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.

Telstra (TLS). A change in management and the advent of the NBN created a major shift in Telstra’s fortunes, and since exhortations to buy the stock began last year the share price has risen 16% in 12 months.

Those urgings appear to have been correct, with only the ACCC standing between Telstra shareholders and an $11 billion payout from NBN Co to lease its infrastructure and have every customer migrated on to the broadband network.

Shareholders voted through the deal with NBN Co (knowing that the alternative would destroy the value of their stockholding through greater competition, higher capital spending and the possibility of losing the 28¢ dividend); it gave the board confidence to confirm it would maintain the dividend in both 2011-12 and 2012-13 and hint at capital management opportunities with the NBN cash. The newsletters think a buyback with the estimated $4.4–5.4 billion post-dividend free cash is the most likely course.

Telstra receives a $500 million break fee if the deal is cancelled after 2014, but if a change of government before that date sees the contract torn up, the telco gets nothing except rental payments for the infrastructure it has already leased to NBN Co.

The change in management and its focus on customer service is the other area of adjustment. Large chunks of management bonuses are now aligned with customer retention and satisfaction, and a $1 billion facelift of mobile and customer services has helped it win back about a million customers. Telstra still trails its rivals in satisfaction surveys but it has plenty of room to move and the financial firepower and strategies to improve.

The weak market has assisted the share price surge and one newsletter pointed out that much of the money once invested in retail stocks has ended up in Telstra, due to its potential for growth post-NBN and position as the largest telco in the country.

Telstra chairman Catherine Livingstone said the company expects data traffic to increase 30-times over the next five years and 1000-times over the next 10. The telco is investing heavily in new mobile technology, such as its 4G network, which allows for downloads up to 10 times faster than the NextG network, and it already has the best mobile coverage nationally.

Telstra, according to the investment press, is a defensive investor’s dream, and with a 9% yield (12% once franking credits are included) it’s not an opportunity to leave for another year.

• Investors are advised to buy Telstra at current levels.

Pacific Brands (PBG). Though some may hope recent events mean a reassessment of PacBrands’ investment potential is under way, they are wrong. The recommendation is still a big fat sell.

A significant 52.9% of shareholders voted against supporting the recent remuneration report, which said that despite management narrowly missing the hurdle that the company hit a 90% EBITDA target, they would still be paid out 60% of the maximum incentives, which saw CEO Sue Morphett paid a $910,000 bonus for 2010-11 when the company made a $132 million loss. But 93% of shareholders also voted for the man in charge of pay recommendations, James MacKenzie, to remain chairman.

External forces meant the board didn’t hit the EBITDA target, but those conditions are exactly what makes the investment press nervous around the clothing manufacturer.

These influences were Kmart’s decision to stop stocking Pacific Brands products such as the iconic Bonds and Rio labels, and the steep rise in cotton prices and other costs. Cotton is used in 20–25% of all products; its price rose from 90¢ a pound at the start of 2010-11 to $2.40 during the year, and closed at $1.67 on June 30.

Other cost pressures came from Chinese wage rises. PacBrands’ outsourcing, cost reduction strategies and portfolio fine-tuning is largely complete, which means short-term gains have been achieved. However, the move to China came just as workers there began to realise their own value and demand higher wages.

The resultant need to start hedging and stockpiling cotton, and higher manufacturing costs in China, means PacBrands has lifted product prices by 10–15%. This will do nothing to make its products more attractive to resellers who can, as Kmart is proving, make higher margins on store-label products.

The other problem is that being a middle-man for basic items is no longer profitable. Myer has its own office in China to start direct sourcing products from 2016, and as more department stores take this route to source higher-margin products PacBrands will come under further earnings pressure.

Management said last week they see none of these factors improving in the coming year. Stalled sales growth and customers focused on value rather than brands are the unwelcome pit inside this sour cherry, and even managers can’t see any of these weaknesses diminishing in the near to medium future.

• Investors are advised to sell Pacific Brands at current levels.

Macquarie Group (MQG). Macquarie Group finds itself in a world where the old way of making money by taking high-risk, high-return bets is no longer possible, both because those bets are not as accessible any more and regulators are doing their best to shut them down.

However, its share price shot up 11.43% to $25.15 last week after it announced a 24% fall in half-year profit, possibly because of an $800 million share buyback, or it could be because of management’s extraordinary 11% cut in costs across the group. Either way, it seems Macquarie is not in as bad a position as its larger and better-known peers on Wall Street.

The results announcement last week showed that half of the Macquarie’s businesses did well: the funds management division grew earnings by a staggering 80%; corporate and asset finance lifted earnings 46% and banking and financial services ticked up 2%. Funds management still suffers from investor jaundice as memories of poor returns during the global financial crisis from Macquarie CountryWide (now Charter Hall Retail) and Macquarie Office (now Charter Hall Office) still weigh, though it does manage $306 billion of funds. The finance division is doing well because Macquarie is sticking to areas it knows such as motor vehicle and aircraft leasing.

The capital markets and securities sectors, however, have been smashed by volatile markets and these have dragged the group result down.

The investment press is waving goodbye to the returns on equity of 20%-plus and expecting future ROE of 10–12%, and is watching the investment bank’s growth strategy carefully.

This strategy has four arms: increase loans; use less leverage; develop businesses such as funds management that have recurring, sustainable revenues; and continue to expand overseas via acquisitions, which could also be funded by asset sales such as the 22% stake in Macquarie Airports, about which CEO Nicholas Moore is reported to have said a “good price” would see it sold.

Gearing has fallen from 568% in 2008 to 263% in 2011. Given regulators will force it to use less debt anyway, this is practical. The $3.5 billion in free cash is also somewhat misleading because under Basel III this will have to be used to meet higher capital requirements.

The overseas expansion is worrying. The acquisition of US fund manager Delaware in 2010 for $516 million was an entry into an area the Wall Street investment banks haven’t really noticed yet, but that market is still extremely competitive and the US banks are bigger and better connected than Macquarie. This is the same in Asia, and the newsletters are approaching this plank of the strategy with caution, although overall they are pleasantly surprised about how far the bank has come and the sensible direction of its growth plan.

• Investors are advised to hold Macquarie Group at current levels.

Ten Network Holdings (TEN). When James Packer and then Gina Rinehart bought into Ten exactly a year ago, the investment press said it could be the watershed moment the network needed to start making some real money. Twelve months on and momentum might be building.

Ten, led by Lachlan Murdoch as the board waits for former Seven executive James Warburton to take over as CEO on January 1, did not see the immediate changes the newsletters were craving because benefits from the relatively speedy management redundancies, a 12% reduction in headcount and $50 million investment in new programming are only just appearing in outlook statements for 2011-12.

Ten might be the best of a bad lot for investors who regard free-to-air television as an anachronistic form that will struggle to compete for eyeballs as more channels emerge, but who still want some exposure to the sector.

Unlike Seven or Nine, Ten has plenty of market share to grow into and programming plans are in place to do this. Local shows aimed at the under-40 demographic, such as Puberty Blues, Reef Doctors and Breakfast, as well as American imports, are part of the strategy to stake its claim as the network for younger viewers.

The key risk here, however, is that younger people are more technologically sophisticated than viewers of the past and consume media across many different platforms, rather than just one. Ten will be competing for this demographic with online TV and platforms that allow entire series to be downloaded without ads, so the strategy could also never fulfill its potential.

Breakfast, in particular, is a central part of this tactic: it will be used as a platform to promote and support new shows. Anthony Flannery from TVNZ was appointed head of news for the new show and lends proven production experience to the program.

Important, too, is Ten’s decision to delay some highly rated Fox series until 2012. Sports will still be the principal programming over summer and the delay gives Ten the time to build up a decent inventory of shows to compete through 2012.

The restructure cost of $85.4 million sent full-year net profit into a 90.5% nosedive to $14.2 million, but Ten could still be a television station on the rebound.

• Investors are advised to hold Ten Network Holdings at current levels.

Santos (STO). A perennial takeover target, Santos is preparing for a fillip in its financial fortunes – in about four or five years. That’s how long it will take for the Curtis Island coal seam gas project at Gladstone, Queensland, and the PNG LNG project to come online. In the meantime, the newsletters suggest buying Woodside Petroleum instead.

The rival company is less risky as its projects are further developed than Santos’s, and they don’t face the same level of sovereign and process risk.

Santos announced that its third-quarter group production rose 7%, sales lifted 6% and revenue grew 13%, thanks to higher output of better-priced liquids than gas. The Cooper Basin wells are recovering after last summer’s floods, while oil output from the offshore Western Australian Mutineer-Exeter wells doubled after work-overs were completed and they came back on line.

But these are small fry compared to the riches envisioned from the Curtis Island and PNG fields, both of which are expected to start shipping gas in 2014 and 2015. The 13.5% stake in PNG LNG will lift Santos’s production by 12 million barrels of oil equivalent (mmboe) and the 30% stake in Curtis Island will add another 20mmboe.

With gas expected to be increasingly in demand as a fuel source this decade these projects should come into production at just the right moment and the newsletters predict earnings to triple in 2016-17 unless, as is also likely, there is a glut as they come on line when Woodside, the other two Gladstone coal seam gas projects, and the other offshore WA projects start to ramp up production.

Planning risks come with both projects as both are at a nascent stage of infrastructure construction, and in PNG Santos must contend with a high level of sovereign risk.

In Gladstone, the problem is in accessing the land to undertake exploration. The unlikely combination of MP Bob Katter, radio talk host Alan Jones and Greens leader Bob Brown are opposing coal seam gas drilling on prime agricultural land, and on Friday the latest protest under way was a blockade by heavy farm machinery on the Liverpool Plains south of Gunnedah in NSW, an area in which Santos had planned to drill an exploratory well.

Vocal opposition by farmers and those who support them is growing against the coal seam gas industry, fed by concerns about water use and the effects of drilling on animals and people on the farmland near wells.

The newsletters say none of these risks, at this point in time, will kill these very attractive projects, but they do make the whole company more risky than its peer Woodside over the next few years.

• Investors are advised to hold Santos at current levels.

Qantas (QAN). After CEO Alan Joyce’s abrupt decision to take Qantas’s war with the unions to the people, it’s time to consider what the newsletters last said about the company.

None has dared to re-analyse Qantas for some months; one decided in disgust to stop covering it entirely in 2008, while others have hung in there and up until August were still recommending it as a buy.

The newsletter that gave up on Qantas three-and-a-half years ago cited a number of reasons that, unfortunately for investors, are still relevant now: the expense of replacing an ageing fleet; a discounted share price compared to rivals; huge competition from lower-cost airlines on every route; and surging fuel and labour costs.

The other newsletters were basing their more recent recommendations on the fact that Qantas was still profitable despite Chilean and Icelandic ash clouds closing the skies to air travel, and could be a contrarian play on consumer demand.

The theory was that Qantas’s share price was discounted compared to foreign peers (this time it’s a positive sign) and the airline’s portfolio of assets was too strong to ignore. Domestic flights surprised in the full-year results, posting a $444 million profit, and the frequent flyer program just kept growing. Jetstar just won’t stop growing and its Asian business returned an $S18 million profit in its first year of operations. The international operations, however, lost $216 million.

Fuel costs weren’t such an issue as surcharges were easily compensating the airline for the price hikes, and while capital spending of about $2.5 billion a year meant shareholders shouldn’t expect a dividend for at least two years, the investment press said management wouldn’t jeopardise Qantas’s BBB rating. Economic and corporate recovery would mean that the higher-margin business and first-class travellers would start to creep back.

The newsletters were predicting that the share price discount wouldn’t last for long but these endorsements came at the very start of the latest industrial relations meltdown; we shall see whether Joyce’s lock-out on Saturday causes a change of opinion among the investment press.

Watching the directors

Fortescue Metals Group (FMG) Neville Power continued a series of purchases that began on September 20 after he joined the board in preparation to take up the reins as CEO. The buy-in of 109,752 shares was Power’s third purchase since his ascension to the board, and the $4.56 a share cost put the total just shy of $500,000. He now owns 399,175 ordinary shares and has 419,255 performance rights to aspire to. Power is the only director since June to buy Fortescue shares in his own name because executives have the option to buy securities with gearing if they use chairman Andrew Forrest’s company Metals Group, which makes Fortescue directors’ trades opaque as they all appear under Forrest’s name.

Myer Holdings (MYR) CEO Bernie Brookes took the opportunity to make some money out the retailer for a change. Myer shares hit a record high in September 2010 of $3.96 and a record low of $1.99 a year later, so Brookes’ five-part sale last week gave him a chance to take some money off the table at an average of $2.50. The total sum was $1.5 million and the total sale was 600,250 shares, which Brookes said was for personal reasons including a house purchase. He now has 7.8 million Myer shares.

Origin Energy (ORG) finance and strategy director Karen Moses sold 120,000 shares for $14.34 apiece (a total of $1.7 million) as the gas company’s shares started to trend back up from a two-and-a-half year low in September. Origin is at the forefront of exploration for coal seam gas in Queensland and New South Wales, and told last week’s AGM that the substance was neither new nor untested and the facts were getting lost in the debate.

-Recent large directors' trades
Date	Company	ASX	Director	Volume	Price	Value	Action
25/10/11	Origin Energy	ORG	Karen Moses	120,000	14.34	$1,720,800	Sell
24/10/11	Fortescue Metals	FMG	Neville Power	109,752	4.555	$499,997	Buy
14/10/11	Orocobre Limited	ORE	James Calaway	254,000	1.38	$350,540	Buy
12/10/11	Crown Limited	CWN	James Packer	2,932,000	8.00	$23,430,649	Buy
07/10/11	WPG Resources	WPG	Lim See Yong	450,000	1.285	$578,250	Sell

Source: The Inside Trader