Morningstar Equities

Morningstar Equities

IRESS Limited IRE| Rising Equity Markets Always Nice for IRESS
Morningstar Recommendation: Reduce
Nathan Zaia, Morningstar Analyst - 02 9276 4491
The strong rise in equity markets over the last twelve months, as well as a number of wealth managers finally reporting a return to positive net equity inflows, point to an improving operating environment for IRESS. Despite mostly recurring subscription revenue, IRESS is not immune to the volatility and level of activity in equity markets. Hence strong performance in IRESS's key geographical regions, Australia (S&P ASX All Ordinaries Index) and New Zealand (NZX50 Index) up 20% and Britain (FTSE 100) up around 15%, are particularly encouraging for the financial markets business, which primarily provides financial data and trading execution. The growth outlook for the wealth management division is less reliant on strong equity markets in the near term, benefiting more from government regulation. Compulsory retirement contributions continue to grow the managed asset base, and advisor requirements to meet stricter compliance and disclosure rules in Australia and the United Kingdom, or U.K., increase the importance of automated and effective client communication.

While the current trajectory of equity markets remains supportive, this is already factored into our existing earnings forecasts and our AUD 8.00 fair value estimate. Both are unchanged. Despite the positive outlook for narrow moat-rated IRESS, trading at 1.25 times our fair value estimate, we believe it is currently overvalued. While earnings from the IRESS order system remain relatively safe, increased competition in other product lines--such as market data--or specialised players in subsectors of the financial planning chain--such as client relationship or portfolio management--remain threats. Following the integration of Avelo in fiscal 2014, we assume average revenue growth of 9% per annum, largely driven by the financial advisory space and further penetration of newer markets in South Africa, Asia and the U.K.

Commonwealth Bank of Australia CBA| Commonwealth Bank's Impressive Business Model on Display
Morningstar Recommendation: Hold
David Ellis, Morningstar Analyst - 02 9276 4582
Commonwealth Bank of Australia (CBA) continues to deliver solid earnings growth, with unaudited first-quarter fiscal 2014 cash profit up 14% on first quarter 2013, to approximately AUD 2.1 billion. There are no adverse surprises, with all key earnings drivers (loan growth, net interest margins, fee and trading income, cost control and bad debts) consistent with our long-term positive view on Australia’s four major, wide moat-rated banks. Despite earnings for the three months ended 30 September 2013 being broadly in line with our original expectations, we increase our near- to medium-term earnings forecasts to account for a better-than-expected outlook for loan growth, operating costs, and bad debts. CBA remains well-capitalised, with strong liquidity and funding positions. We argue capital is efficiently allocated, with the bank's return on equity ahead of peers at 18.4% for the year to 30 June 2013. We like the emphasis on leveraging key technological advantages, and focusing on product innovation and business process simplification.

The bank will benefit from the expected economic recovery as increasing confidence and sentiment translates into a stronger household sector and a broad-based expansion in business activity. We look forward to moderately higher margins, improved trading income, tight cost control and stable bad debts. The expected earnings tailwind from higher net interest margins will be more pronounced when the Reserve Bank of Australia starts increasing interest rates towards the end of 2014 and into 2015 as the economic recovery gains traction. Lower average funding costs will assist the margin as more expensive long-term wholesale funding matures and is replaced with cheaper debt. Reflecting the positive trading update and an improved earnings outlook, we increase our fair value estimate 4% to AUD 76.00. Currently, the fiscal 2014 forecast dividend yield is a still-attractive 5%, grossing up to around 7%. We believe the stock is fairly valued.

Chorus Limited CNU| Chorus' Valuation Hinges on Government Intervention After Regulator Posts Harsh Final Ruling
Morningstar Recommendation: Accumulate
Michael Wu, Morningstar Analyst - 02 9276 4431
The final decision by New Zealand's Commerce Commission (ComCom) on wholesale broadband pricing was disappointing for Chorus, contrary to our view of a better final outcome. While the regulator revised the wholesale broadband price to NZD 10.92 per month from NZD 8.93 in its final decision, it still represents a 50% decline from current broadband prices. The commission applied a two-country benchmark using data from Denmark and Sweden in determining the final price for Chorus. The slight adjustment in the final decision was attributable to a higher weighting to Sweden, and updates on cost inputs and exchange rates. In our view, it is likely Chorus will appeal the decision, and the regulator will determine the wholesale broadband price by assessing the cost in providing the services. Chorus launched a similar appeal in regards to the wholesale copper price earlier this year.

With today's unfavourable final outcome, our fair value estimate of NZD 3.60 and positive recommendation on Chorus hinges on the New Zealand government intervening, and applying the pricing methodology as proposed in the August discussion paper. This also applies to our fiscal 2014 and 2015 dividend forecast of 26 cents per share. Chorus will also require government approval in paying out dividends if its credit rating falls below investment grade. Our base case assumes that government intervention and a credit rating downgrade do not occur. We continue to see Chorus as the most logical player in fulfilling the government's broadband policy in rolling out a fibre network. As of the fiscal 2013 result, the network rollout is ahead of schedule. Chorus's narrow economic moat is derived from efficient scale and cost advantage.

Downer EDI Limited DOW | Downer Maintains Guidance and Continues to Win Contracts
Morningstar Recommendation: Hold
Ross MacMillan, Morningstar Analyst - 02 9276 4450
At the company's annual general meeting, Downer reaffirmed fiscal 2014 earnings guidance, forecasting operating net profit after tax, or NPAT, of AUD 215 million. In fiscal 2013, despite the turmoil in the domestic mining sector, Downer produced a solid earnings result, with operating NPAT growing by 13% to AUD 215 million. Notwithstanding further deterioration in demand for domestic mining services, Downer believes a similar result can be produced in 2014, mainly due to a substantially improved performance from its infrastructure operations. While we believe Downer's revenue growth will stagnate, project management on infrastructure contract work should meaningfully improve and operating costs decline, with the majority of the benefit impacting margins from fiscal 2015. The main areas of improvement are likely to be greater labour productivity, lower procurement costs and higher asset utilisation. We have maintained our fiscal 2014 NPAT forecast at AUD 210 million, 2% below Downer's guidance. Our fiscal 2015 NPAT forecast is increased slightly to AUD 225 million and longer term NPAT forecasts increase 4% to 5% on marginally higher margin assumptions.

No change to our investment thesis or moat rating. Downer is a no moat-rated company with a high uncertainty rating despite position, scale and strong customer relationships being key strengths. Contracting is a difficult industry in which to establish a moat, and Downer has, in past years, significantly underperformed from an operational and financial perspective due to misunderstanding contract risk and poor project management. Downer appears to have learnt the hard lessons, and is building solid positive momentum with substantially better contract performance in the past twelve months. Our fair value estimate increases to AUD 4.80 from AUD 4.40. We view Downer's shares as marginally overvalued, with a further downturn in domestic mining activity remaining a possibility in 2014.

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