Collected Wisdom

Buy Qantas, hold Domino’s and ASX, and sell Fortescue and Leighton, 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.

Leighton Holdings (LEI). Earnings are back on track and Leighton is lining up contracts that mean it will reap the benefits of the mining boom for many years to come. But there is still a monkey on its back.

The big news about Leighton over the past 12 months consists of writedowns on the Middle Eastern business Habtoor, revelations that the Victorian desalination plant and Brisbane airport connection would come in over budget and later than expected, and up to a 47.5% drop in its share price in the past 12 months.

The big Australian development projects are being brought back under control, with the desal plant 90% complete and the airport link in Brisbane 95% done; a system to identify high-risk projects should help to sort out the problems in foreign subsidiaries as well as in the local ones.

New CEO Hamish Tyrwhitt is bringing the risk and construction side of affairs under control, but in a company that is working on 400 mining and infrastructure projects around the world, there’s plenty to go wrong. It’s certain that Tyrwhitt can bring in the money (the value of projects Leighton is handling rose from $300 million to $6.6 billion during his short tenure in the box seat), but there’s uncertainty over whether he’s able to lead a global company.

Habtoor is the key risk to Leighton’s future because of the difficulty in extracting money owed from debtors after projects are completed. Despite $2.3 billion of work on its books, the subsidiary was written down to $379 million last year because of about $575 million of debt owed by Doha City Centre, Dubai Properties and Al Shaqab Equestrian Centre Project.

There are also questions to be asked about whether Leighton’s internal culture, which was responsible for the recent stains on its reputation, has been reformed. An Australian Federal Police (AFP) investigation into alleged Iraqi bribes suggests the rhetoric hasn’t seeped down through the company hierarchy yet, nor is it unreasonable to think that it will take time in such a large company.

Leighton dobbed in its subsidiary Leighton Offshore to the AFP for making improper payments to gain access to Iraqi oil projects three months ago, yet only told the market last week. Some are seeing the disclosure as a good thing, because Leighton wasn’t under any legal obligation to tell the market, but the underlying point is that a rotten culture of risk-taking and overconfidence didn’t exit with one chairman and two CEOs.

Until Tyrwhitt proves he can control the worldwide operations as well as bring in projects and the local ones, and until investors can trust that more unethical activities such as “improper payments” aren’t going to pop up in the news, the call is to stay on the sidelines for the time being.

  • Investors are advised to sell Leighton Holdings at current levels.

Qantas (QAN). Remember Warren Buffett’s line about calling an “aeroholic help line” every time he thinks about buying another airline? Well airline bears may be thinking the newsletters need to get hold of that number, because they’re still calling a “buy” on Qantas.

The reason is that despite a $198 million first-half loss from the international grounding last year and related union strikes, distractions due to weather and volcanic eruptions, and a $444 million fuel cost, Qantas still posted a $42 million net profit for the six months to December 31. “El-cheapo” arm Jetstar, as one publication called it, made EBIT of $147 million (a record for the discount division) while the same at Qantas slid to $66 million from $165 million.

Sure, net profit was 83% lower than the prior corresponding period, but given the past six months of terrible PR and “boil them slowly” union strike tactics, it’s actually quite impressive.

However, the main reason for the surge in Qantas shares just after it released its results is because of the $700 million in spending cuts announced at the same time. The cuts mean the company is far less likely to be forced into a dilutive capital raising. The cuts include dropping the Singapore-to-Mumbai and Auckland-to-Los Angeles routes and eliminating 500 maintenance jobs in Australia. These will start to limit losses from next year onwards.

On the whole, Qantas’ outlook isn’t too bad (for an airline). Union action was very effectively thwarted; it’s swiftly upgrading the fleet; the discount airline strategy is working well as Jetstar continues to rack up the wins; and, combined with the drive to become a smaller, more efficient company, Qantas may even turn into the company investors have always wanted it to be: one able to create the returns that would justify a long-term investment.

It will be difficult – the airline industry suffers from hugely volatile demand and from the opacity of the oil industry, as well as the inevitable high, ongoing capital spending that comes from running expensive machinery safely – but the newsletters are placing their faith in the latest restructure and cost cuts. Even more than that, they say at $1.63 on Friday it’s good value for highly risk-tolerant investors because the 12-month price target is $2.

  • Investors are advised to buy Qantas at current levels.

Domino’s Pizza Enterprises (DMP). A business that sells low-cost takeaways is one of the most defensive investments you can have in times of fiscal stringency, and Domino’s is one of the dream stocks to own (as we pointed out in August last year).

However, a very strong share price and a price/earnings multiple around 20 is too high for the newsletters to stomach, with one saying at that level double-digit growth would have to be guaranteed – a hard promise to live up to in these tumultuous times.

Still, Domino’s has lived up to this promise so far. For the six months to December 31 earnings grew 23%, EBITDA shot up 21.7% and the pizza-maker lifted the fully franked interim dividend by 25% to 13¢.

And while these figures seem enormously high, the tasty little $565 million company hasn’t come close to its peak yet. It has the capacity to increase store numbers by a third in Australia and by more than three times in Europe (where it wants to lift outlets from 326 to 1250 within 15 years). This is not an unrealistic target, even in straitened Europe. France’s 30 stores already have annual sales of a million euros, and the Netherlands lifted same-store sales by 22.7% in the December half.

And with this ambitious expansion plan come economies of scale. Domino’s could double the number of stores in the Netherlands for exactly the same overheads.

But there is no shortage of cheap, quick takeaway food on offer in any of the five countries in which Domino’s operates so the trend of people downshifting their takeaway choices to lower-cost products doesn’t fully explain why it’s doing so well.

Strong management who are willing to innovate are the key to Domino’s success. The stores cross-sell other food products, while new offerings, quality ingredients and revamped store design helps with customer appeal.

Domino’s is one company that also hasn’t been caught on the hop in the consumer rush to embrace social media. It is the most popular pizza website in Australia and it was an early adopter of mobile apps that allow customers to place orders from a smart phone. This gives it a big competitive advantage over fast-food companies that don’t understand just how fast the use of this kind of technology is growing in Australia.

The company is on the ball in social media as well, taking advantage of a free marketing tool to deliver offers and receive feedback from the 410,000 fans on its database: Facebook.

The only thing preventing the newsletters from endorsing this dream run further is the fact that the shares are swiftly moving higher than the $7.15 fair value ascribed to them and the fact that as Domino’s continues raise the bar, market expectations become harder to fulfil.

  • Investors are advised to hold Domino’s Pizza Enterprises at current levels.

Fortescue Metals group (FMG). We’ve said it before: Fortescue’s share price is past its glory days. Back in the 2000s it rode the wave of ever-increasing Chinese demand for iron ore, as its huge resource base, coupled with the drive of majority shareholder and former CEO Andrew Forrest, quickly turned it into the third-largest iron ore producer in Australia. Its share price lifted from 1¢ in 2002 to as high as $12.13 in June 2008.

It still has that enormous resource base and complementary infrastructure exists to shift the ore to export ports. However, Fortescue is yet to become the low-cost producer it has always aimed to be and in the coming years the miners that will remain competitive are not just going to be those that can produce in volume, but at the lowest possible cost as well (for more on this, click here).

Fortescue’s results are not encouraging for those still hoping this goal is alive.

Adjusted net profit for the December half fell by 4%, due to tax expenses, but headline profits were almost double those of the same period last year, hitting a record $800.8 million. Undermining this was the fact that costs are expected to grow past the $US10 billion budget for the development of the Pilbara iron ore project in Western Australia, and, as Tim Treadgold pointed out last week (see Iron ore’s harder times) the sharp increase in costs or ore per tonne from $38.34 in the prior half to $47.97 in the latest half.

The cost blowout is due to an extra $200 million that’s needed for accommodation around Port Hedland and the fact that Fortescue may buy its own mining fleet for the Solomon development, also in Western Australia, which would cost about $US1.6 billion.

The miner has free cash of $2.47 billion, which is about the same as 12 months ago, and net debt of $US 3.72 billion, the total of which has grown 39% as Fortescue has invested more and more of its cash into projects rather than paying off debts.

One newsletter notes that those companies that promise so much and then deliver tend to come back to earth with a jolt when they no longer meet the market’s ever-higher expectations. Even without the charismatic Forrest in the driver’s seat, Fortescue may be able to meet its goal of becoming a low-cost producer and survive in the “new normal” world of lower prices for more ore, but don’t expect it to achieve the lofty heights it once attained, and the market will punish it for this.

  • Investors are advised to sell Fortescue Metals Group at current levels.

Australian Securities Exchange (ASX). The swing from equities by many fearful retail investors is keeping some people at the ASX up at night, although not as much as the growth of dark pool trading and advent of technology such as that which allows high frequency trading (HFT).

CEO Elmer Funke Kupper says the off-market trading done by brokers via dark pools (which take place away from central exchanges like the ASX and usually aren’t accessible to the public) needs to be regulated in a much stronger manner.

HFT technology is an associated threat because those traders are attracted to unregulated pools that give them more control over the prices they pay and receive, all of which impacts on the prices people pay on the central market.

Interloper Chi-X hasn’t made many inroads on ASX’s top line yet, as the area in which it competes only accounts for 6% of ASX revenues.

In the December half, ASX managed to grow revenue and underlying profit by 3%, to $315 million and $181 million respectively, largely due to the 17% rise in revenue from the derivatives business. Derivatives tend to do very well in times of market volatility and most of that gain came in the first quarter of 2012-13. However, revenue from listing fells 15% and cash market values (the marketplace in which trades are made, and also known as the sport market) fell 19% in the first six weeks of this half.

It was a good result for ASX at a time when technology is changing how and where people are trading, and the economic conditions are ensuring many investors remain on the sidelines and keeping their assets in cash or fixed interest products.

  • Investors are advised to hold Australian Securities Exchange at current levels.

Watching the directors

Tanami Gold (TAM) director Lee Seng Hui sold $224,562 worth of shares from Eurogold. The sale of 281,065 shares meant this entity now owns 8.7 million shares for Lee, whose ownership of the shares is diffused through two holding companies. Lee doesn’t have any input into the buy and sell decisions of Eurogold.

Primary Health Care (PRY) managing director Edmund Bateman took advantage of the announcement of a 125% increase in pre-tax earnings, by buying 60,000 shares just after the results were made public for $169,200 (or $2.82 a share) and selling the same amount the next day for $2.95 each, or $177,000. That’s pre-tax earnings for Bateman of $7800.

Bradken (BKN) director Phillip Arnall sold off some of his share in the company last week. He sold $546,065 of shares on market, or 65,000 for $8.401 each. This leaves him with 437,749 shares owned via his super fund. The price he got was a six-and-a-half month high, and came after the company reported a 65% increase in half-year net profit.

Webjet (WEB) director Richard Noon also took advantage of strong half-year results to shift some of his stock on to the market. The 89,100 shares went for $2.944 each and reaped a total of $262,343. Directly and indirectly he now owns 2.2 million shares in Webjet. He missed out on selling at the all-time high share price reached today of $3.15.

-Recent large directors' trades
Date Company ASX Director
13/02/12 Westgold Resources WGR Peter Cook
10/02/12 Bradken Limited BKN Phillip Arnall
02/02/12 Kingsrose Mining KRM Peter Cook
01/02/12 Saracen Mineral Hldgs SAR Guido Staltail
27/01/12 MacArthur Cook MPS George Wang

Source: The Inside Trader

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