our mid-cycle Brent forecast, would see the project approved.

AWE undervalued on market's oil and AAL conservatismThe market is not sufficiently optimistic on the prospect of a recovery in oil prices, project cost reductions and the potential for AAL to add value to AWE. We value producing assets BassGas at 40 cents per share, Casino at 12 cents per share, Tui at 14 cents per share, and Perth Basin gas, including the Waitsia gas field development, at 12 cents per share. Our fair value for undeveloped AAL is 20 cents per share, utilising a 16% WACC comprising the 11% used on AWE's other assets with a 3% sovereign risk premium for Indonesia, and an additional 2% for predevelopment status. On this view, the market is crediting AWE's 50% AAL equity stake at less than zero. An 80% chance of AAL development approval is implicit in our current fair value estimate. This assumes a mid-cycle Brent price of US$60 per barrel (2020 dollars) versus spot at US$47 and futures at US$56.

AAL's returns are aided at lower oil prices by Indonesia's production sharing contract (PSC) regime, which allows for a substantial portion of cost recovery prior to government take, blunting IRR sensitivity to the oil price. Despite this, we expect Brent needs to be US$60 per barrel to get all stakeholders over the line. At US$60 Brent (real) we determine an after-tax IRR for AAL of 40% including Santos' free carry, or 18% if free carry is removed. AWE has an US$88m free carry from Santos, which increases its effective IRR.

Why would Santos approve AAL's development?As AAL project operator, much hinges on Santos' intent, especially in the near term. We think Santos will approve AAL's development principally because the project economics stack up at our US$60 mid-cycle Brent price forecast. But there are a number of other good reasons for Santos to proceed with AAL. Santos has had an Indonesian presence for many years and the country is integral to the company's strategy. Santos will not want to damage its operating reputation with the Indonesian government by dragging its heels on AAL. Given AAL's operating lease expires in 2035, the joint venture will not want to materially delay a decision. As operator, Santos is targeting an FID in second-half calendar 2017 with first oil in calendar 2020.

Mark TaylorSenior Analyst: Basic Materials and Energy

RecommendationMoat RatingUncertainty RatingStewardship RatingMorningstar Style Box™

Price ($)Fair Value ($) Price/Fair ValueBuy Below ($)Accumulate Below ($)

AWE Limited AWE■ Accumulate

NoneVery HighStandard

9

0.591.000.590.500.80


Santos paid US$100m for its 50% share of AAL, excluding US$88m free carry, and may be loath to walk away from such an investment. We think the fact Santos continued to spend at AAL during an oil price rout, including on expensive appraisal drilling, speaks to its intent. Work is going ahead. Recent drilling delivered crude of better-than-expected quality, indicating potential for lower capital and operating expenditure, improved crude pricing, and enhanced project economics overall. Improved economics increase the chance Santos will proceed.

Santos has a stated strategic priority to be free cash flow breakeven at US$35–40 per barrel on a portfolio basis. It seeks returns throughout the cycle. AAL's likely investment requirement is not onerous for Santos on a portfolio basis. Further, at a US$35–40/bbl oil price we estimate Santos' share of life-of-project free cash flows at positive A$290m. Projects capable of meeting Santos' strident investment hurdle are thin on the ground. This again increases the chance AAL will go ahead.

Market underestimates AAL's value to AWEFrom AWE's perspective, we expect cumulative free cash flows from AAL to repay the initial capital expenditure within five years of FID by FY23, three years from first production. AWE's A$457m or 50% share of the A$915m estimated capital cost is further reduced to A$330m by the US$88m or A$125m in free carry. Six years is a short period for shareholders to wait for returns, especially as those returns are large relative to the capital outlays. Even in our bear-case scenario, AAL's initial capital would be repaid within just six years of FID and within the third year of production. However, we don't expect AAL would gain development approval below a Brent price of US$55 per barrel, where project after-tax IRR from

Santos' perspective would likely be below 10%. We think this is getting too close to the minimum incentive price to build a new oil project in Indonesia, with all the risks entailed.

We determine a wide range of potential values for AAL, reflecting leverage to oil prices. But we think the risk is correctly reflected in our very high uncertainty rating and in the 16% discount rate we apply to AAL's forecast cash flows. AAL is at pre-FID status and at least five years from first positive free cash flow, yet contributes 20% of our AWE fair value estimate. But such is the material fair value potential in AAL we feel it cannot be discounted outright. For our bull-case Brent oil price assumption of US$100 per barrel, we estimate AWE's share of AAL is worth A$215m or 40 cents per share using a 16% discount rate. In our bear-case Brent oil price assumption of US$45 per barrel, we estimate AAL is worth just A$15m or 3 cents per share to AWE, assuming the project had been sanctioned in a temporarily higher Brent price window above US$55. The project would not be sanctioned in a US$45 oil price world but we think might still be worth 10 cents per share in option value, equivalent to A$2 per barrel of 2P reserve. Base, bull and bear fair values presented here could increase a further 20% if AAL achieves FID, and as it approaches first production, the discount rating falling from 16% to 14%.

What could AWE look like with AAL's productionWhile AWE's gas fields have reasonable life and comparatively stable cash flows, the more lucrative, genuinely needle-moving oil fields are relatively rarer. This is evidenced by the sharp production spike in FY08 on the back of Tui's oil flows in New Zealand, and potential for similar circumstance in FY21 if AAL is approved. Group production has recently fallen. In addition to field depletion, AWE sold its Sugarloaf and Cliff Head assets, to refocus on Australia, New Zealand and Indonesia. This hollows out production, but transforms the balance sheet to modest net cash status in preparation for new development opportunities. Notwithstanding Waitsia's development and boosted gas flows from the Perth Basin, AWE's production volumes will remain lower than historically until development of AAL or an alternative.

We think AAL a particularly attractive proposition for AWE due to the very large potential cash flows it could generate and the favourably limited free cash outflows in the lead-up to first production. Net free cash outflows for AWE are minimised by

Exhibit 1: AAL has Look-Alikes on the Malaysian Side of the Maritime Boundary Northwest Natuna PSC (AWE 50%)

Source: AWE Limited

NW Natuna PSCOil FieldsGas FieldsProspectsGas PipelinesOil PipelinesMaritime BoundariesPSC areas

KILOMETRES

0 2 4 6 8 10

West Belumut

East Belumut

Mala

ysia/

Indon

esia

Mar

itime

Bou

ndar

y

Northwest Natuna PSC(AWE 50%)

Ande Ande Lumut

AAL-2X-R

AAL-3X AAL-1

AAL-4X


Santos' US$88m free carry, and by a material portion of the staged development expenditure occurring after first production. AWE shareholders won't have to wear large free cash outflows and won't wait long for a return on investment. The comparatively low outflows and short wait for cash returns reduces risk for investors. We think the main fair value risk is in getting to FID stage. Once approved, we think the risk for AWE shareholders greatly reduces, development risk included.

AAL in focusWhile AAL is at pre-FID stage, there are nonetheless a number of points of reference from which to draw strong conclusions, particularly if these are appropriately discounted as in our fair value estimate. Of particular relevance is the existence of at least two producing analogues in Malaysia. In other words, this is all already being done, just over the border in fields with comparable reservoir characteristics. Further, there are no show-stoppers; the technology required for AAL can be bought off-the-shelf. There are, however, features of the field, not all positive, which combine to make this a unique field. We discuss these here in greater depth.

Front end engineering and design for AAL is complete. Development will comprise one well head platform, 33 horizontal wells and a leased floating production storage and offloading vessel (FPSO). Water depth is shallow in this part of the Northwest Natuna Sea, which is a considerable benefit for well head and drilling costs. AWE released an all-up capital cost estimate of US$800m in 2013, a figure not since updated. We assume the cost has fallen by approximately 20% to US$640m to develop AAL's K-sand. In addition to substantial industry cost deflation due to the end of the China-boom, and weaker oil prices, the project

has been further refined with optimised well placement and fewer but longer production wells. Horizontal drilling is industry-common, including AWE's deviated drilling from vertical at Tui.

Approximately two-thirds of the total estimated capital cost is drilling, with the well-head platform and pumps most of the balance. A benefit from a cash-flow and funding perspective is that drilling is likely to last for three years, but two of those after first production. We estimate first oil follows the sixth well's completion. On that basis nearly half of all the capital cost is after first production. From FID, the first one-and-a-half years would be all construction cost, and from then all drilling. The drill rig being on-station for three years reduces cost. An added benefit for AWE is an US$88m free-carry from Santos with the first US$65m before first oil. As part of AWE's sale of 50% of AAL, Santos agreed to fund US$88m of AWE's 50% share of development expenditure.

While the shallow water depth results in drilling and platform cost savings, it also means limited over-pressure, and electrical submersible pumps (ESPs) are required to produce the oil. Further, the reservoir has very good porosity, but comes with sand production. The solutions are common and off-the-shelf and already being used successfully across the Malaysian border. AWE successfully used ESPs at its Cliff Head oil field in Western Australia (sold this year). Sand screens are common, down-hole, and only a problem if back-ended, rather than installed upfront.

AAL crude is not overly waxy but falls within the heavy range; the FPSO will need heated tanks and the ability to cope with high water volumes, not rocket science. Fluid capacity will necessarily push 100,000 barrels per day, of which up to 40,000 barrels will be oil. Heavy crudes attract a discount, in AAL's case no more than US$5 per barrel. Our model assumes a 5.0% discount to Brent, or US$3.00 at our mid-cycle US$60 per barrel.

It will take two-and-a-half years from AAL FID to first oil. FID is slated for second-half calendar 2017, a delay to the prior second-half calendar 2016 target, necessitated by Indonesian legislative changes. New requirements for local content in infrastructure, like the FPSO and well head, have little impact on cost but require additional time for contractors to resubmit bids. The joint venture anticipates a three- to six-month delay to evaluate tenders. We credit first oil production from first-half calendar 2021. The

Exhibit 2: Staged capital expenditure and free carry delivers free cash flow as soon as fiscal 2022 AWE's cumulative share of forecast AAL after-tax cash flows (AUD million)*

M AWE - Base Case M AWE - Bull Case M AWE - Bear Case M Santos - Base Case

Source: Morningstar *Excludes USD 100 million proceeds from sale of 50% of AAL to Santos, but includes free-carry.

-600

-400

-200

0

200

400

600

800

1000

1200

FY18 FY19 FY20 FY21 FY22 FY23 FY24 FY25 FY26 FY27 FY28 FY29 FY30 FY31 FY32 FY33


David Ellis, CPA

Senior Equity AnalystBanks, Insurance and Diversified Financials

The big picture for Australia’s four wide-moat major banks is playing out as expected.

Loan growth is slowing but only modestly; net interest margins (NIMs) are under pressure but well managed; operating cost growth lags revenue growth; and bad debts will continue to increase from historical low levels. We expect the four major banks to need approximately $20bn in new capital over the next three to four years to fund asset growth and satisfy future capital regulatory requirements. As a result, earnings per share (EPS) growth is expected to slow, dividend payout ratios should fall to long-term trend levels, and return on equity (ROE) will decline by two percentage points on average to still-attractive levels of 12%-14%. A stronger-than-expected performance from the Australian

The big picture for the major banks is playing out as expected, but CBD apartment risk is increasing

and New Zealand economies could surprise. In our view, the business, economic, political and operational concerns affecting the banks are not as bad as the market fears, and we do not expect the major banks’ privileged position to change any time soon.

We like the attractive long-term fundamentals of the sector; our current preferred banks are the big retail-focused Westpac Banking Corporation (WBC) and Commonwealth Bank of Australia (CBA). Our preference for these banks is driven by their lower risk profiles, higher ROEs, higher NIMs, lower cost/income ratios, consistently lower loan-loss rates, less volatility in earnings, and larger exposures to the strongly performing New South Wales economy. The key issues concerning investors are the potential for large capital issues, pressure on earnings growth, the likely reduction in ROEs, and lower payout ratios. While higher capital levels will reduce ROEs, they will also strengthen bank balance sheets, making long-term payout ratios more sustainable. Lower payouts are a short-term negative, but rebasing dividend payouts lower is a long-term positive for shareholders.

AAL lease ends in 2035, sufficient time to produce K-Sand's 101 million barrels (mmbls) and G-Sand's potential 36 mmbls. We assume an additional US$160m to develop G-Sand from FY24.

Oil developments in Indonesia fall under the PSC fiscal regime. This in effect treats the joint venture as a contract producer for the government, well understood and tested by industry over many years. All costs are worn by the contractor as the government does not fund development or operating

costs. When production begins, First Tranche Petroleum (FTP) amounting to 10% of total goes to the government. The 90% balance of production goes first to contractor cost recovery, and then any positive balance is again split government/contractor. The contractor's profit share is generally in the order of 30%–40%. The contractor takes nearly all 90% in the early cost recovery stage with any un-recouped balance rolled forward, the payoff for having to fund 100% of the project.

Staged drilling and free carry from Santos will limit AWE's AAL funding obligations to first production. Assuming early stage (K-Sand only) AAL construction and drilling costs of US$640m or A$915m, we project AWE will be required to contribute approximately A$100m prior to first production. From first production, free cash flows will be favourably positive with payback in two years. We assume an average cash operating cost of US$24 per barrel (A$34 per barrel), conservatively high to allow for FPSO leasing and ESP maintenance. All up, FPSO costs are assumed at US$300,000 per day or US$7.65 per barrel (A$11.00 per barrel). Leasing the FPSO reduces project capital costs substantially, but necessarily increases operating cost. K

Exhibit 3: Equity Group Hydrocarbon Volumes to Sharply Decline Without AAL's Contribution Forecast annual equity oil equivalent production for AWE (mmboe)

■ Other ■ Sugarloaf ■ Cliff Head ■ Perth Basin Gas ■ Tui ■ Casino ■ BassGas ■ AAL

Source: Company Filings/Morningstar

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

2002

A

2003

A

2004

A

2005

A

2006

A

2007

A

2008

A

2009

A

2010

A

2011

A

2012

A

2013

A

2014

A

2015

A

2016

F

2017

F

2018

F

2019

F

2020

F

2021

F

2022

F

2023

F

2024

F

2025

F


We acknowledge increasing regulatory risks, the general weakness facing the broader Australian economy, the potential for sharper increases in bad debts, and in particular, the impact of the political and media attention on the banks’ dominant market positions. We forecast modest EPS growth over the next five years, with EPS averaging about 3% per year during FY17-20. There is some downside risk to our medium-term forecasts, given the recent loss of momentum in indicators of household spending in particular, as well as business conditions and the possibility of sharp falls in inner-city apartment prices. We still forecast the major bank payout ratios to fall progressively from an average of 75% in FY16 to approximately 71% by FY20, but we now see the rate of decline as slower than earlier predicted.

The major banks look fairly valued based on current average one-year forward P/E multiples around 12, with the 10-year average one-year forward P/E multiple for the major banks at 11.9. CBA and WBC are the most attractive, trading at a 13% discount to our respective fair value estimates of $85 per share and $35 per share, respectively. Australia and New Zealand Banking Group (ANZ) is fairly valued, based on our $28 fair value estimate, and National Australia Bank (NAB) is trading 7% below its $30 valuation. Our valuations are heavily influenced by our unchanged 9.0% cost of equity. We are valuing the banks at mid-cycle earnings for most key data points, with pressure on NIMs expected to intensify. We forecast medium-term loan growth of approximately 4.7% in 2020, below the 10-year trend rate of 6.7% per year.

Despite major bank stock prices being inexpensive, we see few near-term share-price catalysts that could drive prices higher. Dividend yields remain attractive and should provide share-price support. In our opinion, recent share-price weakness for CBA and WBC more than captures the lower growth profile and the expected capital build in coming years for the mortgage heavyweights. If the economic performance of the Australian economy improves more than expected, the two business-focused banks (ANZ and NAB) will benefit more than CBA and WBC. We see significantly less risk of large one-off capital raisings in 2017, but downside risks remain with the twin headwinds of net interest margin pressure and slowing credit growth. Upside risks include further mortgage repricing in late 2016 and 2017 and lower-than-expected increases in bad debts.

Over the next three to four years, we expect CBA will raise or release $6bn in new capital; ANZ $4.5bn; NAB $4.5bn; and WBC $5.5bn. We maintain our long-term view the additional capital will be raised from future retained profits, selected asset sales, better internal capital utilisation, dividend reinvestment plans (DRPs), and DRP underwrites. We do not forecast large “one-off” on market capital raises in 2017. Such capital build should also address the banking regulator’s call for the major banks to be “unquestionably strong” on capital. In our view, a steady ongoing capital build would fit nicely with the requirement for the major banks to be in the top quartile of global common equity Tier 1 ratios on a harmonised basis, thereby meeting APRA’s “unquestionably strong” requirement for capital.

The Basel Committee is expected to release the final version of Basel IV before the end of 2016, with APRA likely to publish its Basel IV rule changes in the first half of calendar 2017. Increasing political pressure from officials from various countries, particularly in Europe, on the Basel Committee to limit the impact of its reforms suggests a watering-down of the current proposals is a distinct possibility. One example of this is the potential softening of the proposed requirement to use the standardised approach for certain portfolios. Watering-down of the Basel IV capital rules remains highly likely before year-end.

Australian gross domestic product (GDP) growth is running at a surprisingly strong 3.2% for 2Q16, but we expect GDP to decline to a medium-term average of 2.5%. Unemployment is expected to

Exhibit 1: Financial System Credit Growth to July 2016M Housing credit growth M Business credit growth M Total credit growth

Source: Reserve Bank of Australia/Morningstar

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Feb-

01

Mar

-02

Apr-0

3

May

-04

Jun-

05

Jul-0

6

Aug-

07

Sep-

08

Oct-0

9

Nov

-10

Dec-

11

Jan-

13

Feb-

14

Mar

-15

Apr-1

6

Total credit growth of 6.0% at Jun-16. Bus credit 6.2%;

Housing credit 6.6%, O/O credit 7.6%; Inv credit 4.8%


hold steady at around 5.5%-6.0%, indicating some spare capacity in the labour market. We expect the Reserve Bank of Australia (RBA) will hold the 1.5% cash rate steady in the near term, but there could be further cash rate cuts in 2017, as low inflation is likely to persist. Recent data on wage growth has been soft, with growth in the wage price index steadying at 2.1% year on year in 2Q16. We expect wages growth to remain subdued through the next several years at least.

Credit growth is running around 6%, but the rate of growth is slowing modestly. In line with our special report on major banks, published in July, we noted system credit growth is expected to decline modestly to around 5% over the next few years. Bad debts are trending higher from cyclical lows, but we don’t expect a sharp increase, as our base case is the Australian economy holds together and muddles through as the economy transitions from the extended massive stimulus from the mining investment boom and historically high export prices. We forecast bad-debt loss rates to increase steadily over five years from 0.16% of gross loans in FY15 to long-term trend rates of approximately 0.30% in FY20. We expect average NIMs to soften to approximately 1.97% as funding costs and competition for new loans intensify, but major-bank pricing power will limit the damage to profits. In contrast to the popular view held by international investors, we do not expect the Australian residential property market to collapse; rather, we see an extended period of flat to modestly lower house prices. Australian households are far wealthier than many believe, and despite high average household debt/income levels, households on average are in solid positions to weather a financial crisis.

The Australian economy is benefiting from strong growth in residential construction, education, tourism, medical research, professional services, agriculture, and advanced manufacturing. Residential construction (particularly inner-city apartments in Sydney, Melbourne and Brisbane) is at record levels, but the sharp increase in apartment volumes is creating elevated risk for the economy in general and the four major banks in particular. The risk of property developer defaults and potential falls in inner-city apartment prices are increasing the likelihood for higher bad debts across the residential property sector.

The population of Sydney, Melbourne and Brisbane has grown by a third in the past 20 years, and the New South Wales, Victorian and Queensland state governments are forecasting solid population growth of the three capital cities over the next two decades. Despite house prices continuing to increase, demand for well-located capital-city detached housing is expected to outstrip supply for several years at least. Demand continues to exceed supply for desirable properties close to services, transport and employment centres in the capital cities of Sydney, Melbourne and Brisbane. Based on Australian Bureau of Statistics data and New South Wales government forecasts, we forecast Sydney’s population of 5 million to grow by 90,000 per year, or 1.7%, for the next 10 years. The growth outlook rate is stronger in Melbourne, Australia’s second-largest city.

Supply of new city apartments has grown rapidly, but is likely to slow from 2018. Australian dwelling approvals peaked at 240,000 in October 2015, but we expect the build rate to moderate from 2018, reducing the likelihood of the broader market moving to an oversupplied status. Apartment prices will likely fall in oversupplied suburbs and regions, particularly the Melbourne and Brisbane central business districts.

Export prices have rebounded, with iron ore around US$55 per tonne (up 50% from December 2015 lows) and coking coal around US$190, double its price in January 2016. Long-term forecasts for world population growth, world GDP per capita growth, demand for high-quality food, and energy consumption support long-term demand for Australia’s key exports. Australia is forecast to be the equal largest exporter of liquefied natural gas (LNG) in the world, supporting future Australian GDP growth and the broader economy. There are over 2 billion people in Asia outside of China and we expect increasing demand for Australia’s mining resources, agriculture, energy, education, tourism, professional services and property during the next two decades at least. Furthermore, LNG exports are ramping up and will soon be making a meaningful contribution to GDP. K





ANZ Banking Group ANZ■ Hold

WideMedium

Standard0

27.6328.00

0.9919.6025.20

Commonwealth Bank CBA■ Accumulate

WideMedium

Exemplary0

72.9385.00

0.8659.5076.50





National Australia Bank NAB■ Hold

WideMedium

Standard0

28.0130.00

0.9321.0027.00

Westpac Bank WBC■ Accumulate

WideMedium

Exemplary0

29.9235.00

0.8524.5031.50


Analyst John Likos

Recommendation Reduce

At current prices, ANZPG looks relatively expensive, with a 4.58% trading margin, gross yield to reset of 6.48% and a gross running yield of 6.55%. We initiate coverage with a Reduce recommendation.

Investment SummaryANZPG is a fully paid, non-cumulative, convertible, transferrable, redeemable, subordinated, perpetual, unsecured note with a $100 face value and scheduled conversion date of 20 March 2026. Scheduled conversion on that date is subject to conversion conditions. ANZPG may be converted earlier as a result of a trigger event or ANZ exercising an option to redeem, transfer or convert the security two years early on 20 March 2024. Distributions are discretionary, non-cumulative and fully franked with a dividend stopper. Distributions will be paid quarterly in arrears, based on the 90-day bank bill swap (BBSW) rate plus a margin of 4.70% per annum.

Analyst Note On 28 September 2016, ANZ Capital Notes 4 (ANZPG) commenced trading on the ASX. After recommending in our presale note on 16 August 2016, investors do not subscribe to the new issue, we initiate coverage with a Reduce recommendation. We have assigned a Medium investment risk rating to ANZPG. Our medium uncertainty and wide moat issuer ratings for

ANZ Capital Notes 4 ANZPG Hybrid | Banks | 29 Sep 2016

Hybrid Corner Australia & New Zealand Banking Group (ANZ) are unchanged. We consider the newer Basel III-compliant Tier 1 issues, ANZPE, ANZPF and ANZPG to be the highest-risk ANZ-issued listed hybrid securities, largely reflecting less-favourable mandatory conversion terms and conditions for security holders.

At current prices, ANZPG looks relatively expensive placing it "below the curve" for Australian major bank Basel III Compliant Tier 1 hybrid securities.

ANZPG is one of the new breed of Basel III-compliant hybrid security issues, meaning it can be classified as Tier 1 capital for regulatory purposes for ANZ. Securities such as these have more loss-absorption features. These newer features are required by the regulator to offer more protection to bank deposit holders. Investors need to be aware that this is not a defensive or growth asset and should not be treated as such in the asset allocation process. It will not be subject to the same volatility as ordinary shares except in the circumstance where there is a credible risk of unscheduled conversion or default on distributions.

We believe the yield to call on ANZPG is insufficient compensation for its lengthy term to call, which is the longest term to call of any Basel III Compliant AT1 security in Australia. ANZPG’s long term to call makes relative pricing against the ANZ Bank capital structure difficult due to a lack of comparable tenors. ANZ’s floating rate senior unsecured bond maturing on 16 August 2021 is currently yielding 2.73% and a 5-year fixed term deposit is currently paying an interest rate of 2.48%. Morningstar estimates the current grossed up dividend yield on ANZ's common equity for FY16 to be 8.3%. K

Security Investment Risk Medium

Issuer Name Australia & New Zealand Banking Group

Issuer Economic Moat Rating Wide

Issuer Stewardship Rating Standard

Sector Banks

Issue Date 27 September 2016

Issue size (AUD million) 1,622

Call Date 20 March 2024

Mandatory Conversion / Maturity 20 March 2026

Issue Price (AUD) 100.00

Coupon Margin 4.70%

Base Rate 90-day bank-bill swap

Franking 100%

Distribution Frequency Quarterly

SnapshotLast Price $ 100.85Running Yield inc. Franking % 6.55 Running Yield ex. Franking % 4.58Yield to Reset inc. Franking % 6.48Yield to Reset ex. Franking % 4.73

Exhibit 1: Major Bank Basel III Tier 1 Hybrids Trading Margins vs. Term to First Call, 29 September 2016 (%)

Exhibit 2: ANZ Credit Securities Yield Curve, 29 September 2016 (%)■ AT Hybrids ■ Senior unsecured ■ Term deposit

Source: Morningstar Source: Morningstar

ANZPF

NABPB

NABPC

ANZPD

ANZPE

WBCPE

CBAPD

WBCPF

CBAPE

WBCPG

NABPDANZPG

2.00

2.50

3.00

3.50

4.00

4.50

5.00

2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5Years to Reset

ANZPC

ANZPDANZPE

ANZPF

ANZPG

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

0 1 2 3 4 5 6 7 8Years to Reset


Investment PerspectiveThe current ANZ Banking Group was established in 1951, but the brand and origins stretch back to 1835. The push into Asia and the well-regarded Australia and New Zealand franchise is slanted toward corporate and business banking, with increasing exposure to retail banking and wealth. ANZ Bank has failed to deliver higher returns than major bank peers as a result of the lower return Asian businesses. Designed to leverage the bank to fast-growing trade and investment flow, both within Asia, and among Asia, Australia, and New Zealand, the Asian growth strategy is based on higher growth rates than Australia and New Zealand, where household and business credit growth is modest. We are attracted to the outlook for growth and earnings upside, but we acknowledge increasing risks and lower shareholder returns. The author’s superannuation fund owns shares in all four Australian major banks.

$40.00

$35.00

$30.00

$25.00

$20.00

Morningstar Investment Ratings

Analyst Fair Value ($)Price/Fair ValueMoat RatingUncertainty RatingStewardship

ANZ Bank ANZ | $27.45Large Cap | Banks - Global | 28 Sep 2016

Recommendation

Settlement of legal dispute trims FY16 forecast; Fair value unchangedAustralian and New Zealand Banking Group’s (ANZ) settlement of the Pankaj and Radhika Oswal legal dispute will increase the bank’s FY16 bad debt expense by $145m pretax. The commercial settlement surprised, but the upside is the cessation of the $2.5bn claim made by the Oswals following the receivership and sale of Burrup Fertilisers in 2010. We increase our FY16 bad debt expense forecast from $2bn to $2.1bn. Forecast loan losses increase to 0.36% of average gross loans, modestly above long-term trends. Despite the approximate $100m reduction in FY16 cash earnings, the Oswal legal decision is an example of new senior management at ANZ being prepared to take hard decisions rather than delaying with the hope of a better outcome down the track. The bank’s announcement in early May 2016 to rebase the dividend payout ratio target to 60%-65% from 65%-70% over time is another example of a bold decision applauded by the market.

Our adjusted FY16 pro forma cash profit forecast declines from $7.1bn to $6.97bn. We expect earnings per share (EPS) to decline 9.7% due to the lower profit and increased capital raised in 2015. Our $28 fair value estimate is unchanged for the wide moat-rated bank, and despite challenges, we

maintain our positive view on long-term earnings growth. At current prices, the stock is fairly valued, having increased approximately 27% from its one-year closing low of $22.18 per share in February 2016. ANZ’S FY16 result is scheduled for 3 November and we expect a total fully franked dividend of $1.60 per share, down 12% on FY15, based on a 68% payout ratio. We forecast the bank will hit the midpoint of the 60%-65% range of approximately 63% by end FY18. We expect the final FY16 dividend will be 80 cents per share, in line with 1H16.

We forecast ANZ will raise about $4.5bn in new capital over three to four years to fund loan growth and satisfy tougher future regulatory requirements. In line with our long-held view, ANZ estimates additional capital can be sourced from more effective utilisation (reducing capital to low-returning institutional business), gradually reducing the payout ratio to 60%-65%, future retained earnings, divesting assets, dividend reinvestment plans (DRP), and if necessary, DRP underwrites.

We expect modest revenue growth in FY16 over FY15 and expenses growth slower than revenue. Solid lending growth is offset by slightly lower net interest margins (NIMs). Based on APRA’s banking statistics, ANZ’s Australian home lending is up an impressive 7.7% in the year to 31 July 2016 compared with total bank system growth of 7.4%. Household deposit growth is modestly softer at 6.5%, and trails household deposit market growth of 9.4%. We expect group residential loan growth of 5.5% and business lending growth of 5.0% for FY16. ANZ continues to grow its Australian residential loan portfolio due to a strong performance in New South Wales as the Melbourne-based bank more effectively utilises mortgage brokers to expand distribution in Australia’s most populous state, where its branch network is relatively underrepresented.

We reduce our FY16 NIM forecast to 2.00%, modestly below 1H16 of 2.01%. NIM is under pressure from higher funding costs, increasing mortgage competition, and historically low interest rates reducing income on capital and high-quality liquid assets. Recent loan and deposit repricing following the 0.25% cut to the official cash rate in early August will support margins. We forecast a steady but modest decline in NIMs over the next five years to around 1.96% by FY20. An FY16 forecast cost/income ratio of 45.5% is a modest improvement on FY15’s 45.6%. K

Revenue ($m)NPAT ($m)EPS (c)EPS % ChgP/E

ROE (%)DPS (c)Franking (%)Div Yield (%)Gross Yield (%)

David Ellis28.00

0.98Wide

MediumStandard

Hold

18391.0

09/13(a)

6492.0237.9

8.911.615.0

164.0

5.98.5

19578.0

09/14(a)

7117.0260.3

9.412.515.0

178.0

5.57.8

20518.0

09/15(a)

7216.0260.3

-0.012.513.6

181.0

5.68.0

21534.4

09/16(e)

6969.1235.0

-9.711.711.8

160.0

5.88.3

22296.5

09/17(e)

7248.0239.7

2.011.411.7

157.0

5.78.2

100.0 100.0 100.0 100.0 100.0

ANZ S&P/ASX 200

Snapshot

SectorMorningstar Style BoxMarket Cap ($m)Ann. Share Turnover (%)Net Debt/Capital52 Week Hi/Low ($)Total Return - 1 yearTotal Return - 5 year (p.a)Ex-DividendPayable

Financial Services1

80,35963.6

--29.17/21.86

8.213.7

09 May 201601 Jul 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/ANZ

http://www.morningstar.com.au/Stocks/NewsAndQuotes/ANZ




AGL Energy AGL | $18.70Large Cap | Utilities - Diversified | 28 Sep 2016

Recommendation

Share buyback and higher payout ratio feature; Fair value estimate unchangedWe retain our $16 per share fair value for AGL Energy (AGL) following the outlook commentary and on-market share buyback announced at the annual general meeting. Management is guiding for FY17 underlying NPAT of $720m-$800m, up 3%-14% on FY16. We forecast earnings towards the bottom of the guided range. AGL expects the main drivers of FY17 profit growth to be: improved wholesale electricity margins; execution of the customer value strategy; and delivery of operational transformation targets, with AGL on track to meet its FY17 cost savings target of $170m. Guidance includes the impact of the unseasonably mild weather in July and August and the anticipated reduction in gas portfolio EBIT of at least $100m.

The dividend payout policy will change from an existing 60-65% to approximately 75% of underlying NPAT starting with the 1H17 dividend. Management indicated dividends will not be fully franked due to insufficient franking credits, but will be no less than 80% franked. AGL will also undertake an on-market buyback of up to 5% of issued share capital, roughly 34m shares, with an approximate market value of $600m. The buyback will start no earlier than 13 October and complete within a year.

AGL is a high-quality company, with sustainable competitive advantages stemming from its scale and cost advantages from its low-cost coal-fired power stations, warranting a narrow economic moat rating. However, it screens as expensive at current levels, trading roughly 15% above our valuation. We trim our FY17 estimates by 2% to $731m and FY18 by 4% to $758m, assuming higher interest expense given increased debt to fund the buyback. However, the buyback is earnings per share accretive with FY17 and FY18 underlying EPS estimates revised up 0.3% and 0.8%, respectively, to 110.5 and 117.4 cents per share, respectively. K

Rev ($m)NPAT($m)EPS (c)EPS %ChgP/E

ROE (%)DPS (c)Frnk (%)Div Yld (%)Grs Yld (%)

Adrian Atkins16.00

1.17Narrow

MediumStandard

Reduce

11149.0

06/16(a)

700.9103.8

8.016.8

8.4

68.0

3.95.6

11677.6

06/17(e)

731.4110.5

6.417.0

9.2

83.0

4.46.3

12012.7

06/18(e)

757.6117.4

6.315.9

9.4

88.0

4.76.7

100.0 80.0 85.0



CSL CSL | $105.66Large Cap | Biotechnology | 26 Sep 2016

Recommendation

Competition increases in primary immune deficiency with Shire’s Cuvitru; Maintaining fair value estimateCSL Limited’s (CSL) global plasma peer Shire has received approval from the U.S. Food and Drug Administration (FDA) for Cuvitru, a product that will compete directly with CSL’s Hizentra. Cuvitru is an immune globulin subcutaneous 20% solution (SCIG) used for replacement therapy for primary immune deficiency (PID), in adults and paediatric patients two years of age and older. While we expect Cuvitru to be a strong competitor to Hizentra in the PID indication, we believe the subcutaneous opportunity remains well under-penetrated and maintain our FY17 forecast sales growth assumptions for the overall immunoglobulin division at 9% year on year.

Notwithstanding the FDA’s approval of Cuvitru heralding higher competition in PID treatment, we think growth in the underlying market in the U.S. will largely offset the impact of new entrant Cuvitru in the near term.

Accordingly, we retain our fair value estimate of $125 per share for CSL. Given the current 18% discount to our fair value, we regard the stock as undervalued at current levels. Our narrow moat rating on CSL remains intact and is based on costs advantage and intangible assets.

CSL’s Hizentra, launched in 2010, was the first 20% SCIG approved in the market and provided patients with the convenience of self-administration at home. Original FDA approval for weekly dosing was expanded over time to more flexible dosing options by February 2015. In FY16, Hizentra sales totalled approximately US$700m or 11% of CSL’s group revenue, up 31% on FY15. We estimate sales in the U.S., the largest subcutaneous market and representing 66% of the global market, amounted to about US$470m. Reimbursement pricing has yet to be determined, however, we expect Cuvitru to be launched by 2Q17. K



Chris Kallos, CFA125.00

0.85Narrow

MediumStandard

Accumulate

6646.5

06/16(a)

1350.0292.2

-7.834.246.7

137.0

1.41.4

8735.7

06/17(e)

1784.9395.4

35.326.758.3

185.7

1.81.8

9746.7

06/18(e)

2280.7511.2

29.320.757.6

240.8

2.32.3

0.0 0.0 0.0

http://www.morningstar.com.au/Stocks/NewsAndQuotes/AGL

http://www.morningstar.com.au/Stocks/NewsAndQuotes/AGL

http://www.morningstar.com.au/Stocks/NewsAndQuotes/CSL


Investment PerspectiveInsurance Australia Group is one of the two largest domestic general insurers operating in Australia and New Zealand. Despite heritage brands and high market shares, its products are commoditised and sustainable competitive advantages are elusive, hence the pressure from competition on revenue and margins. The firm has finally exited its struggling U.K. business to focus on its core business in Australia and New Zealand and its Asian strategy. The insurance market is mature, with cyclical, price-competitive, premium rates. Large insured events occur without warning, and claims trends are largely beyond the control of management in the short term. Reinsurance protection and capital management mitigate risks to some extent. General insurance is inherently risky, with volatile earnings, but the recent deal with U.S. global insurer Berkshire Hathaway will reduce earnings volatility and increase more stable fee income.

$7.00

$6.50

$6.00

$5.50

$5.00

$4.50



Insurance Aust. Grp. IAG | $5.44Large Cap | Insurance - Property & Casualty | 27 Sep 2016

Recommendation

Faces short-term headwinds but long-term outlook remains positive; $6.00 fair value estimate unchangedProfit growth for Insurance Australia Group (IAG) in FY17 is under pressure from a combination of tough conditions in commercial insurance markets, higher allowances for natural peril costs, the sale of subsidiary Swann Insurance, lower reserve releases, additional costs to implement operational and systems simplification, reversion to a more "normal" tax rate, and continued historically low interest rates. Following a reassessment of these near-term headwinds, we reduce our FY17 cash profit forecast from $950m to $883m.

Our FY17 forecasts imply earnings per share (EPS) growth of just 2.6% on FY16 and a fully franked dividend increase of 3.9%, reflecting an increase in our forecast payout from 73% in FY16 to 74%. The dividend payout target range is unchanged at 60%-80% of cash earnings. On a positive note, pricing in commercial markets appears to be recovering from an extended period of weakness, and there are good signs conditions in both Australia and New Zealand are starting to improve, with FY18 likely to see the start of solid earnings growth.

Our $6.00 fair value estimate and high uncertainty ratings are unchanged. At current

levels, IAG is modestly undervalued, trading at a 9% discount to our valuation. IAG’s investor briefing, scheduled for 8 December, will provide more detail on strategy and could provide a catalyst for a share price rerating closer to our valuation. IAG has a strong balance sheet and surplus capital which underpinned the mid-August announcement of a $300m off-market buyback following the special fully franked dividend of 10 cents per share, paid in March. The buyback tender period closes 7 October and is expected to cover over 2% of outstanding issued capital. The capital component of the buyback is $2.99 per share, with the balance deemed to be a fully franked dividend. For more details on the buyback, please refer to our note of 30 August.

Surplus investment capital in global insurance and reinsurance markets is placing pressure on average rates and underlying profitability, with management’s focus on tight underwriting disciplines causing some loss of volumes. The 20% quota share arrangement with Berkshire Hathaway delivered as expected, providing a 250-basis-point uplift to the underlying insurance margin. Key upside from the quota share includes reduced earnings volatility and a reduced capital requirement. The arrangement lowered IAG’s regulatory capital requirement by approximately $400m in FY16, with an estimated further reduction of $300m over the next two to three years. Despite the quota share uplift, the underlying insurance margin increased by 0.90% to 14.0% in FY16 from 13.1% in FY15. Our FY17 forecast insurance margin of 13.8% is towards the top end of the 12.5%-14.5% guidance range.

FY17 guidance is based on net costs from natural peril events of $680m (after quota share allowance), reserve release of at least 1% of net earned premium, and no material changes in foreign exchange rates or investment markets. Natural peril events cost $659m in FY16. There is upside to our FY17 profit forecasts if reserve releases exceed the 1% of net earned premium. The sale of Swann Insurance will remove $130m from group gross written premium (GWP) in FY17 and beyond. We expect good medium-term growth in GWP for personal lines, on the back of solid growth in insurance policies written and upside from recent premium rate increases. GWP for commercial lines in Australia and New Zealand declined 7% in FY16, but we expect improvement in FY17 to accelerate in FY18. K



David Ellis6.000.91

NoneHigh

Standard

Hold

9493.0

06/14(a)

1306.059.4

5.29.7

23.0

39.0

6.89.7

11149.0

06/15(a)

987.042.3

-28.714.414.8

29.0

4.86.8

8810.0

06/16(a)

867.035.8

-15.515.313.0

26.0

4.76.8

9433.0

06/17(e)

882.836.7

2.614.813.6

27.0

5.07.1

9671.7

06/18(e)

950.940.4

9.913.514.6

29.0

5.37.6

100.0 100.0 100.0 100.0 100.0

IAG S&P/ASX 200

Snapshot


Financial Services4

13,22765.2

--6.17/4.72

20.219.2

06 Sep 201605 Oct 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/IAG


Investment PerspectiveBrickworks is Australia’s largest brick manufacturer. The building products division operates brick, paver, concrete masonry, and roofing tile facilities throughout the country. The sale and/or development of extensive land holdings, which are a legacy of primary brick-manufacturing activities, will supplement earnings for at least the next decade, although timing makes contributions unpredictable. Similarly, the major investment in Washington H. Soul Pattinson provides noncyclical diversification for the building products operations. Brickworks is a conservatively managed group and can be included in long-term growth portfolios.

$16.00

$15.00

$14.00

$13.00

$12.00



Brickworks BKW | $13.47Medium Cap | Building Materials | 22 Sep 2016

Recommendation

East beats west; Fair value lifted 5% to $13.70No-moat Brickworks (BKW) reported in-line FY16 earnings with underlying NPAT of $147m and underlying earnings per share (EPS) of 99 cents, up 22% on FY15. The final fully franked dividend increased from 30 to 32 cents per share, taking the FY16 dividend to 48 cents from 45 cents in FY15, in line with estimates.

Management did not provide formal FY17 guidance, but said the short-term outlook for Building Products remains positive, underpinned by a resilient east-coast housing market, in stark contrast to the West Australian (W.A.) market, where restructuring initiatives are under way. In Land and Development, net rental income will increase, given completing developments in FY17, offset by lower revaluation profits. However, Oakdale West is set to be sold into the Property Trust, generating land sale profits. We expect the investment in Washington H Soul Pattinson (SOL) to continue delivering steadily increasing earnings and dividends over the long term.

We increase our fair value estimate, derived from a sum-of-the-parts valuation, from $13.00 to $13.70, factoring in the recent increase in the fair values of SOL’s investments. We revise earnings upward, given better-than-expected Buildings

Products earnings in FY16 and a forecast lift in investment income. We lift FY17 to FY19 EPS by between 5% and 6%. Despite the revisions, we forecast FY17 EPS to be 12% lower than FY16 and FY18 to be 11% down on FY17, as the residential construction cycle winds down before recovery in FY19-20. Our no-moat rating reflects the highly cyclical and competitive industry in which BKW operates.

Building Products’ underlying revenue increased 7% to $748m and underlying EBIT improved 34% to $75m, with EBIT/sales margin up from 8.1% to 10.1%. Margin improvements were led by a mix of cost-out and price rises. Sales by product were 7% higher in Austral Bricks; 4% higher in Austral Masonry; 11% higher in Bristile Roofing; and 11% higher in Austral Precast. However, Auswest Timbers sales fell 6%, reflecting the downturn in W.A. construction.

Management indicated the pipeline for higher-margin east-coast work remains strong, with around six months of work in hand in bricks and nine months in precast. The resilience of the east-coast market is in stark contrast to W.A., where detached housing approvals are weak. Despite weakness, W.A. remains an important brick market given the greater prevalence of brick usage per capita relative to other markets. The restructure of the W.A. brick operations will include a refit of the Cardup plant and planned closure of the Malaga plant in November, with production being transferred to Cardup, freeing Malaga for sale. Rationalisation of Auswest Timbers’ W.A. facilities is also planned. Both initiatives are intended to reduce operating costs over the long term.

Land and Development increased underlying EBIT by 14% to $74m, driven by the Industrial Property Trust, which saw an EBIT improvement of $14m, of which $15m related to higher development profits and $11m from higher revaluations, partly offset by an absence of asset sales. The Oakdale West site is expected to be sold into the Property Trust in FY17, generating land sale profits.

The investment in SOL generated $60m in underlying EBIT, up 9% on FY15. BKW received $52m in fully franked dividends, and the market value of the investment rose $381m to $1.78bn.

Cash flow from operations was 11% higher at $149m, despite a $33m increase in working capital. Net debt is $269m. The balance sheet is sound. K



Tim Mann13.70

0.98NoneHigh

Standard

Hold

670.3

07/14(a)

101.368.4

1.220.0

5.8

42.0

3.14.4

723.6

07/15(a)

120.281.018.416.8

4.3

45.0

3.34.7

751.0

07/16(a)

147.198.922.115.2

4.3

48.0

3.24.6

773.7

07/17(e)

128.986.7

-12.415.5

6.9

48.0

3.65.1

737.8

07/18(e)

114.677.1

-11.117.5

6.0

48.0

3.65.1

100.0 100.0 100.0 100.0 100.0

BKW S&P/ASX 200

Snapshot


Basic Materials2

2,00830.912.7

16.20/13.13-10.410.9

09 Nov 201630 Nov 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/BKW


Investment PerspectiveChallenger Limited is an active investment manager, providing retirement-income products via its regulated wholly owned subsidiary Challenger Life. Challenger is the clear leader in the Australian retail annuity market, holding an estimated 75% market share and quickly establishing strong brand recognition and broad distribution through aligned and nonaligned financial advisers. The boutique funds management business is growing strongly, but is a small contributor to group profits. Financial reporting quality is improving, but opaque life insurance accounting results in heavy reliance on unaudited management reports. In our opinion, the business model and earnings outlook is high-risk and capital-intensive, but increasingly reliable earnings in the life business is reassuring. Attractive long-term industry dynamics are supported by an ageing demographic seeking financial security in retirement.

Uniquely positioned for surge in demand for retirement income; Fair value up 24% to $10.50 After a change in coverage, we have reviewed our forecasts and raise Challenger Limited’s (CGF) fair value estimate from $8.50 to $10.50 to better reflect the long-term growth opportunities in the booming retirement income sector. We are also moving the fair value uncertainty rating from high to medium. The earnings outlook for Australia’s dominant annuity provider is increasingly positive, with CGF in the right place at the right time to take advantage of strong industry growth trends. We forecast attractive annuity sales growth as we expect more retirees will buy CGF annuities as retirees better understand retirement income risk and increasingly seek guidance from advisers who can access CGF products more readily from a growing number and range of investment platforms.

CGF is clearly a growing business in a growing retirement income market and in our opinion revenue, profit and dividends are expected to continue a solid upward trend for several years at least. FY16 annuity sales increased 22% to a record, annuity margins remained broadly steady at 4.5%, normalised profit increased 8%, normalised return on equity was an impressive 13.7% and fully franked dividends increased 8%. Importantly, annuity sales accelerated in 2H16 with sales up

45% on 2H15. Dividends have doubled over the past five years and we expect strong growth over the next five. Our positive outlook is based on CGF’s high-margin business (net operating margin of 50%), strong cash flow, zero group corporate debt, dividend payout target of 45%-50% and return on equity forecast to increase to 16% by FY21. At current prices the stock is undervalued, trading at a 5% discount to our upgraded valuation. Our no-moat rating is maintained. We expect the next share price catalyst to be the release of 1Q17 assets under management, net flows, annuity sales, and updated guidance on 18 October.

Forecast normalised FY17 profit increases from $387m to $397m and modestly exceeds the consensus estimate of $392m. Forecast EPS increases to 64.5 cents per share. We increase our annuity sales volume and net annuity profit margin forecasts in outer years, reflecting our more positive stance. We forecast five-year compound annual EPS growth of 9.8%. The attractive combination of good sales growth and relatively stable margins translates to higher operating profit.

Australia’s ageing population is increasingly seeking reliable steady income streams in an investment market heavily influenced by historically low interest rates and volatile equity markets. CGF is leveraging this demand-driven market shift with attractive long-term industry dynamics supported by an ageing demographic seeking financial security in retirement. Customer demographics suit CGF’s competitive advantage of offering a “guaranteed” stable income without the volatility and uncertainty of investing in direct equities, bonds and even managed funds.

CGF’s FY16 annuitant key statistics include: an average policy amount of $186,000; average new customer age of 70 years; average tenor of new business 6.5 years; and 99% of sales via financial advisers. The peak age of new customers is 65-70 years with annuitants reinvesting on average two times. Long-term demand is underpinned by strong growth in the size of the pool of post-retirement superannuants and increasing life expectancy.

CGF is the clear leader in the Australian retail annuity market with an estimated 75% market share and has established strong brand recognition and broad distribution. Successfully building scale via investment platforms is a key plank of CGF’s strategy with both retail and industry fund partners.

$10.00

$9.00

$8.00

$7.00

$6.00

$5.00



Challenger CGF | $10.00Medium Cap | Asset Management | 29 Sep 2016

Recommendation



David Ellis10.50

0.95None

MediumStandard

Hold

593.3

06/14(a)

328.760.7

4.69.8

16.6

26.0

4.44.8

662.6

06/15(a)

334.055.3-8.812.612.7

30.0

4.35.9

721.1

06/16(a)

361.758.7

6.113.612.6

32.5

4.15.8

784.7

06/17(e)

397.164.4

9.815.414.3

36.0

3.65.2

839.0

06/18(e)

429.369.7

8.114.214.6

39.0

3.95.6

20.8 85.5 100.0 100.0 100.0

CGF S&P/ASX 200

Snapshot


Financial Services5

5,672122.2

-3.210.18/6.58

44.423.6

01 Sep 201628 Sep 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/CGF




Flight Centre Travel FLT | $36.80Medium Cap | Leisure | 27 Sep 2016

Recommendation

Diversification continues as domestic operations matureFlight Centre's (FLT) latest purchase in Europe has a minimal near-term earnings impact on the group. The estimated $163m in turnover from the acquired businesses in Sweden, Denmark, Norway, Finland and Germany is a mere drop in the ocean compared with the company's total transaction value (TTV) base of $19.3bn. As such, we make no changes to our forecasts, and the stock is trading 9% above our unchanged $33.00 fair value estimate. The purchase (undisclosed sum), nevertheless, continues management's strategy to grow the corporate travel unit and diversify into foreign markets.

The corporate businesses account for a third of FLT's TTV base or $6.4bn, positioning the group

among the top five corporate travel managers globally, competing against the likes of American Express and Carlson Wagonlit. Just as importantly, the acquisition adds to FLT's international operations, which speak for 48% of group TTV. This is a significant increase from just 5% when FLT was first listed on the stock exchange in 1995.

All this is part of a concerted effort to rely less on the Australian unit to drive growth in the future. That is understandable, given the natural limit to how much further FLT can extend its domestic dominance. In fact, while the Australian operation's six-year EBIT CAGR to FY16 is 7%, EBIT has been stuck around $260m per annum since FY13. In contrast, overseas operations boast a six-year EBIT CAGR of 17%, with their EBIT of almost $100m now accounting for 27% of FLT's operating earnings.

While the strategy to expand into corporate travel and overseas has merits, it does not alter our view that FLT is a no-moat business. The company has a highly profitable brick-and-mortar network. However, there is a material risk of disintermediation due to digital technology. K



Brian Han33.00

1.12NoneHigh

Standard

Hold

2640.3

06/16(a)

250.3248.1

-0.815.018.7

152.0

4.15.8

2835.1

06/17(e)

257.5255.3

2.914.418.4

153.0

4.25.9

3010.7

06/18(e)

271.5269.2

5.413.718.0

160.0

4.36.2

100.0 100.0 100.0

CGF’s two core operating divisions are the APRA regulated Life business and the funds management business. The annuity business operates within the Life division and contributes more than 90% of group divisional earnings (profit before corporate expense, interest and tax). Challenger Life reported cash operating earnings of $592m in FY16 up 9% on the back of higher average assets under management with a stable margin of 4.5%. Despite historical low interest rates and volatile equity markets, Life’s cash operating margin has consistently been in the range of 4.4% to 4.5% since 1H13.

Life's FY17 normalised cash operating earnings guidance is $620m to $640m, with the range midpoint an increase of 6.4% on the strong FY16 result. We are forecasting $646m based on strong sales growth and broadly stable margins. The FY17 guidance takes into account the potential impact of lower interest rates on shareholder capital with shareholder capital not hedged for movements in interest rates.

The Funds management business increased average funds under management 11% in FY16 to

$55.1bn, benefiting from solid organic flows of $2.4bn. Despite the positive FUM outcome the division’s normalised EBIT fell 15% to $37m due to an operating loss from recently acquired Fidante Partners Europe.

Pretax FY16 normalised return on equity (ROE) was an impressive 17.8% and CGF continues to target a normalised ROE of 18% pretax through the cycle. Statutory ROE was 12.5% for fiscal 2016 comfortably above the 11% cost of equity we incorporate in our valuation. We forecast the statutory ROE to average 15% over the next five years. The fully franked dividend payout target of 45%-50% of normalised profit is unchanged. Our dividend forecasts are based on an average payout at the top end of the target range.

In our opinion, the business model and earnings outlook has broadened and improved from a high-risk and capital-intensive business to a more medium risk business. Increasingly reliable earnings from the annuity business is reassuring and results in the change in our fair value uncertainty rating to medium from high. K

http://www.morningstar.com.au/Stocks/NewsAndQuotes/FLT


Investment PerspectiveGrainCorp owns significant strategic grain-handling infrastructure along the eastern seaboard of Australia, with large market share in storage, handling and port elevation services. Earnings are heavily affected by seasonal conditions, but the diversification into malt production and edible oil refining and processing reduces earnings volatility and provides new growth opportunities. Cash flow and dividends will also be less volatile. The traditional grain business remains exposed to weather conditions, and so earnings will continue to display a degree of volatility.

$16.00

$14.00

$12.00

$10.00

$8.00

$6.00



Graincorp GNC | $7.95Medium Cap | Farm Products | 28 Sep 2016

Recommendation

Latest crop report positive for storage and logistics but headwinds in other divisions The September 2016 crop report from the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) was quite upbeat, reflecting favourable seasonal conditions and a good outlook for spring rain in most cropping regions. ABARES has upgraded its winter crop production forecast for 2016-17. This bodes well for GrainCorp’s (GNC) Storage and Logistics FY17 outlook. We remain comfortable with our forecasts. Our $7.80 per share fair value estimate is unchanged. At current levels, the stock is trading near our fair value estimate. Our no-moat and high uncertainty ratings are also unchanged, reflecting high earnings cyclicality from grain volumes, driven by volatility, seasonal factors and high fixed costs.

GNC reports FY16 results on 16 November. We are forecasting adjusted NPAT to increase 8% to $48.1m, near the middle of management's $40m to $55m guidance range. For the full year, we expect the broadly similar themes as the first half with Malt continuing to do well while Oil is expected to remain under pressure. The Malt division was the standout performer in the first half on solid volumes, high utilisation rates and the benefit of strategic initiatives. There continues

to be strong demand from craft and distilling markets, which underpin our positive long-term view on the Malt business.

Oil was the weakest performer and we expect continued pressure on global crushing margins. While Marketing had a good half, we expect the competitive environment to remain tough as the business faces strong competition from alternative origination sources. Storage and Logistics benefited from higher grain receivables, however, low carry-in volumes, deferral of grain export volumes and fixed take-or-pay rail costs, which weighed on the first-half result, are also expected to be evident in the second half.

ABARES forecasts the total winter crop production to increase 16% to a record 46.1 million tonnes, primarily driven by significant expected increases in production in Western Australia and Victoria. For the first time since the 2007-08 winter crop, production is forecast to rise across all states. ABARES found seasonal conditions in most cropping regions over winter had been very favourable, with crops in very good condition at the start of spring. Winter rainfall was average to above average in the eastern states and South Australia. Rainfall in Western Australia was more variable but timely with the start of the season mostly very favourable. Some parts of New South Wales and far southern Western Australia have been impacted by very high rainfall over winter. In its latest forecasts, the Bureau of Meteorology is forecasting average spring rainfall in most cropping regions. K



Ravi Reddy7.801.02

NoneHigh

Standard

Hold

4475.6

09/13(a)

174.576.3

-25.215.8

8.5

40.0

3.34.7

4164.2

09/14(a)

94.541.3

-45.922.1

2.9

20.0

2.23.1

4060.0

09/15(a)

44.519.4

-52.945.8

1.8

10.0

1.11.6

4193.8

09/16(e)

48.121.0

8.137.8

2.6

12.0

1.52.2

4352.0

09/17(e)

90.239.487.620.2

4.8

22.0

2.84.0

100.0 100.0 100.0 100.0 100.0

GNC S&P/ASX 200

Snapshot


Consumer Defensive8

1,81961.529.0

9.42/7.20-11.1

6.230 Jun 201615 Jul 2016

27+20+9+44Exhibit 1: GrainCorp 1H16 Revenue Mix

• Malt 27%

• Oils 20%

• Storage 9%

• Marketing 44%

Source: GrainCorp

http://www.morningstar.com.au/Stocks/NewsAndQuotes/GNC


Investment PerspectiveIress provides high-value information and order input, management, and routing services to share-market participants in Australia, New Zealand, the United Kingdom, Canada, and South Africa. Successful diversification into the supply of systems and services for financial advisers complements the firm’s traditional equity-market-focused businesses. Iress’ high-margin systems and services are deeply embedded in client business operations across the equity market and financial adviser client base. Incremental upgrades to products and systems enable price increases, leveraging a fixed-cost base without damaging key customer relationships. Competition in Australia remains low but, given the favourable metrics, should not be dismissed in the medium term. Expansion in regions outside of Australia will continue to leverage successful products. The firm has established a small beachhead in Singapore.

$13.00

$12.00

$11.00

$10.00

$9.00

$8.00



IRESS IRE | $11.88Medium Cap | Software - Application | 26 Sep 2016

Recommendation

Acquisition of Financial Synergy provides modest fair value accretionNarrow-moat Iress (IRE) has agreed to acquire Financial Synergy, a privately owned fund administration software provider to the Australian superannuation and wealth-management sector, for up to $90m in cash. The transaction is subject to commercial arrangements and conditions, and is expected to complete by 31 October. Our fair value estimate increases from $10.50 to $10.70 per share. Shares currently trade about 11% above our fair value estimate.

While this is a relatively small deal for IRE, representing around 6% of group earnings, it has financial and strategic appeal. At an 11.3 EBITDA multiple, the purchase price is not cheap but is earnings-accretive. Our FY17 earnings per share (EPS) increases about 2.3%, in line with management’s expectations of more than 2% EPS accretion. We are particularly attracted by Financial Synergy’s strategic merits as it improves and expands IRE’s offering to clients, given increasing demand for digital access for both clients and employees. Its software supports workflow between key stakeholders and data and services providers in the superannuation space across an array of product types and asset classes. While there

are integration risks, they are somewhat mitigated, as IRE is retaining Financial Synergy’s senior management, along with the founder as a consultant.

IRE launched an $85m fully underwritten institutional equity raising at $11.35 per share, 4.5% below the most recent traded price and 6.1% above our fair value estimate. A share purchase plan (SPP) to raise up to an extra $20m is open for subscriptions from retail shareholders for up to $15,000 worth of shares at $11.35 per share. The SPP opens on 5 October and closes on 26 October. As the SPP price is above our fair value estimate, we recommend shareholders wanting to increase exposure to IRE subscribe to the SPP, if it is consistent with their investment objectives.

The Financial Synergy announcement follows IRE’s acquisition of another business two weeks ago. INET BFA, a provider of financial data and analysis tools based in South Africa, will be acquired for a cash consideration of $14m. The acquisition costs will be funded through available cash and existing debt facilities. The transaction is subject to regulatory approval and is expected to complete no later than the end of November. As with Financial Synergy, management believes the INET BFA acquisition supports its strategy of strengthening IRE’s position in the specific market, in this case South Africa, by offering a broader range of integrated solutions and functional enhancements. K



Gareth James10.70

1.11Narrow

MediumStandard

Reduce

250.6

12/13(a)

53.237.4

-12.022.710.7

38.0

4.56.1

329.0

12/14(a)

60.838.2

2.124.015.4

41.5

4.55.3

361.4

12/15(a)

66.641.8

9.524.016.5

42.7

4.35.3

379.0

12/16(e)

75.246.511.325.517.0

44.0

3.74.7

426.9

12/17(e)

89.353.414.822.219.7

50.0

4.25.1

83.6 40.0 56.2 60.0 50.0

IRE S&P/ASX 200

Snapshot


Technology8

1,87067.832.3

12.58/8.7325.816.2

08 Sep 201629 Sep 2016

32+46+15+7Exhibit 1: Financial Synergy (Acurity Platform) FY16 Revenue Mix Top 20 Clients

• Third-party Adminstrators 32%

• Super Funds 46%

• Banks 15%

• Wealth 6%

Source: IRESS

http://www.morningstar.com.au/Stocks/NewsAndQuotes/IRE


Investment PerspectivePremier Investments operates an array of Australian retail apparel brands: Just Jeans, Jay Jays, Portmans, Jacqui E, Dotti, and Peter Alexander. The firm also owns Smiggle, which sells a diverse range of stationery and ancillary products. Smiggle has limited direct competitors, a unique concept, and an affordable price point; collectively, these give rise to a high-value proposition. Accordingly, the Smiggle brand has been exceptionally successful in Australia and New Zealand and is now core to Premier’s growth strategy, with the firm exporting the brand to the U.K., Malaysia, and Singapore. Long-term upside will arise if the firm can broaden its international expansion to the U.S. or continental Europe. The firm also has a 28% stake in Breville Group.

$18.00 $16.00 $14.00 $12.00 $10.00 $8.00 $6.00



Premier Investments PMV | $16.50Medium Cap | Apparel Stores | 22 Sep 2016

Recommendation

Disappoints slightly; Fair value unchanged at $14.00No-moat-rated Premier Investments (PMV) reported FY16 underlying NPAT of $103.9m and earnings per share (EPS) of 66.1 cents, up 18% on FY15. Margins were in line with expectations though the underlying result was marginally below forecast due to a slightly higher-than-anticipated average tax rate and average borrowing costs. Final fully franked dividend increased from 21 to 25 cents, taking the FY16 dividend to 48 cents per share.

Our forecasts are largely unchanged following the result. We forecast FY17 underlying NPAT $122m, EPS of 77 cents and a fully franked dividend of 58 cents per share, up 21% on FY16. Our $14.00 fair value estimate is unchanged. With shares trading around $16.50, we continue to view PMV as overvalued, with the market probably ascribing too much value to the Smiggle business.

PMV has two good businesses in Peter Alexander and Smiggle, but the performance and outlook for the remaining apparel brands is a mix of lacklustre and weak. For example, sales at Jay Jays (15.6% of group sales) fell 1% over the past year. Part of this weak performance can be explained by an unseasonably warm winter, but the fact per store sales are down by more than 12% over the past five

years points to a brand struggling for relevance. We foresee the target demographic for Jay Jays doing a greater share of their apparel shopping online in the future, the most likely catalyst to lead to a demise of this brand.

The Smiggle brand’s robust growth continued, with sales up 42% to $188m and stores numbers up from 188 to 239 over the year. The accelerated store rollout and low level of disclosure as well as currency movements makes it impossible to get a clear view of the like-for-like sales. Nonetheless, we estimate sales per average store of $881,000, up 17% on FY15. The underlying growth is likely to be marginally higher given sales generated in the United Kingdom are diminished by a recent fall of around 10% in the £Stg. Smiggle stores in the U.K. now total 64 and assuming it can achieve the same penetration rate as Australia, it is plausible the U.K. market could sustain 365 stores. In this regard, management’s planned rollout looks readily achievable with 30 to 40 stores in 2017 and 40 to 60 stores in both 2018 and 2019. Management has guided it is on track to have 200 U.K. Smiggle stores and annual sales of $200m by 2019. Our longer-term forecasts assume the Smiggle brand will be rolled out to continental Europe where we see few direct competitors.

The performance of the Peter Alexander brand was a further highlight, with average sales per store up 5.6% over the year to $1.8m. We like this offering as we think the product is at an affordable price point and is well aligned to the resilient “present giving” category. We forecast further growth in same-store sales and also a continued increase in stores, with five to seven opened annually over 2017 to 2019.

The balance sheet is in exceptional shape with net cash of $177m. This, combined with a franking credit pool of $199m, provides the means to lift the payout ratio, pay special dividends or undertake opportunistic acquisitions.

Australian brick-and-mortar retailers targeting the younger demographic have had a pretty good time in recent years, with household disposable income getting a boost from falling fuel prices and material declines in interest rates. We see few, if any, catalysts for a rebound in the Australian economy and hence household disposable income. We forecast benign same-store sales growth over the coming five years for all Australian and New Zealand stores. K



Tony Sherlock14.001.18

NoneMedium

Exemplary

Reduce

892.6

07/14(a)

73.046.4

3.818.0

4.4

40.0

4.86.8

947.7

07/15(a)

88.155.920.620.3

8.9

42.0

3.75.3

1049.2

07/16(a)

103.966.118.221.1

5.0

48.0

3.44.9

1154.2

07/17(e)

121.977.016.521.4

9.0

58.0

3.55.0

1247.3

07/18(e)

136.185.911.619.2

9.8

66.0

4.05.7

100.0 100.0 100.0 100.0 100.0

PMV S&P/ASX 200

Snapshot


Consumer Cyclical5

2,45644.3

--17.92/12.08

25.330.4

28 Oct 201618 Nov 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/PMV


Investment PerspectiveWashington H. Soul Pattinson is a conservatively managed investment house. The corporate structure is complicated, with interests of less than 100% in a diversified group of companies providing exposure to building materials, coal mining, telecommunications and pharmaceuticals. The separate listing of these companies provides some valuation visibility; however, an archaic cross-shareholding with Brickworks creates unnecessary circular complications. As a holding company, Soul Pattinson does not have access to the operating cash flow of the underlying businesses, but receives dividends. The balance sheet is strong with excess cash, allowing countercyclical investment and the ability to maintain dividends through the cycle. It is difficult to discern a clear investment style but the company’s long-term performance is reasonable. A lack of investment in moaty assets means Soul Pattinson itself lacks an economic moat.

$18.00 $17.00 $16.00 $15.00 $14.00 $13.00 $12.00



Washington H. Soul Pat SOL | $15.70Medium Cap | Conglomerates | 23 Sep 2016

Recommendation

Increasing fair value to $15.50We raise our fair value estimate on Washington H Soul Pattinson (SOL) from $15.00 to $15.50 per share following the FY16 result. We recently increased our fair value estimate for 25%-owned TPG Telecom (TPM) and this, along with higher valuations for unlisted property, drives the uplift. With its higher fair value estimate, TPM now makes up approximately 45% of our sum-of-the-parts valuation, continuing the trend of reducing the importance of SOL’s investment in coal through 60%-owned New Hope Corporation (NHC).

The quality of the underlying portfolio continues to improve, with the importance of no-moat, very high uncertainty NHC waning and narrow-moat, medium uncertainty TPM increasingly prominent. NHC now comprises about 20% of SOL’s fair value estimate, and TPM 45%. The remaining 35% is made up of investments in associates, other listed equities, net cash, and unlisted equity and property. On balance, we still think no moat is the appropriate call. In terms of fair value uncertainty, we also think the trend is towards improvement, but we still think high uncertainty overall is the right call. If TPM grows beyond 50% of SOL’s value, either by itself or in combination with another moatworthy business, we will likely upgrade the moat rating to narrow. The same

applies to our fair value uncertainty rating, which would likely improve to medium.

FY16’s adjusted NPAT increased a slightly better-than-expected 13% to $177m. The result was led by improved performances from TPM, Brickworks, and API, with the collapse in profit from coal via NHC a partial offset. Headline NPAT nearly doubled to $149m. FY16 dividends rose 4% to 52 cents per share, as forecast.

Net operating cash flow was weak at $120m, down from $223m a year ago, reflecting the lower coal prices and the $45m of transaction costs for Bengalla. The balance sheet remains strong, with net cash of $121m. This includes 100% of NHC’s net cash, consolidated on SOL’s balance sheet. Excluding the minorities’ stake in 60%-owned NHC’s cash, SOL’s share of net cash is $90m--robust, but well down on last year’s $825m. Much of the group’s cash was spent with NHC’s purchase of 40% of the Bengalla coal mine. The acquisition appears well-timed but still expensive. We’re not convinced low spot coal prices were factored into the purchase price.

Our near-term forecasts are largely unchanged. We’re expecting adjusted earnings per share to decline modestly from 74 cents in FY16 to 68 cents in FY17 before rising to 74 per cents in FY18. The dip in FY17 reflects an expected drop-off in earnings from associate Brickworks as the property cycle peaks, as well as lost interest income with depletion of excess cash.

With the share price trading around $15.50 per share, SOL shares are fairly valued. The forecast FY17 dividend yield is now nearly 3.5% fully franked. We think it’s likely the annual dividend will steadily rise, as has been the case for more than a decade. We forecast a 2 cents per share annual increase, largely driven by profit growth from TPM, for a forecast 62 cents per share annual payout by FY21, equivalent to a prospective 4% fully franked yield. The compression in SOL’s share price reflects the recent sell-off in interest-rate-sensitive, yield-based stocks, as well as disappointment at TPM’s slowing growth with increasing competition. But with the higher yield on offer, we now think the shares are better value. At a share price of $13.50, SOL would yield 4% fully franked in FY17, and we think that level is relatively attractive, given the lack of income-generating alternatives. K



Mathew Hodge15.50

1.01NoneHigh

Standard

Hold

575.3

07/14(a)

123.251.5

-23.328.4

4.4

48.0

3.34.7

601.8

07/15(a)

156.465.327.021.7

2.8

50.0

3.55.1

579.2

07/16(a)

177.274.013.321.5

4.9

52.0

3.34.7

751.2

07/17(e)

161.667.5-8.823.3

5.3

54.0

3.44.9

722.3

07/18(e)

177.073.9

9.521.2

5.7

56.0

3.65.1

100.0 100.0 100.0 100.0 100.0

SOL S&P/ASX 200

Snapshot


Industrials5

3,77513.8

--18.11/14.59

7.17.7

18 Nov 201612 Dec 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/SOL

http://www.morningstar.com.au/Stocks/NewsAndQuotes/SOL

http://www.morningstar.com.au/Stocks/NewsAndQuotes/TPM

http://www.morningstar.com.au/Stocks/NewsAndQuotes/NHC


Investment PerspectiveVocus is an infrastructure-heavy, corporate-customer-focused telecommunications services provider with an extensive fibre and data centre network built both organically and through 10 acquisitions over the years. M2, on the other hand, is an infrastructure-lite but salesforce-heavy, consumer-focused telecommunications entity; its stellar growth has also been driven by eight major acquisitions. The complementary merger in February 2016 between these companies has transformed the enlarged Vocus into a full-service, vertically integrated player with the necessary ammunition to materially lift its share in all segments of the Australian and New Zealand telecommunications markets. However, there are integration and execution risks, especially given the hyper investor expectations. The National Broadband Network, or NBN, regime also poses a risk to Vocus’ consumer-facing business.

$10.00

$8.00

$6.00

$4.00

$2.00



Vocus Communications VOC | $6.26Medium Cap | Communication Equipment | 23 Sep 2016

Recommendation

Collateral damage but shares at 26% discountSome of the factors responsible for wiping 24% off Vocus Communications’ (VOC) market value since the FY16 results release are disconcerting. However, we view none of them as sufficiently serious to impact our $8.50 per share fair value estimate. As such, shares are now trading at an attractive 26% discount to our fair value.

VOC has felt the brunt of competitor TPG Telecoms’s (TPM) below-consensus FY17 guidance. Investors fear the competitive environment and the impact of National Broadband Network (NBN) will have on VOC. This is curious, as these dynamics are hardly fresh news, but are now being used as justification to derate the sector. Indeed, we believe the NBN impact on VOC is relatively limited (a potential EBITDA hit of around 7%) because only around 20% of its broadband subscribers are higher-margin “on-net” and therefore directly hit by the higher cost of accessing customers as they migrate to the NBN. Further, with just around 7% of the fixed-line broadband subscribers in Australia, VOC’s strategy remains one of lifting market share, with the NBN rollout as a catalyst.

Amid the jittery sentiment, the sudden resignation of chief financial officer Rick Correll could not have come at a worse time, a day after the disappointing

outlook provided by TPM. We are not privy to the reasons behind Mr Correll’s decision. However, we note his seven-year stint with VOC began when it was just a two-year-old minnow, and Mr Correll has laboured through perhaps 13 acquisitions since (including the recent Amcom, M2 and Nextgen transactions)--more than enough to drive anyone to want to take a break.

VOC has long been regarded as a growth stock, one that was trading at a forward enterprise value/EBITDA of 13.8 times as recently as June 2016. This has now derated to 10.4 times our FY17 EBITDA estimate--an attractive multiple given our forecast five-year EBITDA CAGR of 26%.

Another factor impacting VOC’s price is the changed segmental disclosure in the FY16 result. The enlarged business is now segregated into three units: Corporate Australia (corporate and wholesale); Consumer Australia (fixed-line broadband, mobile, energy retailing); and New Zealand (corporate and consumer). This clearly makes analysis of organic growth much more difficult, compounded by the string of acquired entities where businesses are dispersed across all three segments. On the other hand, management is adamant organic growth is still coming through, especially in the corporate fibre and Ethernet unit--one enjoying juicy margins (40%-plus) and return on invested capital (20% to 40%-plus depending on the number of customers to a fibre-connected building).

In the Australian fixed broadband market, management’s near-term goal is to increase VOC’s share of subscribers from the current 7% to over 10%. We see this as easily achievable, given the company is currently snaring 9% to 10% of new NBN connections every week. Also, at least for the time being, the average gross margin per subscriber in dollar terms has remained constant, with NBN margins in line with bundled copper broadband margins. More importantly, VOC’s market share strategy is likely to be aided by the natural migration path of subscribers to the NBN, as it continues its rollout to around 9 million premises by the end of FY18, from the current 3 million. It is the churn event management has long been counting on to drive its fixed-line broadband subscriber growth strategy.

The ACCC has officially given its blessing for the acquisition of Nextgen. We have already incorporated this into our forecasts and valuation. K



Brian Han8.500.74

NarrowMedium

Standard

Accumulate

91.8

06/14(a)

13.616.140.420.612.4

1.8

0.50.8

149.0

06/15(a)

18.117.4

8.132.611.9

3.2

0.60.8

829.9

06/16(a)

101.729.971.924.1

3.8

15.6

2.23.1

1823.4

06/17(e)

234.438.027.216.5

4.9

20.0

3.24.6

2016.0

06/18(e)

293.447.525.213.2

5.9

22.0

3.55.0

100.0 100.0 100.0 100.0 100.0

VOC S&P/ASX 200

Snapshot


Technology8

3,866149.9

19.39.40/5.56

10.335.4

19 Sep 201604 Oct 2016

http://www.morningstar.com.au/Stocks/NewsAndQuotes/VOC


Investment PerspectiveThe commercial terms of SAI Global’s exclusive agreement with Standards Australia to publish and distribute Australian standards must be renegotiated by December 2018, with the current agreement expiring in 2023. This agreement forms the core of SAI Global’s business, and the market is concerned about a less favourable royalty agreement from 2018 and a loss of the contract in 2023. However, while the royalty payments made by SAI are likely to increase from 2019, we expect group EBITDA to fall by only about 15%. SAI still has several years left on the contract and is likely to recontract beyond 2023. About half of group earnings are from activities unconnected to Standards Australia. Both the compliance and assurance divisions operate in large and growing markets and benefit from recurring income. SAI is in play with a AUD 4.75 per share cash bid via a scheme of arrangement, subject to a number of approvals.

$5.50

$5.00

$4.50

$4.00

$3.50

$3.00



SAI Global SAI | $4.67Small Cap | Business Services | 26 Sep 2016

Recommendation

International Private Equity Fund launches cash bidSAI Global (SAI) and Casmar Holdings Pte, a wholly owned subsidiary of Baring Asia Private Equity Fund VI (Baring Asia), have entered into an agreement where Baring Asia will buy 100% of SAI shares it does not own for $4.75 cash per share via a Scheme of Arrangement. Baring Asia currently has a 4.3% stake in SAI. SAI’s Board recommends shareholders vote in favour of the scheme in the absence of a superior offer and subject to the opinion of the independent expert. The scheme also requires Foreign Investment Review Board approval to proceed. Indicative timing is for an SAI shareholder vote to be held in early December with implementation by mid to late December 2016.

We raise our fair value estimate from $4.00 to $4.75 per share, in line with the offer price. At this stage, we recommend shareholders take no action until we have had an opportunity to review the scheme booklet which is expected to be released in early to mid-November 2016. However, shareholders who do not expect a higher bid emerging and want a quick exit should consider selling on-market now.

The emergence of other bidders is possible given SAI has been in play before, though the market is not pricing for this a counter as current share price is trading near the offer price. We understand

Barings Asia commenced discussions with SAI after it started the recent review process on a possible sale of the Assurance business. While a number of indicative proposals were received for the Assurance business, these hadn’t proceeded to the due diligence stage and the Board considered the certainty of the Barings Asia cash bid to be the best outcome for shareholders.

On face value the bid looks appealing representing a FY16 EV/EBITDA multiple of 9.4, a 32% premium to SAI’s last traded price and 19% above our previous fair value. SAI has a number of institutional shareholders on its register with the three holding stakes around 10% each so getting the funds across the line will be critical for the bid to succeed.

SAI’s recent performance has been somewhat patchy. The company reported a flat FY16 EBITDA primarily due to weakness in the EMEA division which suffered assurance client losses. Management stated 4Q16 was “encouraging” and that revenue and profit growth was expected in FY17 with improvement likely across the entire product portfolio. For FY17, we forecast underlying NPAT growth of 2.3% and stable NPAT margin.

There is also uncertainty surrounding pending renegotiation of the Australian Standards contract with Standards Australia which must be completed by December 2018. The relationship with Standards Australia has become increasingly strained with SAI party to three arbitrations against Australian Standards as at 30 June 2016. Despite this we are not completely surprised by a bid emerging. In our most recent note dated 19 August 2016, we talked about the appeal of SAI to private equity and trade buyers given its attributes such as a capital-light business model, defensive earnings, and operating in a fragmented global industry. K



Gareth James4.750.98

NoneHigh

Standard

Hold

527.5

06/14(a)

45.421.5

5.019.310.4

15.5

3.74.8

547.7

06/15(a)

55.626.322.116.110.6

16.5

3.95.1

570.2

06/16(a)

58.627.5

4.814.613.4

17.0

4.26.1

591.7

06/17(e)

60.228.3

2.716.515.6

18.0

3.95.5

613.8

06/18(e)

69.932.916.214.218.1

21.0

4.56.1

69.8 70.9 100.0 100.0 80.0

SAI S&P/ASX 200

Snapshot


Industrials3990

145.833.5

4.78/3.227.13.5

30 Aug 201623 Sep 2016

26+14+30+30Exhibit 1: SAI Global FY16 Revenue Mix

• APAC 26%

• EMEA 14%

• Americas 30%

• Property Services 30%

Source: SAI Global

http://www.morningstar.com.au/Stocks/NewsAndQuotes/SAI

Your Money Weekly | Issue 37, 2016 · 2 Your Money Weekly 29 September 2016 3 Chris Douglas...

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Transcript of Your Money Weekly | Issue 37, 2016 · 2 Your Money Weekly 29 September 2016 3 Chris Douglas...