Alpha POWER Shares (Lonsec) Portfolio - July 2009

 

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

Comments on major outperformers:
AMP (+15.2%) recently reported its interim report for CY09.

Key Points:

• Underlying 1H09 profit of $367m, down 16% (above market forecasts of $342m)
• Reported 1H09 NPAT $362m, down 1% on pcp
• EPS $0.18
• DPS $0.14 (50% franked)
• ROE 31.6%, down from 40.5%
• Capital reserves now 2.4x the minimum regulatory requirement
• Gearing modest at 16%, interest cover high at 10x
• AUM $104.1bn (down from $117.1bn at pcp)

Outlook

“AMP is investing to reshape the business in anticipation of potential regulatory change and changing consumer preferences, from a position of significant strength. This investment involves a series of important change programs, including initiatives to unbundle fees from products and supporting planners to operate on a fee-for-service basis. We are also offering more competitive and targeted products to different customer segments, and sourcing more of AMP Capital’s net cashflows internationally, particularly from Asia,” said Mr Dunn.

Short-term outlook

• Economic and market outlook improving
• Regulatory environment set to change, creating challenges and opportunities

Medium to long-term outlook

Attractive outlook for Australian, NZ and Asian markets underpinned by:

• Ageing demographics
• Mandatory superannuation regime in Australia
• Saving initiatives in NZ
• Economic, social and political developments in Asian markets

Comments:

The interim result came in above expectations and AMP’s capital position looks very strong. Perhaps the only disappointment from the result was that the level of dividend franking has dropped to 50%. AMP intends to increase franking income once again as its taxable profits recover.
From here, AMP has significant operational leverage to improving market conditions. As a top 3 player in Australian Wealth Management (AWM) with AUM of $104bn and a market cap of $12.3bn, AMP is in a strong position to reshape the business in anticipation of regulatory change. An important message from the result is that AMP is not just looking to protect the business but is actively looking for growth opportunities. A key plank in its growth strategy is balance sheet strength to allow flexibility to respond to changing conditions. AMP has $1.1bn in surplus capital and continues to operate its DRP (75% underwritten) to raise further capital.

AMP has some short-term hurdles to overcome in regulatory change but improving market conditions will help mitigate the impact and the long term outlook for the AWM industry remains very robust (see outlook above). AMP continues to manage its costs very tightly and has a five prong plan for growth:

1. Grow planner capacity and broaden distribution
2. Expand into Asia through AMP Capital Investors
3. Grow HNW customer segment
4. Reshape AMP Capital Investors into a top performer
5. Build balance sheet capacity for growth (organic growth and acquisitions)

Based on the 1H09 result, AMP looks to be on track to deliver CY09 EPS of around 38cps and DPS of 0.28cps. If market conditions continue to improve, it is highly likely that AMP could deliver on broker consensus expectations for EPS of 42cps in CY10 which implies the stock trades on forward PER of around 14.6x and yield of 5.1% (based on a 75% payout ratio). Given NAB’s renewed interest in the AWM space (acquisition of Aviva, JB Were) it is likely that AMP will retain at least a market multiple of around 14-15x earnings. Lonsec recommends AMP as an accumulate under $6.40.

CBA (+9.7%) recently reported its FY09 results.
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

 Source: CBA

Outlook:
Commenting on the outlook for the 2010 financial year Ralph Norris said: “The 2009 financial year has been a challenging one and the outlook remains uncertain. However, the Australian economy has been more resilient than many had predicted a year ago and it is pleasing to see that there is some evidence of the beginnings of an economic recovery and improvements in business and consumer confidence but there are still significant risks on the downside.”

“Despite these positive signs, overall credit growth in Australia is expected to slow through 2010 and economic conditions are likely to remain challenging for the Group and many of its customers in the coming year. Accordingly the Group will retain its conservative business settings maintaining appropriate levels of capital, liquidity and provisioning. The Group will also continue with its cautious approach to the management of credit and market risk.”

Comments:
While cash NPAT was only down 7%, earnings and dividends were cut by 14% due to the significant increase in issued capital during the year. That being said, FY09 was probably the most tumultuous year for the global economy and financial markets since 1987. For CBA to come through with just a 7% fall in cash earnings is really quite remarkable. Federal Government and RBA policy during the credit crisis certainly helped but some credit must also go to CBA management. The acquisition of Bankwest at 0.7x book value during the heat of the credit crisis now looks to be an absolute steal (see chart below).

It’s important to note that the Bankwest contribution ($113m after tax) in the FY09 result was only for six months and is after some fairly hefty asset impairment charges. The Bankwest contribution should rebound to around $465m on a normalised basis (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 behind it 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 main reasons:

1. Corporate Loans - listed companies have raised over $100bn in equity to reduce their debt exposure;
2. Residential Loans - Australian house prices are holding up well and employment is proving resilient; and
3. 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 main two 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 forward PER of 13.5x which suggests the stock is fair value at current levels.

Lonsec recommends investors target buying CBA shares between $42-44. 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.

BHP (+9.0%) 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
(based on underlying EBIT before exceptional items and group/unallocated items)

	US$bn	% of EBIT
Iron Ore	6.229	33.5%
Metallurgical Coal	4.711	25.3%
Petroleum	4.085	22.0%
Energy Coal	1.460	7.8%
Manganese	1.349	7.2%
Base Metals	1.292	6.9%
Aluminium	0.192	1.0%
Diamonds/Specialty	0.145	0.8%
Stainless Steel Materials	(0.854)	(4.6%)
Total	18.214	100.0%

Outlook:
“The commodity re-stocking in China now appears largely complete with substantial inventory build in specific commodities over the last three months at end-user level and in strategic stockpiles. Chinese demand has been exceptionally strong in cases in which imports have replaced higher cost domestic production (such as in iron ore) or where commodities have substituted unavailable products (such as copper cathode for copper scrap). BHP expects Chinese demand to more accurately reflect real end-user purchasing in the near term. After intensive destocking, there is emerging evidence of demand improving in North America, Europe and Japan. It is too early to tell whether this improvement is driven only by a re-stocking or a combination of re-stocking and real demand.

Real demand following the stimulus spending will be the key to a sustainable price recovery. However, further improvements in commodity prices in the short term should be viewed in the context of the likely supply responses from latent capacity across the industry. In the long term, BHP continues to expect strong growth in demand for its commodities. Long term prices will continue to be driven by the long-run marginal cost of supply. With reduced capital investment over the past year, supply may struggle to keep pace with demand in the medium term when growth recovers.”

Comments:
This is a revealing and important result; it shows that BHP’s diverse resource portfolio can indeed smooth cashflow 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 that 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.

BHP earned A$2.30 in EPS and lifted DPS to A$1.15. At current levels the stock trades on a PER of 16.3x and dividend yield of 3.1% ff. The stock does look 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)

Current IRESS broker consensus is for FY10 EPS of A$2.60 and FY11 EPS of $3.07. These numbers seem reasonable to me and imply that BHP trades on a FY10 PER of 14.4x and FY11 PER of 12.2x. The main risk to earnings is that 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 look to BUY BHP around the $34-35 level.

Comments on major under-performers:

TAH (+1.1%) is Australia’s largest gaming entertainment company with leading positions in Casinos, Wagering and Gaming. Tabcorp has been trading around the $7.00 level after raising $387m in equity and $284m in a listed bond issue. Since losing its Victorian gaming licence (expires 2012), Tabcorp has implemented a three phase corporate strategy to 1) focus on operational improvement; 2) drive performance in and growth in each core business and 3) prepare for transition to the post 2012 environment. Tabcorp stands to lose about 24% of its EBITDA from 2012 but still has a considerable earnings base up to and post this date. Tabcorp’s attention post 2012 is likely to be on its wagering and casino businesses (especially Star City in Sydney).

Note: TAH was removed from the portfolio on 11/08/09 after going ex-dividend. Lonsec is exiting the position as the recent company result painted a picture of a company under significant headwinds in each of its three key businesses. While the negative outlook for pokies was well known, it now seems the Wagering business is coming under pressure from on-line bookmakers and racing industry re-structure. There is a risk the stock could drift lower, despite its high yield, as there are significant risks to revenue over the medium term. In addition, State Governments are moving into budget deficit and likely to keep increasing gaming taxes. 

Source: Tabcorp

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