The four trades I'm watching

Been distracted by other projects...but quickly the four trades I'm watching are:

1) Short banks (WBC, CBA)

2) Long utilities and defensives (TCL, CEU and TTS)

3) Long gold

4) Oil - is it breaking down or will it hold its uptrend?  (WPL and AWE)

I'll put some definitive thoughts on paper soon, but to spur some thinking:

1) USD - I'm suspicious that there will be a concerted effort from governments to build some strength - longer term the story that the IMF will sell 400 tonnes of gold is a positive, reading between the lines, China will be the buyer and its all part of the 'let's replace the USD as the world's reserve currency' movement

2) S&P500 - everyone is looking at 880 and asking whether it will hold.  I'm not expecting the big sell-off just yet, so am on balance expecting a bounce, but there are a plethora of stocks that look like they are ready to breakdown (so am not betting big until we have some clarity)

3) Base metals - also looking soft - there is a little nervousness emerging about the China growth assumption and whether they will continue to stockpile in the short-term.

ISS - Management guidance for FY2009

I'd like to think that this blog played some small part in prompting management of ISS to provide some clarity on how they were tracking...but alas in the words of the great Sicilian strategist, its "inconceivable".  Nonetheless, its good to get the news...

FY09 guidance

It's yet to make it to their website, but you can pick it up from the ASX site.  A summary of the guidance is as follows:

ISS Group
	12 mth to	6 mth to	6 mth to	12 mth to
	30/6/09	30/6/09	31/12/08	30/6/08
Revenue	17.6	6.4	11.2	18.8
Expenses	19.3	9.5	9.8	14.2
EBITDA	-1.7	-3.1	1.4	4.7
Depreciation	0.4	0.2	0.2	0.2
EBIT	-2.1	-3.3	1.2	4.4

Conclusions

1) Let's assume they made no new sales during the second half (my estimate for H1 was for ~$5m in sales, so take this off and you get close enough to $6.4m revenue for H2).  They did announce a deal with ENLG, so not sure how these numbers will flow through.

2) The Schlumberger deal was a good one for ISS in terms of de-risking the business.  We have a little more clarity on the terms - it looks like ISS get $4m each year - paid semi-annually.  That makes it one-third of the H2 revenues.

3) The H2 revenue should be the low-tide watermark for ISS - given the assumptions it made no new sales and that Babelfish remains relevant and existing customers therefore keep paying their maintenance fees.

4) ISS is caught between maintaining the resources to secure new sales (staff costs ~$5m) and not actually getting them.  It's unfortunate but necessary.  The good thing is that their key target market (resource companies) are likely to enjoy strong commodity prices and therefore should have the cash to pay for the implementation of Babelfish.

In summary, the profitability of ISS remains heavily dependent upon new sales.  This makes for a high risk investment in ISS.  On the plus side, it only takes a couple of sales to make a difference - and they still have the surplus cash to go after these sales.

Do you back them?  Yes - but given the market uncertainty, I'm going to wait to see if they track down towards NTA before committing any more capital (note I own some from higher prices). 

NCM - Newcrest as a proxy for the inflation/deflation quibble

The long road to recovery will be paved with gold - or so some of the recent media commentary would suggest.  What is this all about?  And more importantly, can I take my pick and shovel to the road and get me some of that yella stuff?

In short, I'm in the camp that sees gold tracking higher over time and my favourite proxy for playing this view is Newcrest (NCM).

What's it all about?

One of the key questions being debated by all and sundry is whether we are going to be living in a deflationary or inflationary environment.  The arguments for and against are plentiful and, depending on who you are listening to, can be equally convincing.  For what its worth, I'm inclined to see inflation kick in over time - as governments are going to be loath to have a re-run of the 1937 double dip or the similar experience in Japan as it tried to claw its way out of recession.  For this reason I reckon they will leave their foot on the accelerator notwithstanding the flashing blue light and ever so polite bobby suggesting they pull over.

But for the moment its anyone's guess.  As a result we are likely to continue to witness sharp swings in commodity prices and the USD - but in my assumptive view, within a trend to higher commodities (including gold - though I don't know whether it's a commodity or some form of money) and a lower USD overall.

So to my proxy for this debate...Newcrest

To my mind its the premium gold stock in the country.  They have cleaned up their balance sheet (gearing ~1%!) and are running unhedged on the gold price.  They have a rich inventory of low cost mines (current production at around US$350/oz versus a world average of US$467/oz) and a capable management team.

How to value them?  To be fair, I've never really understood why these stocks trade at the prices they do.  They consistently trade at premiums to industrial companies that have superior earnings growth profiles.  And when I say 'they', it's because its a global phenomenon.  Have a look at some presentations from management (this one and page 9 of this one) gotta say according to these measures Newcrest stacks up as relative 'value'.

On the negative side, NCM is being hit by a rising AUDUSD, which partially negates the rising margins they enjoy from higher gold prices.  (How does this work - Newcrest sells its gold in USD - so it is principally a USD based company - but a fair swag of its operating costs are priced in AUD (labour, head office etc).  It's debt is priced in USD.  You get the drift.)

I think the point here is that gold companies should be viewed as 'trading' positions rather than 'investments' - given I don't understand the 'value proposition'.  Maybe its a meaningless distinction, but to me this helps define the expected holding period and triggers for entry and exit.  In a sense, I hope to trade the volatility in the stock.

So how to assess NCM from a trading perspective?  

Consider the following chart of NCM.

Viewed as a trading stock, the recent pullback in NCM makes a good deal of sense.  The fervour in the media of late is reminiscent of an overly bullish sentiment.  Commentators have been pointing to the smart money piling into gold (look to the various hedge funds that have built up sizable stakes in the metal - MarketFolly tracks various leading hedge funds and has been noting this trend among the Tiger Cubs etc).  In a trading view this hype virtually guarantees a move lower to take out all those suckered in at the recent top.  Note that the recent price action in NCM has been very similar to gold stocks/funds globally (eg. have a look at Newmont and the SPDR Gold Shares ETF).

The question then becomes how far must it fall before these weaker hands are stopped out.  In my experience generally further than you would expect.  Note, for example, the break of the short term trend line.  This is what you would expect if you subscribe to the theory that there would be a pile of 'trading' stops sitting just beneath these levels hoping for the trendline to hold.

In summary I like this analysis from Minyanville, on where we sit with gold.  On this basis, it makes sense to dip the toe in the water around these prices in NCM.  But not large, not yet.

As I say, from a trading perspective these things have a habit of going further than you expect.  I'm sensitive to the arguments from the elliotitians that are looking for a deeper sell-off in gold to around $750.  This is not out of the realms of possibility, as I don't think that the governments around the world are going to throw in the towel on the USD.  We have seen this in the recent jawboning by China and Japan that has helped the USD recover some ground.  Also, G8 meetings have form for organising concerted actions to support the USD.  

In summary, I'm establishing a beachhead in NCM at today's price ($30.80) because I want to be long gold.  But its small.  I'll hope to load up on NCM around $25 - that's where long term support kicks in - and if we get there, the media will be starting to talk about how gold has become irrelevant etc...

Exit IIN - look to re-enter on pullback

It may be fickle, but given my view is that the market is heading lower in the second half (and that the current softness is a precursor to this), I'm enacting the 'discretion is the better part of valour' strategy...so exited the IIN position today.

The rationale hasn't changed - it's a great company with growing earnings despite the economic environment - just that chances are that there will be better entry levels before too long.

AAZPB - Australand ASSETS at a running yield of 15%?

Now for something completely different.  The investment bankerteers have been drumming up support for the property trust sector recently as they and their trading bank buddies try to deleverage the sector by slipping the syringe into investors for more capital.  It seems to be working as every day a new property trust shuffles up for another $1bn.  It's a cloak and dagger operation as such raisings are to the benefit of the conspirators gathered around each victim - at the expense of the retail (and ultimately institutional investors) in the trusts.

Enough of the rant...a property company that I have had a long history with is Australand and I figured it was time to have a look at their preferred securities on issue (the Australand ASSETS - hereafter known by their ASX code AAZPB)

Australand is a property developer with strengths in the commercial, industrial and residential sectors.  They were an early adopter of the stapled security model and as a consequence have built a sizable and diversified investment portfolio.  The AAZPB have the following characteristics:

Type: Floating rate security

Coupon: 90 day BBSW + 4.80% (eg. current bills ~3.25% + 4.8% = 8.05%)

Ranking: Subordinated to senior debt

Maturity: Perpetual

Payment: Quarterly (non-cumulative and unfranked)

Size:  2,750,000 on issue (market cap at $53 per security is $145m) 

Conversion: Principally at the issuers option (at a 2.5% discount)

Now its a smallish issue which means its illiquid whether getting in or out which is a negative.  But that yield of around 15% (ie. $8.05 on $53 market price) looks attractive on the face of it.  How do we assess the relative risk/reward?

For a start, looking at the outright risk side of things, what is the probability that Australand will not make a distribution payment, or worse still, the risk that it goes kapput.

Risks to AAZPB's distributions

To get a sense of Australand's cashflows - which after all are used to pay distributions - in its 2008 financial year (its year end is December) its operations generated $430m in cash ($485m in 2007) - while it invested $673m in new developments, property etc ($428m in 2007).  The cash shortfall in 2008 was financed by an entitlement issue in ALZ's stapled securities that provided around $460m.  In effect this capital raising also financed the distributions on its stapled securities and on the AAZPB's.  The conclusion - absent a requirement to repay debt or an absolute implosion in operating earnings, Australand can manage its free cashflow by cutting back on new acquisitions.  My understanding is that management have stated that they will be net sellers of property this financial year.  That's a tick.

In relation to operating performance, Australand's guidance for the 2009 year is for a fall in operating income of around 30%.  That would put operating profit at around $120m (from $175m in 2008).  While not a good trend (though hardly surprising given the economic climate), its business will continue to be profitable and, from this perspective, cashflow positive.

Key to its cashflow stability is its portfolio of investment properties.  As at 31 December 2008, Australand owned 76 properties with a value of approximately $2.3bn.  The occupancy rate on these properties was ~99% and the average lease expiry was 6.6 years (with rents stepping up by 3.3% per annum).  The average cap rate on the portfolio was 7.54% (7.75% for industrial and 7.25% for office).  At the end of the day, it is the cashflows from these properties that are used underwrite the payment of distributions.  In 2008, net income from the property investment division was $134m.

So how does this all add up for AAZPB distributions.  In the same way that management of Australand note that interest cover was 2.7 times for the year to 31 Dec 2008, let's look at AAZPB distribution cover...Uh, sorry, that's just guess work without more information from management.  But we can get some comfort.

Management have stated that they expect a distribution of 6 cents per ALZ stapled security for 2009 (3c each half).  Now on 1.7bn ALZ securities on issue, that is a potential distribution of $100m.  The distribution on the AAZPB's, assuming a rate of 8% is $22m.  Even if the rate were to climb back to 10% (inflation concerns take hold), the payment is $27m.  That's broadly a 4 to 1 ratio.  Given that there can be no distributions on ALZ securities, unless the distribution on AAZPB's has been made we can, as I say, draw some comfort.

Risks to Australand's viability

Australand has around $1.6bn in debt.  ~$1bn of this matures in 2010.  In this fragile market, the absolute scale of the refinancing is a significant hurdle to overcome.  But it is hardly an untenable position.  Australand's gearing ratio under its debt facilities appears to be measured by Total Liabilities to Total Assets (adjusted for cash).  The limit is 55%, where at the year end balance date it was 47%.

To get a sense of the sensitivity of this covenant to changes in property values, lets assume:

Net Rental income in 2009: $166m plus 3.3% escalation = $171m

At 8.5% average cap rate: Values properties at $2.0bn plus development assets $0.1bn = $2.1bn

Gearing ratio: ~51%

This effectively assumes $200m in writedowns (on a 1% move out in cap rates).  It ignores any cash balance, and assumes no management of inventories or receivables.  In short, it's relatively conservative.  And it still leaves headroom under the covenant.  I'm not saying that cap rates will not move out further than this scenario over time - but it is unlikely that they will be ratcheted up by even 1% in this calender year (based on recent performance of valuation companies - ever wondered why direct property lags the listed market?)

My guess is that the banks will step up to refinance the $950m in CMBS due to mature next June.  They have shown a propensity to simply charge more rather than saying no and bringing the whole house down.  In any event, the refinancing risk falls on the ordinary equity holders - as they will need to fund any shortfall.  Given CapitaLand owns 59% of the equity of Australand, they are highly unlikely to jeopardize this investment.  More likely that they will step up and underwrite an another entitlement issue - maybe take the whole thing private.  In any event, that would be a good thing for AAZPB investors.

In short, it is unlikely that the banks will be running Australand for the foreseeable future.

Conclusions

I'm relatively comfortable with the investment proposition for AAZPB's from an outright "will-I-get-my-money-back" risk.

From a relative risk/return perspective, if you consider that the bank floating rate hybrids are trading at running yields between 4.5% and 6% (and yields to maturity closer to 8%), then a outright running yield for a perpetual, illiquid but otherwise sound credit of around 15% seems about right.  It also compares favourably to a running yield of ~11.4% on the Multiplex Sites (MXUPA).

The next ex-date is 24 June 09 - for the coupon of $1.97 per security.  I'm inclined to put a park some cash in these securities at $53.00.  

now this feels more like a market rolling over

A quick summary of the blogosphere and where the market is at:

• Economic pundits are getting touchy about only talking about the doom & gloom - see Naked Capitalism for a quick list of some of the more prominent
• Technicals on the US market and copper are singing sell - see Slope of Hope, The Evil Speculator, Afraid to Trade, and again on copper - but there appears to be a general reluctance to short the market too heavily (cause it's broken the technical resistance levels all the way up)
• Sentiment is elevated - see Sentiment Trader and The Technical Take
• And some deep pocketed types are buying volatility - see Sentimentrader

The US market is going down - but what about our resource laden All Ordinaries?

ISS - a second half loss for ISS Group?

I admit up-front I like this company (and own its shares at higher levels).  

ISS group has developed an IT platform that assists large multinational companies to manage their information flows. Their principal product is called BabelFish, which for any self respecting Douglas Adams fan should tell you everything you need to know - for the philistines amongst us, there are large efficiency gains to be had for the likes of our major mining companies in having their various management systems effectively talking to one another.

I originally bought into the company when it appeared (to me at least) that they were transitioning from relying on up-front sales revenue to a more annuity 'servicing' style revenue.  You can see this in the following breakdown of their half yearly results (note the maintenance & support and licence fees).

	6 mth to	6 mth to	6 mth to
	31/12/08	30/6/08	31/12/07
Licence	4.121	3.999	1.784
Maintenance & support	1.609	1.286	1.191
Services	4.961	6.050	3.668
Other	0.495	0.218	0.641
Revenue	11.186	11.553	7.284
Employees	5.178	4.314	2.747
Employees - non cash	0.949		0.432
R&D spend	1.665	1.803	1.298
Consulting	0.485	0.884	0.366
Rent etc	0.425	0.279	0.217
Travel	0.265	0.386	0.247
Other	0.817	0.99	0.639
Expenses	9.784	8.224	5.946
EBITDA	1.402	3.329	1.338
Depreciation	0.187	0.142	0.083
EBIT	1.215	3.187	1.255
Interest	0.002	0.002	0.002
Tax	0.026	0.211	0.472
NPAT	1.187	2.974	0.781
Shares on issue	133.625	101.507	99.763
EPS	0.018	0.029	0.008

All looks pretty good?  Consider also that the company 

• has next to no debt 
• its NTA (valuing the technology they have developed at zero) is around 7 to 8 cents, 
• they granted Schlumberger (major US engineering company) an exclusive sales agreement for up-stream oil and gas sales in exchange for a A$17m commitment (to be paid at an undisclosed rate per annum)
• and they have started broadening their client base away from the resources sector and into integrated industrials (they have a beachhead contract with Mars in Australia)

And you can quickly come to the view that current share prices under 20 cents are pretty attractive (~18 cents equates to a P/E of ~5x on an annualised Dec 08 numbers) for a company that should have strong growth prospects leveraging a leading technology that has largely been paid for (note however R&D spend is still ~17% of expenses).

But all is not well.  In their half yearly, management prudently suspended the dividend and stated that they would be trimming their largest cost - employees.  In the context of a global fry-up, that's good.  They also said they were seeing lower interest from potential clients and that at least one contract had been terminated.  That's not so good.

The single biggest hurdle for the company seems to be that while BabelFish is ultimately a cost-saving, efficiency-driving, gill-breathing miracle - it costs a lot to deploy.  It needs to be tailored to clients needs.  The global financial crisis has scuppered the dreams of many a CEO to spend money on new projects and it appears that ISS Group is suffering from this same trend.

The stock brokers Patersons are the only broker that cover ISS.  They have a profit forecast for FY2009 equating to EPS of 1 cent.  This implies an after tax loss of around $0.6m for the second half for ISS.  Given that they share the same bathwater with ISS (they are both based in Perth), it would be a surprise if Patersons was wildly wrong.  Note however, ISS haven't announced anything to to suggest that they will make a loss (and continuous disclosure laws are as applicable in WA as the rest of the country).

So where to from here?  As I say I like the company.  The question is what will the results will look like - how have the gone in managing staff costs down and have sales dried up completely (they have been unusually quite on this front in this half - where they usually announce contract wins as they arise).  Under 20 cents, it still represents a value opportunity on my books - my guess is that part of the recent weakness has been tax loss selling - but it's not for the faint hearted.  I'm going to wait for the results before putting any new money in - you never know, we might get lucky and buy them at NTA... 

Asset allocation - introducing "Hybrid Portfolio Theory"

Interesting article out from the  Venture Populist on what they term as Hybrid Portfolio Theory - forget about the name, but the content is worth reflecting on.

In short, they suggest heavily weighting a portfolio (something like 75% to 90% of assets) towards capital protection, liquidity and income - being treasury bills or the equivalent  - with the balance invested in assets with a high potential for capital appreciation - venture capital, private equity, emerging listed companies, and hedge fund type strategies.

The rationale is primarily based on the poor relative performance of equities as an asset class versus long dated treasuries - both on an absolute basis and on risk adjusted returns.  They conclude that the risk premium for holding equities just doesn't actually exist.

One line in particularly tweeked my aging synapses..."I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors."

In my experience, it is true that high-net-worth investors adopt this kind of strategy.  Variations on a theme exist as you'd expect given we are all individuals with different stories to tell, but generally if someone has significant wealth accumulated they tend to segregate their wealth into these two risk classes.  The pattern I came across was that risk capital is typically confined to the business - seeking to generate returns of at least 20% year in year out - while capital that has been released or realised from the business is parked in bank bills.  This was the same whether the individual was a property developer, liquor retailer or internet guru.

Come to think of it, this is the same investment model that an insurance company will 'typically' adopt (there will always be an AIG or HIH or FAI to muck things up).  QBE's investment parameters are almost identical (95% in highly liquid, high quality credit with average duration of 6 months - with the balance in equities).  

So what is the conclusion?

I'm open to the idea that capital should largely be protected from the vagaries of the equities market.  So having a strong tilt towards income, liquidity and capital protection makes sense.

Also, I agree with their skepticism that equities as an asset class will simply outperform.  Once again it has been made clear by this latest stock market seraglio that most companies are managed by self interested and less than inspiring individuals.  Our task then is to find those few companies that have growing business models that are well managed by quality individuals.  They are likely to be companies that will generate returns of 20% per annum.  They are out there, its a 'wood for the trees thing' - and the good thing in this market is that the rotten trees are all falling over.

IIN - iiNet's FY09 forecasts

iiNet has a been a favourite stock for some time - being the light of promise to the Telstra anti-christ.  A quick review of their 09 forecasts that were released yesterday to see how they are tracking (if you want to short answer - very well - you can hang up now).

Underlying	2007	2008	2009
Revenue	229.6	251.2	415.0
EBITDA	39.1	47.4	65.0
NPAT	11.9	17.7	25.0
Shares on issue	126.60	127.34	151.10
EPS	9.4	13.9	16.5
DPS	6.0	7.0	8.0
Dividend yield			4.7%
Market cap'n			256.9
Share price			1.70
P/E			10.3

They have delivered to the letter on their promises when they acquired Westnet.  At the time IIN was tracking along with EBITDA of $46m and NPAT of $15.2m, Westnet added EBITDA of $12.0 and NPAT of $7.0, and they forecast synergies $6.8m - and voila - combined EBITDA of $64.8m.  You can't ask for more than that - transparency and ability to deliver rolled into one, which for my book adds greatly to the all-too-important the management credibility quotient.

So where should their share price be trading.  Let's take a quick look at some EBITDA multiples:

Valuation based on FY09 forecasts
EBITDA multiple   4x 5x 6x 7x Enterprise value   260 325 390 455 Debt   24 24 24 24 Implied value   236 301 366 431 Shares on issue  151.1 151.1 151.1 151.1 Share price  1.56 1.99 2.42 2.85 Equivalent P/E  9.4 12.0 14.6 17.2

Remembering that IIN acquired Westnet at a EBITDA multiple of 4.3x including synergies (and 6.8x excluding synergies), then the very low end of a valuation range would imply a share price around $1.69 (using this same 4.3x).  

Now I know we are battling through a global meltdown of epic proportions, but to me these numbers look pretty compelling.  In summary,

• IIN is growing it's business in what was a mature and stable market, because technology has unleashed opportunities that the incumbents are loath to embrace.  Why else is Telstra trading on a dividend yield of 9% and P/E under 10?  I'd back IIN to continue to grow market share (even without further acquisitions).
• The core business is more of a 'must have' than a discretionary spend for its client.  In fact as the disruptor, IIN's core service offering undercuts the incumbents with a cost saving proposition in a time when consumers are more focussed on saving money.
• IIN is well managed by a team aligned with shareholders
• IIN has a debt to equity ratio under 20% and free cashflow that more than covers its capex requirements  

On this basis I'm a happy holder - cause the risk/reward is skewed to the upside.  To my mind an EBITDA multiple of 6 to 7 times seems like fair value in today's climate that puts IIN's share price through $2.00...

Eulogy to the Grasshopper

Growing up in a prepubescent town like Canberra in the 70's, we were force-fed morality from our two television channels. To me the teachings of the grasshopper turned wandering monk were a soothing antidote to the sacherine tones of Little House on the Prairie, the Brady Bunch and Happy Days.

So hearing that David Carradine had departed this earthly paradise was a melancholy moment...but what is with the knots and tourniquets?   Is it an actor/musician thing?  Too many days alone in hotel rooms with nothing much to do?

"Death by misadventure" will be the coroner's verdict.  Misadventure - an adventure gone wrong - like a parachute failing to open or drowning in your own vomit.  It's death while having fun (or at least your version of it).  I guess at least he died with a smile on his face.

Okay - can we have our correction now please?

A new bull market or a bear market rally.  I'm still to be convinced we are off to the races again.  In fact, I'm firmly in the camp that renewed vigour in global growth will be a longtime in gestation.  A quick recap as to why:

1) US - it's long list of problems starts withe a fragile banking system that is still undergoing recapitalisation (notwithstanding its overall health has improved with lots of new capital and a yield curve that makes it a great time to lend long and borrow short).  The banks will improve over time - but not immediately.  The US home market remains awash with inventory and again it will take time for this to be taken up.  When you couple this with an aging population that has started to save again - the question becomes where will the spending growth come from?  

2) China - has joined the stimulus party in earnest propping up its own economy and in turn commodities.  In the longer term there is no doubt that the industrialisation process will continue.  However, over the near term its economy remains reliant on exports - and let's face it, this isn't a particularly bright spot for any country right now.

3) Europe - has all the same problems as the US - it's just lagging in the deleveraging and recapitalisation process.  The EUR has benefited against the USD recently from the deleveraging that has gathered momentum - but I do not interpret this as Europe is outperforming the US.  It's not.  The movement in the crossrate is a function of capital flows for all the wrong reasons.

So to the reasons why I see a correction in equities and commodities markets:

1) Real US economic activity is stagnant (at best) - the Dow Transports continue to slosh about its lows - supported by the rail freight data for May that shows renewed weakness.  According to Dow Theory, a new bull market requires both the Dow Transports and the Dow to making new highs.  This is pretty logical - if the Dow Transports are viewed as a proxy for economic growth, there just isn't any...

2) A smorgasbord of markets have reached resistance that should prove a convenient turning point (equities at their 200 day moving average, gold bumping against its highs).  Commodities markets are overbought while the USD is oversold.  Longer dated interest rates are also due for a correction having run ahead of themselves on a combination of inflation fears and distaste for a world where the volume of government debt is exploding.  These markets have all been feeding off each other - expect the same effect in any sell-off.

3) Volatility - has broken its recent downtrend, while the Put/Call ratio is indicating a level of complacency

ConnectEast - performance versus expectations

Connecteast (CEU) has struggled with the rest of the toll road world to come to terms with falling valuations for leveraged assets.  It has the additional burden of being a relative newcomer - still operating in its 'ramp up' mode.  It released traffic numbers for May today, and consistent with a road building a client base, the traffic continues to build.  But are they good value around 30cents?

For a start, let's consider their free cashflow - that as the directors have said, will determine distributions after March 2010.  The following table summarises (very roughly) the key parameters:

	Current traffic	PDS traffic	For 2c dist'n
Avg daily trips	157,000	258,000	200,000
Avg gross daily toll	486,700	799,800	642,940
Avg toll/trip	3.10	3.10	3.21
Days	360	360	360
Annualised
Revenue	175.2	287.9	231.5
Opex	63.0	63.0	65.3
EBITDA	112.2	224.9	166.1
Interest expense	149.1	119.6	119.6
Interest income	25.5	7.1	7.1
Free cashflow	-11.4	112.4	53.6
Units on issue (m)	2554	2554	2554
Distribution	0.02	0.02	0.02
Distribution	51.1	51.1	51.1
Debt assumptions
Total debt	2024	1624	1624
Interest rate	7.37%	7.37%	7.37%
Interest expense	149.1	119.6	119.6
Cash	637	177	177
Interest rate	4%	4%	4%
Interest income	25.5	7.1	7.1

The quick conclusions are:

1) at current traffic volumes - CEU is not yet breakeven in terms of cashflow

2) if the traffic volumes as forecast in the PDS were realised - CEU could pay approx. 4c p.a.

3) to cover a 2c distribution - CEU requires avg daily traffic of around 200,000

(The assumptions 

- operating expenses of $63m were taken from the PDS - CEU's current run rate is in excess of this but there should be little excuse for exceeding the original forecast as the road moves to a steady state

- avg daily toll is indexed to inflation - for simplicity have only included the scaled up number in last column

- cash is reduced by $460m - being $400m to repay debt and $60m to cover cash shortfall across fixed distribution period.  I have ignored the effects of the DRP)

A word about the traffic assumptions - the real culprit here has been the initial assumptions used in the PDS.  The forecast was for average daily traffic volume of ~185,000 for the first month then stepping up to 258,000 over a 15 month period (to Oct09).  The actual experience had traffic starting at 135,000...  On the positive side, during the free trail period the ADT was 270,000 - so there is some evidence of underlying demand volumes.

So the question becomes - do you think that Eastlink will get to ~200,000 daily trips by the first refinancing period (March 2010)?  If yes, a 6.6% tax deferred yield that will grow as a function of inflation and population over its 45 year term seems like a reasonable proposition (and that is before the debt refinancing bonanza that Macquarie assumed in the PDS)... If not, then expect the price to come under increasing pressure as March 2010 rolls round and traffic fails to materialise.

(Disclosure - Long CEU)