24–30 october 2009 telstra-nomics: a $25b incentive to haggle · telstra-nomics: a $25b incentive...

E v E r y p u b l i s h E d a r t i c l E f r o m t h E i n t E l l i g E n t i n v E s t o r w E b s i t E

publishEd this wEEK

Imagine a soccer game where the score is 2–0 in the second half. Without even looking at the field, you can make an educated guess about the behaviour of each team; the one that’s yet to score will be on the offensive, while the competition will be ‘’shutting down’’ with a defensive formation and delaying tactics.

The scoreboard dictates the incentives which, in turn, dictate the behaviour. This insight lies at the heart of economics and is crucial for Telstra shareholders, too.

In the case of the negotiations currently underway between Telstra and the government over compensation for the company’s ‘’customer access network’’, here’s what the scoreboard looks like; at an $8 billion valuation, Telstra’s compensation would equate to 64 cents per share, at $33 billion the figure would be $2.65—a whopping gap of more than $2 per share. (That compares with yesterday’s closing price for Telstra shares of $3.24.)

On the other side of the compensation issue is what the

government needs from Telstra to build its National Broadband Network (NBN). This consists, essentially, of two things.

Firstly, the NBN Company needs access to the ducts and pits used by Telstra’s current copper wire network. Secondly, it needs to prevent Telstra from offering a competing service once the NBN is up and running.

Without the first, the NBN would pose an even larger logistical challenge than it already does. Without the second, Telstra is likely to undermine the economics of the NBN by competing fiercely using its copper network.

predictionsNow we know the scoreboard,

how accurately can we predict the behaviour?

With so much on the table, we can expect Telstra to be talking up the value of its network, while the government will be trying to minimise any required compensation payment. Yesterday’s

business headlines were dominated by the leaking of an ACCC report which referenced a ‘’depreciated historic cost value’’ of $8 billion. This figure clearly favours the government’s side of the negotiation, though the comprehensive 252-page document also contained a $33 billion valuation based on ‘’optimised replacement cost’’.

The key point is that these two figures likely frame the limits of the negotiation. And there are no prizes for guessing which side will be pushing for $8 billion and which will be aiming for $33 billion.

Having recently spent several weeks analysing Telstra, it’s clear that any figure less than, say, $15 billion would be bad news for Telstra shareholders. So you can bet your bottom dollar that, like a soccer team on the counterstrike, Telstra will be creating a few headlines of its own in the coming weeks as it seeks to maximise the value of its shareholders’ largest asset.Article first published online for Business Day, www.smh.com.au, 27 Oct 2009.

telstra-nomics: a $25b incentive to haggle

2 4 – 3 0 o c t o b E r 2 0 0 9

portfolio changes portfolio stock Date buy/ sell no. of shares price ($) Value ($)

Flight Centre FLT 26Oct Sell 200 16.5 3,300Macquarie Airports MAP 26Oct Buy 227 2.3 522Platinum Asset Management PTM 26Oct Sell 450 5.99 2,696QBE Insurance QBE 26Oct Buy 230 23.31 5,361RHG Group RHG 26Oct Sell 11,800 0.745 8,791

recommenDation changesServcorp upgraded from Long Term Buy to Buy

feature articles page

Ask The Experts 12Business Day: Do NAB’s woes point to UK opportunities? 10Business Day: Suncorp’s sad state of shareholder affairs 11Growth Portfolio takes profits 6The case for oil 9

DetaileD stock reViews stock asX coDe recommenDation page

Flight Centre FLT Hold 2

upDates Billabong BBG Hold 6Servcorp SRV Buy 6

2 the intelligent investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

STOCKS IN DETAIL

a new perspective on flight centre: part 3

over the past few issues, we looked at how this travel business has morphed over the past five years. here, we take out our crystal ball to see what the next five years might bring.

flight centre (flt) $16.13

26 Oct 2009BLUE CHIP INDUSTRIAL

$1.6bn $3.39–$16.55

2.5 3

HOLD

INFORMATION CORRECT AT

STOCK CATEGORY

MARKET CAPITALISATION

12-MONTH SHARE PRICE RANGE

BUSINESS RISK out of 5 SHARE PRICE RISK out of 5

OUR VIEW

In this series, we’ve dissected Flight Centre’s two main businesses. Part one focused on the significant headwinds facing the company’s traditional leisure operation and we posited that management might be deliberately milking the business and reinvesting the proceeds in its rapidly growing corporate travel business, the subject of part two.

We also made the case that the leisure business is unlikely to grow much in the coming years, in contrast to the corporate business that will keep moving ahead. To wrap up our three-part analysis, we’ll try to piece together how these two trends are likely to combine, to gauge what Flight Centre might look like in five years’ time.

What better way to do this than with some financial forecasts? You might find the going a little tiring over the next thousand words if you have an aversion to numbers, but it’s the most useful way to illuminate the effects of changes sweeping the company, and there’s a bright light at the end of the tunnel. Our journey then concludes with a relatively simple roadmap to measure Flight Centre’s progress.

Educated guessworkLet’s start with our ‘best guess’ for how the business

might progress over the next five years, and follow with a scenario analysis to discover how Flight Centre’s prospects might change along with key variables.

In the fullness of time, forecasts rarely prove accurate. In this case, we’re using incomplete information to make

estimates of numerous important internal factors. For example, we’re trying to estimate the profit margin on corporate travel sales when the company doesn’t even tell shareholders the total amount of corporate travel sold. There’s a lot of educated guesswork involved.

And then there’s external influences, such as the global economic tide. Though reality isn’t likely to neatly fit our model over the coming years, the point of the exercise isn’t to accurately predict the future; it’s to consider what possible futures might exist and to gauge whether the odds are stacked towards a pleasant outcome for shareholders.

In Table 1, we’ve published our ‘best guess’ estimate based on our analysis from the past month’s research. Let’s roll down the table line by line and discuss the key assumptions, starting with the company’s leisure business.

We’ve opted for zero growth in Total Transaction Value (TTV) over the coming five years; we’re looking specifically at (the lack of) organic growth, rather than acquired TTV. Flight Centre could possibly make more acquisitions in the leisure business, but this would require more capital (debt or new shares) and that would create further dilution as we move down the table.

that’s debatableIntelligent bystanders could (and probably will) argue

that this estimate is too bullish or too bearish, depending on their viewpoint. But our best guess is that the trend evident over the past few years—almost flat organic TTV—is likely to continue. And if the economic recovery continues at this pace for a while yet, then perhaps there’s scope for some organic TTV growth, a matter we’ll come back to.

For the next line, the Revenue-to-TTV ratio, we’ve opted for 16%. We made the claim in part one that this ratio has been on the rise lately for the leisure business, but we’re not banking on further margin expansion over the next


wARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary.The Intelligent Investor and associated websites are published by The Intelligent Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288).

DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.COPyRIGHT The Intelligent Investor Publishing Pty Ltd 2009. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only.

DISCLOSURE In-house staff currently hold the following securities or managed investment schemes:AAU, AEA, AHC, ANZ, ARP, AVO, AWE, BEPPA, BHP, CBA, CDX, CHF, CLS, CND, COH, COS, CRS, CXP, DBS, EFG, FLT, GMPPA, GNC, HVN, IDT, IFL, IFM, IVC, KRS, LGL, LMC, LWB, MAU, MFF, MLB, MMA, MNL, MQG, NABHA, NXS, OEQ, OSH, PLA, PRY, PTM, RHG, ROC, SAKHA, SDI, SFC, SGN, SHV, SIP, SOF, SRV, STO, TAN, TGR, TIM, TIMG, TIMHB, TLS, TRG, TRS, TWO, WBC, WDC and WHG. This is not a recommendation.Thanks to IRESS for the charts and price information.

Important information about The Intelligent Investor

horsE sEnsE ‘Models are to be used, not believed.’Henri Theil, Principles of Econometrics.

3the intelligent investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 8305 6000 Fax: (02) 9387 8674 [email protected] www.intelligentinvestor.com.au

The Intelligent Investor 24–30 October 2009

been generated to pay the tax office, bankers and, most importantly for us, shareholders. In contrast with profit after tax, EBITA ignores how the company is financed and is particularly useful in assessing the performance of the underlying business.

corporate travelUnlike the leisure business, we’re expecting good

growth in TTV from the corporate operation. We’ve opted for a growth rate of 12%, which is probably conservative given the recent growth rates from this division, and the depressed nature of business in the base year 2008/09.

In fact, our best estimate would include a few significant rebound years of 20-25% growth, if not starting this year, then next. As highlighted last issue, significant new client wins are being hidden by existing clients ‘downtrading’, and this is likely to result in a year or two of very fast growth when business conditions pick up. But we’ll be conservative and assume straight line TTV growth of 12%.

Last issue we estimated that Flight Centre’s corporate revenue-to-TTV ratio would be towards to top of the

five years. Rising margins have been caused by the migration of low-margin bookings to online alternatives, and that trend should continue, but an offsetting force might become apparent if travel providers push for lower margins generally.

The next line, Revenue, is a function of the assumptions in the prior two lines. Next comes the ratio measuring Earnings before interest, tax and amortisation (EBITA) to revenue. We estimate this figure was 8% in 2008/09, provided we ignore one-off writedowns and (hopefully) temporary operating losses at Liberty.

You’ll notice that over the next two years the ratio moves up to 11%. This isn’t an optimistic assumption, but rather reflects a mild rebound from current depressed levels. Between 1995 and 2004, this ratio ranged between 15–20%. We’ve opted for a lower number to account for some of the headwinds a bricks and mortar travel agent faces. From this ratio, we arrive at an EBITA estimate for the leisure operation.

While not technically the ‘bottom line’ profit, EBITA is the most useful measure of Flight Centre’s—or in this case, its leisure division’s—operating profit. It’s an accounting figure representing how many dollars have

table 1: best guess estimate 2009A 2010E 2011E 2012E 2013E 2014E

leisure (incl wholesale)

TTV ($m) 7,300 7,300 7,300 7,300 7,300 7,300

Revenue-to-TTV ratio (%) 16.0 16.0 16.0 16.0 16.0 16.0

Revenue ($m) 1,168 1,168 1,168 1,168 1,168 1,168

EBITA-to-revenue ratio (%) 8.0 9.0 11.0 11.0 11.0 11.0

EBITA ($m) 93 105 128 128 128 128

EBITA-to-TTV ratio (%) 1.28 1.44 1.76 1.76 1.76 1.76

corporate

TTV ($m) 3,900 4,368 4,892 5,479 6,137 6,873


Revenue ($m) 273 306 342 384 430 481


EBITA ($m) 33 43 62 77 86 96


total

TTV ($m) 11,200 11,668 12,192 12,779 13,437 14,173


Revenue ($m) 1,441 1,474 1,510 1,552 1,598 1,649


EBITA ($m) 126 148 190 205 214 225


Net interest received ($m) 12 10 7 5 2 0

Profit before tax ($m) 138 158 197 210 216 225

Profit after tax ($m) 97 111 138 147 151 157

Shares outstanding (m) 99.7 100 100 100 100 100

Earnings per share ($) 0.97 1.11 1.38 1.47 1.51 1.57

Payout ratio (%) 0 40 45 45 45 45

Dividends per share ($) 0 0.44 0.62 0.66 0.68 0.71


STOCKS IN DETAIL

industry’s 5–8% average; our best guess is 7%. We’ve estimated the EBITA to revenue ratio at 12% for 2008/09, a depressed number for corporate travel but one that reflects the company’s depressed overall EBITA-to-revenue ratio of 8.8% last year. The ratio then heads up to 20% over the next few years; as explained last issue, ‘evidence suggests that corporate operates at a significantly higher EBITA-to-revenue ratio than leisure travel’. It could be that 20% is conservative—if our claim that corporate and leisure are ‘similarly profitable’ holds true, this ratio is possibly closer to 25%.

putting it all togetherThe next five or so lines include the estimate for TTV,

Revenue and EBITA for the whole company, obtained by adding the estimates for the two divisions. Here’s where we get a glimpse of how the combination of a languishing business and a rapidly growing business might look.

The Revenue-to-TTV ratio trends downwards over the five-year forecast, which makes intuitive sense considering the increasing importance of corporate travel to Flight Centre. The EBITA-to-revenue ratio is heading in the other direction, reflecting a forecast improvement from depressed conditions in 2008/09 and the increasing importance of the corporate travel business.

Let’s now briefly consider how the company will fund the growth in its corporate division. Net interest has traditionally been a source of profit for Flight Centre, rather than a cost, because of its significant cash ‘float’ from customers paying in advance. Last year, the company received $12m more in interest from its deposits than it paid in interest on its loans.

But the corporate business is likely to prove more capital-intensive than leisure, for reasons detailed last issue. So the forecast assumes Net interest runs down to zero over the next five years. That’s the equivalent of the company progressively borrowing $150m at 8% to fund organic growth in the corporate business, which should prove ample.

Whether we account for the increased capital requirements here or in terms of the number of shares outstanding—equity is the other form of financing available to the company—won’t make a great difference to the final forecast. But it is important to count it somewhere.

Totting it all up, Profit before tax rises to $225m by the 2014 financial year, from $138m in 2009. After deducting tax and dividing by the number of shares outstanding, our earnings per share forecast increases to $1.57 by 2014.

Though that’s a price to earnings ratio (PER) of 10 based on today’s share price, it’s also misleading. More usefully, it implies earnings per share growth of 10% per annum. So if investors are prepared to pay a PER of 15 for this business come 2014, today’s buyer is looking at average annual capital gains of 8%. In addition, shareholders might expect an average dividend yield of 3-4%, for a total return of 11–12% per year—a decent result.

a different routeBut this is just one guess from a wide array of potential

futures, so let’s now consider a few alternatives, beginning with a much more difficult future. For our ‘tough future’ estimate, we’ve changed three key variables from our ‘best guess’ estimate. Firstly, we assume that online competition intensifies to the point that Flight Centre’s leisure business not only stops growing, but that TTV goes backwards at a rate of 5% per year. Due to this competition, we’ve also assumed the Revenue-to-TTV ratio shrinks by 1% each year to 11% by 2014, rather than 16% in our ‘best guess’.

Lastly, we assume corporate growth hits a wall and TTV remains at 2009 levels; we’ve also left the shrinking net interest figure from our ‘best guess’ estimate. In this case, the $150m borrowed doesn’t reflect money invested in the growth of corporate, but rather cash needed to close unprofitable retail stores and fund severance pay.

table 2: tough future estimate 2009A 2010E 2011E 2012E 2013E 2014E


In Table 2, we’ve highlighted how this change might effect earnings per share. You can see the full range of assumptions behind the numbers in a spreadsheet available on our website. EPS might still be in excess of 80 cents per share, but it would be hard to pay a low enough multiple for a stock in that sort of decline. If Flight Centre faced a future of significantly declining leisure TTV and no corporate growth, the reality is likely to be uglier than these numbers imply, and we’d very likely regret our current Hold recommendation.

free upgradeOf course, this is not the future we expect. And even

our ‘best guess’ leaves room for pleasant surprises, so let’s consider a more ‘bullish’ case. Assuming our caution on the leisure business proves somewhat unwarranted, we’ll allow for 5% growth in organic TTV from that division. For the corporate business, we’ll include two big rebound years for TTV, 20% growth in 2010 and 25% in 2011, before returning to 12% growth for the remaining three years. Under this scenario, we’ll also increase the corporate EBITA-to-revenue ratio to 25% in the latter years, which brings the EBITA-to-TTV ratio for the corporate business in line with the leisure business.

Though this is a ‘bullish’ scenario, we need to be realistic and have therefore increased the Net interest expense to allow for an extra $100m in required capital by 2014. Table 3 shows what might eventuate, with EPS of $2.10 by 2014 (workings are available in this spreadsheet). Following the bullish-but-not-impossible theme, if in 2014 investors put the stock on a multiple of 18 times earnings, today’s buyer would be looking at capital gains in the vicinity of 19% per year and a further 4-5% in average dividends.



table 3: bullish estimate 2009A 2010E 2011E 2012E 2013E 2014E


One of the great pitfalls of financial modelling is that once you create the numbers, you start to believe them. Rather than get bogged down in our own creation, now’s a good time to take a step back.

The point of these three examples is to show that the range of potential outcomes for Flight Centre is wide. The examples are also useful in showing what the company needs to achieve for it to be a successful investment for shareholders.

Flight Centre today looks vastly different from what we envisaged at the time of our 2005 report, which is why we’ve undertaken this detailed three-part analysis. Shareholders should be aware that the business model is no longer about rolling out new retail stores to replicate past success. The growth engine now is corporate, so the focus will be on growth in corporate sales staff and new account wins.

a simple measuring stickBut the number one indicator of whether Flight Centre

will remain successful is growth in overall TTV. It’s absolutely essential that the company is able to grow overall TTV, as this is what gives it bargaining power with airlines and hotels. It really doesn’t matter whether that growth comes from leisure or corporate, although we’ve laid out the case as to where it will ultimately come from.

We can also envisage a scenario, perhaps a decade down the road, where Flight Centre’s TTV exceeds $20bn, versus $11bn in 2009. If that transpires, we’re confident the company will receive adequate compensation from travel providers and the margins in our ‘best guess’ estimate are achievable. If corporate doesn’t continue to grow, though, total TTV is likely to stagnate and we’ll likely look back on this Hold recommendation with regret.

table 4: roadmap

1. Is overall organic TTV growing at a reasonable rate (>5% per year)?

2. Does the overall revenue-to-TTV ratio match our expectations of 16% for leisure and 7% for corporate?

That makes a useful roadmap to follow. If TTV continues growing then the plan is likely to be on track. If growth doesn’t eventuate this year and, in particular, in 2011 and beyond, it’ll force a rethink.

The next most important factor is the Revenue-to-TTV ratio. We expect to see a high ratio over the coming years, although it will unavoidably fall as corporate becomes more important to the company’s future. That’s perfectly fine. What we don’t wish to see is further unexpected deterioration, which would likely indicate a worsening bargaining position with travel providers. If TTV continues rising and the Revenue-to-TTV ratio holds up

reasonably well, everything else that matters to shareholders is likely to fall into place.

metamorphosisThe central thesis of this three part series hasn’t

revolved around spreadsheets and mental gymnastics. Numbers are outputs, not inputs. The key story is how Graham Turner and his management team are quietly shifting the fundamental focus of this business away from leisure travel and towards corporate, as a way of dealing with the threat posed by the internet. The speed with which this appears to be progressing says something about this management team’s unique business building skills.

The question we’ve tried to answer is whether this is sufficient to offset the abruptly changing dynamics of the travel industry. Though the initial signs are encouraging, shareholders won’t be able to declare victory for at least a few years yet.

It was only a few months ago that this stock was priced for collapse. Back then, very little needed to go right for shareholders to do well. With the stock up 375% from the low in March, however, today’s shareholders are clearly betting against a disastrous future.

recommendation guide

Long Term Buy Below $10

Hold Up to $18

Take Part Profits Up to $23

Sell Above $23

If the stock keeps moving up, it’ll soon reach a point where shareholders become reliant on a rosy future in order to achieve a reasonable outcome. While we are impressed with the company’s transformation, there are considerable risks to its growth plans. As such, we’re likely to sell down, or completely part company, with this long- held stock if such a situation eventuates. We’re not willing to risk our chips if the bullish scenario becomes fully ‘priced in’ and the attached recommendation guide shows our current thoughts on valuation.

We’re mindful that this three-part detailed analysis has demanded a significant investment of your time and attention. Hopefully, this has paid off with a deeper understanding of the fundamental ways in which Flight Centre and its industry have changed over the past five years. We’ll keep you up to date as the situation progresses and our recommendation remains HOLD.

Note: In the special reports section of our website, you can download a spreadsheet with the numbers behind our

‘best guess’, ‘tough future’ and ‘bullish’ estimates. There’s also a ‘Choose your own adventure’ tab, where you can input your own assumptions.

Disclosure: The author, Gareth Brown, and other staff members own shares in Flight Centre.


the case for oil

billabong international (bbg) $10.74

27 Oct 2009BLUE CHIP INDUSTRIAL

HOLD


STOCK CATEGORY

OUR VIEW

At today’s annual meeting surfwear retailer Billabong International reiterated expectations for a 5% increase in net profit in 2010 (in ‘constant currency’ terms). However, if exchange rates hold around current lofty levels, the accounts will show a 6% fall, excluding the prior year’s impairment charge.

While you should expect profits to fluctuate given the company’s largely unhedged and broad geographic spread of revenues, earnings per share (EPS) would then have fallen to around 57 cents, from 61 cents in 2009 and 82 cents in 2008, prior to June’s dilutive rights issue. That puts Billabong on a forecast price to earnings ratio of 19, which isn’t unreasonable if we’re near or past the bottom of the cycle and Billabong’s brands haven’t been mortally wounded by heavy discounting, particularly in the US.

Chairman Ted Kunkel also made a song and dance about setting the executive bonus hurdle at 33% EPS growth over the next three years, but that implies EPS would have barely moved between 2008 and 2012, if it were achieved. We expect Billabong’s future will be tougher than its past and it’s slated for a full review over the next month. The share price is up 26% since 20 May 09 (Hold—$8.52) and, for now, we’re sticking with HOLD.

Nathan Bell

serVcorp (srV) $3.82

29 Oct 2009SECOND LINE INDUSTRIAL

BUy


STOCK CATEGORY

OUR VIEW

Servcorp’s share price has dropped to $3.82, making the 1-for-11 entitlement offer at $4.00 comparatively less attractive. You can currently pick up shares cheaper on the market than through the offer. If you were planning on participating in the offer, we recommend picking up the equivalent number of shares on the market at the current price instead; the 4.5% discount will more than make up for brokerage costs.

Should the share price bounce back significantly above $4.00 before the offer closes on 6 November, we might sell these newly acquired shares again and participate in the entitlement offer—a double-dip arbitrage opportunity. In line with our advice to you, we’re adding 136 shares to the Growth Portfolio at $3.82 and may do more trades if the opportunity presents itself. We’ll make a final decision on the offer by next Wednesday, two days before it closes. Note, Servcorp will collect its cash one way or the other as the offer is fully underwritten, so this price weakness won’t affect its plans. The stock is down 18% since 16 Oct 09 (Long Term Buy—$4.65) and we’re once again upgrading to BUY.

Disclosure: Staff members own shares in Servcorp, but they don’t include the author, Nathan Bell.

COMPANY UPDATES

FEATURE ARTICLES

for several years, and when prices were booming in the sector, our analytical team operated without a resources analyst. since then, the oil price has fallen and we’ve now added a new resources analyst to the team. is oil still a worthy investment?

Whichever way you look at it, oil companies are different.Think, for example, how an oil producer compares

with an ordinary industrial company like supermarket retailer Woolworths: Woolies has a lock on its suppliers and, along with Coles, operates a virtual duopoly that gives it ample pricing power. It has a prominent brand and a supply chain that enhances its market dominance. Most of the factors that affect its profitability are within its control.

That’s far from the case with an oil company. The single most important factor affecting its profitability—the price at which it can sell its oil—is utterly beyond its control.

When the price of oil falls, so does the profitability of even the largest, most efficient oil producer. An investment in an oil producer is therefore inherently volatile and more risky than an investment in an ordinary industrial company.

So why would you invest in an oil company at all?There’s really only one reason; because you’re confident

that, over the long term, the price of oil is going to rise. And that’s the case we’re making in this review. After doing so, in subsequent research pieces, we’re going to take an overview of 27 stocks in the sector and then select a handful of the most promising that we’ll subject to more detailed research and recommendations.

introducing ‘peak oil’In 1956 the delightfully named Marion King Hubbert,

a Shell geologist, predicted that by the 1970s US oil production would peak. He was labelled a madman. For



almost a century the US had been one of the world’s largest oil producers and conventional wisdom held that there was plenty of oil remaining. That thinking turned out to be wishful. ‘Hubbert’s Peak’ came to pass. Since the early 1970s US production has declined by almost 50% (see accompanying chart).

Peak oil theory takes Hub bert’s hypothesis and applies it to global oil production, suggesting that worldwide oil production will rapidly decline following its peak, thought to be around 2010. Geologically speaking, this makes sense. Oil fields that perform splendidly in their early stages will progressively deteriorate as they age. But economically speaking, the marginal cost of oil production trumps peak oil theory every time. And this forms the crux of our argument for higher oil prices.

Let us explain. As more hydrocarbons are taken from a reservoir, extraction rates deteriorate. A geological rule of thumb is that the average field will naturally decline by about 5% a year, caused by a combination of deteriorating pressure, increasing levels of water production, or damage to the reservoir rocks. A large proportion—up to 50% or more—of the original oil resource cannot be profitably extracted because it’s simply too expensive to get the stuff out. Long before geological limits are imposed on oil production via peak oil, economic limits kick in.

us field production of crude oil (thousand barrels per day)

0

2,000

4,000

6,000

8,000

10,000

I2008

I1988

I1968

I1948

I1928

I1908

Source: US Energy Information Administration

peak oil, meet marginal cost

That means total production depends more on the price, rather than the quantity, of oil. So, as investors, we can think about oil as an unlimited resource with a variable price. The absolute quantity of oil in the ground isn’t all that important in discerning the direction of oil prices. What’s important is the cost of extracting an extra barrel. Economists call this the ‘marginal cost of production’ and it’s a more useful way of thinking about oil as a potential investment.

The marginal cost of a barrel of oil incorporates information on the quantity of oil and, through the cost of extraction, where it’s located and how difficult it is to get at. Peak oil theory tells us only about the quantity of oil and nothing about the cost of accessing it. The difference between the two can be immense.

Deep below the Santos basin off the coast of Brazil, several massive new oilfields have recently been discovered. We mean it when we say deep. The Sugarloaf, Jupiter and Tupi fields were found 4km beneath the seabed under a further 2km of thick salt layers. Getting the oil means digging through salt layers rather than rocks, increasing

the risk that wells will collapse even when cased in cement. If this weren’t demanding enough, the oil pumped back to the surface can be hot enough to melt the drilling equipment. Needless to say, oil from this source will prove expensive to extract. This goes to show that—despite what first year economics students may be taught—quantity can increase without necessarily causing the price to fall.

The chart below shows the global marginal cost of production for 2008, one of the most successful in terms of exploration in the past 20 years.

global marginal cost of production 2008 (by region)

In Saudi Arabia, home of the world’s cheapest oil, producers face a full life cycle (that is, including amortisation and cash costs) marginal cost of US$20 per barrel. In Russia, it’s about US$25 per barrel. North Sea fields have a marginal cost of about US$60 while the new deepwater discoveries off the Brazilian coast are expected to cost US$70 per barrel. Deepwater Gulf of Mexico, where a single well can cost US$100 million to drill, has a marginal cost of US$80 a barrel. Deepwater production from Angola and Nigeria, considered (along with offshore Brazil) to be exciting new frontiers within the industry, operate with marginal costs of about US$90 per barrel. And at US$100per barrel and more, Canadian tar sands and unconventional sources come into play.

These are revealing figures. In deepwater Gulf of Mexico and Angola, and in Nigeria, the market price is lower than the price of production, making it uneconomic for the average producer. The most recently celebrated discoveries off the coast of Brazil would only be marginally profitable at today’s prices, suggesting that future supply is under threat unless the price of oil rises.

In fact, at current prices of around US$80 a barrel, global supply will struggle to produce more than 80m barrels of oil per day. That’s not enough, according to the US Department of Energy, to satisfy demand. So far in 2009, global oil demand has been estimated at 84.6m barrels a day and is forecast to rise to 86.4m by 2010.

What does this tell us about future oil prices? In the short term, not much. Over the long term though, the price of oil should equal the marginal cost of production. If the market price is lower than the price of producing an extra barrel of oil, producers will cut production to

00

20

40

60

80

100

120

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80

Cumulative quantity (million barrels per day)

Range of marginal full cycle costs

2007

US

doll

ars

1 2 3 4 5 6 7 8 9

1011

1213

1415

1 Saudi Arabia 2 Other Middle East3 Russian Federation4 China5 Libya6 Mexico

7 Other South America, Europe and Eurasia, and Africa8 UK North Sea9 Other North America10 Brazil Deep Water

11 US Gulf of Mexico Deep Water12 Angola Deep Water13 Nigeria Deep Water14 Canadian Oil Sands15 Other South America and North America

Based on estimates Based on field models

Source: Horizon Oil, April 2009


of richer countries, the industrialisation and affluence of the developing world is adding hugely to the demand for oil-based products. Developing nations want the cars and consumables that we’ve enjoyed in the west for decades. It’s hard to see how the demand for oil won’t rise with these aspirations.

Is there a flaw in this thesis? The greatest risk to higher oil prices lies in the substitution effect where, as oil gets more expensive, consumers start to change their behaviour. People drive less, use natural gas and other substitutes more often and car manufacturers develop smaller, more fuel efficient vehicles. When oil hit US$147 a barrel in 2008, we saw the beginnings of such behavioural change—what economists call ‘demand destruction’.

Certainly, substitution and demand destruction will create a natural ceiling for oil prices but, for the reasons we’ve canvassed, this ceiling is likely to be higher than current prices. There’s a slight chance a new substitution technology (cold fusion anyone?—Ed) will be discovered that will adversely affect oil demand. Or breakthroughs in drilling technology might rapidly cut marginal production costs but these are very low probability events.

In summary, there’s a strong case for higher oil prices. As demand rises, higher prices will be needed to encourage more production, the effects of which aren’t likely to have much impact on consumer behaviour.

The investment case is somewhat trickier; as costs for oil producers are likely to rise as the ‘easy oil’ disappears. But there are bound to be a few wonderful success stories in the sector and, over the next few weeks, we’ll be examining 27 stocks in the Australian oil sector, from multibillion dollar giants to budding exploration minnows. We’re hopeful of finding some exciting opportunities for you.

Gaurav Sodhi and Greg Hoffman. First published online 27 Oct 2009.

avoid losing money. Similarly, as the market price rises, new sources of oil with higher marginal costs will be developed. Marginal costs, therefore, are instrumental in determining future oil prices.

substitution and risksHaving dealt with the supply side, what of demand?

Whereas oil producers can adjust their output based on their marginal cost of production, consumers have less flexibility. Oil is central to the global economy and embedded in our lives in a way that is hard to overstate.

The mundane act of eating a home-cooked meal illustrates the point. From the fertiliser used to grow the produce, to the fuel in the semi trailer that delivers it to the retailer, from the bag you use to carry the produce home in, to the heat you use to cook it. And it doesn’t stop there. Oil and its by-products are central to the knife and fork you use to eat your meal and the chemicals you use to clean the pots and dishes you’ve used along the way.

a crude way to grow

01950 55 60 65 70 75 80 85 90 95 2003

5

10

15

20

25

30

Sources: Marc Faber; BP EIA; IEAOil consumption per person, barrels per year

Chart sourced from The Economist, 2004

United States

Japan

South KoreaChina

Whilst oil demand in the developed world may remain stable, or even fall, thanks to lower population growth and the higher representation of services in the economies

FEATURE ARTICLES



a broad group of stocks has helped edge the growth portfolio in front of the index, but we’re trimming several ballooning positions in anticipation of future opportunities.

As value investors, our bottom-up approach aims to unearth securities trading at significant discounts to intrinsic value. Earlier this year a flood of opportunities meant we were able to diversify the Growth Portfolio more than usual without sacrificing potential returns, as we explained in Part 1 of this two-part performance update.

At 30 June 2009, 80% of the portfolio was invested in stocks boasting positive recommendations. But having since returned 33% (the All Ordinaries Accumulation Index has returned 24%), the situation has changed, as you can see in the charts.

With numerous opportunities having matured, the margin of safety afforded by low prices has shrunk from the width of a Los Angeles freeway to a narrow Melbourne laneway. Several large positions have also unbalanced the portfolio. With investors regaining their confidence, we’re now taking protective measures in preparation for future opportunities.

spring cleaningRHG Group, formerly Rams Home Loans, has increased

nearly 15-fold from its low. As we explained on 19 Oct 09 (Hold—$0.705), we’re prepared to leave some value on the table as the share price closes in on our intrinsic value estimate of one dollar. With RHG up a further 6%, and its portfolio weighting approaching 15%, we’re reducing our stake by around a quarter, selling 11,800 shares at $0.745.

We’re also slightly reducing our stake in Platinum Asset Management. Though the current price to earnings ratio of 27 seems daunting, the fund manager has enormous operating leverage. Once analysts and portfolio managers are paid, a dollar of revenue barely sheds a skin of value as it morphs into pre-tax profit. We also wouldn’t rule out founder Kerr Neilson announcing some large deals in future, so we’re selling 450 shares, which trims the position from 9% to 8% of the portfolio.

Flight Centre also has enormous operating leverage, due to bonuses it earns when it clears sales hurdles agreed with airlines. Though the stock was priced for Armageddon in March, the remarkable turnaround in investor sentiment and the strong Aussie dollar have lifted Flight Centre to

6.9% of the portfolio. We’re cutting our stake from 900 to 700 shares, as the risk/reward equation becomes more evenly balanced.

trading cyclicals for blue chipsWith cyclical stocks having recently outperformed

blue chip stocks, we’re boosting our stake in QBE Insurance to around 5%, by purchasing 230 shares at $23.31. Though we’d like to add more blue chips to the portfolio, we’re not comfortable paying current prices. We’re prepared to wait for better opportunities.

With nearly 50 cents of value currently on the table, we’ve elected to take up our entitlement of 227 Macquarie Airports (MAp) securities at $2.30, as part of its 1-for-11 entitlement offer. Though Macquarie Group remains MAp’s largest securityholder, it’ll no longer be pulling the strings (in theory at least). Note that the offer is non-renounceable which means that if you do nothing, you’ll get nothing. The offer closes on Wednesday 28 October, so you’ll need to act quickly if you haven’t already.

Serviced office provider Servcorp is also conducting a 1-for-11 entitlement offer, but it’s underwritten, as we discussed recently on 13 Oct 09 (Buy—$4.25). However, you have until 6 November to make a decision. With the share price recently falling below the four dollar offer price, we’re waiting as long as possible, as it might end up cheaper to buy stock directly on market.

With $13,060 in our war chest and a few Yuletide dividends to come, we’re locked and loaded for future opportunities. If the market keeps bubbling along, we’ll consider taking more chips off the table.

a healthy level of fearRespected value investor Seth Klarman of Baupost

Group has said, ‘Risk control to us is a consistent and disciplined investment approach where every opportunity is individually and meticulously evaluated on its fundamentals, a strict sell discipline, a willingness to hold cash when opportunity is scarce, and a healthy level of fear. Selling, in particular can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted.’

growth portfolio transactionsSTOCK BUy/ BUy/SELL NO. OF PRICE VALUE (ASX CODE) SELL DATE SHARES ($) ($)

Macquarie Buy 26 Oct 09 227 2.30 522

Airports (MAP)

RHG Group (RHG) Sell 26 Oct 09 11,800 0.745 8,791

Platinum Asset Sell 26 Oct 09 450 5.99 2,696

Management (PTM)

Flight Centre (FLT) Sell 26 Oct 09 200 16.50 3,300

QBE Insurance (QBE) Buy 26 Oct 09 230 23.31 5,361

growth portfolio takes profits

portfolio split of current recommendations

30 June 2009

Buy 44%Long Term Buy 32%Hold 19%Speculative Buy 4%Sell 0%Cash 1%

21 October 2009

Buy 5%Long Term Buy 31%Hold 62%Speculative Buy 0%Sell 0%Cash 2%


temperament means holding cash won’t burn a hole in your pocket, then your patience may be rewarded. As always, you can view a full listing of the Growth Portfolio in the Portfolio section of the website.

Disclosure: The author, Nathan Bell, and other staff members own many of the shares mentioned. For a full list of holdings, please see the Staff portfolio on our website or page 2 of the print edition. First published online 26 Oct 2009.

Deciding when to sell is never easy, but we must guard against falling in love with our best performing or favourite stocks. If you’re a risk-averse investor and a few high performing stocks are currently dominating your portfolio, consider trimming those positions in favour of cheaper stocks or future opportunities offering a larger margin of safety.

Even bull markets are prone to setbacks. If your

FEATURE ARTICLES

BUSINESS DAY (WWW.SMH.COM.AU

do nab’s woes point to uK opportunities?

yesterday i asked our team of analysts a simple question; which markets can you think of that might still be near a cyclical low point? as natural contrarians, we’re always searching for opportunities that are being overlooked by others.

I received a raft of varied and interesting answers, among them: ‘Iceland’; ‘small property developers’; and ‘the UK’. It was the last one that rang in my ears as I left the meeting and cast my eye over National Australia Bank’s latest accounts.

Earnings from the bank’s UK businesses fell by a whopping 69% to £78m as the charge for bad debts surged from £175m to £421m for the year (a 140% increase). To add insult to financial injury, those tattered pound profits translate to fewer Aussie dollars than they would have last year; the pound is—pardon the pun—in the doghouse.

While Australia astonishes the world with its economic resilience, the UK continues to live out something closer to the financial nightmare many of us feared at the beginning of this year. ‘Operating conditions were consistent with the deepest UK recession in the post war period’ explained NAB’s management in its commentary, ‘Domestic property values declined, on average, by 20%

from their peak and commercial property fell by 45%.’For Australian investors, staying abreast of conditions

in Blighty is more than just an interesting intellectual exercise.

Plenty of well-known Aussie stocks have exposure to the struggling UK economy. Apart from NAB, other high-profile stocks with UK operations include Westfield, Macquarie Group, QBE Insurance, Cabcharge, Flight Centre, Computershare and Stockland.

In the short term, this exposure has hurt these businesses. Westfield, for example, has pared back its previous UK expansion plans. But, as Australian investors learned in the early part of this year, it often pays to buy when things look gloomy. So what’s the key point for those with an eye on the long term?

If the pound continues its recent downward trend against the Aussie dollar, any gains might be tempered. But when the UK economy finally recovers, some of the stocks mentioned above are bound to benefit. So casting an eye over stocks which have the potential to post handy gains from any eventual economic recovery in the UK might prove a profitable pastime.Article first published online for Business Day, www.smh.com.au, 29 Oct 2009.



shareholders are the ultimate owners of a company; unfortunately many of them don’t act like it.

As somebody who’s currently standing for the board of a publicly listed company (RHG Group), I’ve been taking an interest in the voting at recent shareholder meetings. The history of change through shareholder action in Australia is disheartening and Wednesday’s Suncorp meeting provides a case in point.

For starters, less than 54% of total shares were voted. And, by number of shareholders, the figures were even more astonishing; fewer than 10% of Suncorp’s 219,000 owners bothered to vote at all. And this in relation to an iconic stock from which shareholders have seen billions of dollars lost over the past two and a half years.

In July I wrote a piece for our members titled Suncorp shareholders: Time to take a stand where I laid out a case for change.

Take Ian Blackburne, for example. He’s been on the board since August 2000; a year in which Suncorp shareholders received 46 cents per share in dividends. This year, nine years on, they received just 40 cents. So they’ve gone backwards by 13% over nine years.

As a director, Blackburne has overseen John Mulcahy’s disappointing stint as CEO, the disastrous top-of-the-cycle takeover of Promina and the boom-like remuneration terms awarded to new CEO Patrick Snowball. So, considering this rather compelling case for change, how did the Suncorp votes fall?

To shareholders’ credit, Blackburne’s re-election received the largest ‘’against’’ vote of the day; 66.3 million shares were voted against his re-election. Yet those seeking board renewal were swamped by those opting to stay with the status quo; 597.4 million share were voted in favour of Blackburne’s re-election.

So he’ll be staying on, collecting an annual pay packet from shareholders of more than a quarter of a million

dollars for attending 20 meetings a year (though he missed one in 2009).

‘’Ever since 1934’’ wrote Ben Graham in our company’s namesake, The Intelligent Investor, ‘’we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their managements.’’

Graham encouraged shareholders to ‘’demand clear and satisfying explanations when the results appear to be worse than they should be’’.

Unfortunately, apart from a minority of justifiably aggrieved shareholders, his urgings—now more than 50 years old—continue to go largely unheeded.

We’re currently in the midst of annual meeting season; shareholders’ best chance to exercise their ultimate power as the owners of the business and influence the shape of the board of directors that oversees their investment. Unfortunately, there are two main impediments to change.

The first is that the large institutional investors often have strong relationships with directors. This makes them disinclined to vote against incumbent directors. Several ‘’off the record’’ discussions I’ve had confirm that many fund managers push the boundaries in relation to extracting information from managers and directors.

The relationships which allow this ‘’information flow’’ might be jeopardised by voting against the board’s recommendations at the annual meeting. So, rather than upset the information flow apple cart, fund managers often just toe the line and stick with existing directors, even when there’s a clear case for change.

Secondly, too few smaller shareholders take voting at annual meetings seriously enough to even bother filling in the form. Until that situation changes, Australia’s boardrooms are likely to remain cosy affairs. And those who fail to vote have no right to complain.Article first published online for Business Day, www.smh.com.au, 30 Oct 2009.Australia dollar on the rise

suncorp’s sad state of shareholder affairs


flood of new listings. Unless the listing of retail corporate bonds takes off so we end up with a broad market of different choices, it’s not something we intend to put much time into because there won’t be opportunities for most retail investors otherwise.

Corporate bonds are a tradeable form of debt, just like government bonds. In contrast, BEPPAs are a hybrid security that has some of the characterstics of debt and equity. They’re much riskier than most corporate bonds. I have no idea regarding the changes to the market since 1982 and earlier, sorry.

flight centre and printing problem

hi guys can you please pass on my congrats to gareth and anyone else who worked on the recent flt series. it was excellent and as a shareholder gave me a great insight into how you believe the company is evolving and how to track its future progress. cheers noel ps the article doesn’t print properly, i have experienced this with other articles as well. noel k

Gareth Brown: Thanks for your kind words Noel. It’s an interesting process taking a fresh look at a stock we’ve been covering for so long, and I’m glad to hear you enjoyed it. I just tried to print the review online and ran into problems when using Firefox as a browser (it only printed down to the large table and no further). But then I used Safari and it printed fine. I’ll look into that issue. In the meantime, if you don’t get any success using another browser, perhaps try downloading the PDF here and print pages 8–11 as a short term workaround.

flight centre

hi guys. really enjoyed reading your three part series on flt. my question is, if the company is shifting focus to corporate travel, why did they bother buying liberty travel - a large bricks and mortar traditional leisure travel retailer? this was the largest acquistion the company has ever made and has been the cause of most of the challenges encountered in 2008–2009. shaun c

Gareth Brown: That’s a great question, it doesn’t quite fit my theory, does it? I was specifically referring to organic growth, and it seems that the company isn’t getting the same bang for its buck on investment in organic leisure growth that it used to. Management now refers to the number of ‘businesses’ rather than ‘stores’, and that’s because most of the increase in recent years has come from corporate. Store numbers have been reasonably flat.

In Liberty, I think they saw what appeared at the time to be a cheap way to add TTV to the enterprise, and it’s total TTV that drives their bargaining power with travel providers. I also think they highly valued the wholesale operation which came with it. According to management, the acquisition plugged a gap in their wholesale offering

please note that the member questions below have undergone minimal or no editing and appear essentially as they do online.

the aussie dollar is at 18 months highs. Do u guys see it continuing? Do u recommend we take advantage of it? steve J

Gareth Brown: The rising Aussie dollar was something we spent a lot of time discussing in the latest Stock Take podcast (it’s the podcast from 21 October). We discuss the issue in much greater detail there than I can do here. Broadly, the rising currency benefits many importers and hurts many exporters. But longer term, the key issue is pricing power, which decides whether currency gains get competed away and whether currency headwinds can or can’t be passed on to end consumers.

anZ ex date

i notice that anZ has an ex div date of nov. 5 but has not yet announced a dividend . is this unusual? when can we expect to know? ian w

Gareth Brown: I’m not sure why that date has popped up on the ASX and various broker websites. Judging by last year’s dividends, though, this is around the time it’s due to go ex dividend, and so the date may be accurate. The bank announces its results on 29 Oct and will declare any dividend then. The complete information on the dividend and ex date should be available on the ASX by the following business day

corporate bonds

re: corporate bonds. in russell napier’s, “anantomy of the bear”, (mentioned in one of your podcasts) he regularly mentions corporate bonds. i have done a search of the internet and searched tii website for ‘corporate bonds’ and came up with 318 options. could you please direct me to the best article that simply explains these investments and answer these questions; 1. how do corporate bonds differ from the likes of beppa, 2. have any drastic changes happened to the structure of corporate bonds since the great bottoms of 29, 32, 49 and 82 he discusses, 3. is the corporate bond market in the usa similiar to that in australia? thank you for the responses to previous questions i have submitted. michael l

Gareth Brown: The corporate bond market is much smaller and less liquid in Australia, and there are significant differences between the markets. Conventionally, corporate bonds are traded in unlisted markets between sophisticated investors. When Tabcorp listed some bonds on the ASX earlier this year, we were hopefully it would be the beginning of an easier market for small investors to access. But so far there hasn’t been a

ASK THE EXPERTS



in terms of American, Mexican and Carribbean product - these are products it now sells across its network. So this helped its margins across the board.

I don’t think that management are ignoring leisure travel, just that they can’t grow in that space like they used to. Liberty was an opportunistic way to cheaply add to leisure business and improve the wholesale business, or so it seemed. It’ll be a few more years before they can declare the acquisition a success or failure.

gpg takes control of mmc contrarian

i must say i was somewhat surprised to see gpg get above 50% holding for mmc. i don’t intend to sell at 50c. from your experience what do you think will happen next, if anything, apart from the current offer continuing? anthony w

Gareth Brown: Me too! This doesn’t really change the situation and I’m quite comfortable with GPG taking control. But they are making noises about delisting MMC Contrarian (in order to scare others into accepting their low-ball bid). We’ll think on the matter and get back to everyone before the newly extended deadline of 6 November, but we’re still leaning towards a Hold recommendation.

mmc contrarian

mma—why do you think gpg wants them. good/bad for mma? mike c

Gareth Brown: It’s a low-ball bid, offering 50 cents for assets that are worth at least 60-65 cents. Who wouldn’t want to take control of the company at that price? GPG could arrange a 50 cent per share capital return and still have something of value (the action we wish the past two MMC management teams would have undertaken). GPG may strip the company as such, or it may have a bigger-picture strategic vision. But the value on offer is probably the driving motivator.

Is it good for MMC is another matter - it depends on whose point of view you’re talking about. If you’re a minority shareholder, GPG are likely to try every trick in the book to make you sell to them (they’ve already threatened to delist the stock). But if we are able to stay on as minority shareholders, then I’m quite comfortable having GPG as a dominant shareholder.

leaked telstra document

thank you for the thorough analysis of telstra. it’s revealed a lot about telstra that i hadn’t realised, although i already held some reservations about the sustainability of the dividends. now that senator conroy has let slip previously confidential information about telstra into the public domain (http://www.smh.com.au/reports/nbnreport.pdf), i was wondering if you might comment on which of your assumptions/figures may be revised in light of the latest telstra

data? Din cGreg Hoffman: Thank you for the feedback; that’s

exactly what I hoped people would take away from it. Given the lack of share price movement, it’s easy to think that not much is going on with the stock. In fact, the opposite is true.

With regard to today’s leaked document, it is most applicable to the valuation of the fixed line business. My take on it is that it’s part of the bargaining process. Somewhat predictably, the government is trying to talk the price down, while Telstra is doing the opposite. The wide range of outcomes discussed in the press ($8bn up to $33bn) represents a $2 per share ‘swing’ in Telstra’s valuation. There’s a lot more water to flow under the bridge in these negotiations, so there’s no immediate impact. From a valuation standpoint, it looks like the final outcome will probably fall within the range I arrived at on page 23.

Question on bEppa’s valuation

re beppa and gareth browns summary. i will accept that the 6.2 cents of accrued distributions is probably correct. however i would very much like to know how gareth values the ordinary shares exchanged for beppa at 37 cents. in the formula for exchanging beppa to shares you always get the quantity of shares which will pay back the par value of the beppas of $1 plus a discount and an allowance for any accrued moneys owed on the beppa. i understand that bbi are probably asking us to overthrow this formula in our vote but i have not seen any mention of this in the prospectus. i have not yet received the correspondence from bbi relating specifically to beppa and if they are asking us to overthrow this formula. this must be the case if gareth is valueing the shares exchanged for beppa at 37 cents.could gareth please provide the specifics of how he has arrived at this valuation? also are the beppa holders going to receive the 6.2 cents as a cash payment in the resolutions to be passed at the bbi meeting. peter c

Gareth Brown: Peter, I’ll refer you back to Steve’s analysis of 9 Oct, which explains this is more detail. In that review, Steve highlights the recapitalisation in five points. Reading your query, I think you’ve missed the implications of point 4, in particular, but also point 5. BEPPAs will convert and end up with almost 100% of the current entity, but then that entity gets recapitalised and they end up with 16% of that new entity. Our valuation is derived from the price others are paying for 84% of that new entity, less something for the fact the deal might fall over.


ASK THE EXPERTS

thorough explanation by management, more than the six lines it got in the explanatory memorandum. I’d share your scepticism in the meantime.

still not comfortable with mcmillan shakespeare

bought mms a couple of weeks ago on the advice of ind.analyst r montgomery ,so was dismayed at the wiping out fear in your Q&a section. some more info.pl. nicole c

Gareth Brown: No need to be dismayed – we regularly disagree with other analysts. We don’t cover McMillan Shakespeare and so I won’t go into great detail on the matter. But as we highlighted in this article, we think the company has a lot of attractive qualities but we are concerned about its reliance on a quirk in the system that allows health workers to salary package just about everything that the rest of us have to pay post-tax dollars for. The business is likely to be very profitable as long as this system is in tact. But we’re not sure what the odds are of this system being dismantled, we’d need to be confident it wasn’t at risk before getting involved in the stock. We’re not. We wouldn’t be buying this stock just because it has a high return on equity.

ten year bonds and fully franked dividends

hi i hope you can help me with this. given the current 10 yr treasury bond yields 5.63% guaranteed, this is equivalent to 8.55% with franking=100 for a share, with no safety margin. there are very few shares performing this well at present., except for stapled securities. Doesnt this mean bonds are the way to go in the medium term? robert m

Gareth Brown: I like the way you’re thinking, in terms of using opportunity cost as a guide – it’s the right way to think. But you’ve made a mistake in the mathematics. The ten year bond is a pre-tax return, it’s not the one that should be ‘grossed up’ - it’s the fully franked dividend from shares that should be grossed up.

If stocks are yielding 4% fully franked, that would be equivalent to earning 5.71% (that’s 4 divided by 0.7) pre-tax. So, on a post tax basis, a 4% yield from a fully franked dividend is roughly equivalent to the bond yielding 5.71%. Of course, as you’ve noted, there’s risk, dividend growth and margin of safety to consider. But fully franked yields in excess of 4% would beat the interest on the ten year bond as it stands today.

rhg tax rebate, not franking credits

in your note about rhg on 19th october, you suggested that a $1.00 ff divi would come with a 21cent rebate. my understanding is that a divi of “X” comes with a 3/7X rebate ie 43 cents with a cash divi of $1. perhaps you could clarify. John h

Gareth Brown: The 21-cent figure is the correct one, but this has confused a few members so Steve’s explanation is obviously lacking. You are correct that a $1.00 fully franked dividend would come with 42.85 cents worth of franking credits. But Steve isn’t referring to the value of the franking credits, but the value of the tax credit this would entitle him to. He holds his stock in a super fund taxed at 15%. He gets $1.00 in cash plus 42.85 cents in franking credits. At tax time, the tax offices says this is equivalent to receiving a $1.4285 dividend, and says Steve owes 21.43 cents in tax on the dividend ($1.4285 * 0.15). But Steve has offsetting franking credits of 42.85 cents, so he actually gets a rebate of 21.43 cents from the tax office.

Steve skipped a step in describing his workings (his maths teacher would be very disappointed), but it’s the right number. Hope that makes sense.

wilson pulling a swifty?

Do you have a view on wil’s proposed amendment to the constitution to only put to the owners shareholder actions that are supported by 2 directors? their rationale is that this will reduce costs by eliminating frivolous actions but i don’t recall any and i’ve owned the stock since inception. this proposal takes away my right as an owner to consider issues that might not be supported by members of the board (e.g. a windup) that have a rather tight and intermixed relationship through various related entities. i’m disappointed they bundled this up with other sensible amendments to the constitution hence i’m forced to vote against the lot. i’m also disappointed that geoff wilson would seek to treat shareholders this way as a had a fair degree of respect for him. gary a

Gareth Brown: I hadn’t read the AGM documents from Wilson Investment Fund, so thanks for sending your thoughts in Gary. This resolution is being put to both WIL owners and WAM Capital owners. If I was a shareholder, I’d vote against it. The amendment may guard against ‘frivolous and vexatious’ changes, but it might also protect management from the full force of shareholder democracy. It may well be that this amendment is perfectly reasonable, but if so I reckon it deserves a very

24–30 october 2009 telstra-nomics: a $25b incentive to haggle · telstra-nomics: a $25b incentive...

Documents