Alpha POWER Shares (Lonsec) Portfolio - September 2009
Comments on major outperformers during the month:
CBA (+12.5%) recently posted its FY09 profit result.
Key Points:
- Cash NPAT $4,415m, down 7%
- Cash EPS $3.06, down 14%
- Final Div $1.15, down 25%
- DPS $2.28, down 14%
- ROE 15.8%, down from 20.4% in FY08 due to lower earnings and increased equity capital
- Net interest margin 2.11%, up from 2.02% in FY08
- Group cost to income ratio 44.6%, reduced from 48.9% in FY08
- Tier 1 capital ratio 8.1%
- Total provisions to Risk Weighted Assets of 1.92%
- Acquired Bankwest and a strategic stake in Aussie Home Loans
- AA credit rating
Comments:While cash NPAT was down 7%, earnings and dividends were cut 14% due to the significant increase in issued capital during the year. That said, FY09 was probably the most tumultuous year for the global economy and financial markets in living memory. For CBA to come through with just a 7% fall in cash earnings is remarkable. Federal Government and RBA policy during the credit crisis certainly helped but some credit must also go to management. The acquisition of Bankwest at 0.7x book value during the credit crisis looks to be an absolute steal in hindsight (see chart).
Source: CBA
It is important to note that the Bankwest contribution ($113m after tax) in the FY09 result was for six months only and is after some fairly hefty asset impairment charges. The Bankwest contribution should rebound to around $465m based on a 15% return on book value of $3.1bn. The other points of note are that the Group asset impairment charge increased from $930m to $2,935m over FY09 while the mark-to-market of investment portfolios deducted another $196m. While CBA hit a perfect storm during FY09, it could easily have three tailwinds in FY10 being: a reduction in asset impairment charges, a recovery in investment income and a stronger contribution from Bankwest.
Lonsec notes the bad debt outlook has improved considerably in FY10 for three reasons:
- Corporate loans - listed companies have raised over $100bn in equity to reduce their debt exposure;
- Residential loans - Australian house prices are holding up well and employment is proving resilient; and
- Commercial loans - the global and domestic economic outlook has gradually improved which will help unlisted companies.
So the Banks have less to worry about with corporate and residential loans moving forward. Commercial loans in Australia and offshore banking exposure (NZ) remain the areas of concern but an improving economic outlook in Australia and NZ should help reverse the trend. Indeed, WBC recently made comments that suggest the peak of the asset impairment cycle is near.
The current FY10 IRESS broker consensus forecast is for cash earnings of $4,862m and EPS of $3.16. Lonsec’s model portfolio manager believes the forecast is too conservative with a result around $5bn and EPS of $3.29 more likely. The major swing factor will be the level of asset impairment charges over FY10. That implies CBA currently trades on a FY10 PER of 16.7x which looks very expensive, however, FY11 earnings should rebound by at least 20%, as the asset impairment charge rolls off, resulting in the FY11 PER falling to ~14x.
Lonsec recommends Buy under $50/share. Our bias is towards Australian Retail Banking and Australian Wealth Management rather than Business Banking and offshore Banking. This strategy has proven very effective over the past two years and we believe it will hold over the medium to long-term. Lonsec’s pecking order is CBA, WBC, NAB and ANZ.
NAB (+8.0%) continued to rally during September on positive sentiment towards the Banking sector and the relative undervaluation of NAB shares versus CBA and WBC. NAB continues to increase its presence in the Australian wealth management sector with recent acquisitions including:
- Aviva Australia for $825m
- 80% of JB Were Retail for $100m
- Challenger’s mortgage business for $385m
NAB is due to report its FY09 result in late October. The current FY09 IRESS broker consensus forecast is for EPS of $1.98 and DPS of $1.46 which implies NAB is trading on a forward PER of 15.7x and yield of 4.7% ff. The shares look fully valued in the short term but FY10 earnings could increase markedly if NAB reduces its asset impairment charge, as the economy improves ($1.8bn in 1H09). Lonsec recommends Accumulate under $31/share, cum final dividend.
WBC (+7.7%) recently released an update on its June quarter 09 result.
Key Points:
Unaudited cash earnings of approximately $1.1bn
Total lending up by 1.3%
Mortgage lending strong but business lending softer
Deposit growth strong, up 2.3%
Impairment charges $865m (up from $811m in the March quarter)
Increased impairment charges are coming from Aust. commercial lending and NZ portfolio
However, the rate of increase is unlikely to be repeated in coming quarters
Strong Tier 1 capital ratio of 8.2%
Collective provision to credit risk weighted assets of 1.33% (up from 1.25% at March 09)
Comments:An encouraging update with cash earnings on track to meet FY09 IRESS broker consensus expectations of ~ $4.5bn. Impairment charges have moved up again in the June quarter but WBC seems to be taking a prudent approach (WBC conducted an extensive review of its portfolio and loan watchlist this quarter) and expects the rate of increase to slow from here. Impairment charges are due mainly to its commercial lending portfolio of unlisted companies and NZ. The consumer lending portfolio continues to experience only a small rate of delinquency. Lonsec notes Westpac has a strong balance sheet with a Tier 1 capital ratio of 8.2% and an additional buffer of 1.33% coming from the collective provision. WBC retains its AA credit rating which ranks it amongst the top 12 Banks in the world in terms of credit quality.
The trading update confirms Westpac is on track to generate Sept FY09 cash earnings of around $4.5bn or EPS of $1.53 per share and DPS of $1.14 (75% payout). That implies WBC trades on a FY09 PER of 17.5x and yield of 4.3% ff. However, earnings are expected to lift considerably in FY10 as the asset impairment charge recedes and investment income improves. The current IRESS FY10 broker consensus forecast is cash earnings of around $5.0bn or EPS of $1.70 per share implying that WBC trades of a FY10 PER of 15.7x. Lonsec recommends investors Accumulate under $26 ahead of the FY09 result, due late October.
Comments on major under-performers:
BHP (+3.9%) recently reported its FY09 results.
Key Points:
BHP’s underlying result came in slightly above market expectations of ~ US$10.5bn
The main exceptional item was a US$2.5bn charge for the mothballing of the Ravensthorpe Nickel laterite operation near Esperance, WA
Record net operating cash flow of US$18.9bn (up 5.9%) during a tough year was a key highlight
Impressive profitability with an underlying EBIT margin of 40.1% and underlying return on capital of 24.6%
BHP has a strong balance sheet with gross debt of US$16.4bn and cash of US$10.8bn, resulting in net debt of US$5.6bn
Gearing (ND/ND+E) is only 12.1% and underlying EBITDA interest cover is very strong at 57x
Underlying EPS of US$1.93 (AUD$2.30), down 30% on the pcp· DPS US$0.82 (AUD$1.15), up 17.1% over the pcp, lifting the payout ratio to 43% from 25%
Capital and exploration expenditure of US$10.7bn, up 20% on the previous year
Strong pipeline of projects – four new projects approved and the formation of the WA Iron Ore Production Joint Venture with Rio Tinto announced
Jac Nasser (ex Ford) to succeed Don Argus as Chairman from 2010
Divisional/Sectoral Profitability
| | US$bn | % of EBIT |
| Iron Ore | 6.229 | 33.5% |
| Metallurgical | 4.711 | 25.3% |
| Petroleum | 4.085 | 22.0% |
| Energy | 1.460 | 7.8% |
| Manganese | 1.349 | 7.2% |
| Base Metals | 1.292 | 6.9% |
| Aluminium | 0.192 | 1.0% |
| Diamonds/Specialty | 0.145 | .08% |
| Stainless Steel Materials | (0.854) | (4.6%) |
| Total | 18.214 | 100% |
(based on underlying EBIT before exceptional items and group/unallocated items)
Comments:This is a revealing and important result; it provides evidence that BHP’s diverse resource portfolio is able to smooth cash flow and earnings when extreme volatility in market conditions is experienced, as in FY09. Another key message is that BHP’s balance sheet has never been stronger which puts the company in an excellent position to invest for growth via a pipeline of organic growth projects and/or acquisitions.
Lonsec notes that Iron Ore, Coal and Petroleum underwrote the resilient result contributing about 89% of EBIT. Some may be surprised to learn BHP’s energy division (Petroleum + Thermal coal) contributes nearly 30% of EBIT. This is a key distinguishing feature of BHP over its peer group and is the reason the market often speculates that BHP might be interested in acquiring WPL to boost its gas exposure.Current IRESS broker consensus is FY10 EPS of A$2.00 and FY11 EPS of A$2.71. These numbers seem reasonable and imply that BHP trades on a FY10 PER of 19.8x and FY11 PER of 14.7x.
The stock looks fully priced in the short term but there are some good reasons to expect EPS to recover over the short to medium term including:
Investment in a number of organic growth projects (roughly US$8bn per annum being spent on exploration and growth capital expenditure)
An improvement in base metal (particularly copper) and oil prices during 2009
A recent recovery in spot iron ore and coal prices
WA Iron Ore JV with Rio Tinto (about 3-5% EPS accretive if approved)
Possible merger and acquisition activity (BHP has very low debt levels)
The main risk to earnings is the global recovery fails to gather momentum (major risk for the developed world) and hence commodity prices also fade. Offsetting this risk somewhat is an outlook for continued weakness in the USD, due to US quantitative easing policy, which should help keep commodity prices firm in the short to medium term. BHP offers exposure to the growing demand for commodities expected from the major developing economies of China and India, over the medium to long term. It also offers a diversified commodity portfolio that can act as a hedge against inflation and possible USD currency weakness. Investors should Buy under $38.
TLS (0.3%) looks like a value play at these levels with a high dividend yield and low PER. However, the fixed line business represents about $20bn or half its $40bn market cap. The Government wants TLS to structurally separate its fixed line assets so that the NBN can acquire them. Subsequently, TLS will not be able to compete against the NBN and will become another customer, just like Optus or any other retailer.
Lonsec holds major reservations over TLS’ ability to secure adequate compensation for its assets. This then leads to concerns about its financial structure in the future. Lonsec is also concerned that TLS’ fixed line margins will materially shrink, post implementation of the NBN. Remember, TLS will hold a passive equity stake in the NBN without any management control. It will be a retailer like the other Telco providers.
It is possible that TLS will be adequately compensated with a portion in cash. However, given the harsh negotiating tactics employed by the Government so far, Lonsec would prefer to wait this one out before assessing again later. Lonsec expects the stock to range trade between $3.00-3.50 over the short term but has potential to drift lower over the medium term. Lonsec has removed TLS from the Lonsec Core Model Portfolio but continues to hold the stock in the Lonsec POWERS portfolio. This is because the Alpha option overlay works well with a range trading high yielding stock and should be able to generate significant income from dividends and option premium. The bought put position acts to mitigate any concerns about the stock drifting lower.
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.
Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information that has not been verified by Lonsec. The conclusions, recommendations and advice contained in this document are reasonably held at the time of completion but are subject to change without notice and Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, employees and agents disclaim all liability for any error or inaccuracy in, or omission from, the information contained in this document or any loss or damage suffered, directly or indirectly by the reader or any other person as a consequence of relying upon the information.
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