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Pretty soon, the QR National prospectus will hit your mailboxes. Its the biggest float since Telstra’s 2006 offering and the second largest in Australia’s history, so the PR companies and the communication consultants will be out in force doing their job for the vendors. But who will represent the buyers? We will! Value.able Graduates, sharpen your pencils! If you have any thoughts to share right now, go ahead. We already have received a number of comments:

Lloyd says:

“Your summary of the pending QR National IPO at the start of Your Money Your Call and the parallel discussion in the Eureka Report are on target, with one exception, that of Business Leadership which is the dead elephant in the room that no one seems willing to discuss. So I’ll raise the topic here. Management at QR National are some of the same people that arguably ran BHP onto the rocks in 1998. The problem that led to the disaster was that of the arrogant culture of the “Big Australian”. The culture led to massive errors in capital allocation in a capital intensive industry with disastrous consequences for shareholders that continued for a long time. Fast forward to the QR National IPO advertising campaign. Notice the parallels in the advertising for the for the float with the “Big Australian” ethos of the nineties? And QR National is a very capital intensive business with massive structural and business cultural deficiencies that are the result of its existence to date as a Government owned sheltered workshop.  The leadership ethos appears to be such that the “planets are aligned” for shareholder value destruction on yet another grand scale. Regards, Lloyd”

Lloyd’s observation that some people who ran “the big Australian” during arguably, its dark days, are those involved now with the campaign to “be involved in something BIG” at QR National is well worth thinking about and speaking to your advisor about before subscribing.

At a dinner party on the weekend the subject of QR National came up and what is interesting is that the campaign is leveraging the well-known ‘China-needs-our-coal’ theme. But outside of the financial markets sentiment towards coal is not inspiring. Many retail investors believe coal is dirty, the cause of global warming and on its way out. CEO Lance Hockridge has previously rejected invitations to discuss climate change and as Paddy Manning of The Sydney Morning Herald noted on Saturday: “In 2007 a NASA climate scientist, James Hansen, likened coal trains to ”death trains – no less gruesome than if they were boxcars headed to crematoria, loaded with uncountable irreplaceable species’‘.

While diesel trains may be better for the environment than trucks, the 200 million tonnes of coal QR National carries per annum (2/3rds of the nations export volume) is not. Perhaps the retail component of the offering may not be as easy as previously expected. Paddy Manning again:

“Last week Professor Ross Garnaut, author of Australia’s 2008 Climate Change Review, told ABC Radio he thought world coal demand would peak before 2020 unless carbon capture and storage (CCS) – or some other use for massive carbon dioxide emissions – succeeds.

Garnaut is not pessimistic about CCS being commercially viable at scale in the right locations. But the Chinese want their demand for coal to peak before 2020, and while he admits that’s ”not a certainty”, Garnaut thinks there are ”reasonable prospects of China achieving objectives along these lines”.

”China over recent years and in the years immediately ahead represents a large majority of the global growth in coal use, and with other developed countries seeking to reduce total emissions absolutely by substantial amounts, such a change in trajectory in China would be likely to be associated with a peaking over the next decade in global coal use.”

Investors want a growth story. If the idea gets about that coal demand might peak within a decade, it could seriously weaken demand for QR shares.”

On the other hand, it is noted by many that Australian coal tends to produce lower emissions per unit of energy and steel production in the case of coking coal (our coal is a higher quality). With climate change on the agenda, demand for Australian coal could increase even when coal demand globally is falling.

The marketing machine has its work cut out but if hype can get even the biggest floats over the line, our job here will be to cut through it and answer a simple question.

Should you invest in QR National long term?

Lets get the conversation going with a couple of simple bullet points:

1. 1. Strongly supportive themes; privatisation, commodity demand, and a monopoly (monopolies are great businesses to own and QR National owns 2300kms of track on which it will deliver 160 million tonnes of coal annually)
2. 2. ABARE says coal volumes will rise more than 9% next year
3. 3. Chinese demand to peak before 2020
4. 4. Private interests have already tried to buy the below rail assets for $4.85 billion and the above rail assets for $2 billion
5. 5. 2011-2012 EBITDA forecast by float promoters of $1.1 billion (never ask the barber whether you need a haircut)
6. 6. EBITDA for a capital intensive business is NOT what the investor owns! The company will have plenty of interest to pay on $2 billion of debt then, lots of equipment to maintain and replace and a not shortage of tax
7. 7. Capital intensive business
8. 8. Low return on equity forecast for 2012 – after a two year turnaround program
9. 9. Moving from government ownership to private ownership should make the company more efficient
10. 10. Old contracts signed on uncommercial terms will roll off and new contracts will immediately boost revenue and profits (some newspapers suggest 22% increase in profits to $1.1 billion)
11. 11. Tens of thousands of job cuts have already been made – perhaps the low hanging ‘cost cutting’ fruit has already been picked?
12. 12. Chinese demand for coal will always be strong?
13. 13. Coal prices will always be high?
14. 14. Unions campaigning against the sale of state assets note that Telstra and Brisconnections were bad floats for investors

Brokers have estimated an enterprise value of between six and a half and nine and half billion dollars. I am not sure however what debt figures they have used (whether it is the $500 million QR National will start with or the $2 billion its expected to draw down in the next couple of years). Assuming $500 million, the promoters therefore may be reckoning on a market cap of around $7 billion. Of course never ask a barber whether you need a haircut!

QR National expects to boost pre-tax profits from $204 million to $427 million this financial year, and by 35 per cent to $578 million in 2011-12. But this could at least partly be attributable to a reduction in interest from the repayment of loans. In any case, investors own post tax profits which would reasonably be estimated to be about $390 million – a 5.5% return on contributed equity?

You should ignore the comparisons of P/E that will inevitably be seen. Comparing the P/E of QR National to, for example, Asciano, may be as useful as comparing the P/E of Myer to the P/E of David Jones at the time of the float – both fell precipitously after the money was in the vendor’s pockets.

Another thing to be careful of looking at are the stats available on other large Australian Commonwealth privatisations. Bank West, CSL, CBA, GIO, SGIO, Tabcorp and Unitab were all outstandingly successful examples, generating double digit returns annually for investors and Bank West GIO, SGIO, NSW TAB and Unitab were all taken over. But Qants and Telstra have been duds and the annual return from NSW TAB was not so crash hot, despite its takeover. The message is that yes, there are profts to be made from privatisations but only from those where economic value has been added.

The prospectus for QR National will invariably focus on growth – growth in revenues, growth in profits, improvements in efficiencies.

The price to pay however will be determined by the equity and the return that equity can generate. That is something we’ll focus on here.

For now we all await your thoughts. When the prospectus is released we’ll have a good look.

In the meantime, please contribute your thoughts, valuation estimates and any other insights you have.

If you are considering an investment in QR National, be sure to seek and take personal professional advice and you can come here for insights that will generate the questions to ask your adviser.

Posted by Roger Montgomery, 27 September 2010.

UPDATE – The Sydney Morning Herald (Passengers sought for latest float) and The Sunday Age (Board QR National float with caution) have published my insights in the past week.

by Roger Montgomery Posted in Companies, Investing Education.

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While everyone else seems to have moved on from reporting season, I’m still digging my way through a mountain of analysis. I am almost done.

Based on the amount of comments contributed here at my blog it seems you have enjoyed reading my insights as much as I have enjoyed sharing them.

Before I get into what I have uncovered from last week’s filings, congratulations are in order. Gavin was the first Value.able Graduate to correctly pick the three companies I omitted from Part III’s second table – congratulations Gavin. Gavin picked all three despite there being thousands of companies listed on the ASX and only having six pieces of financial data. Amazing!

Congratulations are also in order to Mike and Pat, who picked all three. Great digging fellow Value.able Graduates!

The missing companies are ARB Corporation (ARP), Wotif.com (WTF) and Mineral Resources (MIN).

As always, please undertake your own research and seek and take personal professional advice before you go rush out and buy anything.

I also wanted to say a big thank you to all who have posted comments. Our Value.able investing community has benefited greatly from your contributions and insights and I am excited by the great sense of community that you have developed. I must say a special thank you to our regular contributors – the quality of your comments are amazing, and more importantly, respectful and non-judgmental. Keep them coming!

If you haven’t yet posted a comment, now is a great time to start. The Value.able community is here to share ideas and help each other. If something is on your mind, I guarantee there is someone else with a similar question. So please contribute as much as you can or ask as many questions that you may have.

Now onto my lists – despite all my digging, there is only one new entrant into my A1 Montgomery Quality Rating this week. With three companies experiencing rating declines, on a net basis we actually lost two A1s. You can see them below.

Dominion Mining (DOM) had the largest rating decline, from an A1 to an A3. It still displays high quality metrics – with $16m in cash on the balance sheet and no debt (just watch out for those capitalised exploration expenditures), but my Montgomery Quality Rating declined. Why?

As you know, I tend to shy away from commodity businesses. It is not that they are difficult to understand, but rather difficult to forecast with a great deal of confidence – forecasting how much they will produce and when, their cost of production and/or project establishment and development costs and then ultimately, what price they will get for their production. There are simply too many variables that management can get wrong and many that are completely out of their control.

To this point I proffer Dominion (ASX: DOM), which in the most recent financial year, despite a higher average gold price, saw production slip from 98,755 ounces to 80,570 and cash production costs blow out from $438 to $697 per ounce. The combination of lower production and lower efficiencies transformed a highly profitable business into a barely profitable one in the space of 12 months. Now that’s operating leverage!

Indeed if you took all of the hitherto-labelled ‘resource evaluation and mine development expenditure’ expenses straight to the Profit and Loss account as opposed to the Balance Sheet, DOM would have made a loss of several million.

Given the many variables and accounting flexibility, if exposure to this sector is your goal, perhaps your focus could move from those who ‘look for’ and ‘produce’ to those who ‘service’ – the suppliers of the picks and shovels and those engineering businesses that install, maintain and replace all the picks and shovels. In my opinion, there are fewer variables and the economics haven’t changed since the days in 1851 when a gold rush in Ballarat saw 10,000,000 grams of gold delivered to Melbourne’s Treasury.

Back to my A1’s… the only entrant this week is Centrebet International (CIL). Remember that this is in addition to the 30 revealed so far in my previous posts – Part I, Part II and Part III. My A1’s now total 31.

CIL is in the business of online wagering and gaming and appears to have carved out a niche in Australia’s multi-billion dollar gambling market.

Take a look below and you will also see those companies that have achieved an A2 Montgomery Quality Rating since my previous blog post. The average ROE of this group is an impressive 23.39% (albeit around half that of my A1’s) with an average gearing level of -36.05%. There are plenty of Balance Sheets here reflecting a net cash position.

Combine my A1s and A2s (78 in total) published in the past couple of weeks and you have an excellent starting point from which to begin your own digging (by doing your own research and seeking independent personal and professional advice).

I will also mention that I may own any of the above companies and that I may buy or sell at any time – even tomorrow, and I am under no obligation to keep the list up to date in any way, shape or form. Before you do anything, YOU MUST conduct your own research and I insist you obtain independent personal and professional advice considering your needs and circumstances.

Value.able gives you the simple steps to follow to estimate a value for each company yourself and some thoughts to consider in regards to qualitative factors, such as competitive advantage. If you are not already a Value.able Graduate, why not?

Also remember that the share price may halve tomorrow. DO NOT buy shares in any company simply because I like it or own it – that is not investing, that is speculation. Speculating that I am right is not investing. That is the exact opposite of the value investing doctrine I espouse.

Reporting season will soon be a distant memory and the media, analysts and ‘investors’ will start to think about other things… the economies of the US, China and Europe will start to tickle the minds of idle analysts and commentators, but your focus should remain on great quality companies trading at very big discounts to intrinsic value.

Posted by Roger Montgomery, 15 September 2010.

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I met with Justine and Dickie, the CFO and COO of Decmil recently, and got a good understanding of how cash flows through the business.

I am comfortable that the disastrous acquisition track record of the past is now just that; past. The board now appears stable, culture within the business appears to be excellent and if Justine and Dickie’s enthusiasm is anything to go by, their reputation, which has taken 31 years to build, will see them continue to secure projects from blue chip clients (don’t ask me what ‘blue chip’ means).

There are of course macro risks in supplying picks and shovels. The GFC for example didn’t dent BHP and RIO’s aspirations, but it did dent the banks’ willingness to lend on new projects. A macro shock could thwart the capex plans of many resource companies and this would inevitably impact Decmil and its peers. Operating leverage however is not as high as you may think and I invite you to investigate.

So go forth and conduct your own research and as always, seek professional financial advice. You can also use the steps in Value.able to calculate the value of Decmil yourself.

Posted by Roger Montgomery, 14 September 2010.

by Roger Montgomery Posted in Companies, Energy / Resources.

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That’s what Peter Switzer asked me on Wednesday night on the Sky Business Channel. My response? I focus on A1 businesses that I need to focus on the least (just twice a year when half and full year results are released). As for the stocks… you’ll have to watch the interview.

Switzer TV with Peter Switzer was broadcast on 8 September 2010 on the Sky Business Channel.

 Click here to watch other interviews at my YouTube Channel.

Posted by Roger Montgomery, 10 September 2010

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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.

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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.

What do you think?

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.

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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.

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The second full week of reporting season has just been and gone and saw another 80-100 companies report their financial results. More than 200 have reported and yes I am working feverishly to keep up and cover them all. I am happy to report that I’m ready for another week.

So far the results have been mixed. Information Technology, Banking and Mining/Oil & Gas Services sectors have stood-out, receiving high Montgomery Quality Ratings. The remainder have been distributed somewhat randomly amongst the other sectors.

And having analysed all of them so far, I can reveal that only 11 (5.5%) of the 200 have achieved my coveted A1 status (an additional six on top of the five from my previous post). These businesses have all passed my rigorous stress tests and come up trumps.

You may be surprised that after another full week and 80-100 individual results, only six additional companies have made it. But my A1 rating system has been specifically formulated to yield only the best and it is performing its function very well.

Of the six companies, three held onto their A1 status. These are Carsales.com.au (CRZ), Forge Group (FGE) and Monadelphous (MND) which have been joined by 3 new entrants in DWS Advanced Business Solutions (DWS), Finbar Group Limited (FRI) and SMS Management and technology (SMX).

Unfortunately, on a net basis we lost one A1 this year with four other businesses experiencing ratings declines from A1. These businesses include CSL limited (CSL), Consolidated Media Holdings (CMJ), Integrated Research (IRI) and McMillan Shakespeare (MMS). While CSL and CMJ have both declined to A2 status – nothing to be sneezed at, IRI and MMS have had larger rating declines.

Most notably, MMS has declined materially in terms of quality as I predicted it might after its acquisition, and it is now a ‘B3’. The mostly debt-funded acquisition of Interleasing (Australia) is the cause of this fall which I will cover in a separate post.

There are also another 20 A2 businesses that have passed my stress tests and rate in the top 15 per cent of the market in terms of overall quality.

Don’t forget to combine these lists with the A1 and A2 businesses I highlighted last week to continue identifying the best of the rest and stay tuned, I will post my intrinsic valuations for all 11 A1 businesses soon.

Finally, an update on my Telstra valuation. Last week I said that my valuation following the annual result was $2.50. I have updated my numbers and now get $2.30.

I sincerely hope that my Telstra comments have served your research well and that you have not been caught by all of the “it’s high yield and therefore a cheap stock” talk.

While others may have been tempted to buy shares for ‘yield’, you can use Value.able to first discover the intrinsic value. To save you a little time, Telstra’s valuation has declined since it listed. Even in the past year intrinsic value has fallen from $3.00 to $2.30! And the share price has fallen from $3.55 to the current $2.77.

In reality this is a widely reported and closely tracked company and its weighting in the index ensures a level of support from the large, conventional, index-based and tracking-error-focused funds. Indeed this is one of the reasons it has taken so long for Benjamin Graham’s weighing machine to catch up to the valuation – ten years! An improvement in the clarity for Telstra (forgetting whether its profitable for the business) could be enough to result in substantial price rises. Of course as a disciplined value investor focused on only the highest quality business, I cannot let that speculation tempt me.

Read Part I.

Posted by Roger Montgomery, 24 August 2010.

by Roger Montgomery Posted in Companies, Investing Education, Value.able.

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We are now two weeks into one of the most important times of the year for investors – reporting season. Eighty companies have reported to date, some good, some not so good – I know this because I track every single one. Yes, I am very busy. Are you wondering which companies are my A1’s now and which stocks I am interested in? In the last two weeks you will have heard me on TV saying I have bought a few things. Well, I don’t buy C5s so read on.

TLS was a clear disappointment, as it has been since it listed. I have been on the front foot for a long time saying that this is a company to avoid, I hope you took notice. My valuation has fallen now from $3.00 to almost $2.50. If anyone can turn it around however I think Thodey can.

Qantas should have come as no surprise. A $300 million cash loss and I wouldn’t be surprised to see another raising of capital or debt.

Personally though I am not interested at all in TLS or QAN as investment candidates. I am only interested in the highest quality best performing businesses available – it’s here that intrinsic value can be created rather than destroyed and with reporting season just about to kick into top gear from this week, to find them, I put each company through the same rigorous process.

My initial screening process is a vital part of the investment process as it allows me to determine those companies that deserve to retain their place in the short list and it also highlights new opportunities as they arise. But to do this for some 2,000 listed Australian companies can be a very burdensome task unless you have a systematic way of analysing and comparing results in a consistent manner.

For me, it involves pulling out some 50-70 profit and loss, balance sheet and cash flow data fields from each annual report to populate my five models. All of these models employ industry specific metrics to calculate my quality and performance scores. This allows me to rank all companies from A1 – C5 to sort the wheat from the chaff.

For those not familiar with my ranking system, A1s are the simply the best businesses and the safest to own, while C5s are the poorest performers and the least safe.

Out of the 80 companies that have reported, only 5 have achieved my coveted A1 status – around 6.25% (the best of the rest).

NVT, JBH and COH had my A1 rating last year and retained it this year and there are 2 new entrants in MCE and RHD, with GCL (it was an A1 last year) having a dramatic rating decline. I tend to shy away from resource companies for obvious reasons.

On my blog I have previously spoken about NVT, JBH and COH and also mentioned ITX, so please revisit those thoughts. itX is under takeover and Navitas, it was recently reported, had been approached some time ago by Kaplan – a company I have done some consulting work for and a subsidiary of Warren Buffett’s Washington Post company – so a big tick for the A1 to C5 Rating system!

That only leaves MCE, an engineering business that currently generates most of its returns from the manufacture of riser buoyancy modules for deep-sea oil rigs. Its order book is already underwriting a doubling of revenue for 2011. The 2010 result revealed profits had almost tripled and significantly exceeded prospectus forecasts and it is producing returns on equity of 49% – a rate that is unavailable generally elsewhere. Borrowings amount to about $8 million compared to equity of about $60 million (of which a little over 10% is capitalised development and goodwill intangibles).  Best of all, the share price over the last week is a long way below my estimate of its intrinsic value.

If you have seen me on TV or heard me on radio in the last week or so you would have heard me mention that I had bought something, MCE is it. Please be mindful that if you act rashly and go and push the share price up, you will be helping me perhaps more than yourself. Also remember that I am not recommending the stock to you and that I cannot forecast the share price direction (although I am pleased with its performance since my purchase). The share price, I warn you, could halve, for example if there is a recession and or the oil price plunges – delaying expenditure of the construction of oil rigs globally. I simply am not recommending it to you.

Also remember that I am under no obligation to keep you informed of when I buy or sell nor answer any specific questions, which means 1) you have to do your own research and 2) you have to be responsible for your own decisions. Seek and take personal professional advice BEFORE you do anything.

Moving on, another 13 companies have achieved my second highest rating of A2. They are listed below with their prior years rating so you can compare.

Noteworthy in this list is the excellent performance of the Commonwealth Bank (which I continue to hold in my Eureka Report Value Line portfolio, along with JBH and COH) and those companies I generally classify as being in the Information Technology sector including OKN, ITX, CPU and ASW. Both sectors appear to be doing well in aggregate.

While focus should always be placed on the A1’s (the top 5-7% of the market) at any one point in time, A2’s are still very high quality businesses. The use of the two lists in tandem will therefore provide you with an excellent starting point in isolating those who have reported high quality financials and performance levels above the average business. An important first step in the Value.able Montgomery brand of investing.

It is from here that I will select candidates worthy of further analysis (qualitative and quantitative) and possibly meet with company management, if I have not already done so. Once again I have taken you to the river I fish in, you have my fishing rods and tackle box. Now up to you to catch the right priced fish.

Please use these two lists as a starting point to conduct your own research and use Value.able as a guide to estimate your own valuations. If you don’t yet have a copy you can order one at www.rogermontgomery.com so you too can do your own valuations. Remember to always focus on the highest quality and best performing business available.

If you focus on the best when they are cheap and simply forget the rest, you should avoid more (if not all) of the disasters and should be able to build a portfolio that will give you a greater chance of out-performing the market.

Happy reporting season!

To be continued… Read Part II.

Post by Roger Montgomery, 17 August 2010.

by Roger Montgomery Posted in Companies, Insightful Insights, Investing Education.

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Here we are in the midst of reporting season and there are some reasonably predictable results. Qantas reported a profit today that was less than a quarter of its profit more than ten years ago. The airline reported a $112 million profit but that was boosted by $1 billion of revenue from its Frequent Flyer program and a $300 reduction in employment costs. For those of you interested in the real numbers, the company actually lost $302 million (see my chapter in Value.able on cash flow) and this can be explained by the very wide gap between the depreciation item in the profit and loss statement and the real expenditure on property plant & equipment. Depreciation looks backwards, but new planes cost more.

Separately, JB Hi-Fi’s result was excellent but my concern is that its $94 million of cash flow (of which $67 million was allocated to dividends and $20 million allocated to paying down debt) is superfluous to its needs. Take a look at the biggest asset on the balance sheet – Inventory of $334 million. Then take a look at the creditors item in the current liabilities section. Almost the same amount!

Think about it this way; the suppliers are funding the inventory so the company doesn’t even need cash to pay have the stuff it sells and that are on its shelves. Actually it really does, the gap is about what is left over once we subtract the debt repayment and dividends from the cash flow. It is small though. Once the debt is gone and the cash keeps growing it may do something that could harm intrinsic value.

Now don’t get me wrong; JB Hi-Fi is an amazing business that retained its A1 status in this result and the risk associated with its plans to roll out more stores is very low. I also think intrinsic value will continue to rise at a satisfactory rate. The concern for me with all this cash (and there is no evidence of it yet) is that the company increases the dividend payout ratio again. This would mean a reduction in the rate of growth of intrinsic value. It could stop being the “compounding machine” it has been to date. Return on equity also appears to be flattening, which could mean within the next few years, the valuation may plateau (but at a higher level than the current price).

On an unrelated issue, I note that back on 4 May 2010, I put together a list of the companies that I though represented the last of value in a blog post entitled Do these three companies represent the last of good value? ITX was one of the companies listed and I note the company has announced “itX confirms that it is in discussions with an interested party regarding a preliminary non-binding indication of interest to acquire 100% of the ordinary shares in itX.”

I’m pleased to strike another one up for the quality rating and valuation approach advocated here at my Insights blog!

Posted by Roger Montgomery, 12 August 2010

by Roger Montgomery Posted in Airlines, Companies, Insightful Insights.

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