Despite global and domestic economies continuing to be difficult, pockets of value are still available, says Rhett Kessler manager Pengana Australian Equities Fund. ‘There’s a mountain of cash on the sidelines,’ Kessler says, ‘and the noise-driven volatility is helpful but the $A is overvalued.’

The retail sector is facing three challenges – structural, cyclical, price harmonisation – and residential property prices and unemployment are creating headwinds. ‘At the same time, the resource sector is potentially oversold but hard to value,’ he says.

Tatts Group

•    National lottery business:      60c     $2 billion of value

•    Wagering:                           34c     $1 billion of value

•    Other:                                06c     $ tiny

The Tatts group is an example of an attractive holding for an absolute-return strategy, says Kessler.

‘The lottery business is a good business because it is a long-dated Government-regulated monopoly with no debtors or inventory risk and there is no global precedent for dilution barriers created by local brands,’ Kessler says.

Similarly, the wagering business a good business because Tatts is the lowest-cost producer and has no debtors or stock.

The question then remains, Kessler says, ‘Can we acquire it at the right price?’ – the current sustainable after-tax cash earnings yield of 7 per cent is growing at 10 per cent+. ‘Tatts should be one of 20-25 stocks in portfolio,’ he concludes.

News Corp

•    Cable (content) business:     55c     $35 billion of value

•    Fox Studios (Content):         15c     $10 billion

•    European PayTV:                 15c     $10 billion

•    US TV Station Group            11c     $7 billion

The cable business is a good business because it is an economically resilient industry and News Corp is a scale player with large operating leverage (including international) and long-term (five to 10 years) recurring income contracts, Kessler says.

The film studio is a good business because it is an economically resilient industry with the major studios representing a global oligopoly due to scale requirements and entrenched distribution networks. ‘It has a complex and enormously profitable lifecycle of cashflows from successful product,’ Kessler says, ‘with substantial value in libraries.’

Management is competent and demonstrates an excellent track record of building and running required core competencies, with good capital management skills.

Again, the questions is ‘Can we acquire it at the right price?’ with current after-tax cash earnings yield of 6 per cent, with high growth in non $A.

Duet Group

•    Dampier Bunbury Pipeline:     50c     $1.2 billion of value

•    Multinet:                           26c     $0.6 billion of value

•    United Energy Distribution:   24c     $0.5 billion of value

The regulated asset utility business is a good business as it is economically resilient, and has long-term monopoly type assets. ‘It has no stock, and secure debtors, plus very high EBITDA margins with minimal maintenance capex, and regulated returns based on fair WACC,’ Kessler says.

Management has a demonstrated track record of success in required core competencies – particularly achieving good regulatory outcomes, and has demonstrated good capital management skills.

Can it be acquired at the right price with current pre-tax cash earnings yield of 10 per cent, paying 8 per cent with growth?


•    Import, Distribution and Marketing (IDM) of transport fuels throughout Australia: 90c  $5.4 billion of value

•    Refinery business (Kurnell in Sydney and Lytton in Brisbane):                           10c  $600 million of value

The IDM business a good business because demand is predictable and non-cyclical, and has low working capital requirements, according to Kessler. The scale required to procure, store and distribute environmentally sensitive product is important – Caltex has 30 per cent of Australian market.

The reliability brand and infrastructure required is in situ for Caltex which has a stable customer base.

Structural growth provides significant margin enhancement, Kessler adds, as does the shift to high-octane fuel and diesel. ‘Global macro trends dictated by OEMs are very positive for price mix (selling more higher-margin product and less commodity product),’ Kessler says.

The refinery business is a good business because the pattern of highly capital-intensive with volatile earnings – mainly due to variability of crude oil – is its main input cost.

As well, Caltex has announced the closure of the Kurnell refinery (its oldest, and most capital intensive) from FY14 and its conversion to an import and storage facility.

All these factors will affect Caltex positively, Kessler says. ‘There’ll be less earnings variability, and much lower capital intensity – the remaining refinery business will constitute about 15 per cent of total business. The “new” Caltex should generate superior stable after-tax yields and ROIC metrics.’

Caltex will be a dominant player in the fuels market with superior import facilities and infrastructure, and will be viewed has a distribution/retail business rather than a refinery business – a better quality business.

Can we acquire it at the right price? The current sustainable after-tax cash earnings yield is 8 per cent, growing at 6-7 per cent.