Alpha POWER Shares (Lonsec) Portfolio - July 2008

Alpha POWERS Portfolio – July 2008

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

Lonsec comments on major out-performers:

WBC (+7.8%) Westpac recently released a market update confirming it is well positioned in the current environment to pursue its strategy including the proposed merger with SGB. WBC is on track to deliver FY08 cash eps growth of 6-8%. Loan volumes continue to fall but WBC is outperforming system growth at 1.5x. Asset quality remains good although stressed loans have increased. WBC conservative risk profile means it is not at risk from significant asset portfolio write-downs that have affected NAB and ANZ. Given the current environment, WBC expects higher collective provisions in the 2H.

Westpac Chief Executive Officer Gail Kelly said that despite slowing economic growth, Westpac continues to perform well. “Managing risk remains a priority for us and we are maintaining our strong lending and credit risk disciplines. Importantly, Westpac also has a strong capital and funding position, allowing us to effectively respond to the more difficult operating environment. We are not distracted by problems in our credit portfolio, enabling us to focus on our strategic agenda. Putting customers at the centre of our business is at the heart of this agenda,” Mrs Kelly said.

SGB takeover timetable

20 Aug 08	Final ACCC report due (no issue on banking, some issues on Wealth Mgt)
30 Aug 08	Expect ACCC approval
29 Sep 08	Scheme booklet to be mailed to SGB shareholders
6 Nov 08	SGB EGM and Scheme meeting
7 Nov 08	Court Approval Date
1 Nov 08	Implementation date

It is starting to become clear that Westpac is the best managed major Australian Bank in terms of profitability and credit quality. You can see this from the relative share price performance of the major Banks over the rolling 12 months:

Major Banks performance on the rolling year to 13 August 08

WBC	ASX	Westpac Banking Corp	-5.1%
SGB	ASX	St George Bank 2925	-6.6%
CBA	ASX	Commonwealth Bank.	-13.9%
NAB	ASX	National Aust. Bank	-30.5%
ANZ	ASX	ANZ Banking Grp Ltd	-35.5%

This market update shows that WBC is streets ahead of NAB and ANZ in terms of earnings growth and credit quality. Lonsec believes that CBA is the next best and hence CBA and WBC are our two key Bank exposures.

The WBC takeover of SGB looks increasingly likely with ACCC approval now received and ANZ & NAB unlikely to bid given capital constraints. CBA has already stated that it is unlikely to bid for SGB, most probably because the ACCC would have issues with its NSW market share. 

If the WBC goes ahead as expected, then WBC should easily outperform the peer group in terms of earnings growth as it will be able to extract very substantial synergies given the similarities between WBC and SGB ie both retail based banks with strong WM arms. The larger capital base of WBC/SGB will also increase its credit rating which will be very important in the current tight credit market conditions. Lonsec recommends that investors pick up CBA and WBC on weakness with a medium to long-term view on earnings growth.

TLS (+6.1%) Telstra recently reported a 13.5% increase in FY08 NPAT to $3.7bn and a final dividend of 14cps. The result largely met guidance and expectations. Telstra’s sales revenue has increased from $21bn in 2004 to $25bn in 2008 which is a good turnaround given the ~$3bn decline in the fixed line revenue base over this period. However, this revenue growth has been fueled by large investment in the mobile and internet business and a reduction in margins. A large amount of capex has also gone into improving and simplifying back office and IT systems.

From here, the trick is to maintain revenue growth, increase margins and reduce capex. If Telstra can do this, then its free cash flow will increase from $3.9bn to $6-7bn by FY10 (according to management targets). That would be equivalent to free cash flow per share of 62-63 cps or double current EPS! For those that are wondering, Telstra’s current free cash flow of $3.9bn easily covers the annual dividend payment of $2.9bn. If Telstra borrows to pay a dividend it is because its expansionary capex exceeds its free cash flow less the dividend payment. In other words, you could also say it is paying for its dividends out of free cash flow and increasing debt levels to fund expansionary capex. The key point is that capex should be dropping quite markedly over the next 2-3 years and free cash flow should increase.

Given the bullish outlook for Telstra’s revenue, margins and free cash flow, one could wonder why the share price isn’t doing better. The answer is that the Labor Government’s plan to build and partly fund a new National Broadband Network (NBN) is both an opportunity and a threat for Telstra. While it seems that Telstra is the natural builder of the network (from a funding and operational point of view), it is clear that many parties do not want Telstra managing or operating the network (due to its tendency to act as a monopolist!).

If the Government awards the network to a competing consortium it will need to pass legislation to gain control of parts of Telstra’s infrastructure. Telstra’s broadband revenue could become at risk (over time) from the new network depending on the new industry structure. A decision on the National Broadband Network is not expected until later in the year and is highly likely to be extended out to 2009. The final decision could be positive, neutral or negative for Telstra depending on the final structure including management and ownership terms. The Govt. has $4.7bn of taxpayers money allocated to this project, so it would not want to stuff it up. It will want benefits for the taxpayer but must also offer an acceptable ROI for investors.

There is a fair way to go on the NBN and Lonsec continues to closely monitor developments. In the meantime, Telstra offers a solid 6.5% fully franked yield and trades on a current P/E of 14.3x. Assuming the NBN does not adversely affect it, the company also offers reasonably strong earnings growth over the short to medium-term which is becoming increasingly rare amongst the industrials. Accumulate under $4.60.  

Lonsec comments on major under-performers:

GPT (-31.5%)  

Clearly negative sentiment towards the LPT sector and concerns about an International Property JV with Babcock and Brown has weighed on GPT’s unit price. The units now trade at a 45% discount to the last stated NTA of $3.86 and on a yield of 11.6% (based on revised distribution guidance of 20 cps).

The JV Fund’s debt is non-recourse to GPT; that is the debt is ‘ring fenced’ to the JV Fund. The worst that can happen is that the portfolio falls in value by 30% or more and the equity is wiped out. It’s important to realise that the market has already priced this scenario into the GPT unit price.

At $1.73 the market has discounted GPT’s NTA by $2.13 or ~ $4.7bn. GPT’s equity in the JV is $2bn representing 15% of GPT’s total asset base of $13.3bn. So it looks like the market has written off all the JV Fund net equity, all the other international assets and then even more off the Australian property portfolio which makes up about 70-80% of GPT’s total assets. Again, for GPT to lose all of its $2bn in net equity in the JV Fund, the JV Fund portfolio would have to drop in value by 30% - this seems unlikely given the reasonable quality of the portfolio and the low yield curves in Europe and the US. (see portfolio breakdown below). GPT is not a forced seller given the JV Fund portfolio yield exceeds the cost of debt and the debt has a weighted average term to maturity of 5.8 years.

Even if GPT lost all of its equity in the JV Fund (seems unlikely) its NTA would fall by ~ $0.91 cpu to $2.95. Now it could be argued that the Australian portfolio might be also worth less in current market conditions (perhaps 15% less) but it also has to be recognized that GPT has a large $4.6bn development pipeline and a wholesale funds management business which would also need to be considered.

Lonsec has always been aware of the risk of the leveraged JV Fund but believes the market is overly pessimistic towards the Fund and its impact on GPT’s market value. GPT had been earning an ROE >10% on net equity but this seems unlikely moving forward given the property cycle is turning and credit conditions have tightened.

At the heart of GPT lies a high quality diversified Australian portfolio which is supplemented by a fairly major $4.6bn property development pipeline. Lonsec believes that GPT (ex-international assets) is worth around $2.90-3.00 per unit (taking into account: Australian property portfolio, Australian funds management and Australian property development).

GPT valuation: 

Last stated NTA	$3.86
Estimated Australian assets NTA	$2.95
15% discount to NTA	$2.50	(yield 8.0% at revised 20cpu distribution)
30% discount to NTA	$2.07	(yield 9.7% at revised 20cpu distribution)

So based on all the public information currently released on GPT, you can buy GPT for the Australian portfolio and assets outside the JV Fund quite comfortably under $2.00 per share. GPT has an additional $0.91 tied up in the JV Fund which it is likely to get part of back over the next 2-3 years as the portfolio is wound down. Lonsec expects at least $0.36 per unit to be returned. Lonsec recommends that investors buy GPT up to $2.07 for yield and capital upside (as the market price reverts back closer to NTA over time). 

WPL (-20.3%) Woodside retreated as the oil price retreated from the US$145 level to the US$114 level. Short-term there are concerns about a global slowdown in the G8 countries spreading to developing countries. However, demand for energy, particularly gas fired energy, is likely to continue to grow as diesel and coal becomes more expensive under carbon emission trading schemes (carbon tax).

The British Gas (BG) off-market takeover offer for ORG at $15.50, highlights the rocketing value of gas reserves as an important ‘clean’ energy source. WPL production is 70% gas (natural gas and condensate converted into light crude oil, LPG and LNG) and its huge reserves are nearly all gas reserves offshore WA, Victoria and NT.

Woodside 1H08 production was 36.5mboe with the company targeting CY08 production of 80-86mboe. It seems the company will (once again) struggle to meet production targets but the rising oil price (and gas price) has more than compensated. It should be noted that most oil and gas companies are struggling to meet production targets and in fact many have declining production profiles. Woodside stands out as it should be able to actually grow production over time as it has a good pipeline of major LNG growth projects including Pluto (offshore WA), Browse (offshore WA) and Sunrise (Timor Sea). Consensus earnings per share for CY08 are $3.77 but increase to $5.80 by CY10. The main risks to these forecasts are the price of oil & LNG and project capital costs blowing out. Lonsec recommends a BUY under $61.65

ORI (-16.5%) Orica recently announced plans to raise between $600-900m via a 1:8 entitlement offer priced at $22.50 per share and to de-merge or “spin-off” its Consumer Products business in early 2009. Orica will become entirely focused on chemical products for the global mining industry. The capital raising will restore strength to the balance sheet and allow Orica to pursue growth opportunities. The Consumer product business will be de-merged to existing Orica shareholders in early 2009.

ORI post de-merger: 

The Consumer Product business has leading brand names and market share:

KEY DATES

Insto entitlement offer opens	Monday 21 July 2008
Insto entitlement offer closes	Friday 25 July 2008
Record date	Friday 25 July 2008
Orica re-commence trading	Monday 28 July 2008
Retail offer opens	Monday 28 July 2008
Retail offer closes	Monday 18 August 2008

Non-participating shareholders will receive consideration for their entitlements through the bookbuild process.

De-merger of Consumer Product business is expected in early 2009

The ORI Step-up Preference Shares will remains securities of ORI and will not participate in the de-merger of the Consumer Product business.

INVESTMENT OPINION

The rights issue is a case of short-term pain for long-term gain. The $900m equity raising will strengthen the balance sheet which had become a bit stretched after a spate of recent acquisitions over the past three years. Clearly, in this market it is better to put to bed any concerns about gearing as soon as possible. Gearing (D/D+E) will fall to 30-36% - below Orica’s targeted 35-45% range. A stronger balance sheet will also allow Orica to pursue some of its growth plans including a proposed new $550m ammonium nitrate plant in Bontang, Indonesia.

The proposed de-merger of Consumer Products (about 15% of Orica’s 2007 EBIT) recognizes the different strategic and operating characteristics of wholesale mining services v retail consumer products. Orica is expected to remain an ASX Top 50 stock while the new spin-off is expected to be an ASX Top 200 stock. Interestingly, de-mergers have historically created more value for shareholders than mergers.

Orica also confirmed that 2008 earnings are expected to be higher than 2007.

Overall, a short-term negative in terms of earnings dilution per share but outweighed in the medium to long-term by a stronger balance sheet that allows Orica the flexibility to pursue various growth options in the buoyant global mining services industry.

ORI shareholders should take-up their 1:8 entitlements at $22.50 per share. The Consumer Product de-merger will not occur until early 2009, so no action is required here until then

TAH (-11.5%)

Portfolio Manager comments on Tabcorp last result follows:  

Tabcorp reported FY08 results today.

Net operating revenue	$3.9bn, up 1%
EBIT	$897m, flat
NPAT	$517m, flat
Gaming licence charge	-$488m
Wagering business writedown	-$194m
Star City writedown	-$25.8m
Reported NPAT	-$165m
EPS	98.5cps
DPS	47cps (special dividend given reported loss)
Casino EBIT	$369m, down 4.5% mainly due to smoking bans
Wagering EBIT	$264m, up 4.2% despite $17m hit from Equine Influenza
Gaming EBIT	$261m, flat due to smoking bans and higher gaming taxes offsetting revenue growth of 4.8%
Net Assets	$2,771m
Net Debt	$2,097m
ROE	18.6%
Gearing (D/D+E)	43%
Interest Cover (EBIT/Interest)	5.5x
BBB+ Credit rating maintained

$475m Star City expansion planned including new 5 star hotel, re-orientation of façade towards Sydney Harbour and expansion of all facilities

DRP to be fully underwritten  

Outlook

Business has been restructured and balance sheet cleaned up Operational improvements put TAH in a strong position to handle a slowing economy TAH will now focus on further operational improvement and customer service New growth initiatives have been implemented including:

• $475m Star City Casino expansion over 2009-2011
• Keno business expansion in NSW, targeting an increase from 170 to 600 hotels
• Expansion into NT on-line wagering market

Aiming to maintain DPS at 94cps despite softening economy Unlikely to go offshore in the short to medium-term

Victorian Gaming Licence

Tabcorp will pursue its rights to compensation for revoking its gaming licence post 2012. Tabcorp firmly believes that the Victorian Government must pay it at least $597m and up to $687m including interest costs. However, given the Victorian Government’s current stance to not recognise the obligation, it has elected to write-off $488m now and the balance over the next four years.

INVESTMENT OPINION

Given the number of challenges the company has faced over the past year including smoking bans, higher gaming taxes and equine horse influenza; this was a very good underlying result. The wagering result (EBIT up 4.2%) was a stand-out performance given a $17m hit from the equine horse influenza. The gaming result was also very credible. It shows that operationally, Tabcorp has made great progress over FY08. New management seem to be doing a very good job.

On Vic Gaming, Tabcorp intends to improve short-term profitability up to 2012 ie reduce capex in the business. It is still reviewing its post 2012 options but is unlikely to acquire venues to maintain gaming licences. However, it does see an opportunity to operate and service the gaming machines for venue operators.

On Wagering, the company wrote-down the business by $194m, yet increased EBIT over the year. However, given the problems in the structure of the NSW racing industry and the advent of on-line bookmakers operating out of NT and TAS, it is sending a clear message to the NSW and Victorian Govt that the value of the industry is in decline unless industry and regulatory changes are made. With TAH entering the NT market, it is also sending a message that the NSW and Victorian wagering licences will not be worth as much if the racing industry continues to be undermined by on-line corporate bookmakers that contribute nothing to the racing industry. TAH’s Vic wagering licence comes up for renewal in 2012.

The Company is staking much of its future growth on the Sydney Star City Casino where it has recently renewed its exclusive licence for a further 12 years. TAH is planning a major $475m expansion to transform the Star City into a world class casino and entertainment destination. Expansion plans include new 5 star hotel, re-orientation of the Casino towards Sydney Harbour and major expansion of entertainment and gaming floor space.

Balance sheet wise, the company looks ok with gearing of 43% and strong interest cover of 5.5x. The S&P credit rating of BBB+ has been maintained.

Tabcorp intends to remain focused in domestic growth and market share for the short to medium-term, at least.

Overall, this was a solid result amongst a ‘perfect storm’ of issues over FY08. Management have come through with flying colours. FY09 will be another tough year with a slowing economy and higher interest costs but that situation will apply to all listed companies. If Tabcorp continues on its path of operational improvement and has an issue free year from a regulatory viewpoint, it could very well produce a flat to modest increasing in NPAT over FY09. Lonsec believes that such a result will be quite good relative to most other industrial and financial companies. The company is currently valued at about 9.2x current NPAT and the stock offers a dividend yield of 10.4% fully franked. This seems fair compensation for the loss of Victorian gaming earnings post 2012 (still 4 years away). TAH will obviously be working hard to plug this gap over the next four years. Lonsec believes the stock offers good value from a yield perspective with upside possible from operational improvement, changes to NSW and Victorian racing industry structure, expansion of the Casino business and movement into on-line gaming.

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