Blue chips head for writedowns

PORTFOLIO POINT: As a string of blue chips are ready to announce writedowns, Telstra and Foster’s appear well placed for improvement.
When you look at the highly divergent stock performance in the ASX 50 in February you can understand why the very last thing I would be doing is giving money to an index fund! The index is a complete sideshow at the moment and this is all about stock picking. Actually, in reality, it’s more about avoiding falling knives. This divergence is amazing.

Clearly there are three Macquarie vehicles in the bottom 10 performers of the ASX 50 for February. While I was leading the caution on Macquarie during January and early February, I am of the view that downside trade has now played out in the head shares after a 35% fall in the month.

I realise some of Macquarie’s competitors are now questioning Macquarie’s capital adequacy, but a cynic would question the true motivation for that questioning. All I know is that the last time I saw “broken model” research on Macquarie the stock proved to be tremendous value. I am of the view that long-term technical support will hold around $16. However, the chorus of Macquarie corpse kickers has never been louder and I do see opportunity when so many people are cheering a share price down.

I have no idea how to value Macquarie Infrastructure and Macquarie Airports but the good news is I that have hired a top-rating infrastructure and utilities analyst in Sanjay Magotra (ex Citigroup) and I’ll let Sanjay work out if these things have any value. Interestingly, Sanjay’s last piece of research on Asciano is looking pretty accurate despite the controversy it caused at the time.

Poor old Qantas just had a complete debacle of a month: a leaked equity raising, capacity reductions, a credit rating downgrade AFTER the capital raising, and fierce headwinds from the collapsing global travel sector. I was cautious on Qantas, but you’d have to say it encountered the perfect market storm in February and is now trading below a realistic NTA. It does looking interesting for a bounce trade if nothing else.

Two global trends clearly came to Australia in February: the derating of “old media” and “insurers”. Fairfax Media and Axa had dreadful months but hopefully Fairfax’s capital raising will stop the rot there for a while. What it won’t stop is the questioning of carrying values in the old media world, particularly goodwill associated with mastheads. That debate will continue.

Of course, the month wouldn’t have been complete without two listed property trusts being the two worst performers. One thing I am NOT buying for any bounce trade is a LPT. There’s too much risk of waking up one morning and finding the banks have pulled the plug, leaving your equity worthless. If I am going to look for bounce trades they have to be in companies with no insolvency risk.

Let’s get ready for another wildly divergent month. I may not be today, but I just have the feeling risk may do a little better than safety this month. That trading rubber band remains stretched too far in favour of safety. But that is what you would expect in a sentiment capitulation. Good riddance to a summer of market discontent!

I smell someone taking a haircut

Call me old-fashioned, but I was just looking through some listed companies with decent scale debt and I am just amazed how banks say they think they have located most potential bad debt exposures on their books. That is not what the equity market is telling them.

I was just looking at the equity market caps vs the debt piles that these industrial companies have at the moment and I wonder how banks can say they are comfortable with an exposure where the equity market gives them a valuation, like Gallileo Japan Trust of $13 million yet they have $935 million of debt?

I realise people tell me it is hard assets and they can always be sold, but the reality is that banks are not lending against hard assets – they are lending to the operating companies of these hard assets. They leant against interest cover, not loan to value ratios in most cases.

For example, Asciano owns key infrastructure assets but how can its lenders be comfortable with a $300 million market cap and a $4.7 billion debt heap? Perhaps the lenders think shareholder equity will be wiped out and debt will be repaid, but it very rarely works that way.

The chart below points out the equity value versus debt pile of a selected group of Australian listed companies.

nEquity value vs debt pile
Company	Code	Equity market cap $m	Debt pile $m	Mkt cap as % of debt
Centro Properties Group	CNP	73	6100	1.2
Galileo Japan Trust	GJT	13	935	1.39
APN European Retail Property Group	AEZ	14	896	1.56
Tishman Speyer Office Fund	TSO	33	1724	1.91
Macquarie DDR Trust	MDT	33	1717	1.92
ING Real Estate Community Living Group	ILF	18	930	1.94
Valad Property Group	VPG	57	1892	3.01
ING Industry Fund	IIF	103	3125	3.3
Mirvac Industrial Trust	MIX	18	536	3.36
Macquarie Countrywide Trust	MCW	159	3558	4.47
Hedley Leisure and Gaming Property Fund	HLG	38	758	5.01
Babcock & Brown Japan Property Trust	BJT	119	1802	6.6
Asciano Group	AIO	321	4700	6.83
Macquarie Office Trust	MOF	504	3120	16.15
Pacific Brands Limited	BPG	123	740	16.62
Goodman Group	GMG	722	3478	20.76
Transpacific Industries Group LTD	TPI	559	2350	23.79
Abacus Property Group	ABP	194	719	26.98
ING Office Fund	IOF	445	1414	31.47

Clearly the chart above tells me the shareholders of these groups have taken very heavy haircuts but surely it’s also implied that their lenders are also about to take some sort of haircut? While Australian banks are already pricing lower dividend yields, I remain of the view that haven’t had their day of reckoning in terms of asset writedowns. The equity market is attempting to tell the banks they have some very serious problems on their hands.

Macquarie Group; increasing transparency, decreasing P/E

While Macquarie shares had another horrible trading day yesterday in response to weekend press commentary, I found it encouraging that Macquarie released more detailed information about the financial and asset position of its listed funds. While the market is currently not choosing to believe Macquarie’s version of its capital adequacy, the company should be congratulated for increasing transparency and allowing investors to make a more informed decision.

Yesterday’s market release was far more useful than the previous “We have excess capital” statements and I think it’s a major step in the right direction in the battle to stop the share price rot. Giving the market detail is the only way to fight a campaign of Chinese whispers. There is no such thing as too much detail.

Macquarie is another example of concurrent cyclical P/E (price/earnings) and E crunch. We all know 2009 will be damn close to bottom of the cycle earnings for Macquarie, but its P/E is also being crunched. There is no economic textbook that says P/E and E will be concurrently crunched at the bottom of the cycle, but this is the new momentum world we operate in.

To me that is the opportunity in names like Macquarie. I’d be covering shorts in it as I think the short trade has now run its course. Macquarie at worst should have earnings of $3 per share. There is every chance it is trading on 5 times bottom-of-the-cycle earnings.

I’d suggest 10 times bottom of the cycle ($30) is a more appropriate multiple, so on that basis the brave could double their money in Macquarie Group from these levels. It’s brave, but I don’t think it’s stupid. There is a difference.

Foster’s: wine at beer prices

While I remain optimistic that a tradeable rally in risk has started, there is little doubt that all the recent statistics suggest both global and domestic economic growth will remain weak. As a result I expect continued pressure on cash flows and further earnings downgrades in the broader market.

Consequently my strategy remains focused on deep franchise value, and my fundamental (as opposed to trading) recommendations continue to support companies with defensive industry positioning and high-quality balance sheets. I recently highlighted the defensive nature of the healthcare sector, however Foster’s has similar characteristics with strong cash flows and a dominant position in domestic brewing.

In the context of a poor reporting season, Foster’s interim result was good and in line with my earnings expectations (up 4% to $411 million). Importantly, in a very tough operating environment, the duopoly position in domestic brewing supported strong cash realisation (90%) and operating cash flow of $473 million. The strength of the cash flows and a strong balance sheet with net debt/equity of 76%, and EBIT interest cover of 7.9 times, has significantly reduced the risk for an imminent equity raising. In contrast, I expect further capital raisings for the industrial sector.

In addition, Foster’s announced the outcome of its long-awaited strategic review. This initiative is a very positive move, which will unlock genuine long-term value for shareholders after the ill-conceived multi-beverage strategy. It appeared obvious to anyone with only a slight appreciation of wine, that the driver of a beer truck would struggle marketing Grange to liquor retailers!

In addition, there is little doubt that after Southcorp acquisition the wine division has struggled with too many brands, which have cannibalised the existing product range. The new strategy is to structurally separate the Australian beverage business into two separate divisions, for wine and beer. The wine strategy is expected to result in $80 million in writedowns and the sale of 36 non-core Australian and Californian vineyards as well as the mothballing or sale of 37 different brands.

Since the interim, the wine divestment strategy has gained new impetus with Constellation Wines completing a vineyard sale at Lake Cullulleraine, Victoria, equating to $36,000 a hectare. This was above expectations, and indicates that despite current trading conditions investment interest remains in the wine industry. My contacts indicate that the Lake Cullulleraine property is one of those flagged for disposal. Importantly, my assumed $80 million writedown of the wine division against the vineyards earmarked for sale ($243 million book value) implies an average of $32,600 a hectare. This represents a 10% discount to the Constellation transaction and any writeback of provisions due to better than anticipated sale outcomes would be a real positive in the current environment.

In the meantime, Foster’s is adopting a “back to the future” strategy and focusing on the higher return (return on equity of 20%-plus), annuity-style earnings from the domestic brewing division. In this regard it appears the new management is driving a renaissance with December-half beer volumes – up 3.1% versus 2.1% in the previous corresponding period. However, this understates the strong December/January volume growth of 9.5%, which is in line with Lion Nathan.

In fact the recent guidance by Lion implies 2008-09 earnings growth of 11%, which highlights the resilience of the domestic brewing industry in a weak economy. The Lion guidance represents the real upside given Foster’s new focus on the beer division. This has been a very difficult and brave decision by the board, but it is the right strategy and represents a very important inflection point for the long-term earnings profile, providing the opportunity for a genuine re-rating.

In addition, management have effectively initiated a demerger of the beer and wine divisions which has significantly enhanced the corporate appeal. History shows with the Rinker takeover, the BHP acquisition of Western Mining, and the break-up and sale of Mayne Pharma, that demergers generate corporate interest.

Similarly with the current structural separation of the beer and wine division, Foster’s will become a real target in the context of the ongoing global consolidation process. Remember, Molson Coors already owns 5% of Foster’s via a swap arrangement.

My forecast 2008-09 earnings per share of 39.3¢ implies earnings growth of nearly 7% and a price/earnings multiple of 13.7 times. In a very difficult and deteriorating operating environment, where 2008-09 ex-bank industrial earnings growth is minus 12%, Foster’s represents genuine, defensive value.

In contrast to the vast majority of industrials where payout ratios are approaching 100% and yields are unsustainable, Foster’s has ability to generate strong cash flow well in excess of dividends. As a result my forecast 2008-09 dividend of 27¢ represents a sustainable yield of 5% on a conservative 68% payout ratio. In addition, management expects the strategy review to generate a further $100 million in cost savings out to 2010-11. As a result, if the current improvement in beer volume continues, my earnings estimates and target (valuation of $6.10) could prove conservative.

Shout yourself a few Foster’s shares; this will prove to be the bottom in the stock.

Telstra: 1800 OVERSOLD

Telstra has fallen about 40¢ since announcing its December-half earnings and the departure of chief executive Sol Trujillo. The amazing part of this is that the stock price fall has all occurred while the stock has been cum a very solid 14¢ fully franked interim dividend.

I had attempted to warn Telstra in these notes that Trujillo’s premature departure would lead to a share price derating and that is exactly what has occurred. The market perception is that Telstra is a rudderless ship, left with no chief executive, four years into a five-year transformation. The market has now priced the stock down to a “growthless utility” multiple with high regulatory risk and management uncertainty. Consensus earnings forecasts have also been lowered by about 5% for this year to reflect a slowing consumer and business sector.

While the concerns above are valid, they are clearly all well known and reflected in the share price. What is not is some sort of “hybrid” national broadband network outcome that involves Telstra, the appointment of a high-quality chief executive, the likely 16% earnings per share growth in 2009-10 or the near 9% fully franked annual dividend yield the stock offers.

The market has priced in Optus being selected as the preferred bidder for broadband network. However, I remain of the view that none of the consortiums can deliver what the government seeks. It seems others agree, with Business Spectator saying “the builder would probably need three times the government’s proposed $4.7 billion contribution to make economic sense of building fibre out to backblocks of regional Australia (goal is 98% of the Australian population)”. The sensible network would be a mixture of fibre, wireless, satellite and some upgrading of the existing copper”.

I agree and I maintain our view that a full-fibre network will not be built unless built by Telstra. The far more sensible solution is a hybrid one. By that I mean a fibre backhaul to underserved areas (regional) utilising wireless and existing access infrastructure for the last mile. This delivers an affordable outcome ($3–5 billion cost) versus full fibre of $15 billion. I expect an announcement from Senator Stephen Conroy, Minister for Broadband, Communications and the Digital Economy, in the next few weeks but the very worst-case scenario for Telstra is already discounted into the share price.

On the chief executive front, my spies tell us that Foxtel chief executive Kim Williams is in the running. Williams is considered an excellent operator and in my view would be an excellent choice for Telstra. I have met him a couple of times and I’d suggest he is extremely switched on and extremely decent. He would also be likely to have a more workable relationship with government and regulators than the current chief executive. That is important for Telstra shareholders.

Telstra’s price/earnings (P/E) multiple has averaged 15 times during its life as a listed company. However, today on 2009-10 numbers that P/E is about 9.5 times. As I mention above, that is the P/E of a growthless utility with high regulatory risk and management uncertainty. Interestingly, even though consensus numbers have come down for 2009-10 after the December-half results, the fact remains the consensus sees Telstra’s earnings growing by about 16% next year with the dividend up about 10%. I think those lowered estimates are attainable which suggests Telstra is an extremely cheap stock.

Telstra should generate earnings per share of about 35¢ next year. Between now and the end of 2009-10 it should pay a final dividend (August) of 14¢ fully franked then a total of 30¢ fully franked in 2009-10. That is 44¢ fully franked over 18 months, which equates to an 18-month yield of 13.75%. If you bought them yesterday while they were still cum the interim 14¢ fully franked dividend, the 18-month yield would be 17%. That beats cash at the bank!

This is the bottom in Telstra. All the risks are priced in and the greater risk is those risks are over-stated. Telstra shares have been pressured by forced selling by value funds that have lost mandates and by quant funds selling the consensus downgrades. I think Telstra can recover to command 12 times 2009-10 estimates which would equate to a price target of $4.20 over the next 18 months. This stock is 1800 OVERSOLD.