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.

Fortescue (FMG) Well, there goes the iron ore neighbourhood. As the spot price sank beneath US$100 a tonne a week ago and kept sinking, billions of dollars was wiped off the values of Australia’s miners – particularly the marginal cost, single-resource second tier.

The largest of this tier is Fortescue, straddling the gap between BHP and Rio Tinto (down 3.4% and 3.3% in the past fortnight respectively) and names like Atlas Iron, Mt Gibson and Gindalbie (down 23%, 13%, and 27%). The newsletters didn’t like the look of Fortescue back in April, and they like it even less now.

In spite of the familiar sight of chairman Andrew Forrest buying several million more shares last week, he couldn’t prop up the scrip, which fell more than 20%, hitting a low of $2.81.

It’s the worst time for price pressure at Fortescue, with capex previously scheduled to peak in late 2012 and through 2013 ramping up to a target production of 155 million tonnes per annum. This has now been heavily scaled back to 115mtpa, and drops capex by $1.6 billion.

This means lower production forecasts, and correspondingly weaker earnings, are forecast across the coming three years and while the spot iron ore price will recover from the current lows beneath $US90 a tonne, analysts are adjusting longer-term price expectations down from US$120 to US$110-15. The implications for Fortescue are significant, wiping more than 25% of EPS.

Then there’s debt, which is, and has always been, massive. At close to US$10 billion forecast for the end of the coming fiscal year, the newsletters are sceptical that the small 2-3 times interest cover will allow enough freedom in comparison to its much larger, diversified, established and unindebted rivals.

Some in the investment press remain supportive of Fortescue, and depending on the size of potential US and China stimulus on top of announced Eurozone bond buying, the iron ore price could recover more than expected. The reduction of worker numbers is expected to save $300 million, and the successful $300 million sale of a power station last week also removes immediate pressure. One notes that heavy short selling of the stock anticipates an equity raising, but with so many saleable non-core assets this would not seem to be the likely path for the company.

However it feels like the end for the iron ore euphoria, and of all the widely-held stocks in the sector it is Fortescue with its high debt, developing production, high capex casts and single-commodity focus that is most vulnerable.

• Investors are advised to sell Fortescue at current levels.

Austal (ASB) With some very large US government contracts, a growing order book and a uniquely skilled workforce and intellectual property reserve, it is somewhat disappointing that Austal can’t turn that into profits.

Reported net profit for the year came in at $11 million, as revenue improved 30% to $652.4 million. That’s a big difference between income and costs, and some of the investment press note this profit becomes a loss when adjusted for some non-recurring gains.

The company’s share price hasn’t been a stellar performer in recent months either, shaving off 29% since the start of May. However, it looks like the worst could be over.

The main source of revenue growth – and of cost overruns and profit problems – comes from the company’s US division joint venture contracts with the US Navy to build nine Joint High Speed Vessels (JHSV) and five Littoral Combat Ships (LCS). The investment press expects time to iron out the kinks that have plagued the start of these projects, and the company expects margins to improve to 10% by the end of fiscal 2014.

Austal’s Western Australian shipyard (still remembered by some as the builder of Greg Norman’s lavish $70 million super yacht, which was Austal’s excuse for a similarly poor profit result a decade ago) is short on work. The construction of some Cape class patrol vessels will ramp up and keep work ticking over for several years yet but the newsletters highlight the focus has shifted to the US and Asia, which could spell the end for local operations.

In all, revenue is expected to continue to grow with the large order book of US Navy contracts. If Austal can get a handle on costs, then it will translate to a strong period of earnings in the coming five to eight years. But investors should see yet another weak full-year result as evidence of the risks at hand if it can’t.

• Investors are advised to hold Austal at current levels.

IMF Australia (IMF) The world’s of law and finance often cross over, but rarely so clearly as in the field of third-party litigation funding. After considering the prospects and performance of IMF, the newsletters have come back with a verdict – and it’s good.

IMF investigates, manages and then funds various forms of litigation, a practise often associated with smaller litigants against larger and well-funded opponents. The minimum claim size is $5 million, and as well as the preparation and planning elements of the business, it also generally indemnifies against large legal costs. This means the business is close to a law firm in the experience it requires, but more like a bank in terms of lending and risk.

Performance has been strong in 2012, with net profit up to $43 million from just $23 million the previous year, and the company is paying a 10c fully-franked dividend. Since listing in 2010, it has a substantial success rate settling the vast majority of cases it has taken. It also helps that IMF has an estimated 80% market share of Australia’s litigation funding market and has opened an office in New York to access the lucrative (and litigious) US market.

The newsletters note that the company’s success is partly attributable to the selective nature of the business, taking on only a tiny percentage of the thousands of possible cases, and the experience of senior management who are also major shareholders.

For investors looking for some legal exposure, and finding the unlisted partnership structure of law firms a major barrier to entry, IMF provides a side door – and a healthy history of very strong returns from its case load. As the market leader, it is also well placed to capitalise on growth in the sector and the 8% fall in the share price since late August may represent a good entry point for a very interesting young business.

• Investors are advised to buy IMF at current levels.

Sedgman (SDM) Behind the headline-grabbing iron ore price deterioration, a slower weakening of the international coal market has also shifted the landscape for commodities investors. Sedgman, which along with Leighton subsidiary Thiess builds and operates coal handling plants, has seen its share price deteriorate almost 25% since the end of August on the back of the poor outlook, but the newsletters still argue there are reasons to hold on.

Chiefly, the full-year result just reported was very strong. Revenue lifted 17%, EBIT jumped 44%, and net profit was 45% higher at $37.8 million. Dividends more than doubled to 11c, fully franked, representing a grossed up yield of 8%.

In spite of a generally slower resource investment landscape, the company’s order book still stands at close to $500 million, with a further $280 million of projects in “advanced discussion”.

The question over the company, however, is just how far demand slows. Sedgman has a strong position in a specialised sector of the coal industry, but that also limits their diversity and increases risk. Investors willing to bear this risk may actually benefit from part of a slowing coal sector, as some companies outsource operations work to the company to cut costs in coal handling. Margins in the construction division increased to 9.9% for the year, a very good result, but these are expected to shrink as the slowdown puts pressure on the contract terms Sedgman can achieve.

The company is well positioned to hold a small profit in a demanding and difficult time for the resources industry, and depending on how severely you view the pressure on Australian coal in the coming years, it could provide a reasonable half-way point to direct exposure.

• Investors are advised to hold Sedgman at current levels.

Sirtex Medical (SRX) With a very successful product finally delivering some long-promised results, the journey from perennial healthcare straggler to major bio-tech company appears to be gaining steam for Sirtex. If some of the latest research and testing is successful it could expand the company’s single-product reliance, and since that product is performing quite well in the meantime, the newsletters are holding on.

Net profit for the year jumped almost 50% to $17.1 million, and earning per share rose by the same amount. The company pays a small dividend, yielding about 2-3%, and has about $50 million of cash at hand.

Sirtex produces and sells a treatment for liver cancer, developing over the past decade from a small discovery to a major listed operation. Margins are very high at over 80%, and the newsletters say market penetration remains low with very large upside as the treatment becomes more accepted and widely used following large clinical trials.

Five such trials are currently under way, with thousands of test patients, and their success – likely considering the weight of already-published research backing the positive effects of the treatment – would boost usage.

The company is also researching better delivery systems and technology for the product, which works by injecting tiny irradiated spheres into the patient.

While the product is developed and sound, and expected to deliver stable revenue for many years, there is a risk from the single income stream and somewhat limited upside. However, for investors who have been waiting some time for the recent price improvement (the company has lifted 27% in the past three months) it represents a validation and potentially the start of a successful and steady period of slow growth.

• Investors are advised to hold Sirtex at current levels.

Watching the Directors

It was a week for the sellers as a string of directors pocketed million-dollar-plus pay cheques, reducing their holdings. Among the biggest sellers were two McMillan Shakespeare (MMS) executives, led by founder and non-executive director Anthony Podesta who sold 4 million shares on market at the end of August for a total of $46.3 million, or roughly $11.58 each. Chairman Ronald Pitcher then sold four parcels of shares between September 4 and 7, totalling 80,000, for a little under $983,000, or $12.28 apiece on average. McMillan shares closed more than 2% higher today at $12.50.

AGL Energy’s (AGK) managing director Michael Fraser was also in a selling mood, although he also picked up some incentive plan shares, offloading 83,000 shares for $15.22 apiece, for a total of about $1.3 million.

There were two director sellers at IMF (IMF) as well this week (for more detail see above). Marketing director John Walker sold 575,500 shares from his vehicle Legal Precedents, for an average of $1.41 per share, netting a total of more than $800,000. Meanwhile managing director Hugh McLernon sold 563,500 for the same amount. IMF is currently providing litigation funding for several high-profile cases, including the class action against ANZ over bank fees.

On the buying side a familiar name popped up, as Wal King sank $284,000 into Ausdrill (ASL), where he is deputy chairman. The former Leighton chief bought $100,000 shares at $2.84 – incidentally where the scrip closed today after rallying more than 3%. The mining services group posted a record full-year profit last month, rising 53% to $112 million.