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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 Origin Energy 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 Woodside Petroleum’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. 2 Weekly Review | Issue 333b 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 bhp 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 Telstra’s Sensis division, owners of The Trading Post. In New Zealand, as in Australia, classified advertising has migrated online. But instead of it segmenting into three or four different sites, Trade Me is New Zealand’s eBay, carsales.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.

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