Why it pays to read the Account Notes

In August 2021, this information was particularly useful given DOW didn’t provide any formal quantitative guidance for the market and the accounts were complicated by the transition to an Urban Services business and hence included: 'Core' and 'Non-Core' operations, businesses in wind down, businesses to be sold and acquired amortisation.

Below we have extrapolated these projections out to FY2024 and sampled three (sell-side) analyst reports from August 2021 to contrast internal views at the time to those of the market. Notably, these projections are likely to have changed materially since then due to 10 months of challenging performance and deteriorating labour markets, but we feel it provides some interesting comparisons, nonetheless.

For the three key divisions we make the following observations:

Transport

• Analyst C’s projection was almost identical to that computed from our analysis however analysts A and B were more than 15% higher.
  
• The key reason for this is potentially due to recency bias, with the Transport Division beating expectations at the FY2021 results.
• Fast forward six months and the Transport Division actually increased by 16% in the 1H FY22, but Analysts A and B have updated their projections for the division to $272 million and $295 million.

• The market was projecting increases in Facilities but not to the extent DOW was internally. This saw the average FY24 projection for Facilities 11% below our implied calculation
• This could be a function of a few things, including the impacts of COVID, the expected recovery being hard for the market to comprehend, the growth potential of Defence being underappreciated by the market or a range of other factors.
• Fast forward six months and the Utilities Division actually increased by 7% in the 1H FY22 and Analyst A’s updated projection is around $214 million. Analyst B’s projection is $212 million and Analyst C’s is $198 million.
• At the half-year, $38.6 million was reclassified towards Facilities (from Utilities and Asset Services).

Ultimately, the internal budgets provide no guarantees of achievement. The first-half performance is a prime example of that, and can be prepared and/or reviewed by a management team and board that are frankly more optimistic than other teams. But we believe it provides a good place to start when making our own projections.

As noted above, we think the near term environment remains challenging for DOW, particularly a labour perspective. This means higher near term earnings risk, but the longer-term view from August 2021, validated by internal budgets remains the achievement of around $500 million of EBITA from a core Urban Services portfolio. The success of these budgets (which may be pushed out by 12 months now) to us supports a share price target of more than $7.

QBE Insurance Group (ASX: QBE)

In trying to understand and develop projections for QBE recently, we asked ourselves a several questions around the rates of return achievable across operating and investment operations. This included “what is the appropriate long term investment return to assume for their investments portfolio?” This question was somewhat answered by management in the notes to their accounts.

Projected returns

The key driver of an insurer’s investment returns is obviously interest rates. At 31/12/21 the duration of QBE’s portfolio was 2.1 years with 93.8% of the portfolio in fixed income assets and 6.2% in ‘risk’ assets. QBE are targeting taking risk assets to 15% which theoretically would increase returns of the portfolio, (by ~50bpts). QBE has traditionally earned a margin of ~50-100bpts above government bond rates. At the time the annual report was prepared the US 2 year bond rate was ~1.5% which has since risen to ~2.5%. Hence it reasonable to expect ~3.0-4% investment returns (assuming stable yield) in 2024+ for QBE. But what does 3.43% imply for investment returns? We have addressed that question in the table below and performed an analysis comparing the implied investment return to that of a handful of sell side analysts.

There are a couple of points to make about this analysis.

1. It was completed prior to QBE’s AGM update on 5 May 2022, in which QBE announced a 1Q22 exit total investment return of around 2% (hence we have already started to see the sell-side upgrade projected investment income)
2. The above analysis assumes that there is no deterioration in combined operating ratio as a result of higher interest rates. For example, it could be argued that given the strong returns on equity available on investment returns, the underwriting margins are competed away

What's the edge or insight on the stock? We believe the market was potentially underappreciating the earnings benefit to QBE from higher rates, and there's a good chance of substantial valuation upside.

Healius (ASX: HLS)

The healthcare firm Healius is not a name I've spent much time deeply analysing and although it probably offers the least variance to market from our analysis, given relatively predictable revenue streams, we still found its FY21 Goodwill (B2) note more informative than most and have presented our analysis of it below.

This compared to a sample of analysts at the time:

We can only see FY2024 as the outer year so have had to presume the revenue growth rate is reasonably consistent over the time period. The reality is probably more nuanced given the decline in PCR (polymerase chain reaction) testing from an elevated FY2021 base. Thinking about this another way, presuming industry growth rates stabilise at around 5% (pre-COVID levels) and discount back FY26 budgeted revenue ($1,627 million), this level implies FY24 budget revenue of $1,475 million, a level still 9% higher than the sample.

Since this release in August 2021, we have seen a half-year result from HLS and started to get greater clarity over the path of PCR testing in Australia to help shape our view of the future. We have probably not captured all the recent downgrades as Medicare data has come through, and HLS updated the market last week. But in late May, Analyst A was projecting FY2024 Pathology revenue of AUD1,466m while analysts B and C had both lowered their projected revenue by a few percent.

At the very least, HLS's Goodwill note will be one worth keeping an eye on in August.

Cleanaway (ASX: CWY)

The waste management firm Cleanaway is the original of Goodwill notes for us and it probably represents the most detailed of the impairment testing notes we see in the market, providing a wealth of useful information. It should be apparent by now, but we’ll repeat that CWY’s note uses board approved budgets. In CWY’s case, the coming years should provide a better forecast of future earnings than any external parties (including ourselves) can conjure.

Analyst comparison - EBITDA

As we noted below, we have compared a sample of sell-side analysts in August 2021, following the company's results to the implied EBITDA of divisions. As we note below there are a couple of issues with this:

• It doesn’t include value of the recently acquired Sydney Resources Network (SRN) from Suez, Waste to energy opportunities (presumably not generating earnings in FY24), Container Deposit Schemes (CDS) or other circular economy opportunities. We have adjusted for the first of these, noting SRN delivered net revenue of $193 million and EBITDA of $77 million in CY2020, assuming this level in FY2021, compounded at the same rate as Solid Waste Services

• Similar to our comment for HLS the visibility on sell-side projections beyond the next 3 years is limited. Hence we assume a consistent level of compounding to compare to FY2024 levels rather than FY2026 levels

Despite these issues, the analysis implies that the sell-side (particularly analyst C) sat below internal CWY projections of earnings for a business that has a history of exceeding budgets. Interestingly now though is that FY24 consensus EBITDA is at AUD741m, reasonably in line with the FY24 EBITDA implied by the above analysis.

Analyst Comparison - Capex

Chester has projected potential revenue for each of the segments in FY2024 including SRN, this is within 3% of FY24 consensus revenue. To segmental revenue, we have applied budgeted capex percentages. We have had to assume a percentage applied to SRN (assumed lower than Solid Waste Services) and an amount dedicated towards Corporate / Other comparable to FY2021 D&A.

The analysis suggests that CWY capex spend is potentially budgeted to be higher than market projections (not even including the added spend on Waste to Energy Projects).

Goodwill Headroom + Net Assets = Implied Internal valuation

The above table implies the market cap is at a premium to the value implied by the internal valuation calculation. There are a number of aspects that potentially account for this, including its failure to include the following areas of upside:

• SRN Assets. The acquisition of these assets was completed on 18 December 2021, but the forecasts above do not include these assets or synergies from these assets.
• Waste to Energy Opportunities. CWY’s first project in Western Sydney was blocked but they are still considering projects in Sydney, Brisbane, Melbourne (and elsewhere). Waste to Energy will be NPV accretive so likely provides upside to the value assessment above. However, it must be remembered that Waste to Energy earnings will also be used to replace landfill earnings (which have a finite economic life)
• CDS and other circular economy opportunities. There are additional Container Deposit Scheme or circular economy (recycling opportunities) not included above
• Some boards/management teams can be more conservative or optimistic than others, CWY may outperform budgets and the valuation could exceed that presented in the notes

As noted above the market potentially underestimates the capital investment required in the business over the next five years. 
The market is also prepared to pay a higher multiple for the utility-like nature of the assets than that inferred by a discounted cash flow valuation

Closing

While having insight into a company’s internal forecasts doesn’t guarantee results against those budgets, it is a meaningful reference point for anyone looking to prepare forward projections of a company’s earnings. Hopefully, this note has inspired more people to join us in analysing the accounts in August, for that little bit of extra luck going forward.