Mark Draper

Mark Draper

Mark Draper (GEM Capital) and Shannon Corcoran (GEM Capital) talk with Nathan Bell (Head of Research at Intelligent Investor) about the investment cases for Sonic Healthcare, Telstra and Magellan Financial Group.

 

 To listen to the podcast, click on the link below.  Podcast time 41 mins.

 

Music clip by Joel Laundy

Wednesday, 06 October 2021 08:55

The Great Energy disconnect

Each month Mark Draper (GEM Capital) writes for the Australian Financial Review.  Here is the column that appeared in the 6th October 2021 edition.

 

The oil and gas sector is one of the most unloved sectors in the market according to Luke Smith, Resources Portfolio Manager at Ausbil Investment Management.

The demand destruction for energy resulting from pandemic lockdowns saw oil futures briefly trade as a negative value in April 2020 as oil demand endured its largest fall since 1945.  Since that time the oil price has recovered from around US$20 per barrel to now over US$70 per barrel.

Hugh Dive, CIO at Atlas Funds Management adds that LNG is currently selling for around 4 times the price it was 12 months ago.

Dive says that normally share prices in energy companies are highly correlated to the underlying prices for oil and gas, but currently there is a disconnect.  Despite the oil price rising 250% from US$20 per barrel to over $70 barrel since April 2020, the share price of Woodside has barely moved, and the energy sector trades well below their pre COVID levels.

Gaurav Sodhi, analyst at Intelligent Investor believes that oil equities are severely mispriced by investors who have given up on stocks that don’t tick the ESG box (Environment, Social, Governance).  

Smith says that the long term oil demand outlook is structurally challenged for reasons including the automotive industry moving to electric vehicles over combustion engines.  This is causing some investors to question whether the current strength in energy prices is sustainable.  Of the broader commodity set, oil markets have been one of the hardest hit by COVID, and given the materiality of transportation to demand, is yet to fully recover.  Transportation represents 60% of overall oil demand and during COVID lockdowns passenger vehicles, buses, freight, maritime and aviation transportation was severely impacted.

We have seen a recovery in road and maritime activity according to Smith, however uncertainty remains around the return of international travel.  Jet fuel represents 7% of overall oil demand.

 

 

Dive is of the view that world oil markets are rebalancing after the collapse in demand during 2020, which can be seen in the chart.  While policies in Western countries will reduce oil demand through moves to clean energy, these are likely to be offset by increases in demand from China, India and other Asian countries.

Smith’s near term bull case for energy revolves around the lack of investment in new supply since the prior downturn in oil markets in November 2014.  He believes that the combination of reduced investment overall, and misdirected investment away from large scale oil developments, supports the expected tightness in markets over coming years.

Dive says that climate change remains a risk to the energy sector, but paradoxically these concerns may see few new major producing assets being developed, putting upward pressure on oil prices.  While rich countries such as Norway can mandate that all taxi’s are Tesla’s,  developing nations are unlikely to accept lower growth rates and slower reductions in poverty to meet climate targets set by rich European nations.

The recent fund manager survey conducted by BofA Securities, showed the energy sector was the most underweight sector in the market relative to its history.  

Sodhi is of the view that oil prices are likely to be higher than most anticipate.  He says that there is little doubt that equity prices don’t reflect oil prices, and that it is easy for investors to ignore the energy sector when energy producers are not making money.  As oil producers start to print good cash flow numbers, perhaps as early as next reporting season, the market will either change its mind or investors will get rewarded with dividends.  

Ausbil’s preferred investment in the sector is Santos due to superior management and its diverse portfolio of low cost assets with an exceptional growth outlook.

Dive and Sodhi like Woodside which they describe as ‘fantastically cheap’ with a cost of production below US$5 per barrel, low gearing at 19% and a huge franking account balance.  

The case against investing in energy according to Sodhi revolves around the possibility of the Saudi’s potentially wanting to monetise their huge resources faster than expected.  They could flood the market with oil, thinking that getting something for oil is better than leaving it stranded.

Energy shares are cheap and investors need to assess whether they represent good value or are a value trap.

Tuesday, 14 September 2021 13:19

Investment GEMs podcast - September 2021

Mark Draper (GEM Capital) and Shannon Corcoran (GEM Capital) recently spoke with Clay Smolinski (Co-Chief Investment Officer, Platinum Asset Management) about whether he is optimistic or pessimistic about COVID.

We also spoke with Clay about what the recent regulatory changes introduced by the Chinese Government mean for investors ..... plus more.

Click on the image below to listen to the podcast.

 

Thursday, 09 September 2021 13:43

Utilities - high income with growth

Investing in utility companies is the equivalent of buying “Water Works” or “The Electric Company” on a monopoly board.  It’s not the excitement of owning Mayfair, but they pay a steady income to their owners.  Utility owners on the ASX also enjoy relatively high levels of income, some as high as 6%, within a stable business.

Utilities according to Hugh Dive, Portfolio Manager at Atlas Funds Management are characterised as businesses that have some form of monopoly, extensive capital to construct their assets, steady demand and varying degrees of government regulation.

 

Gerald Stack, Head of Infrastructure at Magellan Financial Group likes to illustrate the idea of utilities by referencing electricity.  There are four distinct aspects to the provision of electricity starting at power generation.  The electricity is then transported over high voltage transmission lines before the voltage is reduced and transported over distribution lines to consumers.  The final stage is that electricity is marketed to consumers through retailers.  

Only the transmission lines and the distribution lines are considered utilities by Magellan as they are the only parts of the electricity chain that are monopolies.  Generators and retailers are excluded by Magellan as they are subject to competition and are therefore generally not considered utilities.  This is an important aspect of investing in utilities, as investors owning parts of the chain that are subject to competition and price changes, will receive a different outcome.

Stack believes that investors should own utilities for their predictable, reliable profitability which typically means that dividends are also reliable and predictable.  

Dive says that utilities can provide a hedge against market falls.  During the sharp 21% ASX fall in March 2020, regulated utilities were among the least impacted stocks on the ASX.  Spark Infrastructure and APA Group only declined by 4% while Ausnet posted a 1% gain.

Investors can gain exposure to Australian utilities via ASX companies including Spark Infrastructure (powerlines and transmission), Ausnet (gas pipelines, powerlines and transmission) and APA Group (gas pipelines).  Alternatively investors can access exposure via Infrastructure funds, which also have the benefit of being able to seek global opportunities.

Dive and Stack both agree that the main risks to investing in utilities relate to regulation and interest rates.

Investors need to understand that utilities can earn income that is regulated, or revenue which is contracted.  Typically regulated income allows the utility to earn what the regulator assesses as a fair rate of profit and usually the regulatory regime is fixed for a period before being reviewed.  For example electricity distributors in Australia usually operate under 5 year regulatory periods.  Contracted revenue occurs when there is a legal contract for services between the utility and the end user.  

Investors also have to feel comfortable with the jurisdiction they are investing in.  Australia, UK, US and Canada are generally considered regions where investors have comfort in the regulatory framework and can obtain recourse through the legal system.  Some developing countries require more caution in this area.

Utilities are often financed with a significant amount of debt, therefore a change in interest rates can have a material impact on operating profits without the protection afforded by regulation, according to Stack.  However the regulatory regime will normally allow for protection from the impact of changes in interest rates so that profitability is largely unaffected.  Changes to interest rates can not only impact operational profits, but also the assessment of fair value of the utility by the markets.  Generally lower interest rates result in higher utility values and of course the reverse applies.

A significant pick up in inflation that could lead to central banks raising interest rates could lead to a reduction in appetite for investment in regulated utilities.

While utilities are traditionally known as an income play for investors, there is potential too for growth.  The need for communities to reduce carbon emissions to ‘net zero’ offers significant opportunities for electric utilities.  Key steps in the transition include significant increases in the amount of renewable energy and the electrification of economies including electric cars.  Renewable energy projects and the need to increase the capacity and reliability of the electricity grid offer significant investment opportunities.

High income with growth, it’s little wonder that the utilities sector is starting to attract takeover attention.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article appeared in the 8th September 2021 edition

Wednesday, 11 August 2021 07:56

Smart ways to play reopening trade

To many Australians right now, the re-opening of the economy must seem like a mirage.  Investors should consider the opportunities that come from depressed share prices in sectors hit hard by lockdowns, otherwise known as the re-opening trade.

The re-opening trade seeks to invest in businesses that have been negatively impacted by COVID-19 and are trading well below their valuation based on a normal operating environment.  Obvious candidates include travel, shopping centres, airports and even private hospitals which have suffered due to cancellation of elective surgery.

Investors must ask themselves whether the current state of lockdowns and border closures is a permanent feature or not.

Nathan Bell (Head of research, Intelligent Investor) says that reopening the economy will be as bumpy as it is inevitable, as the cost to taxpayers and businesses is already stratospheric and Australia can't afford to be left behind the rest of the world.

So far, the number of hospitalisations and deaths in countries with highly vaccinated populations that are reopening, such as the UK, are low for those who've been vaccinated. Provided this continues, international borders between similarly vaccinated countries will be opened according to Bell.

The vaccination rates in the US, UK, China and Europe are high, evidenced by the graph below.

 

In Europe the average number of departing passengers hit 2.1 million per day in the last week of June, up 39% on the 1.5 million recorded just three weeks before.  

Hotel occupancy in the US has doubled from 35% to 70% in the first six months of the year and US airlines expect passenger numbers to be close to normal within a matter of months.  Dan Moore (Portfolio Manager, Investors Mutual) says that US consumer spending is actually ahead of pre-COVID levels.

In China, 99% of pre-COVID aircraft are flying again.  The International Air Travel Association recently forecast that global passenger numbers recover to pre-COVID levels by 2023.

These statistics indicate that Australia could head toward a speedy recovery in the travel sector once the vaccine program becomes well advanced.

Moore is looking at countries who are ahead of the curve with vaccinations and analysing data such as mobility, employment activity, consumer spending, housing and industrial production as a way of developing a lead indicator for Australia.

Moore’s advice to investors seeking to profit from the reopening trade is firstly to look for depressed share prices, but checking this is not due to a large dilutive equity raising.  He then suggests investors ask themselves whether the company’s future prospects are permanently impaired.  Moore favours focussing on companies with a strong balance sheet so they can weather short term set backs, and are industry leaders.  He cites United Malt, one of the largest global suppliers of malt to the beer and whiskey industry as a good example.

Moore likes Virgin Money, a UK bank that is priced at a fraction of its Australian counterparts when measured using a price to book basis.  The reopening of the UK economy has seen an increase in consumer spending, resulting in growth in credit card lending and mortgages for Virgin Money.

Moore is wary of some travel companies that do not have strong balance sheets.

Bell’s advice about the best ways of playing the reopening trade is “carefully”.  He says that  many stocks impacted heavily by COVID have already had a full recovery baked into their stock prices, while others have vulnerable balance sheets that could disintegrate if the economy doesn't get back to 'normal' relatively soon.

Bell adds that Stocks such as Star Entertainment, Auckland Airport and skydiving company Experience Co will be direct beneficiaries of the great reopening with solid balance sheets and plenty of room for their valuations to increase as profits and dividends recover.

Another sector that has been hard hit by the pandemic is the energy sector whose share prices are not yet reflecting the recovery in the oil price.

The key risk facing investors choosing to invest in the re-opening theme is a return to lockdowns in countries with high vaccination rates such as the UK, US, the Nordic countries and Israel.  

Investors will learn a great deal about this in the coming months.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article was published on Wednesday 11th August 2021.

Wednesday, 11 August 2021 07:52

Smart ways to play reopening trade

To many Australians right now, the re-opening of the economy must seem like a mirage.  Investors should consider the opportunities that come from depressed share prices in sectors hit hard by lockdowns, otherwise known as the re-opening trade.

The re-opening trade seeks to invest in businesses that have been negatively impacted by COVID-19 and are trading well below their valuation based on a normal operating environment.  Obvious candidates include travel, shopping centres, airports and even private hospitals which have suffered due to cancellation of elective surgery.

Investors must ask themselves whether the current state of lockdowns and border closures is a permanent feature or not.

Nathan Bell (Head of research, Intelligent Investor) says that reopening the economy will be as bumpy as it is inevitable, as the cost to taxpayers and businesses is already stratospheric and Australia can't afford to be left behind the rest of the world.

So far, the number of hospitalisations and deaths in countries with highly vaccinated populations that are reopening, such as the UK, are low for those who've been vaccinated. Provided this continues, international borders between similarly vaccinated countries will be opened according to Bell.

The vaccination rates in the US, UK, China and Europe are high, evidenced by the graph below.

 

In Europe the average number of departing passengers hit 2.1 million per day in the last week of June, up 39% on the 1.5 million recorded just three weeks before.  

Hotel occupancy in the US has doubled from 35% to 70% in the first six months of the year and US airlines expect passenger numbers to be close to normal within a matter of months.  Dan Moore (Portfolio Manager, Investors Mutual) says that US consumer spending is actually ahead of pre-COVID levels.

In China, 99% of pre-COVID aircraft are flying again.  The International Air Travel Association recently forecast that global passenger numbers recover to pre-COVID levels by 2023.

These statistics indicate that Australia could head toward a speedy recovery in the travel sector once the vaccine program becomes well advanced.

Moore is looking at countries who are ahead of the curve with vaccinations and analysing data such as mobility, employment activity, consumer spending, housing and industrial production as a way of developing a lead indicator for Australia.

Moore’s advice to investors seeking to profit from the reopening trade is firstly to look for depressed share prices, but checking this is not due to a large dilutive equity raising.  He then suggests investors ask themselves whether the company’s future prospects are permanently impaired.  Moore favours focussing on companies with a strong balance sheet so they can weather short term set backs, and are industry leaders.  He cites United Malt, one of the largest global suppliers of malt to the beer and whiskey industry as a good example.

Moore likes Virgin Money, a UK bank that is priced at a fraction of its Australian counterparts when measured using a price to book basis.  The reopening of the UK economy has seen an increase in consumer spending, resulting in growth in credit card lending and mortgages for Virgin Money.

Moore is wary of some travel companies that do not have strong balance sheets.

Bell’s advice about the best ways of playing the reopening trade is “carefully”.  He says that  many stocks impacted heavily by COVID have already had a full recovery baked into their stock prices, while others have vulnerable balance sheets that could disintegrate if the economy doesn't get back to 'normal' relatively soon.

Bell adds that Stocks such as Star Entertainment, Auckland Airport and skydiving company Experience Co will be direct beneficiaries of the great reopening with solid balance sheets and plenty of room for their valuations to increase as profits and dividends recover.

Another sector that has been hard hit by the pandemic is the energy sector whose share prices are not yet reflecting the recovery in the oil price.

The key risk facing investors choosing to invest in the re-opening theme is a return to lockdowns in countries with high vaccination rates such as the UK, US, the Nordic countries and Israel.  

Investors will learn a great deal about this in the coming months.

 

Every month Mark Draper (GEM Capital) writes for the Australian Financial Review - this article was published on Wednesday 11th August 2021.

Wednesday, 14 July 2021 07:53

Retail investors guide to IPO's

Every month, Mark Draper (GEM Capital) writes an article about investing for the Australian Financial Review.  

This  month he writes about how retail investors should think about IPO's (initial public offerings or floats).  This article appeared in the AFR during July 2021.

 

Every retail investor dreams about doubling their money on day one of a hot IPO (initial public offering).  But Myer, Dick Smith and Nuix demonstrate that not all IPO’s turn out to be profitable.  With the likelihood of a flood of IPO’s in the second half of the year, investors should dust off the IPO playbook to ensure they don’t end up owning the next Dick Smith.

Hugh Dive (Chief Investment Officer, Atlas Funds Management) believes that the most important question for an investor to ask is who is the vendor and why are they selling.  Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business, or the vendors are using the proceeds to expand their business.  IPOs, where the owners are looking solely to exit the business entirely (such as in the 2009 Myer IPO), tend to see poor outcomes for investors.

Investors also need to understand whether the vendor will continue to own any shares post IPO and ‘have skin in the game’ and for how long.  While continued vendor ownership doesn’t guarantee success, it does result in some alignment of interests with new shareholders at least in the short term.

Vince Pezzullo (Deputy Head of Equities, Perpetual) firmly believes that any IPO candidate must fit in with the investor’s usual investment strategy.  Retail investors in the past have been guilty of chasing a quick trading profit via IPO’s, often deviating from the types of investments they would usually make.  

Matt Williams (Portfolio Manager, Airlie Funds Management) agrees and says that while it might sound simple, the IPO has to be a good business with good prospects.  Some ingredients to determine whether the IPO is a good business would include the level of recurring earnings, debt levels and whether the industry sector has a favourable outlook.

The difficulty facing retail investors wishing to participate in IPO’s is access to information.  IPO investors are confronted with the task of understanding a new company with limited and often misleading financial data often referred to as pro-forma accounting within a brief marketing period.  Some of the accounting tricks that IPO’s have used in the past include amortising expenses so costs are transferred from the profit and loss account to the balance sheet, writing down of inventory pre IPO to artificially boost profitability post IPO, and cutting regular maintenance expenditure to boost profit.  Investors would be wise to read the cash flow statements and balance sheet positions in the prospectus to look for red flags.

The prospectus is generally considered an unfriendly document to retail investors due to its length and complexity.  Williams says that before investing in an IPO it is critical investors do their homework so they know what they are buying.  This involves reading the prospectus, particularly the ‘bad stuff’ including the Key Risks section.  Usually in the key risks section there is information showing the sensitivities to profitability should certain conditions change such as interest rates, currency, input costs etc.  Williams believes this is critical in assisting the investor make a decision on what to do next after the IPO lists.

If an investor can get comfortable with the quality of the IPO on offer, Pezzullo then suggests looking at whether the price is attractive.  Assessing the IPO price compared to other listed companies in the IPO’s peer group would be a useful measure of this.

Dive says there is a fundamental informational imbalance between the seller and the buyer of the IPO.  The seller knows the business intimately and is choosing the time to sell their stake in the business to be IPO’d at the time when conditions are most favourable to the seller.

Dive advises to ignore the hype around recent IPO success stories and look at every IPO from the initial position that the seller is trying to trick you into buying something that they are selling and then slowly work backwards towards a position of trust.

Finally, Warren Buffett says about IPO’s "It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer."  When it comes to IPO’s - Buyer beware!

 

With some again calling for the re-introduction of a mining tax, does this signal the top of the iron ore price cycle?

Three of the largest 20 companies on the ASX are iron ore miners, so Australian investors need to be across the iron ore price.

For most of its traded life, iron ore was sold on a contracted basis and sales were direct between two parties.  This was a stable period for prices where they averaged between US $20-30 per ton until a spot market with daily pricing was introduced in the mid 2000’s.

Since this period, the spot price has probably averaged US$50 – 70 per ton according to Gaurav Sodhi (Deputy Head of Research, InvestSmart).  Today it trades at over US$200 per ton.  Sodhi says that this is an extremely unusual event to see iron ore at over US$100 per ton and has only happened once before.

 

The current high price is a result of rising iron ore demand from China, Australian miners operating at capacity and supply constraints from Brazil who is the second largest iron ore producer according to Hugh Dive (Atlas Funds Management).  The dam collapses in 2019 and COVID in 2020 removed around 85 million metric tons (MT) from Brazil’s annual production to around 300MT.  For perspective, China currently imports around 1bn MT per year.

The similarities to 2011, the last time the iron ore was very high, are that demand is being driven by a US$506bn stimulus plan announced by the Chinese Government in May 2020.  This is slightly smaller than the US$586bn package announced during GFC which saw the building of steel intensive bridges, rail lines and airports.  The difference to 2011 so far is that the supply response this time is slower.

During a boom though it is usually difficult to see what will bring it to an end.  Sodhi highlights producers in the Pilbara are currently trucking iron ore hundreds of km’s to port at a cost of US$100 per tonne and still making a very high margin.  

Dive believes that there are 5 events that could lead to lower iron ore prices.  He says that the period between 2012 and 2016 provides a good road map as to how the ‘air’ gets taken out of the iron ore price, though the situation is likely to unravel faster in late 2021/22.  

  1. Brazil moves back to full production of around 380MT pa with goals to increase to 400MT.  Current annual production is forecast to be around 335MT this year, and appears to be rising
  2. Chinese consumption of iron ore slows as the impact of stimulus measures fade
  3. High prices incentivise production.  Mt Gibson Iron recently opened up closed mines that had been flooded.
  4. New entrants into the market such as Mineral Resources expand from contract mining and mining services to producing their own iron ore
  5. In the medium term, China naturally shift to using electric arc furnaces (EAF).  EAF utilises scrap steel and electricity rather than iron ore and coking coal to produce steel.  As an economy matures it starts to generate scrap steel from things including buildings that are torn down and cars that are recycled.  In the USA, 70% of steel is produced by EAF, whereas in China, it is only 15%.

Should the iron ore price fall, all iron ore miners profits would be impacted, however Sodhi says that the most exposed are high cost producers who have entered the market to exploit current conditions.  He says that small producers like Fenix won’t be able to sustain operations in a ‘normal’ environment.

Dive highlights that iron ore accounts for 100% of earnings for Fortescue while only 79% for Rio and 69% for BHP.  Mt Gibson Iron generate all of their earnings from iron ore.

Low cost producers such as BHP are likely to be less impacted as they can still make healthy margins even when iron ore is US$50 - $70 per ton, but investors should ‘google’ BHP’s price chart during the 2012 – 2016 iron ore collapse.

Iron ore investors who are enjoying high share prices and dividends, should ask themselves whether the current iron ore prices will hold forever and, (here are the 4 most dangerous words for investors), whether ‘it’s different this time’.

 

This article was written by Mark Draper (GEM Capital) and was featured in the Australian Financial Review on Wednesday 16th June 2021

Tuesday, 18 May 2021 12:54

Semiconductors - the new oil

Semiconductors (semis) are to the technological revolution what oil was to the industrial revolution.  Today there is a severe global shortage of semi’s, and it matters.

The shortage has resulted from a combination of natural disasters impacting manufacturing regions on top of what was an already fragile supply situation.  Severe frosts in Texas saw Intel shut production for a few weeks, and Taiwan, which is responsible for over 50% of all semi manufacturing, is suffering from severe drought. Semi manufacturing is a very water intensive process according to Delian Entchev (Senior Analyst, Aoris Investment Management).  He says that up to 20 million litres of water a day is required for one factory.

The shortage matters not only to those investors with exposure to semi companies, but investors also need to think about the domino effect on other industries that rely on semis.

The obvious products relying on semiconductors are PC’s, tablets and smartphones but many investors would be surprised to learn that semis are in other household items such as a fridge, lawn sprinkler, tv and microwave. 

The auto industry is another large market for semis and has been one of the high profile casualties of the chip shortage.  Several car factories around the world were forced to temporarily shut down production due to insufficient supply of semis.  Ford Motor Co anticipates a $2.5bn chip shortage cost. 

Recently the CEO’s of Cisco and Intel, respectively major buyers and producers of semi’s, predicted that the shortage could last another couple of years because demand continues to increase and production can’t be ramped up overnight.

Runways for Growth

Entchev says that the average petrol engine car contains around $100 of semis while a full battery electric car contains up to $1,000 of them.  Clearly the shift to electric cars will provide a growth runway for semis.

Douglas Isles (Investment Specialist, Platinum Asset Management) says that other growth tailwinds for semis include the move to 5G, the Internet of Things, autonomous driving, artificial intelligence and machine learning. 

The semi design industry generated revenues of US $466bn in 2020 and leading IT research firm, Gartner estimates that the industry can grow on average by 5-6%pa over the next 5 years.  

Entchev says that there are many different ways that investors can participate in the semi industry growth including:

-       Suppliers of materials such as silicon wafers on which semis are built

-       Producers of semi manufacturing equipment

-       Companies that provide outsourced manufacturing of semis

-       Software used to design semis

-       Chip designers such as Intel and Samsung

Isles says that Platinum Asset Management has had a large exposure to the semi sector since 2018, but their investment in Samsung goes back over 20 years.  Samsung has evolved to become a dominant player and today adjusting for cash on its balance sheet trades on about 12 times forward one year earnings (source: Factset)

Entchev says that Aoris’ preference is to invest in businesses that indirectly benefit from the advancement in semis, as it is very difficult to predict which semi companies will win in the future. A good example is Accenture, the largest global IT consulting business, which helps its customers deal with the technological changes that semis enable, like cloud computing.

Investors could also gain exposure to the semi industry through global managed funds and global ETF’s.

Risks

The semi industry is fast moving where customer needs can change quickly resulting in today’s products becoming redundant.  

It is generally considered that this is a cyclical industry, with two of the largest end markets being to automotive and industrial customers, however Isles said following industry consolidation the economics of semis has improved.

And then there are the geo-political uncertainties surrounding Taiwan which dominates semi manufacturing.  One of the most important developments in the semi industry has been outsourced manufacturing.  In the 1970-2000’s semis were all made internally by the companies that designed them.  Taiwan Semiconductor Manufacturing Company (TSMC) with support from the Taiwanese government created the first company dedicated to manufacturing designs from other companies.  Today TSMC has 52% share of all semi manufacturing and over 80% share of the most advanced chips.

The electronic components of devices that we take for granted today are an important long term investment thematic.

 

 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review during May 2021.

In the last 5 years Telstra shareholders have had little to cheer about as they have watched the NBN punch a hole in earnings, resulting in a share price slide and dividend cuts.  That is now changing.

In the recent profit result, not only did Telstra forecast earnings growth for the first time in 5 years, but also outlined a timetable to change its legal structure by splitting the company into 4 parts.

The proposed legal structure within the Telstra Group, expected to be completed by December 2021, includes:

  • InfraCo Fixed, which would own and operate Telstra’s passive or physical infrastructure assets: the ducts, fibre, data centres, and exchanges that underpin Telstra’s fixed telecommunications network.
  • InfraCo Towers, which would own and operate Telstra’s passive or physical mobile tower assets, which Telstra is looking to monetise given the strong demand and compelling valuations for this type of high-quality infrastructure.
  • ServeCo, which would continue to focus on creating innovative products and services, supporting customers and delivering the best possible customer experience. ServeCo would own the active parts of the network, including the radio access network and spectrum assets to ensure Telstra continues to maintain its industry leading mobile coverage and network superiority.
  • International, will be established under a separate subsidiary within Telstra Group and includes subsea cables

 

After being negative on Telstra for years, Gaurav Sodhi (Analyst, Intelligent Investor) believes the new structure is a good move.  He says that there are a lot of assets within Telstra that aren’t being adequately valued.  Separating them will recognise the value of infrastructure style assets that can generate stable, recurring revenues, resulting in a far higher valuation than the present share price.  Sodhi’s sell trigger of $5 on Telstra provides some guidance on the value he sees.

The Towers business carries a modest asset value of just $300m on Telstra’s balance sheet after heavy depreciation.  Once towers are in place and connected to the fibre backhaul, they are expensive to replicate and therefore extremely valuable.

Experience overseas shows that Telstra is following a well trodden path as it seeks to increase shareholder value.  Will Granger (Analyst, Airlie Funds Management) says that mobile tower companies can trade at EBITDA multiples (earnings before interest, tax, depreciation, amortisation) ranging between 21-27 times earnings.  Telstra by comparison currently trades on an EBITDA multiple of around 8 times.  Granger believes through a partial or full sell down of these assets, Telstra can realise this valuation arbitrage and increase shareholder returns.

Gaurav supports this view by referencing American Tower which is listed in the US.  It is the largest tower business in the world which bought AT&T’s long distance phone lines years ago and used them to host mobile infrastructure and are today valued at over US$100bn.  American Tower trades at over 20 times EBITDA while AT&T trades at just 7 times.

Granger adds that Vodafone spun off its mobile tower assets in March of this year on an EBITDA multiple of around 20 times.

Granger sees few downsides for the proposed restructure other than Telstra risking their network advantage if the mobile towers separation is not properly structured.

Sodhi agrees and said that American Tower and Crown Castle have been so successful because they host multiple networks from a single piece of infrastructure.  They have been able to scale nicely.  For Telstra’s tower businesses to do the same, Telstra would have to allow other networks access to those sites.

There is a clear trade off here.  In order to maximise the value of its infrastructure, Telstra needs to allow other networks access to it.  If it does that, it risks its network superiority.  Sodhi believes that Telstra is likely to opt for a lower value for its infrastructure to protect its network superiority.

The ACCC is another risk to this restructure.  Sodhi says that while its been hard to predict the reaction of the ACCC in recent years, he doesn’t believe there would be too many objections.  A split of the towers and infrastructure assets potentially opens the door to other networks also utilising those assets which could even the playing field.

Telstra has been a serial underperformer over the past 5 years, but investors must be forward looking and responsive to new information.  The split is new and its happening this year, and investors may do well to reconsider Telstra.

 

 

This article was written by Mark Draper and appeared in the Australian Financial Review during the month of April 2021.

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