Hope is a dangerous thing

When the Chariman of the Federal Reserve starts to sound like a technical analyst desperately searching for evidence to support an optimistic view of the world its time to be concerned.

"Consumer spending which has proved quite resilient despite the housing downturn and increases in energy prices might continue to grow at a brisk pace, stimulating a more-rapid economic expansion than we currently anticipate,"

Yeah it might, then again it might not and what if it doesn't? Well that's probably a little too frightening to think about just now. For the time being Bernanke's testimony seems to be aimed at reassuring markets rather addressing the real concerns of an economy grinding to a halt.

Here's another:

Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy,"

Not particularly reassuring in the same way a doctor telling a paitent with malignant cancer that the tumour in his neck has yet to spread to the brain. Benrnake continued on:

...."The implications for these developments for the housing market as a whole are less clear,"...."The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

So from the Fed's top banking offical Susan Biers the language has now been changed from "contained" to "seems likely to be contained" An amazingly hopeful sounding statement in the context of Biers earlier observation that the current problems going on in credit markets "is just the begining."

And so the scenario that all is calm continues to be expounded and the market rallies on any evidence that props up the offical position. However at some point optimistic assertions in the face of conditions that support none becomes an act of denial. Then the question becomes: How long can a state of denial be maintained?

Sub prime / US housing / US Earnings

Just when you thought it was safe to venture out into the markets again volatility rears its ugly head. For those with a memory past yesterday this will come as no surprise yet the market continues to act as though everyday is a new beginning devoid of memory. The sub prime debacle is proving to be a real nuisance, the latest casualty being homebuilder Lennar Corp who reported a 73% fall in first quarter earnings from a year earlier. So much for the sub prime problem being contained to a narrow sector. Lennar Corp's CEO commented that:

"The typically stronger spring selling season has not yet materialized. These soft market conditions have been exacerbated by the well-publicized problems in the subprime lending market,"

All important US housing data released on Monday saw new home sales fall 4% to an annual rate of 848,000 against an expected rise to 985,000. Even more alarming was the stock of unsold homes rising to 8.1 months, its highest level since January 1991.

Turning to earnings Zacks tells us that US 4Q06 earnings growth came in at an impressive 13% about 3% above expectations. Expectations for 1Q07 are currently at about 8% however if the last 2 quarters are any indication that could easily be bumped up to 11%. More interesting is Zacks revisions ratio which has fallen to 0.80 for FY07 earnings indicating analysts are cutting their earnings estimates. How many more quarters of double digit earnings does the market have left in this cycle? Consensus seems to be not many or none.

So we have sub prime problems that just won't go away, a slump in housing that continues to get worse and slowing corporate earnings. Add to that the latest figures showing consumer confidence on the wane and the case for a deteriorating economic outlook continues to get stronger. However in a market with the attention span of a hyperactive child the focus turns to dissecting Bernanke's testimony to determine the likely direction of interest rates. The market's view seems to be that the slightest hint of a rate cut will keep the good times rolling. Another view might be that the need for rate cuts is just more evidence of a stumbling economy.

PWK - Project Runway Update 2

PWK announced today it had moved a step closer to undertaking the planned construction of the undersea cable known as Project Runway aimed at increasing Australia's international cable capacity. The main points of the announcement were:

* Firstly PWK has put a price tag on the project at $200m.

* Secondly that an expression of interest (EOI)has been sent to interested domestic and international parties to solicit firm commitments. Further to this that PWK has already commenced negotiations with key parties and is now engaged in contract negotiations with those parties.

* Thirdly that an initial marine survey has been conducted ahead of schedule enabling regulatory planning to begin in collaboration with consultants and governments in several countries.

Also of note was Managing Director Bevan Slattery's remarks about current capacity constraints in the Australian market which costs Australian providers more than 1,000% more than in the US. The $200m price tag is more than PWK's current market cap and is going to entail a significant capital raising on PWK's behalf. Once again management's ability to execute is paramount and since they have consistently delivered on their promises over the last two years I'll stick with them for what should be an interesting journey. PWK shares closed up 10% at $3.25

PWK appoints ANZ as advisor to project runway

On Friday PWK announced that they had appointed ANZ Investment Bank as advisors to Project Runway. ANZ will act as a financial advisor and "provide assistance in identifying and implementing the debt and equity structure of Project Runway." Obviously PWK are committed to making the undersea cable from Guam a reality. I have no idea how much such an infrastructure project will cost but I assume it must be considerable if advisors need to be engaged to work out the funding requiremnts of the project.

This course will alter PWK's balance sheet and growth profile significantly. I may have jumped ship if it were not for the quality of management and their publicly stated commitment to not proceed with the project unless they have binding revenue generating contracts that make the project financially viable. These developments will be interesting to watch in the coming months.

QAN - never look a gift horse in the mouth

It seems some don't know a good thing when they get offered it. This article suggests some vested interests think the Qantas bid of $5.60 ($5.45 in cash plus the fully franked $0.15 dividend) is too low and undervalues the business. In a note last week JP Morgan now values QAN at $5.68 and adds that there is 'enormous upside risk' to earnings because of current trading conditions. Interesting.

Let's have a look at QAN's fundamentals. Average ROE of 13.1% over the past 5 years. The business is highly leveraged with $6.5bn in Equity and $5.5bn in Debt. Even with a forecast 35% increase in NPAT for FY07 ROFE is an uninspiring 10.9%. A higly capital intensive business with the inherent business risks of running an airline fair value lies around $2.60. Management has confirmed analyst estimates of a record profit for FY08 of around $860m. Even assuming this I can get no more than $3.77 per share.

If anyone knows where I can get a copy of JP Morgan's valuation for QAN please let me know, I could do with a good laugh.

BEN shareholder's bonanza is BOQ's bonfire

Bank of Queensland offered 0.748 shares of its own stock for each Bendigo Bank share plus $5.50 in cash. Based on closing prices for both stocks on the 16th March 2007 the offer amounts to $17.92 per BEN share, a 36% premium to BEN's 16th March closing price. Sound like a juicy deal for BEN shareholders? You bet and it gets even juicier if you bother to look at the numbers.

Notice how the offer is based on share prices without any reference to value. What we need to look at is what BEN and BOQ are actually worth. Firstly BEN, over the last 5 years the bank has averaged a modest 17.5% return on equity, compound average eps growth of 15.7% and paid out just over 70% of earnings as dividends. With $6.19 equity per share and assuming similar returns going forward I value the company at around $9.16 per share.

Turning to BOQ, a 5 year average return on equity of 19.3%, compound average eps growth of 13.8% and an average dividend payout ratio of 74%. With equity per share of $6.48 and assuming similar returns going forward I value BOQ at $11.36 per share. Thus using the offer parameters of 0.748 BOQ shares for every BEN share plus $5.50 in cash values BEN at $14.00 per share a 53% premium to BEN's current value. A generous offer indeed. What does BOQ get in return? All the usual talk about synergy and size are bandied about with the only hard numbers offered up being $70m in cost savings.

There is some doubt about whether the deal will go through. Hopefully for BOQ shareholders it won't whilst with BEN shares closing at $17.10 today, an 87% premium to their current value, BEN shareholders must be thinking Christmas has come early this year.

Sub prime meltdown overdone? Not by a longshot

It seems the meltdown in the subprime mortgage market has taken a back seat, at least for the time being as US investors focus on the health of the economy and more specifically the all important housing data due out this week. However the sub prime story is far from over. To reiterate the comments of the Federal Reserve's top banking official Susan Bies

"this is not the end, this is the beginning"

There seems to be some sentiment around at the moment that the stock market's reaction to sub prime revelations was overdone, that exposure to low quality mortgages is contained to a narrow sector of the market. You see this time around it was different. Banks no longer hold the the mortgages they initiate, they've got more sophisticated and sold them off as mortgage backed securities which in turn have been gobbled up by derivative vehicles such as CDO's (see previous article for an explanation of CDO's). The risk has been spread over a greater number of investors so the damage will be lessened.

This new found sophistication and the abundance of cheap money combined with good old fashoined greed ensured a steady of flow of low quality mortgages even in the face of rising interest rates. Of course this new sophisticated approach of spreading risk is all smoke and mirrors. The music has started to slow and a few have been caught holding the bag. The latest to be handed a bag of goodies is H&R Block who have written down the value of their discontinued mortgage business to the tune of almost $30m with more writedowns looking likely before they can offload the business.

When the music stops completely there will be plenty of bags to go around. Imagine as a US investor waking up one moring to find that your 401k has been belted because it has exposure to sub prime mortgages via some derivative product you didn't even know about? Stay tuned as the subprime mess continues to unravel.