Australia’s 10 best businesses

Special report | Published NOVEMBER 2012

Intelligent Investor PO Box Q744 Queen Vic. Bldg NSW 1230 T 02 8305 6000 F 02 9387 8674 [email protected] www.intelligentinvestor.com.au Intelligent Investor

A letter from the Research Director

Dear Member,

In August and September last year markets were, to use a technical term, somewhat jittery. And ’s 10 Best Businesses in those months—the time of year when research commenced on our reports in 2009 and 2010 —we were so busy upgrading stocks for you that we didn’t have a chance to prepare the report. E Insurance The investment opportunities included (Strong Buy at $22.97), QB (Strong Buy at $14.62—yet to reward our patience) and (Long Term Buy at $11.47). In fact, that might be a good ‘buy’ signal to note in future: if the team at Intelligent Investor is too report, it’s time to buy (the busy upgrading stocks to produce the Australia’s 10 Best Businesses market is up more than 10% plus dividends, since). This year we’ve banked a few profits and our buy list has dwindled. One upside of having fewer new opportunities to investigate (apart from the profits) has been gaining some analytical breathing space for a detailed project such as this. The starting line up remains the ASX200, expanded in 2010 from the ASX100 considered in the inaugural 2009 report. And the timing of the decade under analysis means that resources-related stocks form the highest proportion of the top 10 that we’ve seen to date. In this report you’ll find not only the raw numbers—thought-provoking in themselves—but a good deal of interpretation and reflection as well. We start on page 2 with an explanation of the ‘four filters’ process used to determine our list of finalists and then, on page 3, the heavy lifting commences. Please pay careful attention to the caveats and warnings raised in the reflections section. This year more than ever we must be vigilant not to fall into a couple of common investing traps in examining such numbers. We explain this in more detail on page 7.

Yours sincerely, CONTENTs page

The four filters explained 3 Reflections on Australia’s 10 best businesses 6 Of great businesses and great investments 7 tells a few tales 7 Snapshot of Australia’s top 10 businesses 9 Nathan Bell Is Monadelphous the greatest? 10 Research Director IRESS: Does fear bring opportunity? 11 BHP Billiton: Hedge or hog? 13 Fleetwood debt free, not risk free 16 Why CSL is a top 10 business 17 Coca-Cola Amatil’s wet summer 19 Put some Woolies in your basket 20 The earnings hole 22

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The four filters explained

Like most ‘best of’ lists, determining Australia’s 10 Best Businesses involves some subjectivity. In our first report of this kind in 2009, we opted for a ‘four filters’ approach. The process was fine-tuned in 2010 and the starting line-up expanded from the ASX100 index to the ASX200. This report retains that methodology and source of contenders. Let’s take a look at the four filters.

Filter 1: Sustained double-digit dividend growth The first of the four filters is simple yet powerful: To have grown dividends per share by more than 10 per cent per annum over both the past five and ten years (without a break in payments). This may seem a simple metric but it’s potent when applied over a full decade. Few weak businesses can sustain double-digit dividend growth over a 10-year period. This filter helps weed out companies built on shakier foundations. Dividends aren’t just relevant to separate the best from the rest. In fact, dividends have provided around half of the total return from the Australian sharemarket over the past 20 years. That’s important to keep in mind when searching for opportunities; the best companies tend to generate (and pay out) increasing amounts of cash. Dividends have Filter 2: Return on Capital Employed (ROCE) provided around half of The second filter is return on capital employed (ROCE—commonly pronounced ‘roh-kee’), the total return from the a key ratio our analysts consider in evaluating businesses. This metric provides an indicator Australian sharemarket over of the economic strength of a business; a company with a high ROCE is more likely to the past 20 years. generate superior investment returns over the long run. We haven’t made adjustments to reported numbers, on the premise that using a decade of data should smooth out most irregularities. Calculating ROCE involves taking the reported earnings before interest and tax (EBIT) and dividing it by the combined amount of capital provided by shareholders and lenders (including both short and long-term debt). From those stocks that made it into the second filter, we’ve eliminated those that failed to provide an average return of at least 12% on their total capital. For a quality business, this hurdle shouldn’t prove difficult to clear.

Filter 3: Return on Incremental Capital Employed (ROICE) Our third filter is return on incremental capital employed (ROICE), a measure of how much extra profit is generated compared to the additional capital (both debt and equity) that’s been added over a given period (the past 10 years, in this case). When it comes to equity, much of this extra capital tends to come from retained earnings (that is, profits not paid out as dividends). We’re seeking those companies that have used extra capital profitably over the past decade, something that ROCE alone does not adequately capture. In fact, the difference between the average ROCE and ROICE can provide good insight into the success of a company’s strategy and direction. As with our second filter, we’ve set a hurdle rate for this measure. In this case, of 15%. If a business can’t deploy additional capital at a rate of return above 15%, it doesn’t deserve a place on the list of Australia’s very best businesses.

Filter 4: The Great Business Index The fourth and final filter is a ranking system. Using the stocks that are still standing, we rank each based on the results of the prior filters. For example, the stock with the highest 10-year dividend growth is ranked number 1 in that category, the runner-up number 2 and so forth. The ranks for each stock across the three filters are added together, giving a minimum possible score of 3 (if a business ranked number 1 on every filter). The stock with the lowest score is crowned the top business, and so on down the list until we have our top ten.

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First Filter: Dividend per share growth That only 17 stocks from the entire ASX200 index made it through our first filter speaks to its potency. The big banks, prized by investors for dividends, all fell a long way short of a 10% dividend growth rate over the past five years ( was the best at 6.3%, NAB was the worst at just 0.7%). In Chart 1, you can see the results of the 17 stocks that made it through, ranked by their 10-year dividend growth rate. At the bottom end of the range we have , Chart 1: 10-year dividend making the cut with a respectable annual dividend growth rate of 11.6% (and a five-year growth rate rate of 11.2%). The clear winner was Monadelphous, boasting an astounding 10-year

0% 10% 20% 30% 40% 50% annual dividend growth rate of 43.0% (and a five-year figure of 19.6%). MND With 7 of the 17 stocks being resources-related, it’s tempting merely to conclude that CPU the rising tide in the sector over the past decade has lifted all its boats. But, while that is ORG part of the story, as we discuss on page 12, the fact that BHP made the list while ASL BHP didn’t underlines the importance of management’s ability to profitably invest those profits ALQ not paid out to shareholders—what the pointy heads call ‘capital allocation’. CSL Rio’s audacious 2007 acquisition of Alcan was ill-timed and badly priced (for its own NCM IRE shareholders). As a result, Rio has failed to surpass its 2008 dividend level to date, while FWD BHP shareholders have enjoyed a rise of more than 50% since that year. MTS The Rio/BHP divide shows clearly how poor management (or strategy) can undo RHC the good fortune of favourable industry tailwinds. The same might be said for Leighton COH WOW Holdings, which has run into problems of late and failed to make the list after doing so CCL in both 2009 and 2010. DJS Overall, nine stocks that made our previous list on this score didn’t make the cut in FLT 2012. These were , , Toll Holdings, Cabcharge, Source: Capital IQ UGL, Leighton Holdings, QBE Insurance, Sonic Healthcare and Downer EDI (which went from being a regular dividend grower to paying out nothing for the past two years). On a positive note, three stocks are new to the list this year; IRESS, ALS (formerly Campbell Brothers) and Ausdrill. With nine removals and three additions to our previous list, let’s take our 17 contenders through to the next stage. Second Filter: ROCE We calculated the average ROCE for each stock over the past decade and, as in previous years, eliminated any stock that failed to clear a 12% hurdle on this measure. One stock Chart 2: 10-year ROCE didn’t make the grade on this measure, so it’s with our best Trump/Bouris voice that we say to : ‘you’re fired’. 0% 10% 20% 30% 40% 50% 60% 70% MND Chart 2 shows that almost half the field (8 of 17) posted average ROCE in the teens, IRE while Monadelphous topped the class with an amazing 65.1%, beating IRESS’s impressive COH 62.6%. BHP With Origin dropping out, 16 candidates move on to our third filter. FWD WOW FLT Third Filter: ROICE MTS This filter is related to ROCE. But rather than measuring the return on the amount of CSL ALQ capital employed, it focuses on the return attributable to the additional amount added to CCL business over a period. ASL Australia’s best businesses should be able to invest additional capital at healthy rates DJS of return, which is why 15% is our benchmark on this measure. So if a business has an CPU NCM additional $10m of capital invested in it now, compared with 10 years ago, it needs to have RHC more than $1.5m in additional annual profits to show for it. ORG Computershare, Cochlear and failed to make the grade here and Source: Capital IQ Ausdrill only scraped in with 15.4%, but the rest of our 16 contenders cleared the 15% hurdle with ease. Cochlear is the most notable elimination, after topping our inaugural list of Australia’s 10 Best Businesses in 2009 (and being runner-up in 2010). The reason it fell short this year was the expensive voluntary recall of its Nucleus CI500 product in September 2011, which hammered profits by more than $100m. It was the right thing to do by Cochlear’s customers and if the company is able to get back on track in 2013, then it’ll almost certainly break back onto the list in 12 months’ time. Computershare is another high profile casualty, after making the top 10 in both our previous lists (5th place in 2009 and 6th in 2010). The cyclical parts of the group’s operations are currently struggling and it employed significantly more capital by acquiring

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Mellon Investor Holdings in the US on 31 December, 2011. This meant the full amount of additional capital is factored into our calculations but the business only contributed half a year’s earnings in the 2012 accounts. Even with a full year’s earnings from Mellon next year, Computershare is likely to need an upturn in financial markets activity before it once again stakes a claim to being one of Australia’s top 10 businesses on this measure (read more about important investing lessons from Computershare on page 7). Filter 4: The Great Business Index Tallying up the rankings of our 13 finalists in each of the previous categories, we arrive at a ‘Great Business Index’ for each. This year it produced a clear winner, a clear loser and a few tied results. was the bottom-ranked of our top 13, only breaking into the top 10 on a single measure (being dividend growth, and only then in 9th place). That said, its Chart 3: THe great business index numbers in absolute terms are very respectable and the stock has been an outstanding 0% 10% 20% 30% 40% 50% 60% 70% 80% investment for its long-term owners. There’s no shame in being the worst of the very best. MND Flight Centre ranked comfortably ahead of Ramsay but not high enough to beat any of DJS the other contenders. That left 11 contenders for the top 10. CCL A simple application of the Great Business Index resulted in a tie for second place FWD between IRESS and BHP Billiton and a three-way dead heat for ninth place between IRE CSL Metcash, Ausdrill and David Jones. We split these ties by ranking them on ROCE—a robust BHP measure given it averages results over 10 individual financial years (giving less wiggle room FLT than dividend growth and ROICE, both of which take single beginning and end points). ALQ This secondary ranking saw David Jones fail to make the cut, sliding down from ninth WOW place in 2010 to 11th on this year’s list. And on current trends, with dividends and profitability MTS under siege, it’s unlikely to be a contender next year. ASL So, for the second time running, we crown Monadelphous Australia’s Best Business. Once NCM again this outstanding company was top of the pops on every measure. Even acknowledging CPU COH the sector’s strong tailwinds, this is a remarkable achievement which shows management has done a fantastic job of making hay while the sun has shone on the mining sector. Source: Capital IQ Through a superior ROCE of 62.6%, IRESS takes second place ahead of BHP Billiton (average ROCE of 34.1%) with bronze. But the vast gulf between the scale of the two enterprises should be acknowledged. IRESS earns exceptional returns on $122m in capital, which is admirable, but BHP earns great returns on more than 700 times that capital base ($90bn-plus). In fourth place is Fleetwood Corporation. Both of this company’s business lines have enjoyed favourable backdrops: manufactured accommodation from the mining boom and recreational vehicles from Australia’s growing herd of grey nomads. Fleetwood’s management has flagged that profits may fall this year due to resource project delays and there’s every chance that Mr Market will overreact when he sees those numbers flow through. That’s certainly what he did four years ago when we last upgraded Fleetwood to Long Term Buy, so this is definitely one to add to your watch list for the coming year. Blood products group CSL rounds out the top 5. Alongside Woolworths, this home- grown biotech success story is the only company to make the list in all three Australia’s 10 IRESS earns exceptional Best Businesses reports to date. returns on $122m in capital, ALS (formerly Campbell Brothers), at number six, is another to have ridden the resources which is admirable, but BHP wave. Providing laboratory services to the industry is the modern equivalent of selling picks earns great returns on more and shovels to miners. than 700 times that capital Coca-Cola Amatil arrives in seventh place. After many years of negativity, we reappraised base ($90bn-plus). this business back in 2009 (see Reassessing Coca-Cola Amatil, June 2009, issue 274). And while we haven’t yet seen a suitable opportunity to issue a positive recommendation, we are much more appreciative of its charms and it’s not surprising to see it make the list. Speaking of unsurprisingly good stocks on this list, Woolworths delivers the goods in eighth spot. While dividend growth has slowed over the past couple of years, its stellar performance prior to that is more than enough to carry it through. It’s interesting to note that to pass our first filter in 2020, Woolworths will need to make a dividend payment of more than $2.98 per share in that year—for which it will likely require more than $3.5bn (depending upon how many shares are on issue in 2020). That, in turn, would probably demand a net profit of about $5bn, compared to this year’s underlying profit of $2.2bn. It’s an interesting prism through which to consider the company’s future. An outbreak of inflation would likely help but, absent that, management will probably need to get the Masters concept very right or be successful in getting pharmacies into supermarkets to hit the mark.

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With lower returns expected across the board, however, Woolworths is unlikely to be the only company struggling to make the cut in 2020. And as we explained when upgrading the company to a Long Term Buy recently (see Put some Woolies in your basket, issue 355), prospective returns in the high single digits are sufficient to make it an attractive investment in the current environment. The top 10 finishes with a flourish—a three-way tie between David Jones, Ausdrill and Metcash. We’ve already revealed that David Jones finished in 11th place, so all that’s left is to separate grocery wholesaler Metcash from another resources boom beneficiary, Ausdrill. So without further ado, ninth place goes to Metcash (ROCE of 20.7%), ahead of Ausdrill in 10th (ROCE 17.1%).

Table 1: australia’s top 10 businesses Rank Stock 10-year rank roce rank roIce rank Total Div. growth

1 Monadelphous Group 43.0% 1 65.1% 1 76.7% 1 3

2 iress 20.3% 6 62.6% 2 39.6% 5 13

3 BHP Billiton 24.0% 3 34.1% 3 31.9% 7 13

4 Fleetwood corp. 19.3% 7 29.0% 4 44.5% 4 15

5 CSL 22.0% 5 19.6% 8 38.4% 6 19

6 Als 22.3% 4 17.2% 9 25.2% 9 22

7 coca-cola amatil 14.1% 11 17.2% 10 47.9 % 3 24

8 Woolworths 14.3% 10 27.3% 5 23.8% 10 25

9 Metcash 18.8% 8 20.7% 7 18.0% 11 26

10 Ausdrill 25.5% 2 17.1% 11 15.4% 13 26

*Note that rankings are 1–13 based on the 13 stocks making it to the final filter. Only the Top 10 are shown in this table.

Reflections on Australia’s 10 best businesses

In 2009’s inaugural Australia’s 10 Best Businesses report we wrote:

‘Before diving into the official results, honourable mentions go to Billabong International, WorleyParsons and JB Hi-Fi. None of them have been listed long enough to make the cut for round two—Billabong was listed in August 2000, WorleyParsons in November 2002 and JB Hi-Fi in October 2003. Yet all three seem on track to make the grade when they hit their 10-year anniversary.’ Billabong’s foray into the retailing industry was We’ll take our humble pie with all the trimmings, thank you. Billabong’s woes have been arguably the wrong strategy, well documented since the ink dried on those words and the company’s travails underline executed poorly. how difficult it is to sustain performance over a 10-year period. A company must successfully manage internal variables including its products or services, finances and its people while taking account of broad economic conditions and any specific changes in its marketplaces. Management must adjust the sails accordingly, set an appropriate strategy and then execute effectively on that strategy. Billabong’s foray into the retailing industry was arguably the wrong strategy, executed poorly or, at the very least, undertaken with exquisitely unfortunate timing. We upgraded the stock to Speculative Buy in July this year in anticipation of a turnaround (see Billabong’s road to recovery from 25 October for our latest review), but much damage has already been done. Hopefully we’re not jinxing WorleyParsons when we say that it continues to have every chance of making next year’s list given its ASX odometer ticks over the 10-year mark in November. But JB Hi-Fi will have to wait until it posts its 2014 accounts to be in the running. If management can reverse recent falls in earnings and dividends, then it’ll definitely be in with a shot at the top 10. But a profit turnaround is no sure thing, so we’ll watch with interest.

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Of great businesses and great investments

The crucial distinction between a great business and a great investment has been a recurring theme in previous Australia’s 10 Best Businesses reports. This year we’d like to highlight that distinction more than ever, with half of the top 10 consisting of stocks with direct resources exposure: BHP, Monadelphous, Ausdrill, ALS and Fleetwood. That’s up from four stocks in 2010 and just two in 2009. As discussed above, 10 years seems enough time to iron out a fair degree of luck and many cyclical ‘bumps’. But Australia’s resources boom has been so large and sustained that it’s important to acknowledge its buoying effect on these numbers. Regular readers will know we didn’t participate in the blind optimism which pervaded the sector at the top of the boom and, as they say in the ads, past performance is no guarantee of future returns. This is especially so today. The final collection Investors have marked down the prices of resources-related stocks over the past six months in anticipation of tougher conditions ahead. If that view proves correct, then we’ll likely see of stocks should be seen the number of such stocks in contention for this report’s title dwindle over the coming years. as a ‘thought starter’ for The final collection of stocks should be seen as a ‘thought starter’ for investment ideas, investment ideas, not a not a buy list. And this year’s numbers—which share a starting point with the resources buy list. boom—could offer more than their fair share of traps for the unwary. Of the five non-resources stocks in the top 10, we recently upgraded Woolworths to Long Term Buy and we’d love a chance to own the others at the right price; indeed CSL and Metcash have both sported positive recommendations at some point over the past 15 months (although we reversed course on Metcash in August, see The Metcash earnings hole, issue 351). As for the resource-related stocks on the list, BHP Billiton isn’t too far from attracting a positive recommendation. Its breathtaking diversity shields it from the precipitous profit drops to which more specialised groups are susceptible. Fleetwood we’ve already flagged in this report. A 10-year share price chart graphically illustrates how this is a stock that can quickly be dumped by investors. We’ll be waiting and watching to see if others become overly pessimistic about this one—we’ve made Chart 4: FWD 10-year share price good money from it in the past and a chance to repeat the dose may not be too far away. Of the other three stocks, we remain wary. Despite acknowledging management’s $15 bravura performance at Monadelphous in ideal conditions, we don’t have a good feel for $12 how badly profits might suffer in a nasty downturn. The same goes for ALS and Ausdrill. We wouldn’t rule out ever buying them but we’d $9 need to see how the businesses behaved under conditions much different to the past $6 decade and then make a judgment at the time relating to their stock prices. In the end, a dollar made from Woolworths spends just the same as one made from $3 Ausdrill and, as Warren Buffett has long counselled, it’s important for investors to recognise $0 the boundaries of their circle of knowledge (‘It’s not how big the circle is that counts, it’s Nov 04 Nov 06 Nov 08 Nov 10 Nov 12 how well you define the parameters,’ he has sagely noted).

Computershare tells a few tales

Computershare makes the same point in the opposite way. While those businesses that have benefitted from the resources boom have produced numbers that are almost certainly unsustainable on the upside, the cyclical elements of Computershare’s business are currently at a low ebb. It’s the flip side of the same lesson. The key idea is that cyclicality can temporarily boost or obscure a business’s underlying attractiveness (or lack thereof). There’s no doubt in our minds that Computershare is a better business than Ausdrill. It has a much stronger competitive position. Yet Ausdrill sneaks on to our top 10 list while Computershare misses out. Computershare’s business strength is almost certainly understated by its 8.6% ROICE—partly

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due to the timing of the Mellon acquisition (the business didn’t contribute profits for a full year) but also because of current market conditions. In this light, Computershare’s 10-year average ROCE of 16.1% is more reflective of its true quality than its low-looking ROICE of 8.6% (while Ausdrill’s 17.1% average ROCE most likely way overstates its underlying economic attributes). Our task as investors is twofold. Firstly, to figure out whether we’re dealing with a cyclical business (which, in a lengthy boom, can do a convincing job of masquerading as a fast grower). Secondly, we must attempt to look ‘through the cycle’ when considering valuation measures such as a PER, dividend yield or equivalents. Paying a high multiple for boom-time profits is one of the most painful investing mistakes there is. That’s because the stock price drops at an even faster rate than profits as investors reverse the process and pay a lower multiple for lower earnings. To move on to another layer of complexity, a cyclical business can also be a growth stock over time—with each peak in earnings surpassing the last. In fact, that’s precisely our view of Computershare. And, reflecting on the introduction to our upgrade to a Buy recommendation back in July 2002 at $2.08, you can see the theme of investors getting too despondent at cyclical low points: We all know markets can overreact, sometimes pricing a stock too highly and at other times too cheaply. And we’ve also heard the old adage “buy in gloom, sell in boom”. These are clichés because they usually contain a grain of truth. Which brings us to Computershare. After hitting the heady heights of $9.88 during the dot-com boom, the press and many analysts have now changed their tune. We’ve seen one Paying a high multiple report that showed the stock was trading below the analysts’ valuation, yet they refused to for boom-time profits is one make a positive recommendation. of the most painful investing The reasons given were “poor profit visibility, low management credibility and further mistakes there is. downside risks to 2H02 earnings expectations.” Stuff like that warms our hearts. Here’s someone who has crunched the numbers, thinks they stack up but can’t bring themselves to call the stock a buy. The dot-com boom high of $9.98 referred to in that article also makes another crucial point. Since hitting that lofty price, Computershare has grown profits at a very healthy pace. Earnings per share have soared from 7.5 to 48 cents. That’s a compound annual growth rate of 16.7%, or 24.5% if you measure to the last cyclical high in 2010. Yet anyone who paid $9.98 per share in late 2000 and held on has done poorly. They were paying 998 cents for just 7.5 cents of earnings back then. You can do the math on the PER that implies, but suffice it to say that any time you’re paying a triple digit PER, you’re banking on an extraordinary outcome—simply superb growth (the kind Computershare has delivered) just won’t cut the mustard. Along the same lines, James Montier of respected funds manager GMO wrote a white paper last year titled The Seven Immutable Laws of Investing in which he examined the performance of what Fortune magazine dubbed ‘Ten stocks to last the decade’ in August 2000. A decade later an equally-weighted $100 portfolio of those stocks would have been worth—wait for it—just $30. The stocks were Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley and Genentech. Montier reports the average PER at purchase for these stocks was 347. This may sound like a simple lesson and you might think that such mistakes are confined to the most irrational booms of the past. We’re all smarter today, right? Yep. Just ask those who paid a PER of more than 100 in Facebook’s float earlier this year. Some of those people now want to sue the company for their subsequent losses. Well, in addition to their legal bills, we suggest those people invest in a mirror. And you can bet that Facebook won’t be the last triple-digit PER stock you’ll ever see. So, to borrow the emphatic written style of the Facebook generation, we declare: Price. Always. Matters. Please make a note of that and remind us of it here at Share Advisor if you ever think we’ve forgotten. And, with that request, we’ll bid you adieu by saying that we hope you’ve enjoyed reading this romp through the numbers and accompanying reflections as much as we enjoyed putting it together for you. The 10 best businesses report has always been about stocks to watch rather than stocks to buy; high performance tends to come with a high price. Over the next few pages we’ll outline which top 10 stocks are worth buying, holding and selling today.

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Snapshot of Australia’s top 10 businesses

Monadelphous CSL As a provider of engineering services, you might think CSL has morphed from an obscure former government lab into Monadelphous earned its place at the top of the class by virtue of the largest healthcare business in the land. Part of a global oligopoly its exposure to the resources boom. Providing the engineering grunt that supplies blood plasma, CSL also has one of the largest research behind mining projects has no doubt been a handy business as budgets in corporate Australia, which has yielded successes like commodity prices have taken off, but Monadelphous is more than Gardasil, the groundbreaking cervical cancer vaccine. New treatments just a company in the right place at the right time. for Alzheimer’s and other diseases are also in the works. Despite Monadelphous has managed to eke out a rare competitive getting bigger, CSL retains an innovative streak that, yet again, earns advantage—stemming from its reputation for operational excellence. it a spot on our Best Businesses list. The company’s commendable conservatism and cash-rich balance sheet has spared it the woes of some peers. With performance metrics ALS well above average and a formidable track record, Monadelphous Despite being among the oldest businesses on this list, ALS deserves first place as Australia’s Best Business. is also one of the newest entrants. Formerly known as Campbell Brothers, ASL has been in business since 1863. During its long history, Iress it has done everything from manufacturing soap to selling instant Tens of thousands of finance workers use Iress software to research noodles and canned fish. More recently, the company has and execute trades each day. This small Australian software company morphed into a significant lab tester. The mining boom has helped dominates the local market and takes on giants like Bloomberg and grow the business enormously; it now operates 300 labs across 50 Thomson Reuters internationally. The secret of their success has less countries, testing samples for clients in the mineral, pharmaceutical to do with brilliant software and more to do with its powerful lock and industrial sectors. on users. Iress is trying to grow overseas but there is little doubt that Australia will continue to play a large part in the company’s success. Coca-Cola Amatil Coca-Cola Amatil doesn’t own the iconic Coke brand. It does, BHP Billiton however, own bottling and distribution rights in Australia and other Long known as the Big Australian, BHP Billiton has grown to regional markets, including Indonesia, Fiji and New Zealand. Efficient overshadow even that impressive moniker. Admittedly, BHP’s growth operations, rights to one of the world’s great brands and growing owes much to the growth of China, but the success of this markets have made CCL enormously successful. commodities colossus is also testament to the quality and diversity of its assets. Iron ore, coal and petroleum have been key divisions Woolworths for BHP, generating sensational margins. And its diversified business Woolies ticks almost every box for quality; a terrific track record, a model helps to smooth out volatile prices. Few companies can match stable business, high barriers to entry and stunning financial metrics. the size and quality of what BHP produces from some of the largest Few supermarkets around the world are as dominant or as profitable. and lowest cost mines in the world. If the China story remains intact, And it will be a bigger and better business a decade from now. No then prepare for BHP to get even bigger. Best Businesses list would be complete without it. Fleetwood Metcash Through good luck or good management, Fleetwood’s star has Both investors and competitors have long underestimated the been hitched to two important wagons over the past decade; the perennial number three grocery retailer, but Metcash does have resources industry and Australia’s ageing population. Among other unique advantages. As a wholesaler, rather than an operator of retail things, the company’s manufactured accommodation division runs stores, Metcash generates significant free cashflow and it is the only ‘Searipple Village’ in the town of Karratha in Western Australia’s Pilbara independent national wholesaler of groceries. As competition in the region, providing single-person accommodation for up to 1,500 sector intensifies, Metcash is changing. Will this be the last year it inhabitants. Karratha has boomed due to its strategic location close makes an appearance on this coveted list? to the nation’s key iron ore deposits and the North West Shelf project. Fleetwood has also profited from the growing herd of ‘grey Ausdrill nomads’ buying caravans and setting off around the country for the As mineral prices have soared this decade, so has demand for retirement trip of a lifetime. You’ve probably been stuck behind one drilling and blasting. Ausdrill has been a prime beneficiary of that of its Coromal or Windsor vans at some point. Directors, presumably growing demand. Starting with a single drill rig in 1987, Ausdrill now cognisant of Fleetwood’s good fortune, don’t seem to harbour any operates in nine countries across many commodities. Be aware that grand plans to become the next . Excess profits have been there is probably a strong cyclical element to this business’s recent paid out to shareholders via a number of hefty special dividends over success, so whether it’s still on the list come 2015 will all come down the past decade. to China and the length of the current resources boom.

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From the vault | First published 16 Jun 2010

Is Monadelphous the greatest?

The long term success of Monadelphous suggests that this business is a cut above Key points the competition. That’s still not enough to earn an upgrade. Monadelphous has a strong record of operating and financial performance ‘It’s just a job. Grass grows, birds fly, waves pound the sand. I beat people up’. When Management have been trying to diversify the pressed, American boxing legend Muhammad Ali was adamant; what he did was nothing business from its reliance on the resources sector special. It was the way he did it that made him ‘the greatest’. The business remains cyclical, and has benefited Monadelphous is perhaps similar. As a provider of engineering services, the company from an investment boom has no special moat around its business and no obvious competitive advantage. Any gaggle of engineers can be organised into a competitor with minimal fuss, and because many of its customers are commodity producers, they tend to expand production at the same time. The engineering industry is thus characterised by lots of competition and chronic cyclicality. Like the great boxer, however, Monadelphous is remarkable not for what it does, but the way it does it. To its customers, who expend billions of dollars to develop projects, skill and a track record that demonstrates skill are worth paying for. It’s time to closer examine how this company has excelled in an otherwise difficult activity.

Number crunching In a highly competitive, cyclical industry, we should expect razor thin EBIT margins, fluctuating revenues and lumpy dividends. Yet Monadelphous shows no signs of cyclicality; it has been growing steadily since it was bought by current management in 1988. Nor are there any indications that this is a tough, competitive business; earnings per share have rocketed more than tenfold since 2002 and dividends have risen steadily (see Table 1).

Table 1: Monadelphous’s profit summary Monadelphous Group | MND 2002 2003 2004 2005 2006 2007 2008 2009 Date 6 Nov 2012 Revenue ($m) 155.6 244.8 223.4 391.7 534.2 968.4 958.6 1,127 Current price $20.65 NPAT ($m) 4.7 7.0 8.5 16.6 29.4 60.4 69.5 74.2 Market cap. $1.9bn EPS (cents) 6.5 9.5 11.1 21.1 36.4 73.5 83.2 87.5 12 mth price range $18.31–$24.37 DPS (cents) 3.51 6.25 7.5 19.25 33 66 72 74 Fundamental Risk Medium–High Share price risk High There is little doubt that this business has performed superbly over a long time. But we Our View coverage ceased need to distinguish between a growing industry and a great business; is this really a great business or have the last ten years simply been kind to engineers? If there’s something special about Monadelphous, it should show up when we compare some key metrics to Table 2: Competitor key metrics its peers (see Table 2). Mkt eBIT roce ROA per As you can see from Table 2, Monadelphous earns amongst the highest EBIT margins cap margin (%) (%) ($m) (%) in its industry, suggesting superior cost control, pricing power, or both. We would ordinarily use return on capital employed (ROCE) to compare the returns from the industry. But in Monadelphous 1,106 9 NA* 28 14 Monadelphous’s case, the company carries more cash than it has equity on its books, so Leighton Hldgs 9,321 6 25 10 15 this figure becomes meaningless. Using return on assets (ROA) as a proxy is less pure but WorleyParsons 5,567 11 28 17 18 the high numbers generated by Monadelphous are consistent with a picture we have long United Group 2,103 5 16 9 14 suspected; this is a better than average engineering business. Downer EDI 1,538 5 18 9 8 Happy customers Transfield 1,438 –2 –6 –3 12 The bulk of Monadelphous’s profits come from its Engineering Construction division Bradken 955 10 17 13 13 and its Maintenance and Industrial Services division. The long term and recurring nature of Ausenco 246 6 9 6 9 work from these two divisions provides some buffer against cyclicality; more than 40% of *Capital employed is negative due to the company’s its contracts are recurring for at least five years and about 80% for more than two years. unusually high cash balance Like loyal shoppers, customers of Monadelphous return; it has a 90% contract retention rate, meaning that nine out of ten customers that use its services come back. The high

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retention rate and long term nature of its contracts is evidence of an impressive operating record and excellent reputation. Chart 1: Composition of revenue The company’s success has been aided by being in the right sectors at the right by sector time; more money has been spent on iron ore and coal expansions (two specialties of 100% Monadelphous) than other commodities over the current boom. And since Monadelphous is also able to work on the logistics and infrastructure that are vital for the expansion of 80% bulk commodity production, it has been particularly sought after. 60% But management has acknowledged that the company has benefited from favourable industry conditions. Revealing a conservative streak, management has actively sought to 40% diversify away from the minerals sector into energy and infrastructure (see Chart 1). This 20% is a bit like Muhammad Ali giving up boxing and turning to football; it was with his hands that he found success, not his feet. 0% FY07 FY08 FY09 HY10

For all seasons Infrastructure Energy Resources It is hard to fault the company’s performance to date; it has regularly paid dividends, Source: company presentation 2010 barely raised additional equity and rarely turned to debt. For all these virtues, however, Monadelphous remains a cyclical business and needs to be treated as such. Chart 2: Mining employment and The most important driver of demand for Monadelphous is mining investment; the investment* amount of money companies are willing to spend on development and production. This level changes with commodity prices and as Chart 2 shows, it is higher now than at any % 15 Mining employment** other time over the last 150 years. Share of total That mining employment, the top half of Chart 2, has not risen much suggests that the 10 massive spike in mining investment (the bottom half of the graph) is being spent on exactly 5 the type of capital expenditure that Monadelphous provides; processing plants, pipelines, and % project development. Things are as good as they ever have been for the engineering industry. Mining investment While there is nothing to suggest that this cannot continue for many more years, mining 4 Share of GDP expenditure cannot stay at such elevated levels forever. The very fact that miners are spending 2 billions on capacity expansion is sure to mean that at some point, supply will increase and prices subdue, along with investment. The difficulty is that no one can be sure when this might happen. 0 1859 1889 1919 1949 1979 2009 Buying the stock under such conditions is risky; investment plans are fickle. It is easy to imagine a scenario where commodity prices fall, credit is unavailable, and mining plans shelved. *Annual This is a business best purchased amidst fear. We thought the concern about falling mining ** Data before 1890 are for VIC, NSW, QLD and SA investment caused by the RSPT might have created the opportunity to pick up Monadelphous at an Source: Reserve Bank of Australia 2010 attractive price, but so far that has not been the case. Therefore, having identified Monadelphous as the pick of the sector, the best thing to do is to wait for a better buying opportunity.

From the vault | First published 5 Jul 2012

IRESS: Does fear bring opportunity?

Market sentiment has turned against IRESS, and with it may come a buying opportunity. Jason Prowd investigates. Key Points There are risks, especially in the principal Australian ‘Brokers: it’s as bad as it’s ever been’ (SMH article, 5 Jun 12). While it might be the business kind of headline to get a contrarian investor’s juices flowing, that will be cold comfort for Management has been working to reduce these risks Andrew Walsh, managing director of IRESS, which makes its money oiling the wheels of Still too expensive to upgrade the broking and financial services industries. The Business Day article goes on to compound the pain, with Michael Manford, executive chairman of Patersons Securities, saying: ’This is a tough time for the markets, a tough time

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for investors and a tough time for those working in the industry, especially stockbrokers.’ IRESS | IRE Ouch. Those wheels aren’t so much in need of some oil as a root-and-branch rebuilding. Date 6 Nov 2012 Concerns over the possible effects of such a rebuilding explain why investors have

Current price $7.56 been fleeing IRESS, pushing its share price down 31% since reaching a post-global financial crisis high of $9.67 on 31 May 11 and 21% since we originally recommended the stock in Market cap. $980m The Iress money making machine on 20 Jul 10 (Long Term Buy—$8.40). 12 mth price range $8.93–$8.10 It’s a massive share price fall for a business that by most financial measures has Business Risk Low–Med performed fabulously over the past decade. Indeed, total returns over the eight years prior Share price risk Medium to the recent peak were a buffett-beating 25% a year. So should we panic? Max. portfolio weighting 3% In short: No. But before unpacking why, let’s quickly review IRESS’s business.

Our View Hold IRESS sells software systems to the finance industry via two businesses: ‘financial markets’ and ‘wealth management’. The first designs software for stockbrokers to manage their trading systems and provides detailed financial information on listed companies. The wealth management division focuses on creating software for the financial planning Chart 1: ASX trading volumes ($bn) industry, helping businesses manage compliance and customer accounts. 1,600 It’s in the financial markets business that cost-cutting by brokers presents the biggest threat. 1,400 Short-term risks real 1,200 1,000 IRESS’s financial markets business is exposed to activity in equity markets and the 800 profitability of that activity. If equities are on the nose, there’s a real risk of brokers cutting IRESS subscriptions and services. Indeed, brokers such as Wilson HTM, Bell Potter and 600 Euroz have already flagged their interest in cutting costs. 400 Chart 1 explains why: Equity trading volumes haven’t returned to pre-GFC peaks. 200 Furthermore IRESS, like any software company, has high fixed costs, and this only ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 exacerbates the threat. Losing just a few clients could devastate earnings. ASX trading volumes For the far-sighted investor, however, this is nothing to fret about. Any drop in earnings Source: ASX from lower trading volumes should prove temporary. Even during the GFC, IRESS emerged relatively unscathed, barely losing a customer from its Australian financial markets business (see Chart 2). The time to buy a cyclical business is now when conditions are deteriorating. The time Chart 2: Financial markets ($m) to panic was when shares were trading at nearly $10, not now at around $7. 8 Success begets risk

7 But larger more permanent risks loom. Currently IRESS’s Australian financial markets business generates 65% of the company’s profits (see Chart 3) with IRESS controlling nearly 5 the whole market data and broking market. But industry developments could undermine the profitability of this business. 4 If (when?) a recession bites there might be a consolidation of the broking industry, and with it might come a lean, more efficient broking model where demand for IRESS subscriptions diminishes markedly. Alternatively, brokers could develop in-house software and 3 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 platforms. Even renewed competition from international data providers such as Bloomberg, Monthly subscription revenue Thomson Reuters, Fidessa or S&P Capital IQ is not out of the question. Global financial crisis These risks are real and, if they came to fruition, they would have a serious impact on Source: Company reports earnings. However, they are also ever present in this sort of industry, so they need to be seen in context. In fact, international competitors have already tried to breach IRESS’s monopoly of the Australia market without success. Brokers have also shown limited interest in developing Chart 3: IRESS profit by division/ proprietary systems and the industry has been moving towards external solutions such as geography IRESS’s. What’s more, IRESS doesn’t overtly exploit its market dominance, limiting excessive price rises and constantly developing products that exceed client expectations. Financial mrkts (AU) 66% Wealth mgmt (AU) 16% Management has a plan Financial mrkts (CA) 10% Financial mrkts (SA) 6% Management, thankfully, is acutely aware of its overreliance on the Australian market Wealth mgmt (SA) 2% and is rectifying this by diversifying IRESS’s product offerings and geographic exposure. Firstly, expansion into the wealth management software market looks very sensible. Source: Company reports Demand for wealth management software isn’t correlated to demand for equities. Indeed, even if ‘equities are dead’, money still needs to be managed. Ever-increasing compliance burdens are also driving demand for sophisticated software systems. Furthermore, once these systems are installed and integrated into clients’ internal

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systems, they are very difficult to disentangle. Combined, these factors mean wealth management is a growing, attractive business, one that IRESS has grown to 25% of revenue in just nine yea rs. Secondly, IRESS is expanding overseas. We’re typically sceptical of overseas expansion plans but IRESS’s military-like discipline has resulted in a slow, steady, low-cost approach that’s yielding results. For example, its Canadian operation was started in 2004 via a beachhead acquisition of KTG Technologies, and has since grown to 15% of revenue. This market still has further The time to buy a growth opportunities as IRESS currently only focuses on sell-side broking clients. cyclical business is now when South Africa has also proved an area for growth. Starting with Spotlight in 2007 it has conditions are deteriorating. since purchased Peresys in 2011 for 375m rand (about $56m at the time). IRESS can still increase its presence in this market due to the rising demand for financial advice. But with an economy half the size of Australia or Canada, growth will have a natural limit. IRESS is also building businesses in Singapore and the UK. Growth in these markets could be excellent, especially in the UK where there are an estimated 5,000 independent financial advisory firms. All these markets are much more fragmented than Australia, meaning the benefit of controlling a monopoly is yet to be won, and explain why expansion abroad can yield results. IRE recommendation guide long term buy Below $6.00 Growth needed, not cheap enough yet Hold Up to $9.50 IRESS is an excellent business with a clear understanding of the risks it faces and a plan take part profits Above $9.50 to deal with them. But IRESS’s future isn’t going to mirror its past; while growth remains a necessity for a successful outcome, in future it is likely to come from overseas markets. But with IRESS currently trading on an adjusted free cash flow yield between 6.0–7.1% and a dividend yield of 5.7%, we’re getting adequate compensation while we wait for that growth. For new investors, however, we’re willing to wait for a wider margin of safety. Around $6.00 we’d upgrade to Long Term Buy, until then HOLD.

From the vault | First published 20 Jun 2012

BHP Billiton: Hedge or hog?

The world’s biggest miner is no cyclical pig. Gaurav Sodhi argues it makes the perfect hedge for China sceptics. Key Points BHP’s past losses have been mistakes of capital The popular image of BHP Billiton is as a cyclical business that makes decent money allocation in the good years but loses it by the bucket load in the bad years. In truth, BHP has not Profits have already peaked made an operating loss for more than 20 years. That period includes major global upheavals: Remains the pick of the sector the Asian financial crisis, Russian and Argentine debt defaults, September 11 and, of course, the global financial crisis. Yet despite the multitude of crises, BHP has remained resilient, generating operating profits in the face of each calamity. That’s not to say it has all been smooth sailing. The acquisition of Magma Copper in the 1990s ultimately cost more than $4bn and almost brought the company down. The complex Ravensthorpe Nickel project cost more than $3bn a decade later. And then there are the years of accumulated losses from steel. Losses from those ventures, however, were absorbed by profits from elsewhere in the empire. Time and again, BHP has been saved from disaster by high-quality, low-cost assets that make money throughout the cycle. Writeoffs and restructures, rather than lower commodity prices, have caused losses. BHP’s errors are of capital allocation—failures of management. In this review we’ll delve into the decisions that management might make in the future and how they might affect the business.

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Impressive assets The commodity boom has undoubtedly helped but, even before China became a by-word for boom, BHP’s operating divisions were making ample profits. BHP Billiton | BHP Table 1 shows the return on assets (ROA) since 2002 by commodity group. Date 6 Nov 2012 Iron ore, celebrated today as the focal point of the boom, has always been a terrific business.

Current price $34.85

Market cap. $185bn Table 1: BHP ROA by commodity, 2002–2012 Return on assets (ROA) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 12 mth price range $30.09–$38.82 Iron ore 34% 27% 25% 44% 64% 56% 54% 71% 44% 76% Fundamental Risk Low Petroleum 24% 23% 24% 31% 39% 31% 46% 33% 36% 34% Share price risk Med–High Base metals 1% 6% 14% 20% 42% 46% 51% 7% 31% 43% Max. Portfolio weighting 5% Coal 17% 5% 4% 11% 34% 21% 22% 64% 25% 29% Our View Hold Total 9% 10% 14% 20% 30% 32% 32% 15% 22% 30%

In 2002, iron ore prices were about $30 a tonne, yet BHP still generated ROA of 34%. In fact, since 2002, the lowest ROA recorded for iron ore has been 25% in 2004. ROA has been growing steadily as prices have risen to over $130 a tonne, but there is more to BHP’s success than simply riding the bull. It operates the second-lowest-cost mines in the world (after Rio Tinto), an ideal base from which to catch the wave of rising prices. If prices fall again, as we expect they will (see Iron ore: It’s (not) different this time—see issue 309) BHP will be making money from the Pilbara long after competitors have gone broke. The same can be said of the petroleum, coal and base metals divisions. In each case, We’ve modelled three BHP operates low-cost assets that will continue to mint cash throughout the cycle. possible futures for BHP. Unless, of course, management stuffs it up (as they are known to do every decade Each leads to very different or so). Some suggest new mistakes are now being made. The decision to spend up to outcomes. $100bn on expansion has been controversial. BHP argues that as the lowest-cost producer in the industry, it benefits from expanding output throughout the cycle. Weaker competitors can’t invest billions among falling prices but the mighty BHP can. And it should, they say. To critics, such as fund manager Blackrock and, yes, us too, such cries reek of hubris. The aim of business shouldn’t be to get as large as possible. Acting less like Napoleon is no bad thing.

Three scenarios With capital allocation so important it’s worth thinking about how those decisions might change over the next few years. We’ve modelled three possible futures for BHP. Each leads to very different outcomes. In the first scenario, we assume the company maintains the immense capital expenditure program it has promised. About $100bn will be spent, mostly in iron ore and petroleum, over the next 5–6 years. That money alters the relative importance of each commodity to BHP and it does change the business. As Table 2 shows, we assume BHP’s asset base increases and return on assets falls, first to the company’s 10-year average, and then below it. By 2017 we assume BHP will earn only 50% of its historic ROA. This makes sense: A miner as big as BHP can’t expect higher prices and higher output simultaneously for long.

Table 2: Scenario 1 outcomes 2012 2013 2014 2015 2016 2017

ROA (%) 30 21 17 17 17 13

EBIT ($m) 31,255 23,642 20,198 21,483 23,197 18,683

NPAT ($m) 21,179 15,849 13,439 14,338 15,538 12,378

EPS ($) 4.00 2.99 2.54 2.71 2.93 2.34

DPS ($) 0.80 0.30 0.25 0.27 0.29 0.23

PER (x) 8.0 10.7 12.6 11.8 10.9 13.7

Yield (%) 2.5 0.9 0.8 0.8 0.9 0.7

Even as the return on assets falls, higher volumes ensure that profitability stays high. By 2017 BHP will be earning half the ROA but about 65% of last year’s profits. Lower margins are replaced by higher volumes. The company’s position as the custodian of large, low-cost assets makes this transition possible and it constitutes a vital change; as margins decline, more capital is required to generate additional cash. Last year, for example, 90%

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of the increase in profits was due entirely to price increases. Easy profits of that sort won’t reappear. This alters how much cash is available to shareholders; in scenario 1, we assume BHP’s payout ratio falls to half its long term average. The effect on dividends is calamitous. In scenario 2, we assume BHP drops its ambitious capital expenditure plans. We also assume BHP’s ROA returns to its 10-year average. Profits will ultimately be smaller in the absence of an enlarged asset base, but BHP will be able to pay out more cash as dividends. The financial results of such an outcome are shown in Table 2.

Table 3: Scenario 2 outcomes 2012 2013 2014 2015 2016 2017

ROA (%) 21 21 21 21 21 21

EBIT ($m) 22,132 22,657 23,182 23,707 24,232 24,757

NPAT ($m) 14,792 15,160 15,527 15,895 16,262 16,630

EPS ($) 2.79 2.86 2.93 3.00 3.07 3.14

DPS ($) 0.59 1.14 1.17 1.20 1.23 1.26

PER (x) 11.5 11.2 10.9 10.7 10.4 10.2

Yield (%) 1.8 3.6 3.7 3.7 3.8 3.9

In the third scenario (see Table 4), we assume prices fall from a demand shock and BHP responds by canning its expenditure plans. Lower prices force ROA down to half the company’s 10-year average. This is our bear case. Amid lower prices, BHP still remains stupendously profitable, generating earnings before interest and tax of over $11bn, but return on assets falls from last year’s 30% to a more modest 15%. Even in such a scenario, the twin profit engines of iron ore and petroleum generate ROA of 25% and 19% respectively. In such a world, the rest of the commodities sector wouldn’t emerge unscathed. Miners reliant on a single commodity or those further up the cost curve (almost everyone other than Rio) would generate cash losses and miserly rates of return. Faring even worse would be mining services businesses. Many of these businesses, Not holding BHP or Rio even high-performing ones such as Monadelphous and WorleyParsons, now trade on PERs over 20. Investors are treating cyclical businesses as growth stocks and hard times at all is an implicit short of the will lead to both lower prices and lower multiples. resources sector. If you don’t Today’s BHP investor won’t face that double whammy. Today’s modest PER of less wish to make such a bet and than 8 already assumes lower commodity prices. This is as it should be. All three of our want exposure to resources, scenarios suggest BHP’s profits have already peaked. BHP is the best way to get it.

Table 4: Scenario 3 outcomes 2012 2013 2014 2015 2016 2017

ROA (%) 21 21 15 15 15 15

EBIT ($m) 22,132 22,657 16,559 16,934 17,309 17,684

NPAT ($m) 14,792 15,160 10,891 11,154 11,416 11,679

EPS ($) 2.79 2.86 2.05 2.10 2.15 2.20

DPS ($) 0.59 0.60 0.43 0.44 0.45 0.46

PER (x) 11.5 11.2 15.6 15.2 14.9 14.5

Yield (%) 1.8 1.9 1.3 1.4 1.4 1.4

That doesn’t necessarily mean owning the stock today is a mistake. It is possible that concerns about China are misplaced and that commodity prices rebound. Perhaps the BHP recommendation guide stronger for longer chorus is right, after all. Not holding BHP or Rio at all is an implicit Long Term Buy Below $30.00 short of the resources sector. If you don’t wish to make such a bet and want exposure to Hold Up to $40.00 resources, BHP is the best way to get it. Sell Above $40.00 Value hounds will complain that the stock isn’t quite cheap enough. We agree. Assuming an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 8 suggests a price of about $26. We’d be interested in building a small exposure to the Big Fella below $30 and would recommend increasing the portfolio weighting, up to about 6%, at around $26. It’s quite possible that with growing pessimism, those prices appear. Even if they don’t, BHP is no hog. It is, in fact, the perfect hedge for China bears. HOLD.

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From the vault | First published 19 Apr 2010

Fleetwood debt free, not risk free

Fleetwood has hitched its wagon to the resources boom. That’s great Key points as long as the boom continues, and the competition remains in disarray. The mining boom has flattened profits Highly cyclical business There are a lot of reasons to like Fleetwood Corporation, a Western Australia-based producer of caravans and manufactured accommodation. Not only is Fleetwood an Price reflects growth, not cyclicality owner-managed company, it’s debt-free, it produces excellent cash flow, and its long-term performance has been outstanding. fleetwood | fwd These reasons—along with a cheap share price—were behind our last recommendation upgrade on 25 Nov 08 (Long Term Buy—$4.35), although we’ve also made recommendations Date 6 Nov 2012 at higher prices. We subsequently downgraded to Take Part Profits on 16 Apr 09 (Take Part Current price $10.03 Profits—$6.06) and the share price has risen 55% since then. Market cap. $590m Table 1 shows that revenues and profits have risen nicely over the past few years. ‘Grey 12 mth price range $9.31–$13.46 nomads’ have hitched Fleetwood-manufactured caravans to their four wheel drives and Fundamental Risk Medium–High driven around Australia, while the mining companies have needed cheap and temporary

Share price risk High accommodation for employees in remote locations. But, as usual, it’s the numbers beneath the surface that require the most scrutiny. Our View coverage ceased Chart 1 shows that Fleetwood’s story is a tale of two divisions. The global financial crisis meant demand for Fleetwood caravans declined, resulting in divisional profit slumping in 2009. While profits in the recreational vehicles division look like they’ll stage a recovery in 2010, it’s no longer the main game. chart 1: fwd divisional ebit ($m) Since 2004, profit from the manufactured accommodation division has risen more than 50 fivefold. Shareholders in Fleetwood have the mining boom to thank for their prosperity—and the generous dividend stream. But how long will it continue? 40 Tailwinds mask risk 30 It’s impossible to know, but we’ve highlighted concerns in articles such as The China 20 bubble (see issue 292). And the significant tailwinds over the past decade might be masking the underlying risk and cyclicality of Fleetwood’s manufactured accommodation division. 10 Profit variability was evident in the 2010 first half result. Revenue and earnings before interest and tax (EBIT) for the manufactured accommodation division fell 50% and 24% 0 2004 2005 2006 2007 2008 2009 respectively (good cost control limited the damage to profitability). Recreational vehicles Contracts in this business are irregular, so revenues and earnings will be lumpy. Manufactured accommodation Fleetwood noted that the previous period was ‘positively impacted by the Worsley project’ and that ‘Revenue in the current period was negatively impacted by client delays in awarding contracts and by unsustainable price competition’. Fleetwood also owns and operates the 1,500 room Searipple Village in Karratha under a contract with Woodside Petroleum. While Woodside will need accommodation for its chart 2: 5-year share price employees in Karratha for years to come, the current contract expires on 31 December 2010. Another extension seems highly likely, but contracts like this one always seem $12 great—until they’re not. There’s a reason why Woodside prefers to rent rather than buy. $10 The chances are that Fleetwood’s profits will grow for several years to come. It’s at the $8 pointy end of the mining boom, after all. But a prospective PER of 15 necessarily implies significant and sustainable profit growth. This might occur, or it might not; but we don’t $6 want to pay a fancy price for a cyclical business. $4 With no debt, Fleetwood isn’t going bust any time soon. And we applaud the company’s

$2 strong management and cost control over the past 18 months. Lesser competitors, such as Nomad Building Solutions, have been left in Fleetwood’s wake. But with the company’s $0 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 share price having recovered sharply, we’d prefer to deploy our capital in stocks with less downside risk. We’re recommending shareholders take the rest of their profits and downgrading to SELL. We’re also ceasing coverage until another buying opportunity presents itself.

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From the vault | First published 10 Apr 2012

Why CSL is a top 10 business

CSL enjoys attractive economics and exemplary management. Jason Prowd explains why it’s one of Australia’s best businesses, and the price to buy it. Key points Healthcare stocks have attractive economics Australian investors searching for world-class businesses—the kind value investors crave— CSL is run exceptionally well have limited options. Slightly too expensive to upgrade, remains a Hold Resource, energy, and financial services companies comprise over two thirds of our local market. In the United States, this figure is less than one third. For some reason, in the area of health, Australia has managed to produce some truly world-class companies. Sonic Healthcare, Fisher & Paykel Healthcare, Cochlear and CSL have all graced our buy list and the latter two made it onto our coveted Australia’s 10 Best Businesses list (available to download from the Special Report section of our website). Since floating in 1994 at $2.30 a share (the equivalent of 77 cents today, following a three-for-one share split in 2007) blood products manufacturer CSL’s share price has risen nearly 5,000% to $35.62. Shareholders have also banked over $5 a share in dividends. This success has been no accident.

Pricing power People are careful about what enters their body. Why else would we pay four times as much for Panadol when generic paracetamol does the same job? (For more on behavioural biases tune into our interview with Dan Ariely, available from the Podcast section of our website) This is especially true with blood products where viral infections such as human CSL | CSL immunodeficiency virus (HIV) and hepatitis can easily spread without careful control. Date 6 Nov 2012 That gives companies operating in this market strong pricing power. CSL also enjoys two main barriers to entry. First, strict licensing regulations make Current price $47.48 it costly for would-be competitors to enter the industry. Second, even if a new entrant Market cap. $23.6bn passes the first hurdle, it has to sustain large losses until volumes reach a point where 12 mth price range $29.52–$48.64 it can compete with the incumbents (this is an industry with substantial economies Business Risk Low of scale). Most companies don’t make it, which explains why the market is equally divided Share price risk Medium among three big operators. Max. Portfolio weighting 4% The story gets even better. As countries become wealthier, they spend more on healthcare (see Chart 1). With two thirds of CSL’s potential consumer base located in Our View Hold emerging markets, it’s almost certain that its market will continue to grow. Usage is increasing for other reasons, too. Up until the 1970s, haemophilia treatments were rudimentary and life expectancies were low. Now, thanks to new treatments, sufferers live long enough to have children of their own, some of whom inherit the disease. Chart 1: Healthcare spending This has significantly expanded CSL’s market. (per capita, $US ppp)

New treatments 8,000 7,000 Lastly, as is common in healthcare, new uses are found for existing products, which goes 6,000 some way to explaining why CSL’s return on incremental capital employed has exceeded 5,000 50% a year for the past decade. 4,000 CSL competitor Baxter, for example, is currently in late stage trials for the use of 3,000 intravenous immunoglobulin (IVIg) in the treatment of Alzheimer’s disease. This could 2,000 open a huge new market for CSL’s products but, because the product already exists, 1,000 it’s comparatively cheap to get it to market. 0 1970 1980 1990 2000 2010 These factors alone make CSL an attractive investment proposition. The quality of its management is really icing on the cake (see CSL: Reasons to be cheerful from 23 Jun 10 United States Australia United Kingdom (Long Term Buy—$34.07). Source: OECD Health Data 2011 Consider for a moment how unusual it is to find effective management in highly profitable industries. To often they become lazy, avoiding difficult short-term decisions at

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the expense of longer-term performance. Fairfax is but one example. Obscenely profitable for decades it (largely) watched from the sidelines as the internet destroyed its business model. That complacency now points to possible bankruptcy. CSL’s management hasn’t let success breed complacency. It has been most adept at identifying and capitalising on industry consolidation through a series of shrewd, strategic acquisitions and then managing the integration of new businesses with exceptional finesse.

Efficiency dividend Each year, the company becomes more efficient. With the assets-to-sales ratio falling from 1.6 to 1.0 over the past decade it now uses fewer assets to produce each dollar of sales. Shareholders aren’t treated as patsies, either. When the proposed buyout of Talecris (since acquired by Spanish-based Grifols) collapsed in 2009, it swiftly announced a share buy-back instead of splurging on an ill-conceived acquisition. This is a management team with its collective ego in check. What of the competitive environment? The industry is split equally between Baxter, CSL and recently merged Grifols-Talecris. New competition is unlikely but continued exceptional profitability relies on these players competing rationally, which means not too competitively. This is a company There’s always a risk that landmark discoveries might create wholesale changes in not subject to the whims of industry dynamics but, thus far, R&D expenditure is producing incremental rather than the economic cycle; it enjoys revolutionary change. growing demand … and it The development by Baxter of a new intravenous immunoglobulin (IVIg) product, HyQ, can fund continued share which requires monthly rather than weekly doses, is a typical example. It could result in a buy backs from operating loss of market share for CSL but, spending $360m a year on R&D itself, it is very much in cash flow, further boosting the nature of the R&D cycle. earnings per share. Another potential threat to profitability comes from governments cutting back on healthcare spending. Evidence from the US (CSL’s key market) suggests these cuts will allow only modest price increases but the risk of more dramatic impacts remain. Finally, there’s the operational risk of contamination of a product batch that could result in products being banned from sale. Smaller rival Octapharma recently experienced such a damaging ban and all companies in this market are exposed to this risk.

Franchise strength The strength of CSL’s franchise and its profitability mean it can carry these low probability, high impact risk with relative ease. This is a company not subject to the whims of the economic CSL recommendation guide cycle; it enjoys growing demand that should see earnings rise by around 5% a year; and it can Long Term Buy Below $35.00 fund continued share buy backs from operating cash flow, further boosting earnings per share.

Hold Up to $50.00 For these reasons, this is not a business that one should sell lightly. Indeed, for most of 2011 we were able to recommend CSL as a Long Term Buy when it was trading at around Take part profits Above $50.00 16 times earnings, the classic example of a good business at a fair rather than cheap price. For that reason, this is not a stock that fits the buy and sell strategy (see issue 330), although it’s not one to set and forget either. After factoring in the current $900m share buy back, CSL is trading on a forward price-to-earnings ratio of 18, a few dollars above where we’d upgrade to Long Term Buy. With a share price up slightly since 28 Mar 12 (Hold—$35.13) we’re sticking with HOLD but would look to upgrade once again around $33.00. This is a business worth paying up for and we await the moment that delivers the opportunity. Note: Watch out for an upcoming interview with Chief Financial Officer, Gordon Naylor. Note: The Growth portfolio owns shares in CSL. Disclosure: Staff own shares in CSL, but they do not include the author Jason Prowd who, sadly, didn’t have any free cash when the shares hit $26.12 in 2011.

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From the vault | First published 21 Dec 2012

Coca-Cola Amatil’s wet summer

The weather is once again impacting Amatil’s summer. But the news isn’t all bad. Key Points Coca-Cola Amatil announced a mildly disappointing forecast for the second half ended Cool, wet summer and belt-tightening impacting 31 December 2011. Sale of Pacific Beverages is a good outcome On a constant currency basis and before significant items (the way we tend to think Amatil might acquire Foster’s non-beer businesses about this company’s progress), management expects to deliver second half net profit growth of around 5%. Shareholders might have hoped for a larger rebound after a tough, rain-affected prior period. Again, the weather hit sales this period, with another cold and wet start to summer in the east (particularly in New South Wales). Weak consumer spending was also cited earlier in the period, and your analyst concurs. Accustomed to paying €1 for his weekly 500ml Coke in European vending machines, he’ll opt for acute thirst over the $4 charged for 600ml at train station vending machines in Sydney. Greedy buggers. Fortunately for Amatil, though, other consumers have since loosened the purse strings somewhat since the recent interest rate cuts, with Australian beverage volume growing again since early November. Coca-Cola Amatil | CCL As previously mentioned, the company announced it will sell its half of the Pacific Date 6 Nov 2012 Beverages beer business to joint venture partner SABMiller for $305m, generating a one- Current price $13.27 off profit after tax of $165m. Amatil will be restrained from re-entering the beer business until the end of 2013, Market cap. $9.9bn although re-entering is exactly what management intends to do. As speculated in 12 mth price range $11.30–$14.19 The Australian Financial Review, global beer giant Grupo Modelo is unlikely to be happy Business Risk Low with competitor SABMiller holding the rights to distribute Corona in Australia (acquired via Share price risk Medium the Foster’s takeover). Amatil is a potential alternative distributor. max. portfolio value 4% The company will soon begin due diligence on Foster’s spirits, ready-to-drink and Our View Hold non-alcoholic businesses, as well as its Fijian operations, which it has an option to acquire in whole or part. The cost of this acquisition is likely to fall between $100m and $180m. Partly offsetting the profit from the Pacific Beverages sale is $105m (after tax) in one- ccl recommendation guide off costs associated with the restructure of SPC Ardmona, which has been a thorn since long term Buy Below $9.50 acquisition in 2005. Upsets aside, our thoughts are little changed from Coca-Cola Amatil: hold Up to $15.00 The real thing of 11 Oct 11 (Hold—$11.99). Amatil is a high quality business but, like the take part profits Above $15.00 product in Sydney’s vending machines, it’s a little too expensive to buy at the moment. HOLD.

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From the vault | First published 23 Oct 2012

Put some Woolies in your basket

Woolworths’ sheer reliability gives it an edge in an era of low returns. It’s time Key Points for an upgrade. Margin of safety achieved through reliability, price and value When Ben Graham explained the term margin of safety he said that for ‘the ordinary Company has ‘earning power’ ahead of bonds in common stock, bought for investment under normal conditions, the margin of safety lies almost any scenario in an expected earning power considerably above the going rate for bonds.’ Upgrading to Long Term Buy Generally, Graham satisfied this requirement by focusing on price. But there are other ways to achieve it. Over the years, Warren Buffett looked increasingly to the quality of a business—the so-called ’moat’ around its economic castle—to pep up the ‘earning power’. Woolworths is far from being the cheapest stock on the market, and it can’t claim the business quality of a Coca-Cola or Gillette. What it does offer is a broad margin of safety through sheer dependability: In almost all conceivable circumstances it offers earning power ahead of bonds, and in most cases considerably so. That’s the case we’re going to make in upgrading this stock. Most people are familiar with the idea of Woolworths as a ‘defensive’ stock because it gets its money from selling ‘staples’ that people need even when times are hard. But it runs deeper than that. Woolworths provides low-priced ubiquitous items that people want to buy quickly, all at once, and close to home. Whether we’re talking about toilet paper or early-season mangoes at $4 a pop, it’s the retailer that adds the value for the customer in this situation rather than the supplier. Even if you do buy your groceries online, you probably want to get them from one website and one delivery or collection point. It makes little sense to get these items Woolworths | WOW piecemeal from distant locations—much better to use the established distribution networks Date 6 Nov 2012 of the large grocery chains. And Woolworths has one of the best, lowest cost distribution

Current price $28.76 networks in the country. market cap. $35.8bn Earnings power 12 mth price range $24.12–$30.88 It all adds up to tremendous earning power. In 2007, its last full year as an independent Business Risk Low entity, even Coles managed a return on capital employed (ROCE) of 23%. That number Share price risk Low–Med would be beyond the wildest dreams of most companies in Australia, yet Coles was just Max. portfolio weighting 7% about to be taken over following years of underperformance. Woolworths, of course, scores

Our View Long Term Buy higher still, achieving a ROCE of 27% in 2007 and 25% in 2012. So what could go wrong? Retail is weak. The consumer environment is poor and online competition is increasing. That affects Harvey Norman, JB Hi-Fi and Billabong International but Woolworths is much less exposed. If you’re focused on the long term—and you should be—looking beyond the weak consumer environment shouldn’t be difficult. Greater and more effective competition is a bigger worry. Coles is resurgent under Wesfarmers’ stewardship, Aldi is expanding and Costco is entering the Australian market. But Woolworths has entrenched strengths from its excellent store locations, distribution network and low cost of doing business. Possibly the biggest threat is of management, quite simply, stuffing up. Early indications are that new chief executive Grant O’Brien is doing well. Last week’s first-quarter sales result showed a pleasing 2.3% like-for-like sales growth in supermarkets and an excellent 3.4% like-for-like sales growth at Big W, despite price deflation of about 6%. The company has also finally got the Dick Smith monkey off its back, as we wrote on 2 Oct 12 (Hold—$28.90). However, other supermarket chains have messed things up in the past. It’s not a possibility we should discount altogether.

20 Special report | Australia’s 10 best businesses

So how bad could it get? The obvious lousy performance benchmark is Coles before its 2007 takeover by Wesfarmers. Back then, the earnings before interest and tax (EBIT) margin for Coles’s food and liquor division sank as low as 3.4%, after bumbling along at between 3.6% and 3.9% for Table 1: Wow profit breakdown the previous three years. But these numbers were so far below par (in 2007 Woolworths’ under disaster scenario supermarkets division managed an EBIT margin of 5.0% and in 2012 it made 6.5%) 2012 Disaster scenario that they didn’t have to be tolerated for long before takeover interest began to stir, with Supermarkets sales ($m) 48,565 48,565 Wesfarmers eventually paying 24 times Coles’s depressed earnings. Another struggling supermarket is the UK’s Tesco, which we wrote about recently in our Supermarkets EBIT margin 6.5% 3.7% special report—Ripe for the Picking: Overseas stocks to buy right now. Its shares tumbled Supermarkets EBIT ($m) 3,169 1,797 14% on 12 January this year when it warned that its ‘increased investment into lowering prices’ over the Christmas period had ‘not offset the deflation it [had] driven’. Big W sales ($m) 4,180 4,180 Tesco’s EBIT margin was around 6% during the good times in the middle of the last Big W EBIT margin 4.3% 3.2% decade. In the latest half-year to 25 August, it fell to 4.9%. So much for bad times, which Big W EBIT ($m) 178 134 is why it’s on our international stocks Buy list.

Disaster scenario Hotels sales ($m) 1,204 1,204

If overnight Woolworths became the disaster that was Coles and its supermarket Hotels EBIT margin 16.3% 12.0% margins dropped permanently from 6.5% to, say, an average around 3.7%, group earnings Hotels EBIT ($m) 196 144 would almost halve from an underlying 180 cents per share in the 2012 financial year to about 91 cents. Other EBIT ($m) With supermarkets contributing almost 90% of Woolies’ sales and EBIT (before corporate (includes corporate, overheads), other adjustments make little difference. Still, as you can see in Table 1, we’ve discontinued ops, India, –191 –191 knocked the other divisions down a bit anyway. home improvement and property) Woolies is extremely unlikely to suffer this kind of collapse. Indeed, this analyst is willing to bet that even in Grant O’Brien’s worst nightmares things won’t get this bad. But even if they did, at current prices Woolies would deliver an earnings yield of 3.1%, bang in line Total EBIT ($m) 3,352 1,884 with the current 10-year Australian government bond yield. Net interest cost ($m) –284 –284

Let’s look at it another way. Assuming a payout ratio of 70% (which the company has Profit before tax ($m) 3,068 1,600 consistently stuck to over the past five years) and a resulting dividend per share in our Tax ($m) –885 –480 disaster scenario of about 64 cents, the dividend yield drops to 2.2%. Net profit ($m) 2,183 1,120 Now that ain’t much but, having allowed for some retained earnings, we should also allow for the growth they might generate. With returns on capital still as high as 14.3%, Shares on issue (m) 1,222 1,234 even under our nightmare scenario, the growth more than makes up for the 1% given up Earnings per share ($) 1.79 0.91 in the dividend compared to the earnings yield. Share price ($) 29.20 29.20

Even with 1% growth, the total return (yield plus growth) edges ahead of the 10-year Earnings yield bond rate. More likely, but still very conservatively, let’s assume sales and profits rise at (EPS divided by the rate of inflation—about 2%-3%. That would deliver total returns closer to 5%, leaving share price) 6.1% 3.1% bonds far behind.

Raising stake Of course, were any of this to occur, the share price would suffer, but this analysis looks at the value you would receive if you simply held on. In fact, if the share price suffered Table 2: Potential long term too much you might even take the opportunity to buy more, which is exactly what Warren returns from wow under various scenarios Buffett did with Tesco, raising his stake from 3.2% to 5.1% on the day the stock plunged Dividend growth total 14% back in January this year. yield rate return So the nightmare scenario still keeps you in line with—or somewhat ahead of— Disaster 2.2% 2.5% 4.7% government bonds. What of the upside? The company is expected to make earnings per share of about 188 cents in the current Neutral 4.5% 4.5% 9.0% year and to pay dividends of about 132 cents. That would give an earnings yield of 6.4% Optimistic 4.5% 7.5% 12.0% (more than twice the 10-year bond yield) and a dividend yield of 4.5%. In a neutral scenario you might expect Woolies to maintain current margins while growing sales alongside economic growth, which corresponds to real GDP growth plus inflation, or about 4%–5% over the long term. That would amount to a total return of about 9%: Three times the bond yield. For a stretch target you wouldn’t add much to margins—the company would probably prefer to grow sales a bit quick than push its margins higher—but you could certainly imagine earnings growing quite a bit quicker; after all, over the past 10 years underlying earnings per share have compounded at an annual rate of just over 13%. Those days are surely over, even with the investments currently being made, notably

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in the store network and the Masters home improvement chain, but 7%–8% a year is wow recommendation guide certainly plausible. That would provide a total return in the region of 12%, or about 4 Buy Below $26.00 times the bond yield.

Long Term buy Up to $33.00 All up, Woolworths shares will probably deliver returns of between about 5% and 12% over the long term, with the most likely result being about 9%. The risks are low and hold Above $33.00 management quality is high. In the current low return environment, that’s reason enough to upgrade Woolworths to a LONG TERM BUY. At around $26—implying a dividend yield of 5%—we’d love the opportunity to upgrade it further. The model Growth and Income portfolios own shares in Woolworths.

From the vault | First published 31 Aug 2012

The Metcash earnings hole

The share price is up but the problems in its main business are intensifying. It’s Key Points time to put this stock back on the shelf, explains James Greenhalgh. Severe deterioration in Metcash’s Supermarkets business In its guidance update on Wednesday, Metcash, in a roundabout way, said, ‘don’t worry, Management is trying to plug the earnings hold with nothing to see here. Please move along.’ And that’s what we’re going to do, but not in the ‘growth initiatives’ way the company may have hoped. Sell any remaining shareholding Red flags waving for Metcash, published on 10 Jul 12 (Hold—$3.25), explained how shareholders need to look past the spin to the serious problems now emerging in this business. At least management now admits that earnings per share (EPS) will actually fall in 2013. But that isn’t the whole story. A forecast 1%–3% decline in EPS, less than analysts were expecting, boosted the share price. Since 10 Jul 12 it’s up 13%, giving us a chance to get out before the damage really starts to hit. What most analysts have failed to notice is the ‘earnings hole’ opening up in the company’s Supermarkets division—formerly IGA Distribution—this year. Management admitted in the guidance update that deflation, marketing investment, promotional activity and cost increases are making life difficult this financial year. The company was already losing market share in 2012; this year it will accelerate. So-called ‘growth initiatives’ aim to plug the hole. What they also do is obscure the problems in Supermarkets, which won’t be solved by sending a mop and bucket to aisle three.

Diversions On 28 June, when Metcash announced its full-year results and capital raising, we were also told the company had bought a 75% stake in Automotive Brands Group and the metcash | MTS remaining 50% of Mitre 10. On Wednesday, Metcash announced a few more diversions. The company’s liquor arm has signed a new liquor distribution contract, supplying an Date 6 Nov 2012 extra $650m of liquor to hotel customers, as well as establishing ‘joint venture’ agreements Current price $3.59 with some of its hotelier and Mitre 10 customers. Market cap. $3.2bn The liquor distribution deal is sensible enough but what of the joint venture agreements? 12 mth price range $3.12–$4.37 In fact, they’re equity investments in the company’s customers. Metcash is buying stakes business Risk Med–High in hotels and Mitre 10 businesses, similar to the equity stakes it has bought in some IGA customers. Share price risk Med–High The company’s own performance is now much more closely linked with that Max. portfolio weighting 3% of its customers. If they hit trouble, Metcash will be caught in the fallout. Witness the Our View Sell company’s $106m of writedowns on some IGA joint ventures in Queensland following April’s strategic review. So let’s add the figures up. In 2013, Metcash will have the benefit of a full year of Franklins (an estimated additional $10m of earnings before interest and tax) and cost

22 Special report | Australia’s 10 best businesses

savings from the April strategic review ($25m). It will also have full ownership of Mitre 10 (another $10m of EBIT), a stake in Automotive Brands Group ($8m) and earnings from the new liquor distribution contract ($10m). All Incremental 2013 earnings up, that’s an additional $63m of EBIT Metcash will have in the 2013 financial year that it Initiative EBIT ($m)* didn’t have in 2012. Franklins 10

Yet management has forecast EPS will fall by 1%–3% in 2013. Something is wrong Cost savings from strategic review 25 here. Without the $63m in additional EBIT, the earnings hole in the Supermarkets division Mitre 10 acquisition 10 would be glaring. The recent flurry of activity is a useful distraction from that fact. Automotive Brands acquisition 8 There’s an argument that, as a group, Metcash will perform and that earnings and their source shouldn’t matter. But the haste with which management has moved to obscure the Liquor distribution contract 10 earnings shortfall in Supermarkets is in itself cause for concern. Total 63

Rising debt * These figures represent earnings on top of those reported in the 2012 financial year And any errors will be magnified by debt. In its guidance update, Metcash also announced it had spent most of the funds from the June capital raising. This takes net debt back above $900m. Despite the capital raising, debt levels aren’t as conservative as one might hope. Perhaps most worrying of all is that management, which we once revered as plain The company’s own speaking, now seem incapable of it. The second-last paragraph of the guidance update says that the company expects to continue its high dividend payout ratio. What it does not performance is now much say is that the 28-cent dividend won’t be cut. more closely linked with A cut should be expected. Not in 2013, perhaps, as chief executive Andrew Reitzer that of its customers. If they will prefer to leave the company on a high. Bad news might be forestalled until after his hit trouble, Metcash will be departure. But come it almost certainly will. caught in the fallout. Metcash is groaning under the weight of a rapidly deteriorating main business, a flurry of growth initiatives and surging debt, all but a few months before Reitzer’s departure. The buy and sell strategy from 10 Oct 11 explained why we’re happy to exit a worsening situation at fair value, particularly in a market like this. There’s no urgency but the underlying deterioration of the Supermarkets division is likely to become clearer over the course of this financial year. It would be good to get out before then. mts recommendation guide We recommended Metcash as an outright buy on 9 Aug 11 (Buy—$3.67). Before Buy Below $2.50 then it was a long standing Long Term Buy, recommended on 14 Sep 10 (Long Term hold Up to $3.50 Buy—$4.40), for example. In almost two years since then, it has paid $0.55 in dividends. This is no disaster. The real worry is that it may become so. sell Above $3.50 With the situation deteriorating, we’ve reduced the prices in the recommendation guide and now suggest you sell any remaining holding (we exited the positions in the model portfolios at lower levels). SELL. Disclosure: The author, James Greenhalgh, owns shares in Metcash.

Important information Intelligent Investor Share Advisor PO Box Q744 Queen Victoria Building NSW 1230 T 1800 620 414 | F (02) 9387 8674 [email protected] share.intelligentinvestor.com.au

PERFORMANCE Past performance isn’t a reliable indicator of future results. Our performance figures are hypothetical and come from the recommendations made by The Intelligent Investor. Transaction costs haven’t been included. We encourage you to think of investing as a long-term pursuit, as stocks can fall and you can lose money on the stockmarket. To read our performance report, go to www.intelligentinvestor.com.au. 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. Not all investments are appropriate for all people. 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 2012. Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box Q744 Queen Victoria Building NSW 1230. Ph: (02) 8305 6000, Fax: (02) 9387 8674. DISCLOSURE As at 6 November 2012, in-house staff of Intelligent Investor held the following listed securities or managed investment schemes: AIQ, ARP, ASX, AWC, AWE, AZZ, BAO, BBG, BER, BRG, CBA, CIF, CPU, CRC, CSL, CUE, EBT, EGG, FKP, IFM, IGR, KRM, MAU, MCE, MFG, MQG, NWS, PTM, QBE, RCU, RMD, RNY, SEK, SKI, SRV, STW, SYD, TAP, TAU, TGP, UXC, VMS, VRL, WDC, WES, WHG and WRT. This is not a recommendation. DATE OF PUBLICATION 6 November 2012

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