John Banos analyzed the strong profit growth of Australian listed companies in FY04. He summarized the latest profit results of QBE Insurance, Woolworths, Commonwealth Bank, and Telstra. QBE and Woolworths showed strong insurance profit and earnings growth respectively. Commonwealth Bank's earnings growth was modest and its Colonial acquisition expensive. Telstra's profit was unchanged from 3 years prior despite appearances of growth.

1. September 2004
John Banos report: issue no 34
My analysis of the FY04 profit bonanza for
Australian listed companies
Summary
Economics &
Investment Strategy
Australia
Chief Strategist
John Banos, CFA
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I have been analysing the Australian equity market for around 15 years and
in a number of respects the past twelve months has been the strongest
profit-reporting period that I have witnessed. Using ABS figures for
companies with 20 or more employees, pre-tax corporate earnings in the
year ending June 2004 increased by 18% from a year ago – such growth is
remarkable, particularly when it occurs in the 13th
year of an economic
expansion.
I analyse the latest profit results of four large Australian companies – QBE
Insurance, Woolworths, Commonwealth Bank and Telstra. QBE Insurance
and Woolworths are in my model equity portfolios. Commonwealth Bank is
not included in my portfolios, but it can be used as an early warning signal for
ANZ, Westpac and St. George (all three in my portfolios) that have
September year-ends and will be reporting in the next two months. I analyse
the Telstra result to reinforce the reasons why I am not recommending the
stock.
My model equity portfolios are shown in Table 1. This month I replace
Westfield America (from the high-income portfolio) and Westfield Holdings
(from the growth portfolio) with Westfield Group – following the merger of the
Westfield companies.
Table 1: Recommended equity portfolios for retail investors
Growth Balanced High-income
ANZ Bank ($18.77) ANZ Bank ($18.77) AGL ($13.50)
BHP Billiton ($13.22) BHP Billiton ($13.22) ANZ Bank ($18.77)
QBE Insurance ($13.14) Centro Properties ($4.60) Centro Properties ($4.60)
Macquarie Bank ($35.30) QBE Insurance ($13.14) St George Bank ($22.03)
Resmed ($7.04) St George Bank ($22.03) Stockland Trust ($5.82)
St George Bank ($22.03) Tabcorp ($14.94) Tabcorp ($14.94)
Westfield Group ($15.56) Westpac Bank ($17.00) Westfield Group ($15.56)
Woolworths ($13.64) Westfield Group ($15.56) Westpac Bank ($17.00)
Source: HSBC. Share prices as at 15 September 2004.
QBE Insurance
QBE Insurance first made a big impression on me around ten years ago. I was then chief
strategist of McIntosh Securities – a firm well known for organising the Australian
investment conference in New York in November of each year. I would give the opening
speech to around 100 US institutional investors, and this was followed with speeches
from around 20 chief executives of large Australian companies. While the Australian
economy had begun to recover from the 1991 recession, I recall that corporate earnings
(after lots of write-downs) were still very patchy in 1993 and 1994. Many speeches from
chief executives in 1994 were around the following lines: “Sorry about the recession, high
interest rates and poor profit results in the past three years, but we promise you things
are likely to improve going forward.”

2. September 2004 John Banos report: issue no 34
In contrast, the message from John Cloney (then Chief Executive; now Chairman of QBE
Insurance) was very simple: Management would continue to do what they had done for the
past twenty years and he showed a chart showing consistently rising profits and dividends
during this period. Good management make it sound so easy even in industries – like
general insurance – that are inherently risky.
Insurers make money in two ways – most obviously from their insurance business (premium
income should normally exceed outflows from claims and other expenses) and secondly
from their investments. Insurers invest not only their shareholders’ capital, but also the
funds from policyholders. QBE Insurance typically invests policyholders money very
conservatively (cash or very short-dated government bonds) and shareholders funds a little
more aggressively (shares or fixed interest). A common way to see how well an insurance
business is going is to compare insurance profit to net earned premium. According to QBE
Insurance’s latest profit statement, this ratio reached 13.1% in the six months to June 2004 –
the highest in at least ten years. Very significantly, management has upgraded its insurance
profit expectations for the remainder of 2004 and 2005 from 11-12% of net earned premium
to 12-13%.
On the other hand, investment earnings of QBE Insurance are very low at the moment, but
there is likely to be upside going forward. The company generated investment earnings of
only $120m in the past six months on an investment portfolio (policyholders’ and
shareholders’ money) of $14.4b – this amounts to an annualised return of only 1.8% per
annum. However, as US cash rates (currently 1.5%) continue to rise, investment earnings
on US$ cash deposits could pick up significantly. Furthermore, if equity markets improve
this could also provide a boost to investment income.
Table 2. QBE Insurance
6 months to June 2001 2002 2003 2004 Compound
growth (p.a.)
Gross earned premium ($m) 3,795 4,332 4,821 4,763 +8%
Insurance profit ($m) 126 160 259 409 +48%
Net profit, reported ($m) 122 115 241 320 +38%
EPS, diluted (cents) 25.4 18.1 36.3 41.8 +18%
DPS (cents) 16.5 16.5 20 24 +13%
Net tangible assets per share
(cents)
366 371 409 393 +2%
Source: QBE Insurance financial statements for six months to June 2004
One has to admit that all major Australian general insurers – including Insurance Australia
Group and Promina – are performing very well at present in what is a very favourable
environment for insurers. So why is QBE Insurance still my favourite in the sector? I have
most faith in Frank O’Halloran (current CEO) and his team. When conditions in the
insurance sector inevitably deteriorate, I believe management strength will become a critical
variable. QBE Insurance’s management were brilliant in raising more equity capital after
September 11. In my opinion, they are also doing the right things now – building up
reserves and making sensible acquisitions – to try and maintain double-digit growth in
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3. September 2004 John Banos report: issue no 34
reported earnings in FY04 and FY05. The I/B/E/S consensus of stock market analysts
expects EPS growth of 26% in FY04 and 14% in FY05.
Woolworths
One of Australia’s smartest retail analysts (better if we do not mention his name here) told
me in July 1993 (when Woolworths floated) that the stock was unlikely to rise strongly from
its issue price of $2.45 (now $13.64). The reasons appeared to be sound: Woolworths was
already the biggest supermarket business in the country, so ability to continually grow
market share was likely to be limited. Secondly, demand for food and other necessity items
was unlikely to grow faster than GDP over the long term.
In contrast, I have had a more positive view on the Woolworths share price for most of the
past decade. I have admired the rapid growth of Wal-Mart in the US and in the rest of the
world. In my opinion, Woolworths is probably the closest Australian equivalent to Wal-Mart.
Also, both companies have very similar slogans – “everyday low prices” (for Woolworths)
versus “always low prices” (for Wal-Mart). If Wal-Mart with a market cap of A$326 billion can
still provide rapid earnings growth, why not Woolworths with a market cap of under A$15
billion?
As is evident from Table 3, Woolworths has succeeded in growing revenue at around 10%
per annum – or significantly faster than Australian GDP – in the past four years. Initiatives
such as increasing trading hours to 24 hours in some stores; opening more liquor stores;
and selling (discounted) petrol have assisted to grow revenue. Critically, though,
Woolworths has succeeded in growing EPS at 20% per annum – or double the growth rate in
revenue – in the past four years. This has been through cutting costs out of the supply
chain; reducing funds employed in working capital; and undertaking share buybacks. This
formula should be repeatable going forward and I have no reason to doubt management’s
forecast that net profit is likely to increase by 10 to 15% in FY05. Assuming 12.5% EPS
growth (possibly conservative) puts the stock on a prospective PER of 17.3x (FY05
earnings) – which appears fair value for a very high-quality business.
Table 3. Woolworths
Year to June FY01 FY02 FY03 FY04 Compound
growth (p.a.)
Group Sales ($m) 20,915 24,473 26,321 27,934 +10%
EBIT ($m) 707 833 946 1,065 +15%
Net profit, after income notes
($m)
428 523 610 688 +17%
EPS, pre goodwill (cents) 41 52.5 60.7 70.1 +20%
DPS (cents) 27 33 39 45 +19%
Source: Woolworths annual reports for FY02, FY03 and FY04
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4. September 2004 John Banos report: issue no 34
Commonwealth Bank
The Commonwealth Bank share price has increased by only 9% since the end of December
2002. This compares to +13% by ANZ (in my recommended portfolios) and +22% by St
George (also in my portfolios).
Commonwealth Bank appears to have provided strong growth in net profit in FY04 – see
Table 4. However, the FY04 result included an appraisal value uplift of $201m, compared
with a reduction in the appraisal value of controlled entities of $245m for the previous year.
It is better to look at the trend in the past four years and during this period EPS has
increased by only 1% p.a. despite the charge for bad and doubtful debts falling by 11% p.a.
The bank has increased dividends per share by a much stronger 10% p.a. in the past four
years, but I am firmly of the belief that in most cases it is earnings rather than dividends that
matter most for shareholders.
Commonwealth Bank paid $9.12b to acquire Colonial in 2000 – this comprised $4.47b for
the wealth management business (Colonial First State) and another $4.65b for the remaining
assets (principally Colonial State Bank). In my opinion, the acquisition of Colonial’s banking
assets made sense. However, I believe Commonwealth Bank paid too much goodwill to
acquire Colonial First State at the top of the cycle for funds management businesses. Since
then, Colonial’s key fund managers (Greg Perry and Ian Harding) have left and the business
has lost market share.
Looking forward, Commonwealth Bank management forecasts growth in cash EPS
exceeding 10% per annum over the three-year period to June 2006. Also, the bank is
targeting productivity improvements of 4-6% per annum over this period. In my opinion,
these targets appear excessively bullish given the bank’s recent track record. Furthermore,
the bank is paying out most of its profits to shareholders as dividends, retaining only a small
amount to fund future growth. However, even if growth is half what management expects,
this still amounts to a reasonable total return for shareholders. Commonwealth Bank
provides a prospective dividend yield of over 6% (I/B/E/S forecast) for FY05.
My preferred bank stock (out of the big five) is ANZ at present. It is trading on an attractive
PER of 11.6x FY05 earnings (sourced from the I/B/E/S consensus) versus 11.9x (also
I/B/E/S) for Commonwealth Bank. ANZ’s lower rating probably reflects market fears that its
acquisition of National Bank of New Zealand will lead to a loss in market share in the New
Zealand market. This will probably prove to be the case, but John McFarlane (ANZ’s CEO)
has built up an excellent track record in running a very tight ship, reducing the overall risk of
his portfolio and executing strategies extremely well. In my opinion, ANZ has the best
prospects (among the big five) for a possible re-rating in the year ahead.
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5. September 2004 John Banos report: issue no 34
Table 4. Commonwealth Bank
Year to June FY01 FY02 FY03 FY04 Compound
growth (p.a.)
Total income ($bm) 8,824 9,068 9,399 10,491 +6%
Charge for bad & doubtful
debts ($m)
385 449 305 276 -11%
Net profit, reported ($m) 2,398 2,655 2,012 2,572 +2%
EPS, statutory (cents) 189.3 209.3 157.3 196.8 +1%
DPS, ex specials (cents) 136 150 154 183 +10%
Source: Commonwealth Bank’s annual reports for FY02, FY03 and FY04
Telstra
To the less sophisticated investor, it would appear that Telstra performed very well in FY04 –
with net profit increasing from $3.4b in FY03 to $4.1b in FY04. To make the appearance
even more impressive, Telstra’s profit was the largest of any listed Australian company.
Lastly, the dividend was increased from 24c in FY03 to 26c in FY04.
On closer investigation, however, Telstra’s result failed to impress me. For a start, the
increase in net profit in FY04 arose largely due to a $965m write down of their investment in
REACH (Asian investment) in FY03. Furthermore, their FY04 profit was no different from
what was achieved three years earlier – see Table 5. Therefore, in real terms (after inflation)
the company’s profits are shrinking. Some investors may be pleased with the higher
dividend declared for FY04 – to reduce the funds available to management to make more
(expensive) acquisitions. However, in my opinion, a dividend payout ratio of 80% (DPS of
26c in FY04; EPS of 32.4c) is too high. This reinforces my suspicion that Telstra may
continue to lose market share in the years ahead as it under-invests in new technologies.
Table 5. Telstra
Year to June FY01 FY02 FY03 FY04 Compound
growth (p.a.)
Revenue ($bn) 23.0 20.8 21.6 21.3 -3%
Net profit, reported ($bn) 4.1 3.7 3.4 4.1 0%
EPS (cents) 31.5 28.5 26.6 32.4 1%
DPS, ex specials (cents) 19 22 24 26 +11%
Source: Telstra’s annual reports for FY02, FY03 and FY04
John Banos, CFA
John Banos is a representative of HSBC Bank Australia Limited, ABN 48 006 434 162 AFSL NO:
232595. He owns shares in the following companies that have been discussed in this report – ANZ
Bank, QBE Insurance.
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6. September 2004 John Banos report: issue no 34
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