Yours sincerely, Greg Hoffman Research Director, The Intelligent Investor. REport compiled 22 NOVEMBER 2010

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1 REport compiled 22 NOVEMBER 2010 Dear Investor, Hoping that it might be a repeat of past government floats like Commonwealth Bank and CSL, the float of QR National captured the attention of many investors. In the event, it listed at $2.54. As our prospectus review explains on page 10, there were some good reasons for that. There s quite a valuable lesson in this fable: What captures our attention is not necessarily what should capture our money. In fact, an argument can be made for an inverse rather than a positive correlation between those two things. Whilst many brokers, especially those earning fees from the float, were analysing the prospects for QR National in great and persuasive detail, we uncovered three attractive stocks that haven t been getting much attention at all. All three, we believe, are better businesses sporting a higher yield. This special report contains our very latest research on those companies. But before you dig into it, please let me explain how this report is structured. Inside, you ll find a detailed piece of research on each of these three stocks. It tells you about the business model, the company s finances and the relative attractiveness of its pricing. Most of this research was produced over the past few months but has been subsequently updated with a short note. Indeed, Challenger Infrastructure will be updated again over the next few days, with a possible downgrade from Buy for Yield to Long Term Buy, so watch out for it. Both the original research and the updates are included in this special report and I urge you to read all the research pertaining to each stock before deciding to act. Once you ve done that, you might like to then return to the table published below, updated with the most recent price data as of Friday 19 November COMPANY ASX CODE SHARE PRICE AT 19/11/10 FORECAST YIELD EV/EBITDA* RECOMMENDATION MAp Group (MAP) % 12.7 LONG TERM BUY Spark Infrastructure (SKI) % 13.8 LONG TERM BUY Challenger Infrastructure Fund (CIF) BUY FOR YIELD QR National (QRN) % 9.2 AVOID * Enterprise value over 2011 forcast EBITDA All figures correct as of 19/11/10 I d also like to make a final point that, for income investors especially, a portfolio approach to these stocks is something you might like to consider. Not only should you think carefully about the total percentage of your portfolio that you want to allocate to infrastructure stocks, you should also consider how you d like to spread that allocation between these three companies. Whilst one particular stock might have a special appeal to you, it s important to consider offsetting that enthusiasm by diversifying your risk across two or more of these stocks. I trust you ll enjoy the report and find the research enjoyable and profitable. Yours sincerely, Greg Hoffman Research Director, The Intelligent Investor

2 The Intelligent Investor MAp Group MAP Price at review $2.85 Review date 24 Jun 2010 market cap. $5.3bn 12 mth price range $2.08 $3.34 Fundamental Risk 3 Share price risk 3.5 Key points Long Term Buy MAp s security price has recovered sharply from its low in 2009, but it still offers value Few businesses boast MAp s attractive economics or wide competitive moat, and a cyclical recovery in passenger numbers augurs well for future profits Though we recommend keeping MAp to 5% of a well-diversified portfolio, conservative investors should stick to 3% to 4% given MAp s high gearing Chart 1: Estimated high value of MAp s airport stakes ($m) Sydney Airport (4,379) Copenhagen Airport (780) Brussels Airport (833) ASUR (275) MAp s security price has increased 120% since March But lower airfares, recovering passenger numbers and ample investment opportunities mean it still has plenty left in the tank. After watching the security price tumble 48% following our initial upgrade on 24 Apr 08 (Long Term Buy $3.05), we upgraded MAp Group (then known as Macquarie Airports) to outright Buy on 25 Feb 09 (Buy $1.575). Upgrading a business of this ilk after it lost so much altitude might, with hindsight, appear to be a cinch. But a level head was needed to ignore the herd rushing the exits, fearing the group s onerous pile of debt would bring it undone if the credit crisis lingered on. Dwindling passenger numbers across the group s airports (the various airports are listed in Chart 1) only served to heighten fears, as did the collapse of Sterling Airlines, which had called Copenhagen Airport home. Clouds lift The dark clouds have largely dispersed since then, and contrarian buyers have enjoyed a breathtaking total return (capital gains plus dividends) of 101% since 25 Feb 09. But, more importantly for today s buyer, MAp s tank is still loaded with jet fuel. The recent recovery in MAp s security price is largely due to an abatement of fear that had surrounded the group s debt levels; offloading European and UK airport stakes at high prices has helped MAp build a cash cushion of around $775m (you can see MAp s financial results by downloading the accompanying spreadsheet from our website, which also contains a detailed valuation). Future returns will be tied to a cyclical recovery in passenger numbers, the structural decline in real (inflation-adjusted) airfares and management s ability to add value. Let s consider each lever in turn. The passenger numbers recently announced for May confirmed an improving trend across MAp s airports. The number of airlines expanding capacity across new and existing routes also provided a level of comfort. Asian airlines have been particularly busy and are emerging as an enormous growth opportunity for MAp as they shed strict regulation at home (Australia and China recently agreed to increase the seating cap on flights between the two countries, which augers well for a more robust open skies agreement). Given Europe s economic woes, the recovery at Copenhagen Airport and Brussels Airport has lagged behind Sydney Airport. But we re comforted that MAp has plugged the gap left by Sterling Airlines, which lends credibility to Copenhagen s position as Scandinavia s international hub. Absent another bout of turbulence from an economic downturn, the cyclical recovery plus MAp s high operating leverage (see Shoptalk) and financial leverage (debt) should trigger respectable, if not rapid, earnings growth. Westfield on steroids The leverage in MAp s business means that small and steady growth in passenger numbers creates significant growth in profits and cash flow available for distributions. Between 2005 and 2009, for example (as you can see in Chart 2), passenger numbers across MAp s airports increased 2.3% annually, yet revenue, profit and earnings per security increased a remarkable 5.2%, 8.7% and 15.9%, respectively. 2

3 Special Report Three Infrastructure stocks better than QRN Chart 2: 5 year performance MAp s track record of consistent delivery 5 year traffic performance 1 $m CAGR +2.3% 5 year revenue performance 1 A$m 1,200 1, CAGR +5.2% The leverage in MAp s business means that small and steady growth in passenger numbers creates significant growth in profits and cash flow available for distributions. Shoptalk 5 year EBITDA (post corporate expenses) performance A$m CAGR +8.7% 5 year EPS performance CAGR +15.9% Operating leverage: Operating leverage is an indicator of how a company s profitability fluctuates with changes in revenue. For a company with high operating leverage, each additional dollar of sales becomes increasingly profitable. So as revenue grows, profit grows faster. But if revenue shrinks, profit also shrinks faster. The greater the percentage of a company s cost base that is fixed in nature (as opposed to variable costs that move up and down with sales), the higher the operating leverage. Because the vast majority of MAp s expenses are fixed, most of each additional dollar of revenue falls through to bottom line profit. 1. Proforma results are derived by restating prior period results with current period ownership interests and foreign exchange rates, and exclude ASUR. Source: Reproduction of slide 34, MAp ASX release, May 2010 At the heart of this alchemy, and the primary reason we favour MAp over Australian Infrastructure Fund, is management s skill in turning unproductive land into profit centres, and once-dull concrete boxes into Westfield s on steroids. The formula is fairly simple: attract as many airlines as possible, increase the selection of routes, cream as much profit from the 70m shoppers that pass through MAp s airports each year and collect rent from service providers, including retail outlets and cabs. Unlike Australian Infrastructure, MAp covets international airports, as they re more profitable than domestic-focused airports; earlier check-ins and longer layover times give international passengers more time to empty their pockets waiting for their flight. International airports also boast a wider assortment of airlines, which dilutes damage if a major airline goes belly up, as they occasionally do. The experience of chief executive Kerrie Mather and her assembled cast of property and retail experts is also a powerful competitive advantage, as their cookie-cutter approach can be rolled out easily across airports filled with commercial potential after having languished under government ownership. Though it languishes behind the rest of the world in privatisations, budget deficits might trigger a wave of airport sales in the US. All things being equal, we d likely support a capital raising if MAp found a juicy target. Open skies the limit Further over the horizon, increasing numbers of so-called open skies agreements are fuelling new routes and increased competition between airlines, making international air travel more affordable. In addition, discount airlines like Tiger Airways which are a nightmare for incumbent, national flag carriers are heaven sent for MAp; their low fares are producing a revolution in air travel. In Europe, for example, discount airlines are expected to increase their market share from 33% currently to 50% by 2015, which bodes well for MAp s European airports. Few businesses boast MAp s attractive economics or wide competitive moat; the relative consistency of regulated airline charges and increasing numbers of locked-in customers provide ample opportunities to reinvest in retail initiatives at highly attractive rates. Chart 3: MAp gains altitude $5 $4 $3 $2 $1 $0 Jun 06 Jun 07 Portfolio Point Jun 08 Jun 09 Jun 10 Though we recommend keeping MAp to 5% of a well-diversified portfolio, for conservative investors a limit of 3% to 4% might be more fitting, due to MAp s relatively high gearing. map Recommendation guide Buy Up to $2.60 Long Term Buy Up to $3.20 Hold Up to $4.50 Take Part Profits Above $4.50 3

4 The Intelligent Investor Though an economic or financial crisis, or a cloud of volcanic ash, might knock performance in the short term, airline traffic is very likely to continue growing faster than general economic growth, which is why we re comfortable with MAp s relatively high gearing. The icing on the cake is a forecast distribution yield of 7.4%. The security price has fallen 7% since 7 May 10 (Long Term Buy $3.06) after dropping its 11-cent interim distribution (ex date today). MAp is a wonderful business trading at a fair price, and is suitable for most portfolios (see Portfolio Point). LONG TERM BUY. Note: We re currently scheduled to record a podcast interview with CEO Kerrie Mather on 13 July. Disclosure: Staff members own MAp Group stapled securities, but they don t include the author, Nathan Bell. MAp Group MAP Price at review $2.59 Review date 6 Jul 2010 Want to know more? Buy For more detail behind our positive view of MAp Group, head to the MAp company page where you ll find full reviews, including MAp s jet-fuelled future (see issue 298) and MAp worth the queue (see issue 289). map Recommendation guide Buy Up to $2.60 Long Term Buy Up to $3.20 Hold Up to $4.50 Take Part Profits Above $4.50 MAp Group s security price has fallen by 20% since reaching $3.27 on 6 May, with fears of another leg down in the European economy weighing particularly hard on the airport owner due to its 31% stake in listed company Copenhagen Airports and 39% stake in Brussels Airport. Though mindful of the risks, we re not overly concerned with MAp s European airports as the vast majority of the stock s value resides in its crown jewel, a 74% stake in Sydney Airport, and MAp s finances have improved substantially since the credit crisis erupted. While a crash landing for the global economy would likely let the air out of MAp s distribution (MAp currently pays out virtually all of its earnings as distributions, so there s no wiggle room if lower passenger numbers pull the rug from under profits), our view is that any setback would prove temporary. As we discussed on 24 Jun 10 (Long Term Buy $2.85), there are some hefty tailwinds blowing in MAp s favour, including increasing passenger numbers due to the signature low airfares offered by an expanding fleet of low cost airlines. In the long term, passenger numbers are relatively predictable and highly likely to grow, and we re comfortable that MAp will capitalise on the array of opportunities before it. The recent selling has been overdone in our view and a forecast 8.1% distribution yield means we re increasing our portfolio limit to up to 6% of a well diversified portfolio and upgrading this wonderful business to BUY. Disclosure: Staff members own MAp Group stapled securities, but they don t include the author, Nathan Bell. MAp Group MAP Price at review $2.96 Review date 25 Aug 2010 Want to know more? Long Term Buy For more detail behind our positive view of MAp Group, head to the MAp company page where you ll find full reviews, including MAp s jet-fuelled future (issue 298) and MAp worth the queue (issue 289). MAp Group s half-year result (it has a calendar year end) shows the airport owner is emerging as a better business in the wake of the global financial crisis. Following a 6.8% recovery in passenger numbers, revenue increased 9.3% to $557m. Though operating and net profit increased 15% and 18% respectively, earnings per security growth of 8% lagged due to the securities issued to Macquarie Group (as payment for MAp s management internalisation). An 11 cent interim distribution had previously been declared (down from 13 cents, ex date already passed) and management confirmed that the board expects to declare a 10 cent final distribution. Despite the impact of the giant volcanic ash cloud earlier this year, profits are bouncing back across MAp s three airports. Though earnings haven t recovered to previous highs at the Copenhagen and Brussels airports, they re reaching new heights at Sydney Airport (which accounts for most of MAp s value). Following the recent sale of MAp s stake in Mexican 4

5 Special Report Three Infrastructure stocks better than QRN Airport owner ASUR, securityholders can also expect the imminent announcement of a special distribution likely to total 12.5 cents. That would leave around $800m of cash in MAp s kitty, which seems to be earmarked for retiring debt attached to the airports. We d support this move as interest rates and margins on new debt facilities are likely to be much more expensive than existing facilities. Though we expect there s more growth in the pipeline, the 14% rise in the share price since 6 Jul 10 (Buy $2.59) means we re downgrading a notch to LONG TERM BUY. Disclosure: Staff have interests in MAp and Macquarie Group, but they don t include the author, Nathan Bell. MAP Recommendation guide Buy Up to $2.60 Long Term Buy Up to $3.20 Hold Up to $4.50 Take Part Profits Above $4.50 Five years late, the arguments made for infrastructure are about to bear fruit. A safe, growing 8.7% yield is now available, with the stock at a 42% discount to the $1.80 paid by float investors. In 2007 infrastructure stocks were hot. Marketed as a safe way to earn a high income, it was hard to imagine how owning essential infrastructure assets delivering a regulated return could turn out to be a loser. Turns out it wasn t hard after all. Investment banks and managers carved out a king s ransom in fees whilst weakening typically complicated structures with large licks of debt. Spark Infrastructure, whilst not boarding the acquisition train, got caught up in the ensuing panic. Since peaking at $2.10 in March 2007, the security price has fallen 50%. Fearing painful losses and distribution cuts and boy, we weren t disappointed we recommended members steer clear of the sector. Now we re about to continue that contrarian thread and upgrade Spark to an outright Buy at a time when no one else wants to hear of it. In Spark s case, the pessimism and disappointment that covers the sector is misplaced. Boasting an 8.7% yield and built-in capital growth, the company is poised to deliver what was virtually impossible at far higher prices; attractive, safe returns. Loose connections Spark holds a 49% interest in South Australian electricity distributor ETSA and Victorian distributors Powercor and Citipower. It s managed by a joint venture between Cheung Kong Infrastructure (CKI) and Deutsche Bank, but CKI and Hongkong Electric own the controlling 51% stake in the underlying assets. As we explained when we initially upgraded the stock in Spark s WACC-ed up returns on 1 Jul 09 (Buy for Yield $1.085), Distribution networks constitute the poles, lines and substations that get the electricity from the end of the large transmission lines to your front door. Retailers like AGL Energy and Origin Energy pay the companies in which Spark owns a stake tariffs to access their networks. Each electricity distributor enjoys a regional monopoly. To protect consumers, every five years the Australian Energy Regulator (AER) dictates what it deems to be a fair return from a distributor s network, or regulatory asset base (RAB see Shoptalk). Around 70% of Spark s revenues are governed in this way. Stable load Over time electricity usage is fairly stable. But Spark can increase its regulated revenues Key points Spark upgraded to outright Buy It is suitable for growth and income investors as some capital gain is expected from this price The 2-for-7 entitlement offer closes 5pm, 21 October Spark Infrastructure SKI Price at review $1.05 Review date 20 Oct 2010 Market cap. $1.3bn 12 mth price range $1.05 $1.43 Fundamental Risk 1.5 Share price risk 2.5 Shoptalk Buy Regulatory asset base (RAB): is a proxy for the value of Spark s operating assets that are used to calculate the prices (or tariffs) it can charge electricity retailers to access its network. The larger the RAB, the higher the regulated returns Spark receives. 5

6 The Intelligent Investor Chart 1: SKI 5-year share price $2.50 $2.00 $1.50 $1.00 $ Oct 06 54c final instalment paid Oct 07 Oct 08 Oct 09 Of the risks, Spark s onerous management contract is perhaps the most obvious. ski Recommendation guide Oct 10 Buy Up to $1.10 Long Term Buy Up to $1.25 Hold Up to $1.40 Take part profits Up to $1.50 Sell Above $1.50 by expanding the electricity network or adding new capabilities like smart meters, which help modernise an ageing network. For example, ETSA s recently struck agreement permitted an 85% increase in capital expenditure. That threatened to overload Spark s finances, which explains the 2-for-7 entitlement offer discussed in Capital raising for Spark Infrastructure on 22 Sep 10 (Buy for Yield $1.145). A final ruling for Powercor and Citipower which together produce slightly more revenue than ETSA on their ability to increase prices is expected on 30 October. Depending on the outcome, Spark expects its RAB to increase between 6.9% and 9.2% per year over the next five years (we re hoping for the best but expecting the worst). Don t expect distributions to grow that quickly, though. In fact, they could fall beyond Network expansions are costly and regulated revenues aren t transmitted to Spark until the money is actually spent. That s okay by us. Cash reinvested in the network increases the value of the network and the regulated revenues it delivers, which should eventually lead to higher distributions. The remaining 30% of Spark s revenues, which include home meter and street light installations, are unregulated. They potentially offer higher returns but, unlike a regulated tariff, can come to an abrupt end. Electric shock Of the risks, Spark s onerous management contract is perhaps the most obvious. Held hostage to the whims of CKI and Deutsche, securityholders have virtually no control over their investment. Thus far, though and unlike its peers Spark hasn t embarked on debt-fuelled overseas acquisitions, nor has it abused its power. That makes some sense. CKI also has a 9% direct stake in Spark which means there is an incentive, however small, to think and act more like a shareholder. Although the share price chart might suggest otherwise, Spark s underlying revenues are remarkably predictable. The only thing that has really changed since we first recommended the company is a slight share price fall. As US author and investor Jim Grant says, In science, progress is cumulative, in finance, progress is cyclical. These factors mean we re now recommending Spark for up to 5% of a well-diversified portfolio. The cyclical turn away from the sector means this is no longer an opportunity just for income investors. Capital growth should now form a larger part of Spark s total returns. At the very time investors have lost heart in the story spun back in 2007, Spark Infrastructure is about to deliver. With a safe, growing yield, assured capital growth and an attractive security price, we re upgrading to BUY. Applications from eligible securityholders planning to participate in Spark Infrastructure s 2-for-7 entitlement offer must be received by 5pm, 21 October. If you haven t received your paperwork and wish to participate, call your broker or the offer hotline on The recent review Capital raising for Spark Infrastructure explains the offer. Note: We re also taking up our entitlement in the model Income portfolio. We re buying 1,014 securities at $1.00 per security, which comes to $1,014. Disclosure: Staff have interests in Spark Infrastructure, but they don t include the author, Nathan Bell. 6

7 Special Report Three Infrastructure stocks better than QRN The Australian Energy Regulator (AER) has agreed to meet Victorian electricity operators Powercor and CitiPower 49% owned by Spark Infrastructure half way, after initially taking a tough stance on electricity price increases. Annual growth in Spark s regulatory asset base over the next five years will now fall somewhere near the middle of its previous guidance of between 6.9% and 9.2% (actual returns are heavily skewed to the final four years). This level of growth means Spark can fund its share of expansion for longer than the three years we expected and helps ensure future capital raisings are further away. With regulatory certainty for the next five years and cash in the bank following Spark s recent capital raising, its next major challenge is balancing distribution growth with the expansion plans of the underlying assets. While Spark has committed to paying a 9.11 cent distribution in 2011, we ve said before distributions could fall before moving higher over time. With the security price increasing 7% since Spark Infrastructure upgraded on 20 Oct 10 (Buy $1.05), we re downgrading a notch to LONG TERM BUY. Disclosure: Staff have interests in Spark Infrastructure, but they don t include the author, Nathan Bell. Spark Infrastructure SKI Price at review $1.12 Review date 2 Nov 2010 Long Term Buy ski Recommendation guide Buy Up to $1.10 Long Term Buy Up to $1.25 Hold Up to $1.40 Take part profits Up to $1.50 Sell Above $1.50 Having sold its largest asset, Challenger Infrastructure is in control of one exciting and one respectable business. But high leverage means the range of potential outcomes is still wide. And what about that yield? Do not trust financial market risk models was number five on successful US investor Seth Klarman s list of 20 lessons from Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people not computers assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science. Klarman s warning also applies to discounted cashflow models, which are often used to value infrastructure groups like Challenger Infrastructure Fund. Boasting a staid gas pipeline network and a worldwide collection of industrial storage tanks backed by longterm contracts, you might think pinning down Challenger s value would be relatively easy. However, as we re about to explain, that s not the case. Challenger s dull assets belie the rollercoaster ride endured by securityholders, as you can see in Chart 1. We initially upgraded Challenger on 1 Jul 09 (Buy for Yield $1.50), when the group s major asset was 15.3% of Southern Water, which has a monopoly over Challenger Infras. Fund CIF Price at review $1.610 Review date 16 Mar 2010 Market capitalisation $533m 12 mth price range $1.41 $2.01 Fundamental Risk 2.5 Share price risk 3.5 Hold 7

8 The Intelligent Investor Chart 1: Challenger ebbs and flows $5 $4 $3 $2 $1 $0 Chart 2: Inexus Financial performance Mar Mar H/Y Revenue (LHS, m) Underlying EBITDA (LHS, m) EBITDA margin (RHS,%) Source: Inexus presentations Mar 09 Table 1: Inexus s valuation Mar June 2009 Low valu ehigh value EBITDA ( m) EBITDA multiple (x) Business value ( m) ^Debt ( m) (461) (461) Equity value ( m) Equity value (AUD$m) CIF 82.5% share (AUD$m) ^ Using debt instead of net debt adds another thin layer of protection. Table 2: LBC s valuation 30 June 2009 Low value High value EBITDA (US$m) EBITDA multiple (x) 9 13 Business value (US$m) 868 1,253 ^Debt (US$m) (578) (578) Equity value (US$m) Equity value (AUD$m) CIF 66.2% share (AUD$m) ^ Using debt instead of net debt adds another thin layer of protection water infrastructure in south-east England. Southern Water has recently been sold, leaving Challenger sporting an 82.5% stake in UK utility Inexus, 66.2% of LBC Tank Terminal Group, which owns petro-chemical storage tanks situated mostly in the US and Europe (but also in Shanghai), and $230m of cash. Our valuation weapon of choice for this diverse basket of assets is a sum-of-the-parts valuation. Let s begin with Inexus. Inexus connects Inexus is the UK s largest independent gas transportation business and chiefly owns the last mile of gas pipes that help warm British homes, like Envestra in Australia. Connection charges aren t regulated but ongoing access fees which provide a steady flow of cash and 90% of profits are. Unlike typical regulated assets, profits have been multiplying rapidly, despite the UK property malaise that has applied the brakes to new connections. As you can see in Chart 2, profits increased by 61% between 2007 and The momentum has also carried into 2010, with half-year profit to 31 December 2009 increasing 21%, to 21m. Margins have also increased from 58% in 2006 to 72% currently, as the average cost of adding new homes to the network decreases (this is known as building scale in the financial argot). Expansion into electricity, water and fibre-optic connections is also bearing fruit. However, Inexus is being weighed down by 461m of debt, which is more than 15 times 2009 s earnings before interest tax depreciation and amortisation (EBITDA) of 30.5m, as you can see in Table 1. Though Inexus currently boasts rapid growth, high margins, reliable cashflows and the support of its lenders (who recently rolled the debt over until August 2012), we can easily imagine a scenario where Challenger would be forced to liquidate Inexus at a price that wouldn t cover the debt. Fortunately the debt is non-recourse, which means Challenger wouldn t need to make good on any shortfall. Like a US homeowner, Challenger could simply toss the keys and walk away. So at worst, Inexus would be worth zilch. Though we ve made this our base case, Inexus is likely worth something. The top end of our valuation is bound by a more optimistic EBITDA valuation multiple of 19; for perspective, we recently used 17 for Sydney Airport, which is MAp Group s crown jewel. But if recent growth rates stretch another three years, our estimate could be conservative. Now let s turn to LBC. Bulk profits Despite generating substantially lower margins than Inexus, LBC is a respectable business. Over 80% of contracts are take-or-pay, which means customers pay rent even when a giant storage tank is left empty. No single customer accounts for more than 10% of revenues, and more than 50% of contracts boast customers that have partnered with LBC for longer than 20 years. On the downside, LBC shoulders a heavy debt burden. It isn t regulated, either, which reflects its vulnerability to competition and recession. Though overall utilisation rates have remained healthy at 94% during the downturn, they re much higher in the US (99%) than Europe (90%). Our valuation is hemmed in by EBITDA multiples of nine and 13 at the low and top end, respectively. Like Inexus, the wide range of values reflects the large lump of debt that matures in Let s now bring it all together. Adding it up Table 3 (on the next page) shows our valuation estimate. Tipping our hat to management fees, we ve cut the combined value of Inexus and LBC by 10% at the top end and a flat $45m at the low end to add another layer of protection to our base case. We ve then added the $230m of cash and divided the sum by the number of securities outstanding, which has been falling recently due to a buyback. The wide valuation range reflects the large licks of debt within each business. But the assets are also unhedged, which leaves our valuation vulnerable to further falls in the British Pound, US dollar and Euro. On the flipside, our valuation would benefit if the Aussie dollar stumbled against these currencies. Let s now consider the forecast 8.8% distribution yield. 8

9 Special Report Three Infrastructure stocks better than QRN Current distributions are mostly flowing from cash reserves, as distributions haven t been cut to reflect the sale of Southern Water and LBC is withholding distributions to rein in debt. Management is betting that increasing cashflows at Inexus will pick up the slack as its cash pile shrinks. In a change for the better, we re also encouraged by several securityholder friendly moves, including the buyback. For the moment, at least, management isn t preoccupied with increasing its own fees. Connecting the dots In the 1934 edition of Security Analysis, Benjamin Graham distinguished between investment and speculation. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. At the current price, and given the wide range of potential outcomes, Challenger arguably fits the latter rather than the former. So conservative investors might give Challenger Infrastructure a wide berth. For those comfortable with more risk, despite the security price falling 14% since 20 Nov 09 (Hold $1.855), we re prepared to wait for the odds to improve further before upgrading. HOLD. Portfolio point If you re searching for securities offering safe and attractive yields, then check our current list of Buy recommendations. Though Challenger s yield might be superior, there are plenty of companies offering a more predictable range of outcomes and that boast dividends well covered by current profits. Table 3: Challenger s valuation Low value High value Inexus ($m) LBC ($m) Management fees ($m) (45) (65) Cash ($m) Net value ($m) Securities on issue (m) Value per security ($) CIF Recommendation guide Buy for Yield Below $1.50 Hold Up to $2.30 Sell Above $2.30 Challenger Infrastructure Fund s security price fell sharply on Friday following the announcement that Emil Pahljina would replace Steve Bickerton as chief executive. Following several divestments that have reduced the group s debt, it s not surprising that Bickerton wasn t interested in managing Challenger s two remaining, staid assets; Bickerton prefers the cut and thrust of corporate activity. So will Bickerton s departure usher in a period of stability? Not necessarily, as Pahljina also comes from a wheeling and dealing background. Though having worked on the acquisition of LBC (Challenger s storage tank business), he should know Challenger Infrastructure inside and out. The question is whether he intends to manage the business in its current form for the benefit of securityholders, or whether his appointment signals the beginning of a new strategy. We don t know the answer but, based on the facts laid out on 16 Mar 10 (Hold $1.43), the fall in the security price looks overdone. Challenger owns two high quality businesses that are churning out cash and have shrugged off the economic downturn. We also expect distributions will rise over time, but right now the 9.9% forecast yield also looks attractive. Though we re switching back to a positive recommendation, it comes with the caveat that we re prepared to change our mind if we spot strategic changes that aren t in the best interest of securityholders. BUY FOR YIELD. Challenger Infras. Fund CIF Price at review $1.415 Review date 29 Mar 2010 Buy for Yield 9

10 The Intelligent Investor Challenger Infras. Fund CIF Price at review $1.31 Review date 19 Aug 2010 Want to know more? Buy for Yield Despite the relative reliability of the chemicals storage business and the attractive distribution yield, Challenger Infrastructure Fund is not a stock for the proverbial widows and orphans. We recommend keeping the stock to between 2% and 3% of a risk tolerant portfolio. For more detail, head to our Challenger company website where you ll find full reviews such as Challenger Infrastructure s 8.8% yield (see issue 291). cif Recommendation guide Buy for Yield Up to $1.40 Hold Up to $2.00 Sell Above $2.00 Challenger Infrastructure Fund has announced its full year result. And it s a reminder that, although the downside is relatively well supported by the stable chemicals storage tank business, the potential upside is hitched to the UK utility connection business, Inexus. The storage tank business registered a slight fall in utilisation rates, from 94% to 92%, a 3% fall in revenue, to US$238m, and a 2% fall in operating profit to $US94m. This reflects the general economic malaise in the US and Europe rather than any fundamental problem with the business. Despite a profitable reinvestment track record, we re a little sceptical of plans to expand capacity at existing sites when we could be in for a long period of subdued economic growth. The investment will also eat into Challenger s cash balance, which might be needed to reduce Inexus s onerous debt pile (currently around 10 times operating profit). Despite increasing revenue and operating profit by 6% and 11% respectively and recently rolling over its debt facility, Inexus still needs a long term financing solution and strong growth. Otherwise Challenger s distributions will be cut and the current security price could be above fair value. Though we ve lowered the prices in our recommendation guide to increase our margin of safety, the 7% fall in the security price since 29 Mar 10 (Buy for Yield 1.415) and 10.7% forecast distribution yield mean we re sticking with BUY FOR YIELD. Disclosure: Staff have interests in Challenger Infrastructure Fund, but they don t include the author, Nathan Bell. Key points QR National s hunger for cash means returns to shareholders are likely to be low Without a government subsidy and dubious accounting policies, the forecasts would look much worse Despite the hype, this float is poor quality and overpriced to boot QR NATIONAL QRN listing price: $2.80 Fundamental Risk: 4 Share Price Risk: 4 our view: Avoid James Greenhalgh really wanted to like the QR National float. But financial engineering, soon-to-balloon debt levels and feeble cash flow derailed his enthusiasm. This is a poor quality, over-priced offer. The front cover of QR National s prospectus shouts BE PART OF SOMETHING BIG. Size, the promoters should be informed, is not a sensible investment criterion. If it were, we d have recommended Babcock and Brown and ABC Learning Centres in 2007 when they boasted market capitalisations greater than QR National (for the record, we didn t). But when you re selling something as fundamentally unattractive as QR National you need a pitch, a narrative around which the parties selling out can talk a few people into buying in. For this float, size happens to be it. Why? Simple. There s not much else on which to make a case. Let s start with QR National s astonishing hunger for capital. Top quality businesses produce prodigious cash flow. QR National consumes it in a way only bad businesses can manage. There will be $7.2bn in capital expenditure between 2008 and 2012, a figure dwarfing the $3.4bn in operating cash flow the company expects to produce over the same period (see Chart 1). Remember that s before deducting interest and tax. Yes, building tracks and acquiring locomotives and wagons to haul coal is an expensive business. But when said business consumes a lot more cash than it produces, that s a big red flag. Management, naturally, will argue that the capital expenditure will deliver profit growth 10

11 Special Report Three Infrastructure stocks better than QRN and there s some substance to that claim. Earnings before interest, tax, depreciation and amortisation (EBITDA) are forecast to rise from $417m in 2008 to $1,101m in But focusing on EBITDA is a bit like saying earnings before costs ; all that capital spending means depreciation and amortisation vital costs to consider will also rise from $318m to $523m over the same period. Then there s the financial engineering, something the Queensland government was keen to avoid after float shockers like RiverCity Motorway. But the tricks are there nonetheless, chief among them the capitalisation of interest on assets under construction. Chart 1: Cash in and out ($m) , ,557 1,030 1,965 1,792 Dubious accounting Here s how it works. Based on an assumed interest rate of 7% (and it could well be higher), QR National will be paying out an annualised $203m of cash interest from And yet, page 107 of the prospectus indicates that only $53m of interest expense will be recognised in that year. Some of the difference relates to timing, but a significant part of it relates to interest capitalisation. It s legal but far from conservative. The effect is to make the profit look better, at least in the short term. It s all part of the narrative. QR National looks conservatively financed. The current debt of $500m compares favourably to the market capitalisation of $6.8bn (at the maximum retail price of $2.80 a share). The trouble is it won t stay that way. By the end of 2012, QR National s capital expenditure program means it will have drawn down additional debt of $2.4bn, giving it about $2.9bn of debt by the end of That s a huge increase that puts the company on a fundamentally different footing, especially if business conditions deteriorate. Finally, there s the will they, won t they? government subsidy. QR National has three divisions, only two of which are profitable. The third, QRN Freight, lost $96m in Quite by magic, the freight division will become profitable in 2011 and The government will wave its subsidy wand to the tune of $150m in 2011 and $148m in There s no guarantee the subsidy will persist after 2015 when QR National s contract with the Queensland government ends. The debt levels, heavy capital expenditure program, government subsidy, and aggressive accounting treatments demand a circumspect eye. We d look past these shortcomings or at least try if we could purchase at the right price a monopoly business like this one F Operating cash flow before interest and tax Capital expenditure 2012F Not worth book value At $2.80, you re acquiring QR National at book value. But sometimes capital-intensive businesses, as this one surely is, aren t worth even that. Certainly, the forecast return on equity is well below par at 5.4%. Neither do we have much confidence in management s capital allocation skills. QR s managing director Lance Hockridge is a former executive of the equally capital intensive BlueScope Steel, a company we ve long disliked, while its chairman John Prescott was responsible for BHP s Magma Copper fiasco in the 1990s. Other metrics fail to excite. At $2.80, QR National will be trading on a 2012 forecast PER of 19 very high for a capital-intensive business. Its 2012 forecast unfranked dividend of 8.3 cents implies a paltry yield of 3.0%, which is why the float is pitched as a growth story; a story, in effect, that s a play on coal volumes going up. The Queensland government is fortunate that the market is willing to price QR National on similar multiples to Asciano, another capital intensive company we ve also had cause to avoid (see Asciano deserves a wide berth, see issue 305). Of course, it s in the Queensland government s interest to price this float keenly. A stag profit on listing may help to pacify unhappy voters, and the government fully intends to sell its remaining stake (somewhere between 25% and 40%) after The fact that QR National s coal company customers were prepared to pay more than $5bn for its best bits before the float may also put a floor under the stock. But it s a dangerous game to look for short-term profits in difficult or overpriced businesses. In this case, QR National is both. After the disappointment that was the Myer float, we were hoping QR National might be a more interesting proposition. If anything, it s worse. AVOID. Key information Retail offer closes 12 Nov Institutional bookbuild Nov Listing date 22 Nov No. of shares (m) 2,440 Indicative price range ($) Maximum retail price ($) 2.80 Market capitalisation* ($m) 6, PER* (x) Div. yield* (%) 3.0 Franking (%) 0 * Based on $

12 The Intelligent Investor We hope this special report has been useful to you. If you know anyone who might also find it valuable, please feel free to send them to the following page on our website where they can sign up for a 15-Day Free Trial to The Intelligent Investor and get this special report, plus its companion, The Case for Essential Infrastructure, completely free of charge: Please note: If your friend has already had a free trial with us in the last 12 months, he or she will not be able to take out another free trial and get the reports for free. He or she can, however, become a member and receive both reports as part of full membership to The Intelligent Investor along with all the other benefits that members enjoy: company research and stock recommendations, model portfolios, Ask the Experts, Investor s College, regular podcasts, and much more. To become a member, please visit: Important information The Intelligent Investor PO Box 1158 Bondi Junction NSW 1355 T F (02) info@intelligentinvestor.com.au WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people. DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRIGHT The Intelligent Investor Publishing Pty Ltd The Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN (AFSL No ). PO Box 1158 Bondi Junction NSW Ph: (02) Fax: (02) DISCLOSURE As at 22 Nov 10, in-house staff of The Intelligent Investor held the following listed securities or managed investment schemes: AAU, AAZPB, ABPDA, ACK, AEA, AEJ, AHC, ALL, ALZ, ANZ, ARM, ARP, AVG, AVO, AWC, AWE, AYT, BBG, BER, CAH, CBA, CCK, CFE, CHF, CIF, CLS, CMIPC, CNB, CND, COH, COS, CRC, CSL, CVW, DVN, EBT, EFG, ELDPA, FGL, FLT, FXL, GNC, GRB, HNG, HVN, IDT, IFL, IFM, IMF, IVC, KRS, LMC, LWB, MAP, MAU, MFF, MLB, MNL, MQG, MTS, NABHA, NBL, NWS, OEQ, ONT, PIH, PLA, PTM, QBE, RFL, RHG, RNY, ROC, SDG, SDI, SFC, SGN, SHL, SHV, SKI, SOF, SRH, SRV, STO, STW, TAN, TGP, TIM, TIMG, TIMHB, TRG, TWO, WBC, WDC, WHG. This is not a recommendation. DATE OF PUBLICATION 22 Nov