Collected Wisdom

Buy Sonic Healthcare, hold Newcrest and Flight Centre, and sell Transpacific, 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.

Newcrest Mining (NCM). The high-profile, PNG-based Lihir gold mine is failing to live up to expectations and people are beginning to suspect that the rising price of gold is papering over cracks at Newcrest, especially as the precious metal – its main revenue source – hits $US1636/oz and “low cost” becomes the phrase of the year for resources companies.

What’s gone wrong is that mechanical and electrical problems at the mine knocked 50,000-60,000 ounces off production in this quarter alone. Repair programmes are starting, but the cost impact will be $200,000 per annum for several years.

Moreover, although Newcrest stuck by its 2012 production guidance of 2.43-2.55 million ounces of gold and 75,000-85,000 tonnes of copper, the tail-off at Lihir to 65,000-75,000 ounces of gold will put pressure on that target.

It’s concerning some people that when Newcrest and Lihir Gold merged in 2010, the suitor didn’t do enough due diligence on the condition of the infrastructure and now its shareholders are paying the price. Others are worried that although this event looks like a small setback, it comes after a year of missed targets.

Newcrest has a tendency to go after technically challenging projects in difficult places. PNG isn’t politically stable and even though it’s a hot bed of mining projects, that doesn’t mean it’s become easy to work in.

Then again, the half-year results don’t exactly reflect any turmoil experienced by certain projects. Headline net profit after tax rose 50% to $659 million on the prior corresponding period, operating cash flow hit $1 billion and sales shot up 19% to $2.34 billion.

And if management can use that huge gold price – and the impressive profitability and cash flow that comes with it – to fix the cracks while no one is looking too hard, these blips shouldn’t be too much of a problem. On the other hand, if they mess it up and the gold price begins to trend lower, Newcrest isn’t going to be attractive to many investors.

  • Investors are advised to hold Newcrest Mining at current levels.

Transpacific Industries Group (TPI). Death and taxes aren’t the only certainties in life: collecting the rubbish we humans create is another. It follows that an investment in an industrial-sized rubbish collector should be a sure bet, but there’s always one example that will disprove a theory and Transpacific is it in this case.

Transpacific was one of those companies that went into the 2008 financial crisis with far too much debt, having been on an acquisition spree beforehand. CEO Kevin Campbell is slowly paring the debt away, but the company still has $1.1 billion on its books (its market cap is $1.3 billion) and as a result dividends are still non-existent and net debt to equity is 52%.

First-half reported net profit fell 49.5% to $16.5 million, but the underlying figure was up 25.2% to $35.2 million.

The newsletters say that although the massive debt is draining the company’s strength, it’s the lack of demand from construction and industrial clients that is cooking Transpacific at the moment – 58% of all revenue comes from these two areas. The weak east coast economy is impacting on demand from builders and councils, exacerbating the impact of a withering manufacturing industry, and the only real upside from the New Zealand business is the clean-up work in and around Christchurch.

It doesn’t help that Transpacific’s accounts are quite complex, as it does everything from making rubbish bins to distributing heavy-duty vehicles to providing recycling and industrial cleaning services.

This brings us to what management are doing to turn Transpacific into a profitable company again. A five-point plan is underway to sort out which businesses the company should remain in, and to get that huge debt pile down to a more realistic level.

In October, Transpacific raised $311 million in equity and consolidated a number of debt facilities with one new $1.5 billion syndicated facility. It used $235.1 million of that money to buy back subordinated convertible notes at a discount (the total on issue is $309 million) and this should mean the second half is a little more profitable.

However, the newsletters say debt needs to come down by another $250 million before Transpacific tries any new growth initiatives, and because of the uncertainty around when it can do this – as well as the high debt level – they are avoiding Transpacific for the time being.

  • Investors are advised to sell Transpacific at current levels.

Flight Centre (FLT). What are the risks that could derail this stock? A hard landing in China (even Michael Feller thinks this isn’t likely now); a fall in the Australian dollar; and weaker consumer confidence – a detail that, as one newsletter puts it, someone forgot to tell Flight Centre about.

For the six months to December 31, total transaction value in Australia increased 9%, net profit jumped 15.7%, full-year guidance was upgraded to $270-290 million from $265-275 million, and the interim dividend grew 14% to 41c.

It’s well on track to achieve that guidance, which is 10-18% above last year’s net profit.

And not only is Australia doing well, but total transaction value for the UK and the US rose 16% and 36%, respectively, as the company focuses on high-margin corporate travel. Dubai, China, Hong Kong and Singapore all grew strongly off small bases and it’s here that Flight Centre has an excellent opportunity for expansion in growing markets.

The flip side of this good fortune is that Flight Centre relies on cyclical leisure travel for 70% of total travel value and 87% of EBIT still comes from Australia. Once the dollar starts to come down, the attractiveness of these pricey holidays is going to disappear, and with it the super-charged profits.

The online strategy is still concerning the newsletters, although not enough for them to stick with the 'sell’ call they had on the company when we last reviewed it a year ago.

They still say the number of stores is too high, but that a unique selling point is Flight Centre’s ability to match web clients with a consultant, and as a household brand it’s well placed to make its mark online. This could result in higher costs for using the website to book travel arrangements, making the company less competitive, but it is also a key move into a world where people are often happier to do something now and at home, rather than having to make the effort to go into a store.

  • Investors are advised to hold Flight Centre at current levels.

Downer EDI (DOW). The first thoughts to usually pop into an investor’s head when confronted with Downer EDI as an investment is Reliance Rail and the NSW Waratah trains, which wrecked the company’s reputation as it repeatedly failed to build and deliver any trains on time or on budget.

However, things may be changing – not enough to look at Downer as a sure-fire, contrarian investment just yet, but enough perhaps to put it back on the watch list.

For the first time in some years, Downer delivered a set of results free from enormous writedowns. It was boosted by the high-achieving mining division, which delivered just over half of the total $160 million EBIT – or a 78.6% rise in revenue on the prior corresponding period. This was due to winning major contracts from operators such as Fortescue's Pilbara Christmas Creek iron ore mine, BHP-Mitsubishi coal projects in Queensland, and a $570 million services deal last week with Gindalbie Metals at its Karara iron ore project.

But it’s taken a $175 million bailout from the NSW government into the Waratah trains joint venture (in exchange for 100% equity) to give Downer the kick it needed. So far it has finished seven trains; is promising 12 by June and 28 by the end of the year; and, according to the head of the project Ross Spicer, it’s on track to deliver all 78 trains by the middle of 2014.

Still, revenue from the rail division fell 13.8% as foreign players start to put pressure on the division, leading to reduced margins.

Overall, the company has a high 57% net debt to equity but is still forecasting full-year net profit of about $180 million. The newsletters think that if Downer can continue to capitalise on its position as a decent mining services provider, there’s a chance (provided it’s not derailed by further problems in Reliance rail) its net profit could be even higher.

The question is, can Downer maintain the momentum?

  • Investors are advised to hold Downer EDI at current levels.

Sonic Healthcare (SHL). Pathology provider Sonic has had its problems in the past but as a long-term punt on the global health care industry, it’s not a bad way to invest.

It reported a solid first-half net profit last week of $143 million and a 9% lift in group revenue as its diversified field of assets in Australia, Germany and the United States braced each other in the face of economic and regulatory headwinds.

Starting with Australia, rising GP visits are proving positive and pushed revenues up 8% in the first half. Add to this the fact that higher volumes of testing equates to lower per-unit costs, and you’ve got a lift in profit margins of 1.5%. All of this indicates that the local industry is rebounding after last year's changes to how the government funds medical services. It also suggests that worries about how means testing the 30% private health insurance rebate will affect the wider industry are abating.

In the US, the entire health industry is being jolted by the “Obama-care” reforms that will add about 30 million people to the health insurance market, and will be affected by the legislation proposing to cut Medicare fees by 2% from January next year. Sonic managing director Colin Goldschmidt said insurance companies won’t try to decrease payouts when the Medicare fee cuts come into force.

Sonic only managed to increase revenue in the US by 2% in the first half and this doesn’t seem great when the industry average is traditionally around 5%. It’s not so bad, however, when compared to the revenue growth of the two largest US operators: zero.

Germany is where the company's future lies – organic revenue grew 6% and margins expanded, as they have done for the last three years. But the newsletters' key point is that in Australia it took 10 years for Sonic to realise the full potential of its local operations, so they say Germany has a long way to run before it does the same.

Over the long term, exchange rate fluctuations and regulatory blips aren’t going to be as relevant to Sonic as rising incomes and aging populations.

  • Investors are advised that Sonic Healthcare is a long-term buy at current levels.

Watching the directors

Mineral Resources (MIN) director Joe Ricciardo earned $5.2 million from the on-market sale of a 400,000 block of shares. The $13.15/share sale sends his stake down to a still-healthy 1.5 million, and didn’t appear to have much of an impact on the company’s share price, which fell from a $13.26 high on Thursday when he began to sell to a low on Friday of $13.08. Ricciardo has been selling his stake down since 2010, with his last purchase of Mineral Resources shares in July 2009.

Adelaide Brighton (ABC) non-executive director Raymond Barro underpinned the buy-side of director trades last week, spending a whopping $15.4 million on shares in the building products supplier. He made the trade through Barro Properties on February 16-17 for an average price of $3.02. The Barro holdings now sit at 27.5% of Adelaide Brighton’s register. Barro is a heavy hitter who in the past six months also spent $15.4 million and $13.6 million in September and August respectively buying Adelaide Brighton shares, via indirect holdings.

BHP Billiton (BHP) ferrous and coal CEO Marcus Randolph told the market his $2.5 million sale of company shares was to pay a tax bill. He offloaded 70,000 shares onto the market at $36.13 each, leaving him with 351,550 shares left in his kitty. The sale was made on Thursday, just before the share price slid heavily after BHP paid its interim dividend on Monday.

Valentine’s Day passed UGL (UGL) director Robert Denham by as the $131,882 share purchase he put in his wife Carolyn’s name was nine days late. Then again, Denham only joined the board on February 20 so his 10,000 stake (that cost him $13.19 a share) is his first purchase. Denham’s resume includes being CEO and chairman of US financial services and trading company Salomon Inc.

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