Rudi On Thursday

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

(This story was originally published on Wednesday, June 03, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

“The world is changing very fast. Big will not beat small any more. It will be the fast beating the slow.”

(Rupert Murdoch, News Corp.)

I stumbled upon the above quote while reading through Pipe Networks’ ((PWK)) corporate profile today. Even though Rupert Murdoch probably had a different context in mind, and I know for certain Pipe Networks did, I felt it was nevertheless apt to put the quote above my editorial on the day the Australian share market managed to surge, and close, above 4000 again.

One oft heard conclusion, and not only from worrybeads and investment bears in the market, is that shares in Australia, as well as in the US, look quite expensive post the advances made since early March. I note, for instance, that Commonwealth Bank ((CBA)) shares are now valued at 12.7 times this year’s anticipated earnings for shareholders. Given EPS growth is expected to be minimal in FY10, the PER is only slightly lower on FY10 consensus numbers.

A PE ratio above the historical average of 12.5 might not deter those investors who believe the worst is over and a new bull market started in March, but I am not one of them. Similarly, with the Australian dollar now above US80c, BHP Billiton’s ((BHP)) price-earnings ratio on the basis of FY10 consensus estimates has blown out to 23.

One could argue those forecasts are bound to be lifted if the world economy does heal quickly and recovering demand further pushes up prices for copper, oil, coal and iron ore, but even at this year’s consensus EPS forecast, the P/E runs at 17.4. I don’t think anyone is going to dispute that BHP’s earnings per share (EPS) will be lower next year than this year.

This, however, doesn’t mean there’s no true and indisputable value to be found in the Australian share market, even without having to raise the risk profile considerably.

This takes me back to where I started this week’s editorial: Pipe Networks.

There are two major stockbrokers who currently cover the company (out of the ten we monitor daily) and this explains why a company such as Pipe Networks doesn’t tend to show up in our lists of highly rated stocks. We usually put the limit at a minimum of four broker views (to lower the risks regarding the data from which those lists are drawn).

Pipe Networks is a small cap, in terms of market capitalisation as well as interest from brokers and investors, but in terms of earnings growth it is one of those “fast growers” that could easily beat the “slow ones” in the years ahead. In case you never heard of the company, Pipe Networks delivers bandwidth and other services to internet service providers (ISPs) in Australia. EPS growth tends to come in double digits – year-in, year-out.

One reason to not get immediately excited about Pipe Networks is because with the share price at around $4.30 investors are already paying 20 times prospective earnings per share for the present financial year. This is on the basis of forecasts by RBS Australia and BA-Merrill Lynch, who both rate the stock a Buy. If we move our attention to FY10, which is probably more accurate given the overall environment as well as the time of the year, the PE ratio falls to 15. More reasonable, but far from dirt cheap.

At such multiples the dividend yield is quite low (2-2.4%) and Pipe Networks does represent more risk than your average blue chip; for the simple reason that it is a much smaller company.

The first thing I did today was to compare our data with those on ThomsonReuters, which has six brokers that cover the stock. They all rate it Buy. Consensus estimates are pretty close to FNArena’s, so those PE ratios don’t change.

If we shift our focus to FY11, however, things all of a sudden look a lot more attractive. If current broker forecasts prove correct, Pipe Networks will grow its EPS from 12c two years ago, to 16c last year, 21c in the present year, 28c next year, to 37c in FY11. What this implies is that the shares are only on a PE of 11.6 on FY11 forecasts – you have just witnessed the magic of rapid, non-dilutive growth.

What also becomes immediately clear is why this company is on the radar of many fund managers as well. One would have to assume the share price will catch up with the underlying growth, sooner or later. After all, that’s how value investors reap the rewards of their prescience. Even if one has the feeling that at the current price level investors are not really buying a bargain; everything is relative. BHP Billiton is trading at higher multiples with a lot less growth in sight.

Most of all, what are the chances BHP shares will be able to match the performance of Pipe Networks shares in the years ahead?

Consider that, all things being equal, if investors are willing to pay between 15-20 times prospective earnings per share today (and brokers think that is ok and still rate the stock Buy), this should translate into a share price of $5.50-$7.40 once FY11 comes into focus. I’ll spare you the effort of having to look for your calculator: the FY11 share price range represents a gain of at least 29% and possibly as high as 72% – dividends not included.

Another small cap stock that is increasingly being referred to as “value” is Solomon Lew’s Premier Investments ((PMV)). I mentioned Premier Investments in my editorial last week (see Rudi On Thursday, 27 May, 2009) . Two days later WilsonHTM initiated coverage with a Buy and this week newly renamed Smith Barney Morgan Stanley added the stock to its recommended Value stocks, along with Arrow Energy ((AOE)), Downer EDI ((DOW)), James Hardie ((JHX)) and Wesfarmers ((WES)).

I do note Smith Barney has different criteria for “value” than I do. On a shorter term horizon there appears little, if any growth in store for any of these stocks, including Premier Investments (see also our story “Premier Investments Mis-Priced?” from 28 May 2009).

Given that Arrow is presently trading at a FY10 multiple of 74, Downer on 9.5 (but with no projected growth), James Hardie on 28, Premier on 12 and Wesfarmers on 19, I’d prefer Pipe Networks time and time again.

Maybe that’s because my interpretation of “value” is closer to what Smith Barney would categorise as “growth”. Its list of recommended growth stocks includes Consolidated Media ((CMJ)), Metcash ((MTS)), Newcrest Mining ((NCM)), Orica ((ORI)), Origin Energy ((ORG)), Ramsay Health Care ((RHC)) and Sonic Health Care ((SHL)).

Alas, with the exception of Newcrest, which trades at much higher multiples, none of the growth projections for any of these stocks comes even close to what should be in store for Pipe Networks.

Returning to my comments at the beginning of this week’s editorial, market strategists at Smith Barney also believe share markets in the US, as well as in Australia, have moved beyond the point of “compelling value”. The following sentence, in wonderful analyst-lingo, was plucked from their report:

“Equity valuations are less supportive than they were, while the overall fundamental outlook still remains unhelpful”.

As I said above, everything is relative.

Pipe Networks shares are currently trading at their highest price level in twelve months, and only 16% below their $5 peak in 2007. CBA shares still have a gap of 69% left to fill, while for BHP Billiton shares the gap is still 35%.

With these thoughts I leave you all this week.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Greg, Andrew, Grahame, Chris, Rob, Joyce, Pat and George)

P.S. I – Smith Barney’s Australian equities strategist, Graham Harman, believes the upcoming reporting season in July-August will likely turn out to be the “worst in memory”. Maybe investors should take note?

P.S. II – One of FNArena’s most bearish market commentators, Daniel Goulding, publisher of weekly The Sextant Report, continues to persist in his view that the share market is still heading for a new low. In this week’s edition, Goulding admits the roll-over process takes longer than he had anticipated, but this doesn’t mean that the new leg down won’t occur, he maintains. Goulding draws a parallel with his warning in September 2007 that the bull market was over and yet the share market continued to surge for weeks to a new all-time peak, before finally starting the down-trend that brought us here. Says Goulding: “I have little doubt that I will be proven correct about new lows for the market in the future. The real question is how early am I?”

P.S. III – One thing we all should consider, a different view on modern government debt in the US (a bit of fun about something very serious):

http://www.youtube.com/watch?v=P5yxFtTwDcc

P.S. IV – Following on from my Weekly Insights this week about the weakening US dollar, the following chart is from SVB Financial and shows the largely inverse relationship between US bond yields and strength/weakness for the greenback (remember: rising yields mean investors are selling bonds, and vice versa).

Apologies to those readers who might be reading this story via a third party channel, you may not be able to view the chart.

P.S. V – US yields are expected to rise further.

Click to view our Glossary of Financial Terms