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WEEKEND LADDER

A summary of the week’s results

04.12.2015

Week Ending 04.12.2015

Eco Blog

Australia’s GDP growth continues to track along at a respectable, but hardly stellar, pace. The national accounts showed quarterly GDP growth of 0.9% and an annual rate of 2.5%, again defying some of the more bearish predictions, although generally in line with expectations.

While the headline figure would have pleased most, including the RBA, as is often the case, the composition of the GDP numbers reveal a more complete picture of the underlying trends in the economy. Of particular note was the contribution to economic growth from net exports, which perhaps masked some of the weakness emerging in other areas. Net exports contributed 1.5% to the quarterly growth figure, bouncing back after a weak June quarter. This reflected a recovery in resources-related volumes after these were impacted by weather in the previous quarter as well as the ramp up of new LNG production.

The key concern from the GDP figures was the weakness in domestic demand, which fell by 0.5% in the quarter; the worst such outcome since the GFC. The soft conditions in the mining-heavy states of Queensland and Western Australia are well established now. The quarterly growth rates for NSW and Victoria were also noticeably weaker, although both have performed well on a 12 month basis.

GDP: State Final Demand

Source: ABS, ANZ Research
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The key known weakness is widely understood, being business investment. Business investment fell over 4% for the quarter (a 0.6% drag on GDP) and has now fallen 10% over the last 12 months, with mining investment the primary driver. As a proportion of GDP, mining investment has now almost halved over the last three years, and this is expected to continue into next year.

The path for 2016 may become more difficult and there are several economists still of the view that further monetary stimulus will be required. The main problems cited include the ongoing drag from mining capital expenditure, a lack of any improvement in investment from other industries, a fading impact from both the housing sector and a rebased $A. A better growth outcome will therefore most likely rest on households, who to date have shown a high level of caution, with savings rates remaining elevated and income growth low.

For the time being, retail sales have maintained a steady rate of growth, with a 0.5% month on month gain for October. Somewhat surprisingly, department stores led the way across a range of industries (although this may have been a temporary outcome as a result of sales activity), while strength in food sales appear to have offset a softer result in cafes and restaurants. 

October Retail Sales, by Sector

Source: ABS, Escala Partners
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From the perspective of the states, Victoria and NSW were the core drivers for the month. What remains to be seen is if the current retail momentum can be continued into next year as we approach a peak in the current housing cycle (which could affect demand for housing goods) and with an ongoing lack of wages growth across the economy.

The RBA’s assessment of economic conditions was largely unchanged from November with the release of the monthly monetary policy decision. The RBA elected to leave the cash rate on hold for a seventh month in a row and has been pleased with the moderation of housing prices, particularly in Melbourne and Sydney. Spare capacity across the economy is currently leading to low inflationary pressure, which should persist in the near term, giving the RBA the option to reduce rates further if required.

Other central banks also remained in focus this week. In the US, Janet Yellen gave a speech on the US economic outlook and monetary policy. The speech was anticipated due to the prospect that the Fed may begin to hike interest rates later this month, and the consensus interpretation was that this view had been confirmed.

Yellen expressed confidence in the US economy to continue its current trajectory of moderate expansion, supporting ongoing employment growth, falling labour market slack and thus a movement in inflation toward the central bank’s 2% objective. The influence of factors that have been impeding growth are expected to recede in the medium term, including the strength of the US dollar, weak growth in overseas economies and lower oil prices.

The Fed chair also talked to the concept of the ‘neutral nominal federal funds rate’, that is, the rate that would be neither expansionary nor contractionary. The estimate of neutral rate fell significant during the GFC through a range of factors that impacted aggregate demand, such as household deleveraging, contractionary fiscal policy, slow productivity growth and tighter access to credit. As these headwinds reduce, the rate is expected to continue to climb steadily. The chart below shows estimates of the 'natural real rate of interest', a measure that is closely related to the neutral rate.

Estimates of Real Natural Rate of Interest

Source: Federal Reserve
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With a Fed rate hike now firmly in the picture in two weeks’ time, the November jobs report for the US (to be released tonight) has taken on an extra degree of significance. Expectations were raised through the week with the publication of the ADP/Moody’s Employment Report, which indicated employment growth of 217,000 for November. In reality, tonight’s employment number is just one of many that the Fed will analyse, with Yellen herself this week downplaying the weight of any particular data point.

In Europe, Draghi upset markets with an increase in stimulus measures that fell short of expectations. With inflation remaining low, the European Central Bank (ECB) cut its deposit rate further, from -0.2% to -0.3% while also increasing its quantitative easing timeline out to March 2017, however opted against adding to its monthly bond purchases. While the ECB delivered on its intentions to expand its monetary easing, markets were sold off given the more accommodative actions taken by Draghi in the past.

We have previously noted the steady recovery that has been underway in Europe, so in this sense, the package announced overnight should perhaps not be as surprising. While the euro jumped against the $US overnight in response to Draghi’s announcement, it is possible that it could resume its downward trend, with the policies of the respective central banks beginning to diverge.

Fixed Income Update

There has been much discussion in markets regarding recent spread widening for credit products within fixed income. This readjustment in risk premium has been across the board, with high quality investment grade securities down to unrated high yield all trading at higher credit spreads than earlier in the year.

The 90 day BBSW has not been immune. As a reminder, the commonly called BBSW rate is the Bank Bill Swap Rate and it measures the interest rate at which banks will lend to each other on a short term basis. It reflects the rate at which an investor is indifferent between receiving a fixed or a floating rate of return. It also takes into account the risk of default of a bank (and not being able to fulfil its obligations on the swap) by incorporating a banking sector risk premium over the risk free rate (i.e. government bonds).

For fixed income investors, the main relevance of BBSW is that it is the benchmark upon which coupons are calculated on floating rate bonds. While there are published BBSW rates out to 6 months, the 90 day BBSW is the most used reference rate for floating rate notes, including hybrid securities (180 day BBSW is also used, but less frequently).

With credit spreads widening, the BBSW rate is now trading at a premium to the cash rate of 27 bp (basis points). This is 17 bp wider than at the beginning of November. For holders of floating rate notes that are resetting their coupons today as opposed to this time last month, the investor is picking up an extra 0.17% p.a. (for this quarter) in their returns. The chart below illustrates the upward movement in BBSW vs the cash rate in November.

Cash Rate vs 90 Day BBSW in November

Source: Iress, Escala Partners
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While the credit spread widening has resulted in a fall in price for securities (as seen most obviously in our listed hybrid market), this is only a mark to market loss. As long as investors do not sell out of their securities prior to maturity and there is no default on the issuer, then investors will receive their money back plus the interest over the term. The advantage, however, is that as BBSW is now trading at a higher margin to cash, holders of floating rate bonds will receive a lift in real return on their coupon income. Whereas the trading margin that the bond holder bought at was determined at time of purchase, the investor still gets to benefit from the increased margin between cash and the BBSW rate.

The Australian listed hybrid market has been one of the big underperformers for domestic investors in fixed income this year. Following the origination of the $3bn CBA Perls VII deal completed late last year, the market has struggled to absorb the additional supply and together with global factors, has resulted in this sector trading down over the last 12 months. At an initial interest margin of 2.80% for this CBA deal, it is clear now that investors weren’t being fairly compensated for the inherent risks of this asset class.

However, it may appear that this market is (finally!) starting to stabilise. While throughout this year the hybrid sector typically weakened following any new supply, this has recently abated. The AMP deal (AMPPA) that launched in October offered an initial trading margin of 5.10%. This bond is now trading above par ($100.75), with a trading margin on the secondary market of 4.94%. This indicates that issuers are correctly pricing their new bonds and are not being opportunistic when coming to market. The new Macquarie hybrid deal that was launched last week with a margin of 5.15% was oversubscribed, which will hopefully bode well for its performance in the secondary market. 

Globally, European bond markets have been jolted overnight with the ECB not delivering the amount of quantitative easing that the market was expecting. Bond prices fell dramatically following the announcement, as yields rose. Germany’s 10 year Government bund (bond) yield spiked 20bp in one day, which was the biggest single move since 2012.

German 10 Year Bund Yield

Source: Iress, Escala Partners
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While the credit spread widening has resulted in a fall in price for securities (as seen most obviously in our listed hybrid market), this is only a mark to market loss. As long as investors do not sell out of their securities prior to maturity and there is no default on the issuer, then investors will receive their money back plus the interest over the term. The advantage, however, is that as BBSW is now trading at a higher margin to cash, holders of floating rate bonds will receive a lift in real return on their coupon income. Whereas the trading margin that the bond holder bought at was determined at time of purchase, the investor still gets to benefit from the increased margin between cash and the BBSW rate.

The Australian listed hybrid market has been one of the big underperformers for domestic investors in fixed income this year. Following the origination of the $3bn CBA Perls VII deal completed late last year, the market has struggled to absorb the additional supply and together with global factors, has resulted in this sector trading down over the last 12 months. At an initial interest margin of 2.80% for this CBA deal, it is clear now that investors weren’t being fairly compensated for the inherent risks of this asset class.

However, it may appear that this market is (finally!) starting to stabilise. While throughout this year the hybrid sector typically weakened following any new supply, this has recently abated. The AMP deal (AMPPA) that launched in October offered an initial trading margin of 5.10%. This bond is now trading above par ($100.75), with a trading margin on the secondary market of 4.94%. This indicates that issuers are correctly pricing their new bonds and are not being opportunistic when coming to market. The new Macquarie hybrid deal that was launched last week with a margin of 5.15% was oversubscribed, which will hopefully bode well for its performance in the secondary market. 

Globally, European bond markets have been jolted overnight with the ECB not delivering the amount of quantitative easing that the market was expecting. Bond prices fell dramatically following the announcement, as yields rose. Germany’s 10 year Government bund (bond) yield spiked 20bp in one day, which was the biggest single move since 2012.

Corporate Comments

Spotless Group (SPO) released an entirely unexpected downgrade this week, blaming weaker economic conditions, the delay and deferral of tender decisions and slower integration of recent acquisitions. Earnings growth for FY16 had previously been guided to “materially exceed” the FY15 results, an outlook that had been given when the company presented its full year results in August and as recently as late October at its full year results.

At face value, the new guidance was equivalent to a 7-8% downgrade to consensus figures on an underlying basis, with a further 10% impact from what SPO has referred to as “one-off and other charges”. These include bid costs written off on tenders, acquisition and restructuring costs, higher depreciation, amortisation and interest costs associated with acquisitions, contract mobilisations and IT implementation costs. Poor integration of a number of acquisitions appear to be central to SPO’s downgraded guidance, with the company noting that excluding acquisitions, its business was “performing well with margins being maintained.”

The quite bullish guidance recently reiterated by the company and the time in which it has taken to downgrade is a cause for concern and, in our view, is a blow to the credibility of management. It is clear that this is the reason that saw the stock sell off much more heavily this week than the downgrade to earnings would suggest. As the experiences of Slater and Gordon and Dick Smith will attest to, bad news and uncertainty has recently been punished quite severely by the market.

With a new CEO beginning just in the last few weeks, it is entirely possible that he has viewed the business with a fresh set of eyes and reset expectations. In light of this week’s developments, we will be reviewing the position of the stock in our model portfolios.

Dick Smith (DSH) disappointed again this week with a further profit warning. Since listing, Dick Smith has been widely recognised as a lower quality option in the consumer electronics space of the Australian market. Promoted as a value-type stock in the sector, the company has attempted to improve performance through a strategy revolving around increasing margins through the promotion of private label products, rolling out new stores and increasing its presence in the online retail market.

Like-for-like sales growth, however, has been elusive for the company over this time and its sales have deteriorated rapidly in the space of a few months. Since its full year result in August, sales have been propped up by a heightened level of promotional activity that was designed to protect its market share, with gross margins taking a hit. This much was noted in its trading update in late October, however with its November trading below expectations despite these initiatives, the company has now conducted a review of its inventory levels and taken a significant impairment charge.

Inventory issues are hardly a new problem for Dick Smith and a risk that most retailers face on an ongoing basis. Upon taking ownership of the business three years ago, the previous private equity investors cleared out a significant amount of aged inventory, providing a temporary boost to the company’s cash flows. The fact that there has been a recurrence of this 

Spotless Group (SPO) released an entirely unexpected downgrade this week, blaming weaker economic conditions, the delay and deferral of tender decisions and slower integration of recent acquisitions. Earnings growth for FY16 had previously been guided to “materially exceed” the FY15 results, an outlook that had been given when the company presented its full year results in August and as recently as late October at its full year results.

At face value, the new guidance was equivalent to a 7-8% downgrade to consensus figures on an underlying basis, with a further 10% impact from what SPO has referred to as “one-off and other charges”. These include bid costs written off on tenders, acquisition and restructuring costs, higher depreciation, amortisation and interest costs associated with acquisitions, contract mobilisations and IT implementation costs. Poor integration of a number of acquisitions appear to be central to SPO’s downgraded guidance, with the company noting that excluding acquisitions, its business was “performing well with margins being maintained.”

The quite bullish guidance recently reiterated by the company and the time in which it has taken to downgrade is a cause for concern and, in our view, is a blow to the credibility of management. It is clear that this is the reason that saw the stock sell off much more heavily this week than the downgrade to earnings would suggest. As the experiences of Slater and Gordon and Dick Smith will attest to, bad news and uncertainty has recently been punished quite severely by the market.

With a new CEO beginning just in the last few weeks, it is entirely possible that he has viewed the business with a fresh set of eyes and reset expectations. In light of this week’s developments, we will be reviewing the position of the stock in our model portfolios.

Dick Smith (DSH) disappointed again this week with a further profit warning. Since listing, Dick Smith has been widely recognised as a lower quality option in the consumer electronics space of the Australian market. Promoted as a value-type stock in the sector, the company has attempted to improve performance through a strategy revolving around increasing margins through the promotion of private label products, rolling out new stores and increasing its presence in the online retail market.

Like-for-like sales growth, however, has been elusive for the company over this time and its sales have deteriorated rapidly in the space of a few months. Since its full year result in August, sales have been propped up by a heightened level of promotional activity that was designed to protect its market share, with gross margins taking a hit. This much was noted in its trading update in late October, however with its November trading below expectations despite these initiatives, the company has now conducted a review of its inventory levels and taken a significant impairment charge.

Inventory issues are hardly a new problem for Dick Smith and a risk that most retailers face on an ongoing basis. Upon taking ownership of the business three years ago, the previous private equity investors cleared out a significant amount of aged inventory, providing a temporary boost to the company’s cash flows. The fact that there has been a recurrence of this 

problem in a matter of years (despite the company noting an improvement in inventory management) perhaps speaks more to the lack of resonance of the store format with consumers; a difficult task for any management team to turn around.

The inevitable parallel that many investors will draw from the announcements this week from Spotless and Dick Smith is that both were recently re-floated on the ASX by private equity groups. While this fact should certainly invite a higher level of scepticism and greater scrutiny when screened as a potential investment, the recent track record of private equity floats (listed in the table below) would dispute the theory that investors should avoid these companies altogether once floated.

We don’t believe that all IPOs that come out of private equity should be tarred with the same brush. The quality of the company, its competitive position in the market and its prospects to generate earnings growth in the medium to long term should all be factored in to the investment decision.

Some of the poorer performers on the list, such as Dick Smith, Nine Entertainment (and if one were to go back further, Myer), have longer-term structural issues that can be papered over somewhat in the short term

At this stage, we don’t believe that Spotless falls into this category, as its issues look more like a case of poor management through the integration of its acquisitions. 

Performance of IPOs Floated by Private Equity Since January 2013

Source: Bloomberg, Escala Partners
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TPG Telecom’s (TPM) AGM this week offered little in the way of new information for the market, however it was an announcement from Telstra (TLS) that generated more media attention. Early in the week, Telstra decided that it would be lifting the international roaming rates on its mobile plans quite materially, in a move that has gone against the general trend of more competitive pricing in the industry.

While Telstra later announced a partial backflip of these changes, it does highlight the challenges that the company faces in continuing to grow its earnings in the current environment. For several years now, Telstra has taken market share in the mobiles space as a result of a strategic decision to more closely match its competitors’ pricing, in addition to the network issues that Vodafone, in particular, has faced. Telstra still offers the highest cost plans in the telco industry in Australia, something which it is able to defend primarily through the strength of its brand name and, in mobiles, its superior network coverage. The gap between it and its rivals in the latter has been closing and we have previously highlighted the erosion of its advantage in broadband as the NBN is gradually rolled out across the country.


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