Cost pressures hit company results

12/03/2008 - 22:00


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The ASX Materials Index, which is where the mining and energy companies can be found, has been supported by takeover action in the sector and a strong outlook for iron ore, coal and energy producers of all sorts.

Cost pressures hit company results

The ASX Materials Index, which is where the mining and energy companies can be found, has been supported by takeover action in the sector and a strong outlook for iron ore, coal and energy producers of all sorts.

While the China euphoria surrounding this part of the Australian market looks sound in the long term, in the short term, a crack in market confidence holds significant risks.

The February profit reporting season revealed significant cost pressures on individual company results.

Despite the recent strength in commodity prices, as outlined last week, Briefcase now believes that the risk to the share price of most resource stocks in the short term is all on the downside.

Rationalisation of Australia’s resources sector has been long expected.

Successful companies in the resource industry require a critical mass of funding support, along with diversity of product and location so as to ensure longevity via a depth of physical resources and the ability to provide equity support for exploration and development of new projects through the economic cycle.

Recent growth in the number of players in the industry has become counterproductive, spreading skills and assets too widely for the overall efficiency of the industry.

So it is no surprise to see BHP wooing Rio Tinto, Perilya in talks with CBH Resources and now Oxiana merging with Zinifex.

It is interesting to see how Oxiana’s MD, Owen Hegarty, has come full circle by returning to his roots.

The planned merger of his company with Zinifex will return Mr Hegarty to where he began his rise in the industry, selling metal for the old Broken Hill Associated Smelters (BHAS), which was a forerunner of Pasminco, which in turn preceded Zinifex.

••• Global stock markets are clearly in a prolonged bear phase.

The question now is just how low this cycle will take the market and how long will it take to unfold? Briefcase previously predicted that the All Ords Index could fall to 4,600 points before a base can be declared, and this target has not gone away.

A move to 4,600 represents a fall of 800 points, or a further 15 per cent below its recent level, taking the total decline since last November’s peak to 32 per cent.

Any further falls from this level would signal a major economic or social disconnect and would not be viewed as a healthy or cleansing bear market, but must pre-suppose that there would be some significant damage to the underlying fabric of the global economy.

At present, Briefcase thinks that there are still far too many ‘new money’ bulls out in the market, spruiking their wares as if nothing had changed.

The market will be close to its cyclical base when all those voices are silenced and even they become bears.

The bull will be vanquished by either the duration or the depth of the bear phase, or a combination of both.

A short sharp pullback leaves many bulls unscathed, but a prolonged bear market period leaves them selling their polo fields and eastern suburbs houses in Sydney and Melbourne, while the ‘for sale’ signs are already posted in Perth’s western suburbs.

Once a decent respect for risk has been restored to the market, which could be as early as May, but more likely by September, the market will begin building for its next bull phase.

Briefcase definitely sees growing signs that the final act of this play is about to unfold.

Several highly geared companies and financial services businesses with poor business models have already shown the strain, and some will ultimately fold.

At the bottom of the market cycle, newspapers will be full of stories of bankruptcies, receivers and administration orders, closing factories, rising unemployment, falling house prices and rising inflation.

Australian courts look like being clogged for many years with the aftermath of these events, trying to sort out who was responsible, who acted illegally or irresponsibly, and who can pay.

Clearly Briefcase believes that those with cash are in the best position, while those who can hold on to their current portfolio will ultimately survive and prosper.

Short-term deposits or bills offering interest rates of between 6.5 per cent and 7.5 per cent, provide little incentive for investors to switch out of cash and dive into the market at the moment, but those wishing to put together a portfolio, can now buy quality stocks, such as banks and some of the better utilities and property companies on a franked dividend yield of 7 per cent to 9 per cent.

Selected stocks, such as many in the energy and utility area, (Roc Oil, AGL, Origin, Arc Energy) have already reached bear market, bargain basement levels, but could be sucked even lower in the final market capitulation.

A sound policy at the current time might be to selectively invest half of the total for an intended portfolio value now and look to invest the remainder by September.

Well-chosen banks and financial intermediaries (ANZ, Westpac), property stocks with strong balance sheets (GPT, Mirvac), utilities and oil production, and development companies (AWE, Nexus, Otto, Horizon Oil) currently look to be the pick of the bunch.

••• There have been some standout profit results, but the magic of a bear market is that they are usually completely ignored, so buyers are able to position into stocks while sentiment holds them down.

Briefcase’s task is to attempt to weed these stocks out from the sludge of over 2,200 profit reports released in February.

Briefcase finds it hard to see which companies in the ASX 200 Index could fall sufficiently in order for the market to retreat to that 4,600 target level on the All Ords Index.

Given the hammering already meted out to the banks and property sector, the obvious candidates are the big resources stocks – BHP, Woodside, Fortescue and Rio Tinto – since they have, so far, been less affected by the overall fall and make up a sizeable proportion of the market’s weighting.

Despite global friction in Israel and on the border between Colombia and Venezuela, Briefcase expects that the oil price may retreat to $US80-85 per barrel in April or May as the Northern Hemisphere warms up in the spring.

A sharp turnaround in commodity prices or the failure of BHP’s bid for Rio would precipitate a sharp fall in the large resource stocks and cannot be ruled out.

Such a collapse in confidence would most likely signal a final market capitulation, accompanied by heavy selling, which would provide the darkest hour for perma-bears such as myself, to recommend purchases.

••• All Australian companies seeking their fortunes along the US Gulf Coast have so far failed to deliver.

Briefcase believes that none of these companies deserves to be listed since they have little chance of ever making real money for shareholders.

Share prices go up and down, providing trading opportunities, but a sustained lift in actual value is always illusory.

Following a series of high-profile dusters and disasters drilled in the US by the likes of Norwest, First Australian, Vicpet, Golden State, Adelphi, Antares, Golden Gate and Emerald Energy, the market is now much less likely to bet on a successful outcome for any single well.

Even the more successful candidates, such as Golden Gate and Strike Oil, find it necessary to regularly return to the market to top up funds, despite their cash flow from operations.

Companies such as Antares and Marion Energy may have reserves in the ground, but they spend at a prodigious rate and the overall margin on production is low, so additional cash is always going to be needed.

Other companies, such as Austin, Emerald, Burleson and Pryme, may have established a small operating cash flow but are unlikely to sustain the expensive drilling and development work required to build a company.

Only companies such as Petsec and Amadeus are totally self sustaining from an operating cash-flow perspective and need additional equity only if a major acquisition is planned.

Others, such as newcomers, Buccaneer and Elixir, look to establish a base of operating cash flow from their projects, but even these profitable projects are only really pot boilers at best and may keep the wheels turning for a couple of years while management searches for the big win, which might establish a ‘company making’ asset.

Most companies find themselves on a treadmill, running hard just to stand still from a shareholder wealth perspective.

In the case of Elixir, cash flow from its High Island and Pompano gas and condensate projects could generate sufficient funds over three to four years to support the company while it drills high impact prospects in the North Sea, provided that it is able to attract farm-in support for these $30 million wells.

• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.  


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