Weekly Broker Wrap: Diamonds, Vehicles, Bribery, De-Mergers And Profits

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This story features BRAMBLES LIMITED, and other companies.
For more info SHARE ANALYSIS: BXB
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

-Diamond shortfall from 2015
-Palladium demand to rise
-Sensitivity to corruption heightened
-De-mergers add value
-Measuring profit warnings

By Eva Brocklehurst

Diamonds are interesting. They've become more interesting to investors as well. Global diamond production peaked at 175 million carats in 2006 and has fallen to below 130m carats in recent years. Mines are now ageing and the rate at which new projects are starting has not compensated for the production fall. Some new discoveries could push production back up to 160m carats in 2018 as the combination of several new mines adds to production from 2016 onwards. Regardless, Citi expects this will only take production back towards the levels of 2006.

The history is indicative. De Beers acted to buy up diamonds in the 1960s, 70s and 80s and built a huge strategic stockpile. A large discovery of diamonds in Canada loosened the hold De Beers had on the diamond market. The company then started selling the stockpile during the surge in demand during the 1990s, thus disguising a tight supply/demand balance. If global economic growth recovers, this stockpile will be one less source of supply as most of it has now gone. The Chinese are also buying diamond rings at a greater rate with an increase desire for luxuries among the population.

Citi observes demand for diamonds is not yet strong enough for the limited supply to create a significant shortage and prices are weaker than they were two years ago. Prices are expected to stabilise until 2015-20 when the structural demand shift and a recovery in the market should mean shortages push prices up. Given the 12-year time span between 2006 and 2018, to stand still in terms of production will not be adequate if normalised growth levels return. Citi compares the diamond market with palladium, where Russia held onto a large strategic stockpile during the Cold War and then released it to the market. Now that stockpile has reached an end, the palladium price has been the best performer among key metals in the past few years.

One thing that can be said is that diamonds are not as liquid as gold and trade more like the art market. Citi notes that the unique nature of diamond quality means it takes an expert to be prepared to bid on an expensive diamond. Nevertheless, the ease of transport makes them attractive to high net worth individuals.

On the subject of palladium, a recovery in developed world car markets bodes well for demand for platinum group metals (PGM). Macquarie notes China's car market has also been growing strongly and remains the largest, with 14% annual growth in vehicle factory shipments in the September quarter. Even in the US, vehicle sales rose 9% in the quarter. Macquarie quotes automotive consultancy, Edmunds.com, which expects US sales to grow to 16.4m vehicles in 2014. Rising US sales are a positive for palladium, which has now almost entirely displaced platinum in catalytic converters for US gasoline vehicles. Two technologies that would radically change this picture are diesel, which uses more platinum, and electric, which uses neither. They pose no immediate threat but are gaining market share. The clean diesel share rose to over 1% of the US market in the third quarter for the first time.

In Europe, car sales are strengthening and if the recovery is sustained, this would be bullish for platinum, which derives nearly 20% of demand from Europe because of the preponderance of diesel engines. It also supports palladium because of the sheer size of that market. There's always reason to be cautious, Macquarie warns. Japanese vehicle sales are expected to be lower in 2014 than 2013 because of a planned increase in consumption tax and because the high base of sales in 2012 and 2013. PGM demand will also be subdued, as the rising share of mini vehicles in Japan, now at nearly 40% from 25% in the mid 1990s, means these small engines use far less PGM. On this basis, one thing Macquarie is watching is the price of diesel. India has become the second largest diesel market after the EU, thanks to a policy that has meant diesel is significantly cheaper than petrol. Macquarie suspects the differential will narrow over time and reduce the incentive to own a diesel vehicle.

Bribery and corruption have assumed the spotlight after media speculation surrounding Leighton Holdings' ((LEI)) business in Iraq was renewed. More revelations have been made over alleged kick-backs in Iraq as well as an Indonesian barge contract and a dam building project in Malaysia. Regardless of the allegations or their veracity, it is clear to Citi that companies are increasingly sensitive to perceived links to corrupt conduct and regulatory enforcement appears to be increasing to deal with the risk.

The broker previously identified ASX100 listed companies that were potentially at risk, based on location and nature of operations. Citi has subsequently evaluated how these companies are mitigating the risks. Where companies have improved from year to year, this is generally because disclosure has increased. Where companies moved down the rating scale, it tended to be because Citi applied more stringent criteria as the analysis evolved. The issue is becoming a focus for various anti-corruption projects. and investors are increasingly wanting to see more detail demonstrating how potential investees are managing risks. The Australian government is under international pressure to strongly enforce its anti-bribery and corruption legislation, and several cases are reportedly under investigation.

UBS has analysed de-mergers, finding that the parent and the de-merged entity typically outperform afterwards. Reasons for this are many, but the most significant is the removal of operational inefficiencies and information asymmetry – the revaluing of the two companies. UBS has looked at all major de-mergers (26) in the Australian market since 1997. On average the de-emerged entity outperforms the market by 10.7% over the year following and outperforms the parent company by 8.5%.

The entity experiences prolonged underperformance in the lead up to the de-merger, perhaps signalling something needs to be done to turn fortunes around. In the three months leading up to the announcement of a de-merger, and as the market starts to speculate, the performance improves. The entity then gives back a good deal of that outperformance once the news is out in the marketplace. When the newly de-merged entity starts trading the de-emerged entity outperforms the parent and continues to do so at least one year after the spin off. The parent also outperforms the market but not by as much. Current de-merging activity includes Brambles ((BXB)) and its Recall business, Amcor's ((AMC)) de-merging of the Australasian packaging unit and distribution business and UGL's ((UGL)) de-merging the DTZ property services business from its engineering business.

Profit warnings. October and November, when most firms hold their AGMs, are the time for potential profit warnings. Ansell ((ANN)), WorleyParsons ((WOR)) and Cochlear ((COH)) recently issued downgrades at their AGMs. Macquarie notes Ansell underperformed the market by around 4% on the day of the announcement while for WorleyParsons it was 5% and Cochlear 0.8%. Macquarie's quant analysis covers 1005 events since September 1998 and finds that those that issue a profit warnings have been roughly 4% lower in average excess return in the month following an event.
 

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