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3 undervalued companies with poor stewardship

Glenn Freeman  |  04 Feb 2019Text size  Decrease  Increase  |  
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It may sound counterintuitive, but bad managerial practices don't necessarily mean a company is worth avoiding. 

The conduct of senior executives can be both a blessing and curse for company reputations, performance and shareholder returns.

The banking royal commission led by Kenneth Hayne QC - whose final report is due on Monday – will go down in financial history for the tales of corporate misconduct it unearthed, which in turn tarred reputations and share prices.

The commission’s findings have implicated the leadership of Australia's most prominent financial institutions, most notably 170-year-old wealth manager AMP and Australia’s biggest lender, the Commonwealth Bank.

Big four CEO

From left: Big four CEOs Shayne Elliot, ANZ; Matt Comyn, CBA; Brian Hartzer, WBC; and Andrew Thorburn, NAB have been hit hard by the banking royal commission

But they’re not alone. Senior figures at insurer QBE and Kerry Stokes’ Seven West Media were also the subject of tawdry headlines in 2017.

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While unsavoury newspaper reports may damage investor sentiment in the short-term, Morningstar analysis takes a much broader view of company management.

Morningstar analysts assign each company a Stewardship Rating - exemplary, standard, or poor - based on how well they think a management team protects shareholder interests. 

This rating examines how well management allocates capital and whether company decisions enhance or detract from competitive advantage, in addition to management incentives and company ownership structures. The rating system also factors in:

  • financial leverage
  • investment strategy
  • investment timing and valuation
  • dividend and share buyback policies
  • related-party transactions
  • accounting practices.

Using the share screener tool on Morningstar.com.au, we've identified three Australian companies that are competitively sound and regarded as undervalued, despite holding a poor rating for stewardship.

TV executive who made headlines

Seven West Media (ASX: SWM) – which derives about 90 per cent of its revenue from Channel 7 – first hit the headlines for all the wrong reasons at the end of 2016.

The inter-office affair between CEO Tim Worner and former staffer Amber Harrison was widely reported in the press, and raised in the company’s first-half 2018 results briefing in February 2017.

Morningstar senior equity analyst Brian Han alluded to this briefly at the time, in his research notes on Seven. While noting Worner's strong background in television programming, Han said: "Worner was mired in controversy on a staff-related issue for several months from December 2016."

But Han views Seven's "mixed" track record of capital allocation as a bigger concern from a corporate stewardship perspective. Questionable decisions include its 2011 acquisition of West Australian Newspapers.

"It is now a company that has a material exposure to the structurally challenged print media industry," Han said.

Morningstar reduced Seven West's FVE twice in 2017 – to 85 cents then 66 cents a share, but it bounced back to 70 cents in August last year. It has dipped into one- and two-star overvalued territory briefly, but today trades at 54 cents – a 23 per cent discount to fair value – and holds four stars.

Minerals Resources earnings cloud

Mineral Resources (ASX: MIN) holds a poor stewardship rating because of the opacity of earnings within its contracting business, a core driver of the miner's revenue.

Morningstar equity analyst Mark Taylor noted late last year the company's impressive financial record and unleveraged balance sheet, but called out its lack of visibility.

"The company does not disclose the earnings split between crushing activity and contract engineering and construction, where the outlook is softer," he said in November. "Despite a good financial record, weak disclosure and increasing earnings risk reflect poorly on management."

However, Mineral Resources remains undervalued by about 20 per cent relative to Morningstar's FVE – largely on the back of a planned partnership with large lithium producer Albemarle Corp, which was announced in December.

"We don’t foresee regulatory impediment, but if no deal arises, our fair value estimate will fall back to $13.50 per share, a decline of 20 per cent all else equal," Taylor says.
At the close on Thursday, Mineral Resources was trading up 2.45 per cent at $15.80.

Riding the building boom

There are a few reasons for the poor stewardship rating of New Zealand-domiciled building materials company Fletcher Building (ASX: FBU), says Adam Fleck, who heads up Morningstar's Australian equity research team.

These include poor capital allocation over several years, organisational complexity and weak risk controls.

"This has led to low returns on capital and poor share price performance," Fleck says.
However, he forecasts steady earnings growth across most of Fletcher's five divisions – building products, real estate, international, construction and distribution – particularly the last two.

Its distribution division is the biggest revenue contributor, encompassing 11 businesses in Australia and New Zealand that drive around one-third of group revenue and almost 40 per cent of earnings.

Fletcher's international segment contributes more than 20 per cent of both revenue and earnings across the group, derived mainly from North America, Asia and Australia.

A couple of divestment plans announced a the end of 2018, including the US$840 million sale of its international segment's Formica laminates business, prompted a 5 per cent upgrade to Morningstar's fair value estimate – to $6.30 a share.

The company was trading at $4.73 at market open today, around 25 per cent below Fleck's FVE.

is senior editor for Morningstar Australia

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