weekly review | ISSUE 333b | 19–25 november 2011

CONTENTs In this issue... STOCK REVIEWS STOCK ASX CODE Recommendation PAGE BHP Billiton BHP Hold 2 Gaurav Sodhi Trade Me TME Avoid 3 BHP has already made big bets on China and India. Now it’s placing Notes ORGHA Avoid 5 Woolworths WOW Long Term Buy 7 another one, on America... (see page 2) stock UPdates Australand Holdings ALZ Hold 9 Nathan Bell, CFA IOOF Holdings IFL Hold 10 features Trade Me is an impressive business. But now isn’t the time to buy, especially not with Fairfax as a controlling shareholder. Nathan Bell Doddsville blog | Oversimplifying impedes real learning 10 explains... (see page 3) extras Blog article links 11 Podcast links 11 Gareth Brown Twitter links 12 Ask the Experts Q&As 12 The latest income security offers a high rate of return in exchange Important information 16 for a few risks buried in the small print... (see page 5) RecomMendation changes

Trade Me coverage initiated with Avoid Origin Energy Notes coverage initiated with Avoid James Greenhalgh Australand Holdings downgraded from Long Term Buy to Hold Woolworths has broken with anagement tradition by hiring outside. PORTFOLIO CHANGES It’s something to watch, not worry about... (see page 7) BUY/ NO. OF PRICE VALUE PORTFOLIO STOCK DATE sELL sHARES ($) ($)

Growth Silver Lake Resources Sell 17/11/11 850 $3.59 $3,051.50 Gareth Brown

Warren Buffett is, as usual, spot on. In searching for investment managers to run Berkshire Hathaway’s portfolio in his eventual absence, he says successful candidates must be ‘genetically programmed to recognize and avoid risk, including those never before encountered’... (see page 10) Intelligent Investor

BHP has already made big bets on China and India. Now it’s placing another Key Points one, on America. BHP will produce massive quantities of shale gas Success depends on rising US gas prices Even when he plays the pessimist, BHP Billiton chief Marius Kloppers can’t contain the optimist within. At last week’s annual meeting, Kloppers warned in one breath of higher BHP embarked on its second big bet volatility and falling commodity prices in the short term. In the next he declared a sanguine future; ‘we are in the early stages of a structural shift in the global economy that will last decades’. No one can doubt what he meant; the supercycle is here to stay. Not content to enjoy the fruits of historically high commodity prices, BHP has embarked on one of the largest capital expenditure programs in the industry. In BHP’s big idea on 31 Aug 10 (Hold—$37.87), we explained how BHP had changed from a mere business into an ideology; an organised gamble on the industrialisation of China and India. Over the next five years, a staggering US$80bn will be spent on new output. It’s difficult to know whether this is gritty or foolhardy. Kloppers clearly believes he’s on the right side of history; His own children learn Mandarin alongside English. And he means for BHP to become a prime beneficiary of the supercycle. That’s why BHP, which began the millennium as a miner of ore, today counts fertiliser, oil and LNG as areas of growth. The company has even joined the expanding shale gas business in the US. Over the last six months BHP has spent US$20bn acquiring massive resources. It now owns among the largest shale holdings in North America with production from these assets set to alter the key petroleum division. The company boasts of a production surge but concern is BHP Billiton | BHP mounting on how margins will fare. Price at review $35.89

Review date 21 Nov 2011 Margins will fall market cap. $191.1bn` The advent of shale gas has revolutionised the US energy market. The world’s largest

12 mth price range $33.97—$49.55 gas market has suddenly and unexpectedly gone from a chronic importer to self-sufficiency. There’s even talk of large scale exports of gas from the US. The process of shale gas Business Risk Low and why it originated in the US is explained in AWE’s shale transformation (Speculative Share price risk Med–High Buy—$1.195) from 04 Aug 11 and ’s fraccing problem (Hold—$45.64) max. portfolio weighting 5% from 21 Jun 10. Our View Hold Although shale gas extraction is an exciting technology, it’s nowhere near as profitable as BHP’s conventional petroleum business, which generates EBIT margins of about 60%. In contrast, the average rate of return on BHP’s new shale output will be around 25%. Once acquisition costs are factored in, it’s unlikely that BHP will earn meaningful returns on capital at all. At least not at current US gas prices. The move to shales represents another big bet made by BHP, this time about America. Unless US gas prices rise, the foray into shales will be a failure. The key question, therefore, is how likely are higher prices? A slow domestic economy and a flood of new gas supply have had the opposite effect. But shales are quite different to conventional gas reservoirs; they require constant capital to be poured into maintaining output and production from individual wells falls away quickly. So to maintain output, producers must continually drill and frack new wells. There’s a convincing case that today’s miserly price is too low to encourage new supply. Only shales that produce oil, as well as gas, are able to churn a profit at current prices. Higher gas prices in the US are, in our view, likely. Yet that misses the point. BHP is getting into the habit of making big, expensive bets; with uranium at Olympic Dam, with potash in Canada and, now, with gas in America. The holder of the world’s best mining assets shouldn’t have to risk its future on a series of gambles. BHP is mining royalty, yet it continues to act like a revolutionary.

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The gambit There are reasons for optimism. The shale gas business eliminates geological risk, for one. Since shales are impermeable, gas tends not to migrate underground and can be confidently confined and counted. The other great benefit is that production levels are limited only by the volume of shales and drilling budgets; BHP have both, in vast quantities. The company’s production is forecast to climb 10% per annum each year over the next decade. Without the great contribution from shale gas, BHP Petroleum’s production growth would be flat. To achieve such heroic growth rates, BHP must invest about $5bn each year in drilling and fracking shales. The company believes it can do this at a cash cost of below US$2 per thousand cubic feet of gas (Mcf). Add non cash expenditures and BHP’s production costs climb to above US$4Mcf, higher than US gas prices currently. Oil produced alongside gas will ensure the operations will make a profit, but the mighty margins of BHP Petroleum will be severely diluted, at least until gas prices start to rise. That is the new gambit that BHP, and its shareholders, have accepted. Having made big bets on China and India, it’s now made another on American gas Recommendation Guide prices. It’s too early to pass judgement on the outcome but the risks are plain to see; Long Term Buy Below $30.00 margins will fall and cash will be consumed in prodigious quantities. Most concerning, hold Up to $45.00 however, is the cavalier nature of the gamble. sell Above $45.00 The share price has fallen 2% since BHP: on the horns of a dilemma from 13 Sep 11 (Hold—$36.59) and, although we’ve lowered the prices in our recommendation guide to reflect the size of the gamble, we’re sticking with HOLD, at least for the time being. Note also the portfolio allocation limit of 5%. Given the concerns over China and increasing supply in a range of resources over the next few years, it’s important not to be over-exposed to this company.

Trade Me is an impressive business. But now isn’t the time to buy, especially not with Fairfax as a controlling shareholder. Nathan Bell explains. Key Points Margins and growth likely to fall in future Fortunes have been made in the migration of classified advertising online. Think of Too expensive to warrant buying in employment site Seek, which last year reported profit of $105m on revenues of $343m. Fairfax, a potentially desperate controlling shareholder, The growth of Realestate.com.au has similarly shrunken the size of The Sydney Morning retains control Herald and The Age. Then of course, there’s eBay, a source of pain for ’s Sensis division, owners of The Trading Post. In , as in , classified advertising has migrated online. But instead of it segmenting into three or four different sites, Trade Me is New Zealand’s eBay, .com.au, realestate.com.au and rsvp.com.au rolled into one. Whilst the jobs division is equal first in market share with its primary competitor, in general items like scary washing machines and Jesus Christ pitta bread (yes, check the prospectus), real estate and automotive, it’s the clear market leader. This is an incredible business but, for reasons we’ll explain, not an incredible investment. Sam Morgan started Trade Me in 1999 whilst working for Deloitte but the project quickly consumed him and he quit his day job. It was a wise decision. When he sold the business eight years later he made NZ$220m and now sits on the Fairfax board, thus proving that even the very rich have their crosses to bear.

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Trade Me delivers an array of impressive statistics; 2.8m of the country’s 4.4m population have a Trade Me account; There are 21,000 message board posts each day; And each Trade Me | TME month 1m members log on to the site. Price at review $1.98 Impressive financials Review date 22 Nov 2011

Our View Avoid Unlike sites like Twitter and Facebook, Trade Me has no problems converting activity into revenues and profits. In each of the past five years, the company has enjoyed profit growth of 15%. Last year it generated revenues of NZ$129m from which it produced NZ$65m in net profit—a massive 51% net profit margin. All this has been achieved with no debt (at least until Fairfax had its way, more on that later) and little additional capital. So far so good. In 2007, in one of its more successful acquisitions, purchased Trade Me for NZ$750m. Now, in desperate need of cash, it’s selling 34% of its holding via a Table 1: Key details broker firm offer (there is no general public offer) at NZ$2.70 a share. This is where the

Offer price (NZ$ per share) 2.7 pitch starts to unravel. Internet businesses can be wonderfully profitable. They require limited capital—building Share on issue following offer (m) 396 an online market place is vastly cheaper than an offline one—and customers typically pay Implied market capitalisation (NZ$bn) 1.1 in advance, which funds working capital requirements. Net debt (NZ$m) 164 Also, ‘network’ businesses like Trade Me are natural monopolies. Buyers want sites Implied enterprise value (NZ$bn) 1.2 that have the most variety of products and sellers want to reach the greatest number of 2012E EV/EBIT (x) 12.4 buyers. As each new member strengthens the existing network, there’s a big first mover 2012E Price-to-earnings ratio (x) 16.5 advantage. And Trade Me has it in spades.

2012E Free-cash-flow yield (%) 6.5 Keeping fees low to encourage listings, Trade Me has enjoyed strong growth in the value and volume of transactions, leading to respective revenue and profit increases of Broker firm offer opens 17 Nov 11 16% and 15% a year for the past five years (see Table 2). Broker firm offer closing date 6 Dec 11 The problem is with the price of the offer, not the business. To justify paying a relatively Expect listing date 13 Dec 11 high 16.5 times forecast 2012 earnings (see Table 1) Trade Me needs to grow profits at (duel listed on NZSX & ASX) least 10% a year to provide adequate returns for the risks involved. That may not sound like much but it may prove difficult. First, Trade Me has already added the most obvious and profitable business lines, expanding from online auctions into vehicles, real estate, jobs, online dating, travel bookings and daily deals. These markets are maturing. For example, sales growth on the main Trade Table 2: Pro-forma Income Me auction site, still the largest revenue contributor by far, has slowed from 11% a year statement to just over 3% this year. ‘07 ‘08 ‘09 ‘10 ‘11 ‘12E Assuming the company won’t embark on a fatal overseas expansion, that means Total revenue (NZ$m) 61 85 96 114 129 145 newer sites like ’treatme.co.nz’ and ’travelbug.co.nz’ must take up the slack. Despite the

Ebit (NZ$m) 47 65 73 86 94 100 prospectus running to well over 100 pages, there’s remarkably little information on the smaller sites from which most growth must come. But we do know they’re smaller markets, Net profit (NZ$m) 33 45 51 60 65 65 delivering lower margins. For this reason, and as Chart 1 suggests, margins are likely to trend lower. A future with sustained domestic double-digit growth is therefore unlikely, but that’s what’s needed to Chart 1: EBIT and net profit margins justify an offer price of NZ$2.70 a share. Let’s assume, though, that the company can grow profits at more than 10% a year. 90% Even then, there’s a very good reason to avoid this float: the major shareholder is Fairfax. 80% Once listed, Fairfax will retain control of a 66% stake, which means Trade Me will be 70% run to benefit Fairfax, not you. The prospectus makes this patently clear, revealing that ‘the 60% interests of Fairfax Media may be different from the interests of [other] investors’. 50% If you think that a legalistic get-out, consider the fact that Trade Me is chaired by David 40% Kirk, former chief executive (CEO) of Fairfax. On a board of five, there are three other 30% Fairfax nominees, including the current Fairfax CEO Greg Hywood. That means that your 20% interests are represented by Joanna Perry, an independent non-executive director, and a 10% 0% former Fairfax CEO. Good luck with that. 2007 2008 2009 2010 2011 2012E This wouldn’t be an altogether desperate situation—Fairfax has every right to stack the EBIT margin Net profit margin board, after all—were the company not so desperate itself. Because of Trade Me-like competitors in Australia, Fairfax’s classifieds advertising business, which once supported its newspaper operations, has died on the vine. The company also carries $1.5bn in debt and last year made a $401m net loss. Within the next year or two, the company’s major metropolitan newspapers may well start losing very large sums of money. All the incentives are in place for Trade Me’s cashflow to be pressed into service at Fairfax. Indeed, that’s already happening. Trade Me is Fairfax’s best business but the company has to sell some of it to lower its debt. After the float, Trade Me will carry NZ$166m in

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debt just so Fairfax can increase the cash it extracts from the business without forfeiting control of it. There’s also a risk that Fairfax uses that control to sell poor Fairfax-owned businesses to Trade Me. The dreaded related-party transactions are a significant risk here. Even at an attractive price—and NZ$2.70 isn’t it—this is a very unequal deal. Of course, brokers, more focussed on a stag profit, aren’t seeing it that way. The book build price of NZ$2.30–NZ$2.70 ended at the top of that range, suggesting the possibility of a profit on listing. If Fairfax can’t resolve its strategic problems and is forced at some stage to sell down its Trade Me stake, at around NZ$2.00 per share, or if growth vastly exceeds our expectations, Trade Me would be a more attractive proposition. Until then, we don’t plan to provide ongoing coverage, AVOID. Note: Issue price converted to Australian dollars as at 21 Nov 2011.

The latest income security offers a high rate of return in exchange for a few risks buried in the small print. Key Points A high margin of 4.0-4.5% over 3-month bank bill rate Partners and kids of investment bankers have been feeling neglected of late. The Fine print is far from ideal massively oversubscribed Woolworth Notes II offer proved the untapped demand for Not quite good enough to recommend low-risk income investments. Now, like seagulls to a chip, investment bankers have been working overtime, designing and pitching similar structures to capital-hungry companies. In less than a month, the first copycat has emerged—Origin Energy Notes. Before diving into the detail, first consider a broader point lost on many investors: Debt markets, like court systems, are adversarial. The very best possible deal for the borrower is likely to prove a poor deal for the lender. When a company borrows money from you, as it does in an issue like this, it isn’t an act of charity. They’re playing a zero-sum game, trying to get the lowest possible cost of financing, borrowing first from those offering the lowest rates and best terms, before moving up the chain until they’ve got the amount they want. Massive oversubscription to the Notes II offer showed that Woolworths didn’t quite get it right. With hindsight, the Fresh Food People could have borrowed all they wanted at lower rates, or on more favourable conditions, or both. Origin Energy and its bankers have learned from that mistake. This is a broadly similar but inferior offer. With few exceptions—such as the AFIC Convertible Notes offer (see page 5) —this process of deterioration is likely to continue until investors tighten up their wallets Origin Energy Notes | ORGHA and the game moves on. Price at review $100.00

Origin Notes v Woolies Notes II Review date 24 Nov 2011 Origin Notes are superior to the Woolworths offer in one sense: The Notes will pay Business Risk Low interest quarterly at a margin of 4.0-4.5% over the 3-month bank bill rate, compared with Share price risk Low–Med 3.25% on the Woolies Notes. The final margin announcement, originally scheduled for Our View Avoid 23 November, will now be delayed until as late as 29 November. Assuming the current bank bill rate of 4.7% holds steady for the life of this security, it would provide annual interest payments of 8.7–9.2%, depending on the final margin. Of course, in the real world interest rates fluctuate, and so will the interest paid on this security. With more debt than Woolworths and less than half the operating cash flow and market capitalisation, Origin should be paying more for its debt. That’s not to say Origin is aggressively financed—it’s not—but it isn’t bulletproof.

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Origin is also in the early stages of a very substantial capital investment program. Its investment in Australia Pacific LNG (APLNG) explains this raising, and perhaps more issues like it. This project all but guarantees that more debt will be required over the coming years. Given that solvency is more dependent on Origin’s future balance sheet than its current one, this is a point on which to reflect.

Table 1: Origin Notes vs Woolworths Notes II ORGHA WOWHC

official ranking Unsecured, subordinated debt Unsecured, subordinated debt

Risk characteristics Debt-like Debt-like

Distribution rate 3 month BBR +4.0-4.5% 3 month BBR +3.25%

Distribution type Cash only Cash only

Compulsory distributions No—deferrable No—deferrable up to 5 years

Cumulative Yes Yes

Principal repayment Cash Cash

Step up date 20 Dec 36 24 Nov 16

Step up increase Margin increased by Margin increased by 1% to 5.0–5.5% 1% to 4.25%

Maturity date 20 Dec 71 24 Nov 36

Of more concern is the fine print. Here, the process of deterioration is most apparent. Origin need not repay these securities until most noteholders are long dead. The maturity date is 2071 compared with 2036 for the Woolworths Notes II. As with the Woolies offering, the Origin Notes ‘step up’ by 1.0%—bringing the margin to between 5.0% and 5.5%—if the notes aren’t redeemed by a certain date. For the Woolies offering that date is in 2016. In Origin’s case, it’s in 2036, a date so far away as to be irrelevant. Both securities have deferrable distributions, which isn’t ideal. The Woolies Notes can be deferred for a maximum of five years. In contrast, Origin ‘intends’ to defer for a maximum Table 2: Key dates of five years but is ‘not obliged to do so’.

Opening date 23 Nov Importantly, if Origin’s corporate credit rating with Standard & Poor’s ever falls below investment grade, the company must defer interest payments. Reassuringly, though, the notes Closing date (shareholder 12 Dec and general offer) are cumulative, meaning deferred interest payments must ultimately be paid, with interest.

Closing date (broker firm offer) 19 Dec Duration dilemma Begin trading (deferred settlement) 21 Dec In last week’s review of AFIC Convertible Notes, we celebrated the ‘free option’ attached Normal trading 23 Dec to that instrument. Here, the situation is reversed; the ‘optionality’ sits with Origin rather First interest payment 20 Mar 12 than noteholders. First call date 20 Dec 16 While noteholders have no right to demand early redemption and thus may not be Step-up date 20 Dec 36 repaid until 2071, Origin has early redemption rights. In fact, it’s able to redeem for $100 on any interest payment date after 2016. Maturity date 20 Dec 71 Remember how debt markets are adversarial? Chances are, if it suits Origin to redeem early then it won’t suit you. Origin is likely to redeem these notes in 2016 if the APLNG comes in on time and on budget, and if credit markets are relatively normal, permitting cheaper, alternative financing. In an environment where a 4.0% or 4.5% margin seems quite generous to noteholders, you’ll likely be repaid in 2016 or soon thereafter. If, however, Origin runs into difficulty with APLNG, digs itself a hole elsewhere, or credit markets tighten substantially—times you’d appreciate repayment—you probably won’t get it. The ability for Origin to redeem at almost anytime also minimises the prospect for capital gain. A non-redeemable floating rate note with expiry in 2071 would appreciate substantially if corporate lending margins shrunk markedly. In such an environment, though, Origin is likely to redeem for $100. Why, then, would someone else be dumb enough to pay you $120? Chances are they wouldn’t.

Comparable security In June 2011, Origin issued a similar hybrid in the European wholesale market. The conditions are a little different, including a fixed rate for the first seven years, but the two securities share many similarities, including an equal ranking, early redemption rights for

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the issuer and a 2071 maturity date. A European banking contact priced this hybrid on his Bloomberg terminal. The security is currently trading at a margin of more than 7.0% over the European equivalent of the bank bill rate. Whilst this isn’t directly comparable with the 4.0–4.5% margin on this offer, it’s clear European investors want a bigger margin for the risks associated with lending to Origin than Australian noteholders are being asked to accept. That explains why Origin is trying its luck here rather than elsewhere. Having two similar securities in existence will also provide arbitrage opportunities for hedge funds. Origin Notes might fall below $100 after listing if sophisticated investors short the Australian security en masse and buy the European equivalent for a low-risk profit.

Better opportunities

In all probability, though, Origin Notes will be repaid in five years time and investors will be reasonably happy with the ride. For those keen to take the plunge, it’s unlikely to be the worst investment you’ll make. But you’d also be taking on the risk of owning a long-lasting security at a time when Origin may trip in its mammoth expansion plans and global markets falter. If you’re happy to bear that risk, Origin Energy ordinary shares, already on our Buy list, are a better proposition. Whilst the ordinary shares carry more risk than the notes, they’ve got substantial upside potential, too. Of recent similar issues, Origin Notes rest between the inferior ANZ CPS3 offer and the superior Woolworths Notes II. It’s not quite good enough to recommend to you but orgha Recommendation Guide we’re hopeful of finding better opportunities among the many income securities likely to buy for yield Below $90.00 be offered over the months ahead. hold Up to $105.00 If the notes ever trade at a 10% discount to face value, we might reconsider, but we sell Above $105.00 recommend you AVOID the initial offer. Note: On 23 November Origin made an ASX announcement stating that ASIC has extended the exposure period for the Origin Notes to 29 November to allow it to ’consider further the terms of the Prospectus, including aspects relating the mandatory deferral of interest payments.’ It sounds like ASIC is concerned about some detail around mandatory deferral. The conditions explained above may alter somewhat as a result, but that’s unlikely to change our opinion. Key dates (see table 2) might also change as a result. We expect the final margin to be announced by 29 November.

Woolworths has broken with management tradition by hiring outside. It’s something to watch, not worry about. Key Points Several important executive changes at Woolworths When a company changes a longstanding management policy, shareholders should Changes flag a slightly more aggressive management pay attention. In Woolworths’ case, the long-standing policy of promoting senior people approach from within is over. Recommendation remains Long Term Buy Last month, Dutch-born Tjeerd Jegen, a former Tesco Asia executive, joined Woolworths as its supermarkets boss—a division accounting for $36bn in sales. He replaced Greg Foran, who departed for Wal-Mart after being passed over for the chief executive’s job in favour of Grant O’Brien (who also commenced in October). There are parallels between Jegen and Scottish-born Coles boss Ian McLeod. Both were overseas appointments and both inspired early confidence. At the recent Investor Day, Jegen, after just four weeks in the job, ably demonstrated an impressive knowledge

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of Woolworths’ supermarket operation. Both are also supporters of the ‘customer first’ strategy. Only the accents differ. Jegen aims to boost the performance of the supermarkets business through product innovation in fresh food and improved tailoring of personalised offers based on loyalty card data. If you buy dog food with your Everyday Rewards card, for example, an offer for pet insurance won’t be far away. So, that’s one thing to look forward to.

Demographic tailoring Demographic tailoring of your local store’s range, more overseas sourcing of grocery items and a doubling of private label merchandise (which has Heinz, among others, up in arms) is also planned. These changes make sense, although the real work is in the execution. O’Brien clearly favours new blood over tradition but there are risks; outside hires are more likely to make mistakes; they’re unfamiliar with company culture; and they increase the chance that carefully nurtured talent departs in frustration. Jegen’s appointment suggests that O’Brien believes Woolies needs a shake-up. woolworths | wow fIndeed, there’s evidence of a more aggressive approach by the new chief executive.

Price at review $24.60 First, O’Brien is adopting a more active approach to the asset portfolio. At the Investor Day, he announced a strategic review of consumer electronics chain Dick Smith. Review date 25 Nov 2011 This is a welcome development. Smaller players like Dick Smith face even greater market cap. $30.1bn challenges than and JB Hi-Fi (discussed in Will the internet kill traditional 12 mth price range $23.58–$28.00 retail—Part 2 from 27 Jun 11). Unfortunately, buyers for the chain will be scarce so keeping Business Risk Low it is the most likely option. Share price risk Low Second, Masters, Woolworths’ new home improvement venture, is O’Brien’s baby. max. portfolio weighting 5% The 150-store rollout is a gutsy move to take on the -owned market leader, Bunnings. Of the five Masters stores now open, O’Brien confirmed they were trading ahead Our View long term buy of expectations. But rolling out 15-20 ‘big box’ stores each year is expensive; Woolworths expects the venture to lose $100m in 2012 (although, as a two-thirds owner, its share will be proportionately lower). Breakeven isn’t expected until around 2015, when the home improvement division— including the wholesale business—should be reporting more than $1.5bn in sales. You can

see how Woolworths’ profit will be depressed by the Masters rollout this year in Table 1.

Table 1: Home improvement: Pain before gain Year* 2011A 2012E 2013E 2014E 2015E 2016E Woolworths net profit before 2,129 2,250 2,370 2,500 2,620 2,750 Home Improvement (HI) ($m)

Profit growth before HI (%) 5.0% 5.7% 5.3% 5.5% 4.8% 5.0%

Home improvement losses^ ($m est.) –5 –70 –70 –40 0 60

Net profit ($m) 2,124 2,180 2,300 2,460 2,620 2,810 Chart 1: Woolworths liquor sales ($bn) Profit growth after HI (%) 5.0% 2.6% 5.5% 7.0% 6.5% 7.3%

($bn) 6 Third, with total sales of $55bn, growth is more difficult to come by. In Four things you 5 don’t need to worry about with Woolworths from 21 Mar 11 (Long Term Buy—$25.94), it was explained how the company is now a slower-growth proposition. The risk is that 4 O’Brien isn’t content with that and takes bigger risks to change it. 3 At the Investor Day, O’Brien retained the company’s 10% growth in earnings per share 2 target but acknowledged that Woolworths would not achieve it in 2012 or 2013 due to the Masters rollout and deflationary headwinds. Questioned on the potential for international 1 expansion, he admitted that it was under consideration but stipulated that a partnership 0 would be his preferred vehicle and that he wouldn’t risk the balance sheet. ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 While this suggests ‘big bang’ acquisitions aren’t on the agenda (thankfully), shareholders should prepare themselves for an international Woolworths. Any expansion would presumably be significantly larger than the Croma consumer electronics joint venture with Tata in India (which seems to be troubled, based on reports that Tata wants to end the relationship). The management changes herald a slight shift up the risk curve and partly explain the decision to lower our recommended Buy price to around $23.00 on 3 Nov 11 (Long Term

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Buy—$23.91). With Coles’ resurgence apparently rattling the company, and management stretching towards a 10% growth target, there’s a risk that it will do something silly. The downside, though, isn’t huge. This is a wonderful business; for every Dick Smith there is a stunning success. Take liquor, for example, where O’Brien made his name. At the Investor Day, general manager of liquor Steve Greentree showed his division has grown sales from $1.7bn in 2003 to almost $6.0bn by 2011. Brands include Woolworths Liquor, BWS, Dan Murphy’s, Langton’s, winemarket.com.au, and its most recent acquisition, Celllarmasters. Woolworths can now produce, bottle and distribute liquor through more than 1,500 outlets. And it will continue growing; Woolworths expects to lift the number of Dan Murphy’s outlets by almost 50% by 2016, for instance. It would be a mistake to underestimate the company. O’Brien might not be Michael Luscombe or Roger Corbett but he’s not about to bet this business on a flight of fancy. wow Recommendation Guide At around $23.00 a share Woolworths would be trading on a prospective price-to-earnings Buy Below $23.00 ratio of less than 13 and a free cash flow yield close to 6%. These are very attractive numbers Long Term Buy Up to $27.50 for a business of this quality, and they’re the meat behind our recommended Buy price. take part profits Above $40.00 Another market downdraught, poor sales results from supermarkets, or disappointment with Masters could help lower the share price into striking distance. Keep some cash available to top up your holding in this, one of Australia’s 10 best businesses. For now, the stock is up 3% since 3 Nov 11 (Long Term Buy—$23.91) and remains a LONG TERM BUY. Note 1: The model Growth and Income portfolios own shares in Woolworths. Note 2: Woolworths held its annual general meeting yesterday. There was no new information announced and we have not commented on it specifically.

Australand recently reiterated its full year distribution guidance of 21.5 cents per security following its third quarter update (it has a calendar year end). That’s a 5% increase Australand Holdings | ALZ from 2010, for an 8.2% yield. But like fellow property developers Abacus and Sunland, Price at review $2.61 Australand is worried about a lack of buyers, flat property values and tighter funding as Review date 24 Nov 2011 banks reduce their exposure to cyclical property markets. Australand has bought some max. portfolio weighting 5% breathing space with a $675m loan facility, with $304m maturing in 2015 and $371m in Our View Hold 2016, though $610m of debt matures in 2013. The residential division expects to increase lot sales by 25% in 2011 as it focuses on affordable housing, but returns on capital remain inadequate. We’d be happier if they aLZ Recommendation Guide exited this capital-intensive industry and focused on growing its $2.1bn property investment portfolio. It remains 99% leased and produces around 70% of Australand’s operating cash Long Term Buy Below $2.50 flow. The $185m flagship development at 357 Collins St in Melbourne is now over 50% hold Up to $3.20 pre-committed and on schedule for completion in 2012. With Australand’s security price sell Above $3.20 increasing 12% since Clouds clearing for A-REITs from 7 Oct 11 (Long Term Buy—$2.34), we’re downgrading a notch to HOLD. Note: The model Growth and Income portfolios own securities in Australand.

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IOOF Holdings | James Greenhalgh

At today’s annual meeting, IOOF announced that difficult equity markets would see profit fall this half. Managing director Chris Kelaher explained that underlying profit would IOOF Holdings | IFL fall somewhere in the range of $46m–$51m for the first half of 2012. That compares with Price at review $5.37 a full year profit of $112m in 2011 (and $55m in the first half).

Review date 23 Nov 2011 The announcement seemed to spook the market, with the stock falling 10% on the day. The lack of growth this year suggests that the previously identified cost reductions from max. portfolio weighting 5% integrating IOOF and Australian Wealth Management are nearing an end (as we suggested Our View Hold on 30 Sep 11 (Hold—$5.45)). Ever-keen on expanding the empire (sensibly), Kelaher is back on the acquisition trail, ifl Recommendation Guide having recently snapped up listed financial advisory company DKN Financial Group. While

Buy Below $4.00 it’s early days, he also announced that cost savings from this acquisition were ahead of expectations. Long Term Buy Up to $5.00 Having already lowered the recommendation guide prices to reflect difficult equity take part profits Above $7.00 markets on 30 Sep 11, there’s no need to lower them again. The stock is down marginally since that update, and remains a HOLD.

Warren Buffett is, as usual, spot on. In searching for investment managers to run Berkshire Hathaway’s portfolio in his eventual absence, he says successful candidates must be ‘genetically programmed to recognize and avoid risk, including those never before encountered.’ It’s the ability to avoid tomorrow’s problems and grasp its opportunities that count in investing. Yesterday is, at best, only useful as a guide—often a thoroughly misleading one. Humans have a burning desire to understand the causes behind disasters that have already happened. I posit that this is because, in our long distant hunter-gather past, understanding yesterday’s problems—where and when bush fires or floods might strike, where lions are likely to be hunting, where and when fruits might be in season—was a useful guide to avoiding tomorrow’s threats. The need to understand was an important evolutionary trait when the past was a strong guide to the future. It’s useful in many elements of our lives still today. But our financial world is more complicated than the savannah, not the least because participants all hold their finger on the trigger; everyone is trying to anticipate what the other person is thinking. Financial disasters are almost entirely man-made, complex and, to a point, unique in nature. Thus, the past is often an unreliable guide. And that’s one of the reasons why hindsight bias now leads us wildly astray. Our hunter-gatherer brains need to simplify a highly complex and changing world in order to feel we understand it. Take the giant debt bubble that expanded over the 2000s and burst in 2008—Australians call it the global financial crisis. While many investors knew something bad was brewing by the middle of the decade (ourselves included), only a few handfuls of investors had the foresight to see just how bad things might end up, bet accordingly, and profit from the implosion (ourselves not included). The reason why? Well, it was very hard to connect all the dots. The GFC required a whole raft of bad incentives, greedy players and poor oversight. To occur, banks had to separate their capital from the lending business (or else they

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wouldn’t have written the loans they did). Investors needed to turn a blind eye to the risk they were taking (or, more likely, their advisors and money managers needed to turn a blind eye). Unscrupulous or unthinking people needed to be properly incentivised to write many loans (including enough of the bad variety). Home buyers needed to be naïve enough to think house prices only went up. Regulators needed to either not understand the risks building up or be constricted from acting. And the Federal Reserve needed to keep rates very low fighting the last battle, all the while pouring fuel on the fire. There are probably another 100 requirements to get the kind of excess and subsequent contraction that we got. But, with the benefit of hindsight, most investors are now confident that they could identify such a disaster were it to develop again. We oversimplify. Thus, what was a highly complex and unpredictable matter prior to the event becomes Time Magazine’s ‘25 People to Blame for the Financial Crisis’ list after the fact. And Time’s article allows us to vote on culpability, so we can eventually whittle the list down to a handful of key players, about the number we can fit in our brains at any one point in time. I’m not saying that the people on this list didn’t play an important, even pivotal role. Alan Greenspan, Angelo Mozilo, Joe Cassano, Stan O’Neil and George W. Bush, among others, deserve to have their reputations permanently tarnished (and I have no idea how Bob Rubin and Larry Summers were spared from this list). And I understand this article is somewhat in jest, but it is indicative of a public yearning for simple answers and scapegoats. If it were really that simple, the GFC never would have happened—we would have avoided it. And now, oversimplifying in our attempt to understand the causes, we do learn to avoid being sideswiped by an identical disaster but not a different one, or perhaps even a similar one. That’s a shame. Oversimplification is human and understandable. But it’s unlikely to make us better investors. The very best investors are always on the lookout for this sort of bias in their own thinking—the rest of us should follow suit.

Below is a list of Doddsville and Bristlemouth blog articles published by our analysts this week.

Doddsville blog | Resistance is futile for Spotless Group

Bristlemouth blog | Dissing the Bluescope Capital Raising Bristlemouth blog | Aunty Leaves Viewers Short

Below is a list of podcasts published to the website during the past week Doddsville podcast | Europe, luck and the middle class

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Below is a list of this week’s article links posted by our analyst team to our Twitter page.

The classic 2000 research paper on Bubble Logic: Or, How to Learn to Stop Worrying and Love the Bull.

Interesting Harvard Business School panel discussion from 2008, includes Seth Klarman.

Alain de Botton: A kinder, gentler philosophy of success.

If you needed another lesson on why you should avoid poor businesses, Bluescope’s capital raising provides it.

Baupost also doubled position in BP Plc and bought aggressively into Hewlett Packard, now its 2 largest positions.

Why there may be more lost than won when you employ stop losses.

Why brainstorming doesn’t work.

CNBC’s recent lengthy Interview with Warren Buffett.

‘I started Groupon to get Eric to stop bugging me to find a business model’, Andrew Mason. John Buckingham of Al Frank Asset Management analyses the value of dividends.

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

Wotif update coming Any chance of an update on wotif, similar to carsales that in the USA. There have been no comparable measurements in was done? David M Australia, but it is know that there are vast numbers of uncharted 23 Nov 2011—James Greenhalgh: Hi David. We are due an update abandoned boreholes. This gas, being methane, is hugely more on Wotif, yes, although it may not be until next month. There is likely potent as a greenhouse gas than CO2. The growing realisation to be a significant adjustment of the recommendation guide prices of this is the reason for increasing opposition to CSG mining by downwards given the relative value on offer since the last review. In farmers and rural communities fearing that their aquifers will be preview, we won’t be looking to upgrade at the current price. contaminated, in addition to the atmospheric pollution caused by the fugitive emissions. A report by respected engineering firm Parsons, commissioned several months ago by Beyond Coal seam gas debate Zero Emissions, has been suppressed, apparently because of its In talking about CSG, Guarav, in your article “Slowly begins impact on the arguments of the Gas Industry. In effect, it shows the gas boom”, you do not seem to take into account the growing that the whole of life emissions from CSG are comparable with opposition in the Eastern States to this sort of gas mining. The gas those of the mining and burning of coal—increasingly considered industry is relying on a report by the American Petroleum Industry as being too dirty for continued use. Thus the claims by the Gas to justify the exploration for CSG. The American Petroleum Industry that gas is a clean alternative to coal are quite false when Institute compendium is the basis for industry claims that coal applied to CSG, upon which much reliance is being placed in seam gas produces lower emissions, but these claims are blown the Eastern States. This does not apply to conventional gas, but out of the water by the compendium itself which says “The the stocks of this are limited on the Eastern Seaboard, hence Compendium is neither a standard nor a recommended practice the move to seeking CSG. Bearing this in mind, don’t you think for the development of emissions inventories” The problem with that the risk of investing in gas is even larger than you intimated? coal seam gas extraction is that it forces out the gas by pumping 21 Nov 2011—Gaurav Sodhi: This is a controversial—and water into a bore hoping that it will be forced out through a emotional—issue. Coal seam gas is hardly new; Origin has been number of expected extraction drill holes. However, gas being gas, producing CSG for 15 years and Queensland gets 80% of its domestic it will go out through any path of least resistance including natural gas via CSG today. Much of the sensible debate is about land access crevices and old abandoned stock water and cropping bore holes. and hydrology. Land access is being addressed. Queensland CSG The result has been leakage (known as “fugitive emissions”) projects have been approved with thousands of conditions attached that have been measured as up to 30% in a field of 12000 wells and it’s hard to see them stopping at this point because of land access.

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The hydrology issue is important and represents a genuine risk. No of WA prices but almost twice today’s rate.” Could you please clarify, one really knows what happens when so much saline water is extracted for me, why the cost of CSG, which I take it predominantly is from from coal seams. It hasn’t been an issue so far but I acknowledge it’s the East coast only, has a market price so much below the wholesale a risk. I don’t agree that CSG LNG is more carbon intensive than coal. cost of non CSG gas on the West coast. The reports I’ve read suggest the opposite is true. There are many 18 N o v 2011— Gaurav Sodhi: I think you’re asking why west coast different types of coal and for some high quality black coals perhaps prices are so much higher than east coast prices? that claim is true. But for the average lump of thermal coal, gas—even It’s important to realise that gas is priced in regional markets. in CSG LNG form—is much less carbon intensive. Because it needs pipelines, gas cannot always be traded and prices vary depending on regional—not national—supply and demand. LNG projects on the west coast, which export their product at oil parity prices, Virgin Blue price fall suck in huge volumes of gas. If west coast prices don’t rise to meet Today, Virgin Blue shares fell sharply by 6%, with no negative the price that LNG operators can offer, gas producers will opt to supply news from the AGM ended yesterday. What are the reasons for the LNG industry instead of the domestic market. There are also other the extraordinary decline? Liu H factors too; WA has big private buyers of gas like Alcoa, and a few sellers. 25 Nov 2011—Gareth Brown: I don’t have any particularly Woodside and Apache alone supply the bulk of the state. Hope that enlightening comments to offer. We made the decision years ago makes sense, otherwise please write in again and I’ll have another go. to avoid Virgin and other airlines, because of the industry’s poor economics. It’s a decision we surely don’t regret, but it means we’ve got little insight here. I had a look through the AGM notes and can’t Tax consequences of MAp capital payment see any obvious reason for the recent fall. Do you know whether the $0.80 cash payment will be deemed That said, I wouldn’t call the fall ‘extraordinary’. Virgin’s stock is a return of capital (with purchase price adjustable accordingly) fairly illiquid these days (perhaps $1m-$2m traded most days). So if or a taxable distribution? Robert W just one fund manager wanted to sell out in a hurry, perhaps because 22 Nov 2011—Gareth Brown: Sorry for the delay getting back to Virgin’s management provided no profit guidance at the AGM, then you Robert. The tax consequences, which are very complex and we it’ll easily push the stock down 2 cents. The seller could be selling don’t understand them fully yet, are highlighted in the Explanatory for one of many reasons. The stock saw several one-day price rises Memorandum starting from page 33. of 2-cents in October, so such a movement isn’t unusual. It won’t be a distribution, that’s certain. But you will effectively be selling your stake in the Bermudian entity for some cash (80 cents per unit) and for additional units in one of the other existing trusts Understanding gas prices 2 (MAT2). The latter should offer scrip for scrip rollover relief (page Hi Gaurav I recently read an article (in business spectator I 34) but the former might trigger some capital gains tax for some think re. BHP) , which suggested that gas prices may decrease owners, depending on their purchase price. For some shareholders as there may be a world over supply. In relation to your recent who’ve held longer than 12 months, the CGT discount will apply on article, I haven’t quite understood why east coast gas prices are any tax owing. I don’t know how to calculate the cost base of the going to rise? Usually when supply increase, prices fall ? Is it the Bermudian entity at this stage, and hope for some more guidance on sheer capital costs involved that requires the producers to seek tax consequences to be released by management over the coming (and get) a higher price to recoup the investment? months. Even with that guidance, the matter is likely to be complicated 21 Nov 2011—Gaurav Sodhi: The short answer is that LNG projects and it might pay to run it past your accountant or tax advisor after create an alternate market for gas supply. Producers of gas can supply MAp has provided more detail. LNG projects or the domestic market. Because LNG prices are so high (it is priced at oil parity) LNG producers can afford to pay higher prices for raw gas and so domestic prices must rise to attract enough SOE shareholders: Take cash or Soul Patts shares? gas for local generation. Given the SOE takeover offers both cash or shares in SOE You are right to point out that massive new gas supplies from would you say that it is best to take the cash and reinvest in shales and CSG could swamp international markets and depress shares in one of the down days in the market as opposed to the gas prices, but a lot has to happen first. Shale gas took of in the US VWAP of the trading period? Simon H because of a host of different reasons—a strong oil services sector, a 23 Nov 2011—Gareth Brown: Apologies for the delay getting back huge pipeline network and strong domestic demand were all present to you Simon. First up, while there are a few points to discuss below, in the US. These factors will have to be replicated elsewhere for gas I don’t have a strong opinion either way on the matter of taking cash supplies to similarly escalate. It’s probably not likely in the short term, or Washington H. Soul Pattinson shares in the Souls Private Equity but certainly a long term risk. takeover, it’ll be strongly influenced by each shareholders individual situation. Generally speaking, the decision should be influenced by whether Understanding gas prices you want to own shares in Soul Pattinson rather than take the cash Gaurav Sodhi, on November 16, 2011 wrote the article “Slowly and invest it elsewhere. Soul Pattinson is on our Buy list, but it’s a begins the gas boom”. In it stated, under the heading It Happened in Long Term Buy and we have some more emphatic Buy and Strong WA: “In 2005, West Australian wholesale gas prices stood at $2.50/ Buy recommendations on that list. It’s not the cheapest stock on the gj. Now they’re between $8 and 9/gj.” Then, below this, under the market, but is relatively cheap. Whether it is the most suitable current heading CSG is different: “today’s prices of $3/gj surely cannot last. addition to your portfolio is a matter I need to leave with you. But a We estimate that prices between $6-$7/gj will be sustained, well short few points for consideration.

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Those who bought based on our recent Ideas Lab article are more downside risk, we’d rather also take the more substantial upside that likely to be predisposed towards taking cash. We took that punt in comes with owning Macquarie ordinary securities, which already sit anticipation of an 8% arbitrage profit, not as an avenue for a longer on our Buy list. term investment. Taking cash is the most certain way to lock in that arbitrage profit. Another area worthy of your consideration (particularly those corporate business who didn’t buy for the short term arbitrage) is the matter of capital FLT—For the purposes of your FLT valuation spreadsheet, gains tax. For those who happened to buy Souls Private Equity at a note that in 30 Aug 11 Analyst Presentation (pg 3) FLT stated price much lower than the bid price of 16.3 cents, then the scrip that Corporate was now 30% of TTV (they don’t seem to let that alternative might provide capital gains tax rollover relief, meaning a number out very often) delayed incurrence of capital gains tax. It’s a consideration although it 24 Nov 2011—Gareth Brown: I had noticed that number, but it’s shouldn’t be the main one. Refer the Scheme Booklet and, if needed, not always released so thanks for making sure I saw it. If someone your accountant or tax advisor. asked me five years ago what percentage of FLT’s business would be The last point I’d make is that you have time on your side in making corporate by now, I’d have guessed closer to 50%. It highlights how this decision, and something of a free option. As you mentioned, for strong the Australian leisure business has been for them. That’s great those taking the scrip (share) offer, the price is dependent on the for today’s profit but, for me, also an area of concern. I’m worried volume weighted average share price of Soul Pattinson over the ten about an Australian outbound travel downturn which, if it eventuated, trading days leading up to the Scheme Meetings on 14 December. would hurt. It’s interesting how success is often a cause for concern. But you don’t have to send in the Election Form (for those that want shares) until 29 December at the latest (if you do nothing you’ll get the cash instead). I don’t know whether the company will announce Executive remuneration structures the VWAP price after 14 December or you’ll need to do your own In general, what should be a reasonable long-term hurdle calculations. But if the market price of Soul Patts is lower on, say, 22 for senior executives? I saw one recently based on increase of December than the VWAP price, then it might be better to buy Soul EBIT, but does this not just encourage the over leveraging of the Patts on the market and take the cash (subject to the capital gains tax company? This seems to be somewhat akin to the Macquarie idea issue discussed earlier). If the market price is higher than the VWAP, of issuing more capital and returning some of this as dividends then you might lean towards sending in the election form (assuming while taking a percentage of capital managed which is now you want Soul Pattinson shares in the first place) as a cheaper way increased). to buy the shares. 23 Nov 2011—Nathan Bell, CFA: There is no single measure that can deal with such a complex issue as executive remuneration, but certainly a return on capital type measure is a far better tool than Macquarie Income Securities EBIT, or earnings before costs as it’s often referred to. And yes, you’re With your current BUY rating on MQG, is it a good time to purchase quite right, using EBIT does incentivise management to lever up a its floating rate note (MBLHB) now at $69.50 for investors interested company without adding any value for shareholders. Or worse, put in a return? In May 2008 you warned investors off buying this at the the company at great risk. then price of $94.50. Have you changed your view? While there is no perfect remuneration package, the fact that 22 Nov 2011—Gareth Brown: Sorry for the delay getting back you’ve found the weakness in using EBIT shows that you’re well to you, my timetable was ransacked by two income security offers qualified to find other red flags. Poor use of options, for example, that came out of the blue (Origin and AFIC), and queries have been high remuneration that is not performance based, or ’at risk’ in the delayed unfortunately. jargon, low insider ownership and the list goes. Why do our big bank My thinking on the MBLHB securities has changed markedly since chiefs earn such huge amounts for running oligopolies? my initial income security sweep in 2007. Firstly, from Macquarie’s One of my favourite chiefs was Jim Sinegal of Costco. He point of view the margin of 1.7% is very attractive, they might not get announced his retirement recently, but like Buffett used to Sinegal financing this cheap for many, many years. So I think of the securities only took a $100k salary and benefited far more from his large stake in terms of running yield only, rather than trying to guess when we in the business. Sinegal did receive an options package, though. This might also make a capital gain (which might not happen for a long is in stark contrast to what Paul Little is doing at Toll on his way out time. Technically it might never happen given the perpetual nature the door. Unfortunately it’s a lot easier to identify poor compensation of the securities). packages than good ones. Secondly, these are stapled securities, and the fine print states that if Macquarie ever skips a payment the securities convert to a preference share. Those preference shares will come with an ordinary Considering ERA? share dividend stopper, but in many ways this security is more like Hi Gaurav, I know you just confirmed on ask the experts that equity than debt. If Macquarie ever gets into deep trouble, distributions you’d still rather avoid ERA, but I was wondering at what price will cease for the entire period of that trouble. would you consider changing your mind? Is all the downside Looking at the running yield alone, which currently adds up to already priced into this stock? At $11.40 it was a sell, at $8 about 9.2% (or BBSW +4.4% expressed in floating rate terms), it coverage was ceased. Now down at $1.80 does it represent any doesn’t stack up. Many of the risks in investment banking are ‘binary’ value even with the risk of lease renewals and an aging mine? in nature—if it goes bad, it’ll go bad in a hurry before Macquarie has Alex H the time to issue new capital and shore up its position—meaning 18 Nov 2011—Gaurav Sodhi: Hi Alex. Ordinarily I would agree these securities won’t escape the pain. So if we’re going to take the with you—everything has its price. The difficulty is that we’ve no way

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of assessing what a reasonable price is for ERA. Primary mining will you Paul. First thing to note is that the numbers for MAp are currently end very soon (2012 from memory) and, after that, the company being somewhat polluted by this asset swap. Today’s price for MAp must rely on additional government approvals, landowner consent and is $3.38 and I think it’s best to think of that as being made up of exploration to continue mining. It’s easy to imagine a grim future and an 80 cent payment to be paid to securityholders soon, and $2.58 I’m not sure additional research would better the odds of success. If for the remaining business. That’s an implied post-scheme market research can’t alter the odds, it’s more of a gamble than an investment. capitalisation of $4.8bn. Pro-form, post simplification debt is about It’s not a situation that appeals. $6.1bn for an enterprise value of $10.9bn. According to the information memorandum, pro-forma 2010 EBITDA (ie if the simplification, asset swap and cash payment had occurred before 2010) was $639m, Centrebet GST litigation meaning an EV/EBITDA of 17, give or take. So the number is higher Hi Guys, I was enquiring whether you had heard anything than what you’ve come up with for Auckland (I haven’t checked that regarding the Centrebet litigation with the ATO. I can’t find any number). information on its progression and the registry that administers We don’t cover AIA so please don’t take the below as a comment the Litigation Rights/Shares is less than helpful. Last I heard on the attractiveness of Sydney Airport over AIA or vice versa. We was that it was being negotiated prior to a hearing should like Sydney Airport but we don’t know whether it’s better than AIA. negotiations have failed to reach an agreement. That was months We just don’t know AIA as well as we know MAp and Sydney Airport, ago. Shareholders were to be entitled to an immediate 10.9 cent and aren’t in the position to make useful comparisons at this stage. payment should it have gone through with the balance of 90% But the following will give you a starting point if you’re trying to make of $90 million payable over an estimated 8-9 years. There is such a comparison. Be aware, though, that airports are complex nothing to be gleaned on this anywhere. Stephen M assets to value. 25 Nov 2011—Gareth Brown: I’m not keeping a very close Firstly, we’d argue there’s no one ‘right way’ to think about valuing eye on developments anymore. But Intelligent Investor Funds airports or any other assets. It depends what you’re looking at and it Management was a Centrebet shareholder, so Steve Johnson has depends on the situation. That said, using EV/EBITDA is probably the been following closely. There’s no news as yet to report. Last Steve least error prone way of looking at the value of most infrastructure heard, management had expected some resolution by the end of assets, it ignores how the asset is financed and other potentially October but there’s obviously been a delay. Given there’s probably misleading matters. It’s how a third party might value an asset if it some negotiation going on between Centrebet and the tax office, were considering taking it over. But it’s not as simple as buying the it’s no surprise they’ve kept mum until that process is complete. We group with the lowest EV/EBITDA, it’s only a useful starting point. hope to hear something fairly soon but there are no guarantees. Steve Rapidly growing airports, such as those in Australia (and perhaps promises to keep me informed, and I’ll write an update as soon as Auckland fits into this category) generally deserve a substantially more details come to light. higher multiple than an airport that’s not growing rapidly, such as many in Europe. That’s because many of the costs are fixed and as revenue grows, a greater percentage falls through to the bottom line, BlueScope Steel capital raising meaning free cash flow grows much faster than revenue. So it’s worth Any thoughts on BlueScope Steel’s capital raising? paying something extra for revenue growth—your thoughts on the 23 Nov 2011—Nathan Bell, CFA: We haven’t been following the comparative future growth of Auckland vs Sydney is important here. company closely for a while, for all the usual reasons; it’s a commodity Likewise, it matters whether the airport is ahead of the curve or business, it has a poor track record of producing consistent free behind it on capital spending. If it’s just finished (and already paid for) cashflow, it’s suffering from increasing competition across Asia etc. a substantial expansion and won’t need to outlay much in the way And given that management has now crucified existing shareholders of growth capital expenditure for years (as is the case with Sydney), with the latest capital raising, this isn’t a company or a management then it probably also deserves a higher multiple. I don’t know where team that we want to wake up next to. Some say there is a price AIA is in that regards but it is important. for everything, but with so many high quality businesses trading at There are multiple other variables, such as whether it’s locked in attractive values we’re happy to steer clear of BlueScope. long term financing at attractive rates, its general access to capital, the regulatory environment, pricing flexibility and many other matters. So EV/EBITDA is necessarily blunt and won’t tell you everything. Auckland International Airport As we move down towards the bottom line, the yield is a useful Hi, I notice AIA () is trading at an EV/EBITDA way of measuring what flows through to securityholders. But again of about 14 times. This seems to be better than MAP currently, a straight comparison isn’t necessarily enlightening, it’ll depend on however, I notice that both the dividend yield and earnings yield payout ratios. For reasons we’ve highlighted in numerous other Q&A (ie NPAT/market capitalisation) are both somewhat lower for AIA responses this year (see 3/ 8 /11, for example), net profit and therefore than MAP. Is there a reason when looking at infrastructure stocks earnings yield is not useful for valuing these complicated assets. you have tended to use EV/EBITDA and is the fact therefore that AIA’s earnings yield is lower simply a result of accounting issues arising once depreciation etc is taken into account? Put another AFIC notes and inflation way, should I be looking at EV/EBITDA for AIA when comparing Hi Gareth, I’m interested in AFIC notes as I do currently to MAP and on that basis have a preference currently for AIA (I own some AFIC shares. But I’m concerned about the threat of am ignoring franking differences on dividends, although as a NZ stagflation—6.25% is a good rate of return now, but in 3 years resident I can claim those on AIA). Paul S time if the share market is flat lining but inflation is high, might 24 Nov 2011—Gareth Brown: Sorry for the delay getting back to this be a poor return? From what I could tell, the interest rate

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isn’t pegged to anything so would stay unchanged. Or am I be ideal but it’ll fare better than many assets. Firstly, it seems unlikely missing something fundamental about the nature of stagflation? that monstrous inflation will hit right away. Even if you’re convinced Thanks Nick that high inflation is coming, if it’s a year or two off then AFIC notes 22 Nov 2011—Gareth Brown: I think this is a great question, one already only have three or four years left to run, perhaps less. It’s that we did discuss internally before I wrote the AFIC Convertible not like you’re locking your money up at low rates for 20 years. The Notes review. Yes the interest rate is fixed at 6.25% for the full five ‘bond’ component of this would do better in a falling interest rate years. My take on this is that if you’re concerned about hyperinflation, environment, sure, but it is only medium term in nature and not you need to think about if from a ‘whole of portfolio’ point of view. incredibly sensitive to higher rates. Ideally, we want to hold a good smattering of assets that will do ok Then there’s the optionality part of it. If sharemarkets flat lines in a wildly inflationary environment but not position our portfolio for then that will be worth nothing. But if markets instead rise then we losses if that environment doesn’t arrive (it’s always about preparing might make some more money. It’s a lower risk sharemarket exposure rather than predicting). So unless you’re putting all of your portfolio than actually owning shares. In a horrendous environment of runaway into floating rate notes, these AFIC securities might deserve a place inflation in the price of goods and services, but deflation in asset values, in a portfolio, even one fearful of inflation. AFIC notes won’t go great but they’ll probably outperform most stocks As for how the AFIC notes will respond to high inflation, it won’t by not going backwards, at least if you’re able to hold until maturity.

Important information Intelligent Investor 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 PO Box Q744 | Queen Vic Bldg NSW 1230 advice from a financial adviser or stockbroker if necessary. Intelligent Investor and associated websites are published by The Intelligent T 1800 620 414 | F (02) 9387 8674 Investor Publishing Pty Ltd (Australian Financial Services Licence no. 282288). [email protected] 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 www.intelligentinvestor.com.au advice before acting upon any recommendation. copyright The Intelligent Investor Publishing Pty Ltd 2011. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only. Disclosure In-house staff currently hold the following securities or managed investment schemes: ABP, ALL, ALZ, ARP, AWC, AWE, AZZ, BBG, BCC, BER, CBA, CIF, CMIPC, CND, COH, CPU, CRC, CSL, CUE, EBT, ELDPA, FGL, FLT, HVN, IAG, IDT, IFL, IFM, IVC, KRM, KRS, LMC, MAP, MAU, MCE, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PGA, PTM, QBE, QTI, RCU, RNY, ROC, SDI, SFC, SGN, SGT, SHL, SKI, SRV, TAP, TGP, TLS, TRG, TRU, TWE, TWO, UXC, VMS, WBC, WDC, WES, WHG and WRT. This is not a recommendation.

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