Yesterday’s Gone, Tomorrow Will Be Different

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In This Week's Weekly Insights:

– Yesterday's Gone, Tomorrow Will Be Different
– Fallen Myths Of 2014
– Australia's Capex Blues: Two Charts
– Bitcoin: Technology's New Frontier
– Updating All-Weather Performers
– Stakeholder Yield Remains Superior

Yesterday's Gone, Tomorrow Will Be Different

By Rudi Filapek-Vandyck, Editor FNArena

The biggest error any investor can make, myself included, is to underestimate the potential for negative news to simply generate more negative news.

This is especially the case in the resources sector where falling prices not only wipe out profit margins, capex plans and asset valuations, from a certain point onwards falling prices render producers unprofitable and then all attention shifts to what management at the company can do to survive as a going concern. Is there enough cash in the bank? What are the debt requirements? How much potential for sustainable cost cutting is there, really?

Investors need not look any further than iron ore producer Atlas Iron ((AGO)) whose share price until April this year was hovering underneath $1, looking "cheap" since the share price had peaked at $4 in 2011 and had still been above $1.50 in early 2013. But as the price of iron ore kept falling, not only did capex plans need to be delayed indefinitely, dividends needed to be cut too. As the price of iron ore kept falling, the focus shifted to how long the company can actually stay in business.

How much is a company worth that is forced to produce at a loss? Atlas Iron has enough cash to stay in business for a few years but it needs ongoing cash flow so production continues while management is looking at all options to reduce cash burn.

Unless the price of iron ore recovers to a level that allows Atlas Iron to become profitable again, the answer to what is the business actually worth might be whatever someone is willing to pay for the company's port access. Investors holding on in the hope that someone is actually going to bid for the iron ore assets might as well start believing in Santa Claus, in my view, as it simply does not make sense for any of the majors to purchase lower quality assets, with a short mine life and a high production cost. No matter how cheap.

Think about it.

It does not make sense for Glencore Xstrata either, which is why they have set their target on Rio Tinto ((RIO)). It doesn't make any sense for mid-tier producers to combine forces, not without a significant and sustainable recovery in the price of iron ore. The board at BC Iron ((BCI)), long time one of the stand-out gems in the second tier layer of the sector, is about to find this out first hand.

BC Iron paid $250m for a full takeover of Iron Ore Holdings only a few weeks ago. Its share price now sits at half a dollar ($0.5) compared to $3.50 in August and $4.50 in May. Atlas Iron, by the way, now trades around 18c.

There are those shareholders who held on can still consider themselves lucky they're not on the register of Lynas Corp ((LYC)) whose shares are now trading around 5c.

A similar dynamic has now gripped the domestic oil and gas sector. At face value, the share price weakness suffered by shareholders in Woodside Petroleum ((WPL)), Santos ((STO)) and Origin Energy ((ORG)) appears greatly overdone as the first offers a healthy dividend yield and the other two are about to turn themselves into reliable dividend payers from next year onwards, when their respective Queensland LNG projects are scheduled to start exporting.

This, however, ignores the reality that, from a certain point onwards, negative news is simply going to bring out more negative news. For Australian LNG producers (and soon-to-be LNG producers) that point has now been reached. Which is why share price sell-offs have accelerated in recent sessions.

To those among you who like to criticise the experts and the analysts for failing to see all of this coming in advance, I'd like to point out that the main reason as to why the industry is now in strife relates back to the fact that the people managing these companies, and making decisions at board level, have also failed to anticipate what was coming upon them.

In plain English: companies in the sector are ill-prepared for low-priced oil.

Analysts at Credit Suisse put the same message to their clientele on Monday morning, declaring on behalf of Australia's large cap oil and gas sector: "Uh-oh, we're in trouble".

What kind of trouble are we talking about?

Not the kind of Atlas Iron or Lynas Corp type of trouble, at least not for the top echelon of energy stocks in Australia. Woodside Petroleum will have to cut its dividend. (I have written and said this before, but as oil continues to fall, this is only becoming more of a certainty). By how much will to a degree be determined by how low prices can fall and for how long the prices of oil and of natural gas will stay at depressed levels.

Woodside shares have now fallen to $34.20 at which level they offer between 8.3%-8.9% in dividend yield for the current year ending in December, depending on what currency translation is being used, plus franking benefits. For next year, the implied yield on the basis of consensus estimates is between 7.2%-7.7%, plus franking.

I think these numbers indicate the market is in full agreement with my prediction. Never a free lunch, remember? The market would not offer Woodside shares at a grossed up double digit yield, unless it believed that kind of yield actually won't be there next year.

Woodside does have a strong balance sheet and it may end up buying assets at a bargain price. We'll have to wait and see.

The news might not be so good for Santos and/or Origin who've made a lot of investments and financial forecasts on the basis of US$100 for a barrel of oil. In simple terms, Origin's $12.5bn share in capex as part of its "transformational" APLNG today represents some 85% of the company's total market capitalisation. Yes, this is what falling prices can do.

Costs and capex will now become key areas of attention. Investors are likely to worry about the need to raise extra capital.

In general terms, lower energy prices, if sustained, will weigh on asset prices and cash flows, thus reducing potential for profit growth and for share price appreciation and what companies can invest and pay out in the form of dividends to shareholders. The star performer in the sector, Oil Search ((OSH)), equally carries a lot of debt, and its return potential by now has been eroded quite substantially too.

To those investors who like to take guidance from analysts' consensus forecasts, I'd say: do not underestimate the impact to the downside from the changed environment for oil and gas producers.

It is far easier for the market to sell down and push share prices to lower levels, acknowledging the new oil environment and outlook, than it is for analysts to recalculate what it all means, and why, and how. It's probably a fair bet that many of the analysts do not know what price should now be used for their models and they might wait and see first whether there's a recovery, or lower prices, or stabilisation first.

In the meantime, do not for a second think this is a local problem only. The oil and gas sector globally is heavily indebted, from mega-producers at the top through to young and upcoming shale frackers at the bottom. All because, you know, just about everybody in the sector assumed US$100/bbl simply looked like a reliable floor price.

You would not want to be reliant on their spending in the year(s) ahead.

As far as the local mid-tier players are concerned, investors will have to make an assessment whether there's enough potential left in a low price environment. The chart below, not for the first time in appearance on my watch, shows the core of the problem: shale oil in the USA might be responsible for today's global glut, and low prices, it also makes unconventional oil elsewhere unprofitable.

Remember, just like in the case of iron ore producers, reserves in the ground that cannot be commercially brought into the market are essentially worthless. This is why share prices for the likes of Beach Petroleum ((BPT)) have been sold down so savagely.

What about BHP Billiton ((BHP))? Gone are the days that stockbrokers and advisors were talking their customers into the stock on the basis of its "diversification" and energy exposure. BHP's shares sank below $30 on Monday, offering an implied forward looking dividend yield of 5%, plus franking.

Just as is the case for Woodside, I think this indicates investors are now seriously contemplating BHP might not raise its dividends this year. Could it be it might be forced to cut them?

A number of analysts had updated their projections in recent weeks and concluded BHP did not have the right cash flow prospects to lift its dividends. It can take on debt given balance sheet strength. It can try selling assets (but the timing seems wrong). It can postpone capex.

Given the fierce criticism from shareholders in recent years, can the BHP board really cut the dividend for shareholders next year? Also given Rio Tinto's commitment -again reiterated last week- that shareholders' loyalty shall be rewarded, and handsomely?

Meanwhile, investors should not take any guidance from price targets and valuations for the Big Australian above $40. I have maintained for years now the BHP share price is destined to trade between $30 and $40 for a long while to come, and I have essentially not given up on this view. However, even lower prices for oil, iron ore, coal and copper have the potential to alter this view to the downside. BHP cutting its dividend -not under consideration right now, I believe- can potentially have the same impact.

Investors should note Credit Suisse recently cut its price target for BHP to $35, which looks much more realistic than the $44 that is still on display whenever Morgan Stanley updates its views. As to why it takes the majority of analysts so long to come up with fresher numbers and updates I can only guess, and assume they are looking into applying new numbers right now. They don't want to be doing it again in a few weeks time, so they are probably awaiting some kind of price stabilisation.

What applies to miners and to energy companies, also applies to the Australian economy. According to a recent survey by finder.com.au, only three out of 37 economists in Australia are predicting at least one more RBA rate cut next year. All 34 are projecting rate rises instead.

But the view of those three is definitely getting a lot more traction in recent days. As a matter of fact, it can be argued both ten year government bonds and the currency weakness are signaling investors are shifting to the three rather than the 34.

One of the stockmarket experts locally, Credit Suisse, has been very vocal and very persistent on this matter, stating in its latest market strategy update its proprietary modeling now showed there's potential for 50bp in RBA rate cuts, or even more. CS sees further slowing growth and rising unemployment eating away at profit growth in Australia. There will be no growth this year, the strategists say. Again. But if the RBA responds through rate cuts, the currency will weaken and international investors will return, helping to push up the ASX200 to 6000 by year-end 2015.

We all know the RBA does not want to further cut interest rates, as it is worried about exuberance in the housing market, but maybe further bad news might simply force its hand?

P.S. This doesn't look like a context that is about to push yield and All-Weather stocks out of favour anytime soon.

Fallen Myths Of 2014

Even during the best of times, the share market remains a public market place where a lot of half-truths and pure plain nonsense are being bandied around.

One of the attractive features of Finance, and one of the reasons why I do what I do and founded FNArena (now more than 12 years ago, would you believe?), is that sooner or later these unfounded myths will be unmasked and exposed for what they really are: myths.

On my observation, 2014 has been particularly cruel with many more myths falling in disrepute this year, causing lots and lots of investor funds to go AWOL during the process.

Here's a quick overview of what did not stand up against the cruel, harsh lessons of reality this year:

– The China slow down doesn't matter because the Chinese economy is now many times larger than in the past

– Iron ore simply cannot stay below US$110/tonne because of Chinese production cost levels

– Relax, China never misses its targets

– Spending on mining services bottomed in early 2014

– The energy sector is a much safer option than mining

– Iron ore simply cannot stay below US$100/tonne because of Chinese production cost levels

– The US dollar is dead and buried and on its way out; the only way forward is further down

– The yield trade is a fad that will die shortly

– Iron ore simply cannot stay below US$90/tonne because of Chinese production cost levels

– Relax, China's slow down is a controlled slow down

– BHP is well-diversified and therefore offers protection

– The Super Cycle is not over, it is moving into the production phase

– BHP is like an industrial company now, and should be treated as such

– Iron ore simply cannot stay below US$80/tonne because of Chinese production cost levels

– Directors at Fortescue are buying extra shares; they know what the share price is going to do

– Inflation is just around the corner (buy gold)

– Companies should not pay out dividends, but invest everything in growth instead

– Small caps do not represent more risk than large cap stocks

– Every investor should have BHP in his/her portfolio

I am happy to entertain more suggestions. Send them to info@fnarena.com

Australia's Capex Blues: Two Charts

On a short term horizon, and while ignoring that published capex intentions are just that: intentions, it is easy to see how last week's capex update by the ABS instilled some positivism in most economists' outlook views for the Australian economy.

Hallelujah!

On a longer term view, however, there's simply no escaping the Australian economy, and engineers and contractors in particular, have one big challenge on their hands.

Investors planning to ignore the obvious warning signals should take a good look at the second chart below, and consider its consequences.

Bitcoin: Technology's New Frontier

Like me, most of you have probably ignored the whole bitcoin sensation to date.

There was a lot of media coverage around this time last year when the "price" of BTC went parabolic, peaking at US$1147.25. Throughout the subsequent volatility, Bitcoin's value has, for the time being, settled below US$400. Judging from those numbers, maybe the Australian Tax Office does have a case to categorise the electronic crypto currency as a "commodity" and thus subject to GST when transacted.

To determine what is, in essence, Bitcoin and its growing popularity, media and finance buffs often fall back on labels such as "electronic gold" or "electronic money". These labels are in itself correct, but they do little to help ordinary citizens and investors understand what Bitcoin is all about.

Oddly enough, and contrary to what "outsiders" (like you and me) are inclined to think, the essence is not about money. 90% of today's Bitcoin owners and enthusiasts are not interested in what is the value of the currency in US dollars, or any fiat currency for that matter.

It is much more accurate to view this young phenomenon through the prism of a new social movement. And the techno-nerds are sitting in the biggest chair at the front with their hands firmly on the steering wheel, letting their imagination run wild. It's all about re-shaping tomorrow's world, while rejecting today's context in which governments and big corporates are all-too powerful and vulnerable at the same time (especially from a security and technological point of view).

Maybe the best way to view what's going on is to imagine Sheldon Cooper and his mates from popular TV sit-com The Big Bang taking on the task of creating a new paradigm for small transactions, without any involvement from the existing establishment. They started in Sheldon's living room and got the rest of the university involved, but they also quickly attracted support from anarchists, anti-globalism activists and from intellectuals, students and artists that previously found their cause, and their "belonging", in the Occupy movement, plus the Wikileaks enthusiasts and just about everyone else who doesn't like Big Government and Big Capitalism.

Ultimately, one would think, big corporates will end up getting involved, and taking their share, just like what happened with the Internet after the first decade of which the first half was mostly spent in obscurity. Between now and then, the possibilities seem endless. Which is the key reason as to why private equity and large investors have become involved.

Imagine someone telling you, back in the late eighties, the Internet is going to rip the heart out of news media, change the way people consume, spend their time, communicate with each other and do business, the world around. Sounds crazy, right? Yet, all it took was for someone to invent the browser. Then someone else introduced emails. Another someone created chatting. And yet another someone laid the first brick for what today is commonly known as social media.

And yes, a lot of ideas died anonymously and notoriously along the way.

Right now, Bitcoin is a nerd's paradise. It's imaginative, it's obscure and it's very, very technical. But it's Open Source, and time will come that someone, somewhere will develop the equivalent of the Internet browser. This might take it to the early adopters in society's main stream. There are riches to be made on the back of this. Which is why private capital and major investors are interested in the first place.

None of this is likely to happen tomorrow. So if you've ignored Bitcoin so far, there's no need to feel any guilt about it. There's a lot of incubation time involved in these technological developments. Bitcoin, simply put, is the next disruptive technology waiting to make its mark. Just like Uber, and solar energy, and 3D printing, and robotics, and stem cell research and so many other technologies currently developing.

Tomorrow's going to look a lot different from yesterday, so much is certain.

Updating All-Weather Performers

This is my final Weekly Insights for calendar 2014. Not only is Xmas approaching, and with it our annual break, but I still have to follow through on my promise to update on the theme of All-Weather Performers (see further below).

All-Weather Stocks have been among the strongest performers in the share market post 2009 and I think the theme is to remain with us for longer. Meanwhile, an updated share price file up until November 30th is available – send email request to info@fnarena.com

Stakeholder Yield Remains Superior

Research conducted both locally as well as overseas suggests stocks from companies buying in their own shares more often than not outperform peers who don't. However, a recent quant research report from Macquarie suggests investors shouldn't narrow their focus to buy-backs only.

Macquarie analysts developed the concept of "Stakeholder Yield" which covers companies ability to reward stakeholders outside the business from the cash generated inside the business. This concept covers share buy-backs, of course, but also higher dividends and paying down debt. Macquarie's research builds a strong case that companies that combine all three strategies to reward shareholders, simply deliver superior returns for their shareholders.

Investors, wherever you are, take note.

FNArena's regular update on share buy-backs:

Ansell ((ANN))
Aurizon ((AZJ))
Aveo Group ((AOG))
Cape Lambert Resources ((CFE))
China Magnesium Corp ((CMC))
CSL ((CSL))
Dexus Property ((DXS))
Donaco International ((DNA))
Fiducian Portfolio Services ((FPS))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Logicamms ((LCM))
SMS Management & Technology ((SMX))
Telstra ((TLS))

We continue to welcome your participation/contributions. Send them to info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, here are my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm

These are my final appearances on TV for calendar 2014. I shall be back in February next year.

(This story was written on Monday, 1 December 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of November available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms