Collected Wisdom

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

WorleyParsons (WOR). The newsletters are presenting a counter-case for engineer WorleyParsons and in doing so they paint a picture of a possible future for several resources sector companies, after softening commodity prices impact on project developments.'¨

But first, there is no doubt that at the moment Worley is a very good business that has levered itself into the resources sector with great success.'¨Revenue has climbed by an average of 55% a year since it listed, return on equity is 16.2% and it has a dividend yield of 3%.'¨

Worley is on the receiving end of largesse caused by the surge in oil prices in 2008, and the mining boom. The steep rise in oil prices led to many previously uneconomic projects coming into production, and the mining boom has been a godsend for engineering and mining services businesses, which have infrastructure, power and construction contracts that will tide them over for the next several years.

Worley was smart about how it’s taken advantage of the boom times by embracing flexibility around contract pricing yet maintaining discipline in its tenders. Management has a talent for tailoring contracts to the needs of clients, and this is a key reason it is in charge of one of Vale’s biggest iron ore developments after having no business with the South American giant just a few years ago.

In tendering, Worley sticks to its guns on price; it doesn’t enter the vicious cycle of bidding too low just to get its hands on quick, up-front cash only to be stuck for funds later on in the project and needing to repeat the performance.

However, the question is not whether Worley is a good investment now, it’s whether the company is creating a competitive advantage while the good times flow and it’s on this basis that the newsletters say “sell”. Compared to competitors such as Halliburton, which is creating a name for itself in deep-sea drilling, Worley is not moving beyond its bread and butter activities by spending money on research and development or creating its own intellectual property.

What this means is that as commodity prices plateau (which they have been doing since late 2011), and more projects move from the construction to production phase, Worley will be just one of many engineering companies seeking the favour – and contracts – of miners.

Apart from a reputation for flexibility and for the quality of its work (which it shares with several other mining services companies in Australia, such as Monadelphous), Worley doesn’t have a substantial differentiating feature, and this is the concern the newsletters have pursued this week.'¨

• Investors are advised to sell WorleyParsons at current levels.'¨

Rio Tinto (RIO). It’s been more than six months since we last covered Rio in this column, yet there has been no change in how the newsletters perceive the mining giant.

Full-year iron ore production out of the Pilbara set another company record, as despite shipping 239 million tonnes in 2011 due to bad weather volumes, including output from the Canadian project, hit 244.6 million tonnes or 2.3% more than in 2010 (Rio works on a calendar year and will announce its financial results in February).

The Simandou iron ore development in Guinea is being fast-tracked into production and expected to make its first shipments in 2015. Prices for commodities softened towards the end of last year but Rio has such a cash-heavy balance sheet that the newsletters are unconcerned about this.

One interesting point is that China is launching its own iron ore trading platform to rival Global Ore. No one expects the major miners to rush to support a trading system designed by their biggest customer, but it’s worth watching in the meantime.

Rio’s copper and gold division had a less successful year, as lower-grade ore from Escondida in Chile and the Kennecott Utah Copper mine meant production was down 22% on 2010. This was expected, however, and Rio is aiming for higher ore grades at Kennecott in the second half of this year.

Refined copper production was 334,400 tonnes for the year, down 15% on 2010. The dramas over at Ivanhoe have been resolved and this will have a big impact on Rio’s copper and gold production. A poison pill clause was removed and Rio is now allowed to increase its holding in the Canadian miner and speculation is growing that it’s moving to gain even greater control over the board.

Ivanhoe’s main asset is the Mongolian Oyu Tolgoi mine, in which it owns a 66% share in partnership with the government. Output is estimated to be about 650,000 ounces of gold, three million ounces of silver and 544,000 tonnes of copper each year for the first decade.

Coal volumes are still recovering from the floods in Queensland and NSW last year, with thermal coal output down 3% on the previous year, semi-soft coal down 7% and coking coal down 2%. These figures were still ahead of expectations. The Mozambique Benga mine, due to come on stream by the end of March, should give Rio’s coal production figures a sharp lift.

The newsletters are bewailing the aluminium division, even though Rio has already said it’s closing or selling most of its holdings due to non-performance. Total closures hit 462,000 tonnes of annual aluminium capacity last year, and although volumes are remaining steady, prices are falling and Rio says the financial results for this division in the second half will be “slightly worse than break-even”.

Right now small variations in production figures mean nothing to a mega-miner like Rio. For this reason, and because of the easily funded $15 billion 2012 capital expenditure program, the newsletters will continue to back Rio as a winner for the foreseeable future.'¨

• Investors are advised to buy Rio Tinto at current levels.

Collins Foods (CKF). If you can tolerate the “finger lickin’ good” references, which the newsletters can’t resist including into their analyses, it’s interesting to find that they aren’t as down on the KFC and Sizzler franchisee as they are of other ex-private equity businesses.

Pacific Equity Partners floated Collins Foods in August at $2.50 a share. Investors, already suspicious of private equity IPOs, were especially narked when not three months later it issued a profit warning that sent the share price down 55%, and forecast a net profit of $18–20 million instead of the $27 million promised in the prospectus.

The downgrade was due to fewer customers walking into their local KFC or Sizzler for a quick meal, but investors were sceptical that such a big change in fortune in such a short time could take such an experienced management team by surprise.

However, the newsletters are choosing to look beyond this. Apart from the big fall in share value (which they think is overdone) Collins Foods is well positioned in a defensive – albeit highly competitive – market. It is the biggest KFC franchiser in Australia and has a presence in Asia via the Sizzler brand (which is largely based in Queensland).

CEO Kevin Perkins has been with Collins Foods for more than 32 years and the company is planning on creating a closer relationship with the global owner of KFC, Yum! Brands. Franchise arrangements are locked in for another 10 years, and Collins Foods has an option over the decade after that.

The share register also makes for encouraging reading. Five of the top senior managers still own 8.3% of the company after the float, and fund manager Orbis Investment Management has also built up a position of almost 12%. NSW KFC operator Copulos Group owns 5%, and it’s always good when a major competitor thinks you’re good enough to buy into as well.

Collins Foods is a well-managed company with a big position in an industry that, in general, does well in periods of low growth as people swap more expensive restaurant dining for the cheaper end of town.

• Investors are advised to hold Collins Foods at current levels.'¨

SAI Global (SAI). SAI is effectively a licence to print money. It has a 15-year worldwide licence from 2003 to distribute Australian Standards, with an option to renew that for another five years after 2018.

It’s been venturing overseas into similar markets (although without the same monopoly position) and the latest acquisition is Compliance 360, a North American provider of cloud-based SaaS (software as a service) governance, risk and compliance services in the US. It will pay $US42.3 million, but SAI expects the deal to add $US17.9 million in revenue in 2013-14.

Compliance 360 comes with a reputation for very high customer satisfaction and services the healthcare, insurance and financial services sectors. The whole business isn’t particularly capital intensive and the newsletters say the benefits of SAI’s ambitious and speedy expansion plans are starting to emerge.

The fact that they lessen the risk to its bottom line of losing the Australian Standards licence is a bonus that can’t be ignored. The Australian Standards make up about 20% of SAI’s business now, and some in the investment press hold concerns about its use of debt to acquire businesses that dilute the impact of the secure, highly profitable local publishing business (about 70% of ASX 200 companies are SAI customers). But these qualms are allayed by the success this approach is reaping in the meantime.

• Investors are advised to buy SAI Global at current levels.'¨

Insurance Australia Group (IAG). A string of natural disasters in 2011 has blasted IAG’s insurance margin forecast out of the water. IAG had an estimated margin of 10–12% but the Thai floods and hailstorm on Christmas Day in Melbourne will cost it between $134 million and $200 million, after reinsurance, the newsletters estimate.

One interesting side issue is that at the start of December IAG had only $25 million of aggregate cover left for 2011, the insurance that protects it from event losses larger than $15 million and capped at $50 million per event. If the hailstorm had happened just a week later, once the new reinsurance kicked in, IAG would have been exposed to less of those losses.

IAG did quite well in its negotiations with reinsurers, paying 13% more for 2012 cover, which is close to its 10–12% guidance. The cover is for up to $4.7 billion of protection, up from $4.1 billion in 2011. The investment press is also keeping a close eye on IAG’s regulatory capital levels, or minimum capital requirements (MCR), because it just bought New Zealand insurance company AMI fir $NZ380 million.

It was about three times book value and IAG issued another $NZ325 million of bonds in November to cover the cost. The MCR was 1.55 times as at June 30 last year, but the newsletters suspect it crept up to 1.7 times after the takeover but will probably fall back in line with guidance to 1.5 times once the new business is bedded down.

CEO Mike Wilkins thinks AMI will provide $30 million in yearly savings, and the New Zealand government will take responsibility for the earthquake liabilities that brought AMI to its knees last year.

IAG doesn’t have a competitive advantage as its products are all highly commoditised, and with reinsurance costs on the rise (mitigated somewhat by higher premiums) and a mature market leaving little space to innovate or move, the newsletters see better value in QBE if you must invest in an insurer.

• Investors are advised to hold Insurance Australia Group at current levels.

Watching the directors

Washington H Soul Pattinson (SOL) non-executive director David Wills, the brother-in-law of chairman Robert Millner, splashed out on $46,525 of shares last week on-market. For his outlay, Wills got 3199 shares for $14.54 each. The deal lifts his “family related interests” to 127,833, while his personal interest remains at 37,381. Wills sits on the board of a company that’s the favourite of both Alan Kohler and Michael Feller, Clover Corp.

Algae.Tec (AEB) chief executive Peter Hatfull spent $24,750 to add 45,000 shares to his account at 55¢ each, so with the stock trading back down in the high 40s now, he’s so far lost on the trade. Nevertheless, he has 8.2 million shares in his own name and almost 1.5 million in his super fund, suggesting he is confident about the company and its technology. Algae.Tec recently signed a biofuels deal with Lufthansa and another with the Sri Lanka subsidiary of Holcim.

-Recent large directors' trades
Date	Company	ASX	Director	Volume	Price	Value	Action
20/01/12	Xtek Limited	XTE	Uwe Boettcher	98,326	0.032	$3,072,688	Buy
20/01/12	Hyperion Flagship Invest	HIP	Emmanuel Po	999,539	1.19	$1,191,530	Sell
6/01/12	Primary Health Care	PRY	Edmund Bate	250,000	3.11	$779,305	Sell
30/12/11	Gold One International	GDO	Barry Davison	200,000	4.51	ZAR902,000	Sell
30/12/11	Fortescue Metals	FMG	Neville Power	117,000	4.27	$499,590	Buy

Source: The Inside Trader