Week Ending 02.09.2016
An unexpected jump in Australian July building approvals barely moved financial markets. One problem was the mix, with free standing housing down 0.6%, but offset by a substantial leap in apartments, up 23.4% in the month. New South Wales registered another record and even Victoria, with a near unanimous view that apartment numbers are running ahead of requirements, saw a decent increase.
Australian Residential Approvals (July)
Approvals don’t necessarily translate into action, though the data indicates that the housing activity cycle will likely protract into 2017. The NAB housing report forecasts a subdued to negative outlook for residential prices, particularly apartments. With rental yields at record lows, it is the uncertain foreign buyer market that may prove to be the key determinant. Approvals in non-residential showed a modest lift and may indicate at least a stable outlook for that sector. The capex intentions survey reinforced this, pointing to a flat non-mining level of investment.
A softening trend in retail sales for July suggests the consumer is not going to save the day. The nominal dollar growth sampled by the ABS rose by 2% over the same month last year and seasonally adjusted sales are tracking at 2.9% growth. In the month, there was no highlight. Department store sales fell by 4.7%, household good spending seems to have taken a significant step down in recent months (though company results show that this is far from uniform), while food retailing growth is annualising at even lower numbers.
Late owls can once again watch the release of the US payroll data out this evening, seen as the most critical data set for the Federal Reserve. The outcome from the Jackson Hole symposium was skewed to a rate rise in coming months. Unhelpfully, this week the ISM manufacturing index fell back to 49.4 indicating contraction. New orders saw the largest decline in trend, but perversely, exports held steady. Imports edged back, bucking the view the currency would handicap the trade sector.
As market participants try to read the body language of the Fed and waver between pricing in rate rises versus holding the line, the US$ index (representing its trade weighted value) has become range bound.
US Fed Funds Forward Rate and USD Index
There is much debate on whether a US rate rise will result in another leg up for the USD. The Yen has been a case in point that rate differentials alone do not determine the currency value.
Compared to earlier this year, it has become harder to find interesting commentary on the Chinese economy. The consensus seems to view the trends as acceptable, indicative of continued growth, but with less vigour than in the past. The main concerns remain around the quality and size of corporate sector debt, specifically the state owned enterprises (SOE). Weaning the economy off their dependence on these mammoths is an immense challenge.
This week, the PMI manufacturing release gave an indication of the problem. Large enterprises, dominated by the SOEs, are expanding, while mid and small companies are contracting.
Manufacturing PMI by Firm Size
The other side of this coin is the services sector. Both the data and feedback from companies suggest that the household sector is vociferously increasing consumption of services, be that travel, education, entertainment or media. As in many countries, it is harder to measure and therefore traditional metrics such as manufacturing, steel consumption or fixed investment spending are likely to understate the real economy.
Fixed Income Update
A challenge for investors in the domestic listed debt market is to achieve adequate diversification through the inclusion of corporate names. In a market dominated by bank hybrids, it was good to see a new corporate name come to market this week. Qube issued a 7 year subordinated floating rate note in order to partly fund the acquisition and development of the Moorebank Freight precinct. The highlights of the deal as outlined by Bondadviser are shown below.
Qube Subordinated Notes (QUBHA)
This new subordinated bond was well received by investors, with the order book said to be three times oversubscribed. Given the strong demand, the issuer priced at the tighter end of the range (BBSW + 3.9%) and increased the issue size to $280m. While the pricing was considered fair, the real attraction of this listing was the simplicity of the structure as it has a fixed term bullet maturity (no call option to extend), mandatory interest coupons and there was no conversion to equity or a perpetual note, as is often the case.
The fall in global sovereign bond rates has been quite dramatic since the collapse of Lehman Brothers in 2008. The chart below illustrates the average yields for 34 countries with more than $50bn of debt compared with five years ago. As a reminder, 2011 was when investors were consumed by fears of a debt crisis in Europe. The median 10-year government bond now yields 1.17%, down from 3.87% five years ago.
The good news for taxpayers in these countries is the huge reduction in interest payments. Japan has saved more than $95bn a year as a result of the decline in rates, while the US, UK and Germany collectively pay $104bn less annually. As global government debt continues to rise, the low interest rate environment certainly supports the cash flows of governments.
Ramsay Health Care (RHC) yet again delivered earnings ahead of guidance, with profit growth of 17% for FY16. The primary driver was the group’s core Australian business, which has exercised a disciplined level of accretive capacity expansion for several years now, tapping into the growing demand in the sector as dictated by the ageing population.
RHC has also increasingly expanded outside of Australia over the last decade, however the return profile from some of these countries has been less favourable. France has been a key target for the group’s global footprint, although the environment has been challenged by government cuts to the sector over the last two years. Hope rests on a change in government in elections scheduled for May next year, which may be more sympathetic towards private hospital operators, although this is not the base case.
RHC’s earnings guidance for FY17 of 10-12% EPS growth is solid, although below the high teens rate to which the market has become accustomed. Maintaining the growth profile will be more dependent on acquisitions, leading the company to venture into new markets. Spain is cited as a possible target. Pursing this strategy may result in a difficult task in which to achieve RHC’s stated earnings targets, with a greater reliance on achieving acceptable pricing for companies acquired, compared with the low-risk nature of its recent brownfield developments. Nonetheless, the company’s balance sheet appears to have sufficient room to accommodate further deals.
Ramsay Health Care: Leverage
In the last five years, RHC has achieved impressive earnings growth, however the stock’s valuation has become more and more stretched, with a doubling in P/E at 31X forward earnings. Valuation remains the most difficult hurdle to overcome, reflecting the premium placed on quality growth companies in the current market environment.
Estia Health (EHE) experienced one of the more severe negative reactions to its full year results, with the stock losing a third of its value after the company missed its guidance (which it issued in mid-April) and provided an outlook that was below expectations. EHE was already viewed as the highest risk of the three recently listed aged care providers as the company was formed from an amalgamation of three smaller businesses just prior to listing. Furthermore, the group had the most ambitious acquisition-led expansion strategy of the three, with management aiming to consolidate what remains a relatively fragmented market.
This strategy has been questioned this week, with misses on the contribution from acquisitions (weaker margins), cashflows and higher corporate costs. The outcome has led to a ‘pivot’ towards organic growth opportunities, although this change has not been viewed favourably, coming so soon after listing. The poor performance of the group has been unfortunately timed, particularly given the government funding reforms that will affect the broader sector (despite the fact that any meaningful impact is unlikely to be felt for at least a further 12 months).
EHE now trades on a material discount to its two aged care peers, although investor confidence in the stock has taken a significant hit and may take some time to adjust. We prefer Regis Heathcare (REG), which has executed better on its growth strategy and taken a conservative approach to capitalise on the ageing demographic theme.
Heavy construction materials company Adelaide Brighton’s (ABC) half year result was viewed as fairly solid, however there was less enthusiasm around forward guidance on prices and volumes. Underlying earnings growth of 8% was achieved on a relatively flat top line as costs were taken out of the business.
A broad geographic exposure across Australia has meant that the buoyant conditions in the eastern markets, driven by high levels of residential construction, has been offset by the weaker conditions in other states. Western Australia, in particular, has been softer on the back of the pullback in activity due to the mining downturn, however still accounts for a quarter of the group’s revenues (the largest of any state).
Some upside for ABC potentially resides in an uptick in infrastructure activity, though an expected cooling in residential activity could offset gains here. In the short to medium term, the stock is likely to receive support from its generous dividend policy. The company has declared special dividends over the last three years in the absence of any large capital expenditure plans, lifting its dividend yield from ~3.3% to closer to 5%. Stronger underlying earnings will eventually need to flow through to improve the sustainability of these dividend payments.
Adelaide Brighton Operations
It should come as no surprise that Harvey Norman (HVN) had a good FY16, given a strong housing market and falling interest rates, helping it to deliver a 23% increase in net profit. The sales growth for the Australian stores tracks the boarder momentum of sector sales.
Yet the opaque nature of the business structure and, at times, left of field investments, do distract from the appeal. On this level, the group provides supplementary support to some franchisees, or so called ‘tactical support’. Effectively this discounts the franchise fee and movements result in relatively large swings in the profit margin accruing to shareholders. The rationale for changes in support is not entirely clear. Naturally, in weak sales environments it has risen, but in today’s strong sales climate, the assumption is that some stores suffer from weak market positions, competition from nearby or other Harvey Norman stores, or may be located in weak markets such as Western Australia. The net impact is a much greater volatility in margin than might otherwise be the case. This year the rent increase from owned stores is below industry trends at 2.2%, indicating a further benefit to franchisees.
Elsewhere, Harvey Norman runs a parallel, though mostly owned rather than franchised, business in New Zealand, reflecting the same housing-related momentum. The Northern Ireland, Singapore and Slovenia/Croatia stores, however, have had a patchy record and contributed a collective 2% to EBIT ex-property for FY16. An ill-timed effort to capitalise on the mining boom through a housing camp JV has resulted in sequential write downs and the newer investment into a dairy operation also incurred a loss. At face value, these are annoying rather than debilitating, but indicate that nothing is certain at HVN.
The dividend was up from 20c (excluding the 14c special) in 2015 to 30c. This now represents a 100% payout ratio, just as the group indicated it would recommence store openings, having held its footprint flat for the last few years. In the context of a largely fully valued market, HVN at a P/E of 15-17X FY2017 may represent relative value, though the range of forecast P/E itself is an indicator of the difficulty in pinning down the profit number.