Kreston market update week ending Friday 16th July 2010

Kreston ANZ

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Kreston Dormers

Kreston Dormers Financial Services Pty Ltd

The ASX 200 extended its two week gains by 2.0%. All sectors were positive as Banks clawed back 3.0% of their late June losses. Utilities was the strongest sector up 3.6% as a takeover offer for Intoll flowed through to other companies in the sector.

The markets have been stronger over the past two weeks after testing the 4,300 level on the ASX 200 for the third time in the past two months. While economic growth is quite reasonable in both the US and China, markets remained concerned about the impact of recent slowing in growth due to government stimulus withdrawal. That will take some time to 'clear' and in the meantime we expect markets to 'range trade' at least in the short term.

	Index	Change	%
All Ordinaries	4,455	83	1.9
S&P / ASX 200	4,441	89	2.0
Property Index	868	10	1.2
Utilities Index	4,293	148	36.
Financials Index	4,360	128	3.0
Materials Index	11,613	135	1.2
Energy Index	14,747	253	1.7

Bank Term Deposit rates were flat this week.

Term	Rate %	Change in rate
3 months	5.65	0.05
6 months	6.00	0.00
12 months	6.11	0.00
3 Years	6.80	0.00
5 years	6.95	0.00

Overseas markets were positive for a 2nd consecutive week. The US S&P 500 rose 2.4% as the company reporting season started on a positive note and the UK FTSE was up 2.1%. In Asia, Hong Kong's Hang Seng rose only 1.0% after economic growth slowed in June. Japan's Nikkei rose 0.4%.

In Australia, the Federal Government revealed the impact of the revised resources tax on its budget estimates and Intoll received a takeover offer. Overseas news focused on growth in the two largest economies - China and the US.

This week's Feature Section reviews a useful but clumsily named measure of the cash a company has earned – Earnings Before Interest Taxes Depreciation and Amortisation (EBITDA).

Australian News

The Federal government released its revised budget projections for the next three years to reflect the major changes to its proposed Resources Tax. The government now projects the budget to achieve a $3.1 billion surplus, up from a $1 billion surplus when the previous version of the Resources Tax was 'on the table'.

You might ask how the surplus could be higher if the revised Resources Tax (now titled the MRRT) has a lower rate. The answer is in the assumptions behind the projections. The Treasurer, Wayne Swan, has stated that the receipts from the 'old' tax would have been almost double than previously predicted as commodity prices are now expected to rise further. Thus the 'new' tax, despite having a lower tax rate, will deliver higher tax receipts than previously estimated. You might then ask how credible are the new set of assumptions.

The problem with projections is that they are invariably wrong. The question then becomes "What is dependent on the projections being right?' In this case the ability to fund tax cuts, increase superannuation contributions and the budget to surplus are at stake. The outflows are reasonably 'certain' whereas the inflows from the tax are based on assumptions that seem to move significantly in a matter of months.

The concern is that this approach builds in more risk to government finances should the very positive assumptions not eventuate. While I support a resources tax in concept, I would prefer the proceeds to be diverted to the Future Fund so the potential impact of falling tax receipts on future government budgets is removed.

RIO Tinto (RIO) reported strong quarterly production numbers for coal (up 9% on the previous quarter) and iron ore (up 4%). This is also driving the very strong Western Australian employment growth which was reported earlier this month.

The Federal Government's approval of the Santos (STO)/British Gas Coal Seam Methane Gas project in Queensland has been delayed by three months on environmental grounds. As this is the first approval for Coal Seam Methane Gas project other companies such as Origin Energy (ORG) will be watching the outcome closely. The technology is essentially unproven and the environmental concerns relate to the water and salt that are byproducts of the extraction process.

Toll road owner Intoll (ITO) received a takeover offer from Canada Pension Plan Investment Board ('CPP'). The takeover offer at $1.535 per share is a 38% premium to the previous day's closing price. It is not a 'done deal' as CPP were part of the withdrawn takeover offer of Transurban earlier this year. Also there are conditions on the offer such as 10% of ITO shareholders swapping shares for a new unlisted security and part of the purchase price tied to the Canadian $.

Overseas News

There was significant economic news from the two largest economies in the world. US news was mixed - negative in that the economy is not expected to grow as fast as previously expected but positive on company earnings. China news was negative in that the economy is not growing as strongly as previous but positive in that the government is successfully bringing growth back to more sustainable levels.

The US Federal Reserve ('The Fed') released the minutes of its June meeting showing a fall in expectations of US economic growth. "The economic outlook had softened somewhat and a number of members saw the risks to the outlook as having shifted to the downside" although they described the change in risks as 'moderate'.

'The Fed' forecasts for 2010 US GDP growth now range from 3% to 3.5% versus April's 3.2% to 3.7%. Whilst lower, it is still a reasonable growth rate. The market however is looking to 2011 and whether the private sector can deliver sustainable growth once the government stimulus program abates.

US unemployment is a major focus and 'the Fed' stated "Participants expected the pace of hiring to remain low for some time". Forecasts were little changed and unemployment is expected to be between 9.2% to 9.5% in 2010.

Below is a chart showing the extent of the fall in US jobs over the past 2 years and the early stages of recovery. It compares the current recovery to past recessions.

The above charts employment or job numbers rather than the level of unemployment which has actually shown a positive trend as job seekers fall out of the workforce. The employment trend in the chart is not entirely negative as there were 225,000 temporary government census jobs ending in June that were partly 'offset' by 83,000 new private sector jobs. As the Fed indicated and the above chart shows, it will be a long road to get US unemployment back to more normal levels.

Compare this situation to Australia, where on the back of the mining boom, unemployment has been falling consistently and is approaching levels regarded as 'full employment'.

The US quarterly reporting season, has been a major driver of markets this week. Aluminium giant, Alcoa and computer chip maker, Intel delivered better than expected profit numbers for the June 2010 quarter. Technology company Google missed analyst estimates although on a positive note (for the overall economy) this was largely put down to increased investment spending to meet competitive pressures. Revenues were up 2%.

The first of the banks to report, JP Morgan announced a better than expected 76% rise in quarterly profit as provision for bad loans reduced.

China GDP rose 10.3% from the 2009 June quarter which is down from the 11.9% growth rate in the March quarter. This reflects the governments attempts to dampen growth to more sustainable levels and was only slightly below expectations. Importantly inflation fell from 3.1% to a less uncomfortable 2.9% year on year. Industrial production fell to a still robust 13.7% from 16.5 which has been the driver of recent commodity prices falls.

Overall these are strong numbers although some analysts question the accuracy of the numbers due to the absence of strong data collection processes. Nevertheless even if the numbers and trends are in the 'ball park' they are positive for future sustainable growth prospects in both Asia and Australia. Complementing China's growth, Singapore's economy grew by 18.1% in the first half of this year. The Asian region generally is delivering strong growth.

Feature Article

Earnings Before Interest Taxes Depreciation and Amortisation (EBITDA)

The name and acronym is somewhat confronting but put simply it is a measure of how much cash a company has earned over the course of the year.

The following example calculates EBITDA 'bottom up':

	Profit before tax	2,000,000
Add	Interest	4,000,000
	Depreciation & Amortisation	10,000,000

Equals	EBITDA	16,000,000

Depreciation and amortization is added back because it is a 'non-cash' item. That is, effectively the company is putting away money for future replacement of equipment that wears out (depreciation) or the falling value of an intangible asset such as a patent or the capitalized cost of a computer system.

Interest is added back as it is not a core part of the business. That is the amount of debt is a financing decision and theoretically does not impact how much revenue the company makes or the directly related costs in earning that revenue.

Tax is excluded as again it does not relate to the core business. It may also be impacted by such things that may bear little relationship to how the business is currently performing e.g. carried forward losses from previous years, changing tax rules.

So EBITDA is an approximation of the amount of cash that the business has made from its core operations. Understanding the cash flows is critical as a business must pay creditors, employees, banks and shareholders with cash. It can borrow to make these repayments for a period of time or sell assets to meet these outflows but eventually lenders will call a halt and/or assets will run out.

There is an old banking adage that 'businesses live on cash, not assets'.

EIBITDA and other cash flow measures are used in a number of ways:

• When valuing a business an investor/analyst will assess the future cash flows of the business to determine whether the price being paid for the business (e.g. shares) is attractive.

• Lenders and investors will compare EBITDA (cash flow) to the level of debt or interest payable. EBITDA to Interest Coverage Ratio measures the ability of the company to meet interest payments. When EBITDA is divided by the company's debt, it measures the number of years it would take to repay the debt principal from the cash generated by the business.

However, EBITDA is only one measure of a company's operating health.

Whilst Depreciation and Interest can be excluded to measure cash flows, equipment will need to be replaced eventually. In that case including depreciation and amortization in an overall profit result is important to understand the long term viability of the company.

Similarly, Tax and Interest are real liabilities and will absorb future cash flows. While it can be argued they are not core, in that debt may be able to be reduced through more equity or tax may be minimized or deferred through clever tax planning, they need to be considered when assessing an investment in a company.

In summary EBITDA can be a very useful measure of cash flow being generated by a company and understanding cash flows should be a prerequisite before investing. Nevertheless it is only one of the financial measures that should be used in assessing the attractiveness of investing or in lending to a company.