Archive for November, 2006

Is oil going to be more expensive?

Friday, November 10th, 2006

For the past couple of months, oil price had fallen from a high of US$78 to a low of US$57. Many reasons were given, ranging from rising US oil inventory to quieter than usual hurricane season in the Caribbean. Consequently, that gave the Dow Jones an excuse to rise on the back of an ?improved? consumer sentiment.

But what are our convictions for oil prices? We have no confidence in predicting the price of oil in the immediate short term. But we have an opinion on where oil prices are heading in the long term?we believe the direction is up. What is the basis of our conviction?

Firstly, we look at the fundamentals?the dynamics of supply and demand.

On the demand side, the rises of China and India in the 21st century, with their massive populations, will have an immense impact on the world?s total demand for oil. As the East (China and India) get wealthier by the day (see our article, Transference of wealth from West to East), you can expect the rise (in numbers and prosperity) of their middle-class to increase the strain on the earth?s resources. Today, the US, with a population of only a fraction of China and India, consumes far more than its proportionate share of the earth?s resources. Imagine how much China and India will consume as they attain towards the current living standards of the US! Next, we have to ask ourselves another question: will the increase in usage of alternate and renewable energies eventually supplant the usage of oil? While we do not know how the usage of such energies will turn out in the future, we can be sure that it will take quite a long time for the world economy to retool and wean itself from oil. This is because the world economy is running on the basis of cheap and abundant energy.

Now, let?s look at the supply side. According to a growing consensus in the scientific community, the world is approaching the stage of Peak Oil. Put it simply, the Peak Oil theory states that the world?s oil production has reached the peak and is entering the stage of terminal decline. One common misunderstanding of Peak Oil is that the world is running out of oil. No, the world is not running out of oil?the world is running out of easily accessible oil. This factor, along with the inadequacy of the world?s oil infrastructure led to dwindling of the global spare oil capacity to a 20-year low. With razor thin spare capacity, all the world needs is an unexpected supply disruption to cause oil prices to shoot up as it had happened recently. Thus, as the article in the Sydney Morning Herald said, there is an urgent need to increase global oil production capacity:

THE world’s top finance ministers and central bankers will meet in Melbourne next week to discuss attracting $US8 trillion ($10.4 trillion) in energy investments to avoid production shortfalls.

The startling forecast of the 30-year investment funding needed to bolster inadequate oil and gas capacity – which implies that the oil price could soar far above yesterday’s $US59 a barrel – is in an International Energy Agency report commissioned by the G20, which is to meet on November 18 and 19.

A third factor may lead to increase in oil prices?monetary inflation. Since oil is priced in US dollars, any deterioration in the quality of the US dollar will have an upward effect in the nominal price of commodities, oil included. We will discuss this issue in more detail in the future.

Qantas rose on takeover rumour

Wednesday, November 8th, 2006

Yesterday, as reported by the Australian Financial Review (AFR), there were rumours of Qantas being a takeover target. Consequently, the share price shot up from $4.20 to $4.31. At one point, speculators were trading Qantas shares at the record high of $4.36.

We marvelled at the foolhardiness of the speculators who, based on this gossip, rushed to buy Qantas shares. Anyone who knows what they are doing will know that it is highly unlikely that Qantas will be taken over. Firstly, the law forbid any foreigners from owning more than 25 per cent of Qantas and all foreigners can hold a total of only 49 per cent of it. Secondly, we doubt there is any good value for Qantas shares at this level of price.

Needless to say, if any private equity company wants to buy up our holding of Qantas shares, we will gladly sell it to them.

Is the Telstra T3 offering worth a buy?

Monday, November 6th, 2006

Current situation

Currently, the prevailing market mood against Telstra, the largest telecommunication company in Australia, is one of anger. The mum-and-dad investors are angry because many of them bought into T2 (the Australian government?s second lot share sale of its holdings in Telstra) several years ago at $7.40 and now the share price is worth around half of that. To make matters worse, Sol Trujillo, the current CEO who took over the reins last year, engaged in a public wrangle with the government over regulatory issues and deliberately ?talked down? the share price even further. Since the government intended to sell its third lot of Telstra shares to the public, it was highly displeased to see that happen. There is no doubt that PM John Howard hates Mr. Trujillo?s guts. So, when you combine a volatile cocktail of engineered falling share price, quarrel with the government and massive job cuts, you get a fire of rage.

Thus, Sol Trujillo became the bogeyman.

As contrarian investors, we watched the unfolding drama with amusement. We are more inclined to see Sol Trujillo more as a hero and less of a villain. Compared to the previous CEO, Mr. Trujillo is a visionary who dare to overturn the tables and challenge the status quo. On the other hand, as expected, there was some digging of dirt by the media on Mr. Trujillo. But what do you expect the media to say on a bogeyman?

We sympathize with the mum-and-dad investors (that include the father of one of ours) who paid the exorbitant price for T2. But our advice is this: get even, not mad with Telstra. Part of the reason why Telstra had lost so much value since the sale of T2 was due to the fact the government owned half of Telstra?without such part ownership, the government would not have a conflict of interest issue (that is because it is unfeasible to play the dual role of shareholder and consumer advocate), which encouraged nothing more than the unsustainable status quo.

Our impressions

Now that the government is offering T3 for sale, should we subscribe to the offer?

First, we start with a confession. We used to loathe Telstra. As consumers, we felt that they were arrogant, the quality of their products shoddy and their customer service a joke. We remembered watching with glee as consumers launched a class action suit against Telstra for providing shoddy Internet broadband service.

However, since Sol Trujillo took over, our perception of Telstra had changed for the better. We believe they are putting substantial effort to shed their bad image and change for the better. Not long ago, we were paid twice to take part in two surveys conducted on behalf of Telstra in a consumer study on telecommunications. In the surveys, we were asked questions that gave us the opportunity to air out our unfavourable impressions on Telstra and their products?we were brutally frank in our comments. Lately, we also noticed the marketing blitz by Telstra. We admit that we liked what we saw. If we base on the assumption that the products work as advertised, we can say that as consumers, Telstra is finally giving us what we want. That is a good sign for us, as investors?if consumers (including ourselves) absolutely love a business?s products, it is likely that we will love the business?s shares too.

Critical issues

But wait, hang on! Before we get carried away, let us first examine these critical issues with regards to investing in T3.

Firstly, Telstra is undergoing a significant overhaul and transformation of its business, which carries considerable risks. Since they are in the process of investing heavily for their future, their net profit for the next few years may decline temporarily. Along with regulatory uncertainties, their earnings beyond next financial year can never be forecasted with any accuracy. Therefore, any amount of quantitative analysis will be woefully inadequate in analysing the merits of this investment. For the case of Telstra, qualitative analysis plays a more significant part in our evaluation of T3. The flip side of qualitative analysis is that since it is more of an art than science, it is far more prone to our subjective bias. In view of all these uncertainties, we can expect fluctuations and volatility in Telstra?s share price in the next few years ahead.

Secondly, contrary to what the press, government and financial market analysts are trying to convince us, basing our investment decision purely on the 14% dividend return in the next financial year is foolish. First (this is the minor point), you have to understand that in actual fact, the dividend return is less than 14 per cent?the magic number ?14? is based on the price you paid for the first instalment of T3. Including the second instalment (which is yet to be determined at this stage), which is payable in May 2008, the total return will be lower than the magic number of ?14.? That is true even if you save the money meant to pay for the second instalment in a high-yield deposit in the interim between the payment of the first and second instalment. Anyway, this is not the most important point. The main reason why basing our decision purely on the magic number is foolish is because if the underlying business turn out to be doing very badly (implying the share price and T3 price will probably fall significantly), the 14% dividend in the first year will not be enough to compensate you for the overall loss in the investment. Thus, we have to stress this point: your decision to invest in T3 will have to be rooted in your conviction of the future earnings of the business. Forget about the magic number.

Thirdly, the current Telstra dividend amount is actually higher than its net profit. Thus, they have to pay you for the dividend. That may sound forbidding, but at this point in time, with their yearly cash in-flow in the order of billions, the company is not suffering from terminal financial cancer. But at the same time, please be aware that this trend is not sustainable unless Telstra invest to increase their future profits.

Will Telstra decline irreversibly?

In Telstra?s T3 prospectus, it said,

Telstra?s traditional high margin PSTN revenues have been, and will continue to be, negatively affected by both intense competitive pressure and customers migrating to alternative platforms, such as wireless, high bandwidth Internet, IP telephony, and web and managed services.

In view of this, many are predicting that Telstra?s business is heading towards extinction and that it is suffering from permanent and irreversible decline into oblivion. We disagree with this doom and gloom prediction. The logic behind such prediction is based on extrapolation of the past status quo (the situation before Sol Trujillo took over) into the indefinite future and assumption that Telstra will stand in the sidelines idly and do absolutely nothing to save their business from technological obsolescence. With Sol Trujillo taking over, such extrapolation and assumption lead to fallacious conclusions.

The question we would like to ask those doom and gloom predictors are: if Telstra?s competitors in the ?alternative platforms? will eventually destroy Telstra?s last bastion of profits, what is stopping Telstra from embracing those ?alternative platforms? and counter-threatening their competitors? business? At this point in time, Telstra still possess considerable (although declining) competitive advantages that are exceedingly difficult for their competitors to overcome. With their existing competitive advantages, we believe their competitors have more to fear from them encroaching into their competitors? businesses than they have to fear from their competitors nibbling away their existing business. Take for example the case of Unwired, a provider of wireless Internet broadband service provider. Telstra is already in the business of providing wireless broadband and along with other new products (e.g. NextG), value-added cross-selling of existing products (e.g. Foxtel movies), sales reach and marketing prowess, which company do you think have more to fear?

To appreciate the considerable market power that Telstra still possess, we have to understand the strengths of their competitive advantage.

The first and most important competitive advantage that Telstra have is their cash position?the amount of cash that Telstra earn annually exceeds all their domestic competitors put together. For the doom and gloom predictors? worst-case scenario to happen, the national usage of ?alternative platforms? has to cross over from the marginal market to the mainstream mass-market. For this cross over to ensue, Australia?s Internet telecommunication infrastructure, which is in an abysmal state, has to be upgraded and overhauled significantly. Not one of Telstra?s domestic competitors has the financial firepower to invest billions of dollars to undertake this mammoth task. Furthermore, they are too fragmented and divided to take a united stand against Telstra and unilaterally take on such costly projects. So far, Telstra is the only one (other than the government) who has the financial firepower to do so. As such, this gives them significant weight when dealing with the ACCC. Australia desperately needs an upgrade and overhaul of its Internet telecommunication infrastructure in order for its economy to remain internationally competitive in the 21st century. Australia is falling behind many Asian economic tigers in this area and further delay will imperil its economic development. We believe that the Australian government needs Telstra to undertake such an economically vital project and we have no doubt that Telstra will take full advantage of the government?s weakness as leverage in their battle against the ACCC. Thus, we foresee further political tussle between Telstra and the government in the days ahead.

Assuming that Telstra will eventually be the ones developing Australia?s Internet telecommunication infrastructure (after extracting significant concessions from the ACCC), they will have control over two crucial variables?the timing of the launch and the first access to the mass-market. Whoever controls the timing has the first movers? advantage?the power to strike first at the most opportune time. Whoever has the first access will grab the first and bigger slice of the pie before the rest, which is a major competitive advantage. In view of that, Telstra can succeed by embracing and monopolising the ?alternative platforms? by using their existing competitive advantage. The crucial qualifier for this outcome is that Telstra will win the fight against the government and ACCC. As a note of interest, the ACCC recently declared that they will keep a hands-off approach on Telstra?s new NextG mobile and wireless Internet network. At this point in time, it is still too early to say whether this is the beginning of a trend. But if it is for Telstra?s non-legacy infrastructure assets, then it is indeed very good news for Telstra.

Is vertical integration Telstra?s strategy?

Will Telstra remain just a telecommunication company in the future? This is a very interesting question. If the answer is ?yes?, we would not be keen in investing in Telstra because there are much more lucrative opportunities elsewhere. We suspect the answer will be ?no? because if we were Sol Trujillo, we would have taken the strategic path to transform Telstra to one that is more than a telecommunication company. We believe this strategy is the key to Telstra?s future.

To understand the nature of this strategy, we have to understand the concept of ?vertical integration.? It is the integration of disparate set of individual technologies, platforms, products and services into a complete package that serves a need. A very good example of vertical integration is Apple’s iPod. An iPod is more than a MP3 player?it is part of an ecosystem of software (iTunes), service (Music Store), hardware (iPod), and content providers (media, record and TV show companies) to deliver to the consumers a complete entertainment experience.

Another reason why the ?alternative platforms? had not gained traction in the mass-market is because to have a working solution on it, consumers had to understand a wide array of different systems, hardware, software and technologies and do the vertical integration themselves. This is not always feasible for the average mum-and-dad. For a business to deliver to the mass-market a vertically integrated package, it needs to have ownership or control of the various parts of the system, including the platform (the Internet telecommunication infrastructure) that the system sits on. To be in such a position, a business would require deep pockets to embark on costly investments. So far, Telstra is the only business that fit this requirement.

Vertical integration can also lead to market power. A business that can serve the mass-market with a vertically integrated solution will have its customers locked into its system. This is because each component within the system is so interdependent to each other that without any one of them, the whole system will not work. For any competitor to succeed, it has to first build an entire infrastructure of an alternative system and then convince consumers to switch. As Telstra embarks on a path towards vertical integration, we can see it gradually building another future monopoly right under the nose of the ACCC. We hazard a guess that usually by the time the ACCC decides to do something about it, it would be too late.

Vertical integration is probably the reason why Telstra is acquiring businesses outside its traditional realm of telecommunication. Hence, we believe that ten years from now, Telstra will be radically different from today?it may not even be called a telecommunication company.

Would we subscribe to T3?

The deadline for the T3 offer is a few days away. We believe it is a good investment, though it certainly carries risks and there can be better value elsewhere in the market. Any investment in Telstra requires a long-term horizon of at least five years. In the meantime, we expect more fights and tussles between Telstra and the government and ACCC, which may drive down the share price via negative sentiments. Investors in T3 have to be mentally and emotionally prepared for such happenings.

We believe that if Sol Trujillo and his team can pull off such a radical transformation, Telstra?s share will be worth very much more in the future. But if they fail, the results can be unpredictable. At this point in time, the management looks to be doing the right thing. So, the decision to invest in T3 is a vote of confidence in Sol Trujillo and his team, which is very subjective in nature.

We leave the decision up to you.

Tide turned

Saturday, November 4th, 2006

The US stock market tide is turning, after being spooked by the latest batch of economic data suggesting that the economy may fall into recession. Last Friday, the Dow Jones retreated back to below 12,000 points?the first six-session drop since mid-2005.

We are not the least surprise by the fall. As we said before, the financial market is currently at an inflexion point, which is the point of confusion. As such, market sentiment will be seesawing with no clear conviction. Our conviction still stands?the US economy is very sick and by implication, the stock market will eventually follow. For us, we are hedging our financial well-being with gold.