Alpha POWER Shares (Lonsec) Portfolio

Alpha POWER Shares (Lonsec) Portfolio - January 2009

Note: Recommendations made within Lonsec Model portfolios may differ from other research published by Lonsec.

Lonsec comments on major out-performers:

WOW (+3.9%) announced first half sales growth of 8.8% for the 27 weeks to 4 January 2009. Despite falling consumer confidence levels, Woolworths still expects sales growth in the upper single digits for the year. WOW will report it half-year profit results on 27 Feb 09 and will update its full year guidance at this result. Current market expectations are for a FY09 NPAT of $1,815m, EPS of $1.47 and DPS of $1.02. That suggests WOW currently trades on a forward PER of 18.7x and dividend yield of 3.7%. WOW trades at a premium because it is Australia’s leading consumer staple retailer, in terms of distribution, market share and operational efficiency. Investors should target buying the stock around the $26 level.

Comments on major under-performers:

NAB (-9.3%) drifted lower in line with the Banking sector over January. While the Bank is well capitalised and highly profitable at the moment, the market remains concerned about its UK Banking exposure. Lonsec expects NAB to generate FY09 EPS of $1.94 and DPS of $1.55 which is equivalent to a PER of 9x and dividend yield of 8.9% at current levels. BUY below $20.

WBC (-7.8%) Westpac recently provided a market update.

Key Points:

1st quarter cash earnings of $1.2bn estimated
Total lending up 2.4% over the quarter
Australian mortgage and business lending is strong
Institutional and NZ business slower
Customer deposits up 9.6% over the quarter
Impairment charges rose to $800m in the quarter up from $144m in the pcp
Provisions increased to 0.60% of Gross Loans and Acceptances
Three specific corporate exposures (ABC Learning, Allco, Babcock) accounted for $360m of the $800m charge
Corporate and commercial portfolio seeing a rise in arrears
Consumer portfolio experiencing only a small increase in arrears
BT Financial Group impacted by poor asset markets but life insurance and wrap cash flows strong
Merger with SGB progressing well with high levels of customer retention and engagement
$13bn of wholesale term funding completed to date (about 60% of WBC’s FY09 requirement)
Over $3.8bn in core equity raised over the last 4 months
Tier 1 ratio stands at 8.3% (8.5% after recent SPP)

Comments:
A first quarter result of $1.2bn puts WBC on target for a 1H09 result of around $2.2bn which is slightly better than CBA ($2.0bn). Investors should note that WBC is now the largest Australian Bank by market cap after its merger with SGB (see table below). It is also generally perceived as the lowest risk Bank of the majors. (see chart below)

Similar to the other majors, Westpac is experiencing strong growth in the Australian Banking business but rising asset impairment charges are keeping profits subdued. While three specific charges hit the 1Q result hard, the rise in general collective provisions signals asset quality is deteriorating. The depth and length of this trend will be crucial to the performance of WBC (and all the Banks) over the short to medium term. Once provisions adequately cover bad debts and the asset impairment trend levels out, then Bank profitability will recover rapidly.

Lonsec expects that individual Bank performance will start to diverge further from here depending on the general bad debt experience of each Bank, which only time will reveal.

The market expects WBC to generate a FY09 profit of $4.4bn which represents EPS of $1.51 and DPS of $1.20 (at 80% payout) which implies WBC is currently trading on a forward PER of 11.2x and a dividend yield of 7.0% ff. Investors should look to BUY around $16.

Australian Banks by market cap

WBC    $49bn
CBA     $43bn
NAB     $35bn
ANZ      $27bn
MQG    $6.2bn
SUN     $5.5bn
BEN     $2.4bn
BOQ     $1.2bn

CBA (-6.9%) CBA recently released its 1H09 results.

Key Points:

Cash Profit down 16% to $2,013m (as expected due to update last week)
Cash EPS $1.46 (down 19%)
DPS $1.13 (maintained)
ROE 15% (down 5.8%)
Cost to Income 38.2% (down 3%, impressive)
Australian Bank income up 21%
Wealth Mgt down 16%
International (mainly NZ) down 4%
Impairment charges $1.6bn
Impairments mainly related to specific charges
No evidence of systemic deterioration in credit quality
Although arrears rates are trending up albeit from a low base
Total provisions stand at $3.6bn (1.79% of Gross Loans and Acceptances)
Tier 1 ratio 8.75%
Credit rating maintained at AA
Acquired Bank West and stake in Aussie Home Loans during the period
Div going ex 16 Feb 09
SPP up to $10,000 at lower of $26 or 5 day vwap up to close
2H09 expected to be more difficult
Outlook very uncertain
Final Div will be assessed at the time, no guarantees it will be maintained

Comments:
Shouldn’t be too any surprises for the market given CBA provided an update last week. As expected, the Australian Banking operations are experiencing strong growth but WM, NZ and impairment charges are keeping profits down. The Bank is in a strong position to handle a slowdown in the economy and likely increase in bad debts. There is no major deterioration in the book thus far. You have to take a very bearish view on the economy and unemployment to be selling CBA at these levels.

Based on 1H-09 EPS of $1.46, it would be reasonable to expect FY09 EPS of $2.60 which implies a trading range around $26 (assuming a PER of 10x). If we assume a payout of 80%, then DPS will be cut to $2.08 from $2.66. That implies a yield of 8% at $26.

Post the credit crisis, the major Banks now dominate financial intermediation (deposit taking and lending) in the economy. Their market share and market power is increasing each quarter. Profitability is rising as net interest margins recover. The only issue holding the Banks back is the level of impairment charges v provisions over the short-term. If arrears rise higher than expected, then provisions will need to be increased further. However, once it is clear that provisions adequately cover future impairment charges then Bank profitability will be restored very quickly.

Some commentators that are bearish on the Banks, point to the 1990-1992 experience where provisions rose to 6% of Gross Loans and Acceptances. (At this stage CBA is at 1.8%). But in 1990 interest rates were soaring to 17% and the Banks were collapsing under the weight of corporate bad debts. Clearly, conditions are much less benign this time. Not one Bank, Building Society or Credit Union is in trouble and interest rates are falling rapidly. The major uncertainty this time around is how well the economy will hold up against a global recession. Debt levels are higher but interest rates are lower, so consumers and businesses can service the debt. It is only when income is lost that debt servicing becomes a major issue.

Lonsec remains positive on the major retail biased Banks that also have a decent exposure to WM (insurance and superannuation), on a long-term view. For this reason, we retain key exposures to CBA and WBC. NAB is our next preferred with ANZ least preferred. BUY around $26.

IMPORTANT NOTICE: The following Warning, Disclaimer, Disclosure and Analyst Certification relate to material presented in this document published by Lonsec Limited ABN 56 061 751 102 ("Lonsec") and should be read before making any investment decision.

Warnings: Past performance is not a reliable indicator of future performance Any express or implied recommendation or advice presented in this document is limited to "General Advice" and based solely on consideration of the investment and/or trading merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the recommendation or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek further advice on its appropriateness.

Disclosure as at the date of publication: Lonsec does not hold the product(s) referred to in this document. Lonsec’s directors, officers, representatives, and their associates, may hold the product(s) referred to in this document, which may change during the life of document, but none receives or gains any other benefit as a consequence of the recommendation or advice presented in this, this document. Lonsec considers such holdings not to be sufficiently material to compromise the recommendations or advice, and the Analyst at the time of publication is not aware of any holdings. Lonsec receives brokerage or other benefits (e.g. application fees) for dealing in financial products and its associated companies or introducers of business may directly share in the brokerage or benefits

Analyst Certification: The analyst(s) certify that the views expressed in this document accurately reflect their personal, professional opinion about the financial product(s) to which this document refers. The analyst has an interest in shares referred to in this report but Lonsec considers such holdings not to be sufficiently material to compromise the recommendations or advice.

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