Stock Review

We've upgraded a few blue chip stocks in recent months, and many more are starting to look reasonably priced. These four, some of Australia’s best businesses, are firmly in our sights.

In this issue’s feature article, Time to buy blue chips?, Greg Hoffman explained why we’re getting excited about blue chip stocks for the first time in years. The point of this article is to flesh out the arguments for upgrading some of the highest-quality stocks available to Australian investors. In the weeks ahead, we’ll be providing some meatier analysis, and potentially upgrades, on most of them.

QBE comes back to earth

In our 2007 seminars, when QBE’s share price (QBE – $16.00) was trading above $30, Steve Johnson explained why he might be interested in this insurance giant at around $16. It seemed crazy at the time, but that’s roughly where the stock sits today. Steve will be re-running his numbers over the next month, but the attractions are reasonably obvious.

QBE is a very well run insurer. The second page of a CEO presentation on 9 March 2009 highlights this graphically. Over the past five years, the company has achieved an average combined operating ratio of 88% across its global operations, with the worst year being 91.2% in 2004 and the best being 85.3% in 2006. In other words, for every $100 in premiums collected, the company has on average paid out $88 in claims, commissions and total expenses – giving it an underwriting profit.

Bull case
First-rate management
Proven underwriting discipline
Excellent returns on capital
Bear case
Cyclical industry
Falling investment returns
Succession risk

Consistent underwriting profits are the holy grail of the insurance business: it effectively means you get paid to hold other people’s money, and then you get any returns you can make on that money thrown in for free. In the past five years, across six different divisions, the company has reported underwriting profits in every instance.

In 2009, QBE is expecting to achieve a combined operating ratio of 88% – subject, as always, to large catastrophe risk. But low interest rates mean the company’s cash and short-term fixed interest-focused portfolio will generate lower investment earnings. That conservative approach sits well with us, though, as does the company’s significant surplus capital position.

PERs are notoriously misleading in insurance, so rather than take a stab in the dark we’ll discuss a range of possibilities in our full review. But the historic yield of 7.9%, mostly unfranked, alludes to a reasonable price for this excellent business.

Sizing up Sonic Healthcare

Like other stocks in this review, Sonic Healthcare (SHL – $10.64) has long been on our wish list but absent from our buy list. It’s the market leader in pathology (blood and tissue testing) in Australia, with close to half the domestic market.

The pathology business has excellent economics. Firstly, the doctor decides how much testing is required, while the government picks up most of the bill. So patients won’t tend to skip a couple of blood tests just because times are tough and Sonic’s revenues are therefore quite predictable.

Bull case
Excellent business economics
Favourable demographics
Overseas markets still fragmented
Bear case
Capital hungry business model
Complicated regulatory environment
Overseas expansion adds risk

On the expenses side, this is a business where size counts. The testing is generally centralised, so the company that can pump the most blood through the biggest laboratories, with the most efficient network will earn the biggest profit margins. In Australia, that’s Sonic – although the recent Primary Health Care takeover of Symbion might give it a good run for its money.  While Sonic doesn’t split out its margins for Australia, its overall 2007 pathology operating margin was 20.7%, compared with Symbion’s 15.5%.

Because of the glare of the competition regulator, Sonic is unable to make significant acquisitions in Australia. It’s bought four pathology businesses in the US in the past two years, and is now the third-largest provider in that market. We expect more growth to come. The company is also the market leader in Germany, and has interests in Switzerland and the UK.

The biggest concern is the capital-hungry nature of that growth – financing all these acquisitions isn’t cheap. That means equity issues, and plenty of debt – the company currently has $1.5bn of debt, which amounts to a net debt-to-equity ratio of 58%. The underlying cash flow available to service that debt is quite stable, but investors are currently questioning debt in any form. It’s an important issue we’ll consider in our full review.

In the year to 30 June 2008, the company achieved earnings per share of 73.5 cents. This year, it should exceed 85 cents, putting the stock on a forecast PER of 12.5. Directors increased the interim dividend by 10% to 22 cents. That justifies a closer look at this high quality business.

Let’s look at Leighton

This construction company and contract miner (LEI – $19.62) is well diversified by country and industry – in the half year to 31 December 2008, 56.5% of revenue came from infrastructure, 27.5% from contract mining and 16% from property. It doesn’t lend itself to a one-size-fits-all analysis.

But let’s look at probably the most important part, Australian infrastructure. Very few companies can even bid on most big infrastructure jobs in Australia. For example, for RTA road tenders over $80m, only eight companies currently meet the requirements to bid. Leighton owns four of those, and part of a fifth. And because of past bad experiences, governments now usually require a performance bond of up to 20% of the project’s value, giving Leighton an advantage because of its size and balance sheet strength.

Bull case
Excellent management
High returns on equity
Large government infrastructure spend
Bear case
Property downturn
Contract mining to slow
Collapsing private infrastructure investment

Leighton’s divisions have a reputation for doing the job right. Management is mindful of risk and the correlation between various projects, and is careful not to bet the company on one project, industry or country.

But risk has gone up in recent years. The balance sheet isn’t quite what it used to be – moving from a significant net cash position a few years back to a net debt-to-equity ratio of 34% at 31 December 2008. The company has also moved into contract mining in Mongolia, and taken a 45% stake in Middle Eastern construction company Al Habtoor Engineering. These might make sense as part of a diversified portfolio, but they bring new risks.

The company has a huge forward order book – almost $40bn of future projects – but while that number is important, it says little about the potential cheapness of Leighton’s stock. Return on equity over the next five years is unlikely to match the 27% achieved over the past five, but 15–20% should be achievable. If Leighton can come in at the top of that range, then paying twice book value – roughly where the stock sits today – should work out well.

At $60 or even $40, it was easy to call Leighton’s stock insanely overpriced. Today’s saner price, while unlikely a bargain, is calling us to look closer.

Renewed interest in Brambles

Brambles (BXB – $4.96) owns two global businesses. Recall is a leader in document management – helping customers with document storage, converting documents to digital format, data protection, and document destruction. But the bulk of the value lies in Brambles’ other operation. CHEP is the world leader in equipment pooling systems, most recognisable as a blue wooden pallet sitting under a pile of goods.

For customers, there’s an overwhelming logic in using a pooling system, effectively renting rather than owning the pallets outright. This is especially so when products move multiple times before reaching the consumer, as is happening now more than ever. CHEP recognised this trend early on, and turned the insight into a market dominating position. Although market share statistics are hard to pinpoint, CHEP’s list of global customers – including fast moving consumer goods (FMCG) giants Nestle, Kraft, Kellogg’s and Proctor & Gamble – is indicative of its position.

Bull case
Strong competitive position
Growth opportunities
Essential service
Bear case
Monopoly under attack
Capital intensive
Good management is crucial

Unlike some other monopolies, though, CHEP actually has to do some work to earn its living. It owns 251m wooden pallets at a current initial cost of US$18 each, and about 10% of those pallets need replacing each year (and the remainder need regular repairs). That makes the business capital intensive – over the past five years an average of 44% of Brambles’ cash generated from operations (before tax and interest) has been reinvested as net spending on plant, property and equipment.

The monopolistic nature of the business is under attack. As reported on 28 Oct 08 (Hold – $7.68), Wal-Mart is chipping away at CHEP’s stranglehold on the pallet pooling system. And while CHEP relies heavily on FMCG movements, which tend to hold up quite well even in difficult times, a severe global recession is underway. The recent announcement that CHEP Americas would scrap 7m pallets earlier than their use-by date (to reduce operating costs) was surprising. We don’t currently know how much of that to attribute to a recession or whether Wal-Mart’s initiatives are having an effect.

What is obvious, though, is that Brambles is no longer being priced as an outstanding business. When we sold out on 8 Jun 04 (Sell – $6.04) – the last time those following our recommendations to the letter would have owned Brambles’ shares – it was trading on a dividend yield of 3.3%. Today, that yield is 7.1%, prompting us to take a closer look at this high-quality business.

Gareth Brown

What's this?

Back to top Back to Stock Reviews List

Sorry, your email address seems to be incorrect. Please check and try again.
You need to ensure that you have registered your details and your Internet Browser accepts cookies.