eureka report high lights m2

Hi

Investment Wiz Mongomery high lights M2.


PORTFOLIO POINT: When traditionally defensive investments perform on par with the money-under-the-mattress technique, it's time to start looking at less obvious options.


The word ?defensive? gets bandied about quite a bit in markets like this one. It?s a comforting word and the last resort of the stockbroker when clients are about as interested in stocks as they are in a case of the shingles.

After all, how else can they keep a straight face when they ask you to buy stocks when US unemployment remains terminal, European banks are facing a crisis of Wagnerian proportions and financial markets around the world are falling into a screaming heap.

OK, that was a bit dramatic but it?s important for readers to remember that when equity markets collapse the only truly defensive investment is cash ? and in an inflationary environment even that won?t work.

Institutional fund managers traditionally turn to US Treasury bonds which they consider to be at the top of the tree when it comes to ?safe? and ?defensive? investments. But what is safe about a guaranteed loss of purchasing power? Buy US Treasuries today and you will have lost money after inflation. Nothing defensive about that.

So while ?defensive? may in fact be a relative term, I began to ponder what kinds of business revenue streams could truly be regarded as defensive in a market that threatens to make mincemeat of everyone.

After a great deal of thought and agonising I decided that the only truly defensive investments were companies involved with food, energy, government contracts and recurring revenue streams.

There are at least two industry groups that may just have one, if not both of the latter characteristics which may come as a surprise to you if previously you had not considered telecommunications or IT services companies as defensive.



It must be stressed however that these sectors aren?t completely immune to exogenous risks such as an economic downturn, customer churn, integration risks or poor cost control. Nevertheless some members of this group of companies have the comfort of multi-year maintenance contracts to cover relatively low overheads, in addition to growth opportunities.

With a variety of levels of recurring revenue as well as some government contracts, companies like ASG Group (ASZ), DWS Advanced Business Solutions (DWS), Oakton (OKN), Reckon (RKN), Technology One (TNE), Hansen Technologies (HSN) and SMS Management & Technology (SMX) may enjoy true defensive cash flows even in a period of economic uncertainty. ?May? is the key word here and investors would do well not to ignore it.

To expand on my theory about defensive businesses we should note that a recession is not going to see you cut off your internet at home. Nor would a business. How else are they going to do their banking, marketing and customer service? A recession is not going to reduce internet penetration or traffic data volumes. In fact, it might even improve them!

For that reason there may be defensive characteristics among telecommunication companies like iiNet (IIN), Amcom (AMM), M2 Telecommunications (MTU), Vocus (VOC) and yes, even Telstra (TLS). With these themes in mind, it is worth exploring the quality, prospects and value of these candidates.

DWS, Oakton and SMS all provide IT services as does ASG who, along with Technology One, also develops and supports software solutions. All of these companies generate some of their revenue from government contracts. Hansen develops CRM, billing and smart metering data management software for electricity retailers and while its customers aren?t necessarily from government nearly three quarters of its revenue is recurring.

Importantly each of these businesses enjoys the benefits of low capital intensity. Unlike an airline or a heavy equipment manufacturer an IT company?s most valuable asset is its staff members and despite the rather creative history of the accounting profession, it has yet to come up with an agreed method of capitalising staff on the balance sheet.

The result of this low level of tangible assets to equity ratio is that returns on tangible equity and on equity are very high. These are both very attractive attributes. With the exception of ASG which is forecast to generate a return on equity of 15.43% for this financial year, and Oakton which is recovering from a difficult 12 months and has warned it may not meet its revenue forecasts, each of these IT businesses are expected to generate a return on equity of more than 25%!

Interestingly each business also receives a MQR (Montgomery Quality Rating) of A2 or better, though Oakton earns an A3 rating. In terms of value however, recent market volatility isn?t delivering any serious bargains just yet. While plenty of the broker research I see suggests you should be buying a few of these companies I suggest waiting a little while longer.

Based on my most recent calculations most of these companies are trading above intrinsic value. ASG Group is trading 20% above its intrinsic value, DWS Advanced Business Solutions 7% above, Hansen Technologies 36% above, Oakton 22% above and Technology One 48% above intrinsic value. Only SMS Management & Technology (SMX) is trading at a discount to my estimate of intrinsic value and that margin of safety is relatively small at 4%.





Time, then, to keep looking. In the telecommunications space, Amcom is forecast to earn a return on equity over the next few years of no more than 9%. Short of speculating about a takeover (although I would never rule it out) we can look elsewhere.

iiNet is expected to earn a respectable 17.4% return on equity and receives a B3 quality rating which is unfortunately at the tail end of the investment grade scale. Importantly however, the company is trading at only a 4% discount to intrinsic value which is just not cheap enough for me in these volatile times.

TPG receives a C3 rating, which is below investment grade so we can move on immediately from there. Finally, M2 Telecommunications ? a company I will be seeing this week for a chat ? is forecast to generate a return on equity of 35%, receives an A1 quality rating and is trading at a 13 per cent discount to intrinsic value.





I believe this is the one worth investigating further, and that?s precisely what I will be doing this week. I am particularly interested in the motivation for changes to the management structure and precisely how much strategic work management now has the capacity for. Remember, the bus with the pedal already to the metal doesn?t necessarily go any faster because you change shoes.




Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.