It's Dubai, it's Greece, it's Dubai....

The eyes of the world may be on the cost of Grecian debt, however, Dubai probably should not have been so swiftly forgotten. The cost of insuring Dubai World’s debt against default is now back around the levels it reached last year after the Government announced its debt standstill.

The catalyst was a report that Dubai World was considering repaying lenders only 60 cents in the dollar over a 7-year period. Although Dubai quickly denied these claims, the fact remains that it is yet to find a path out of its indebtedness and could well require further support from its more affluent neighbour, Abu Dhabi.

Meanwhile, the necessity to support Greece increased somewhat with the news that economic growth in the country contracted by 0.8% in the fourth quarter, compared to expectations of 0.5%. The Government also revised down the previous three quarters. These were not minor adjustments either. The first quarter changed from a 0.5% contraction to -1%, the second from -1.2% to -1.9% and the third from -1.7% to -2.5%.

"An excessive expansion of the money supply will always stimulate asset bubbles and the PBoC is quite right to drain liquidity from the economy to avoid future instability."

The current state of play is that the European Commission has agreed to support Greece if required. There is however no detail on exactly what form this support might take.

Europe will want to avoid the situation in Greece deteriorating, which could trigger contagion through the rest of Europe. It is for this reason that we do not expect Europe to stand by and allow Greece to become the sovereign version of Lehman Brothers. Nevertheless, it seems increasingly unlikely that Europe’s more prudent countries are prepared to burden their tax payers with the cost of a Grecian bailout.

This is not simply because it is politically unacceptable to force taxpayers to support their neighbour’s failure. It is also due to the fact that other areas of Europe have already taken a considerable dose of the nasty medicine required to balance their books, without receiving bailout funds.

Ireland has for instance instituted tough fiscal policy measures to return its economy to more sustainable levels. It would prove too damaging to the credibility of the European Commission were it to cave in to Greece’s ability to do the same. It therefore appears that the offer of support is designed to buy Greece sufficient time to show that it can do the right thing and restore confidence.

Greece is however on report and the European Commission, European Central Bank and the IMF are all watching closely. If the country does not demonstrate by March 16 that its policies are taking effect, it will have tougher measures forced upon it. This stick minus the carrot approach may be enough to avoid the need for financial support.

In the event that financial support is required, we would expect the IMF to provide it. This would avoid the political difficulties associated to a directly taxpayer funded solution. Certainly, policy makers are all too aware of the threat posed by the potential contagion of Greece’s debt crisis and simply will not allow such an event to occur.

Europe is unlikely to return to the status quo even once these issues recede. The situation with Greece, Portugal and the other main offenders underlines the inherent weakness of the union. Monetary union is not possible without political union. While Europe remains comprised of separate sovereign states, its foundation will remain inherently unstable.

Meanwhile, China moved back into the spotlight this week following the country’s surprise move to raise its bank reserve requirements. The People’s Bank of China was expected to lift reserve requirements again, following its 50 basis point hike in January. It was not expected to move quite so soon though, playing into the markets’ fears that the PBoC could be a little heavy handed in its efforts to rein in credit expansion.

It is not correct in our view to translate the PBoC’s actions as negative. China unleashed a mammoth stimulus effort to maintain growth through the GFC, which has driven a significant expansion in its money supply. An excessive expansion of the money supply will always stimulate asset bubbles and the PBoC is quite right to drain liquidity from the economy to avoid future instability.

On a more positive note, US retail sales rose 0.5% in January, coming in well ahead of expectations for just 0.3% growth. The data was particularly encouraging given that the Commerce Department’s accompanying comments revealed that consumers are increasing their spending on luxury goods. This of course bodes well for consumer confidence and a continuation of the recovery process. Adding to the cheer, the November and December figures were revised upwards.

Here in Australia, the RBA released the minutes from the meeting that produced the surprising decision to keep interest rates on hold this month. The minutes effectively repeat the policy statement, flagging such things as uncertainty around household spending and the durability of the housing market in the face of stimulus fade.

The RBA also has some concern over ongoing sovereign debt issues, although views these risks as balanced for Australia against strong Asian led growth. Given that the question of sovereign risk is yet to be resolved, it is possible that the RBA could yet hold rates firm in March.

The market deems this unlikely, particularly given last week’s ripper of an unemployment report which revealed a better than expected decline to 5.3%. This certainly adds to the argument for a March rate hike. Nevertheless, we view the likelihood of a hike next month more as a 50/50 call.

Either way, the fact remains that the RBA is still on a tightening bias and further rate rises will come through during the course of the year.

Turning to the technicals, the ASX200 dropped to its lowest level since mid September 2009, briefly touching 4464.90 on February 9. The local bourse spent the remainder of the week back above the 4500 level to gain an additional 93 points to print an intra-week high of 4593.30 on February 12.

The ASX200 continues to respect the short term moving average (green line) at 4557 and is currently finding difficultly in breaking higher. The current short term downtrend remains intact, with overhead resistance at 4593.30, then the long term moving average (red line) at 4708.

However, should the local bourse drift lower, immediate support is located at 4464.90, followed by major support at the 50% Fibonacci level at 4332.15.

The Dow Jones bounced higher last week since breaking below the 10,000 level, reaching a weekly high of 10,161.57 on February 11. Similar to the ASX200, the short-term moving average (green line) is providing immediate resistance at 10,100. Should the move higher continue, overhead resistance lies at the long-term moving average (red line) of 10,330.

However, another move lower, in line with the short term downtrend will see the February 5 low of 9,835.09 come under pressure, followed by firm support at the 61.8% Fibonacci retracement level of 9,720.38.

Gold has bounced off the recent low of US$1,044.55 on February 5 to reach an intra-week high of US$1,102.15. The move higher has been slow coming, with the daily trading ranges between US$20 – US$30.

Should Gold break out from the downtrend, this would spark a resurgence of positive sentiment, which will in turn cause an accelerated move higher towards the long term moving average (red line) of US$1,121.30. Should the bulls breach this resistance level, we would expect the January 11 high of US$1,161.75 to be next.

On the flipside, should the downtrend line hold, expect the major support level at the 50% Fibonacci retracement of US$1046.61 to be tested once again.

Strong cashflow facilitates dividend growth

The capital intensive nature of the mining industry can make for a frustrating investment experience in many cases. Positive cashflow from a successful development can disappear into expensive exploration programs before investors get their hands on it. Investors hold those miners whose operating cashflow is sufficiently strong to support a dividend in higher regard than those that don’t.

Newcrest bolstered their image in this respect. Management unveiled an interim $0.05 dividend (paid on 16 April 2010, unfranked) in amongst last week’s first half to 31 December 2009 earnings report. The miner has not paid an interim dividend since 1994 and the news was certainly a pleasant surprise.

Newcrest reported underlying first half profit of $266.6 million, representing 10% growth on the previous year’s $241.6 million. This was a particularly robust result, given that sales declined from $1.294 billion to $1.187 billion.

Although Newcrest benefited from higher gold prices, gold sales volumes fell 14%. The benefit of by-product copper payments was also less, with both the price of copper and volume of sales down 4% and 7% respectively.

"The company’s free cash flow has been positive for each of the 3 years following Mr Smith’s appointment."

Nevertheless, Newcrest’s profitability improved through a significant reduction in costs. Mine production costs came in at $527.9 million, compared to $555.6 million in 2008. While we would like to slap management on the back for this, the savings were in part due to the good fortune of lower energy prices. Indeed, costs associated to “fuel and lubes” decreased 35.1% to $43.2 million.

The cost savings were not passively achieved in their entirety though. Management’s various cost saving initiatives have borne fruit, with lower costs for both maintenance and contract mining. Reduced maintenance costs can often be the forebearer of bad news. This is not the case for Newcrest, with cost savings derived from improved planning of scheduled maintenance, rather than cut corners.

The company’s ability to increase the dividend is testament to CEO Ian Smith’s managerial success. Since Mr Smith joined Newcrest from Rio Tinto in July 2006, he has turned around the company’s financial performance. Newcrest failed to deliver a single year of positive free cash flow from 2001 to 2006.

The company’s free cash flow has been positive for each of the 3 years following Mr Smith’s appointment. This includes last year in which Newcrest’s capital expenditure (excluding exploration and the Harmony JV acquisition) of $785 million set a record high for the company.

Newcrest is getting closer to realising a return on this expenditure. Ridgeway deeps, the Gosowong expansion and Hidden Valley will all become operational in the second half. Encouragingly, Ridgeway Deeps and Gosowong are both on time and budget. In fact, Ridgeway Deeps is on track to come in $40 million below its budget at $505 million. Hidden Valley is however around 3 months behind schedule.

These projects, in addition to Cadia East, will provide the foundation for management’s ambitious aim of expanding Newcrest’s gold production over 5 years. If achieved, this will take Newcrest’s gold production to 2.3 million ounces by 2014. Management also expect to deliver a 30% boost to copper production over the same timeframe, thereby assisting on the cost front.

It doesn’t stop there either. Management is currently assessing the next wave of development projects. These include O’Callaghans in the vicinity of the core Telfer project, Wafi-Golpu and Namosi, which are all progressing towards pre-feasibility. We will provide more detail on these projects as they near execution.

Suffice to say, Newcrest has a high quality asset base that has the potential to support longer-term production growth. Meanwhile, the quality of Newcrest’s assets is matched by its balance sheet. The company’s net debt to equity stood at just 3% as at 31 December 2009. Given its recently negotiated 3-year $600 million credit facility, Newcrest certainly has the financial capacity to drive its projects forward and take advantage of opportunities that may arise.

Turning to the charts, since reaching a high of $39.75 in early December 2009, Newcrest underwent a short-term change in trend to the downside. This saw Newcrest dip to a recent low of $30.51 on February 5, breaking below the 61.8% Fibonacci retracement level by 35 cents, before bouncing swiftly off this support.

This move was perhaps unsurprising given that the Relative Strength index (RSI) had fallen deeply into oversold levels. Looking at the longer term, we believe that downside risks are relatively limited, with solid chart support evident between $28.12 (50% Fibonacci retracement) and $30.86 (61.8% Fibonacci retracement).

The bottom line for all gold miners is that their share price movement is ultimately determined by the price of gold. While gold may remain in its consolidation phase for some time, we expect to see further record highs in the months and years ahead. Miners with favourable cost and production profiles based on world-class assets, such as Newcrest, are positioned to capitalise on this.

As such, we continue to recommend the stock as a buy to Members without exposure around $32.34.

Newcrest Mining will remain held in the Fat Prophets Portfolio.

Going great guns

As Members may recall, we took some of our gold profits off the table late last year. We did this due to our fears of a period of underperformance from the gold miners, associated to a loss of investor enthusiasm for the metal itself. While gold’s current correction is yet to find a base, we do not expect the precious metal to breach US$1,000.

Indeed, US$1,000 is likely to be as strong in support as the key psychological level was as resistance. This will ultimately drive a re-rating across the gold sector, which we expect to occur later this year. In terms of which, we recently re-established buy recommendations on Lihir Gold and Newcrest Mining. This week we are doing the same for industry up-and-comer Avoca Resources.

Avoca’s produced 50,952 ounces of gold through the 2009 fourth quarter, at an operating cash cost of A$458 per ounce. This is particularly significant given that it represents the third consecutive quarter where production has exceeded 50,000 ounces. This greatly reduces the risk associated to management’s previous guidance for production of more than 190,000 ounces of gold for 2010.

The big news during the quarter was the announcement of the first underground resource at Chalice of 118,000 ounces of gold. The current resource at Chalice underground is 720,000 tonnes of ore, grading 5.1 g/t (grams per tonne) of gold. The resource is contained within two lodes, Atlas and Olympus. Atlas is the smaller of the two ore-bodies with 142,221 tonnes at 3.8 g/t.

The grade at Atlas is low for an underground mine and at the current gold price the operation’s profitability would be rather thin. This is unlikely to be an issue, given that production at Atlas is not scheduled until 2014, in the region of 17,000 ounces of gold.

The Olympus ore body will be developed first with a resource of 577,861 tonnes grading 5.5 g/t. Avoca expects the gold recovery to be high at about 98%. The forecast cash operating cost of A$518 per ounce is equivalent to around A$90 per tonne, which is reasonable in our view.

Of particular interest to us is the exploration potential at Chalice and the surrounding area, which remains excellent. There is an inferred resource already in existence between Atlas and Olympus, shown on the image below. Management hopes to firm up the existing resource to indicated status through planned drilling.

The development of the Chalice underground mine will start with dewatering of the open pit. Underground mining will begin in mid-2010, and stoping should begin by late-2011. The forecast levels of gold output from Olympus are 55,000 ounces in 2012, rising to 44,000 ounces in 2013.

When the Trident mine was producing 20-30,000 ounces per quarter it was losing cash after investment expenditures. There was cash outflow of A$11.3 million last year after investing activities, which is clearly not sustainable.

We have spoken with Avoca on this issue and from the June quarter of 2009, Trident has been cash flow positive after investment expenditures. We are looking forward to seeing the 2010 first half financial statements to see how much cash Trident has generated in the half year.

In other news, Ramelius has accepted Avoca’s final offer of $A0.65 in cash and 0.325 Avoca shares for each of the company’s Dioro shares. This was widely expected, although it is still positive to see Avoca finally wrap up the Dioro drama.

From a charting perspective, Avoca Resources rebounded strongly from the February 1 low of $1.535, to reach a recent high of $1.945 on February 12. This represents a gain of 41 cents or 26.71% over a two-week period. The spike in price was coupled with the breakout from the short-term downtrend line, which saw a resurgence of buyer support.

The 50-day moving average remains above the 200 day, which is an indication of momentum to favour the upside. Should Avoca continue higher as we expect, immediate resistance lies at the key psychological $2.00 level, followed by the December 3 2009 high of $2.26.

As such, we recommend Avoca as a buy to all Members around $1.80.

Recovery is a long hard slog

Boral’s new chief executive, Mark Selway, is understandably positive about the company’s long term potential. But he is faced with at least another half-year of heavy operating losses in the US and a commercial construction market in Australia that is going backwards.

“Boral has lost $195 million of operating profits over the last two calendar years and could conceivably extend that to $300 million by the end of this financial year”

In August last year (FAT 438) we recommended Members sell half their holding in Boral after the stock had risen 35% from our original entry point of $4.05 in June 2009 (FAT 431).

We are now recommending Members sell their remaining holding.

Fat Prophets initially recommended buying Boral around $4.05 in June (Fat 431). Boral reached a high of $6.40 in mid October 2009 and has since retraced. The recent low was at $5.22 on February 1. This represents an easing of $1.18 (-18.44%).

Our original premise for owning Boral was based on the nascent recovery in the Australian housing market, accompanied by significant government spending on infrastructure projects. We expected the US housing recovery to take much longer, but Boral was in a strong position to capitalise on it when it turned.

Revisiting those assumptions this week, after Boral reported its half-year result for the six months ending 31 December 2009, we are disappointed with the rate of recovery in those key areas. Let’s take a closer look at each factor.

US housing market

We highlighted the risk that the recovery in the US would be a prolonged affair and this has indeed played out.

It is a well known situation that housing starts in the US are 60% below the 50-year average of about 1.5 million new houses each year. At around 570,000 starts on an annualised basis, there is a ray of hope that the market is stabilising. Boral currently believes that its own businesses in the US can reach break even when housing starts are around 900,000 to 1 million on a yearly basis.

There is the added problem of a significant overhang of existing housing stock. At 3.3 million units of existing dwellings, according to the US Census Bureau, it is approximately 1.5 million units higher than its long run average. Until that excess supply is depleted, there will be little demand for new homes and certainly heavy pressure on the value of all housing stock.

Members will not be surprised to learn that Boral’s US brick and tile plants are currently running at around 20% of their capacity utilisation. What inventory is being produced is facing heavy competition and prices are going backwards in order to sell it.

Mr Selway expects another half year of operating losses from its US business. Boral has lost $195 million of operating profits over the last two calendar years and could conceivably extend that to $300 million by the end of this financial year.

Given that he has only been in the role for a month, it is too early to expect a decision on how to rectify this situation. Mr Selway has also just appointed Mike Kane as President of the US division who will also need to quickly decide on a course of action.

Australian Non-Residential Construction

The disappointing aspect to the half year result was the revelation that non-residential activity in Australia had slowed significantly. Boral’s related businesses have struggled as a consequence.

We had previously expected government stimulus spending to benefit the sector and that has been the case. But the major beneficiaries have been schools and hospitals and these are not ‘material intensive’ projects as Boral describes them.

The more valuable work exists in the commercial and industrial sectors and recent data suggests this has dropped precipitously.

In Boral’s businesses, this is reflected in the `decline in its cement division figures. Revenue declined 7% in the half year, but operating profits in cement dropped by 24% to $45 million in the face of extra competition in Queensland and pressure on import parity pricing of cement due to the higher Australian dollar. This divisional result was somewhat masked by the inclusion of its Asian construction materials business which is doing relatively well.

Australian housing market

Housing starts in Australia are still below their long term required rate of around 185,000 per annum.

Although the current rate of 142,000 is an improvement on recent lows, progress has been artificially boosted by generous first home owner grants and low interest rates. As these factors begin to fade, the momentum may dissipate from the housing sector. Confirming that trend, housing finance figures for December 2009 showed finance approvals dropped 2.5% and are now 7.1% below the September peak.

Financials

Boral has performed strongly in the last few years to lower its cost base and reduce its financial risk. The company has worked hard to maintain its position as a leading supplier of construction related materials and this will deliver excellent returns when activity picks up.

The balance sheet remains conservative and Boral delivered a very good operating cash flow result in the latest interim profit report. But the improvement was derived from lowering capital expenditure to below sustainable levels and reducing inventory to increase working capital. Ultimately these factors will have to reverse when activity lifts, so the more desirable improvement in cash flow needs to come from a measurably higher level of operating profit.

Conclusion

Boral is still a well run company with excellent positioning in most of its main markets. It is financially sound and will comfortably survive the prolonged decline in building activity.

Mr Selway reaffirmed guidance that the company would achieve consensus profit of around $123 million for the 2010 financial year. That is about 13% below last year’s figure.

Should Boral break above the short term downtrend line at $5.75, we should see a resurgence of upward momentum sending prices higher towards the $6.00 resistance level.

Conversely, Boral remains range bound in a descending triangle, which has been in place since October 2009. Should Boral break to the downside of the descending triangle, the first area of major support is found at the 50% Fibonacci retracement level of $5.09. Should this level fail, the next key level of support lies at $4.77, which is the 38.2% Fibonacci level.

Our sell recommendation is based on our changed view that the US is taking much longer than hoped to begin its housing market recovery. Additionally, we are disappointed at the lack of non-dwelling commercial building activity in Australia that is not government induced.

We are therefore recommending Members take their profits on Boral now by selling at around $5.60 per share.

Getting a little expensive

Although we remain confident that net demand of uranium will rise significantly over coming decades the rate of increase is hard to predict. Resource focussed portfolios should rotate out of stocks with ‘toppy’ valuations into those offering better value. Given the alternatives on offer, Paladin Resources will be removed from the Fat Prophets US Portfolio.

Production for the quarter was a record 987,310lb of U3O8. Output should have been higher, but Kayelekera has been slower to ramp-up than the company planned. Inventory was reduced with sales of 1.1Mlb at an average price of US$56.54/lb which was above the prevailing spot price. The company entered into a new long term contract for delivery of 4Mlb starting in 2012.

Paladin's strategy selling under long-term contracts is currently working well. The average price received was significantly higher than the average spot price of US$45.44/lb.

The company did not release a 4Q09 financial update as it did for 3Q09. The last time that we reviewed the company we discussed the outlook for uranium and noted that 3Q09 continued a history of net losses after tax. We also stated our concern for the high earnings multiples that the stock was trading on but the market seems to have justified this because a price hike in uranium was just around the corner.

Paladin will not report a net profit at the current price of uranium which is US$42.50/lb. The spot price of U3O8 has been sliding since June 2007 when it reached US$137.30. Needless to say, high prices in 2007 triggered a huge increase in exploration budgets to find uranium. There were many successes.

On the supply side, production from Kazakhstan has increased and the US is still a net seller from stockpiles. Another round of de-commissioning nuclear war heads would push any price revival even further out.

What looked promising not long ago now looks weak. The uranium market looks like it will be in oversupply this year, with a surplus building for perhaps another two years. In the case of uranium the good times seem to always be just around the corner.

Australian uranium producer ERA has predicted a challenging year for 2010 and so it will also be for Paladin. Paladin’s MD Mr John Borshoff believes that the long term price needs to be US$75 to US$85 per pound to sustain the industry. The industry is a far cry from being profitable at the current price.

Uranium is a highly specialised industry. If the outlook is benign for the next 12-24 months, it is time to switch into a company better placed to take immediate advantage of the global economic recovery, like BHP Billiton (an integrated miner which as some uranium exposure).

Technically, we can see from the weekly chart of Paladin that the stock managed to break its long term downtrend during the course of 2009 but then consolidated sideways, failing to sustain a move above resistance around the $5 mark.

Taking a closer look at the daily chart we can see that since failing at resistance around the $5 mark the stock has continued lower, breaking support around the $3.70 level. Last week the share price gapped down through this support, after forming a bearish flag continuation pattern, which suggests more downside ahead.

"We would think that by 2030, most of the reactors more than 30 years old will have been permanently shutdown"

The new long term contract was with a major Asian utility and covers the delivery of 44Mlb commencing in 2012. The company has not named the customer but there are twenty nuclear power plants under construction in China, six under construction in South Korea, and five under cocurrently nstruction in India.

Paladin has reported that work is well advanced to send a trial shipment of uranium directly to China. This will test the logistics of shipping from Africa to Chinese conversion facilities.

Uranium miners are intently focussed on India and China because this is where the biggest growth in future demand will come from. In addition to reactors that are under construction, there areplans for another 37 planned for China, 23 for India, 13 for Japan and 8 for Russia. Looking even further ahead to 2030, there are 120 proposed for China, 37 for Russia and 15 for India.

At Paladin's Langer Heinrich mine, Stage 2 has ramped-up with all circuits operating at design capacity. Output from Langer Heinrich was 841,995lb of U3O8 for the quarter. Tonnes of ore crushed have risen during ramp-up to a record 177,427t in December. Paladin is confident that Stage 2 design output of 3.7Mlb per annum is currently being achieved.

Stage 3 expansion to 5.2Mlb per annum is forging ahead. Site earthworks have started but there has been an increase in the capital cost from US$71M to US$99.5M. The cost is higher because the scope of the project was revised to lower operating costs and/or to improve recoveries.

The Board has signed off on the Stage 4 expansion to 10Mlb per annum. An internal study has indicated an internal rate of return of 25% which is quiet reasonable. A 36,000m drilling program will be completed by mid-2010 which will convert inferred resources into indicated status for the Stage 4 feasibility study.

Kayelekera facility is having issues with the wash screen as it has not achieved the target throughput. The problem will be fixed with the installation of a secondary wash screening facility in 2Q10. Otherwise most areas of the plant are exceeding design capacity. Kayelekera produced 145,315lb for the quarter.

The long term outlook for uranium demand has not changed. Over the next twenty years global demand is expected to at least double, and in theory the price should stage a strong rebound. However, for the time being there is certainly no shortage of supply.



There has also been a trend in some countries like Switzerland, Spain, Finland and Sweden to expand production from existing reactors. If we look at the best estimate for installed capacity, the World Nuclear Association is forecasting the global nuclear capacity to rise from 372,693MWe to 872,115MWe in 2030, assuming that all the planned and proposed reactors are built.

What is not known is how many of the current 436 operable reactors will be decommissioned by 2030. Most of the older reactors were built with operating lives of 25-40 years. However, in recent times engineering assessments are increasing the operating lives of some reactors. For instance in the USA, 60 reactors have had their lives increased from 40 to 60 years. The life of one reactor in Japan has been increased to 70 years.

The IAEA provides data on the age distribution of operable reactors. There are 134 reactors over 30 years old. Sixty four reactors are over 35 years old and 9 reactors are over 40 years old. We would think that by 2030, most of the reactors more than 30 years old will have been permanently shutdown, although there can be no guarantee of this.

All that we can confidently say is that net demand will rise significantly over coming decades but the rate of increase is hard to predict. The outlook for supply will depend on price. It might take up to 2 years to bring the market back in to balance and move the price back above US$60/lb.

At this point in time, we can see no compelling reason to own Paladin. The stock is extraordinarily expensive trading on a 2010 PE of around 50 times. 

Accordingly, we are changing our recommendation from HOLD to SELL for all Members at around $3.48.

Thodey's big hang up

The NBN and its government progenitor are weighing on Telstra like a giant barnacle. Chief executive David Thodey is being driven to distraction by it as he seeks to conduct the Government’s due diligence on NBN Co in lieu of its own lack of a cost-benefit analysis. Telstra is also in danger of frittering away the promised benefits of its own transformation through poor customer service, pricey products and a withering fixed line legacy business.

Turning to the charts, Telstra broke to the downside from a wedge formation, which is a bearish sign. Telstra has since fallen from a high of $3.55 in mid December 2009 to a recent low of $3.12 on February 12. This represents an easing of 43 cents or -12.11%.

NBN distraction

When we last reviewed Telstra (FAT 448) following its annual investor briefing day, we concluded the company was still in a weak position regarding the process and terms of separation of its fixed line network. The government was in a hurry to score electoral brownie points by rushing its legislation through parliament and to unleash its NBN Co. to begin building its new network.

In the absence of the Government’s own homework (Treasury officials confirmed no cost-benefit analysis was requested), Telstra has been left to do all the leg work instead. Mr Thodey has approached the negotiations in a genuine manner but is facing up to a government keen on headlines and unworried about the detail. The Minister’s promised Christmas legislation was spun into a ‘terms of engagement’ agreement and the new parliamentary session is lurking as the next possible opportunity to shove it through.

In the meantime, Telstra has been working feverishly to nut out some of the basics with the government and the NBN Co. to establish the grounds for handing over Telstra’s fixed line business to the new entity.

We sympathise with Mr Thodey’s predicament. He is being asked to orchestrate the creation of a government utility by populating it with his own company’s core business – he’s handing over the crown jewels.

Worse still, the Government is using bushranger tactics to prise it from Telstra’s shareholders with little indication of fair compensation. Minister Conroy is brandishing pistols at Telstra’s Foxtel stake and threatening to exclude Telstra from acquiring any more spectrum to grow its mobile business.

Instead of attending the world’s most important mobile industry barbeque in Barcelona, Mr Thodey is staying home to help untangle the wires for the NBN negotiations.

PSTN trickle turns to a flood

One of the main premises for Telstra’s $10 billion transformation program was to catapult it into a world class telecommunications carrier. That meant building platforms that would not only deliver new technologies (mobile and internet) as good as or better than any other country, but also to facilitate the inevitable decline in traditional telephony business that these new technologies would precipitate.

In some ways, Telstra’s new architecture has hastened the demise of its old business. Nearly 10% of Australian homes now do without a fixed line connection and rely solely on mobile and wireless broadband connections. That’s fine as long as Telstra can maintain its share of those customers’ business in the substituted products.

During the half year to 31 December 2009, Telstra lost 153,000 residential fixed line connections in a total fall of 210,000 fixed lines. The associated revenue loss of $222 million was 6.9% down on the prior comparable half-year period. Mr Thodey noted that this was an acceleration of the trend and was “more severe than anticipated”. It was a combination of fewer phones and fewer phone calls.

The revenue decline may have been signalled in Telstra’s earlier profit guidance downgrades in October and December. The company is now guiding the market to expect revenue to decline by a low single-digit percentage. Telstra reported total fixed telephony revenue in the 2009 financial year of $10,766 million and total group revenue of $25,614 million.

Mobile and broadband engines sputtering

The flip side to this equation has always been that fixed line revenue declines were generally more than offset by growth in mobile and broadband revenue. And here is the next problem for Telstra to address.

Telstra’s mobile revenue increased 4.7% to $3,624 million in the half-year period, up $162 million on the prior comparable period. That wasn’t enough to help offset the decline in the fixed line business. Simplistically speaking, it was a major contributor to an overall 2.9% decline in Telstra’s group revenue in the half-year to $12,389 million.

Telstra reports its fixed line internet revenue as part of its fixed telephony segment. But the story here is integral to the wider problem for Telstra. Fixed line broadband connections dropped by 30,000 in the half-year (since 30 June 2009) to 2.24 million subscribers. The company believes it is seeing a maturing of this market, some substitution for wireless broadband products, and heavy price competition from other carriers (such as TPG Telecom, iiNet and iPrimus).

Tesltra’s response has been too slow. Other than offering more high-speed broadband plans, Telstra has been late in meeting the price-conscious lower end of the market with revised plans. This is presently being rectified but will take some time to gain traction.

In a broad sense, Telstra’s policy of being a supplier of premium communications products and therefore not compromising on price (a relic of former CEO Sol Trujillo’s time) has cost the company market share in both mobile and broadband internet markets. Again, the company has belatedly recognised this and is looking to make up lost ground in a highly competitive market.

The one bright spot was of course the growth in wireless broadband connections. Its share of the total broadband market in Australia has approximately doubled since 2008 to around 40% of all connections. That reflects the huge growth in wireless broadband services and the maturing nature of the fixed broadband market.

Spot fires

There were other problems to plague the result. Telstra’s directories business, Sensis, saw advertising revenue in its Yellow Pages directories decline and the group revenue dropped 8.9% to $950 million in the period. Operating profit increased by 4.8%, however, with the closure of the Trading Post print operations and good growth from the Chinese online businesses.

In Hong Kong, mobile users slowed the pace at which they trade up to newer devices. The CSL New World business delivered slightly lower revenue and operating profit.

The good news

Telstra remains on track to deliver its $6 billion free cash flow target. This was one of the primary goals of the multi-year transformation program and will form a strong basis from which the company can make some big decisions for the future – subject to the NBN process.

Capital expenditure has dropped significantly to approximately 14% of sales, which is now roughly in line with many other global telcos.

Operating expenses declined by 2.1% as fewer employees and contractors were required by the company, travel expenses dipped and costs generally across the company were well contained.

Debt levels have come down too, with reported net debt as at 31 December $1,282 million lower than at 30 June 2009. At $15,240 million of net debt, gearing is now 54.5%, just below the company’s target 55-75% range. Interest cover is therefore a very healthy 10.8 times, well above the target 7 times ratio. Clearly, the balance sheet is in very good shape.

Dividend doldrums

Which leads us to why the Board decided not to increase the dividend for long suffering shareholders? At 14 cents per share for the interim dividend (fully franked), the ordinary dividend has not been increased for over five years.

This was understandable while the company was spending vast amounts of money on the transformation program and was borrowing money in order to pay the dividend. This is no longer the case.

Telstra offered two reasons for the lack of increase in dividend. The company has insufficient franking credits to fully frank the dividend at a higher level. Of course, it could begin paying partially franked dividends but as franking levels diminish, so does the appeal of the dividend yield for some domestic investors.

The second reason relates to the uncertainty of the NBN process. Telstra’s reticence to spend money and its caution in increasing payments to shareholders is understandable with such a big change emerging in the competitive landscape.

Conclusion

The piecemeal approach of the Government to the NBN is a major headache for Telstra. Unfortunately, there is no short term remedy so the company must simply endure the process of separation and try to limit the damage to shareholder value.

Returning to the charts, the short term moving average (green line) has crossed below the long term moving average (red line) which is an indication of a switch of momentum from the upside to the downside. Support lies at the mid September 2009 low of $3.08, followed by major support at the mid-March 2009 low of $2.93.

The NBN process is simply too large and too significant to Telstra’s future and investors would do well to look elsewhere for now.

Hold IPL and SEK

Seek - Hold

First half profit for Seek’s 2010 financial year of $36.6 million was 13% higher than the prior comparable period.

That’s good news for the leading online employment advertiser as the GFC-induced lull in employment growth is beginning to turn around. However, the company’s revenue in its core employment business did not benefit from volume growth. The change in mix towards higher-yielding small to medium enterprises (SME) has lifted the overall yield of the division. This has been a conscious move by Seek to target more government sectors such as health and education as well as the SME businesses that are the basis for the structural shift away from print advertising to online.

As the 2010 calendar year unfolds, Seek is becoming more confident that the volume factor will also make a meaningful contribution, but has cautiously guided the market to expect second half profit to be ‘higher’ than the first half, without being specific.

The well established trend for employment advertising to migrate from print to online continues unabated. Job-seekers are far more likely to look for a job online (73%) and the number of jobs advertised online now outpaces those in print by four to one. But the share of revenue associated with those ads is still weighted in favour of print (59%). That is mainly a function of the pricing of print ads being much higher than online.

Seek helped its half-year profit along by reducing its marketing spend. This did not affect the ‘unaided awareness’ of Seek’s website in the company’s regular market research of this important factor. Seek remains a clear leader in the online sector in every aspect including the number of unique browsers, the number of advertisements and the total amount of time users spend on the website.

Seek’s developing education related businesses are progressing solidly. The domestic student sector is now fully consolidated in Seek’s accounts and is offering an increasing array of vocational courses. The international student business (IDP 50% owned) continues to work on its key relationships with 38 Australian universities and other higher education institutions.

The international investments in Brazil (Brasil Online) and China (Zhaopin) are beginning to take shape under Seek’s guidance but are yet to contribute meaningfully.

The dynamics of the company remain impressive and we expect the improving economy to underpin more growth in market share and in operating profit.

We are happy to retain Seek as a hold in the Fat Prophets Portfolio.


Incitec Pivot – Hold IPL

Management announced last week that construction of the Moranbah (central Queensland) ammonium nitrate (AN) manufacturing facility will recommence in May this year. Management previously slowed construction from February 2009 following a weak outlook for AN demand in the midst of the GFC. Uncertainty over project financing was probably also a factor.

In testament to the improved demand environment, some 90% of the project’s 330,000 tonnes of annual production is contracted to buyers. The facility will begin beneficial operation in the first quarter of 2012. The previous product plan was for beneficial operation in the fourth quarter of 2011. Given that more than one quarter has passed since the project was suspended, this represents an earlier beneficial operation date.

We are also pleased to see that there is no change to management’s previous budget estimate of $935 million.

Elsewhere in the industry, Norwegian fertilizer company Yara International recently announced an agreement to acquire America’s Terra Industries. The acquisition will form the world’s largest mineral fertiliser producer. The move also signals Yarra’s positive view on the likely recovery of the US market.

Yarra will acquire Terra for US$41.10 per share, equating to 14.7 times Terra’s consensus 2010 earnings. By way of comparison, Incitec trades on a consensus 2010 price to earnings ratio of around 14 times, falling to below 11 times consensus 2012 earnings.

We initially recommended Incitec as a buy at around $2.65 in June 2009 and again at around $3 in September. We continue to believe that the industry as a whole will benefit from resurgent fertiliser demand and that Incitec’s 2009 earnings mark a cyclical low. Nevertheless, the stock’s rally to current levels of around $3.50 has seen the valuation return towards fair value. The valuation of the Terra deal certainly supports this view.

As such, we are adjusting our view on Incitec from a buy to a hold at this point.

As an aside, Incitec operates to a September yearend and so will not participate in the current Aussie earnings season. The company will report its first half performance on 10 May 2010.