Alpha POWER Shares (Lonsec) Portfolio - February 2008

Lonsec comments on major out-performers:

TAH (+13.1%) The interim shows the benefit of TAH’s diverse business, with cost finally being controlled. This positions TAH well to recover in FY09 when the effect of equine flu and NSW smoking bans reduce.
Net operating cash flow rose 4% to $318m, up 10% to $241m after capital spend. DPS was flat at 47c, fully franked payable on April 9. Underlying EPS rose a tolerable 7% to 52c. Normalised EPS rose 3% to 50c.
Wagering EBIT dropped 9% to $131m from the flu. Gaming rose just 2% to $139m mainly from the higher Victorian tax. Casinos EBIT rose 22% in actual terms to $207m. Adjusted for the differences from the theoretical VIP win rate, Casinos normalised EBIT was flat at $190m. This time TAH won $18m more from high rollers than expected – losing market share in Sydney but winning more.

The new MD tightened costs well, without curtailing business growth. Group costs fell 1%, much improved from jumping 11% before. TAH will shortly announce further IT outsourcing. Capital spend will moderately increase. This is both to catch-up on under-investment in Casinos and Wagering and to upgrade Sydney’s tired Star City casino. This will gain over $300m spend once finally approved, aiming to be Australia’s best casino – quite a challenge to Crown! Gearing remains relatively moderate for an established gaming company at 61% using net debt/equity. Interest cover is solid at 5.8 times using EBIT.

The exclusive Star City Casino licence was recently rolled over for another 12 years while negotiations on Victorian gaming and wagering licence renewal post 2012 are still progressing. Tabcorp is currently undergoing an operational review to improve efficiency after a spate of takeovers over the past 5 years. The recent equine horse flu outbreak in NSW and QLD came at a bad time for the company but on a positive note the underperforming NSW racing industry is likely to be more open to much needed review and restructure after recent losses. Tabcorp is a yield play (6.6% ff) with prospects for earnings growth due to a focus on operational improvement.

TLS (+12.2%) Telstra has invested heavily in mobiles and broadband internet to generate growth against a declining fixed line business. At the same time the company is transforming its processes and systems to become more efficient. This has seen earnings fall in the past two years and capex increase markedly. Now the company is generating strong revenue growth from its mobile and broadband business and its fixed line ‘bleed’ has nearly stopped. Capex should reduce markedly over coming years and free cash flow should double by FY10 – according to company targets. So far management are delivering on the transformation of Telstra into a more modern and efficient Telco. The main risk that lies ahead is the Government’s plans to build a new broadband network. Telstra may or may not participate in this project. If it does not then there is some major risk to broadband revenues in future years.

However, investors should note that this project is likely to be many years away from completion and Telstra may well be in the box seat to build and manage the network, in any case. Overall, Telstra is an ASX top 10 stock that provides a relatively high degree of earnings certainty (in the short to medium term) from its utility style revenues. Gearing is moderate and interest cover is high. The stocks offers a solid yield with reasonable prospects of growth. Lonsec believes that the stock will outperform in current market conditions.

BHP (+7.7%) BHP reported underlying 1H08 earnings of US$6.0bn, a 3% decline on 1H07. Market disappointment was contained due expectations of a rise in iron ore, coal, oil and base metal prices in the upcoming 2H08 and impressive cost control in the face of considerable industry pressures. Input prices increased significantly and currencies appreciated strongly. Despite this, the increase in half year cash operating costs fell to 1.7%, the fourth consecutive decline since 1H06's peak of 6.7%.

Underlying EBIT rose 5% to US$9.6bn although margins fell from 41% to 38%. The strongest margins were in Petroleum (64%) and Base Metals (62%) while Diamonds (18%) and Energy Coal (15%) were the laggards. Group return on capital fell to 30% compared with FY07's impressive 38%. Some of this reflects capital expenditure on projects yet to fire. Significant volume growth is likely in 2H08 with continued ramp up of Genghis Khan, Atlantis South and Stybarrow (oil and gas), Koala U/G (diamonds), Pinto Valley (copper), Rapid Growth 3 (iron ore) and Ravensthorpe (nickel).

BHP has upped its scrip bid for RIO from 3:1 to 3.4:1. Key aspects of the offer include no cash component and a modest 50% acceptance condition (this reduces the impact of Chinalco’s 12% blocking stake in RIO). The  scrip only offer reduces the takeover pricing risk for BHP shareholders but the scrip ratio does look fairly generous given RIO shareholders will end up owning an inflated 45% of the combined group. The takeover offer will take many months to gain the necessary regulatory approvals but BHP is prepared to be patient. BHP will be hoping that weak equity markets but rising oil and commodity prices will support its share price greater than RIO leading to the offer becoming increasingly attractive to RIO shareholders. BHP’s timing could prove to be excellent.

Lonsec comments on major under-performers:

SGB (-14.5%) The global credit crisis continues to deepen since the first rumblings in the US sub-prime mortgage market around August last year. Credit spreads have spiked sharply higher while many corporate debt markets have become illiquid. While Australian Banks have little direct exposure to US sub-prime mortgages, they do source about 30-50% of their capital from (previously cheap) foreign debt markets while some of the Banks’ corporate clients have also been adversely affected (eg Centro, Allco, MFS) by the seizing up of various debt markets.
To summarise, the negative effects of the global credit crisis on the Australian Banks are:

1. The cost of capital (especially from overseas debt markets) has risen substantially;
2. The seizing up of securitisation markets means the Banks have had to bring off-balance sheet funding vehicles back onto their balance sheets thus constraining their capital adequacy;
3. Some highly leveraged corporate clients may fail leading to an increase in bad debts; and
4. Falling equity and corporate debt markets will hurt investment earnings in the period ahead.

On the positive side, Australian Banks seem to be in a better capital position relative to their overseas peers and many corporate borrowers will have to return to the Banks for debt financing given equity and corporate debt markets are so volatile and expensive. It is highly likely, that the Banks will be re-rated higher at the point where substantial capital raisings are made to secure the capital positions of each major Bank, allowing them to take advantage of market conditions and increase market share.

St George is predominantly focused on the Australian domestic market with a material Australian Wealth Management business which represents about 14% of group earnings. The Bank is well managed and has a leading ROE (23%) and a low cost to income ratio (43%). St. George is a fair bit smaller than the majors with a market cap of about $13bn compared to the majors which range from $40bn up to $50bn. Lonsec expects that St George’s smaller size will make it easier to generate organic growth while its retail banking focus should also help it avoid much of the corporate debt problems that are starting to emerge. The stock is currently on a yield of 7.2% (ff) and the company continues to target 10% growth in EPS over FY08 (subject to market conditions). Lonsec views the stock as excellent long-term value at these levels.

CBA (-12.4%) (see SGB comments above for further commentary on the banking sector)
Of all the major Banks, Lonsec believe CBA is best positioned to etch out earnings growth over the medium to long-term. It has a large retail business and the highest retail deposit base (the lowest cost source of funding) representing 54% of its funding mix and it has the largest exposure to the Australian Wealth Management sector (16% of Group earnings). While CBA maybe penalised in the short-term for greater exposure to Wealth Management (from Cominsure, Comsec and Colonial/First Choice), Lonsec has a positive view on the sector (mainly due to growth in Superannuation) over the medium to long-term. CBA is a long-term BUY.

AIO (-9.6%) the stock has obviously caught out many who were focused on the rail and port assets (like the Lonsec Portfolio Manager) and not the growing gearing levels of the company. Indeed, most brokers still maintain a BUY on the stock. Three things happened over Dec, Jan and Feb 08 that caused Lonsec to change its view on the stock:

1. The company confirmed that earnings are actually trending down (due to issues in the rail business);
2. The company’s interest cost is trending up (due to increasing debt levels and deteriorating debt markets); and
3. The company refuses to sell its remaining 3.44% stake in Brambles and Lonsec has discovered that the debt funding behind the BXB stake is NOT included in the debt figures the company has been releasing to the market (this was not clear in the company’s presentations and there were no financial reports released until Feb 29). This meant that debt levels are some $500-600m higher at about $5bn and interest costs are likely to be about $28m higher at about $370m pa. As a result, gearing is very high at over 67% (net debt/debt+equity) and interest cover (EBIT/interest) is skinny at 1.3x.

All in all, with debt markets continuing to deteriorate during 2008 and a global slowdown looming, we took the tough decision to exit the stock at around $5.00 in late February. Since that date, the stock has fallen to a low of $3.33. Lonsec’s portfolio manager firmly believes that if EBITDA continues to trend down and interest costs continue to trend up, there is a clear risk that the company will be insolvent and its bankers will end up owning the rail and port assets. For this reason, Lonsec took action and has exited the stock.

Lonsec Limited ABN 56 061 751 102 Published by Participant of ASX Group Level 22, 500 Collins Street, Melbourne, 3000 - P.O. Box 46 Collins Street West, Victoria, 8007 General Inquiries: (03) 9623 6345 Dealing Room: 1800 649 518 Fax: (03) 9629 6990

 

© Alpha Structured Investments
Dr Tony Rumble
July 2007