Macquarie Group Capital Notes (MQGPA)

Transcription

1 17 May 2013 Macquarie Group Capital Notes (MQGPA) Recommendation: Subscribe at a minimum spread of 4.2% Overview On 14 May 2013, Macquarie Group Limited announced its intention to raise around AUD 400 million in new regulatory capital to be named Macquarie Capital Notes (proposed ASX Code: MQGPA). These are non-cumulative, unsecured, mandatory convertible notes. Issue proceeds will be used for funding and capital management purposes and more specifically to replace the existing Macquarie Convertible Preference Shares (ASX Code: MQCPA). These notes offer semi-annual interest payments of 180-day bank bill swap rate (BBSW) plus a margin. The margin will be set at bookbuild, with an indicative range of 400 to 420 basis points. Slightly differently to other securities, MQGPA will be franked at a variable franking rate presently set at 40% (compared with 30% for other Macquarie-issued credit securities) making the cash distributions lower. This is in line with the dividend policy for Macquarie CPS, where dividends were set at 40% franking. MQGPA are perpetual securities with a mandatory exchange date of 21 June 2021, subject to exchange conditions. Macquarie Group also has multiple options to exchange the notes prior to this date from 19 June 2018, and subject to regulatory approval from the Australian Prudential Regulation Authority (APRA). Summary and Recommendation We recommend investors subscribe at, or above, our minimum fair credit spread of 4.20%. However, we remind investors that they are not being overly compensated for additional credit or term risk relative to comparable securities. In our presale summary, we gave an indication of how investors should measure the relative value of MQGPA. New issues should offer at least the current trading margin of comparable issues to be considered a rational investment decision. MQGPA is a capital note and its closest comparable securities are bank tier 1 securities (Commonwealth Bank s CBAPC, National Australia Bank s NABPA and Westpac s WBCPD) and non-operating holding company (NOHC) equivalent (Suncorp s SUNPC). However, there is no true like-for-like comparison and therefore any relative value assessment should be taken lightly. MQGPA is offered at a slight premium to the relative value curve shown in Figure 1, indicating the security is relatively cheap. The relative value curve shows the diminishing credit risk premium over time to maturity. Securities above this line can be considered relatively cheap and securities below the line can be considered relatively expensive. However, factors such as issuer outlook, liquidity and supply can distort this picture. It is important when assessing relative value to compare securities with similar maturity dates because as the term to maturity increases so too will the uncertainty of its ability to meet its obligations. Hence, investors should be compensated for term risk. Figure 1: Relative Value Trading Margin % Source: Morningstar Analysts MQGPA: % SUNPC { CBAPC G {{{ NABPA WBCPD MQGPA is eligible capital for Macquarie Group, which is distinctly different to what investors are used to from bank tier 1 securities, and hence investors should be aware of the primary differences. Although we assess MQGPA using our bank analysis framework, we have made some subjective adjustments due to the nature of the assets outside the banking subsidiary. As with other securities, we take into account the current relative value and the long-term fair value of the new issue when making our recommendation. MQGPA is effectively a tier 1 type security, but as it is eligible capital for the group rather than the banking subsidiary, there is no distinction between tier 1 and tier 2 capital. This security is suitable for investors looking for income with a stable to positive view on the credit profile of the issuer. This is not specifically a defensive or growth asset but more appropriately classified as equity income. It will be less volatile than Nicholas Yaxley Credit Analyst Contact Details Australia Helpdesk: helpdesk.au@morningstar.com New Zealand Helpdesk: helpdesk.nz@morningstar.com 2013 Morningstar, Inc. All rights reserved. Morningstar Australasia Pty Limited ( Morningstar ) ABN: , AFSL: (a subsidiary of Morningstar, Inc.) of Level 36 Australia Square, 264 George Street Sydney NSW 2000 is the provider of the general advice ('the service') provided in this report. The service is provided through research including the profiling and rating of companies and the securities they issue. Morningstar does not receive commissions for the service and does not charge companies to be rated. Morningstar is remunerated for the service by subscribers paying a subscription fee. This fee is variable depending on the individual subscriber's specific requirements. Morningstar has no debt or equity relationship with any issuers of any securities. Morningstar may provide a licence for the use and distribution of the service to issuers of securities which are the subject of a research report. Morningstar representatives are remunerated by salary and do not directly receive any commissions or fees. They may be eligible for an annual performance payment which is discretionary and based on reaching agreed performance levels. Please refer to our Financial Services Guide (FSG) for more information

2 17 May Table 1: Morningstar s Key Qualitative Data Points Issuer Risk Business Risk Economic Moat Macquarie Group Medium Medium None National Australia Bank Low Medium Narrow Westpac Banking Corp Low Medium Narrow Commonwealth Bank Low Medium Narrow ANZ Bank Low Medium Narrow Suncorp Group Medium Medium None Source: Morningstar the common equity, but securityholders will not be able to participate in any capital upside. Macquarie Group s issuer risk is considered medium primarily due to its AUD 4.0 billion in excess capital. Macquarie s issuer risk is less favourable than the major banks (which have low issuer risk) due to earnings uncertainty and lack of sustainable competitive advantages. We have an economic moat rating of none for Macquarie, whereas each of the top four banks enjoy narrow moat ratings. Macquarie is overcapitalised and meets all the investment hurdles in our assessment of its legal obligations. However, we have some concerns over corporate event risk as, historically, Macquarie has not accepted sub-par return on equity, so it may use excess capital to continue to repurchase common equity or make bolt-on acquisitions. Neither would be positives for capital investors. However, we derive confidence in the fact that APRA is comfortable with Macquarie s balance sheet position and has allowed for further capital initiatives. The second part of our analysis takes into account structural considerations that change the risk profile of the security itself. Valuation On an absolute basis the security should offer a margin at, or above, our fair margin of 4.20%. We consider the indicative interest margin on MQGPA to be cheap relative to the closest comparable securities, but in line with our fair margin. Our long-term fair margin of 4.20% is based on a credit risk premium (3.40%), an illiquidity value (0.10%) and an additional 0.70% to account for the small probability of deferred distributions. Morningstar s credit risk premium is based on mapping our security risk rating to the probability of conversion/default. This probability is based on global empirical corporate default data over the past 25 years. The structural terminology in MQGPA makes the loss-given-conversion higher than loss-givendefault/conversion in previously issued Macquarie hybrid securities, and hence we assume 0% recovery at the point of non-viability. Issuer Credit Perspective Morningstar s issuer credit perspective is our assessment of an issuer s ability to meet its legal obligations in a full and timely manner. Our process is based on four key pillars; business risk, stress test, solvency score and distance to default. This assessment is specific to the financial health of the issuer. We then consider the security s structural elements to formulate our investment risk rating for the security itself. It is important for investors to look at all elements of our analysis before participating in the issue. Business Risk Morningstar s business risk rating is our qualitative assessment of the presence of any sustainable competitive advantages (economic moat), macroeconomic drivers of the industry (regulation, housing growth, unemployment), the reliance on debt capital markets (domestic and foreign) and quality of management and sub-committees (risk and capital). Macquarie Group is unique within the domestic financial services landscape as essentially it has the regulated bank division (Macquarie Bank) and the rest, which is regulated by the proprietary economic capital adequacy model. Morningstar believes that Macquarie Group does not possess sustainable competitive advantages supporting an economic moat; however, the volatile business units (securities and capital markets) are slowly becoming a smaller part of the overall operation, removing some uncertainty for the business. For this reason we award a medium business risk rating. Economic Moat The economic moat concept is a cornerstone of Morningstar s investment philosophy and is used to distinguish high-quality companies. An economic moat allows a firm to sustain excess returns over a business cycle. Without a moat, profits are more susceptible to competition. Companies with a narrow moat are likely to achieve normalised excess returns beyond 10 years while wide-moat companies are likely to sustain excess returns beyond 20 years. Despite solid global growth potential, we consider Macquarie Group does not possess sufficient competitive advantage to warrant an economic moat. Macquarie Group s primary point of difference has been its expertise and strength in niche investment banking sectors and asset markets. Exploiting this advantage, the company has built market share in key global markets, but larger peers have moved into this space, increasing competition for fees. A recovery in markets will also provide greater impetus for Macquarie Group s larger competitors to encroach on

3 17 May its more niche markets and potentially capture a higher proportion of high-margin and fee-based income. Increasing scale in funds management and corporate finance does provide moat characteristics due to strong business unit returns on equity and annuity-style income streams. There is no assurance that return on equity will rebound in the short term as this is heavily dependent on a recovery in the poor-performing, market-facing businesses. Expansion is focused on leveraging Macquarie Group s specialist niche skills, but competitive advantages in infrastructure, energy, commodities, utilities, property and fixed interest are mild at best. While Macquarie Group can be viewed as a growth stock, earnings will remain volatile due to its reliance on market conditions. The acquisition of U.S. fund manager Delaware Investments has been a key enabler of annuity-style income growth. The corporate and asset finance business is growing through both organic means and purchases of leasing and asset portfolios. Management Overall, we assign Macquarie Group a standard stewardship rating with the investment bank safely guarding precious capital during and post the global financial crisis (GFC). CEO Nicholas Moore is a well-regarded and long-standing Macquarie executive, commencing with the group in Prior to promotion to CEO in 2008, he was responsible for Macquarie Group s very successful investment banking operations. Chairman Kevin McCann s background is in commercial law and he has been an independent Macquarie Group director since Macquarie Group s executive team members are all long-serving employees, but there have been a number of key retirements during the past few years. Criticism concerning Macquarie s fee take and staff bonus plan, combined with the recent underperformance of many of its funds, impact the investment bank s reputation and public standing. Management strength is the ability to reinvent the business as conditions and industry dynamics change. Despite holding surplus capital, management has not wasted capital on expensive and ill-judged acquisitions and expansion strategies. Strong and dynamic management over many years built Macquarie Group into a very successful and profitable Australian investment bank. Conservative capital management, executive expertise and a dynamic can-do attitude are trademark Macquarie Group characteristics. Macquarie Group benefited from impressive earnings growth pre-gfc with strong returns on equity and increasing profitability. However, the decline of its highly-geared, captive specialist funds model and weak investment market conditions have caused earnings and return on equity to suffer. Despite the current low confidence in global investment markets, the long-term outlook remains positive for Macquarie Group. Strong management and a disciplined focus will ensure earnings will rebound as markets recover, boosting return on equity to more satisfactory levels. Bank Solvency Capital, Funding, Liquidity & Asset Quality Morningstar assesses the financial health of an issuer using a purely objective assessment based on bank-specific accounting metrics. Our solvency score measures a bank s most recent performance in four key areas: capital adequacy, asset quality, earnings power and liquidity. These measures are scored against a fixed set of thresholds set by Morningstar s global credit committee. Capital To accurately assess an issuer s capital adequacy, a benchmark is needed, whether it be a peer, regulatory standard, security-specific term or self-imposed requirements. These are easy to measure for traditional banks due to transparent reporting and requirements set out by APRA. However, Macquarie Group is far less transparent with a complex balance sheet structure and relies on a Macquarie-developed model (economic capital adequacy model, or ECAM) to manage its capital efficiently. This makes analysis of the group s capital leverage and sensitivity to asset price movements more difficult. Despite this complexity, reported capital levels are strong, with Macquarie Bank having a core tier 1 capital ratio of 11.6% at March Based on harmonised Basel III metrics, surplus capital at March stood at AUD 4.3 billion. APRA has also not objected to Macquarie Group s capital plan that was submitted as part of the 2012 stress tests and allowed the AUD 500 million buyback and increase in payout ratio from 50% to 80%. APRA s unique regulatory framework for Macquarie Group defines eligible capital (outside of the banking subsidiary), being share capital, retained earnings, reserves and hybrid instruments such as Macquarie Capital Notes. Going forward, it is difficult to be confident that the group will remain overcollateralised at the expense of a low return on equity. Macquarie Group has proven to be selective in its acquisitions, but we would argue that shareholders will push for a return of excess capital if no corporate events are on the table.

4 17 May Capital uncertainty was also made evident by APRA s recent announcement of proposed requirements for conglomerates. The new framework is not final, but APRA has confirmed that Macquarie Capital Notes will receive transitional capital relief until the first optional exchange date (19 June 2018). This new framework is still in discussion and unlikely to take effect until early Funding and Liquidity The funded balance sheet of the consolidated group totalled AUD 88 billion as at March 2013, broadly unchanged during the year. Short-term debt represents 17% of total funding, including equity. Central banks across the globe have improved the mechanics for allowing groups such as Macquarie Group to access liquidity and funding through repurchase agreements and the Reserve Bank of Australia (RBA) is no different. The cost of funding for Macquarie Group is higher than that of the four major banks because the cost of term debt is a function of its wholesale credit rating. The funding and liquidity position is unique for Macquarie Group, primarily due to a specific funding alternative known as internal securitisation. This is where an issuer uses a form of government funding as a means of providing group liquidity. This is not specific to Macquarie Group; however, as a means of funding for residential mortgages it is their optimal outcome for capital and liquidity. Macquarie Group has historically funded its operation through commercial paper (short-term funding), but this was quickly changed during the financial crisis where counterparts rapidly reduced their exposure to peripheral issuers and Macquarie Group was forced to look elsewhere for funding. Stress Test Loss Absorption Cushions Morningstar s bank stress test score evaluates an issuer s capacity to handle additional losses on its loan and securities portfolios. This ability depends on the bank s initial capital position, provisioning and its 12-month forward pretax, preprovision earnings (PPE). Macquarie Group comfortably passed all the stress test requirements set out under our methodology, primarily due to overcapitalisation of the group. Morningstar s stress test is arguably not as severe as APRA s own hypothetical stress tests, which are intended to test the boundaries of severe but plausible macroeconomic deterioration (due late 2013). Morningstar regards the underwriting quality for Macquarie Group s loan and securities portfolios as satisfactory, but it receives a score of good in the stress test as its post-test tangible common equity ratio remains adequate despite burning capital under our stress-case assumptions. Distance to Default The final measure in Morningstar s credit opinion is distance to default. This is an adjusted form of Morningstar s structural model of default. This measure provides a statistical guide to the probability of an issuer meeting its obligations (without covenants). This does not have a large impact on our overall assessment, but is designed as a quantitative measure of default probability. Importantly, our fundamental assessment suggests that our default probability estimate is conservative (higher) than other market-based assessments (that is, implied default probability from credit default swaps). Structural Considerations Morningstar s credit opinion is a measure of strength of an issuer and the probability that it will meet all future obligations. It does not form a complete view on individual securities such as MQGPA. The best way to think of our credit opinion in the context of MQGPA is a probability of non-conversion. Importantly, this is not probability of default, which has a lower probability (see Figure 2). Morningstar considers redemption or resale as positive outcomes for the investor, but conversion is where risk increases. Conversion of MQGPA will only happen where: 33Macquarie decides on optional exchange at the specified dates (beginning 19 June 2018), subject to APRA approval and satisfying specific conversion conditions; 33Mandatory exchange, subject to conversion conditions, at 1% discount to the volume weighted average price (VWAP) on mandatory conversion date (21 June 2021); 33Unscheduled conversion due to: 33Non-viability event trigger The mandatory exchange date is 21 June 2021 (for valuation purposes this is the date which Morningstar uses as the expected maturity date). On this date, securityholders of MQGPA will be exchanged into Macquarie Group common equity at a 1% discount ($101.01) to the volume weighted average price (VWAP) of Macquarie Group common equity during the 20 business days preceding the mandatory conversion date. Exchanging the notes for common equity is subject to (among other factors): 33First scheduled conversion condition the VWAP of Macquarie Group shares on the twenty-fifth

5 17 May business day preceding the scheduled conversion date is greater than 56% of the issue date VWAP. 33Second scheduled conversion condition the VWAP of Macquarie Group shares during the preceding 20 business days of the scheduled conversion date would be less than, or equal to, the maximum exchange number applicable to a mandatory exchange date. 33No delisting event applies. These conditions are designed to protect the securityholder from short-term volatility in the Macquarie Group share price which might unnecessarily affect the scheduled conversion calculation. The most important conversion type to understand is unscheduled conversion. This is an unlikely, but severe, scenario where losses are large, and we would argue concentrated, within a geographic (or other concentrated region) regions. Unlike recent bank tier 1 securities there is no common equity trigger, but it does include the non-viability trigger and hence the risk profile is asymmetric with a low probability that the security will be converted, but loss-givenconversion can be high. Figure 2 shows a theoretical example of how the capital value of the convertible note would work relative to its share price. We can see from the chart that the share price of an issuer will retreat significantly quicker as the level of capital reduces (this can be due to losses exceeding provisions), but the price of the convertible note will only begin to reduce once it approaches the unscheduled conversion triggers. Ultimately, if the issuer defaults (which is a highly unlikely event), the value of both securities would be zero. Hence, we conservatively assume nil recovery. Note that this chart is designed to display the theoretical price whereas, in reality, market prices are much more volatile. Non-Viability Trigger Event The point of non-viability is the second line of defence before a public injection of funds if necessary to support the issuer. This point has not been clearly defined and it will remain subjective for APRA s Figure 2: Theoretical Capital Risk Profile for Equity and Hybrid Instruments Issuer Operating Environment Issuer Share Price ($) LHS Issuer Hybrid Price ($) RHS Share price Theoretical point of non-viability Min Tier 1 ratio (plus Capital Conservation Buffer) Share price upside 30 limited as retained 120 capital very high Theoretical jump 5 to default 20 0 APRA Common Equity Tier 1 Ratio SPECULATIVE HIGH MEDIUM LOW ISSUER RISK RATING Source: Morningstar

6 17 May purpose (which is ultimately to protect the public from having to support a failing banking institution). It is Morningstar s opinion that the point of non-viability is before default or insolvency because it is in the interest of APRA to maintain solvency in domestic banking institutions. APRA has given guidance to the meaning as it could include serious impairment of Macquarie Bank s financial position. However, it could extend to measures such as solvency, capital and liquidity. The non-viability trigger ultimately gives APRA discretion to convert MQGPA into equity when it deems it appropriate. Unscheduled conversion will occur using a predefined calculation with the number of shares received being a function of a calculation known as the conversion number. This conversion number has a maximum limit (known as the maximum conversion number) which will automatically write down the value of the investment depending on the common equity share price over the preceding 5 days (% days VWAP). As non-viability conversion is forced Morningstar assumes 0% recovery. Inability Event If for some reason Macquarie Group is unable to exchange MQGPA within five days of a non-viability event, then MQGPA would be written off instead of converted. Securityholders would have no rights to claim against Macquarie Group in this circumstance. Distribution Payment Conditions As part of the APRA prudential requirements, dividends on MQGPA securities are at the issuer s discretion and subject to conditions (see point 2.3 of the prospectus). Morningstar incorporates a risk premium into our fair value to account for the small probability that dividends are not paid. MQGPA also includes terminology which restricts payments of dividends on common equity (dividend restriction) if distributions on MQGPA have not been paid. These restrictions are not as strong as dividend stopper conditions from older hybrid securities, but will be the standard for Basel III compliant securities. Acquisition Event In the event that Macquarie Group receives an unconditional takeover bid (or scheme of arrangement) an acquisition event will have occurred (provided it is not deemed an NOHC event) and MQGPA will automatically exchange for common equity. Exchange will occur using the same calculations as per the scheduled exchange date. Other Risks Excluding the risks described above, MQGPA securities are subject to a number of other risks which investors should be aware of: Market Risk MQGPA has embedded equity risk (through the conversion process) which means it is exposed to market risk as a consequence of its trading activities and/or the management of its financial position. Therefore, it is reasonable to suggest it is exposed to adverse movements in levels and volatility of interest rates, foreign exchange rates, commodity prices, credit prices and equity prices. Interest Rate Risk MQGPA resets on a semi-annual basis. Technically, this is defined as short duration and therefore changes in benchmark interest rates will have a minimal impact on the capital performance of the security. Systemic Credit Risk Although idiosyncratic credit risk has been assessed in this document, systemic effects can have an impact on the performance of the security. This risk is difficult to quantify, but Morningstar mitigates this risk by incorporating a systemic risk premium in its fair value assessment. Event Risk Event risks arise as a result of unforeseen or unexpected events such as natural disasters, political reforms, mergers and acquisitions. K Early Redemption Event Macquarie Group also has the option to exchange/ redeem/resell MQGPA at face value on any payment date if it deems a tax or regulatory event has occurred. This option is subject to APRA approval and the securityholder should not expect that APRA will give this approval. Hence, Morningstar uses the mandatory conversion date for pricing purposes.

7 17 May Table 2: Comparable Converting Major Bank Capital Securities MQGPA NABPA WBCPD CBAPC Name Macquarie Group Convertible NAB CPS Westpac Capital Notes CBA PERLS VI Notes Type Mandatory exchange Mandatory conversion Scheduled conversion Mandatory conversion Issuer MQG NAB WBC CBA Issue Size Around $400m $1.51bn $1.38bn $2.0bn Face Value $100 $100 $100 $100 Issue Date 19 June March March October 2012 Margin above Base Rate [ %] 3.20% 3.20% 3.80% Base Rate 180-Day BBSW 90-Day BBSW 90-Day BBSW 90-Day BBSW First Call / Exchange/ Redemption Date 19-Jun Mar Mar Dec-2018 Mandatory Exchange / Scheduled 21-Jun Mar Mar Dec-2020 Conversion Date Step-Up None None None None Distributions Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Discretionary, non-cumulative, fully franked distributions with a dividend stopper. Capital Trigger Event No Yes, if common equity tier 1 ratio is equal to or below 5.125% Yes, if common equity tier 1 ratio is equal to or below 5.125% Yes, if common equity tier 1 ratio is equal to or below 5.125% Non-Viability Trigger Event Yes Yes Yes Yes Conversion into ordinary shares Yes Yes Yes Yes Ranking Above MQG ordinary shares Above NAB ordinary shares. Above WBC ordinary shares. Above CBA ordinary shares. Solvency Condition Yes Yes Yes Yes Ranking Above SUN ordinary shares and tier 1 securities. Above WBC ordinary shares and tier 1 securities. Above NAB ordinary shares and tier 1 securities. Above ANZ ordinary shares and tier 1 securities.

8 Page 8 of 8 Investment Detail Print date 17 May 2013 Disclosure and Research Methodology Limited Financial Services Guide Morningstar Australasia Pty Limited ( Morningstar ) ABN: , AFSL: (a subsidiary of Morningstar, Inc.) of Level 36 Australia Square, 264 George Street Sydney NSW 2000 is the provider of the general advice ('the service') provided in this report. The service is provided through research including the profiling and rating of companies and the securities they issue. Morningstar does not receive commissions for the service and does not charge companies to be rated. Morningstar is remunerated for the service by subscribers paying a subscription fee. This fee is variable depending on the individual subscriber's specific requirements. Morningstar has no debt or equity relationship with any issuers of any securities. Morningstar may provide a licence for the use and distribution of the service to issuers of securities which are the subject of a research report. Morningstar representatives are remunerated by salary and do not directly receive any commissions or fees. They may be eligible for an annual performance payment which is discretionary and based on reaching agreed performance levels. Please refer to our Financial Services Guide (FSG) for more information Listed corporate income securities Morningstar covers around 30 listed income securities. Our methodology is forward looking, based on our expectations of future cash flows. Analysis is carried out by our income securities team, which is a subset of the equities research team and thereby utilising the equity analysts expert knowledge and cash flow models of the underlying businesses. The focus of Morningstar s analysis is to assess the degree to which the underlying business is capable of supporting the commitments required by the securities. We analyse the following factors to place the security in one of the security risk categories of: Excellent, Investment Grade, Speculative or Distressed: 33Business Risk comprising an assessment of whether there is an economic moat (presence of sustainable competitive advantages), the strength of management and how uncertain future cash flows are; and 33Financial Risk based on testing the company under a series of leverage and cash low ratios. We then calculate the yield that is justified by the risk of the security based on a transition model which identifies a range of credit spreads, primarily based on historic default rates. We add a spread to account for transaction costs associated with illiquidity, and small additional spreads to represent the inconvenience or risks associated with non-cumulative dividends or the security being a perpetual. Listed Income Securities coverage criteria Coverage of around 30 listed income securities is based on client demand, determined on a set of guidelines, which include issue size being at least AUD 200 million, the underlying corporate or its listed parent being covered by Morningstar s equity research team, Morningstar s judgement of the investment merit of the security and the strength of existing and likely demand from our retail investor, broker, financial adviser, and institutional clients. Timing and frequency of income security research reports 33Pre-IPO research reports on securities that meet the coverage criteria are published in the first week after the launch of the issue. 33Ongoing research reports are updated at least six monthly or sooner in the case of a major event. 33Income Securities Monthly reports provide a roundup of current pricing and recommendations and an outlook for the market. 33An archive of income securities research reports is available on Morningstar s Adviser Research Centre platform and Morningstar s retail investor website. Research report content Income securities research reports contain detailed issuer analysis and an investment recommendation on the security. Reports contain the following content: 33Recommendations Subscribe/Don t Subscribe for IPO reports. Buy, Accumulate, Hold, Reduce, Sell or Avoid once security is trading. 33Investment Rating overview of the risk and investment appeal of the security 33Analyst Note analysis of a key event and implications on the investment appeal of the security 33Thesis analysis of the business risk and financial risk of the underlying business 33Contract Summary description of the specific characteristics of the security 33Security Valuation key inputs to the valuation of the security 33Risks analysis of potential risks to the underlying business and security 33Investment Perspective of underlying business Investment Rating, Risk, Growth, Profitability and Financial Health of the underlying company 33Forecasts and key ratios of the underlying business 33Note: Morningstar Australasia does not provide credit ratings. Morningstar s income securities analysis builds on the modelling expertise of the equities research team, including: 33At least five years of detailed pro-forma financial statements 33Extensive analysis of free cashflow and return on invested capital 33Uncertainty and scenario analysis, including upside and downside cases 33Forecasts of leverage, coverage and liquidity ratios 33Estimates of off-balance sheet liabilities Economic Moats Just as moats protected castles from invaders in medieval times, businesses with economic moats have strong defences against their profits being competed away. We ascribe a moat rating to each stock researched: Wide, Narrow or None. The moat is the competitive advantage that one company has over other companies in the same industry. Moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. Without a moat, highly profitable firms can have their profits competed away as other companies see how attractive the market is and try to move in to reap some of the rewards themselves. Across our research, we have discovered five economic moat sources: Intangible assets, switching costs, network effects, cost advantage and efficient scale. Intangible assets include strong brands which encourage repeat sales and support price rises over time. Intellectual property rights like patents, trademarks, copyrights and government approvals are other intangible assets that can lead to moats. Switching costs make it too expensive or time-consuming to shift to an alternative supplier. The network effect is a virtuous cycle allowing strong companies to get even stronger. It occurs when the value of a particular good or service grows as the number of users grows. Cost advantage can derive from increased scale and efficiency, allowing the company to increase margins. Efficient scale occurs when a limited market is effectively served by existing players and the profit opportunity does not justify entry by others. Business Risk Business risk captures the fundamental uncertainty around a firm s business operations and the cash flow generated by those operations. The following factors are key to determining business risk: 33diversity of revenue sources a company with diverse revenue stream should have more reliable revenues as weakness in one area may be offset by strength in others. 33cyclicality of revenues for example revenues of a housing products supplier will be tied to cyclical property demand cycles and will be more volatile than a supermarket retailer which should have more ongoing demand. 33the firm s fixed-cost structure companies with high levels of fixed costs will have greater swings in earnings as revenues move up and down. 33financial leverage companies with excessive debt levels may run in to troubles should conditions deteriorate, potentially causing unwanted asset sales, dilutive equities issues or even bankruptcy. 33contingent events examples include outstanding litigation, risk of aggressive acquisitions at high prices, asbestos liabilities etc. Declaration Declaration of personal shareholdings, disclosure list. These positions can change at any time and are not additional recommendations AAO,ABC,ACG,ACL,ACR,AFI,AGK,AGS,AGX,AKF,ALL,ALS,AM P,ANO,ANP,ANZ,APA,APN,ARD,ARG,ASB,ASZ,ATI,AVX,BEN, BFG,BHP,BKI,BKN,BLY,BND,BNO,BOL,BOQ,BSL,BTU,BWP,BXB,CAB,CBA,CCL,CDD,CGS,CIF,CND,COF,COH,CPA,CRK,CRZ,CSL,CSS,CTN,DOW,DTE,DUE,EGP,EPX,EQT,ERA,ESV,EVZ,FMG,FX J,GBG,GFF,GMG,GPT,GWA,HIL,HSN,IAG,IFL,IGR,IIN,ILU,IPD,J MB,KAR,KCN,KEY,KMD,LEG,LEI,LLC,MBN,MCR,MFF,MIO,MP O,MQG,MSB,MTS,MUN,MYR,NAB,NEU,NHC,NMS,NUF,NUP,NVT,NWS,OSH,PBG,PBT,PGM,PMV,PNR,PPT,PRG,PRY,PTS,Q BE,QFX,QUB,RCR,REX,RFE,RHC,RHG,RIO,RKN,RQL,SAKHA,S EK,SFW,SGP,SGT,SHV,SMX,SOL,SRH,SRX,STS,SUN,SVW,S WM,TAH,TCL,TEN,TLS,TOL,TPM,TRF,TRS,TSE,UGL,UXC,WAL,WAM,WBB,WBC,WCB,WDC,WES,WHC,WHG,WOW,WPL, ZGL,