Telstra offers clear and present value

PORTFOLIO POINT: It’s the cheapest mega-cap stock in the ASX 20, offering absolute and relative value.

While some analyst nitpickers got in a tizz about the fractionally lowered guidance that came out with Telstra's better-than-expected results, the market has fallen for a classic new chief executive trick of clearing the decks and lowering expectations to make them easier to beat.

Sure, I didn’t get the buy-the-fact trading response I expected from the Telstra result, but make no mistake: the result and the trends in the result were better than consensus expectations and reaffirms my very strong belief that Telstra shares are exceptional absolute and relative value. In fact they are the cheapest mega-cap stock in the ASX 20 on current prices.

These are our analyst’s forecasts for Telstra over the next three years. I only want to focus on 2009-10. For the year ahead, Telstra offers 12% earnings per share growth, 8% earnings EBITDA growth, $6 billion free cash flow, a return on equity of 32% and a fully franked dividend yield of 8.2% – all for a forward price/earnings multiple of 10.

That is cheap, very cheap, particularly for a company that grew profits by 10% during the global financial crisis.

The nitpickers who point to Telstra fractionally lowering its forward guidance miss the fact that the stock is priced as a growthless junk bond with regulatory risk. How could you argue that a stock on a 50% price/earnings discount to the market and a 100% dividend yield premium to the market is pricing in any growth? Of course it isn’t and that is why I can’t get away from the absolute clear and present value Telstra offers.

The easiest game in town is to be a Telstra basher. But bashing stocks that offer such compelling value is simply not the way to make money. The way this will work is that the regulatory risk of the national broadband network will be pushed back and pushed back and the market will realise there is no network without Telstra’s participation and co-operation. As that occurs, Telstra’s price/earnings multiple will expand to reflect the lower regulatory risk.

Telstra shares are on their relative lows versus the market and command a huge discount to other leading Australian companies. Telstra shares are cum the final 2008-09 fully franked dividend of 14¢ until August 23. I see the opportunity to pick up a 13-month yield of 12.2% fully franked by simply buying Telstra shares today. I see very little to no capital downside and that means I’d rather be in Telstra shares than unfranked cash or government bonds. In fact, Telstra now looks very cheap versus Australian banks, which are really a yield play, too.

But Telstra is a yield plus growth story. My price target is $4.03, which, if achieved in the next year, would translate to a 24% total return before you take into account franking credits. On my quant screens, Telstra is one of very few stocks that get a green light on all variables.

Just remind yourself of one thing before you tell me that all the analysts hate Telstra. Didn’t all the analysts also hate banks at the bottom? And who told you to buy banks at the bottom as yield plays with free upside growth call options?

Telstra is 1800 CHEAP. Buy and hold it for the next 13 months.

Aquila and the coal sector carve up

Six weeks ago I wrote about why I liked the old-fashioned dirty coal sector. Early this week, one of the stocks mentioned, Felix Resources, emerge as the target of a $3.5 billion takeover bid by Chinese interests. Clearly, the number of options to get direct coking coal exposure at a pure play or mid-cap level is getting harder and that’s why you have to find the next emerging producer before the Chinese do.

Felix being taken out by the Chinese at a big price means Aquila should be trading above $8, as there is so little left of any scale in the independent high-grade coking coal space. Aquila will either be taken out in time or the Chinese will finance its growth. Aquila shares have underperformed in recent times, due to a persistent large seller, but that liquidity appears to be drying up and I expect positive news from Aquila over the short term.

In terms of news flow in the immediate future, Aquila has flagged that it wants to sell 20–40% of the Washpool coking coal development next to Curragh (owned by Wesfarmers). It also intends to sell 20% of its manganese asset in South Africa. I expect developments on these transactions this quarter and would expect an end customer from the steel industry to be the buyer. Also, from December this year, Vale has six months to buy out its 24.5% stake in the big Belvedere coking coal mine; that stake has been valued at about $400 million.

On the iron ore side, its partner AMCI, with whom it hasn’t been getting on (industry rumour), is trying to sell its 50% stake in the West Pilbara iron ore joint venture. That asset is planned to be a 25–40 million tonnes per annum player and recently there was an agreement signed with Fortescue Metals Group to look at jointly developing Anketell Point as a new export Port for the Pilbara.

I have followed Aquila Resources for many years now. I know the management very well and they are switched-on. Aquila has Brazil’s Vale as a partner in the Queensland coal assets and I continue to believe Aquila is highly undervalued here, particularly to a strategic buyer. Aquila's share of coal production as it brings on growth assets could be about 6.5 million tonnes a year of coking coal, which is big by anyone’s standard.

Today I read brokers saying the coking coal market is heading to $US200 a tonne at the spot level, up from the $US128 contact price, because there are no stockpiles around in the commodity.

The one thing the Chinese have stuffed up in the whole recent commodity price correction is not getting enough coking coal and iron ore exposure. They still rely far too much on a handful of producers in both commodities and they have to fund new large players like Fortescue and Aquila near term. We value Aquila on a full takeover at $12.91.

Aquila should be trading above $8. The company is poorly researched by global brokers, who most probably think they make school shoes, and its register is dominated by offshore funds rather than locals.

This is a $1.5 billion market cap company that is under-owned by domestic institutions yet has high quality assets and is cum developments that will allow analysts to utilise see-through valuations of their key assets.

Emerging visibility will drive Aquila above $8 in the short term. I am sure that the takeover of Felix resources is not the last we will be hearing from the Chinese in the Australian bulk commodity space. For Aquila, even the technicals look good after completing the “Batman Cape” formation! Aquila is a trading and fundamental buy up to $6.50, pending a rerating to $8 in the short to medium term.

Deja vu with ConnectEast

When I first read Warren Buffett’s book, the one quote that stuck with me was that “a monopoly toll bridge is my dream investment”.

Wouldn’t we all love to own a monopoly toll road that saw traffic growth at GDP-plus and was able to increase toll charges in line or above the inflation rate. Even better would be if traffic was being fed on to that road by the construction of interconnecting motorways. Well Warren, I have found your dream investment and it’s called ConnectEast.

Our infrastructure analyst first recommended buying ConnectEast at 31¢. It’s worth remembering he is also behind the Buy recommendation on Asciano, which has been an absolute cracker. A few weeks ago, when ConnectEast hit around 42¢, I encouraged a little profit-taking. Today I want to come back into the stock, but this time as a medium-term investment, not just a quick trade.

ConnectEast reminds me greatly of Hills Motorway. Hills Motorway was another crucial piece of monopoly infrastructure connecting a growth region to other ring roads. In the early days, Hills Motorway traffic numbers disappointed, but traffic gathered steam as motorists realised the time saving was worth the toll, the stock got rerated and eventually was taken out by Transurban, which owned the feeder motorways.

Hills Motorway was the missing link in Transurban’s Sydney asset base and it ended up paying about $11 a share for Hills Motorway. To put that in context, in the early traffic days, Hills was below $2. The chart below shows the latter part of its listed life.

Don’t get me wrong. I think Transurban bought a great asset and paid a good price for a long duration monopoly asset with clear synergies. The lesson for investors, however, is to buy these new monopoly toll roads as they are in the traffic ramp-up stage, just as impatient analysts get frustrated.

Of course ConnectEast’s equity has been doubly punished because not only did initial traffic disappoint but the company also listed just before the global financial crisis really took hold. ConnectEast, like all long-duration infrastructure assets, was heavily geared and the market was worried that the company wouldn’t be able to roll or refinance its $1.5 billion debt load.

While there is still some debate about ConnectEast’s debt load, I think focusing on the debt will not make you money in ConnectEast’s equity.

Our view is that ConnectEast has “turned the corner” with both traffic and revenue delivering solid growth. The thematics for the stock remain compelling, with prospects of higher traffic growth driven by dedicated bus lanes on the competing roads; improved connectivity; and recovering economy. Although the balance sheet remains tight, ConnectEast should avoid equity raising as surplus cash goes towards debt reduction.

ConnectEast has reported a good set of traffic statistics for July with average daily traffic rising by 19% over the previous corresponding period. Encouragingly, the volumes continue to build, with traffic in the last week of July up 20%.

More importantly, average daily revenue has risen by 8% over the preceding month, due to the 3.7% per annum lift in toll charges on July 1. I forecast ConnectEast’s EBITDA to more than double in the next 12-14 months.

The thematics for the stock remain strong driven by:

• Dedicated bus lanes being introduced on the competing roads.
• Improved connectivity with adjoining arterial roads, with the proposed development of Peninsula Link.
• An improvement in the economy should result in additional commercial and commuter traffic on the road.
• Cost reductions.
• Corporate appeal.

The balance sheet remains tight with skinny interest coverage of about 1.3 times. However, improving traffic and little need for additional capital means that the surplus cash can go towards debt amortisation, thus reducing the need to inject more equity. Conversely, an equity injection of about $250 million should ease investor anxiety and allow the stock to rally and reflect its true value of 49¢ a share.

I rate ConnectEast a Buy up to 40¢. My valuation is 49¢ and I believe, through time, that it makes absolute sense for Transurban to own ConnectEast. The revenue and cost synergies are large, let alone financing synergies. The lesson in Hills Motorway was to buy at exactly this stage of ConnectEast’s life. The true equity value of this monopoly toll road is significantly above the current equity capitalisation of $970 million.

Charlie Aitken, head of institutional dealing with Southern Cross Equities, may have interests in any of the stocks mentioned.