Collected Wisdom

Buy QBE and Wesfarmers, hold Treasury Wine Estates and Saracen, and sell Southern Cross Media, the newsletters say.

PORTFOLIO POINT: This is an edited summary of Australia's best-known investment newsletters and major daily newspapers. The recommendations offered represent the views published in other publications and may not represent those of Eureka Report.

QBE Insurance Group (QBE). How many chief executives could admit the year’s net profit will be 40–50% lower than expected and get away with it? That’s what QBE Insurance’s Frank O’Halloran did last week and although the market hated it, the newsletters say this is a buying opportunity in the world’s best-managed insurance group.

O’Halloran said that 2011 was on par with 2001, when the company had to admit that it didn’t have enough capital to pay out claims after the September 11 terrorist attacks and was forced into a capital raising.

Floods on Australia’s east coast at the start of the year, repeated flooding in Victoria, more floods in Thailand, earthquakes in Japan and New Zealand and fires in Western Australia have added up to a $500-million blowout in catastrophe claims totalling $2.3 billion, nearly double the 2010 figure.

As well as higher claims, the European crisis caused credit spreads to widen and a $160 million loss on the QBE bond portfolio (management are quick to reassure that the company has no exposure to the weaker countries in Europe), and lower sovereign interest rates have affected the discount rates used to value liabilities, and as such those liabilities have increased. This is an accounting quirk but it still appears on QBE’s balance sheet as an unrealised loss of $200 million.

All in all, it’s not looking good for QBE’s upcoming full-year results (it reports on a calendar year basis), but the company has the full sympathy of the investment press.

One newsletter repeated a comment it made the last time we discussed views on QBE, saying that insurance companies won’t wear the cost of claims for much longer. QBE is already pushing through a 10–15% increase on premium rates – which is exactly what it should be doing – and it expects underlying profit margins to return to 15% in 2012.

The final dividend was cut from 66¢ to 25¢, which will help preserve the balance sheet.

Every insurance company will have a bad year and the nature of the business is risk, so investors shouldn’t have a huge chunk of their portfolio devoted to QBE anyway. But QBE is one of the best insurance businesses available in the world and the newsletters say 2011 was just another unfortunate blip, to which the company is responding exactly as it should.

  • Investors are advised to buy QBE Insurance Group at current levels.

Southern Cross Media (SXL). It’s been a turbulent three years on the market, so when a company’s share price has fallen more than 50% from recent highs it’s either a buying opportunity or there’s something fundamentally wrong.

In the case of Southern Cross, there are so many factors that could lay waste to its future growth only the very brave would venture in. In a show of bravado, one newsletter thinks it’s a buy but the others are far too unsure about the outlook for the regional radio and television operator.

To be clear, it’s not that this is a bad company – Southern Cross is very good at managing costs and may even exceed its $13–15 million savings target set after the $740 million acquisition of FM radio network Austereo last year – but the wider sector is very sick.

In general, revenue from metropolitan radio is usually resilient when advertising rates weaken, but this is not the case now. Metro revenue fell 0.3% in the six months to December 31 and there’s no reason to think this will improve much. The response by advertisers to shock-jock Kyle Sandilands’ latest outburst won’t help, with some refusing to sponsor anything he’s associated with and others quitting their relationship with Austereo entirely.

Regional radio revenue fell 0.7% in the same time, but at least forecasts for those markets are that there will be some recovery (a lift of about 1%, to be exact).

As for the free-to-air television side of the business, the newsletters can’t get much gloomier. Lack of advertising has been sucking the life out of it for some time and Southern Cross is in the worst possible situation: it relies on Ten Network in a content sharing deal, putting it at the mercy of the bigger network. Southern Cross doesn’t have the financial firepower to make or buy all or most of its content and using recycled programming ensures it won’t make stellar profits.

Pay television’s foray into sports broadcasting is another significant threat. The deal struck by Foxtel to broadcast every AFL game live is one example; its access to every game of this popular sport will make pay TV start to look far more attractive than free-to-air.

In the first quarter of 2012 television revenue fell 5.6%. Those running the big three free-to-air networks, Ten, Seven and Nine, don’t expect the advertising market to pick up again soon and it’s not likely Southern Cross is going to buck this trend if they can’t.

  • Investors are advised to sell Southern Cross Media at current levels.

Saracen Mineral Holdings (SAR). Gold miner Saracen has been quietly going about its business with no major problems or exciting blips interrupting the flow of gold from its West Australian mines.

Output slipped 9% below the company’s expectations in the three months to December 31, to 27,301 ounces, but this was due to a six-day shutdown of the Carusoe Dam milling facility for a gearbox change. The newsletters say that normally this wouldn’t take a whole week, because critical spare parts should be kept on site, but wet weather held up the delivery of vital couplings.

The gap between actual and expected output for that one quarter has not dented Saracen’s guidance for the year; it still sees a full year result of 120,000–130,000 ounces.

While the flagship Carusoe mine provides the ready money, the Red October underground development is where the future lies and is what will help push production up to the targeted 250,000 ounces a year by 2015.

The project contains higher-grade gold than the current operations are producing, which will lift the average grade from 1.25–1.5 grams per tonne to 2.5 grams. The access portal was built in October and so far 460 metres of drilling has been done, with about half of that coming in December.

Saracen will need to start thinking about its milling situation once the underground mine opens, as the Carusoe facility is at capacity and won’t cope with the extra 208,000 ounce resource estimated from Red October. The options are to expand that mill or build a new one closer to the Red October site; no decision has to be made until next year.

Other exploration is well under way as rich, shallow veins have been identified in an area called Butcher Well and higher grades have been found at the nearby Whirling Dervish and Twin Peaks sites.

Saracen is a low-cost miner and by December 31 was sitting on $60 million net cash. It closed out a put-call hedging portfolio that, one newsletter said, effectively capped the gold price at $1250 an ounce last year, and it’s now able to fully benefit from any future price rises.

  • Investors are advised to hold Saracen Mineral Holdings at current levels.

Wesfarmers (WES). The chemicals and fertiliser business is a small part of the Wesfarmers operation, but an investor tour has given the newsletters cause for thought about what is still a valuable part of the wider business.

Wesfarmers sold the Premier Coal business in the final weeks of 2011 for $90 million. It also wrote down the Coregas business by $190 million, which was suffering after BlueScope Steel shut down its No 6 blast furnace at Port Kembla.

Following these developments and the site tour, the newsletters believe the chemical and fertiliser business is going to continue its strong run, while the energy operations will come under increasing pressure.

Wesfarmers approved a $550-million expansion of the Kwinana ammonium nitrate plant, the only manufacturing operation in Western Australia, to meet demand from the state’s mining industry for explosive-grade ammonium nitrate. The focus will be on supplying iron ore miners and the works will increase production from 260,000 tonnes a year to 780,000 tonnes in the first half of 2014. Five to 10-year contracts were locked in before approval was given, underwriting the expansion costs.

Wesfarmers expects this will be more than the mining sector needs until about 2020, and it intends to divert the remainder into fertiliser production in the meantime.

Fertiliser is a less predictable game. Demand relies on the weather, stock prices and farmers’ costs but the newsletters expect demand to be strong in the peak sales period, from December to July.

It is the energy side that is bringing down division estimates for 2012-13 earnings before interest and tax (EBIT) by $90 million, to $215 million.

The Coregas writedown, a $25–30 million fall in EBIT from Kleenheat due to deteriorating economics in the WA LPG market, and the loss of $10 million a year in earnings from enGen (sold in July for $40 million) will affect this year’s bottom line. The following financial year should be OK though, with expectations of an EBIT rebound back to $275 million.

Average weighted FOB prices for coal exports from the Curragh mine dropped in the 2012 March quarter, to $US230 a tonne. This is down 19% on December prices and 37% from the September quarter, so while volumes sold are higher than in the second half of fiscal 2011-12, prices are still not meeting the newsletters’ expectations.

Over on the retail side, Kmart and Target are named as victims of very soft retail conditions, and net profit expectations for the whole company have been pared by 9%, to $2.43 billion.

And yet, Wesfarmers as a whole is still very attractive to the investment press, due to the strong performance and market share of Coles and Bunnings.

  • Investors are advised to buy Wesfarmers at current levels.

Treasury Wine Estates (TWE). The demerger from Foster’s was never going to fix all the problems in the wine business, nor was the road after going to be easy. But the investment press says shareholders should look beyond the travails Treasury is facing today because it’s being set up to reap benefits in the future.

The wine market is not an easy one to navigate and there are some aspects that could undermine Treasury’s 2012-13 profits.

One is that although sales in Australia, New Zealand and Asia are strong, European and American sales are not. As an indication of the US market, the largest distributor there, Constellation Brands, said sales in the country rose 1% in the second quarter but fell 8% in the third (ending November 30).

So just as people are purchasing less, Treasury has ended the heavy discounting in the US that was being used to encourage volume sales. This was necessary to save its margins but is creating a bigger hit to volumes than expected and the company is seeing is a drop-off in sales at the lower-priced end of its offerings.

Consumers’ collective shift to buying fewer, higher-priced wines and less cheap plonk showed up in the 2011-12 accounts as revenue per case rose 6.2% but volume sold fell 11% and sales fell 5.7%. That shift means Treasury is facing a large problem: 45% of sales come from the US (although 80% by volume comes from Australia) so any move by consumers towards cheaper wines just as Treasury is reducing discounting will further harm margins (and volumes) and fewer top end sales won’t be able to outweigh the damage.

In saying that, the removal of the discounting and promotions strategy is probably the most important “hurt now, help later” approach taken by the board and the newsletters say that the recovery of brand reputation is well worth the pain now.

And sales in Asia are finally starting to live up to the hype, leaping 10.5% in the 2011-12 fiscal year. Cost reductions and wine’s popularity in New Zealand and Australia will also counterbalance problems north of the equator.

The disastrous country manager approach has been scrapped and replaced with managers for “foundation brands” Rosemount, Penfolds, Wolf Blass, Lindemans and Beringer. This will improve accountability and the focus on each brand, while a hedging strategy to lock in exchange rates will at least remove the likelihood of unpleasant surprises, even if those rates aren’t particularly favourable right now.

  • Investors are advised to hold Treasury Wine Estates at current levels.

Watching the directors

Beginning the year with a bang, Primary Healthcare (PRY) managing director Edmund Bateman sold 250,000 shares on market last week for an average of $3.11 each. In the grand scheme of director share ownership, it didn’t take a significant bite out of his portfolio, which still consists of 35.5 million Primary shares through four different indirect entities and in his own name. The sale was from his personal stash, which now sits at 577,782 shares.

Ironbark Capital (IBC) director Ian Hunter shuffled some of the chairs between his super funds last week, selling all Ironbark shares from one and adding to another. Out of the Supentian fund he dropped the whole parcel of 121,130 shares in it, and the Supentian AFT Hunter Pension fund picked up 317,679 shares. The total amount of money moved hit $94,479.65.

The CEO and managing director of small explorer Black Range Minerals (BLR), Tony Simpson, has bought himself a $24,000 packet of shares and upped his holding to two million shares and two million options. The extra one million shares cost 2.4¢ each, half the price of the boom years in 2000 although interestingly only 0.4¢ off 2007 highs. Simpson was only appointed to the board and the top job in December, and the company is hoping his experience in the US will give a push to its own projects in that country.

Ten Network (TEN) non-executive director Christine Holgate has locked in an extra $25,000 of share in the flailing television network. This is her first foray on to the Ten register and she now owns 28,250 shares. Holgate has a smart resume to recommend her. It includes being CEO of Blackmores, managing director of business sales at Telstra and managing director of marketing for Europe, Middle East and Africa at JP Morgan.

-Recent large directors' trades
Date Company ASX Director
06/01/12 Primary Health Care PRY Edmund Bateman
30/12/11 Gold One International GDO Barry Davison
30/12/11 Fortescue Metals FMG Neville Power
29/12/11 Kagara KZL Kim Robinson
28/12/11 Global Construction Serv GCS Vincenzo Gullotti
20/12/11 Collins Foods CKF Kevin Perkins
16/12/11 Origin Energy ORG Grant King
16/12/11 Discovery Metals DML Morrice Cordine
12/12/11 Mermaid Marine MRM James Carver
12/12/11 Mermaid Marine MRM James Carver
12/12/11 Adelaide Energy ADE Carl Dorsch

Source: The Inside Trader

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