-Exploration subdued, margins tight
-Production exposure key to FY15
-Risk overwhelms value for many brokers
-Questions over value of investments
 

By Eva Brocklehurst

Brokers feared mining service provider Ausdrill's ((ASL)) interim result, posted late on the last day of reporting season, might have some more negative news. As it turned out, the results were broadly in line with expectations, but then brokers had been warned. The company signalled back in November that FY14 would be substantially weaker than FY13, with profit likely to be down 60%. The outlook remains subdued and the company now expects FY14 revenue to be at the bottom end of the prior guidance range. Any improvement in FY15 is predicated on some recent contract wins and increasing volumes on existing mining contracts.

Many contracts have finished in the production related businesses, which has created excess capacity within the group. The company has been tendering for work in both Africa and Australia which, assuming success, should replace a substantial portion of the work that has ceased. On the exploration side, activity is showing no signs of recovery in the near term and margin pressure is evident. Ausdrill expects an increase in capex spending in 2014 will be limited to the major miners. Equipment is in significant surplus and this impacts the rental market. The company expects these conditions to persist in the near term.

Deutsche Bank has a Buy rating on Ausdrill. Taking on board the subdued outlook and downgrade to medium-term earnings forecasts, the broker still thinks the company is relatively well placed. The broker's positive assessment is based on the fact that Ausdrill's production stage exposure, the mature point in the resources cycle, is around 66% of revenue. The company also has diversity in its favour, in terms of geography, commodity type and service provision and this underscores its potential upside, in Deutsche Bank's opinion.

This may be well and good but JP Morgan is not convinced, downgrading the stock to Underweight from Neutral. The broker has become more concerned about the outlook and is not prepared to concede the near-term operational headwinds and high gearing. As the stock is trading above the broker's average valuation of 79c a share, JP Morgan does not believe investors are being compensated appropriately for the risks. The broker notes the weakness in discretionary mining spending will keep hurting the company and excess levels of equipment industry-wide are likely to lead to greater pressure on margins. The broker believes it will take some time to improve profitability. Moreover, JP Morgan believes Ausdrill has lost the strong links to mine production volumes in Western Australian iron ore and the gold sector. The broker espoused this theme in November at the time of the profit warning and downgraded then to Neutral from Overweight.

One positive aspect, according to JP Morgan is that growth for CMS Africa has been encouraging, reflecting a greater proportion of head contract mining services being delivered by the group. However, this will require greater inventory investment, in order to have the right equipment in the right places and, with the fall in the gold price over the past 18 months, miners are still re-evaluating plans and this could mean further changes to Ausdrill's contracts. 

JP Morgan also questions the company's decision to make investment in companies such as Azumah Resources ((AZM)) and Mutiny Gold ((MYG)), in order to secure a preferred contractor position. The total investments are relatively small but the broker thinks investments of this nature are not necessarily the best use of capital at a time when the balance sheet is highly leveraged. If these investments perform poorly, or the company is unable to convert the preferred positions into contracted work, then there's little value in JP Morgan's view. The broker also thinks the acquisition of Best Tractor Parts was poorly timed, as end market conditions began deteriorating.

Macquarie has a Neutral rating. The broker thinks the company may be well managed but is now trading at a steep discount to net tangible assets, and then there's high gearing levels and the ongoing gold price volatility. CIMB found the margin decline painful and the outlook cloudy. The fact that Africa was not as weak as was expected put a brighter tinge on the result but, in Australia, the broker thinks the amount of available contract mining work continues to diminish.

The risk profile is overwhelming the valuation appeal for CIMB, for now. On the positive side, there is potential for the company to outperform if the market is confident that conditions have bottomed. Still, the broker notes gold companies are the most cost conscious in the current environment and this makes it hard to be more positive. This broker also thinks debt reduction will remain elusive, hampered by structural working capital constraints, given the location of work, and adverse currency movements. It adds up to a Hold call for CIMB.

There are two Buy ratings, two Hold and two Sell on FNArena's database. The consensus target is $1.12, signalling 22.8% upside to the last share price. Dividend yield is at 6.8% on FY14 forecasts and 7.7% on FY15.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Dividend pay-out increases
-US growth to continue
-Stock too expensive for many
 

By Eva Brocklehurst

James Hardie ((JHX)) has gone from strength to strength recently. The third quarter results bettered broker expectations, with higher prices and lower costs offsetting a shortfall in US fibre cement volumes.

When FNArena last looked at James Hardie, ahead of the first quarter, the observation was made by Goldman Sachs that the company had not responded very well to the first signs of improvement in US housing starts. The reason given was that the initial recovery was centred on low value multi-residential developments and, with an upturn to single dwelling construction and more broad-based recovery, the fortunes of the company would change. Now, it seems the company has started to score on this measure. The third quarter result was not robust but brokers were pleasantly surprised with a US28c special dividend.

To the brokers, this special dividend not only signals a change in strategy to return more capital to shareholders but also that management is very positive about the growth outlook. Deutsche Bank believes, despite the increase to capex intentions for FY15-17, the company can pay a US40c special dividend in FY15 and FY16, as well as continue with its buy-back. Underpinning these expectations is management's raising of net debt forecasts to more than US$500m by FY16.

UBS observes that, during the downturn, volume declines were limited by the company actively growing the renovations market to over 60% of volumes. Now, a 10% growth in housing starts translates to 17% growth in total US volumes for James Hardie. This ability to maximise such leverage makes the stock attractive and may signal renewed success in growing market share, according to UBS.

Having said that, the broker thinks the US recovery may be buffeted by a tapering of the US Federal Reserve's quantitative easing, as well as the weather. In terms of the latter, the upcoming US spring season should help to gauge the strength of the US housing recovery. Nevertheless, the broker thinks the stock is too expensive. The market is seemly pricing in super-normal margins and high market share. UBS expects profits will ultimately be whittled away by competition, or margins will be maintained at the expensive of market share. Either way, a Sell rating stays in place.

James Hardie surprised JP Morgan with the extent of the reduction in unit operating costs. As confidence is building, the market's attention is shifting more to what James Hardie could be worth, in JP Morgan's opinion. If price growth, market share and terminal margins all reach JP Morgan's top assumptions the stock could be worth up to $19.50. Such assumptions are not for the faint hearted, the broker acknowledges, as they require perfect conditions. Hence, JP Morgan's base case price target is $13.80 and the recommendation is Neutral.

Credit Suisse has a slightly different take. The broker senses that management is confident about generating sufficient free cash flow to meet liabilities and fund growth as well a return capital and expects this belief, for now, should overshadow an emerging soft patch in housing activity in the US. The current strength in the US market has led the company to accelerate capacity expansion, having previously announced a 26% increase in US fibre cement capacity at a cost of US$136m. If the business continues on the same trajectory, Credit Suisse thinks the capex budget will be revised higher.

The broker gives credit to the company's operations team and has greater confidence in the company's ability to penetrate the market with its pricing model. Why then downgrade to Neutral from Outperform? The run up in the share price over the past quarter has made the stock expensive and Credit Suisse awaits a more attractive entry point.

James Hardie is one of the most difficult when it comes to formulating an investment outlook, according to CIMB. The US housing market recovery has further to go and the company is growing its share in a growing market. The returns are impressive and shareholders should soon see a greater portion allotted to them. It's all good, but the valuation plagues the broker. CIMB's discounted cash flow valuation of $11.07 is 25% below current price levels. Even on FY16 earnings forecasts the stock trades at a price/earnings ratio of 19 times, adjusting for asbestos. Hence, CIMB's fundamental valuation is retained and so is a Reduce rating.

Macquarie liked the strong results but didn't like the increase in new asbestos claims. Management is not sure whether this is the start of a trend but the broker think the situation needs to be monitored closely and the next KPMG report in May may provide some insight. Still, the company is a long way from its targeted gearing level, implying substantial scope for further capital management. James Hardie is now operating at a higher pay-out ratio at 50-70% of underlying profit, ex asbestos, against 30-50% previously. Macquarie notes, even if operating at the top of this range, the company would need to pay out an increasing number of special dividends to push the balance sheet to the targeted gearing level. The broker is upbeat and has raised the rating to Outperform from Neutral.

A lot of commentary is on the growth in the US market but what about Australia? Credit Suisse notes the renovations market here is soft and this is constraining volume growth. Still, approvals for detached homes are increasing and James Hardie's business is expected to track this growth. New Zealand's market continues to improve, particularly in Auckland and with the Christchurch re-building. In the Philippines growth is steady in James Hardie's core markets. UBS notes the recovery in Australia is sluggish. Housing approvals are strong, particularly detached housing, but renovations and non-residential remain challenging. JP Morgan was expecting a decline in the Asia Pacific earnings in the third quarter, because of the weakening Australian dollar, but the division managed to generate earnings growth of 7.2% thanks to a fall in unit costs.

On the FNArena database the recommendations are evenly distributed. There are two Buy ratings, three Hold and two Sell. The consensus price target is $13.97, suggesting 2.9% downside to the last share price and this compares with $12.62 ahead of the quarterly result. Targets range from $11.07 (CIMB) to $16.08 (Deutsche Bank). The dividend yield on FY14 forecasts is 4.3% and 5.5% on FY15.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Strong record in integrating centres
-Growth both organically and acquisitions
 

By Eva Brocklehurst

G8 Education ((GEM)) has caught the attention of two more brokers, with Macquarie and BA-Merrill Lynch deciding its time to initiate coverage. Australia's largest listed child care company has had a stellar run in acquisitions, supported by a very fragmented market. Since March 2010, G8 has acquired more than 200 centres and both brokers expect the company to continue with an aggressive acquisition strategy.

In 2013 revenue rose 55%, reflecting organic growth as well as acquisitions. Macquarie expects earnings to grow 65% in 2014, driven largely by another 63 centres that are expected to settle in April. While there's risk in bedding down any acquisition the broker considers G8 has delivered a strong track record in integrating centres. The broker has kicked off with an Outperform rating and $4.20 price target. The key to the stock's value is management's ability to identify potential acquisitions in strategic locations, acquire them at reasonable cost and then realise efficiencies as they are incorporated into the company. Macquarie is attracted to the fact that, on estimates, smaller private operator child care centres make up 83% of the market in Australia yet G8 holds just 3.3% market share of the long day care market. G8 also owns 18 centres and 50 franchises in Singapore.

The industry is also receiving government support, improving the affordability of day care. Macquarie expects the industry to also be underpinned by a higher level of household disposable income as the level of female participation in the workforce rises. This is a key factor in any decision to use child care services. Population trends are also supportive, with Australian statistics showing the number of children aged 0-14 are expected to increase by 8.5% out to 2016, from 2011.

Where are the risks? There is increased competition. A number of consolidators entered the market in 2013, according to Macquarie, and this could affect acquisition multiples and G8's longer term strategy. Changes to government assistance can also impact on child care affordability and affect the company's growth outlook. Macquarie does find it difficult, given the pace at which the company has grown, to track just what growth is internally generated and what is acquired. There is a risk that such an aggressive acquisition strategy could mask underperformance in the base operations. Still, at this point, Macquarie finds no evidence this is the case with G8.

Merrills has initiated with a Buy rating and $5.00 price target, noting the company is benefiting from increasing demand for child care services. This broker also hails the strong track record in integrating centres. Merrills thinks the rapid growth in numbers gives the company the opportunity to lift occupancy rates and fees and maximise floor space. The broker likes the potential for value accretive growth in a market where around 80% is available for consolidation. On the organic side, Merrills sees approximately 32% of earnings growth out to FY15 driven by revenue synergies and operational efficiency improvements.

Merrills observes the child care service industry, as a whole, has relatively low profitability. Average pre-tax profit margin of the not-for-profit centres ranges from 1-2%. Still, the broker believes there's opportunity for G8 to produce margins well in excess of the average and, indeed, the company sustained a 14.5% pre-tax margin for 2012. Occupancy rates are also considered one of the risk factors as, given the cost constraints of an increasingly qualified workforce, a minimum of 75-80% occupancy is required for profitable functioning.

As at December last year the company owned 252 centres and managed another 48. On the FNArena database the latest two brokers join CIMB and Citi covering the stock. All have Buy ratings. The consensus price target is $4.18, suggesting 7.1% upside to the last share price. Targets range from $3.70 to $5.00. The consensus dividend yield is 4.0% on FY14 estimates and 4.8% on FY15.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

-Digital hurdle to overcome
-Acquisition opportunities
-Customer expansion potential
 

By Eva Brocklehurst

Brokers have largely taken up neutral ground on Recall ((REC)), which has scored a few more coverage initiations after listing on ASX in December. Recall was the information management and document storage arm of Brambles ((BXB)). New recommendations have concurred with a view that, while the company has a strong recurring revenue theme, growth will be modest.

Citi is the latest broker on FNArena's database to initiate coverage of the stock, ascribing a Neutral rating and $4.55 price target. Citi envisages growth opportunities exist, but these are factored into the share price ahead of delivery. Growth is expected to be on the back of acquisitions but also new customers, the success of which will be measured in terms of returns. On the expansion side, Citi suspects the majority of growth will come from existing clients that commit storage to Recall in order to justify a new facility and networks.

The broker is not convinced that the company will be able to replace, or indeed improve on, physical document storage growth with the digital variety. In fact, Recall may be the number two globally in physical records management but is one of many providers in the digital marketplace. The broker considers this to be one of the larger risk profiles for the company and management must provide sufficient assurance they can overcome the risks. Therefore, despite a defensive growth profile and strong free cash flow, Citi finds value is better elsewhere in the sector.

Goldman Sachs has also commenced coverage with a Neutral rating and $4.74 price target. This broker also highlights the risk with digitising document storage. Paper prices have also created volatility in earnings and Recall sells a substantial quantity of recycled paper. A higher paper price helps recycled paper sales while the converse is also true.

Goldman notes the company operates in a highly fragmented, low growth mature market with higher growth rates coming from emerging markets. The broker expects opportunities for acquisitions will not go uncontested, given the company's main competitor, Iron Mountain, and other private firms are pursuing similar strategies. The company has also estimated 65% of the potential storage market is yet to be tapped. These are potential customers yet to outsource their document storage, something Goldman thinks provides more of an opportunity, as increased regulatory and compliance standards create a value proposition for the handing over of information management.

In January, UBS kicked off with a Buy rating and $4.80 price target. The broker expects Recall to grow earnings by 7% per annum. UBS notes the stock is unique in that it derives two thirds of revenue from outside North America and this gives it the edge when it comes to growth. UBS observes a material slowdown in revenue growth since 2009, with the five years to 2008 generating 8% per annum against only 2% since. This is construed as a case of cyclical realities, driven by lower transaction revenue. Carton storage volumes have growth by 5% over the same period. UBS thinks the high conversion cost of existing cartons will slow the digital incursion and contain the impact to new volumes. The Buy rating is based on the high quality of the business and the high level of recurring revenues. In this respect UBS echoes the views of the other similar rating on the database, CIMB.

CIMB regards Recall as offering exposure to a stable earnings stream, decent returns and reasonable dividend yield (2.2% on FY14 and 4.0% on FY15 consensus earnings on the database). The long term structural challenges exist from digitisation, but low growth expectations provide the buying opportunity for the stock in the immediate aftermath of the de-merger. The broker also considers the uncertainty over the course of digital storage take-up creates an initial opportunity to buy the stock. CIMB commenced coverage with an Add rating and $4.88 price target and believes earnings upside exists in the form of potential acquisitions, increased conversion of the potential market and a higher paper price.

On the FNArena database the stock has two Buy (or equivalent) ratings, four Hold and one Sell. JP Morgan, which initiated coverage with an Underweight rating under the broker's sector-relative rating model , is the lone occupant of the latter bloc, not wanting to value the stock aggressively. Price targets range from JP Morgan's $4.07 to $4.88 (CIMB). The consensus target is $4.53, signalling 1.2% upside to the last share price.

See also No Shortage In Challenges For Spun-off Recall on December 16 2013 .
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.

- Growth, diversity and defensiveness
- High margin cash generation
- Asian expansion

By Greg Peel

“Pact with upside,” says Morgans. “Packed with opportunity,” says Macquarie. “Diversified, defensive and inexpensive,” says Credit Suisse. “Initiating coverage with a Buy rating,” says Deutsche Bank.

Yes, Deutsche could perhaps do with a more imaginative sub-editor, but the fact remains brokers are very keen on recently listed packaging company Pact Group ((PGH)) as an investment. Indeed, each of the four above brokers has initiated coverage of Pact over the past week. All of them has ascribed a Buy or equivalent rating.

Pact is the leading supplier of rigid plastic packaging and metal containers in Australia and New Zealand. Australia presently accounts for 71% of revenue and international (including NZ) for 29%. Within the international business is a growing exposure in Asia, currently representing 6% of revenue. If Pact is able to acquire Indonesia’s leading packing company Dynapack, as it is attempting to do, emerging market revenue will grow to around a 25% share of group.

Pact primarily converts plastic resin and steel into packaging and related products for customers in the sectors of food, dairy, beverage, personal care and other household consumables, chemical, agricultural, industrial and others. According to market research firm Smithers Pira, the global rigid plastics industry should increase at a compound annual growth rate of 5.3% over 2012-18, including Australasian growth of 4.0% per annum and Asian growth of 8.4% per annum. Pact is diversified and defensive, notes Credit Suisse, with 75% of revenue sourced from hundreds of food and consumer products customers within the region. Within most segments Pact is the market leader, and the company focuses on segments in which import competition is less viable.

Pact has guided to FY14 revenue of $1.2bn which would represent compound annual revenue growth of 16.8% from FY03, Macquarie notes. Earnings growth has been driven by acquisitions, organic growth, new product development, productivity and “relentless focus on costs”. Profits margins are lofty at 16.9% and have been consistently maintained at a similar level.

Brokers have set their initial valuations based on PE ratios for international peers and for closest local peer Orora ((ORA)), recently spun-off from Amcor, with a premium added above the more fibre/box oriented Orora. All expect PGH will trade below its discounted cashflow valuation, despite generating significant defensive cashflows, until the company has gained more of a track record. Pact only listed in December.

The FNArena database shows an initial consensus price target of $4.12, representing 18% upside to the last traded price. Given PGH listed within FY14 we need to go out to FY15 for a full year’s forecasts, which suggest earnings growth consensus of 10.4% for a 5.8% yield.

There is some risk that Pact may need to go to the market for additional equity were it to win the Dynapack bid.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.