Week Ending 01.08.2014
In a notable number of circumstances, the economic pattern is not following the textbook outcome. With great expectations, the current Japanese government threw the proverbial kitchen sink at its moribund economic status in 2013, intending to stimulate growth through credit expansion and a lower Yen. To date the data has been, at best, subdued and the Yen unwilling to capitulate. The weak domestic consumption trend could be ascribed to the impact of the meaningful rise in sales tax in April, while the fall in June industrial production reported this week of 3.3% took production to levels below the start of the year and showed a worrying rise in inventory. The sticky Yen may be at the heart of this, though it would be uncomfortable to have to rely only on a currency move to get activity in Japan. Instead, it would appear that neither the Japanese household nor the corporate sector have embraced the concept that they would have to change behaviour to get the economy on a growth trajectory.
Japanese Industrial Production and Inventory (Index)Enlarge
This outcome is not specific to Japan. Globally, the tidy link between monetary policy – cut interest rates to stimulate activity and benefit from a fall in the value of the currency – is not playing out as neatly as the central banks would like. The reasons are multi-fold and generally well known;
· Low investment spending even with low interest rates due to excess capacity, lack of pricing power and uncertain demand growth,
· Household need and desire to build savings
· Unsupportive fiscal policy and often fragile and unpopular governments
At the FOMC meeting of the Federal Reserve governors, the language clearly leant towards warning financial markets that the time of an interest rate rise is advancing. The Committee noted that inflation is unlikely to fall to problematic lows and that labour market was showing improvement. The preliminary release of Q2 GDP at 4% growth was another positive point, suggesting the rebound from the first quarter was well underway. Payroll data has become the one eyed focus as the Fed has clearly established that a supportive labour market was the essential ingredient to its deliberations. The unofficial, but widely watched, ADP Employment Indicator was a little softer than expected at 218k, with non- farm official payroll statistics to follow overnight Friday. The run rate of an average 200k jobs growth has taken unemployment to 6.1% with increasing signs of selected labour shortages and an incremental upward move in wage rates.
Assuming things go to plan, one should expect the Fed to indicate its intention to move on the Federal Funds rate within coming months. The debate is then likely to turn to the timing and final ‘neutral’ rate.
The median for the US Fed funds rate was 4.8% in the 1990-2006 period, one of inflation control and reasonable economic growth. Over the same time frame Canadian rates were similar at 4.5% whereas the UK, which has tended to struggle with modest bouts of inflation, the median was 5%. For Australia the median was higher at 5.5% over the same time frame, a function of a variable CPI and economic response to rates.
Increasingly, economists are coming the view that the rates for the foreseeable future will have to settle at a lower level than before. The rationale is that GDP growth will be handicapped by high levels of government and household debt for some time. Currently the FOMC sees long run rates at 3.75%, but there are some which take the view it may be no more than real GDP or around 2.0-2.5% given the elevated sensitivity of growth to higher rates. In Australia, the cash rate may settle at about 4%, with the banking system working off a higher spread on lending than before. This does not reflect an undue margin grab by the banks, but rather their cost of capital due to required regulatory ratios and the costs associated with a greater dependence on longer term, sticky deposits.
Investors may wonder why we elaborate on this topic. In our view, it is one of the most critical arguments in valuing equity and debt securities at present. Equity bulls make the case that a lower risk free rate supports higher equity prices. Low inflation should also present a lower hurdle for dividend yields. Debt market participants tell one this rather reflects a sombre view of low corporate profit growth, hampering the return from equity investments. A slow rise in rates to a low peak implies fixed interest securities do not have to suffer inordinately from capital loss with a rate rise.
Naturally, the path to this outcome is likely to be littered with uncertainty and bouts of cyclicality. The debate on the post quantitative easing upwards trend in global rates can be expected to escalate through the year.
Local economic news included dwelling approvals, which fell 5% in June. The pipeline of construction activity that comes from past growth in approvals will work its way through the economy over the coming months, but it is clear that this will plateau at a lower level than in the past. Similarly, credit growth picked up - most importantly, business credit recorded a decent increase. The chart tells the story; things are getting better, but it would be misleading to expect anything like a return to 10%+ growth. And without credit as part of the fuel, overall growth has to be lower.
Private Sector Credit Growth - JuneEnlarge
We can add little to the current disturbing geopolitical tensions, and comment from a financial market perspective is not to in any way imply we only focus on these issues. Investment markets have, to date, largely stepped aside from the risks. The historically low European bond yields are perhaps the only expression of unease. Naturally, if events were to escalate, it is likely to result in an overall sell off of risk assets and see yields on bonds tighten even further. Other possible outcomes include a spike in energy prices, especially into the northern hemisphere winter. Higher energy prices tend to have an accentuated impact on household spending and could result in the fragile growth in Europe taking a step back. In the event of any unsettled response from credit markets, it is probable the ECB would directly intervene to stabilise the situation.
The week therefore ended on a sombre tone. Argentinian default made a ready headline for those looking for a reason to sell risk assets, but in reality the combination of an extended rally, valuation pressure, a host of tensions and the hint of higher interest rates combined to do what many have suggested inevitable. Argentine’s impact is small as the value of debt outstanding is low, representing 1.3% of the Emerging Market Bond Index compared to 20.3% when the country defaulted in 2001. Of the current debt, less than $30bn is held by foreigners.
ALS Limited (ALQ) reminded us that conditions remain difficult in the mining services sector when it provided guidance, indicating that it expects its first half profit (the six months to 30 September 2014) to be 26.5% below that of last year – a figure that was considerably below market expectations. The key reason for this outlook was a familiar story – ongoing weak demand in its minerals division, which is closely linked to exploration spend in the global mining industry. The company’s energy division has also been affected, with coal markets weak and the postponing of work in the oil and gas industry.
ALS has done a commendable job in recent years to grow its non-resources earnings base, however it still retains significant exposure to the volatile nature of resources end markets. If, or when, a recovery occurs here, the company still retains significant leverage in terms of its overall profitability. This week’s update, and other recent commentary from competitors and industry participants point towards a protracted recovery. With the company in a downgrade cycle at present, an above-market forward P/E of 17x still sees the stock screen as expensive.
The weakness in coal markets was also highlighted by Rio Tinto’s (RIO) announcement that it had divested its Mozambique coal assets for US$50m, a pittance compared to the A$3.9bn paid for assets in the takeover of Riversdale Mining in 2011. The price received by RIO, however, was not entirely unsurprising given that it had largely written the assets down at the beginning of last year, at the same time as it parted ways with its former CEO, Tom Albanese. The project failed not only because of softness in the coal price, but because of difficulty in developing the appropriate infrastructure to support the project, with its plans to transport coal by barge down the Zambezi River failing to receive the necessary approvals.
While clearly an unsatisfactory outcome for shareholders, the size, diversity and profitability of RIO’s combined operations provided an adequate buffer to absorb such a material loss, something that many smaller mining companies would not have been able to do. The main positive to come out of these developments was a more refined focus on capital allocation and improving earnings by running existing assets more efficiently, the benefits of which have been flowing through in recent results, and which will also be evident in the upcoming reporting season.
QBE again tested the faith of investors with a downgrade to its expected first half earnings, after many had thought that last December’s downgrade had left the company with a clean slate from which to rebuild. The primary problem this time was a top up of reserves to address higher than expected large claims from its Argentinian workers’ compensation business, while strengthening global bond markets through the first half of this year (against the expectations of most) also impacted the business. Compounding these issues was the realisation of lower top line growth, partly explained by the strength of the US dollar compared to last year.
While QBE’s valuation looks relatively attractive and a path to earnings recovery is evident through forecasts for more favourable fixed interest and currency markets, much scepticism will remain until management is able to deliver a clean result. Until then, the stock will likely be a high risk/reward proposition.
Leighton Holdings (LEI) also reported during the week, with a first half result that was above expectations. The headline numbers, however, hid a number of issues that the company currently faces. Of most concern would be the poor cashflow conversion of the group, which has been an ongoing problem for LEI. Investors currently expect that LEI will recover its high receivables balance, however its recent track record has been poor. This has led to some pressure on its balance sheet, with gearing rising above its targeted range.
LEI has also had a fairly high exposure to the wave of capital spending in the resources sector in Australia. With much of this work starting to roll off, the challenge for the company will be to replace this finished work. The trend in work in hand points towards a negative indicator for future revenue generation, with this number declining by 10%. In addition to this, LEI’s expectation of margin embedded in this book has reduced. The increased control exercised in the first half of this year by LEI’s parent, Hochtief, has added a further level of uncertainty around the company’s future and strategic direction.
Resmed’s (RMD) quarterly profit was mildly disappointing, with a poor result in the US offset by good growth in the rest of the world. In the last 12 months the environment in the US has been more challenging for RMD, as it has faced a more competitive pricing environment following changes to reimbursement of medicare patients. This has led to a disrupted market, and a lack of any significant product launches during the period has hurt RMD comparatively more. With a new flow generator in the pipeline, it also appears that some of RMD’s retail customers have held off purchases in the recent quarter in anticipation of the new product.
FY15 is shaping as a better year for RMD, giving it will be cycling most of these issues over the course of the year. The chart below demonstrates a solid track record of returns over the last five years. With a significant untapped market, solid balance sheet (the company is net cash) and market-leading technology, we believe the long-term outlook for the stock is sound.
Resmed: EPS Growth
Navitas (NVT) dropped further after the release of its full year results. On an underlying basis, profit was up 10%, however a large goodwill impairment relating to the loss of its contract with Macquarie University led to an overall 31% decline in profitability. As we noted a few weeks ago when the company revealed the insourcing of the Macquarie contract, the growth outlook for NVT has become clouded over the possibility that other universities adopt the approach taken by Macquarie. The University Programs division is the largest for NVT, hence it be difficult to replace this lost profitability if it loses further contracts. While Australia is a key market for NVT, the group is increasingly looking towards overseas markets, in particular, the US, to drive earnings growth in the medium term.
Woodside Petroleum (WPL) failed in its attempt to buyback a large part of the remaining stake that Shell had held in the company. To recap, WPL had reduced Shell’s shareholding when it undertook a share placement with institutional shareholders last month, and had planned to reduce this further through a buyback, which had to gain 75% approval from its remaining shareholder base. The deal failed because of the perceived lack of fairness in how Shell was being treated compared to other shareholders – while it was at a large discount to WPL’s share price, a large franked dividend component enhanced the after-tax proceeds. The Shell buyback would have removed the large Shell shareholding overhang and improved WPL’s earnings per share, yet a number of large institutional shareholders felt aggrieved that they were not given the opportunity to participate.
An equal-access buyback may be on the table now, however it has not been confirmed by WPL. Even if this were the outcome, the reduction in Shell’s shareholding will obviously not be as great, and hence the overhang issue will still remain partially unresolved.
Finally, today Kathmandu (KMD) highlighted the fickle nature of the retail market, when it provided a further earnings update for FY14. The company, along with a number of others in the sector, had downgraded sales expectations for the year during June, as a relatively warm start to winter led to lower sales figures. Since then, however, a “more normal winter pattern” has emerged, and hence KMD’s sales figures have improved to reflect this. Shorter term cyclical impacts such as these should generally be ignored when assessing the investment merits of such companies, although they can provide opportunities for stocks with sound longer-term fundamentals. Other retail stocks predictably outperformed the benchmark index on Friday as a result.
Sector Focus - Small Resources
The small resources sector of the Australian equity market has delivered disappointing returns to shareholders over the last three years. While all companies in the broader sector were caught out by the large drop in commodity prices after China’s extensive post-GFC stimulus came to an end, closely followed by the Eurozone debt crisis, single-commodity stocks were impacted to a greater extent, with balance sheets becoming stressed, the economic returns of proposed projects slashed and profitability dropping sharply.
Within our recommended Australian equity portfolios, we have preferred to gain exposure to the resources sector via the large diversified miners, BHP Billiton (BHP) and Rio Tinto (RIO). The quality of their asset base (largely being lower cost in nature compared to their peers) and diversity of operations gives both groups a greater capacity to invest through the cycle, including in periods of commodity weakness.
In the next 12 months, another key difference is the potential for capital management by the diversified majors. The large cost-out programs that BHP and RIO are undertaking has so far delivered significant ongoing savings for both groups, with stronger balance sheets now giving the companies the option of delivering increased returns to shareholders, either in the way of higher dividends or share buybacks.
Because of the characteristics described above, small resources companies exhibit a higher degree of volatility compared to not only the benchmark index (S&P/ASX 200), but also with their larger-cap peers. The chart below demonstrates this, which shows the rolling year standard deviation of monthly returns of each of these indices:
Rolling Year Volatility
Volatility has reduced significantly among small resources stocks this year, perhaps reflective of more stability in commodity prices (there are, of course, exceptions to this, such as iron ore and nickel). Increased supply across most commodities and slowing demand has meant that the marginal cost of production has dropped quite significantly – the top 10-15% of most commodity supply curves is generally quite steep, which means that small changes in the supply and demand balance can result in large swings in pricing. For many commodities, this dramatic change has now already occurred, hence the downside to pricing is more limited than it has been.
While forecast prices have reduced somewhat in the last couple of years, companies that are currently in, or entering, the construction phase of a project will benefit from a more favourable environment in terms of their ability to complete these investments on time and budget. With margins of those in the mining services industry coming under some pressure with reduced levels of work available, these savings should improve the economics of projects in the pipeline.
Below we provide some brief comments from the recent quarterly production updates from the sector:
Fortescue Metals (FMG) – has progressed well with its expansion, however further production growth looks to be limited to improving efficiencies at existing operations. The concern for the company is the degree of discount it is receiving for its lower quality product, along with relatively high gearing on its balance sheet.
Iluka (ILU) – its end markets have stabilised, however at much lower levels. Sales volumes have been improving, but pricing remains subdued, pushing recovery expectations out further. The current weakness in China’s property market is the key risk for its zircon product.
Alumina (AWC) – has endured a number of years of loss-making operations, with the fundamentals of the market improving. Higher costs were a concern in the June quarterly production report, and the current share price looks to be factoring in high expectations.
OZ Minerals (OZL) – produced a good production report, however a falling cash balance has concerned investors. The company still faces the issues of a declining mine life with low quality expansion opportunities.
Western Areas (WSA) and Sirius Resources (SIR) – both stocks are amongst the best performers in the ASX 200 this year thanks to their exposure to nickel, which has jumped following a decision by the Indonesian government to ban nickel exports. While this ban remains in place, the outlook for nickel stocks is attractive. SIR is not producing yet, but has taken advantage of the strength in the nickel price to raise equity to fund its Nova development. WSA is the best shorter-term play on the nickel price, and is net cash as at 30 June.