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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Millions of tonnes of waste are created every year. Surely that’s an opportunity? Read Roger’s article at www.eurekareport.com.au.
More than 900 companies reported their results over the past 3 weeks and having reviewed the bulk of them, some still remain. I should have completed digging through the reporting season avalanche within the next week or two. You will have to bear with me for a little while longer.
Rest assured that the companies that are amazing and who deserve a place in the ‘investment universe’ have been prioritised and covered first. While some of the businesses left to cover may make it in, overall I expect that I have broken the back of reporting season and already uncovered in the main those worth focusing on.
So since my last update you may be wondering what has transpired.
Firstly, Information Technology and Mining/Oil & Gas Services sectors have continued to stand out, with a number of additional companies receiving high MQRs (“Montgomery Quality Ratings”). To this we can add businesses that I generally classify as ‘financial services’, for example funds management.
Secondly, there are a number of new entrants into my A1 list this week – 19 in total. This is in addition to the 11 uncovered in my previous posts – Part I and Part II. My A1’s now total 30.
To get to the magic number of 19 for this week there are 15 outright new inclusions, four that continued to hold the rating from last year and eight businesses that experienced a MQR decline. That’s a net increase of 11 businesses with MQRs of A1.
Of the eight businesses that received lower MQRs, all due to specific business issues, Servcorp (SRV) Limited saw the largest decline, followed closely by Worley Parsons (WOR) and Southern Cross Electrical (SXE).
Worley Parsons experienced a number of project delays and deferrals. In particular, services in the Canadian oil sands and minerals & metals sectors, coupled with a material downturn in the United States power markets appear to be the main issues. Also, with a large segment of the business’s operations being conducted in foreign currencies, the continued strength of the Australian Dollar impacted the translation of profits to the tune of $41 million. All these factors had a significant impact on profitability and performance. While Worley remains a very high quality company, the business’s performance slipped.
Southern Cross Electrical was also impacted by delays and project deferrals. In this case the uncertainty around the proposed Resources Super Profit Tax (RSPT) and operational issues following the resignation of the Managing Director appears to have impacted on the frequency of tendering activity and subsequently, the awarding of new projects. All of this – because of the operating leverage inherent in the business – reduced SXE’s margins and profitability.
Servcorp experienced the largest performance decline, falling from 1 to 4 (5 is the lowest). This was mostly due to the $80 million capital raising in October last year, in order to aggressively expand the business. Only time will tell if new management are able to get the business back to its former A1 status. New, wiz-bang ads alone won’t do it, although they may help.
Now don’t go panicking about these companies or their downgraded status. It’s not as though they are C5s! A2 and A3 can be regarded as investment grade (with a smaller allocation), although I would adopt a wait-and-see policy with an A4.
The second table reveals the 19 additional A1s.
If you look to the bottom right of this table you can see the average ROE reported by my A1 list of businesses is an impressive 40.40% – significantly higher than the All Ords average ROE of 9.54%.
Also impressive is the average gearing level of my A1’s at -36.25%. The negative number means that many of the businesses are debt free and have plenty of cash. If you read my McMillan Shakespeare post, you should now see why I avoid businesses that are geared; there is a ready supply of other quality players to look at that aren’t laden with debt.
At this point you may have already noticed that I have blacked out 3 of the 19 A1’s for this week. There is a good reason for that. I am currently researching a number of businesses to see if an investment opportunity is available at current prices.
I will reveal them at a later date along with whether or not I have decided to buy the shares. I have however left you with some important information – their respective ROE and net-debt to equity levels. Note they all have impressive returns on equity and net cash. If you dig hard enough, you may be able to find them before I reveal them.
Posted by Roger Montgomery, 7 September 2010.
Sky Business Reporter Brooke Corte speaks to Roger Montgomery about his new stock market guide book for value investing and online trading, Value.able: How to value the best stocks and buy them for less than they’re worth. Watch the interview.
A review of Value.able by David Press. Read review.
Roger Montgomery’s Value.able will reinvent the way you invest. He reveals his principles for long-term stock market investing in the latest issue of Money magazine. Read article.
Roger Montgomery reveals in his monthly Money magazine column, Value.able stocks, that he now has reservations about JB Hi-Fi. Read article.
Roger Montgomery shares how he buys Value.able stocks for less in the Chartered Accountants Monthly Audio Program. Listen to Podcast.
The retail giant is doubling the size of its share buyback, which should bolster confident in its ability to keep delivering solid returns to shareholders. Don’t believe the hype. Woolworths is well placed to continue delivering solid returns. Read Roger’s article at www.eurekareport.com.au.
The final reporting season avalanche has coincided with a serious amount of snow in the high plains. No matter where one turns, there’s no escaping heavy falls. More than 300 companies have reported in five days and I am completely snowed under. If you haven’t yet received my reply to your email, now you understand why.
To put my week into perspective, up until last Monday morning, around 200 companies had reported (see my Part I and Part II reporting season posts). This week’s 300-company avalanche brought the total to 500. I’m sorry to report that without a snowplough, I have fallen behind somewhat. Around 200 are left in my in-tray to dig through. I will get to them!
Thankfully, there are only a few days left in the window provided by ASX listing Rule 4.3B in which companies with a June 30 balance date must report, and by this afternoon, I will be able to appreciate the backlog I have to work through. So not long to go now…
Nonetheless, today I would like to talk about two companies which I am sure many of you are interested in: BHP and Woolworths. Both received the ‘Montgomery’ B1 quality score this year.
For the full year, BHP reported a net profit of around A$14b and a 27% ROE – a big jump on last years $7b result, which was impacted by material write-offs. Backing out the write-offs, last years A$16b profit and ROE of 36% was a better result than this years. The fall in the business’s profitability has likewise seen my 2010 valuation fall from $34-$38 to around $26-$30 per share, or a total value of $145b to $167b (5.57 billion shares on issue).
With the shares trading in a range of $35.58 to $44.93 ($198b to $250b) for the entire 52 weeks, it appears that the market and analysts expected much better things. While they didn’t come this year, are they just around the corner? I will let you be the judge.
The “market” (don’t ask who THAT is!) estimates resource company per share earnings growth of 50 per cent for 2011. I have drawn a thick blue line to show this on the left hand side of the following graph so you can see where my line intersects.
BHP has a large weighting in the resources sector, so the forecast increase in net earnings by 57 per cent to A$22b is having a material impact on the sector average. Importantly, the forecast growth rate is similar to those seen in 2005 and 2006 when the global economy was partying like there was no GFC. Call me conservative, but I reckon those estimates are a little optimistic in todays environment.
As you know I leave the forecasting of the economy and arguably puerile understandings of cause-and-effect relationships to those whose ability is far exceeded by their hubris. Its worth instead thinking about what BHP has itself stated; “BHP Billiton remains cautious on the short-term outlook for the global economy”.
Given my conservative nature when it comes to resource companies and the numerous unknowns you have to factor in, I would be inclined to be more conservative with my assumptions when undertaking valuations for resource companies. If you take on blind faith a A$22b profit, BHP’s shares are worth AUD $45-$50 each.
But before you take this number as a given, note the red circle in the above chart. Earnings per share growth rates are already in the process of being revised down. I would expect further revisions to come. And if my ‘friends-in-high-places’ are right, it’s not out of the realm of possibilities to see iron ore prices fall 50 per cent in short order. You be the judge as to how conservative you make your assumptions.
A far simpler business to analyse is Woolworths and for a detailed analysis see my ValueLine column in tonight’s Eureka Report. WOW reported another great result with a return on shareholders’ funds of 28% (NPAT of just over $2.0b) only slightly down from 29% ($1.8b) last year. This was achieved on an additional $760m in shareholders’ funds or a return on incremental capital of 26% – and that’s just the first years use of those funds. This is an amazing business given its size.
My intrinsic value rose six per cent from $23.71 in 2009 to $25.07 in 2010. Add the dividend per share of $1.15 and shareholders experienced a respectable total return.
Without the benefit of the $700 million buyback earnings are forecast by the company to rise 8-11 per cent. However, the buyback will increase earnings per share and return on equity, but decrease equity. The net effect is a solid rise in intrinsic value. Instead of circa $26 for 2011, the intrinsic value rises to more than $28.
But it’s not the price of the buyback that I will focus on as that will have no effect on the return on equity and a smaller-than-you-think effect on intrinsic value (thanks to the fact that only around 26 million shares will be repurchased and cancelled). What I am interested in is how the buyback will be funded. You see WOW now need to find an additional $700m to undertake this capital management initiative. So where will the proceeds come from? That sort of money isn’t just lying around. The cash flow statement is our friend here.
In 2010 Operating Cash Flow was $2,759.9 of which $1,817.7m was spent on/invested in capital expenditure, resulting in around $900m or 45% of reported profits being free cash flow – a similar level to last year. A pretty impressive number in size, but a number that also highlights how capital intensive owning and running a supermarket chain can be.
From this $900m in surplus cash, management are free to go out and reinvest into other activities including acquisitions, paying dividends, buybacks and the like. So if dividends are maintained at $1.1-$1.2b (net after taking into account the DRP), that means the business does not have enough internally generated funds to undertake the buyback. They are already about $200-$300m short with their current activities. In 2010 WOW had to borrow $500m to make acquisitions, pay dividends and fund the current buyback.
Source: WOW 2010 Annual Report
Clearly the buyback cannot be funded internally, so external sources of capital will be required. In the case of the recently announced buyback it appears the entire $700m buyback will need to be financed via long-term debt issued into both domestic and international debt capital markets, which management have stated will occur in the coming months. They also have a bank balance of $713m, but this has not been earmarked for this purpose.
Currently WOW has a net debt-equity ratio of 37.4 per cent so assuming the buyback is fully funded with external debt, the 2011 full year might see total net gearing rise to $4.250b on equity of $8,170b = 52 per cent.
A debt-funded buyback will be even more positive for intrinsic value than I have already stated, but of course the risk is increased.
While 52 per cent is not an exuberant level of financial leverage given the quality of the business’s cash flows, I do wonder why Mr Luscombe and Co don’t suspend the dividend to fund the buyback rather than leverage up the company with more debt? This is particularly true if they believe the market is underpricing their shares.
Yes, it’s a radical departure from standard form.
I will leave you with that question and I will be back later in the week with a new list of A1 and A2 businesses. Look out for Part Three.
Posted by Roger Montgomery, 31 August 2010.
It is not unusual for me to seem contrarian in my thoughts about stocks. And it is often the case that I am fond of companies out of favour at least temporarily. As prices rise I become less enthused rather than more so. Quite simply, the higher the price, the lower the return.
The last time I commented about McMillan Shakespeare was 27 May this year (MMS: $2.64). It was then that I stated that if that nothing came out of the Ken Henry Tax Review that permanently impacted MMS’ profitability, the shares were worth $6.01 – you can find me making those comments here.
With the benefit of hindsight, we now know that the legislative concerns surrounding the business failed to eventuate (well not yet – they await the next Government), and the shares have traded as high as $6.45 since.
But since MMS has released its annual results, you may be wondering if and how my thoughts have changed since May. Please keep in mind, as I have said many times before, I am under no obligation to continue analysing a business or updating my comments.
If you watch the interview above, clearly I was happy with the quality of MMS and its valuation being materially above its price. Indeed it was one of my A1’s at the time – so let me fill in the gaps.
As you would be well aware from Value.able, you should not focus on the share price but on the business itself. It’s a simple truth that if the underlying business does well then the share price tends to look after itself. While I am impressed about the price currently trading close to my valuation, am I still happy with MMS as an investment candidate? In short, no.
Things can change pretty quickly in business. One minute you are staring down the barrel of a major financial review with the threat of having half of your business taken away over night, and the next you are on the front foot and announcing a major acquisition. It’s the latter than concerns me.
Three days after my TV interview, MMS management announced the acquisition of Interleasing (Australia) Limited (ILA) in a 34 page information memorandum and 9 days later completed the purchase.
In that IM was a detailed breakdown of the purchase. I had suspected for a long time that management where keenly looking for an acquisition given it was producing so much free cash flow.
Up until this point, MMS had been an A1 every year since 2006. Given my stringent A1 rules, to achieve this rating four years in a row is an excellent achievement by founder Anthony Podesta. But with new management come new ideas, and this time the idea was to take a debt free business and fund the ILA acquisition with $25m of existing cash, $41.3m from the sale of ILA’s novated lease receivables and debt totalling $141.7m. A total purchase price (not value) of $208m.
The impact can be seen on the business’s balance sheet;
Source: MMS 2010 Annual Report
If you tally the circles labelled “1” you will discover that the business now has net debt (total debt less cash and bank balances) of $125.156m. If you then look at the final line of the balance sheet “equity” which stands at $89,417 we can calculate that MMS (which was completely debt free last year) now has a gearing level of 139.97%. This in anyone’s book is a high level of gearing and a material change on the conservative financials in prior years.
If we now look at the circles labelled ‘2”, you will note that the business’s current liabilities (items which generally require repayment within the next 12 months) exceed by more than double the level of current assets (the liquid assets available to meet obligations due within the next 12 months).
In analyst speak; a current ratio of just 0.4972 is generally poor. In contrast the ratio last year was a healthy 1.9694.
While the uplift in earnings per share has been a boon for shareholders, as you can see, there has been a huge price to pay. In summary, the quality of the business has fallen from what I considered to be an A1 business to a B3.
Many will argue that MMS generates huge cashflows and that it still produces excellent (albeit highly geared) returns on equity and it should therefore have no concerns in meeting its interest expenses and maintaining its current capital structure for the foreseeable future. While this is all true, I always prefer to reduce risk in my portfolio by owning extraordinary businesses.
My investment process prevents me from investing in anything but the highest quality companies; one of the characteristics that I look for is little or no debt.
Also, when management start saying “key requirements of this funding” are that our “dividend payout ratio not to exceed 65%”, “interest and debt cover covenants” I have to wonder; are management controlling the business or is the bank?
Posted by Roger Montgomery, 26 August 2010.
