Sector rotation

It's school holidays...games of squash and cluedo, trips to the zoo and other frivolities are the order of the day...

The volume of commentary calling for a correction (orderly or otherwise) is growing.  While on one hand it meaningless noise, it does add to a general sense of foreboding.  Longs are happy to sit on their hands, though the ripcord is never far from reach.

For mine, the Dec XJO puts I bought on this run up are still in play - on balance, I'm expecting a pullback to around the various moving averages around 4550.  I'll trade against the Mar XJO puts if we get some meaningful volatility heading into the new year.

One shape in the charts that has caught my eye are the defensives.  There is a general bid against some of these stocks that suggests that a rotation into these types of stocks could be in the offing.  That would fit with a retracement scenario where investors take profit but look to stay in the market.

Have a look at TCL for example.  It held the $4.00 level over recent weeks with rising volume and momentum divergence.  It is testing its longer term downtrend.  Think I'll look to pick some up over next week if it breaks higher (near term target $4.70)...

 

Steel as a proxy for BHP

Getting back to my ruminations of a couple of days ago – want to explore the world of BHP a little more.

BHP – broker consensus has it a BUY?

While some naysayers in the broker community have deemed BHP a ‘Hold’, the majority of the professional pundits rate it a ‘Buy’.  The investment thesis is broadly based on the principles that:

1)    The developed world has turned the corner, and therefore will resume its demand for commodities,

2)    China’s economy has gathered a ‘fresh head of steam’, and, 

3)    Medium to long-term commodity demand is underwritten by China’s industrialisation. 

Simple enough, and certainly fits with the ‘recession is over’ theme.

While I’m not going to build a full-blown model for the mining behemoth, I think we can have a closer look at this consensually conceived thinking.  Let’s take one analyst’s forecasts as a guide.  Following is a summary of earnings (EBIT) by division:

Some quick observations on the three-year outlook:

-       Petroleum remains a strong contributor on rising volumes

-       Base metals make a resurgence with greater volumes

-       Carbon steel remains the stand-out contributor, after a weaker 2010 reflecting lower prices/higher costs, volume and price picks up again into 2012

-       Steaming coal takes a hit on lower prices in 2010 and kicks up again thereafter on rising volumes and prices

No sign of a global recession there - volumes just going to keep heading higher.  And a similar story with the price assumptions behind these forecasts:

There you have it – volumes rise and so do prices.  Couldn’t have asked for more.  But before we boldly embrace the broker recommendation, let’s test the investment thesis using steel as the divining stick (particularly given it is so important to BHP’s earnings).

China’s insatiable demand for all things steel

Consider the following profile of world steel production since 2003 (from the World Steel Association):

First conclusion is that non-China production has fallen into a ditch.  While it may be climbing from this lower base, it would be fanciful to assume that it is going to reclaim its pre-crash levels anytime in the near future.  Just as construction activity in the developed world benefited from the debt inspired binge, it will struggle along with the chastened consumer in an extended period of fasting.  On this basis, it’s probably not a great idea to hang your hat on the premise that the non-China world is going to drive growth in world steel production.

Not to worry though cause China has taken up the slack.  As of July 2009, it accounts for  approximately  50% of world steel production up from 5% in the early 1980’s.  And while the 2008 year was a slow one by its usual standards (annual growth of only 1% in production volume), 2009 promises to be the harbinger of things to come with at least 10% annual growth seemingly in the bag.

So to support the broker assumptions of growing volume and prices, we only need to look to China’s steel production that will keep growing by 10% to 15% per annum for at least the next 10 years …right?  (Small detail that is beyond my scope here – but the broker in question assumes BHP increases sale volumes of iron ore by more than 20% per annum from 2009 to 2012.  Well, if the big Australian can’t grow its market share, who can?)

I reckon this scenario is a little optimistic for the following reasons:

      1)    China’s internal demand for steel has peaked - We have just witnessed an extraordinary capital injection from the government.  With in excess of 60% of the fiscal package being directed towards infrastructure, and assuming an implied steel content of capital of around 15%, you can pretty quickly see how the recent surge in steel production has come about (and for that matter every other raw material that could be tucked away in a warehouse somewhere).  Without a further impetus from the government (which is not out of the question), it will be a while before the level of internal demand is bettered.

2)    China is an exporter of steel with no markets to export to – what the chart of world steel production doesn’t tell you, is the fact that until recently China has been a net exporter of steel (in fact the world’s largest).  It’s conversion into a net importer wasn’t by choice, as the following chart from the Iron and Steel Statistics Bureau shows:

With the impact of the fiscal support fading, we are about to find out what the ‘real’ internal Chinese demand for steel is.  The question then becomes what happens to the surplus capacity?

One answer may be that steel producers that would otherwise export product may get government assistance to reignite their export markets.  Consider for example, the announcement on 8 June 2009 that the government will refund the 9% value-added tax rebate on exports of several high-end steel products.  This is aimed at effectively undercutting the pricing of Posco in its own market (South Korea was the biggest importer of Chinese steel).

In short, I suspect that we are about to get a clearer picture about the real demand and supply of the Chinese steel industry (granted it will probably have vasoline smeared across the lense but at least the lense-cap will be off).  On current indications, it looks less than supportive for an investment thesis that rests on double-digit growth in Chinese steel production over the next few of years.

3) China will gain pricing power – China’s steel industry struggles against persistent overcapacity (it produced 500mt in 2008 against a capacity at the time of around 600mt) that is spread across a plethora (72) of small and mid-sized producers.  This creates an industry that is particularly vulnerable to demand and supply shocks.  The flipside to the recent fiscally inspired boom is that once it is has passed, producers need to be weaned off the assistance.  In an environment where export markets are particularly hard to find, it’s not surprising to hear reports of rapid stockpiling.  

If you add into the mix that China’s producers operate on relatively thin average margins of around 5.5% (according to IMF working paper “Is China’s Export Oriented Export Growth Sustainable Aug-09) then there are all the ingredients for consolidation of the industry if it comes under stress.  Hence, the statement from the China Mining Association that the industry lost money in the first four months of this year has special resonance.  If you don’t believe me, have a look to the CISA for the direction that this is taking:

From China Steel and Iron Association on 31 July, 2009 – Secretary General of CISA suggested that steel makers accept a single ore price…to regulate excess ore shipments by small steel makers and intermediary traders, which have hampered negotiations by creating unnecessary demand.

(And for a little bit more colour on industry consolidation China style have a quick look at the state sponsored takeover of Rizhao Iron & Steel by Shandong Iron & Steel.)

It is highly likely that the likes of BHP can’t continue to make out like bandits, while the world's steel industry struggles with excess capacity.  Expect consolidation in China's industry to deliver cohesive negotiating positions and pricing power – input prices will share in the pain of the ‘transition process’.

In summary, this doesn’t sound like a glowing endorsement of a financial model that suggests 20% per annum growth in volumes over the next 3 years as well as rising prices.  As a litmus test for the investment thesis, it’s coming up red (or is it purple?).

What this discussion does throw into stark relief is the implicit reliance that world economic growth has on that red-lacquered flight-box China.  The accepted wisdom is that we can rely on China to continue to grow at 8% per annum – cause without this there will be rioting and pillaging on its streets.  There’s bound to be some truth in the myth, but as with all things, the truth is a whole lot more complicated.  My take on it is that China may well continue to grow at 8% per annum, but in the current environment this may not translate to higher prices, perhaps not even higher volumes, for the likes of BHP.

I know this has been rather long but couldn’t leave the following out as I think steelprices-china.com summarises the current market with a certain panache…

The main reason of arousing price decline is that traders and speculators’ selling lead to low market expectation.  Because of the overcapacity, once the downstream demand fluctuates, it will increase the stock.  According to the present, the steel stock will still increase in few weeks.”

The report then goes on to point out how critical the recovery in the US is….  

More and more professionals believe that market risk is increasing. Steel enterprises, traders and end users all think that it will have a big change on September in China’s steel market. There is an important mark is that the change of American economic data in third quarter as American economic recovery is the prerequisite of the global economic recovery. If American economic indicator of third quarter is improved, it will be a huge inspiration to Chinese economy even the whole world. Demand of steel and steel price will increase. Otherwise, the steel price will drop severely.

Copper and BHP

I have a vivid memory of pitching a commodity linked currency contract to a large Australian mining company during the Asian crisis in late 1997. They were already bleeding from their swollen AUDUSD hedge book. The deadpan response of the company’s cardigan wearing Treasurer was: “I’m not going to be the one to sell copper at the bottom of the market”…Copper proceeded to plunge and the company was ultimately taken over.

The crux of our pitch was that with World GDP growth expected to fall towards 2%, metals prices were going to take a hit. Following is a chart of GDP and copper prices since 1990 (source: IMF):

See the Asian crisis? It’s easy to miss given the more recent gyrations. It begs the question – how can copper prices (and commodity prices generally) continue to levitate at current levels in the face of such widespread demand destruction?

Now clearly the world has changed a great deal since the Asian crisis. The desperately low copper prices of the late 90’s and early noughties were the catalyst for consolidation and restructuring on the production side of the ledger. Producers now have greater pricing power. On the consumer side, the emergence of China into full throttle industrialisation logically puts a flaw under medium term demand. BHP sees China doubling its annual demand from current levels by 2025.

To get a sense of the demand and supply equation consider the following table:

There are a couple of things that jump out from this breakdown. The first being the absolute dominance of China, the second being that ‘high income’ countries (to use IMF vernacular) in aggregate remain significant to world demand.

Which leads to the obvious question – if there was a surplus in 2008, then what happens in 2009 when world GDP really falls off the edge (annualised Q1 GDP in US down 6.4%, Germany down 6.7%, Japan down 14.2%). Even if GDP has stabilised and (just maybe) begun to recover in the second half, it is now coming from a low base. Think we can reasonably expect the copper surplus to persist this year.

And going forward into 2010, even if China’s physical demand were to level out at a higher level (say 2 million tonnes per annum) if world GDP grows by 1% YOY after dropping 2.5% the year before, then there’s a reasonable chance that there will be a surplus for that calendar year as well.

So it’s a fair probability that for at least the short to medium term, physical demand for copper will be outstripped by supply.

How then can commodity prices be trading at their current levels? It’s not because the cost of production demands it (witness BHP’s current EBIT margins at around 40%, nearly double that of the dark days of the Asia crisis). Or put another way, who has been the marginal buyer pushing up prices beyond the physical demand for the metal. The answer not unexpectedly is China. The following chart of refined copper imports in China illustrates the point. (Source: China Customs Office)

Impressive isn’t it. The fact is China has been sucking in copper above and beyond its current needs. Macquarie estimates as much as 400,000 tonnes have been stockpiled in the first half. While there have been reports that China has bought 235,000 tonnes for its strategic reserves.

So will stockpiling continue?

As with all things China it is hard to get definitive, but a couple of arguments would suggest not.

Firstly, logic would suggest China does not need to chase the price higher. The whole point about building strategic reserves in a very weak market is to facilitate management of supply when demand picks up. With around 40% of their annual import requirements covered by stockpiles, China’s consumers can afford to be a little less hasty in bidding for supplies even if they are for additional reserves.

Secondly, indications are that liquidity is being reined in. Statements about the reclassification of sub-debt in relation to bank reserves and about how the proceeds of loans should be applied suggest anecdotally (if not in substance) that the Party is concerned about liquidity-fuelled speculation. The fall in new lending in July mirrors the decline in copper imports. Early indications are that liquidity and its handmaidens, greed and lust, are on the wane.

To BHP then – what is its valuation looking like with the share price over $37? Consensus forecasts look something like:

The commodity assumptions underlying these earnings are many and varied depending upon the broker. But as a generalisation on a straw poll, they are pretty much extrapolations of current prices continuing to strengthen from here (UBS for example has forecasts for copper of 223 cents per pound for FY2010 and 255 cents in FY011 - compared to a realised price of 224 cents in FY2009).

In short, I’d class the current valuation as pretty rich. While the long term Chindia industrialisation story remains favourable, as with all things, this fundamental outlook should be risk weighted to reflect the many uncertainties in our world. At 15x to 20x earnings, and on the basis that these earnings are calculated using favourable commodity prices, there is not much room for error (or upside).

On the other hand, maybe we are living on the verge of an inflationary world where the USD will plummet, commodity prices will soar, and China will lead us into another era of excess and fine dining. Maybe…

Under the pump - close-out QBE

QBE marked out a trend reversal on Friday, has been treading water between 20.80 and 21.30, and looks to me like the risks are to the downside for a break out of this consolidation. I don't have the time to think about - closed-out the position.

CEU traffic update and other buys

CEU had a timely uplift in average daily tolls to 158,882 for the month of July. With the increased average toll of $3.22 (ex GST) - CEU is getting close to cashflow breakeven (somewhere in the 160k's depending on your running cost assumption). I'm (hoping) for some market weakness to jump back in...

In general, remain of the view that the markets are marking out some kind of near term top. On the long side, hoping for opportunities to buy ALZ at $0.40 and IIN at $1.60.

Have sold out of NCM - been trading gold like a dog. The key to near term market direction is the USD - and it looks to me like its found a bottom (supported by the fact that bearish sentiment in the USD is at an extreme).

Moving on for greener pastures

Hopped out of CEU and DUE today...they have paid their way but time is marching on

Switched out of WBC and into QBE

The banks have rallied hard on a recovery story that will get picked to pieces...QBE has lagged...

ALZ - On reflection...I'm a buyer at 40 cents

Thought more about Australand overnight. On balance, I'd be happy to start accumulating if it trades down to the rights issue price of 40 cents.

The logic is:

- the downside is priced in. I modelled a scenario where avg cap rates rise to 11%. While I think this is realistically conservative - it is a stretch from here. In any event, the conclusion was that a security price of 40 cents was pricing in this type of cap rate.

- major property market wipeout risks are contained. With gearing down, exposure to an even bigger fall in commercial property (to rival that in Japan in the early 90's) is manageable.

- a 10% tax deferred yield is about right. It compares favourably to current long end rates and in a sense implies a 1% management fee is being paid for passive property ownership (plus the developer).

- the development risks are being reasonably managed. This is a little bit of a leap of faith given it is difficult to quantify the risks around this part of the business from a distance (for example, there are $150m of performance guarantees that sit off balance sheet?). So I make the assumption that, at the very least, this part of the business will continue at breakeven. This is fine as at 40 cents, you are not paying for the development capabilities. It is a call option where the premium are the costs of maintaining the development capability for the longer term

As for the AAZPB, they had a good day yesterday (up close to 20%). At a running yield around 11.5%, there is maybe a little but left in them (eg. GMPPA at 10.2%) but most of the juice has been squeezed from this lemon.

Australand - buy into rights issue?

It was the former managing director of Australand, Brendan Crotty, that told me that property was all about demographics. It's true for investing generally, but has special resonance for property.

Australia has an immigration regime that underwrites our continued population growth - over 200,000 new mouths in 2008 (that's both permanent and non-permanent residents). Even when times get tough, Australia is captive to its immigrant legacy. The demographics of Australia support the builder.

This is not the say the property owner will always have it their way. They won't. We have had easy credit for so long, it is going to take a while for excessive valuations to unwind. But that's property ownership - there is a distinction.

So to Australand's half year results. They are a builder and an owner in equal measure. The question I'm asking myself is - are they value at 40 cents?

Let's try to break it down...

Property portfolio - investment and development ownership

Let's look first at property ownership - the questions here are a) how much pain is priced into the portfolios? and b) how much pain can they bear? Here's a quick summary of the investment portfolio:

	30/6/08	30/6/09
Investment Portfolio value	$2,288	$2,015
Weighted avg lease expiry	6.6	6.4
Avg cap rate	7.54%	8.34%
Avg cap rate - office	7.28%	7.91%
Avg cap rate - industrial	7.75%	8.81%
Occupancy (incl rent support)	98.80%	99.10%

And a quick sensitivity check of how this translates to total property holdings:

Reported invt portfolio value	2015.0
Reported avg cap rate	8.34%
Implied rental income	168.1
Assume cap rate +1%	9.34%
Implied portfolio value	1799.3
Change in value	215.7
Covenant impact	37%
10% decline in devpt assets	143.8
Total Covenant impact	39%

My conclusion from this...

Post the entitlement issue, it's unlikely that Australand will have to pass around the hat for more equity again. Even if property values were to fall by another 25% from here (putting the average cap rate around 11%), the gearing covenant should not be breached (my numbers have it remaining well under 50% in that scenario).

That is not to say the portfolio valuation is cheap at the moment. (Remember shopping centres were priced in the low to mid teens in the early 90's.) I wouldn't be surprised to see the average cap rate push into double digits before this market cycle is done.

So let's assume something like this occurs...again on my numbers (I can't quite match up Australand's rental income, cap rate and valuation - so I have taken the conservative valuation), assuming a 25% decline in valuations from here and an avg cap rate of 11%, this puts the NTA on the securities at $0.39. Given the placement is at $0.40, it is starting to look like reasonable value.

Property development

Now to property development. It's volatile business at the best of times - when the going is good, the BRW Rich list is littered with property developers. Trouble is, times ain't so good.

So how are Australand placed? The theme that comes from their outlook is that they expect the market to remain soft (with some hope of a lift in 2010). Essentially, they remain in 'monetisation' mode - selling assets as and when they can. The residential development business is basically breakeven as margins are being squeezed as they focus on offloading stock. Commercial and industrial development is about one third of the size of 2008 - with no office projects and a few pre-commited projects in the industrial sector. All in all this business could better be classed as 'care and maintenance' for the moment.

On the plus side, if you are buying the securities at 40 cents, then you are basically picking up the development business for nix. This is not a bad deal as Australand are managing down the risks from this part of the business while maintaining the development capability longer term. In particular, the capital commitment looks to be well contained ($44m for the 2009 year) and the model of developing assets that are sold into the trusts remains on foot ($113m for 2009).

So add it all up and what do we get?

Australand at 40 cents looks okay. The yield of ~10% seems about right - they are only paying distributions from the trusts and (as you would expect) nothing from the developer. With rent escalating at ~3% per annum and a reasonably good quality portfolio, the longer term yield is sound as well.

Looking at relative value, Australand looks pretty good. Consider the comparisons Australand published with the rights issue documentation...

	DPS yield	Discount to NTA
Australand	10.30%	43.50%
Stockland	6.80%	12.30%
Mirvac	7.10%	24.80%
GPT	7.50%	27.80%
C'wealth Office	8.50%	38.40%
Dexus	8.50%	38.60%

But maybe that says more about the sector than the absolute value on offer.

Conclusion

Think I have convinced myself that Australand at 40 cents is a reasonable deal. Does that mean I'll be buying it ahead of it going ex-rights tomorrow? Probably not - as my macro view of the market remains bearish. I reckon there will be opportunities to buy quality property companies at deep discounts to fair value in the not too distant future.

There will come a time to invest in the property sector again. The demographics demand it. But based on this latest instalment from Australand - there is no need to rush.

(Postscript - a consolation prize is that the AAZPB are a winner from this latest capital raising. I'll have a quick look at relative pricing tomorrow - but my guess they are a buy...)

Not drowning, waving

Got pulled out of the rip by my friendly market maker. Closed out short on XJO.

The Woman's Day approach to investing

Well not quite - but following are the criteria that I'm going to apply for the beauty pagent...

Valuation

1) P/E versus AAA bond

2) Dividend yield

3) EBIT multiple benchmark

4) Price to NTA

Risk

5) Gearing - debt to debt plus equity

6) Interest cover - EBIT to interest

7) Gearing - change year on year

10) Change in working capital - CA/CL year on year

Reward

8) Return on assets - NPAT to Total Assets

9) Operating cashflow to total assets

10) Change in ROA year on year

11) ROA versus CFROA

12) EPS trend

13) EBIT margin

14) Change in EBIT margin year on year

15) Dividend payout ratio

16) Change in Asset turnover - Sales to total assets at beginning - year on year

Business

17) Quality of Management - measured by decisions, reputation, pay structure, M&A, equity issuance

18) Competitive positioning - industry growing?, pricing power?,

19) Change in shares on issue - year on year

Small XJO short as a trading hedge and selling CEU

I like the odds of a pullback to around 4000 over the next couple of days - the market remains overbought and momentum has drifted over the last 48 hours. So have put on small XJO put position (strike at 4000 - I hate paying up for volatility at the best of times, at least with a closer to the money strike you aren't fighting the smile). The plan is to trade out of it if the market does peel off, while hopefully the trading longs (BHP, WBC, QBE, NCM) will hang in there. See how we go.

Also, took half the CEU position off the table. The buying volume has picked up over last couple of days (looks like 1 buyer got things going yesterday with a volume bid around $0.35), and I can still see further upside from here. But as they say "you never go broke taking profits" and a 26% gain in a couple of months is a reasonable return.

Stocks for review (comments welcome)...

Here's a list of the stocks that are on my broader radar. It's not exhaustive. There are stocks that I've had a history in trading that don't make the cut (at my peril perhaps) simply because last time I looked something was not quite right (eg. management, business model). That doesn't mean I'm a believer in all these. Just there is something in all these that has caught my interest.

I think the objective is to use the reporting season to review (some?) these. I'll take a "Womans Day" questionnaire approach (something I haven't done since way back in 2000) to cover more ground. A score of 7 out of 10 suggests having deeper look - you get the picture.

If there are any that you think I should include please pipe up. Similarly, if you have any views on priorities...I'm all ears (even if I only have two of them).

Technology		Financials		Industrial
ISS Group		QBE		Leightons
IRESS		Westpac		RCR Tomlinson
Wotif		CBA		Worleys
Seek		Macquarie		Hastie
Reckon		APN Property Group		HGL
GBST
Praemium		Retail		Media
		Fantastic Furniture		Mitchell Comm's
Property		The Reject Shop		Photon Group
Australand		SuperCheap		STW Communications
Goodman		JB Hi Fi		Austar
Westpac Office		Wesfarmers		Newscorp
Bunnings Property		Metcash
				Healthcare
Infrastructure		Energy		Cochlear
Connect-East		AWE		Biota
Transurban		Beach Petroleum		CSL
Envestra		Karoon Gas		Neuren
Deuts		Woodside		Blackmores
Viridis		Paladin
		ERA		Telecom
Resources		MEO Australia		IINet
BHP				PIPE Networks
Newcrest		Gaming
Orica		Tattersalls

TTS - dodgy analysis

A short mea culpa before I go on. I bought TTS (13July09) on the back of some dated analysis and a, potentially, good looking chart. After running through the numbers I don’t think TTS is great value above $2.60. Still like the management. Just the broad numbers don’t suggest terrific upside from there without a meaningful win on some of the bids they are likely to lodge. Anyways, its all grist to the mill…on with where I have got to.

I subscribe to the theory – if the value isn’t obvious, or at least readily understood, then it’s probably missing. This is particularly true of financial models. I have been guilty of trying to build the million-variable model in my youth. No more.

So to a quick summary of my views on TTS. I’m going to simply extrapolate the Dec 08 half yearly result. I know there is some seasonality in their business – but for these purposes a straight line from the latest numbers will suffice.

My current take on TTS splits the overall business in two – 1) there are the steady state operations (Tatts Lotteries, Unitab, and MaxGaming) and 2) the run-off and growth potential (Tatts Pokies, the international operations and upcoming local opportunities).

In valuing the business I therefore assume there is a core business that is pretty easy to get a broad grip on. Take the following for example,

	Dec-08 EBIT
Unitab	71.3
Lotteries	46.5
MaxGaming	20.3
H/O costs	-17.0
Group EBIT	121.1
Annualised	242.2
EBITmultiple	8	10	12	14
Valuation	1938	2422	2906	3391

You could argue the group EBIT is conservative – given it includes the corporate costs associated with Pokies as well – but this is an impressionist portrait.

Take your pick which EBIT multiple is appropriate for a business like TTS. From my perspective, I reckon 10 to 12 times would probably work (equivalent to P/E of around 15x). Gaming businesses typically command a reasonably high multiple (CWN trades in a P/E range of 15 to 20). On the flip side, state governments have been a tad unfriendly of late – so there should be compensation for the heightened regulatory risk.

Okay, that’s the ‘core operations’. How about the rest?

I think we can ignore the international for the moment. There is potential there – but nothing has come of this as yet and they have been at it a while. Let’s value these at zero then.

That gets us to the Tatts Pokies business. Let’s assume that the EBIT of $116m for the Dec08 half is replicated across the remaining term of the licence (6 half years). And let’s also assume that TTS is successful in extracting $600m from the government per the original licence agreement (the IPO prospectus assumed $598m). PV these back (I’ve assumed 7% - no particular reason, seems like a healthy premium to the risk free rate) and voila, you get a present value of $1,100m.

Finally, TTS had net debt of $734m at balance date. Capex of ~$45m was running just below depreciation of ~$50m – let’s assume it’s a wash.

So what have we got:

Core business $2,400 $2,900

Tatts pokies $1,100 $1,100

Less debt $ 730 $ 730

Market value $2,770 $3,270

Or, given 1,270m shares on issue, a share price between $2.20 and $2.60.

Conclusion – This analysis is clearly rough. It’s also probably conservative. And it doesn’t take into account upside from TTS winning new business – something I think the management is very capable of doing. But on the face of it, if I want to own TTS, better off waiting for a retest of the lows. I sold out of the position today.

XJO versus XAO

Apologies to anyone who didn't pick it up...the charting software I have been using somehow picked up the All Ordinaries rather than ASX 200 under the code XJO. A little confusing particularly when talking levels...XJO is trading at an approximate 10 point premium to XAO. (Probably should have picked it up earlier - not the first time I needed an editor.)

XJO to follow the US

Following the stop devouring surge on Tuesday, the S&P continued to squeeze higher today. Looks like it should test the downtrend. On balance I favour shorting around there, but wouldn't be surprised to see a quick move through the trendline to clean the shorts out and start the process of a few longs being established at the wrong level (after all we need these to create some downside momentum when the market does finally crack lower).

We are at the front end of earnings season where the good news is plentiful. It is reassuring to know that the stankers at Goldmans have been able to slip a few crumbs in their pockets while helping out at the soup kitchen. And in after-hours, seems that Intel has impressed with its numbers. I'm not that close to it - but I take David Rosenberg's lead...expect core earnings to disappoint over the reporting season.

So, while it's not out of the realms of possibility that we could get a 6 week rally that would take us through 1000, I'm still plumping for the short side. On timing, I'm expecting that we will settle around 900 for the expiry. Then look for market to test lower next week. Question is whether to establish shorts sooner (because levels are attractive) or later (because likely to chew through some theta as the market gets positioned for the next big thing). I like Tim Knight's analysis on this...

For XJO - the Aussie market spent last week trying to pre-empt the US. The failed crap-out on Tuesday put an end to this (and must have hurt quite a few). My guess is that its unlikely that we will have any big moves without a lead from the US.

Looking to the divining rods...

The Weekly chart is still pointing down - we got MACD rolling over and the momentum divergence undermining higher prices. On the Daily however, things are a little more bullish - stochastics have turned up and a run up to the longer term downtrend is not out of the question (~4200!). You can also see the H&S everyone has been muttering about (even though it is a poor facsimile of the one in the US). For mine the most attractive level to short would be around 3940/3950 which is the confluence of previous highs (and lows going back), and moving average convergence.

Defensives looking bid?

Wonder what the equivalent of "my internet connection is down" was in the Victorian age? Wait, I was around then (well almost). Guess I just went to the pub early...

Anyway, to finish on this defensives theme from earlier...a couple of points:

1) Note that Tuen Driasma has suggested buying defensives in the current market...TPC has the relevant slice of Morgan Stanley's research.

2) Seems like there has been a undercurrent of institutional interest in the infrastructure sector locally over the last month - apart from the buying of CEU by CP2, I'm hearing of bids in the likes of SKI and DUE, and even the diminutive VIR had Australian Ethical go 'substantial' recently.

My picks for the sector are:

- CEU as a growth asset, attractively priced with corporate appeal but not without its probloms

- TCL as a diversified portfolio with good mgt and inflation linked revenues and manageable leverage

- ENV as a mature portfolio with fully cashflow funded incremental growth and manageable leverage

- DUE as a mature portfolio with fully cashflow funded incremental growth and a strong balance sheet

- VIR as a renewables portfolio that is dysfunctional at the corporate level as it reduces debt

More on this later...

And back to that TTS chart...the things I like about this are:

1) Momentum and RSI have consistently been trending higher since the low in March 2008. That's a relatively long time to fluff around in consolidation mode - particularly in the context of the market lows in March 2009.

2) Resistance around $2.60 is close. It's where the trend line from the absolute highs comes in, and also where the moving averages have flatlined to as price has traded the broader $2.00 and $3.00 range.

3) Slow stochastics are at a level where a buy signal is also not far away.

Conclusion - maybe I'm early in dipping the toe into the water and buying some at these levels (a lower risk position might be on a break of $2.60). But I like the stock - its management and its risk/reward valuation (more on this later too). And it fits with my defensives theme.

Long DUE and TTS

Don't get me wrong, I'm still a bear on this market over the next 6 to 12 months (heck - I expect a breakdown in the commodities complex sooner than that). It's just that I like the look of defensives at the moment.

We've already spoken about CEU and TCL (at the right price)...and I will get around to having a run through VIR that is part of my super portfolio...but today its DUE and TTS - both of which I bought today.

Time is short - so in brief:

TTS

I look upon it as a quality cashflow business valued on the basis of continuing operations - with upside from potential to win gaming business from Tabcorp.

The Victorian pokies business finishes up in a couple of years. It's a rapidly amortising annuity with a large kicker at maturity (there is no way that the State govt can get around not having to pay the $550m they owe to TTS). The current valuation places little value on this lump sum.

Dick McIlwain is one of the best managers in the country. A clear strategic thinker, he knows how to get the best out of the limited opportunities to bid for licenses. I'm happy to back him as Tatts seeks a booth at the track in Victoria.

Have a look at the chart - I like the stock at current levels. But I'd be buying with ears pinned back if it were to revisit its lows.

...having trouble with my internet connection...an hour has passed since I wrote this note, I should have known it right from the start...or something like that...gotta go pickup the kids

That's whose been buying CEU

Well, I guess it vindicates my view that CEU is a buy for a long term 'infrastructure' friendly investor. CP2 put in a change in substantial holding yesterday (from 27.0% to 28.8%). Guess they have finished now?

CEU - price strength in the face of poor traffic

CEU's latest instalment of traffic for the month of June was hardly heartening. A 2% decline for the month, notwithstanding seasonal factors is not a good result for a road that s'posed to be 'ramping up' (a Macquarie inspired oxymoron to be sure).

Still the unit price has held firm. What is happening? Transurban ready to take the leap perhaps. There are circa $25m pa of synergies to be had. And TCL is trading at a premium to CEU - so a deal could be structured. Ultimately, it must happen. But it's anyone's guess as to timing.

Macquarie and GSJBWere have been talking their books again - suggesting that CEU will need to raise around $300m of equity to support the refinancing coming up in 2010. Their analysis is fair in that at ~155,000 ADT, CEU is unable to carry its debt burden. The question becomes will traffic ramp up through the second half to the breakeven level of around 175,000. And on the rough numbers we worked through previously, CEU needs to make it to 200,000 just to sustain the current 2c distribution. Food for thought indeed...

On the positive side, for a infrastructure investor the current unit price looks cheap. For a long term, deep pocketed investor (an industry fund looking to match its liability profile for example) - a brand new concession in a long term growth corridor with inflation indexed revenues is simply an attractive proposition. These types of investors are less concerned with near term cashflow distributions and more interested in asset IRR's. Austock has an IRR for the business (ie. before synergies for a trade buyer) of ~18% - caveat here, don't know what their assumptions are. In any event, you get the picture, CEU is a relatively attractive proposition for a long term institutional investor.

My relative interest in toll roads (and defensives generally) arises from their price action over the last six months. As prices have tracked lower, momentum has come out of the move. CEU and TCL appear to be trying to find a bottom. Consider the following chart of CEU.

The recent lows have held with rising volume - suggesting to me that buyers have been accumulating the stock. There is a momentum divergence from the March lows (as opposed to financials etc) that can be tracked back to the move through 70c in June 08. RSI similarly trending up while stochastics are turning but yet to break back through 80. And now we have prices stepping higher.

In all, there are the signs of a change in trend. For these reasons, I'm happy to continue to hold CEU.

As for TCL...have a look at its chart - it's displaying a few of the same traits. I've been hoping for a retest of its March lows...then it could get interesting.