Week Ending 01.05.15
After a weak Q1 (0.2%) growth, it is critical for US data to improve to support the near unanimous opinion that US rates will rise later this year. Early indicators are finely balanced. The key appears to be the lack of confidence from the household sector, especially given the expectations that low oil prices would translate into retail spending. The latest reading on consumer confidence shows a fall in April, largely due to uncertainty on the labour market. Jobless claims however came through with the lowest level in 15 years and the employment data for April (due 8 May) is going to be important given the unexpectedly low rise of jobs in March.
Another important sector is the housing market, which has experienced a steady recovery since 2013. Home sales for April were surprisingly weak, but house prices are still making progress. House prices are the benchmark for most consumers for their sense of overall wealth.
US Home Price Change
The FOMC is expected to be finely attuned to the nuances of the household sector. While the labour market has improved substantially, many new jobs appear to be in low wage sectors and income growth has therefore been relatively weak to date. But the impact of pressure to increase the lowest earners may be paying off, with the Employment Cost Index rising by 2.8% after languishing at around 2% for some time.
Employment Cost Index: 12 Month % Change, Private Industry
While the Fed puts forward an eventual reversion in rates to around 3%, few in the financial markets believe it will get there given a relatively low economic growth rate. High demand for US treasuries (due to bonds purchased in Europe and Japan) will in any event reduce the likely impact from rate rises. If the currency therefore bears the burden of what rates don’t do, the investment consequences of a rate rise will be different to that which has been experienced in the past.
Domestically, credit growth maintained its trajectory, chalking up a 6.2% growth rate for the year. Housing investor loans increased by 10.4%, above the number the banking regulator, APRA, has guided to as an upper limit. The question arises, how much longer both APRA and the RBA are willing to let the housing market run before reigning it in? Business credit grew by 5.3% on an annualised basis. This should augur well for investment spending, but appears to be skewed to property rather than across a range of industries.
The NAB Small Business Survey was therefore far from optimistic. Poor demand is the main constraint, but cash flows also appear to have deteriorated and would be a worrying sign for the segment.
NAB Business Survey: Most Significant Factors for SMEs (%)
Unsurprisingly, amongst the sectors, small finance businesses are doing well along with property developers. Beyond these there is little activity which would suggest a pickup in growth; indeed some such as wholesale trade, transport and health services seem to have fallen a notch downwards. Relative to the broadly-based Quarterly Business Survey, small enterprises are doing worse in retail, services and manufacturing. All eyes will therefore be back on the RBA next week as it once again assesses the benefits of a rate cut.
The UK will also be in the news with the election on 7 May. Polls suggest the two main parties are relatively close but won’t be a position to form a government. Just as well, the UK invented the term ‘horse trading’. The economy in the meantime weakened in Q1, yet consumer confidence is at high levels. The survey shows that households believe their personal as well as general economic situation is in reasonably good shape. How the election may change that will be a test for the coming weeks.
Currency markets have become volatile again. Higher iron ore prices, firming oil prices, the weaker US data trend and mixed messages on interest rates saw the Australian dollar rally relative to the $US this week. What can break this pattern? The most likely is better US data with a feedback into a higher $US and subsequently easing commodity prices and inflation expectations. But these clearly won’t be as dynamic as before, given the extent of movement to date. Oil prices, in particular, may prove stickier on the downside with some withdrawal of capacity in the US. That in turn may result in the same outcome; a higher $US, but through a different path. Stronger oil prices may be good for US equities due to the impact they have on capital spending expectations and indicative of better consumer demand in the summer holiday season. Once again, this would be a $US positive as the rate market prices in a rise.
In short, the $US strength is not yet over, but the degree of movement is clearly lower and the influences have shifted from ECB and BOJ easing to data dependence and the cycle in commodities.
Fixed Income Commentary
With this week’s domestic CPI coming out stronger than expected, 3 year and 10 year Australian bond yields pushed higher as the market eased out the risk of a rate cut at the next meeting. Market participants that were originally factoring in a 75% chance of a rate cut in May, are now only pricing in a 45% chance of a cut.
Domestic yields have continued to rise in the last couple of days following upward moves in the US bond markets after the FOMC’s statement acknowledged that economic growth is weak, but is expected to be transitory, with growth to pick up down the track. Despite the weak GDP numbers out of the US and dovish comments by the FOMC, the markets are still of the view that a Fed rate rise later this year remains on the table.
Over in Europe, Greek bond yields trade at their highs as concerns around the economy and the ability to meet their debt obligations continues. However, so far there doesn’t seem to be any contagion effect to the rest of Europe with sovereign bond yields remaining low as the ECB’s QE adds liquidity.
The chart of yield curves below shows that Australia is still to price in the rate cuts on the short end, a possible trade for those who can call it right. But most will note the negative short term rates in parts of Europe.
German bund yields have in fact spiked in the last couple of days after a failed bond auction, positive inflation figures and some commentary from market participant Bill Gross about 10 year bunds being ‘the short of a century’. It appears to be these factors driving the government bond market, rather than any concerns over Greece. Credit bonds are the ones to watch as they remain more reactive to the Greek situation.
Over in Asia, the rating agency, Fitch, cut Japan’s credit rating from A+ to A with a stable outlook. This was cited as Fitch’s “uncertainty over the degree of political commitment to fiscal consolidation.” Further deterioration in the Japanese economy is certainly worth monitoring for a number of reasons, including the fact that they happen to be the largest investor in Australian government debt.
Bank of Bendigo and Adelaide came to market this week with the issuance of a new tier 1 hybrid deal to refinance the maturing BENPE’s. This deal was well received, with orders in access of $450mm for a $225mm deal size. The chase for yield continues. The structure of this bond is a 6 year mandatory convertible preference share, which if not redeemed, converts to equity after 8 years. It came at a spread of +400 over the 180 day BBSW rate. It is Basel III compliant, so contains both non-viability and capital triggers.
Prior to the new deal announcement the listed hybrid market has seen some spread contraction. However, as has been the case previously, there has been selling out of old deals to take up the new deal. This puts upward pressure on spreads, particularly in shorter dated bonds from that same issuer. This market may remain a little more volatile up until the settlement of the new deal as this switching trend continues.
Wesfarmers’ (WES) sales figures for Q3 were generally positive but not a surprise. Coles’ sales increased by 5.4% (or 3.4% on a comparable store basis) and adjusting for the timing of Easter. This is a touch softer than the previous quarters which had tracked around 4% comp growth, but in line with the momentum in the sector and muted price rises. Indeed, the supermarket retailers claim price deflation, something a regular shopper may find hard to swallow. Based on this release, Woolworths’ efforts to resuscitate its sales have not found fertile territory. That is not surprising as its early days and we would expect the price tension between the two players to heat up in forthcoming months. Game theorists may find their efforts to gain share but without margin erosion an interesting challenge.
Bunnings remains a standout business for Wesfarmers, with comparable sales of 9.4% in the quarter. A combination of new housing and a lift in refurbishment activity is likely to provide a decent tailwind for some time. The downside is that with a high import content, the business has absorbed some of the fall in the $A and profit margins are likely to be relatively stable. Once again, it’s hard to believe Woolworths’ Masters brand is making any headway.
Of the other divisions, Officeworks has become effective in combating online offers, delivering good growth. Kmart is the best performer of the discount store trio, with both Big W and Target struggling. We would not bank in this Kmart trend, as this sector has excess capacity. With Big W having written down stock in the half year result, it may rebase its pricing and compete more effectively.
The other divisions of Wesfarmers don’t gain as much attention. Coal production is holding up, but prices are likely to fall in coming quarters. Little light is shed in these quarterly releases on the other two, namely industrial and safety and chemicals.
From an investment point of view, the main problem is the valuation, with the stock trading just under 20X 2015 PE. The case can be made that this does not price in the risks associated with the uncertain supermarket sector, albeit could be warranted based on these quarterly sales figures in the current equity market.
Corporate activity continued this week as M2 Group (MTU) entered the bidding war for iiNet (IIN), trumping an initial offer from TPG Telecom (TPM). MTU’s predominantly script-based offer addressed one of the key concerns of some IIN investors, who had wished to receive equity from the acquirer as opposed to cash. While a cash offer is typically preferred by investors in these scenarios, the attraction of increased participation in the synergies on offer from combing the two companies provided a compelling reason for equity in this instance.
For smaller investors, the ability to receive capital gains tax rollover relief (given the large share price gains made by IIN over a longer time period) would also have enhanced the attraction for equity over cash. In any case, the ability to fund a potential deal from debt as opposed to equity would have been much more limited from MTU, given its smaller size compared with TPM (three times larger market cap)
TPM is yet to counter the MTU offer, although we note that under the deal that it entered into with IIN, it has until next Tuesday to submit a counter proposal. TPM’s share price rise following its initial approach would appear to indicate that it could comfortably beat the offer from MTU and still be able to deliver incremental value to its shareholders.
Meanwhile, an insight into how TPM may approach the situation was revealed when the company announced this week that it had increased its stake in Amcom Telecommunications (AMM) to 18.6%. The move is designed to block the takeover of AMM by rival Vocus Communications (VOC), which was scheduled for a shareholder vote next Wednesday. With TPM stating that it had no intention of putting forward a counter proposal, it appears that TPM is potentially looking to consolidate the smaller telcos sector further, although at its own pace. With TPM already owning 6% of the equity in IIN, there is a slight possibility that it may instead look to build this further and hence vote down the MTU bid. Either way, we note that the strategic prize is significant; the number two position in the Australian fixed broadband market (in which the number of further acquisition opportunities is diminished) and hence a stronger competitor to take on the dominance of Telstra (TLS).
Transurban (TCL) announced that it was working with the Victorian Government to progress a proposal to develop a new tunnel and elevated motorway to provide an alternative route to the West Gate Bridge. The fact that the idea was suggested to TCL would give investors more confidence that, where it to be formally approved, the economics of any proposed project would stack up. It is easy to see why the Victorian Government was keen take this forward, as TCL has stated it will not require any contribution from the state (although they do believe that it will qualify for a level of Federal Government support). In return for TCL’s financial contribution to the proposal it would introduce new tollway for motorists as well as an extension of the company’s existing CityLink concession (which is currently due to expire in 2035).
To us, this highlights the unique position of TCL with its existing network of tollways in Melbourne and its ability to leverage off adjacent roads which it manages and hence benefit from the overall increased traffic flow. It also demonstrates the value of holding an existing concession given the bargaining chip this provides in negotiations.
Suncorp (SUN) and IAG provided updates on the financial impact of recent storms in NSW and hail in Sydney on Anzac Day. For SUN, this amounted to $135m for the storms and $50 - $70m for the hail, while IAG estimated a $250m total net cost. SUN’s FY15 total natural peril costs are now expected to top $1bn, considerably higher than the ~$600m claims experience of the last two years and even above almost $800m of claims in each of FY11 and FY12 (New Zealand earthquakes, Cyclone Yasi and floods in Queensland). Historically, high claims periods have often been followed by increases in premiums in the insurance industry, allowing higher returns in future years as claims normalise.
The more immediate issue for investors will be whether or not the company will still be able to pay a special dividend at its full year result in August. While the special or ordinary dividend may be at a reduced rate, the expectation remains that the company will have this capacity.
Stock Focus: South32
Last August, BHP Billiton announced that it intended to spin off a group of its non-core assets into a new entity, which has since been named South32. BHP shareholders will next week vote on the demerger, and, if it is approved as expected, will receive one share in South32 for every BHP share currently held. So what is the outlook for this new listed entity?
South32 will have a high level of diversification across commodities. The company will have exposure to nickel, metallurgical coal, silver, lead, zinc, manganese, energy coal, alumina and aluminium. Further to this, the concentration of earnings towards its larger commodity exposures will likely be lower than that of BHP Billiton and Rio Tinto, given the high current proportion that each of these currently derives from iron ore. The company, however, will be more sensitive to a select few currencies, with the assets concentrated in Australia, South Africa and Brazil (illustrated below).
Similar to the broader mining sector, the earnings of South32 have been hit hard by the fall in commodity prices over the last four years. Earnings from BHP Billiton’s South32 assets have fallen by 70% over this time and are now lower compared with any time over the last decade.
South32 EBIT by Commodity
Balance Sheet/Capital Management
Upon listing, the balance sheet of South32 will be in good shape. The company is expected to have an initial net debt position of approximately US$700m, indicating a gearing level of approximately 5%. South32 will thus be in a better position than many in the mining sector to pursue acquisition opportunities or to return excess capital to its shareholders.
A key difference between South32 and its larger diversified peers is its dividend and capital management policies. Rather than stick with the progressive dividend policy of BHP, it instead intends to target a minimum 40% payout ratio, allowing it more flexibility to retain capital when commodity markets are weak. Competition for excess capital wil be allocated in a way that maximises shareholder returns, be it capital expenditure, share buybacks or special dividends.
Quality of Assets
The quality of the asset base is high compared with the mining sector, but lower than that of the big diversified miners. The key assets of South32 are predominantly located in either the first or second quartile of industry cost curves. This means that its margins will be higher and it will be in a better position compared to most of its peers to deal with a cyclical downturn in commodity prices.
While South32 has delivered reasonably solid margins through the cycle, the returns from this portfolio of assets is quite inferior to the remaining core BHP Billiton assets. This is best demonstrated by the difference in EBIT margins between these two groups over the last decade. BHP’s core assets have delivered an average EBIT margin of 42%, almost double that of South32 at 23%. It is thus hard to dispute the assertion that BHP is bundling its worst assets into the demerged entity.
South32 and BHP Billiton (ex-South32) EBIT Margins
Mine Life and Production Growth
The mine life of South32’s assets, on average, is much shorter than that of BHP Billiton. The reserve life of its mines is approximately 13 years, indicating that further capital will be required in future years simply to maintain its current production levels. Some of its larger and higher-returning assets are among this group. Cannington (which produces South32’s silver, lead and zinc), which has been responsible for a larger part of the company’s earnings in recent years, has a mine reserve live of just nine years. Likewise, its large Australian manganese mine has a mine reserve life of 11 years.
Consistent with the view that South32 will be a low-production growth company is a slide in its presentation highlighting potential investments. Two of the three listed under “Options Under Analysis” are mine life extensions as opposed to brownfield or greenfield growth options.
Cost Out Opportunity
In the face of falling commodity prices, aggressively cutting costs has been necessary for miners to protect their margins. While it is likely that further cost cutting will be explored by South32 as a standalone entity, significant cuts from here may be limited given what BHP has already achieved in recent years. Further to this, while a leaner model may eventually be employed by South32, the creation of the demerged company will result in an additional layer of corporate costs through the necessary duplication of particular roles.
Potential Upside – Commodity Prices and Currency Depreciation
An uplift in commodity prices would be the most obvious way that could see a material improvement in the profitability of South32. Across its suite of commodities, almost all are at, or close to cyclical low prices. While the downside to prices is perhaps more limited from where we stand today given the losses already experienced in markets, picking the turning point for a recovery is a difficult exercise. The shorter mine life of South32’s assets could also mean that its participation in a recovery could be capped if extended over a longer time period.
What may provide a certain element of promise of a recovery in the underlying commodities is their respective demand profiles. With China gradually moving from an investment-led to a consumption-led economy, the demand growth for commodities used in steel making will begin to taper off. These include iron ore (which the major diversified miners are heavily weighted towards), metallurgical coal and manganese. Commodities that thus have a more extended growth profile include aluminium and nickel. South32 thus has a mix of these different commodity groups, but are better placed than BHP and Rio Tinto.
South32’s core cost currency is the $A, followed by the South African rand. Both of these currencies have depreciated significantly against the $US in the last few years, however further depreciation is a potential source of upside for South32. We would note that, as commodity currencies, any depreciation would likely be associated with weaker commodity prices, offsetting this benefit to a degree.
Alumina and Aluminium Exposure
While a depressed alumina and aluminium price has meant that these assets have struggled to break even over the last few years, analyst reports suggest that these two commodities together could account for over half of the total value of South32. This is a combination of the longer asset life of the alumina refineries and aluminium smelters, along with an expected recovery in price of these commodities. While the longer-term undelying demand for aluminium may be positive, China has shown a propensity to build additional aluminium smelter capacity, contributing to ongoing weakness in pricing.
Performance of Spin Off Companies in Australia
In South32’s favour is the relative performance of companies that have been spun out of larger entities listed on the ASX over the years. Recent examples include Recall (spun out of Brambles), Orora (spun out of Amcor) and DuluxGroup (spun out of Orica). While these companies have benefitted from a more refined focus as standalone companies, generally speaking, management have less of an influence on the profitability of companies in the resources sector. The outcome of commodity prices should be a much larger determinant of whether South32 will be enjoy success in future years.
On balance, we believe that South32 presents as an inferior investment proposition compared with the larger diversified miners. In comparison, South32 falls short on margins (and hence free cash flow), relative mine life and potential for production growth from its portfolio.
The most appropriate valuation measure in the mining sector is net present value (NPV). The net present value method discounts a company’s expected cash flows to the present day. For a resources company, the results can be highly variable and will depend on forecasts for a large number of inputs, including (but not limited to) commodity prices, operating costs, currencies and the production profile. The estimates across a range of brokers suggest a NPV of approximately $3/share for South32.
Another way of looking at the value of South32 is to instead incorporate today’s pricing (or ‘spot’ pricing) into the NPV. This incorporates a higher margin of error and demonstrates what the value of the company may be, without the assumption of a recovery in commodity prices. Using this assumption derives an approximate value of $2/share.
With most mining companies trading at a discount of 20-30% of their estimated NPV, this would suggest that South32 should begin trading closer to the $2/share spot valuation. Given the inherent uncertainty that comes with predicting commodity prices and the current fragility of commodity markets, we believe that this price would represent an appropriate value to exit the stock upon listing.