Week Ending 05.06.2015
First quarter GDP for Australia was reported at 0.9%, or an annualised run rate of 2.3%. At face value, the number was as decent as could be expected, though those that dug deeper insisted on pouring cold water on the good news. Exports growth was 0.5% and inventory added 0.3%. In the quarter domestic demand made no contribution to growth and only 0.8% over the year.
We have discussed these issues in previous weekend notes. In short, the fall in investment spending centred on the mining sector, but is also evident elsewhere and low public spending was balanced by modest consumption growth. For domestic demand to improve, one would have to see business investment spending pick up considerably. The recent capex intentions implies that this is not likely. Consumption spending will be held back by low income growth, essentially flat in the quarter, and households are already slowly reducing their savings rate to accommodate their consumption pattern.
The upside from here could come from a burst of spending in small business through the tax benefit in the budget, with a follow through of rising confidence into the overall economy. Bearing in mind we have an election due next year, another source of upside could come from the long-awaited recovery in infrastructure spending, or public spending in general. The chart below shows the lower level of public sector contribution to GDP (typically representing circa 20% of total) in the past 5 years compared to the prior decades. A combination of government spending in the commodity boom, followed by the struggle with the deficit, has come home to roost. Tolerance of higher government debt is likely and we may get close to where the rating agencies have another reassessment of our credit rating. If government debt does not add to productivity improvements largely achieved through infrastructure and education outlays, the debt will be squandered in unsustainable income support.
Public Demand Contribution to GDP
The recent slight pickup in retail spending faded into April, up 3.6% in nominal terms on the same month last year. Seasonally adjusted sales, which allow for the number of weekends in months and public holidays, suggests a stable to slow decline in the growth rate at 4% p.a.
There are two sectors holding up a little better than the others. Unsurprisingly, one is household good sales, though there has been a shift towards furniture, floor coverings and homewares from hardware and electrical goods. Speciality clothing stores are also doing well, and knocking the socks off department stores. Food retailing edged down, presumably reflecting the price tension in the sector. However, the sharp decline in food away from home is somewhat disconcerting. This often correlates with low consumer conviction on their wellbeing and may be due to the low income growth households are experiencing.
The ABS is running two new series within this release, with one tracking online spending. It shows a persistent circa 30% rise in online, with a strong bias to those with a physical footprint, though this may simply be a single site defined as a store. The ABS sampling of online is not particularly broad, representing only 3% of total retail sales, but does show that Australian adoption of this channel still has some way to go.
The other series is utility spending, with electricity and gas sampled quarterly. After these combined costs rose into mid last year, households should now be enjoying the 3-4% fall in these expenses. Reducing the impost of service costs, specifically regulated prices such as private health insurance, as well as education, would go some way to support better discretionary consumption spending.
Finally, the trade deficit came in at its highest ever. Falling commodity prices are likely to see this pressure continue this year; not an ideal outcome overall, though foreign exchange flows may to some extent supress the $A.
Modest, moderate and subdued were the predominant words used to interpret data out of the US and Europe. After the reprint to negative GDP for the first quarter, US trends are being closely watched to support the general view that Q2 will bounce back into the mid 2% zone. The question on most economic minds is whether the softer pattern is due to the rise in the $US, or something endemic to economic growth in general. The labour market is behaving itself, however, and if the report overnight this Friday shows another move downward in unemployment towards the Fed’s view of the ‘natural unemployment rate’ of 5.1% alongside an uptick in wage growth, bets on the rate decision tighten.
European trends edge ever so slowly in the right direction. Subject to what transpires from Greece in coming days and weeks, growth could pan out as expected. The Greek story is full of opinion and innuendo, however most agree the sticking point of contention between the government and the other European parties is about pension reform, value-added tax and asset sales.
Fixed Income Commentary
The global bond market remains heavily in the spotlight this week, after a significant rally in bond yields globally. This began in Europe in response to renewed hopes of reaching a deal with Greece and data showing a lift off in European inflation. The biggest moves were seen out of Germany with 10yr bund yields surging 35 basis points (bp) higher to 0.88% in the last two days. That was the biggest two-day move since the start of the single currency in January 1999. US Treasuries were not to be left behind with yields backing up across the curve.
Domestically, our local markets have also experienced increased levels of volatility. Post the RBA meeting on Tuesday, the rates market had a small relief rally with domestic yields up 5bp on the 3 year and 5 year bonds and just 3 bp on the 10 year. Unsurprisingly the short dated bond prices were broadly unchanged. However, as is often the case, our market reacted more aggressively to the spike in yields globally that has occurred in the last few days. This led to a subsequent 9 bp jump in 3 year bond yields to 2.01% and a 15 bp upward move in the 10 year yield to 2.89%.
Earlier in the week a further rate cut by the RBA was deemed to be firmly on the table, with the futures market pricing in a high chance that there would be a 25 bp cut by this time next year. However, in the last couple of days this sentiment has clearly shifted with the futures market only reflecting a 38% chance (down from 60% on Tuesday) of a rate cut by October this year and a 52% chance in a year’s time.
Cash Rate Cut: Implied Probabilities from Australia Bills Futures Market
The credit markets have generally remained stable throughout the recent rally in bond yields. However, there is talk that cracks are starting to show, particularly in investment grade credit out of the US. Spread widening at the same time as a backup in bond yields leaves the fixed income markets vulnerable to some capital losses in the short term.
The flow on effect from the weak iron ore price was evident in a trading update from Qube Holdings (QUB). As a smaller logistics provider compared to the key players in the industry, QUB had enjoyed a solid share price run from late 2012 until recently. Its iron ore exposure, however, is now beginning to impact the company. The company has contracts with high-cost operators Arrium (ARI) and Atlas Iron (AGO), both of which would be loss-making under the current iron ore price environment. QUB also provided an outlook for FY16, noting that it “does not expect trading and economic conditions to improve”. The company was previously traidng on a forward multiple of 22X prior to this week’s update, which was partially explained by the upside from its strategic investment in Moorebank, which is to be developed as a large inland rail terminal in South Western Sydney. This multiple,left little room for earnings disappointment and thus the stock was sold off.
UGL meanwhile surprised most with its market update. Following the divestment last year of its property services business, DTZ, the company is now a pure engineering company and thus has a large resources-related exposure. UGL has a relatively new CEO in the role who has undertaken a review of the group’s operations. Reducing overhead costs was a central outcome of this review, with the company expecting to achieve annual cost savings of $33m by FY16. UGL is assuming that the majority of these savings will drop straight through to its bottom line, resulting in improved margins over FY16 and FY17 and a step up in profitability. What is questionable is how much of these savings will effectively be retained by UGL’s customers.
While there are obvious risks in relying on these markets for recurring revenues, poor operational performance on individual projects can also have a material impact on the business. This has been realised with the issues that UGL and its joint venture partners have encountered on the construction of a power station at the Ichthys LNG project in Darwin. Seven months ago, UGL revealed that project changes and events had delayed its progress, resulting in a US$170m provision being taken. UGL’s share of this provision is in excess of a year of its entire underlying profit. With construction now 30% complete, cash flows will be impacted over the next two financial years. UGL has one of the highest proportion of ‘sell’ ratings by brokers (12 out of 15 analysts according to Bloomberg), which appears to be justified given this ongoing risk, the high costs associated with its restructre and the time needed for management to demonstrate that no other negative surprises exist in its current order book.
The pain trade for Metcash (MTS) investors has yet to end. The group will take a $640m asset impairment charge in the full year result to be released on June 15. While it is non-cash in nature, management also stated it will not pay a final dividend, nor one for FY16. Given that the stock was well represented in deep value dividend funds and ETFs, the stock sold off heavily as a result.
Along with others in the food retail sector, years of complacency on pricing and the customer has brought about a potential period of tighter margins and market share shifts. Metcash is likely to be worst positioned to cope with this, given it has to support the disaggregated retailer and itself as a wholesaler.
This stock highlights two issues: value traps are part and parcel of equities and the dividend yield is an imperfect and incomplete picture of a company’s investment merits. The pecking order of having confidence in the company’s management, business strategy, balance sheet and cash flow, industry structure before considering the yield plays out time and again. Prior to this week’s announcement and based on consensus numbers, MTS was offering a
forward dividend yield of approximately 9%. An assessment of the company’s prospects, however, may have suggested that there was a high element of risk to these forecasts.
The table below lists companies in the ASX 200 with the highest forecast dividend yield (consensus data). Many of the stocks that feature high on this list are companies that have faced difficulties in recent times or have been dealing with a challenging operating environment. Those we highlight that would fit this description include STW Communications, MMA Offshore, Skilled Group, Monadelphous Group and Cardno.
S&P/ASX 200: Highest Forward Yield
Several of these high yield stocks also feature heavily in a number of high yield exchange traded funds (ETFs), indicating that they run the risk of being sold down should their expected dividends fail to materialise. Stocks that are well held amongst ETFs include Monadelphous, Mineral Resources, WorleyParsons, Southern Cross Media and Myer. We would regard few, in any, among this group to have a ‘safe’ dividend.
Stock Focus: Tatts Group (TTS)
Tatts Group operates a network of lotteries and wagering businesses across Australia. The company also provides monitoring and maintenance services to gaming machines.
Tatts’ lotteries business is its core division and accounts for over half of the group’s total earnings. The company provides lottery products across all states and territories of Australia, with the exception of Western Australia. While results in any one period can be influenced by the number of large lottery jackpots, viewed in a longer term time frame, this business has a relatively predictable, stable demand profile with low levels of competition. Key in maintaining this position is the licences that the company has across the various states. These are typically long-term in nature, with a weighted average of greater than 40 years. Of the major states, the exception to this rule is Victoria, which is a 10 year licence which expires in 2018. A material extension of this along with improved margins would deliver significant value for Tatts shareholders. Given the size and scale of its lotteries division, Tatts would be the logical acquirer of Lotterywest, Western Australia’s lotteries operator, should the WA government decide to privatise this business.
Tatts also operates a wagering division. The company has exclusive retail wagering licences across Queensland, South Australia, Tasmania and Northern Territory. These retail outlets account for 2/3rds of the group’s wagering turnover. While this division has recently underperformed somewhat, Tatts has been making significant investment, which has included launching a new brand (UBet) in the first half of this year, a new website and mobile apps, a refresh of its retail outlets and a coinciding marketing campaign. The benefits from this investment should flow through to higher revenue growth for this division over FY16 and FY17.
The rise of mobile and online as a delivery medium is both a threat and an opportunity for Tatts. In lotteries, the structural change is a positive, with online delivery a higher margin channel given the absence of commissions. In wagering, the development is both a positive and a negative. The downside is that it has opened up competition, with several international companies entering the Australian market in recent years. However, with consolidation occurring over the past two years, a more rational market appears to be emerging, leading to rising yields. Mobile, in particular, has expanded the overall wagering market, luring more recreational punters. The rising popularity of multi-bets is also a positive development, as these have typically resulted in higher yields for the operators.
Tatts’ smallest division is the monitoring and maintenance service it provides to poker machines. Gaming was historically a core part of the group’s operations, however this was diminished after the Victorian government decided not to renew its licence in 2008. While it was not initially given any compensation payment for the loss of this licence, Tatts was successful in its legal challenge against the State of Victoria and was awarded a $541m compensation payment. Presently, this decision is being appealed, although it would appear that the most likely scenario is that the original decision is upheld. Should this occur, it would open up capital management options for Tatts, which could mean a share buyback or special dividend payments.
We like Tatts Group for its defensive qualities which typically continue to perform well in the face of weak domestic environment. The company has a solid dividend yield (and the prospect of additional shareholder returns), it generates high levels of free cash flow with low ongoing capital requirements and it has a strong balance sheet. We recently added the stock to our model portfolios.