Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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I was surprised to read mainstream financial commentary today, suggesting today’s sell off reflected a “shrugging off” of a “solid” domestic labour report, and that instead, the market focused on disappointing earnings reports from large cap domestic companies and growing fears Greece is moving closer to default. Putting aside the fact you’d go nuts trying to make sense of every zig and zag of the market, lets examine the influences todays market gyrations are being attributed to and come up with a better approach to investing.
First regarding Greece: They ARE BANKRUPT. If a country needs $171 big ‘B’ billions in rescue funds, they are bankrupt. The reports that suggest they will default in mid March “if” they don’t get the money means THEY DONT HAVE THE MONEY! And generally, if you don’t have the money to make interest payments or pay out maturing loans, you call in the administrators, receivers of liquidators.
Deputy RBA governor Guy Debelle told me this week that if you owe the bank $100 its your problem but if you owe them $100 billion, its the banks problem. Not quite sure why this should give us any comfort – its a problem. Suffice to say officialdom is sanguine about the risks in Europe and believe the worst is over thanks to the ECB’s unlimited cheap 5-year facility offer last year.
Turning locally and I thought it worth thinking about that “robust” labour situation in Australia and mentioned above: Jobs are being shed in manufacturing, financial services, banking, retailing and in Qantas’ing. I am getting calls from analysts all over who are being made redundant and looking for work (and I can think of nothing better than taking them all on to create the an Equities Newsletter the likes of which this country has never seen. Lets park that. It beggars belief that anyone would suggest that employees on the east coast of Australia are content and secure. And don’t forget that when one person loses their job, they commiserate with friends and they all stop spending “just in case” it happens to them too.
Permabear Steve ‘Kosciusko’ Keen looked even deeper at this and particularly at the following quote from the RBA’s decision last week not to raise rates; “Information on the Australian economy continues to suggest growth close to trend… the unemployment rate increased slightly in mid year, though it has been steady over recent months…With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy was appropriate for the moment.”
But Steve noted: the “steady over recent months” phenomenon that the RBA referred to above was entirely due to a fall in the participation rate. Had this remained at the November level, the ABS unemployment rate would have jumped to 5.6 per cent last month.
On one side of the investing coin is the idea that you lay out money today to get more back later. The flipside is that buy purchasing today you forego consumption today for the ability to consume more later.
They aren’t quite the same thing of course, because the latter idea introduces inflation and suggests the purpose of investing is to at least maintain purchasing power (generate returns in line with inflation) or increase purchasing power (generate real returns in excess of inflation). In a useful reminder Buffett observes:
“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.””
Therefore an investment that is price stable but loses purchasing power is very risky (think US T-Bonds) while an asset that is volatile in price but almost certain to increase purchasing power over time is less risky than the conventional measures of risk would dictate.
This is how Buffett begins an excerpt of his forthcoming letter to Berkshire Hathaway shareholders HERE. One scenario his introduction does not contemplate of course is deflation. Japanese real estate and equity prices are fractions of their previous levels and a bond offering even a miniscule return would produce an increase in purchasing power. Like many readers, you might reach the conclusion that the absence of this scenario in his letter along with the knowledge of aggressive equity purchases in recent months, indicates he does not believe deflation is a possibility.
The other subject of his letter is Gold. Melted down all the gold in the world would amount to one 68 cubed foot of uselessness. Somewhat ironically he reflects on its purchasing power today – all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money.
But he points out that the companies will have thrown off dividends and the land would have produced food. And so the article leads to the defence of buying businesses as a superior strategy (to owning gold ‘that just sits there’) – as we believe at Montgomery Investment Management, and you might as Value.able graduates (after seeking and taking personal professional advice).
I believe Buffett’s take on the investing landscape is ultimately correct (bubbles are always followed by a bust and nothing goes up forever);
“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.”
But I trust you can see the irony in claiming gold is useless and yet it can buy 16 Exxons and so on. As the chart shows, it has underperformed stocks over the long term and without boasting about it Buffett uses the S&P500 index to demonstrate the superiority of stocks. In a thinly veiled warning to gold bugs he likens the current enthusiasm for gold to the internet bubble and US housing speculation pre-2007.
In his enthusiasm for stocks being best able to retain purchasing power or increase it, I can’t but help remembering that Buffett was a more circumspect proponent of stocks in the seventies – a period of very high inflation. While in 1974, when Forbes asked Buffett how he felt about the stock market at the time, Buffett replied, “Like an oversexed guy in a whorehouse”, his 1979 letter to investors serves as a useful reminder of the limits of any asset to retain purchasing power during bouts of high inflation.
“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative
real return for its owners under inflationary conditions not much more severe than presently prevail.
If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means – and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
That combination – the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”
Another warning to stick to high ROE businesses…
Finally remember that if you are buying stocks, unlike commodities, there exists management risk, execution risk, result risk, competitor risk, economic risk, currency risk etc. Anything can go wrong in a business and frequently does. And while Chalrie Munger has pointed out that “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities”, you must know what you are doing.
I think stocks are indeed the best opportunity to retain and increase purchasing power but only the good quality ones. Knowing what you are doing and sticking to high rates of return on equity, little or no debt and A1 or A2 businesses increases your chances of doing even better than the both the stock market index of which they are constituents and inflation.
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 14 February 2012.
After repotting a reduced annual net profit, what does the current economy hold for JB Hi-Fi’s future performance? Roger Montgomery discusses his insights with the ABC’s David Taylor on The World Today program broadcast 13 February 2012. Read/Listen here.
Following on from our comment yesterday about BHP and comments in the media explaining why we weren’t buyers of BHP or RIO (falling Iron Ore prices and a contracted customer (28% of RIO’s revenue last year) who won’t honor contracts), we are interested in the flow of information through the week.
First the RBA held off cutting rates. Did they know that China would soon be exporting inflation (cost pressures there)? Then the next day China reported…guess what….the biggest jump in inflation…so forget about rate cuts there to help out US and Euro exports?
And now we are hearing that over at RIO a freeze has been placed on contractors and recruitment. Read; “massive overspend / cost inflation”.
Today Bloomberg quoted an analyst on China: “Domestic demand was genuinely weak in January, while exports remained on a gradual downward trend,” said Yao Wei, a Hong Kong-based economist for Societe Generale SA. And “Tom Albanese, chief executive officer of Rio Tinto Group, said yesterday he remains confident of a so-called soft landing in China… Inflation (CNCPIYOY) accelerated last month for the first time since July as food prices climbed before the holiday that started Jan. 22, a statistics bureau report showed yesterday. An index of export orders in the agency’s survey of manufacturing purchasing managers released last week showed a contraction for the fourth straight month. The IMF said in a Feb. 6 report that China’s economic expansion may be cut almost in half from its 8.2 percent estimate this year if Europe’s debt crisis worsens, a scenario that would warrant “significant” fiscal stimulus from the government.(See my postscript).
17/2/2012 PostScript: An analyst we regard highly wrote this to us today:
“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”
Here’s a quick view from Skaffold of RIO. To become a Skaffold member and enjoy having every stock in the Australian market quality rated and valued and all valuations and data automatically updated for every company every day CLICK HERE
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 10 February 2012.
It’s been a lackluster start to this year’s company confession session. Only a few companies have so far bucked the stable / downward trend in revenues and profits.
At the top of this list, reporting what I would consider to be quality results are CCP (SQR A2) – so far the clear standout and a business we own in the Montgomery Private Fund. This is followed by WEB (SQR A2) a business whose Total Transaction Value (TTV) is growing at rates 4x the industry average but is a little expensive in terms of its future prospects for now.
And that’s about it at the quality end of the investment spectrum (with the exception of Breville, Forge and Decmil’s updates). Remember that we rate every single listed company from A1 (the best) to C5 (the worst) so we follow them all. If you want to find opportunities such as CCP before everyone else, take a look at Skaffold.com
There have been a number of other businesses which have reported so far and on face value, while LGD (SQR B2) experienced strong revenue and profit growth; a large proportion of its growth was driven by several recent acquisitions. Organic growth is less than 50% of that being reported currently; something to watch in future reporting seasons.
Now to our friends long Telstra:
(SQR B3) the half year was a little sobering for those who have bought the stock for its dividend yield. Whilst reported Free Cash Flow was $1,795b and dividends paid amounted to $1,738b, one would assume the yield was fully covered. Not so. The free Cash number reported did not include $559m in interest repayments on almost $15b debt. $500m additional debt was borrowed to fund dividends and CAPEX – debt to equity thus increased and is currently 104%. While dividends are being paid, and will probably continue being paid, its just worth noting how they are being funded…
Over at the Big Australian – BHP:
Staying at the big end of town and global diversified mineral and petroleum producer BHP (SQR B1) reported a HY NPAT $9.9b NPAT down on last year’s. The lower results was despite very attractive Iron Ore, Bulks and Petroleum margins – prices which declined in the latter part of 2012 and which may impact profits further in the 2nd half. The acquisition of Petrohawk for $13b (which pushed gearing to 34%) contributed to earnings but couldnt arrest the decline. Industry-wide cost pressures with consumable, labour and contractor costs added $400m to cost inflation! On a more positive note, the project pipeline of $27b and $5b in actual committed projects. In the half total CAPEX (investment) projects + exploration spend was $9b – this continues to support EPC / EPCM engineers, drillers, mud suppliers (Decmil, Forge, Maca, Fleetwood et. al.) which are all operating at full capacity and expanding like there is no tomorrow. However for BHP investors, because the company continuously has to invest in greenfield projects to offset natural production decline, this results in a capital intensive investment program – something investors in BHP 20 years ago might be acutely aware of. Although they have long-life, world class assets and significant cash flows that are able to meet the demands currently, over the past three months profits have been downgraded from circa $25b to circa $19b. Indicative of an economic slowdown and slowing demand for resources. So something to be watchful of is the fact that declining profits = declining cashflows = declining future investment. Albeit the investment future and plans looks like its all boom time right now.
Posted by Russell Muldoon per Montgomery Investment Management, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.
This piece by Satyajit Das was just sent to us and we thought it worth sharing.
Why Europe’s Plan to End the Debt Crisis Can’t and Won’t Work
The most recent summit failed to reach even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions.
The actions need to try to stabilize the European debt crisis are well recognized. Countries like Greece need to restructure its debt to reduce the amount owed – a euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilized by injecting new capital and ensuring access to funding to avoid insolvency.
A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.
Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.
What’s Chinese for Begging Bowl
Another option proposed is to enhance the European Financial Stability Fund using resources from private and public financial institutions and investors through Special Purpose Vehicles (SPV). Few details are available currently.
The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the funds capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralized debt obligations (CDOs) and Structured Investment Vehicles (SIVs).
Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.
China has considerable “skin in this game.” Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.
The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. China’s officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.
China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.
But China seems desperate to be seen as a “global power.” Ego might seduce them into committing more money.
Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.
Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.
The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.
The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.
At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. These problems are far more difficult to fix than the task of finding buyers for the required amount of government debt.
Balancing Imbalances
The EU refuses to deal with fundamental problems. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem – the deflation of the debt-fuelled bubble.
The EU is seeking to enforce the rarely adhered to rules for membership of the euro, the Stability and Growth Pact requires a deficit no larger than 3% in any one year and a Debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.
Strict enforcement of this rule about deficits would prevent counter-cyclical spending by governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.
The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the euro makes dealing with this problem difficult.
For many of the weaker countries, the best option would be to devalue their currency in the same way that the U.S. and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.
An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.
German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker euro–an exchange rate of euro 1 = U.S. $ 2.00 would be a realistic exchange rate if the euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.
Endgame
In chess, endgames require using the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.
The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.
The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidize the weaker economies); debt monetization (the ECB prints money); or sovereign defaults.
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetization.
Unless restructuring of the euro, fiscal union and debt monetization is removed from the verboten list, sovereign defaults may be the only option available.
Regards,
Satyajit Das
And Ray Dalio’s piece will give you a terrific framework to help you understand what Satyajit is talking about, where we are, how we got here and where we are going…Click Here
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.
The ability to pick stocks that never go down, is NOT one of our skills. Plenty of you can attest to that. Value investing using the method we advocate in Value.able and using Skaffold.com cannot prevent losses, it is about minimising the cases of permanent impariment.
Asked by BRW’s Tony Featherstone which small caps we liked we nominated a few. Here’s the list and if you cannot read it properly or would like to also read about the TOP 10 Start Ups of 2011, grab this week’s copy of the BRW.
Remember to seek and take personal professional advice before engaging in any security transactions.
Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 9 February 2012.
Roger Montgomery thinks not, and discusses why in this article published in The Sydney Morning Herald on 7th February 2012. Read here.
Is limited competition placing pressure on interest rates and stifling the RBA’s monetary policy options? Roger Montgomery discusses his views with Ticky Fullerton on the ABC1’s Lateline Business on 7 February 2012. Watch here.
There has been a bit of action on the IPO front over the past few months. Sixteen stocks have been added to the main board of the ASX, as set out below with their actual listing date.
I thought it might be a worthwhile task to run the ruler over them and see if any are potential investment candidates among the newcomers.
Let’s start our exercise at the more speculative end of the investment spectrum. I don’t gamble with money, so let’s eliminate those that are involved in exploration activities given their high risk/high reward dynamics. There are 12 exploration businesses among this group. I will leave these to others who are more suitably qualified in working out whether any opportunities exist here and whether they will find something before their cash runs out.
Of those remaining, well-known NZ website Trade Me and RXP Services are involved broadly in the IT space, Alliance Aviation is involved in mining services and finally Chorus, another NZ company, specialises in Telecommunications. These are the four businesses we will focus on. A brief review of these follows.
Alliance Airlines (AQZ)
I will start with a sector I know well – airlines. A capital intensive industry with lots of competition rarely makes for wonderful business economics (Qantas, Virgin) and despite Alliance operating in a niche market of fly-in, fly-out operations for the mining sector, my view remains the same: I will never invest a dollar into this sector.
Alliance has grown quickly since its formation in late 2002. From nothing, to a fleet of 20 Fokker 100 and Fokker 70LR jets as well as five Fokker 50 turboprops with established, long-term, profitable blue-chip relationships with BHP Billiton, Santos, Incitec Pivot, and Newcrest. That’s an outstanding achievement by management. A distinguishing feature is that approximately 75% of Alliance’s 2010-11 revenue was subject to medium to long-term contracts – recurring revenues.
No matter. Any airline cannot escape competition or its high level of ongoing capital requirements. And for a niche space, four other competitors (Cobham, Network aviation, Qantaslink, Skywest) appear to be a handful in terms of the prices they can charge, competition for future contracts (especially when 44% of 2010-11 revenue was from one client, BHP), ongoing operating margins and future market share gains.
A total 47.6% of Alliance’s forecast for 2011-12 EBITDA will be consumed on refurbishments, maintenance, rotables, new aircraft and property, plant and equipment. This leaves just over 50% to pay taxes, interest and for working capital requirements. And once all is paid for, only a little will be left over for future dividends, buybacks, etc. It is not surprising, therefore, that the prospectus does not forecast a dividend to be paid in 2012.
Despite a pro-forma forecast of $18.1 million NPAT, or 20.1¢ earnings per share, and the shares trading below what the business may be worth, if you ever see me buying an airline, please put me in a straitjacket.
RXP Services (RXP)
Unfortunately, this business has a very, very short history and no real track record. It was formed in October 2010, just 15 months ago, with the purpose of establishing an information & communications technology (ICT) business with a focus on medium/large enterprises and the government.
The founders have done this, but with one drawback. Rather than building a business organically, the purpose of the float was mainly to raise funds to acquire two unlisted businesses in Vanguard and Indigo Pacific. The rollup of these has seen RXP service capabilities expand overnight from nothing into a broad range of management, business and ICT consulting, delivery and support services.
With a number of already listed ICT businesses already competing for market share – SMX, CSG, OKN, many of which have had a chequered operating history as listed entities – the space appears to be a little crowded. I can’t see how RXP will differentiate a commodity product offering.
And turning to its financials, despite the consolidated accounts in the prospectus showing how the businesses may have looked had Vanguard and Indigo been owned in the past, they weren’t; what we see is what would have been a profitable little businesses. But as we have little to go on as to how they will actually function together going forward under new stewardship, we will watch this one from the sidelines for now.
Chorus (CNU)
Chorus is a spin-out from Telecom New Zealand. It is New Zealand’s largest telecommunications utility company, a technical way to describe a business that builds, maintains and repairs existing phone and broadband lines.
Following the demerger, Chorus is a business whose sole focus is on bringing fibre within reach to as many New Zealanders as possible – kind of like our own NBN Co., but not run by the government, even if it has been chosen by the Crown to build NZ’s ultra-fast broadband (UFB) network to 830,000 urban premises, as well as extend fibre further into rural New Zealand through the Rural Broadband Initiative (RBI) by the end of 2019.
Having so far deployed some 2500 kilometres of fibre optic cable, upgraded hundreds of local telephone exchanges with new broadband equipment and installed or upgraded about 3600 roadside cabinets, a target of 20,000 kilometres of fibre optic cable to deliver ultra-fast broadband will probably be met. Management’s recent experience in rolling-out ADSL2+ broadband is coming in very handy and helping to build New Zealand’s fibre future.
There are some obvious tailwinds here, with the long-term nature of this contract and ratings agency Moody’s has assigned Chorus a Baa2, stable issuer and senior unsecured rating. A rating similar to Bulgaria and Kraft foods.
Look under the hood, however, and you can see that about $NZ1.7 billion of net interest bearing debt was outstanding as at December 2011, all current. On just $NZ422 million of equity, it appears that Telecom New Zealand may have also let go of some unwanted baggage in the de-merger.
While 2011 cash flows appear to be well managed and interest payments well covered, I can’t help but be reminded of another infrastructure asset in Asiano when it was demerged from Toll holdings in 2007. It too was saddled with a large debt burden and at the end of its first trading day; Asciano had a market capitalisation of $7 billion. Today it is $4.5 billion.
Trade Me (TME)
Last but not least is the well-known NZ website Trade Me. Similar to eBay international, Trade Me is now dual-listed on both the New Zealand and Australian Stock Exchange.
While this is another spin-off, Fairfax Media Limited (ASX:FFX, SQR B3) has retained a shareholding of 66% – generally a good sign.
On one reading this might be the pick of the recent floats. The business has an moderately geared balance sheet, produces a significant amount of free cash with low levels of ongoing capital expenditure now that the website is mature and has a history of earnings growth which any shareholder, and that includes Fairfax, would be truly happy with. On top of this, with Fairfax retaining a material level of ownership in the business, they are still highly incentivised to continue promoting the website via its vast media network.
On another reading Fairfax paid $750mill for Trade Me (TME) and have just sold 34% of it for $363.5 mill or a total ‘value’ of $1.07Bln. This will help them justify the carrying value on their own balance sheet. Further, since 2007 TradeMe has made net profits totalling $276mill, the bulk of which has been taken out as dividends. So FFX have made an IRR of about 17% per annum. Given FFX have set up the company with market cap of about $1 billion, equity of $631 mill ($721 mill goodwill and therefore negative NTA) and debt of $164 mill, the expected return on equity is just over 10 per cent means FFX have got a return that you might not.
Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.
