Five stocks to buy now

[Pages:11]Five stocks to buy now

Special report | published February 2013

Intelligent Investor PO Box Q744 Queen Vic. Bldg NSW 1230 T 02 8305 6000 F 02 9387 8674 info@.au .au

Intelligent Investor

A letter from the Research Director

Dear Member,

The sharemarket has been on a tear over the past few months, leaving many wondering whether this is aaioofdtubutetwhroitmltleieTuhTEovAnrhetheexoeteattrerksthrusogeoeeemfsprmocpesegforo1otueaeosn3rsttttleenuoty%mrborcermpiaelcecaotrikcu.inakwckasAsrecnna2sftiaitntiishs0necdnhwt1otasrdoee2htclethrhkmt.eoarehaseRnausietosersltcAdnrawcometrliehlantuebhOatnatglroeidrettrsrkisddsgdwetgasaapottlinhonikhrfnodaeeewbissrttlsahli'd:asaetwl1ehTirnvel5hheahitcthdae%rehnogiapetneoehnrnpnvieenoddrdeebaerminssi2ssaititseoemt0ysao'dsn1ovwrora1saentluwio,oinclwrftmraohoeotobtihyvtrtholulfheaeeestrttrthtxnw,heafertptrs.oreohoatesmcraemoieiecvcnapobnakerelnieyttkelahqaftepridtbuewdnteailieilehertsbneintreabmgueecsssesslehmesthraaeioxam.slnalpwubeW.dtaelonhhdOychudeenthnibtiirl'nvaemetetighst.dihonsteelaoeoerfnnelymsusoeodsteaantieschnttr.eotkecrsaaertwdhhoctaoeioytctniaohkvuwddseugti,,.rhhtlohloOooeyrostxwnephkepaeeteryhtps,hcipsereataiionclamtdoestdositiidoshtfyimonfveeteensort.r, adtetrpaIFotcosfteriitva,tehttuhereraettm'ussrofnnisvostetcpstooaumrcbth,eewswstenohecaeketxszpm;eeWdacyota.totT.hlWhweasooteo'rstlswhwtosoh,craAtkhtLsstEh,toiSPsyrdrdoeenppleievoyerrttAryiihsrTpigarouhllrstastab,innSogdyuldetR.n-edesiygMiAteidrrepitnuorrpnta,srB.tiWCcuoPlmaTrprhuaarsvetedatnwhdeitRhpeoasteMtneertimda.l

thoedaAlWothLobEyoe,rtleSwtetyuodr.rrnnthessyinaAnyirodpuoRrretbsaaMnnkdedaBcoWcfoPfuenrTrtlueessatscahinlsycoeoamorfefaenbrduinetcmtohmpehieracsyiaizesinlhdgsfAlooewfsasorpoa'sruenpddoein6pt%eanbdaotaubctulebrirraednnsdtinpthrtiheceeyshg, eapnnudet.rtaintge

reliable growth from reinvesting the capital. These stocks offer your portfolio a strong

backbone

in

uncertain

times;

an

attractive

balance

of

safety,

income, growth and overall healthy returns. In this report we'll explain why.

Yours sincerely,

Nathan Bell,

Research Director, Intelligent Investor Share Advisor

CONTENTs

Put some Woolies in your basket A tempting ALE Sydney Airport on the radar BWP Trust nails it ResMed's dream run continues

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3 5 7 8 9

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Special report | Five stocks to buy now

Several stocks in this report are exposed to a single product (ResMed), a single asset (Sydney Airport) or a single tenant (ALE and BWP). This introduces a degree of risk and we therefore suggest you pay close attention to our recommended portfolio limits.

Blue chip industrial | James Carlisle

Put some Woolies in your basket

Woolworths' sheer reliability gives it an edge in an era of low returns.

When Ben Graham explained the term margin of safety he said that for `the ordinary common stock, bought for investment under normal conditions, the margin of safety lies in an expected earning power considerably above the going rate for bonds.'

Generally, Graham satisfied this requirement by focusing on price. But there are other ways to achieve it. Woolworths does so through sheer dependability: in almost all conceivable circumstances it offers earning power ahead of bonds, and in most cases considerably so.

Most people are familiar with the idea of Woolworths as a `defensive' stock. It makes money from selling `staples' that people need even when times are hard. But it runs deeper than that.

Woolworths provides low-priced ubiquitous items that people want to buy quickly, all at once, and close to home. Whether we're talking about toilet paper or early-season mangoes at $4 a pop, it's the retailer that adds the value for the customer in this situation, not the supplier.

Even if you buy your groceries online, you probably want to get them from one website and one delivery or collection point. It makes little sense to get these items piecemeal from distant locations--much better to use Woolworths' established distribution network.

It all adds up to tremendous earning power, with Woolworths achieving a return on capital employed (ROCE) of 25% in 2012.

Resurgent Coles

Greater and more effective competition is one threat to these returns. Coles is resurgent under Wesfarmers' stewardship, Aldi is expanding and Costco is entering the Australian market. But Woolworths has entrenched strengths from its excellent store locations, distribution network and low cost of doing business.

Possibly the biggest threat is of management, quite simply, stuffing up. Early indications are that new chief executive Grant O'Brien is doing well, but supermarket chains have made a mess of things up in the past so it's not a possibility we should discount altogether.

So how bad could it get? The obvious lousy performance benchmark is Coles before its 2007 takeover by Wesfarmers.

Back then, the earnings before interest and tax (EBIT) margin for Coles' food and liquor division sank as low as 3.4%, after bumbling along at between 3.6% and 3.9% for the previous three years.

These numbers were so far below par (in 2007 Woolworths' supermarkets division managed an EBIT margin of 5.0% and in 2012 it made 6.5%) that they didn't have to be tolerated for long before takeover interest began to stir. Wesfarmers eventually paid 24 times Coles' depressed earnings.

Another struggling supermarket is the UK's Tesco, which we wrote about recently in our special report--Ripe for the Picking: Overseas stocks to buy right now. Its shares tumbled

KEY POINTS

Margin of safety achieved through reliability, price and value

Company has `earning power' ahead of bonds in almost any scenario

Investments being made could raise returns above 10%

Woolworths | wow

Price at review Review date Market Cap. 12 mth price range business risk Share price risk max. portfolio weighting Our view

$31.41 1 Feb 2013

$39.0bn $24.22?$31.97

Low Low?Med

7% long term buy

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Intelligent Investor

If the share price suffered too much you might even take the opportunity to buy more.

Table 1: Potential long-term returns from Woolworths under various scenarios

Dividend Growth Total

yield

rate

return

Disaster

2.0%

2.5%

4.5%

Neutral

4.2%

4.5%

8.7%

Optimistic

4.2%

7.5%

11.7%

wow recommendation guide

Buy Long term Buy

Below $26.00 Up to $33.00

Hold

Above $33.00

14% on 12 January 2012 after it warned that its `increased investment into lowering prices' over the Christmas period had `not offset the deflation it [had] driven'.

Tesco's EBIT margin was around 6% during the good times in the middle of the last decade. In the latest half-year to 25 August, it fell to 4.9%. So much for bad times, which is why it's on our international stocks Buy list.

Disaster scenario

If overnight Woolworths became the disaster that was Coles and margins in its supermarkets division (which contribute almost 90% of total sales) dropped permanently from 6.5% to, say, an average of 3.7%, group earnings would almost halve from an underlying 179 cents per share in the 2012 financial year to about 91 cents.

The company is extremely unlikely to suffer this kind of collapse. But even if it did, at current prices the stock would deliver an earnings yield of 2.9%, not far below the current 10-year Australian government bond yield of 3.5%.

Look at it another way. Assuming a payout ratio of 70% (which the company has consistently stuck to over the past five years) and a resulting dividend per share in our disaster scenario of about 64 cents, the dividend yield would drop to 2.0%.

That ain't much but, having allowed for some retained earnings, we should also allow for the growth they might generate. With returns on capital of 14.3%, even under our nightmare scenario (Coles's returns only fell as far as 23% in 2007), the growth more than makes up for the 1% given up in the dividend compared to the earnings yield.

Long-term growth of around the targeted rate of inflation--about 2% ?3% --would deliver total returns closer to 5%, leaving bonds far behind.

Raising stake

Of course, were any of this to occur, the share price would suffer. But this analysis looks at the value you would receive if you simply held on. In fact, if the share price suffered too much you might even take the opportunity to buy more, which is exactly what Warren Buffett did with Tesco, raising his stake from 3.2% to 5.1% on the day the stock plunged 14% back in January this year.

So the nightmare scenario still keeps you in line with--or somewhat ahead of-- government bonds. What of the upside?

The company is expected to make earnings per share of about 188 cents in the current year and to pay dividends of about 132 cents. That would give an earnings yield of 6.0% and a dividend yield of 4.2%.

In a neutral scenario you might expect Woolies to maintain current margins while growing sales alongside economic growth, which corresponds to real GDP growth plus inflation, or about 4%?5% over the long term. That would amount to a total return of almost 9%.

For a stretch target you wouldn't add much to margins--the company would probably prefer to grow sales a bit quicker--but you could certainly imagine earnings growing faster; after all, over the past 10 years underlying earnings per share growth has been just over 13%.

Those days are surely over, even with the investments currently being made, notably in the store network and the Masters home improvement chain. But 7%?8% a year is plausible. That would provide a total return of almost 12%, well over three times the government bond yield.

All up, we'd expect Woolworths shares to deliver returns of between 5% and 12% over the long term, with the most likely result being about 9%. The risks are low and management quality is high. LONG TERM BUY for up to 7% of your portfolio.

Note: Our model Growth and Income portfolios own shares in Woolworths.

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Blue chip industrial | Gareth Brown

Special report | Five stocks to buy now

A tempting ALE

This owner of pub properties offers a decent starting yield, inflation protection and the possibility of a little extra growth

Except in Australia, across the western world investors are enduring negative real interest rates. Official cash rates, which generally dictate the rates paid on bank accounts, are lower than the rate of inflation, gradually eroding the value of savers' nest eggs.

This is central bank policy designed to deliberately spark a little inflation, but not too much--a delicate balance for policymakers not renowned for their deft touch. The risk, of course, is that the spark ignites a fire and serious inflation emerges.

At a time when many countries seem at more risk of deflation than inflation, perhaps this is an unnecessary concern. But the threat is such that most investors should have some inflation-protection in their portfolio.

Enter ALE Property Group, offering a juicy yield with the potential for it to grow, and in-built inflation protection.

Owner, not operator

Along with sibling Australian Leisure & Hospitality (ALH), ALE was spun out of Foster's Group in 2003. It owns a portfolio of pubs, leased to ALH on very long-term contracts. ALH, subsequently acquired in a joint venture by Woolworths (75%) and Bruce Mathieson (25%), remains the operating tenant in all of ALE's 87 pubs.

The pubs are spread across urban, suburban and regional mainland Australia, although 50% of the portfolio by value is in Victoria. For more in-depth research, we recommend the iconic Young & Jackson in the heart of Melbourne, the Breakfast Creek Hotel in Brisbane or the Crows Nest Hotel in Sydney.

ALE is not really a pub business per se. All of its pubs are leased to ALH on long-term contracts. ALH keeps the more volatile (but lucrative) trading profits while ALE gets paid a predictable and growing rent from a very high-quality tenant. Consequently, it doesn't have to worry too much about economic conditions and government changes to trading hours and pokie licences laws.

The rent ALE receives isn't dependent on current profits either. Instead, it's based on a level set in 2003, increasing each quarter in line with increases in the consumer price index (CPI). In other words, ALE's revenue is inextricably linked to reported inflation. This is the inflation-hedge part of the investment case.

A net debt-to-assets ratio of about 50% (half the portfolio is funded with debt, half with equity) seems high but this isn't particularly aggressive for a structure with such revenue certainty.

Hedge terminations

In the past, ALE's debt burden has also been linked to inflation through a complex series of hedges, but the group undertook a capital raising last October to pay off them off, removing the index-linking of the debt and replacing it with a nominal interest rate hedge.

The benefit of the changed structure is that ALE's debts will no longer `balloon' with inflation. So distributions, previously destined to grow roughly in line with reported inflation, are now likely to grow at a faster clip.

Whereas ALE securityholders should previously have been ambivalent about inflation (being roughly `hedged'), they should now be hoping for it. The stock now offers a high starting yield with inflation-plus growth characteristics.

There is, however, a less appealing hangover from the hedge contracts, which is a dispute with ANZ over $30m of termination costs, equivalent to about a year's worth of distributions.

ALE is vigorously defending its position but ANZ obviously feels it has a strong case. Our valuation of the stock accounts for the possibility of ALE losing this case, but any share price weakness following an announcement on it could provide an attractive entry point to the stock.

KEY POINTS

ALE offers a generous starting yield (6.7%) Yield should grow slightly ahead of reported inflation Rents could increase further on lease expiry in 2028

ale property trust | lep

Price at review

$2.40

Review date

1 Feb 2013

Market Cap.

$465m

12 mth price range

$1.94?$2.43

business risk

Low

Share price risk

Low

max. portfolio weighting

6%

Our view

long term buy

ALE is not really a pub business per se. All of its pubs are leased to ALH on long-term contracts.

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Intelligent Investor

If ALE's management is right on the `significant underrenting' and that condition holds or widens, there'll be a jump in rents payable come 2028.

lep recommendation guide

Buy for yield

Below $2.60

hold

Up to $3.50

take part profits

Up to $3.50

All expenses paid

There are other differences between ALE and the `typical' property trust. Of the portfolio's 87 pubs, all but 3 are leased on triple net leases. This means that the tenant (ALH) pays just about every incidental expense related to the property--from insurance through to maintenance capital expenditure. The cash that flows through to ALE is therefore genuinely net rent.

Then there's the potential kicker from growth capital expenditure. When ALH wishes to expand or improve one of the pubs, it not only needs ALE's permission, it also has to foot the bill.

On this basis, ALH has recently spent about $250m developing many of the pubs (compared to ALE's market capitalisation of about $465m). On the expiry of the leases, these improvements will be owned by ALE.

This adds weight to management's assertion that the portfolio is currently `significantly underrented', meaning that the rents are below where they'd be if the contracts were renegotiated now. This may sound like a missed opportunity but, for today's buyer, it actually provides both a margin of safety and the potential for capital gains.

At the current price of $2.40, ALE offers a 6.7% yield (the last few distributions were predominately tax deferred, although we'd anticipate the majority of future distributions being normally taxable). That's an attractive starting point.

The revenue ALE receives from ALH will rise at the rate of inflation until 2028, at which point ALH has the option of executing the first of four 10-year contract extensions. On extension, the rents will come up for independent review and rent will be adjusted (upwards or downwards) to match the then market rates.

Jump in rents

If ALE's management is right on the `significant underrenting' and that condition holds or widens, there'll be a jump in rents payable come 2028 (actually, there's the opportunity for rent increases of up to 10% in a one-off adjustment in 2018, too).

If ALH doesn't execute the option in 2028 (although we expect it to), then the fact that ALE currently collects below market rents means it stands a good chance of getting a similar or better deal elsewhere, via releasing or sale.

We haven't heard management discuss the magnitude of underrenting but a 5% jump in 2018 and a 15% jump in 2028 (above and beyond the normal CPI increases) would add about 1% per year to the total returns for today's buyer. And that's a fairly conservative estimate.

In all likelihood, today's buyer should enjoy total returns equal to the starting yield (6.7%) plus a little more than the average inflation rate. There's also the possibility of an additional per cent or two from rent renegotiations due in 2028. That's an attractive outlook for a fairly low-risk, inflation-hedged investment.

Liquidity in this stock comes and goes. Some days only a few tens of thousands' worth changes hands, on others more than a million. This means that buying large amounts may require some patience; the same goes for selling, so it's only really suitable for those prepared to take a long-term outlook.

We recommend members looking for reliable income put up to 6% of their portfolios into this stock. But note that if you also own the ALE Notes 2 income securities (ASX code: LEPHC), you should limit your combined exposure to 6%. LONG TERM BUY.

Note: The model Income portfolio owns ALE Property Group staples securities and ALE Property Group Unsecured Notes 2.

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Blue chip industrial | James Carlisle

Special report | Five stocks to buy now

Sydney Airport on the radar

The owner of this infamous airport offers a healthy starting yield and leveraged growth, driven by two of the seven deadly sins.

Walter Chrysler once said that whenever there was a hard job to be done, he would assign it to a lazy man, `for he was sure to find an easy way of doing it'. Gordon Gecko just told us that greed is good.

Whether it's driven by greed or sloth, the human desire to find a better way of doing things is a powerful force, driving economic progress over thousands of years. With so many lazy and greedy people on the planet, this progress has become ever more reliable.

According to the IMF's World Economic Outlook, global GDP in constant prices has grown at an average annual rate of 3.4% since 1980 and only contracted in one year (by 0.6% in 2009). Australia's growth rate has been 3.2% in the same period and has fallen in three years: by 0.01% in 1982, by 0.5% in 1983 and by 1.1% in 1991.

This economic growth has driven the growth in air travel over recent decades. With occasional disruptions, which tend to be short-lived, global passenger growth has averaged a few percentage points above real GDP growth over the years.

Boeing, for one, expects this to continue, forecasting global growth in air traffic of about 5% a year out to 2030, compared to forecast GDP growth of 3.2 per cent. Traffic growth in Oceania is also forecast to be 5%, with traffic to and from the region growing slightly faster than internal traffic.

Operating leverage

All this is good news for Sydney Airport, the company whose only asset is an 84.8% share of the eponymous airport. We won't be so bold as Boeing (we don't have aeroplanes to sell) but we'd expect traffic through Sydney Airport to grow by at least 2?3% over the years.

What's more, the company's leverage will see its earnings grow somewhat more quickly. This leverage was apparent in last year's interim result, which we reviewed on 24 Aug 12 (Hold--$3.18).

On a 100% ownership basis, the airport reported a 1.6% increase in passenger numbers for the six months to 30 June 2012, consisting of a 5.0% increase in international passengers and a 0.2% reduction in domestic travellers. Underlying revenue rose 5.6% to $498.6m while underlying earnings before interest, tax, depreciation and amortisation (EBITDA) rose 6.7% to $401.3m.

Management highlighted the factors behind this operating leverage; passenger growth, inflation linking (or inflation-plus growth) for most of its revenue, economies of scale (costs rise less rapidly than passenger numbers or revenue) and the group's canny capital investment execution (such as the recently completed second multi-story international car park).

Add in the airport's financial leverage (although the listed entity has no debt, the airport has net debt of $6bn at the asset level--a number we remain comfortable with), and the cash flowing into the listed entity's coffers grew 24% compared with the same half in 2011.

Distributions backed by cash

As highlighted previously, this cash flow growth hasn't resulted in distribution growth to ordinary securityholders in recent years. That's because the listed entity used to pay out more than it earned in net operating cash flow. It has since adjusted to a much more sensible policy. With 2012 distributions fully backed by operating cash flow, we expect healthy distribution growth in the years ahead as the airport continues to increase profits.

After peaking at $3.61 prior to Christmas, Sydney Airport securities have subsequently fallen 11% to $3.23.

A small part of the fall--10 cents--can be explained by the stock trading ex distribution on 21 December. That same day, Sydney Airport announced the receipt of an ATO position

KEY POINTS

Exposure to long-term growth in air traffic Sydney Airport earnings to rise faster due to leverage Recent price falls provide opportunity

sydney airport | syd

Price at review Review date Market Cap. 12 mth price range business risk Share price risk max. portfolio weighting Our view

$3.23 1 Feb 2013

$6.0bn $2.54?$3.61

Low Low 6% long term buy

With 2012 distributions fully backed by operating cash flow, we expect healthy distribution growth in the years ahead as the airport continues to increase profits.

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Intelligent Investor

syd recommendation guide

long term buy

Below $3.50

hold

Up to $4.50

take part profits

Up to $4.50

paper outlining a potential tax liability of $79m (plus interest and penalties) applying to 2010 and 2011. Sydney Airport believes its current treatment is correct, but if not the subsequent tax bill might explain another 5 cents of the fall.

More likely the greater part of the fall has been prompted by concerns--inspired by research from Commonwealth Bank and Morgan Stanley--that major capital spending will be required to increase the airport's capacity and/or to build a second airport. This is no doubt correct, but it shouldn't worry investors unduly.

Sydney Airport itself has the exclusive right to own and operate any second airport and, while we acknowledge that this, along with upgrades to the existing airport, would involve considerable capital expenditure, we would expect such investment to generate high returns, as has occurred with previous investments.

The recent fall has boosted the stock's starting yield to 6.5%, providing another attractive entry point to the stock. Note, however, that the stock's reliance on a single asset pegs our recommended maximum portfolio weighting at 6%. LONG TERM BUY.

Note: The model Income portfolio securities in Sydney Airport.

Disclosure: Staff members own shares in Sydney Airport, but they don't include the author, James Carlisle.

Blue chip industrial | James Carlisle

BWP Trust nails it

KEY POINTS

High-quality leases Growth could be boosted by rent reviews and site upgrades

Some concerns over conflicts of interest

bwp recommendation guide

long term buy

Below $2.35

hold

Up to $3.00

take part profits

Above $3.00

This high-quality property trust offers full occupancy, low debt and rents that should rise higher than inflation.

With a distribution yield of 5.9%, with the potential for growth, BWP Trust provides an excellent antidote to low government bond yields and term deposit rates.

Originally spun out of Wesfarmers in 1998, BWP owns 73 bulky goods centres, mostly leased to Wesfarmers as Bunning's Warehouses, spread around Australia and valued at $1,362m in the trust's latest accounts.

With 100% occupancy and Bunnings generating 95% of income, the trust is of very high quality. This reliance on one tenant introduces a degree of risk, but if you've got to have one retailer as a tenant, Bunnings would be near the top of your list.

It faces a lesser online threat than other retailers due to the range of relatively lowpriced items in a typical trolley. Like supermarkets, much of the value is in the distribution network and Bunnings has one of the best around. So, while some retailers are struggling, Bunnings, backed by the financial strength of Wesfarmers, is still growing.

The structure is similar to that of SCA Property Group, recently spun out of Woolworths. However, SCA has more exposure to the economy and the online threat, with 39% of rent coming from specialty retailers.

BWP also has low debt levels, with maturities between 2014 and 2017 and a net debt-tototal assets ratio of 23%. Borrowing costs fell from 9.2% to 8.0% in the year to June 2012.

With Wesfarmers owning the management company, we have some concerns over the potential for conflicts of interest. The management fee runs at about 0.6% of total assets, which is reasonable, but provides an incentive to grow in absolute rather than per security terms.

Indeed, management raised capital during the global financial crisis, somewhat unnecessarily, and there is a risk of this happening again. Still, with low gearing and a high-quality portfolio, any dilution should be minimal. And management has at least shown discipline when making acquisitions in the past.

The leases themselves are typically for 10 years, with up to five five-year extensions, and upwards only rent reviews every five years, either of a fixed amount or pegged to inflation.

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