Week Ending 02.10.2015
The good news is that the Australian housing market is showing clear signs of peaking, allowing the RBA more flexibility in its monetary policy. The bad news is that the housing market is peaking, implying that the economic activity contribution from housing is set to abate and that other sectors now must be able to take its place.
August housing approvals fell by 7%, much more than anticipated, with the highly volatile multi-density sector unwinding the big lift of July to register a fall of 17% in the month. APRAs efforts to restrain investor lending and reports that banks are themselves taking an increasingly cautious view have borne fruit, offsetting the very low lending rates available.
The extreme rise in apartment approvals versus the subdued single home sector is evidenced in the chart below.
In line, housing credit growth has modestly rotated to owners from investors, but does point to a lower rate of lending in the coming year. Some of this is likely to be from the reclassification of properties from investor to owners, as occupiers found themselves subject to the constraints imposed by APRA on investor lending. Meantime, business credit rose by 5.3% year-on-year, edging slightly higher. Capex intentions, however (with another read due in two weeks), are troublesome, indicating low (if not lower) rates of business investment.
The latent question on the level of GDP growth in the coming year is awaiting an answer. Incrementally, economists are reducing their confidence in their forecasts and converging on a mid-2% run rate. For some time, the problem has been the lack of an identifiable sector or driver of growth. Early signs are emerging that the manufacturing sector has started to turn, likely a function of the currency. True growth, however, is far from evident. Indeed, most businesses express a negative view on business innovation.
NAB asked the participants in its quarterly business survey (QBS) and ASX300 companies on their attitude towards innovation. Few companies see Australia as innovative, but view themselves in a somewhat better light.
NAB Business Survey
Companies within decent local business conditions, such as utilities, health, education and business services, see themselves as innovative. Conversely, those with a more difficult outlook nominate as innovative only if they have high business confidence. For example, even with tough conditions for manufacturing, companies that believe they are innovative also have the highest level of confidence out of any industry segment. The outcome points to a small group of winners in manufacturing rather than a broad-based recovery.
Europe is beating an upbeat tone, albeit from a low base. Nonetheless, there is persistent evidence that growth is picking up, and, mon Dieu, even France is making for good headline news with a declining budget deficit and rebounding private consumption. The animal spirits of confidence are perhaps the best indicator that recovery is underway, with retail spending leading the charge. Malta, Spain and Slovenia are the most optimistic, while Greece, Finland and Luxemburg lag.
Given the treacherous investment markets of the past quarter, the economic issue of the impact on households is important. In short, the US household sector seems totally at ease, or rather pays less attention to such events. The Conference Board Consumer Confidence Index moved up to a post-recession high. The job market is seen as strong, both in terms of demand and supply. Notably, it is the under 35’s that are the most optimistic.
US Consumer Confidence
The US economy is largely in line with expectations. Selected manufacturing sectors are showing some strains from the fall in the energy sector and the US$. But as many have reinforced in recent comments, the economy is more than capable of withstanding a rate rise.
One of the last remaining large consolidation opportunities in Australia’s telco industry fell into place this week when Vocus Communications (VOC) and M2 Telecom (MTU) agreed to a scrip merger. Under the deal (which is expected to go to a shareholder vote early next year), M2 shareholders will receive 1.625 Vocus shares per M2 share held. This value will thus fluctuate with Vocus’ share price over the next few months, however the stock quickly traded up close to this implied consideration, with any ACCC issues viewed as low-risk. The announced deal comes just months after Vocus was successful in its bid to acquire Amcom Telecommunications (AMM).
Unlike TPG Telecom’s (TPM) offer for iiNet (IIN) earlier this year, where both stocks rallied on the offer announcement, investor enthusiasm for this deal was much more subdued, with the Vocus share price dropping 12% over Monday and Tuesday (albeit in a weak market). While the deal has been priced at a similar EV/EBITDA multiple to the TPM/IIN transaction, there appears to be less overlap between the two businesses and hence the cost synergy opportunity will not be as great (estimated at $40m on an annual basis). In this case, the revenue synergy potential is perhaps greater, although quantifying this is more difficult.
Vocus is not as well-known to the average Australian consumer, as its focus has been on business customers and the wholesale market through its fibre network infrastructure. M2 services small businesses with its Commander brand and the retail market through iPrimus and Dodo. The combined group will also have a significant New Zealand presence, which is expected to account for around 18% of total revenue. The high level of consolidation that has occurred now across the industry has reduced the likelihood of another bidder emerging for a company that would become a more relevant mid-tier broadband telco, alongside TPG and Optus, all of which are in a stronger position to take market share from Telstra.
Vocus and M2 Brands
Not to be outdone, TPG yesterday announced two commercial agreements with Vodafone Hutchison Australia. TPG has a small mobile business, in which it is a reseller of Optus’ mobile network. These customers will now be transitioned onto Vodafone’s network. TPG will extend its own fibre infrastructure network to Vodafone cell sites around Australia, in order to improve the performance and capacity that increasing data usage is demanding. While the initial capital expenditure investment is high ($300m-$400m, with the majority over the next three years), the revenue should be relatively high-margin and illustrates the strength of TPG’s existing infrastructure position. We have TPG in our model portfolios.
Origin Energy (ORG) finally succumbed to market pressure to raise equity when it announced this week a heavily-discounted four-for-seven entitlement offer. The necessity for the raising was the pressure that was being placed on the company’s balance sheet as a result of the now popular view that oil prices are going to remain lower for longer and not appreciate quite back to levels that were previously expected.
The issue, as we have previously highlighted, was the inherent leverage to the oil price that its investment in its APLNG project had exposed the company. A lower oil price assumption would thus materially impair the expected cash flows from the project in the medium term once it was operating and thus the ability of ORG to begin to pay back its associated high debt levels. An extended ramp up period for the project over the next 12 months also meant that it would be some time before a large step up in cash flow could be realised, given the large ongoing interest and project financing costs that need to first be covered by revenues.
This equity raising is one of several measures that ORG has announced to strengthen its balance sheet over the next two years. ORG had previously announced in recent months other initiatives to repair its balance sheet, the largest being the $1.6bn proceeds realised from its sale of Contact Energy. Other expected savings were also announced this week, including a further reduction in capex and working capital, up to $800m in non-core asset sales, and a rebased dividend. The last of these was required given the new, and much larger, share base of the company. All up, the cumulative total of these expected savings ($6.9bn) is much larger than the $2.5bn raised this week.
From a shareholder’s perspective, the dilutionary impact from the raising will be quite significant, not only due to the large discount to an already-weak share price, but also due to the 57% increase in its share count. To add to its woes, guidance provided by the company for FY16 and FY17 earnings, appears to be below consensus estimates. Offsetting this, however, is a much better balance sheet and the removal of a possible credit rating downgrade, which had been built into the company’s share price over the last few months.
While conducting a capital raising earlier would have been a much better outcome for the company, it contrasts the lack of action taken by Santos, which has been forced into asset sales at the bottom of the market.
The action taken by ORG this week has put the company back on the path to recovery in what has been a difficult environment given the unfortunate timing of the decline in the oil price. There is a high possibility, however, that investors will remain sceptical of the company’s position until it has demonstrated an ability to execute on these changes in coming periods. Given the possibility of sustained weakness in oil markets, our current preference in the energy sector is Oil Search (OSH), which generates strong margins, does not have any material capital expenditure in the short term, but has a high level of optionality in its portfolio.
Origin: Balance Sheet Strengthening Initiatives
AGL Energy (AGL) also provided FY16 guidance for the first time at its AGM this week, with the mid-point of its range 4% below consensus expectations. There are several moving parts within this guidance, however its underlying market conditions appear to be improving. These include a slowing in the decline of residential electricity consumption (which has affected AGL and ORG over the last few years) and better retail margins. AGL is targeting a similar cost saving program to ORG’s utility business over the next two financial years, which largely explains the profit growth expected over this time.
There were mixed signals from the mining sector this week as concerns emerged over the future of Swiss-based global miner and commodities trading house, Glencore. Slowing commodity demand, particularly from emerging economies, and well-supplied markets are now well understood by the market. The extent of the fall in commodity prices has typically been underestimated by the market over the last four years, hence the poor performance of the sector over this time. A sharp selloff in Glencore shares dragged the broader sector lower this week (before it recovered some of these losses), however it should be noted that its issues largely relate to the level of debt held by the company, a problem that does not apply to BHP Billiton and Rio Tinto. The importance of a strong balance sheet in what is a highly cyclical industry cannot be underestimated, particularly given the difficulty in forecasting commodity prices.
The positive news from the sector this week was two transactions which gave some hope that value is beginning to emerge in the sector. The first of these was Rio Tinto’s (RIO) sale of its 40% stake in a Hunter Valley coal mine, which was achieved at a price that was ahead of expectations. Secondly, private equity firm KKR acquired a 10% stake in copper miner OZ Minerals (OZL). Resources companies are not typically the domain of private equity groups, which generally seek companies operating in industries with fairly predictable revenues, however KKR’s portfolio of assets covers more industries than their peers.
Metcash (MTS) had an investor day, presenting its case that it can remain a viable third player in the food retail sector. With Aldi rapidly expanding into its regional strength of SA and WA, as well as the likely ongoing battle between Woolworths and Coles for dominance, the company cannot afford to get it wrong.
The harsh reality is that, as it does not control the retailers, its ability to achieve its goals are severely restrained. It needs to access scanned store sales to take to suppliers, it requires the retailers to maintain sufficiently competitive prices and it would benefit from a uniform offer of fresh food. All of this has to be cajoled out of its retail customers.
The apparently low P/E of around 6X will possibly tempt deep value managers and even a bid from private equity. It does not, however, present a case for inclusion in a longer term equity portfolio.