Value Investor: Three picks for 2015

A famous burger franchise, a gaming technology company and a coal miner are tipped to perform well in 2015.

McDonalds

McDonald's has fallen on hard times of late. An issue with a Chinese beef supplier and changing consumer preferences in the core markets of the US and Europe have resulted in soft like-for-like sales. This has stalled the company’s long standing record of growth, with consensus opinion expecting NPAT of $4.81bn in 2014, down 12 per cent from 2013.

However, despite the current headwinds, we think the future for McDonalds is bright.

The company has embarked on an emerging market restaurant expansion to grow the group’s network by 2.5 per cent next year. And a capital management program to return $18-20bn (21 per cent of the current market cap) through dividends and buybacks will help boost growth at the EPS line. These two initiatives help to pick up the slack while the company rekindles it place with its customers.

McDonald's founder Ray Croc famously said, “I’m not in the hamburger business, I’m in the real estate business”. This couldn’t be truer today. McDonald's has a globally diversified retail portfolio worth considerably more than its $35bn book value.

The stability of the McDonald's model should also not be overlooked, with consistent streams of high-margin royalties from franchisees and rent from the property portfolio. This generates high levels of free cashflow, which allows the company to maintain a robust balance sheet and to organically fund its expansion.

While not a deep value bargain today, McDonald's offers a 3 per cent yield, long-term growth prospects of 6-9 per cent per annum and is currently available at a 5 per cent discount to our $US94 valuation.

Ainsworth Game Technology

Gaming technology company Ainsworth has experienced exceptional domestic and international growth since releasing its breakthrough A560 gaming cabinet in 2011.

Founder, chairman and majority shareholder Len Ainsworth, who owns a 53 per cent stake, leads a team with deep knowledge and experience in gaming systems design. He also founded Aristocrat Leisure in 1953, now the world’s second-largest producer of casino style gaming machines.

Back in June, Ainsworth reported a 23 per cent increase in revenue to $244m and an 18 per cent increase in profit to $62m for FY14.

While this appeared to be a sound result from a company delivering considerable growth, both revenue and profit missed prior consensus expectations. Australian revenue was up 15 per cent to $143m while international revenue grew 37 per cent to $101m. Profitability as measured by return on equity was 31 per cent. Ainsworth maintains a strong balance sheet with cash of $72m and no debt (as at 30/06/2014).

AGI’s FY14 debtor-days ratio of 143 is high, showing it takes a long time for the company to get paid. This requires monitoring.

With slowing domestic demand, AGI is pursuing opportunities overseas, particularly in North America. The latest A560SL system, released in March this year, could spark further growth, with early indications the machines are performing well above the house average.

Earnings are sensitive to gaming machine replacement cycles, discretionary consumer spending, gaming capital expenditure, and changes to gaming regulations. Performance also depends on the talent and creativity of personnel and AGI’s track record of innovating superior gaming machines gives us confidence.

Ainsworth shares peaked early this year at $4.65 but are now trading around $2.18. The decline over this period followed Len Ainsworth reducing his holding by  about 3 per cent, however the stock was put towards options granted to senior management employees at 22.5 cents per share. Further declines were triggered by missed FY14 profit expectations and lowered 1H15 guidance due to delays in domestic approvals in NSW and QLD.

Our FY15 (30/06/15) valuation is $2.80. We recommend a 15 per cent margin of safety, implying a buy price of $2.38. While the stock is currently trading below this price, more conservative investors may care to wait until the new product approvals have been granted.

New Hope Corporation

It was impressive for a thermal coalminer to be profitable at all in FY14 given the fall in coal prices and the strong Australian dollar, which points to New Hope’s low baseline costs of production and efforts to cut costs further during this severe downturn. A number of other mines have closed.

The way for conservative investors to play commodity price cycles is to own miners, which will survive the downturn and not have to cease uneconomic production, and this is one reason we recommend New Hope. Its earnings are supported by its oil production and 100%-owned port.

The $1.1bn cash balance is dampening profitability however our valuation looks through the current downturn to higher mid-cycle profitability, by which time New Hope is likely to have either deployed some of its cash in acquisitions at the bottom of the cycle, special dividends or capacity upgrades in time for the next recovery.

The company expects currently challenging market conditions will continue in FY15, when oversupply will continue to depress spot thermal coal prices, before a gradual recovery in spot prices over the subsequent 12 to 18 months. We agree with this forecast, which is driven by ongoing demand growth and declining supply growth as higher-cost mines cease production.

We also argue China’s initiatives to reduce air pollution from coal burning will play into NHC’s hands, as the Australian miner’s output is low in ash, moisture and sulphur. China continues to open new coal-fired power stations and this energy source’s economics are attractive to the developing world as it tries to lift its citizens out of poverty.

Patience will be required for the gradual recovery in prices to flow to higher reported earnings and dividends but the share prices of cyclicals usually move well in advance of reported results. Approval for the expansion of the New Acland coalmine was required to replace reserve depletion; this week’s announcement of approval by the Coordinator-General is great news.

By Alex Hughes, Jonathan Wilson and David Walker, Equities Analysts at StocksInValue. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.

David Walker owns shares in NHC.