Three the Analysts Missed

I haven't written about Westpac (WBC) since my fingers got stuck in the automated doors of the Rose Bay branch when I was four years old. I've finally recovered from that trauma, and now with every analyst sticking the boot into the company I thought it was time to offer some impartial support.

Westpac shares have been underperforming the market and their bank peers sharply of late, mainly on concerns about the NSW and New Zealand economies. I believe you never go too badly buying the major bank that the analyst's hate most, has the lowest prospective price/earnings (P/E) multiple, and the highest prospective dividend yield. That bank at the moment is clearly Westpac.

Everything you read about Westpac at the moment is negative. The stock price is also under pressure from consistent offshore selling, with sellers seemingly moved to action by the local analysts’ negativity. The negative commentary and order flow are combining to drive heavy underperformance at a time when every other bank has recovered sharply, even the heavily NSW-exposed St George (SGB).

Market speculation is that a large US-based mutual fund has been behind the consistent selling of Westpac shares over the past few weeks, and it's US-based investment banks that are handling the bulk of the selling (boo, hiss!). People can talk until they’re blue in the face about the liquidity of the Australian market, but the fact remains that big order flow still has an impact on share prices.

BT is a growth business

Westpac is only offering 7–9% earnings per share growth this year, but it does actually own some "growth" businesses. I continue to believe the BT Funds Management business is a long-term "growth" business, heavily leveraged to domestic compulsory superannuation growth. I believe the current BT team will continue to deliver the performance turnaround the BT brand needs, and they'll do it without taking excessive risks. The current BT team are lower profile than some of their predecessors, but their performance numbers are way better.

Westpac paid $900 million for BT back in the tough market of 2002, yet this year BT is on track to deliver $320 million of profit to Westpac. That effectively means Westpac bought BT on a three-year forward P/E of 3, and I don't think we are anywhere near the peak of profitability for the BT division.

I'm a massive long-term bull on compulsory superannuation leverage (legislated growth), and believe BT is under-appreciated and undervalued as a compulsory superannuation exposure within the WBC share price.

Nickel’s bright and shiny outlook

The following slides are from Inco's presentation of its June quarter results and nickel market outlook. Inco is the world’s biggest nickel producer, accounting for about 35% of global production. I believe Inco, via its market share, has the greatest insight into both the short-term and long-term outlook for nickel, and its opinions should be listened to.

The heavy consolidation of the resource sector has created global commodity giants, who have far greater control of prices and production. They have pricing power, and the entire relationship between commodity producers and commodity consumers has changed in my opinion.

I don't see the point of trying to second-guess the views of a BHP Billiton, Rio Tinto or Inco. Who am I to question their assumptions? Surely, their insight into their markets and the supply/demand situation is more informed than anyone else, and to back against their views is ballsy, if not downright conceited, in my view.

Although many investors believe current commodity prices are "irrational" and "unsustainable", I want to again remind you of the words of John Maynard Keynes, that "markets can remain irrational for longer than you can remain solvent". You may well be right, but you may have to wait five years to be proven right.

I also want to point you to this amazing set of comments below at the end of the Inco presentation.

I'm on my own putting faith in the views of these global commodity giants. Perhaps I am naive, but naivety and simplicity has generated significant outperformance from the resource sector over the past 24 months.

The spot nickel price is currently about $US12 a pound, and the Inco slides spell out 10 reasons why the world’s biggest producer believes nickel prices will remain strong in the second half of 2006. It also foresees "insufficient nickel supply to meet nickel demand through 2010". All the ingredients for a genuine nickel price spike are in place

The first chart shows that global nickel inventories have dropped by 62% since the end of 2005. The London Metal Exchange has two days of nickel inventory, and you can see why the nickel price has risen nearly 30% in two weeks. In an environment of extremely low inventories and commodity fund investment, the conditions are ripe for a genuine nickel price spike.

The spot price could go to any level. Add in some games that potentially may be played by players in the nickel market for corporate reasons, and I wouldn't be surprised to see nickel reach $US15–20 during the second half of 2006.

That doesn't mean investors should use those sort of average nickel prices to value Australian nickel stocks, but it does mean that the unhedged Australian nickel sector is about to experience a period of super profits, super cash flows, and super dividends. There is potential for up to 100% consensus earnings upgrades for 2006-07 for Australian nickel stocks, and in the quant-based world we operate in, those huge consensus earnings upgrades will have serious short-term share price ramifications to the upside. The entire earnings upgrade will not be capitalised, but a decent portion will be.

I suppose the way I think about this is not in terms of what is an appropriate long-term nickel price assumption or what is the appropriate P/E to apply to a given nickel stock; I think about it in terms of how much cash flow a given nickel stock will throw out if nickel prices hold these levels for the next two years.

Company-changing "super cash flows"

That's how I look at the entire resource sector. I look at it in terms of the company-changing cash flows that the resource sector will throw out over the next two years as commodity prices stay at current levels, or go even higher. I believe there are numerous small and mid-cap resource stocks that will generate more than their current market cap in cash flow over the next two years, assuming current commodity prices persist.

Think about it in terms of being a PAYE employee with a mortgage being given a string of big bonuses that allow you to pay off your mortgage entirely. Imagine the strategic and financial flexibility that gives you, and consider how "life changing" that would be for you personally. That's what's basically going on in the resource sector right now.

I just don't think investors are paying enough attention to these company-changing cash flows, or their long-term ramifications if appropriately harnessed. The sector will be effectively debt-free from BHP Billiton down, and have no choice but to embark on mass acquisitions, mass capital returns or buybacks, or mass special dividends. I just think investors aren't thinking about the ramifications of company-changing "super cash flows" '” there's too much focus on the sustainability of the cycle.

This is an unprecedented situation, and the market just isn't seeing it. Perhaps it will take the 2005-06 reporting season in August for investors to realise just how much cash flow the resource sector is generating, and that's off average commodity prices that are significantly below the spot prices we see today.

I believe investors will be shocked by the cash flow numbers reported in the 2005-06 results, and by the capital discipline of those generating them. The reporting season will lead to a broad upward revision of resource sector estimates for 2006-07, and the all-powerful quant-based funds will drive share prices significantly higher.

Jubilee Mines: a stainless idea

Jubilee Mines (JBM) is always written up by the few analysts who cover this $1.1 billion market cap stock as having a short mine life and being deserving of a low P/E. The analysts believe Jubilee will have to acquire other nickel companies to generate any medium-term growth. But why does the market continue to doubt a company that in the past five years has delivered more than $290 million in net profit after tax and returned more than $190 million in dividends to shareholders?

In the past 12 months, Jubilee has made some significant exploration finds around its existing operations, and I believe it is on its way to having a 15–20 year mine life at the highest nickel grades. It could well be producing as much as 40,000 to 50,000 tonnes of nickel a year in two years’ time as new production comes on, and will not have to tap the equity market for any new money to fund the production expansion because its huge free cash flow and already strong balance sheet gives it the flexibility to self-fund. Jubilee has no debt, and about $100 million of cash on its balance sheet. It has a better balance sheet and EBIT (earnings before interest and tax) margins than any industrial company I can find.

Jubilee’s cash cost is $US2.60 a pound, due to the very high-grade nature of its ore body. It is currently making a margin of about $US10 a pound, which spits out enormous cash flow numbers and gives it unprecedented strategic flexibility.

Jubilee reminds me a lot of Zinifex (ZFX) 12 months ago. It took the market about six months to work out "hey, the zinc price is high but it’s staying high", and then it bid Zinifex up 300%. For every day we have the nickel price around here, or even above $10, the more the analysts will have to upgrade their earnings and dividend assumptions significantly. If the Zinifex example is any guide, Jubilee will be a $15–20 stock as these upgrades come through. (It closed last Friday at $9.02.) Remember, nickel has been the lagging base metal until this point, and the analysts are way behind the eight ball.

Jubilee is a company that currently produces about 11,000 tonnes of nickel from its Cosmos operation, yet is seen as no-growth despite pretty much discovering four new mines in the past 12 months: the Prospero-Tapinos and Anomaly 1 deposits near Cosmos, and the Sinclair and smaller Alec Mairs deposit.

The recent drilling news from Anomaly 1, which although lower-grade than Cosmos, is clearly a money-making opportunity for Jubilee, containing more than 328,000 tonnes of contained nickel in the update resource estimate, and a high-grade core of 125,000 tonnes of contained nickel.

The Prospero discovery currently stands at 60,000 tonnes of contained nickel, and I believe the drilling programs mean that number could go higher. Clearly there is a big chance the current plant at Cosmos will be expanded to 15,000–20,000 tonnes a year in the near term, while the longer-term value really comes out in Anomaly 1, Alec Mairs, and Sinclair. I believe that by 2008 Jubilee could be producing 40,000–50,000 tonnes of nickel a year, which would bring earnings of more than $400 million in 2008-09 if nickel prices remain anywhere around current levels and still $250–300 million if they ease back.

You could be buying this stock on a 2008-09 P/E of 2–3. The cashflow of Jubilee in coming years could be massive, and even after growth capital expenditure of maybe $50–80 million it could be generating $150 million in free cash a year from 2008 and maybe earlier. Even after taking into account growth capital expenditure, that money is likely to go straight back to shareholders in the form of fully franked dividends. Given Jubilee’s history of payout ratios of 50–60%, this company could be spitting out fully franked dividends of 70–80¢ a share in a few years, putting the stock on a potential yield of more than 9%. Jubilee is the classic "growth yield" stock.

Jubilee is a growth stock trading on a value multiple. It's trading at a discount because 90% of big broker analysts think it has no mine life. If the market does not recognise this growth in Jubilee then surely another corporate will move and lock in that arbitrage between where corporates see commodity prices and where big brokers analysts see them.

Remember, chairman Kerry Harmanis, who owns 17% of the company, has delivered on everything since growing this company from a microcap explorer less than seven years ago. He pays big, fat dividends and a mining stock paying out dividend doesn't mean it’s at the expense of growth, it just means he understands what shareholders want. Harmanis's strategy of high returns to shareholders has seen the stock outperform the ASX 200 by 100% over the past two years, and I expect that outperformance to continue. JBM remains a strong buy.

Photon Group (PGA): onwards and upwards

Photon owns 25 specialist marketing and communication service companies. We started following/recommending this company two years ago when it listed at $1.80. It has successfully acquired 20 private companies over the past 18 months. This is no mean feat when you look at other listed companies that have done this and managed to grow and build their companies to where they are today. Under Photon's aggregation model, the companies they acquire remain autonomous but are afforded the advantages of (1) potential access to capital for new initiatives or bolt-on acquisitions; and (2) access to other operating companies and potential client referrals.

We expect Photon's continued profit growth to be driven by both earnings per share-accretive acquisitions and organic growth. We expect favourable economic conditions, and the advertiser testing new media and non-traditional marketing services will underpin organic growth. We also believe that specialist marketing and communication services sector will grow at higher rate than traditional main media advertising. The digital delivery of media through broadband internet, mobile phones, and pay-TV is leading to a wider media choice for consumers and greater media fragmentation.

To quote Microsoft chief executive Steve Balmer on where he sees advertising in the next five years: "It will be digital. Absolutely, it will be digital. What that means is that media will be interactive. It's a huge, huge change. We'll have the ability to get good user's knowledge, and a user's activity, not just demographics '” with user's permission, of course. How do we sustain and feed and tailor and give this person what they're interested in?”

Look at Photon’s acquisition last week, iMega, which is in the US online advertising industry. It is an internet traffic broker /online advertising aggregator, which has relationships (but not formal contracts) with traffic sources/search engines such as Google and Yahoo to push internet traffic to the websites of its advertising clients. It derives revenue when web surfers click through to a client site (currently 200,000 people a day). This move by Photon to the US online market via iMega could also provide the base for further US opportunities over time.

Under the stewardship of Tim Hughes and Matthew Bailey, Photon Group has advanced from float price of $1.80 to a current price of $4.70, compared to STW Communications (SGN), which has drifted from $3.05 two years ago to $2.85 today.

We continue to back Photon because it has proved it can acquire, grow, and build a unique company. There is scope for further upside, and the company offers yield (4.5% fully franked) plus growth, and a dividend payout ratio of 80%. I'm happy to continue to back Hughes and Bailey and the Photon aggregation model, particularly given that I am a user of their services and it has helped my business. Photon is headed to $7 and should be part of your portfolio.