1 December 2011

Special Report
Transport A mixed bag
so invariably new players seem to crop up every now and then. Some airlines, backed by their respective governments, continue to operate even though they drain cash flows and make sub-economic returns. We view airline stocks as trading opportunities rather than core long-term holdings. We dont believe airlines create shareholder value in the longer term given the lack of pricing power and generally low barriers to entry. The Australian domestic sector is dominated by Qantas (QAN) and Virgin Blue (VBA). Regional airlines such as Regional Express (REX) remain niche players. QAN commands a whopping 65% share of the domestic market while VBA has a 25% share. In the premium end of the market QAN reigns supreme with a share of 90%. VBA is a relatively small player in this space but has ambitions to attack QANs stranglehold on this market. It has had some success so far. The domestic business is very profitable for QAN given its large market share, relatively stable yields and less competition than international routes. Nonetheless, the recent industrial action followed by the grounding of aircraft is affecting the company, with demand declining 3% in September. We expect further declines over the next few months as the full impact of aircraft groundings become visible. Unsurprisingly, VBA has capitalised on this opportunity, registering solid demand growth of 5.8% in September. According to the Bureau of Infrastructure Transport and Regional Economics (BITRE), domestic business class fares have risen 9% over the prior year while full economy fares remained steady. This benefits QAN due to its dominant number of premium seats. On the other hand, restricted economy fares declined 25% year-on-year, reflecting intense competition in the leisure segment, mainly instigated by Jetstar. While the domestic business is solid, the international business is a different kettle of fish. QAN is losing approximately $200m on a pre-tax Continued on page 2

Nachi Moghe Senior Equities Analyst

The S&P/ASX 200 Transport Index has moved in line with the broader market over the past three months, but has underperformed the market by approximately 5% over the year. The airline industry in particular has taken a beating, with QAN being the biggest culprit. Its share price has been weighed down by negative investor sentiment pertaining to industrial strike action and the subsequent grounding of aircraft. While the matter has now progressed through to arbitration, it is unlikely there will be any further disruptions or grounding of aircraft, at least in the near term. Consequently, we would expect the stock to bounce to pre-crisis levels over the next three to six months unless economic conditions deteriorate markedly. The transport and logistics sector, which includes companies like Asciano (AIO), Toll (TOL), QR National (QRN) and Qube Logistics (QUB), did far better, handily outperforming the broader market over the past year. Investors seem enthused by the earnings outlook of these firms. QRN has been the standout, surging well above its issue price of $2.55 per share. In our report, we cover three different segments of the transport sector, namely airlines, freight and logistics, and transport of bulk commodities such as coal, iron ore and steel. These sectors have very different competitive dynamics and risk profiles.
Airlines Investing in an airline is not for the faint-hearted. The industry is generally beset by overcapacity and yield pressures. Several airlines have gone bankrupt around the world and yet overcapacity seems to persist. This could be attributed to the fact the barriers to entry for this industry are low,

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1 December 2011

basis annually and is the main reason group returns continue to be abysmally low. Given the sector lengths on international routes, fuel prices have a significant bearing on the profitability of airlines. This is where QAN is being adversely affected. Furthermore, the company faces stiff competition from global players, which invariably tends to dampen yields as well. VBA faces the same issues, albeit not of the same magnitude as QAN. Its long-haul business has generally struggled and its foray into NZ was a disaster. The company has formed a spate of alliances with international carriers, with the intention of getting more traffic into and out of Australia on its domestic flights with minimal capital expenditure.
Freight and Logistics The transport, freight forwarding and logistics industry has a high level of cyclical exposure to global economic conditions. Stronger household and business expenditure on goods predictably converts into increased demand for transport, freight forwarding and logistics services. Prior to the global financial crisis, during stronger global economic conditions, demand for transport, freight forwarding and logistics services was robust and the main issues surrounded increasing pressure on freight movement to fully meet the growing demand.

The GFC resulted in lower global trade, as retailers reduced large inventory stockpiles, causing a significant downturn for the industry. But by 2010, volumes and rates began to slowly rise again until the sovereign debt woes in Europe and recession worries in North America became apparent. The past year has been a period of uncertainty for the global transport, freight forwarding and logistics industry, with large volatility in volumes and pricing.
Bulk Rail and Ports Bulk market volumes have been mixed in recent times and are difficult to forecast. Agricultural product volumes should continue to grow as rising Asian wealth generates increasing demand for Australian food products, with grain the most important for AIOs PN Rail. While shipments on behalf of local steel producers continue to weaken, import substitution should largely compensate and generate additional volumes through Australian ports, therefore also benefiting AIOs Patrick stevedoring business

Transport vs the Market (1 year total returns to November 2011)

S&P/ASX 200
115

S&P/ASX Transportation Index

110

105

100

A new enterprise agreement with the Maritime Union of Australia provides the prospect of improved productivity in the Container Terminals Division (Patrick). The agreement provides for average annual real wage increases of 4.4% over five years, with higher benefits available if performance meets certain goals, but at the same time it delivers significant productivity increases. Patrick has won back market share, which has risen from 45% to 50%. Volumes in the Ports business are much more a function of imports than exports as Patricks ports do not handle mining commodities. Reduced demand from financially weakened, de-leveraging consumers may translate into an extended period of weak volume growth for Patrick. Over the long term, volume growth is unlikely to match past growth in the 510% range. Past volumes increased as Australias manufacturing was increasingly outsourced to Asia and it came back as imports. Many years in the past two decades also benefited from rising consumer debt levels that financed increasing consumption. Patrick and the other stevedore DP World also face the entry of a third stevedore in Brisbane and Sydney, possibly from 2013. While we expect the new player, Hutchison, to target less than a third share due to space constraints, it represents another significant headwind to growth in this part of AIOs business.

95

90

85

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

Apr-11 May-11

Jun-11

Jul-11

Aug-11

Sep-11

Oct-11

Nov-11

Source: Bloomberg/Morningstar

1 December 2011

Outlook The airline sector is likely see capacity growth of around 56% this year coupled with yield increases of the same magnitude. A spate of fuel surcharges implemented over the past six months boosted yields and hasnt caused any demand destruction as yet. Fuel prices are likely to rise this year too and will more than offset hedging benefits and price increases. We think demand is likely to increase in line with capacity growth, resulting in stable load factors.

The downturn in the Australian transport, freight forwarding and logistics industry has been softened by strong economic growth in China, India and elsewhere in Asia. But the industry is restrained by the domestic two-speed economy a booming resources sector in contrast with an ailing consumer sector. Traditionally, the domestic transport, freight forwarding and logistics industry has been more leveraged to the consumer discretionary sector, which continues to falter. Domestically, stronger environmental regulations and the carbon tax will impact the industry, with changes in modes of transport and a move to rail and sea freight the most probable outcome.

On the commodities front, most forecasts see Australian coal exports growing at around 5% a year over the next five years, though the outlook for the Chinese economy is unclear given possible sustained demand weakness in Chinas export markets and growing internal economic imbalances. China has grown thermal coal consumption by 8.1% on average over the 11 years to FY10, 7.1% over the past five years and 6.0% over the past three. For the entire Asia-Pacific region, these figures were respectively 7.1%, 6.2% and 5.4%. Most forecasters expect Asian economic growth to drive continued growth in energy demand, in turn driving strong growth in Australian thermal coal exports with ABARE forecasting over 10% annual growth to 2016. We expect transported steel volumes to rise along with rising domestic infrastructure spend over the medium term. A large proportion of this will be on private-sector resource projects. In FY12, we expect Pacific National Rails volumes to be flat in aggregate, but to average around 4% growth over the next five years. Analyst: Nachi Moghe

Preferred Stocks

Qantas Airways QAN $1.52 Price Recommendation Accumulate 1.70 Accumulate Below ($) 1.20 Buy Below ($) High Business Risk Low Price Risk None Moat Rating 2.00 Fair Value ($)

Qantas (QAN) QAN is one of our preferred stocks in the airline industry. We believe at the current price the stock provides a favorable risk-reward trade-off. However, we would not advocate a buy and hold strategy but rather a trading strategy whereby any strength in the stock price beyond $2.29 per share should be used as an opportunity to Sell.

undertaken by the firm. More importantly forward bookings have recovered and domestic and corporate accounts are back to normal levels, signifying that there has been no real dent to the firms brand image In light of the industrial strike action and potential ramifications for future revenues, we cut our NPAT forecast from $364m to $319m. Our forecast assumes a favorable outcome from arbitration. However, an unfavorable outcome could lead to higher costs attributable to wage increases. Analyst: Nachi Moghe
Regional Express Holdings Ltd (REX) REX is our top pick in the airline sector. Its fleet of small turboprop planes service regional routes on Australias East Coast. It holds monopoly positions on most routes, many too small to be profitably served by the larger aircraft of Qantas and Virgin. Low competition and limited exposure to discretionary tourism travel provide a high degree of earnings stability compared to other airlines. Growth opportunities in the core airline business are limited but increasing charter work and the pilot academy should drive earnings higher in FY12.

Regional Express REX $1.00 Price Buy Recommendation 1.35 Accumulate Below ($) 1.15 Buy Below ($) High Business Risk Medium Price Risk None Moat Rating 1.60 Fair Value ($)

The company expects underlying profit before tax (PBT) to be between $140190mn in the first-half. This represents a decline of 5466% compared to normalized PBT of $412m in 1HFY11. The cost of the industrial action coupled with high fuel prices is expected to impact group earnings by approximately $650m. The industrial action is likely to cost the company $194m in aggregate. Stripping out costs relating to the industrial action and fuel and adjusting for natural disasters last year, pre-tax earnings on a like-forlike basis will be significantly higher compared to 1HFY11. Consequently we believe that the business is tracking well and is being underpinned by domestic and frequent flyer businesses and the ongoing positive impact of cost out measures

1 December 2011

Asciano AIO Price Recommendation Accumulate Below ($) Buy Below ($) Business Risk Price Risk Moat Rating Fair Value ($)

$1.53 Hold 1.45 1.13 Medium High Narrow 1.61

Toll Holdings TOL Price Recommendation Accumulate Below ($) Buy Below ($) Business Risk Price Risk Moat Rating Fair Value ($)

$4.67 Hold 4.65 3.60 Medium Medium Narrow 5.15

We continue recommending risk-tolerant investors Buy around the current price of $1, believing REX offers an attractive risk-return trade-off. On a PE of just 7x last years earnings, REX is too cheap to be factoring in much growth. This isnt surprising considering the poor performance over the past few years but the immediate future looks bright, with EPS expected to grow more than 20% in FY12, starting this half. Completion of the multi-year fleet upgrade is also positive as lower capex requirements means more free cash flow to fund bigger dividends and the share buyback. Analyst: Adrian Atkins
Asciano Limited (AIO) AIO is a transport infrastructure business, with a focus on ports and rail. Its portfolio includes Pacific National's rail and coal operations and Patrick's port and stevedoring businesses. At the current price the stock looks reasonably attractive and would advocate investors start Accumulating below $1.45 per share.

significantly more volatile businesses that rely on import volumes, construction activity, base metal demand and agricultural volumes. Chairman Malcolm Broomhead told the AGM: "While not giving specific guidance, we do however feel comfortable stating that, barring unforeseen events or a further significant deterioration in economic conditions, Asciano will report another solid year of growth in both revenues and earnings across all three divisions." Analyst: James Cooper
Toll Holdings Limited (TOL) TOL is among the dominant suppliers of transport, logistics and freight forwarding in Australia. Scale and market share in the domestic market provides a major competitive advantage, barrier to entry and solid base for regional expansion. TOLs operations are highly leveraged to economic conditions. Significant exposure to domestic retail, fast-moving consumer goods, and the industrial and automotive sectors causes earnings volatility. We advocate investors start Accumulating below $4.65 per share.

The company delivered a solid performance in FY11, with underlying NPAT rising 33% over the prior period. Free cash flow, defined as net operating cash flow minus all capex, was $81.5m compared with cash outflow of $142m in the pcp. Cash flow benefited from lower-than-budgeted growth capex due to delays in regulatory approvals and deferred customer decisions on the Queensland Northern Missing Link coal contracts. A big disappointment for some investors was AIOs strategic decision not to undertake a corporate restructure. Some investors hoped AIO would split into two separate companies, one comprising rail assets and the other ports. They believe creating single-sector exposures would lead to greater realisation of value. The current group blends a very resilient coal haulage business with potentially and

Management believes economic conditions will remain challenging in FY12, with the domestic retail and industrial sectors set to struggle in the next year. A strong December quarter in the retail sector will greatly assist TOLs 1H12 financial results. More than 10% of Australian revenue stems from the consumer discretionary sector. Major customers include Woolworths, Wesfarmers and Fosters. But TOL expects benefits from the strength in the resources sector for Toll Global Resources the Marine Logistics, Mining Services, Offshore Petroleum Services, Energy and Remote Logistics businesses. The company has a solid business model and focused growth strategy based on regional

Morningstar recommendations and forecasts

EPS Code Recommendation SP($) FV($) Moat Rating FY11(a) FY12(e) FY13(e) FY11(a) PER FY12(e) FY13(e) FY11(a) Dividend yield FY12(e) FY13(e)

QAN VBA REX TOL AIO QRN QUB

Accumulate Hold Buy Hold Hold Hold Accumulate

1.52 0.34 1.00 4.67 1.53 3.38 1.41

2.00 0.28 1.60 5.15 1.61 3.13 1.90

None None None Narrow Narrow None None

17.1 14.9 39.3 7.0 6.9 5.9

14.1 1.4 18.1 43.6 8.5 14.2 7.6

19.2 4.0 18.4 47.9 9.9 16.0 9.0

14.2 7.2 15.0 23.4 45.2 20.6

10.7 26.6 5.7 11.0 17.8 24.4 17.4

7.8 9.4 5.6 10.0 15.4 21.6 14.7

0.0 0.0 6.7 4.2 0.0 0.0 3.1

0.0 0.0 7.3 5.4 1.3 1.1 3.4

2.0 0.0 7.4 5.6 2.0 2.4 4.1

Source: Morningstar analysts

1 December 2011

Qube Logistics Holdings QUB $1.41 Price Recommendation Accumulate 1.70 Accumulate Below ($) 1.30 Buy Below ($) Medium Business Risk Medium Price Risk None Moat Rating 1.90 Fair Value ($)

expansion. Recent acquisitions will increase operating cash flow in FY12, but global and domestic economic conditions remain fragile and will limit earnings growth. We do not expect a net material financial impact on earnings from the carbon tax, as it will pass the increased costs onto customers. Analyst: Ross MacMillan
Qube Logistics (QUB) QUB is an emerging player with plans to become Australias first end-to-end logistics provider for customers to get their products from ship to shelf. Vertical integration lets the company capture more revenue along the supply chain and allows streamlining in this historically inefficient and fragmented industry, improving profitability. Long-term growth prospects attract and

management is high calibre, including Chris Corrigan and other former executives from Patrick. Capital raisings to fund expansion, execution risk and a high degree of economic cyclicality need to be considered by investors. We recommend Accumulating under $1.70. Current operations are split into two divisions Landside Logistics and Stevedoring. Development of an inland rail terminal at Moorebank is a key link to complete the logistical supply chain. Moorebank is strategically located on a dedicated freight rail line from Port Botany and at the junction of the M5 and M7 motorways. It is recognised as a Federally Significant Project which will relieve pressure on Sydneys heavily congested roads by transferring up to one million containers per annum to rail. K Analyst: Adrian Atkins