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WEEKEND LADDER

A summary of the week’s results

05.12.2014

Week Ending 05.12.2014

Eco Blog

Global PMIs (Purchasing Managers Indexes), indicative of the trends in the momentum in the manufacturing sector, have been edging down for some months. This week the China official PMI dropped to an 8 month low, with export orders registering a falling trend. In Europe, the big economies of Germany, France and Italy have exhibited signs of faltering, notwithstanding good traction in countries such as Spain and Ireland. Even in the US, capital spending has been lower than most had anticipated at this stage of the cycle.

The charts show the evolution of manufacturing output over the past 15 years. Along with other indicators, the trends imply global growth is consolidating at a below-par rate, with a multitude of implications for interest rates and investment markets. 

Global Manufacturing PMI

Source: Markit
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The extraordinary movements in the oil market are not without repercussions.  In the US, the energy sector has accounted for 30% of capital spending in recent years. Further, this has been mostly funded through bank and private sector credit rather than internal resources. A pullback in the capital plans for this sector will result in lower credit growth. The fall in energy prices, along with most commodities, will continue to filter into low inflation and the indirect benefit to household income may dampen any pressure on wages growth.

Indications therefore imply that the interest rate environment will be even more prolonged than anticipated. Consensus on the Fed’s first move has shifted progressively from mid ‘15 to late ‘15 and many other countries are therefore also more likely to defer any change to interest rates. In Asia, there is a greater likelihood of rate cuts, given the large impact commodity prices have on inflation and also growth stimulation.

These days, consensus views are treated with some suspicion, as many opinions have been proven wrong. The most likely disruption to the ‘lower for longer rates’ theory is that US data improves at a greater rate than anticipated.  As we will note below, consumption spending may come in better than expected and the residential cycle shows no signs of waning. October data on construction spending was above expectations at 1.1% growth. The US will also cycle the weather-affected period of this time last year, when activity in many regions was disrupted by storms.

In the US, Thanksgiving, Black Friday and now Cyber Monday retail sales data is closely watched as indicators of consumer strength. In addition, these events allow a more accurate assessment of the shift towards online spending. Analytics companies are competing to demonstrate their capacity to read the trends. Two cited are IBM Digital Analytics Benchmark and ChannelAdvisor, both of which have a significant digital retail customer base. As has been the case locally, the concentration of spending on specific holidays has mutated into a more protracted period of higher consumption as consumers have become attuned to promotional offers and are able to observe pricing movements in advance of the sales periods. Locally, many are willing to defer Christmas purchases to get a special deal. Digital media is influencing spending in a variety of ways and data from the analystics corporations mentioned above provide a good indication of the trends.

Online sales growth over this US Thanksgiving holiday period is predicted at around 13%, although some put the number slightly higher. Of mobile devices, consumers tend to use smartphones for search and tablets for actual sales transactions. IBM data has smartphones taking 28% of traffic but only 9% of sales, whereas tablets take 9% of traffic and 11% of sales. Desktop still holds its own with 61% of traffic and 80% of sales.

Channeladvisor’s retail customers, which are skewed to younger consumers, have a higher proportion of mobile – 49% of traffic from smartphones and tablets and 35% of sales. Average sales value is flat at US$131, with an average of 4 items per order. The trends show that consumers use mobile to check out product, yet prefer to transact in front of a desktop, implying impulse shopping is not as easily influenced by mobile devices as some might assume.

Apple iOS outpaces Android by some way. Orders from iOS are 24% higher than Android and Apple devices account for 22% of online sales versus only 6% for Android.

Channeladvisor shows the changing pattern of sales over the 4 days.

ChannelAdvisor: US Sales Summary

Source: ChannelAdvisor
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· Amazon remains a powerhouse, though aggressive offers eased though the period.

· eBay starts off weak, but picks up as product shortages and stock shortages in other channels lead consumers into this channel. Stockists for Paw Patrol, Minecraft, Frozen as well as Gro Pros and iAnything led to a resurgence late in the period.

· Comparison Shopping Engines (CSE) have become less popular as price differentials narrow. Google Search (GS) and Search started well as consumer initially looked across channels before fading, presumably as they had identified the likely source of their product. Search is most heavily concentrated in products over US$75 in value.

· Other 3PMs are retailers with online channels such as Best Buys or Sears. Their growth, off a small base, is due to the major investment they have made in online, price matching and promotion in store as a delivery vehicle for purchases. 

Consumers are spoilt regarding their online shopping. Local retailers have, until recently, been slow to embrace online, given their preference to protect sales and price points in store. They should be heartened by the growth in 3PM’s, but also acknowledge the effort, capital and price points that have underpinned the growing success of these omni-channel retailers.

Overall, the National Retail Federation reports that total holiday spending was up 4%, but notes that with the substantial shifting pattern in terms of retailers discounts (now earlier) and consumers becoming more savvy on when to transact, the growth in spending will only be fully measured by year end. Given that US households have gained $60bn from lower oil prices in the past 60 days, it is also an indication that the positive impact is indeed emerging.

Unsurprisingly, the RBA left rates unchanged and provided similar commentary from previous months. The new challenge will be the extent of fall in commodity prices and the impact on the terms of trade. This adds another weak spot for the RBA to consider, with some economists re-establishing their call for a rate cut to compensate for these negative developments.

Australian GDP for Q3 showed a disappointing, 2.7% annual growth rate, now well below forecasts of 3%. As we have noted before, the export sector is contributing much of that momentum. The current account balance for Q3 was better than expected, driven mostly by volumes in mining and slower capital imports. The rural sector shows no volume growth, with a rise in meat offset by lower cereals. A modest rise in prices led the rural sector to make a small positive contribution to the trade balance. Resource volumes were up 4.4% in the quarter while value eased by 2.6%. The full effect of the price changes will likely reduce the contribution in coming quarters before the big growth in LNG starts in mid 2015

The charts below show the movements in the trade balance, which is pulled into the red by services and capital flows. The terms of trade (price movements) has well and truly now capitulated to commodity prices and dragged the AUD along. 

Current Account Balance and Terms of Trade

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The full impact of lower commodity prices has yet to be factored into the Australian outlook. WA’s state income will feel a severe effect, impacted further by soft property activity. On the other hand, NSW’s income should rise due to increased property tax. The complex combination of distributing GST receipts and a tight federal mini budget implies public spending could well be a drag into 2015.

Dwelling approvals and activity has become a key driver of economic growth. October building approvals were up a strong 11%, driven by multi-unit growth in Victoria. Overall, however, the year-on-year rise in approvals was a much more modest 2.5%, dragged down by the sharp falls in non-residential construction. Hopes for an infrastructure-led lift in activity has yet to emerge. 

Company Comments

Metcash’s (MTS) first half results saw the stock sell off sharply. The company’s guidance implies a significant fall in second half profit, and little prospect of any meaningful improvement in 2016 as the group seeks to offer its retail store clients better prices. A change in emphasis and greater discipline may in time provide some sales momentum for the independent food retail sector. However, we believe that they will continue to struggle under the structure of Metcash, which is designed to accrete supplier deals to support its margin. Independents are turning to private suppliers for fresh product and differentiated localised line items and therefore incrementally less dependent on MTS. With the relatively high exposure to SA and WA (and Aldi intending to expand in those markets), life will not become any easier for MTS.  The smaller divisions of liquor, hardware and automotive distribution are also likely to come under increased pressure from the powerhouse of the big players.

Dividends have been cut to a 60% payout with the cash outflow supported by a dilutive DRP scheme. The balance sheet carries high intangible assets equivalent to shareholder funds. With some risks in cash flow due to working capital management, the requirement for a DRP is high.

The share price weakness in MTS increases the likelihood that it becomes a target of private equity. In our opinion, that would be the predominant reason to be an investor. Outside of this, the current situation and risks to profit present an unappealing investment option.

In the meantime, Woolworths (WOW) made a small acquisition in China, Summergate Fine Wines, which distributes liquor as well as running a small retail operation. Liquor has been one area Woolworths can claim supremacy, but global aspirations, such as the group’s efforts to establish a joint venture in India, and even its New Zealand food retail operations, have not lived up to expectations. For the moment, the focus will remain on Woolworths’ capacity to recover its momentum in domestic food retail rather than any opportunity that may arise from these acquisitions.

G8 Education (GEM) provided an earnings update to investors this week, where it stated that it expected to exceed consensus forecasts for earnings for the year ended 31 December 2014. The company had previously given no guidance to the market for earnings, so the news was well received by investors. GEM has been undertaking a growth-by-acquisition strategy in the highly fragmented childcare market in Australia and these plans advanced significantly this year when it took out a large competitor in the sector (Sterling Early Education) which was looking to employ a similar strategy.

While little detail was given in this week’s guidance, GEM also announced that it would lift its quarterly dividend payment by 20% to 6c per share. This decision does appear to be a little puzzling, however, in the context of the capital raising it conducted in October. We have GEM in our extended portfolio as a small-cap growth stock.

One stock that has been a beneficiary of broker upgrades in recent months has been Qantas Airways (QAN). Outside of the energy sector, the airlines have the most leverage to the oil price, and investors will be hoping that this translates into a profit for the business in FY15.  In our view, at best this is a short-term driver of profitability until airfares adjust downwards to reflect a new lower oil price environment. Hedging contracts that the company has in place will also put a cap on the participation in this cost reduction.

A more significant driver of profitability in the medium term for QAN will be increased rationality displayed by the domestic airline industry, particularly with regards to capacity additions. Going from past experience, the sustainability of this current restraint is perhaps more questionable. QAN remains at best a trading stock for those willing to make a call on these shorter-term trends.

Questions regarding the ability of BHP Billiton (BHP) and Rio Tinto’s (RIO) to return capital to shareholders over the short term has again been discussed. RIO held investor seminars over the past week, reiterating its strategy of reducing capex (while still delivering high-returning projects), cutting costs and higher shareholder returns. The decline in the iron ore price has done little to modify its iron ore expansion plans, with the company highlighting an expected 40% internal rate of return and five year payback on this investment in the Pilbara.

Despite weak commodity markets through 2014, a lift in RIO’s progressive dividend is a likely outcome at its February results, although this is coming off a relatively low base. RIO’s debt is now moving towards the low end of its target 20-30% gearing ratio range and the company’s willingness to take on additional debt could play a part in any additional capital returns. 

Sector Focus: Energy Update

Summary

The oil price has fallen 10% since last Wednesday and 40% since mid-June. The causes are both supply and demand related. On the supply side, the expansion of the US shale energy industry has continued as expected this year, and should this year add 1 million barrels a day to global supplies for the third consecutive year. Supply from Libya has also recovered after the disruptions in that country following unrest in 2013. High geopolitical tensions in other regions has failed to have much impact on supply in this time. Demand forecasts have been revised downwards in recent months on slower growth from China, a weakening European economy and Japan slipping into recession. In short, supply growth in 2014 has outpaced that of demand.

The catalyst for the falls seen last week, however, was the outcome of OPEC’s meeting. Despite the weakening environment, OPEC decided to maintain its target of 30 mb/d target (around a third of global supply), with the cartel deciding against production cuts. This outcome was largely foreshadowed, however was a departure from OPEC’s typical response to falling prices in the past through production cuts.

Apart from the decision to maintain current production rates, what was notable about last week’s meeting was the lack of any consensus on how to handle the current environment. Several members pushed for the status quo in production, including the influential Saudi Arabia (which has extensive financial reserves), while others with more finely balanced budgets, such as Venezuela, pushed for production cuts. The next OPEC meeting is not until June next year, leaving considerable time for the market to adjust.

Why has OPEC reacted this way?

The most logical conclusion that one could draw from OPEC’s inaction on production cuts is that it is attempting to halt the supply growth from other producers, primarily the US shale industry. In a way, OPEC is attempting to protect its market share rather than risk fuelling further investment and production growth that could result if it cut production and provided support for oil prices. OPEC members largely have a cost advantage over most of the industry and, as such, can weather a period of lower pricing compared to higher-cost sources. Following the recent declines, a large part of the US shale production is now marginal or even loss-making, and OPEC will be hoping to push some of these producers out of the market.

What is the outlook?

Estimates currently put the oversupply in the oil market at around 0.6-0.7 mb/d which could rise during seasonal weakness in the first quarter of 2015. In the absence of any recovery in demand, there is every chance that this oversupply situation could get worse before it gets better.

Should current low prices persist, the question will be how long it takes for US shale producers to wind back their production growth, which was expected to add an additional 1 mb/d to the market in 2015. There are several complicating factors that could see this play out over an extended period of time.

Firstly, although the full economic costs of shale production may be quite high, in many cases significant capital has already been sunk on land and infrastructure and hence the costs of drilling each additional well could be much lower on a cash basis. This can be viewed in much the same way as how a 

brownfield investment leverages off existing infrastructure. Secondly, hedging and/or drilling contracts in place by producers could see them continue production when it might otherwise appear uneconomic to do so. In a lower price environment, cash flows should be weaker, limiting the capital expenditure and exploration plans of the industry and potentially raising financing issues for the more marginal players.

OPEC itself is also contributing to the oversupply situation in the market, as it has consistently broken its own production quota since it was last set three years ago. If it were to adhere more strictly to its target, this would go a significant way to correcting the current supply imbalance.

In short, prices may have to go lower to have a meaningful impact on curbing US shale production. While analysts have been revising down their oil price forecasts over the next few years, consensus remains for a recovery over this time from current levels towards long term assumptions that are largely unchanged (approximately US$90/barrel). This is also reflected in the change in the futures curve over the last six months. Few have been brave enough to call recent events as leading to structurally lower oil prices in the longer term.

What also cannot be discounted is the role of financial markets in the current downturn. Oil-linked ETF outflows have been particularly high in recent months, following the oil price down, as investors have allocated their capital away from commodities. The US dollar has also strengthened in this time, which is typically a negative for commodities, as this is the currency in which they are priced.

As discussed above, longer term oil price assumptions have not been altered in a material way over the last week since OPEC’s decision, or even since the oil price began to decline in June. Of course, many will treat futures prices and forecasts with a healthy dose of scepticism, particularly when one considers the lack of foresight in predicting the current downturn. Nonetheless, it is these prices which form the basis for the valuation of energy stocks.

The consensus view is that the oil price will remain depressed for at least the next six to 12 month. The most important factor in the near term will be the rate at which US shale investment (and thus ultimately production) is scaled back. The other short term risk factors are the potential for further demand weakness as a result of a softening in the global economy and the ongoing possibility of supply disruptions resulting from the various geopolitical hotspots around the world. The market’s confidence in OPEC’s ability to act like a cartel has also been dented, and what is unclear is how they would react should their current strategy not produce the desired outcome.

Beyond that, this slowdown in supply should lead to a more balanced market in the medium term, and thus a lift in prices. Global demand is still growing at a rate of approximately 1% p.a. As a result, higher prices will be required at some point in the future in order to incentivise new supply, particularly when natural field decline is taken into account. As such, the near-universal view is that a higher price than current will be required in the long term; the question is the trajectory in getting to this point.

As a general comment, despite the drop in oil prices over the last six months, energy equities are implying a more prolonged downturn than what energy analysts are predicting. With longer-term price assumptions cut only marginally, it is only the next few years whereby profitability and hence cashflows will be lower than previously expected. Below we discuss the implications of the lower oil price for the major ASX-listed energy stocks.

Santos

Santos is the most leveraged of the large cap energy stocks. The key reason for this is that its production costs are higher than its peers, and thus its forecast margins and earnings have taken a bigger hit than its peers.

Presently, Santos is only a little over six months away from the completion of its Gladstone LNG project. As a result, the company is still faced with a significant capex bill for 2015, which it estimates at $2.7bn.

With its lower-margin operations and existing high-debt position, Santos has suffered more than other large-cap energy stocks in the current sell-off. Investors have thus attributed a higher probability of a requirement to raise additional equity from the market. In our view, however, unless we see a much larger deterioration in oil prices or a large blowout of costs at Gladstone, these equity raising concerns appear to be overstated. We note that, as at 30 September, Santos had $2.1bn in cash and undrawn debt. Even if oil were to average $60/barrel over the course of 2015, Santos may only have to call on half of this undrawn requirement.

A greater concern for Santos, and one which should see it take action to improve its cash flows and strengthen its balance sheet, is the company’s credit rating. Santos currently has a credit rating of BBB+, however this is at risk of a downgrade in the current environment. Hence, if the company wishes to protect this credit rating, an equity raising cannot be ruled out. We would see this as a last resort, however, particularly following its recent share price decline. Alternative options that would likely be explored before an equity raising is considered would include reducing dividends (or underwriting a dividend reinvestment plan), reducing some discretionary capital expenditure and/or selling assets. Yesterday’s market announcement by Santos indicates that the company is already looking at the various cost levers that it can pull over the next 12 months.

Until yesterday, Santos was considering issuing a European hybrid issue which would have given investors increased confidence that further equity will not be required. The company has since deferred this hybrid issuance, stating that market conditions were not conducive. While its statement infers that it sees no need for an equity raising at this point in time, this risk is obviously higher in the absence of the hybrid issue.

At this point in time, Santos is the best value of the large cap energy stocks, although we caution that it also comes with the highest risk. These balance sheet issues will continue to linger until either the oil price improves, or the company successfully crosses its capex ‘hump’ next year.

Woodside Petroleum

Woodside Petroleum is the best placed of the ASX-listed major oil companies for two reasons. Firstly, its operations are the lowest cost of the majors and it has little debt on its balance sheet. Secondly, Woodside has little in the way of capital expenditure commitments in the medium term, and thus it has no funding issues to worry about.

The downside for Woodside, still cannot be understated. Many investors have held the stock due to the strength of its dividend. While it would still be expected to continue to pay out 80% of its earnings in dividends, earnings and hence dividends will clearly be lower in the current environment.

Further to this, the growth outlook for Woodside has become more difficult under lower oil price assumptions. A floating LNG development had been the primary project which investors had been pinning their hopes on for production growth. The economics of this, however, now look much more marginal, and there presently would be a low probability of this proceeding.

Oil Search

Oil Search remains in a fairly comfortable position in the current environment. While the company has a reasonably high level of gearing, the important factor to note is that its PNG LNG project was completed six months ago now and hence its cash flow position will be particularly strong over the next 12 months. Compared to other LNG projects in the Australasian region, PNG LNG is high margin, largely due to the liquids by-product of the associated gas fields.

With trains 1 and 2 at PNG LNG now complete, the key question for OSH is if or when it proceeds with an expansion of this project. The current environment may slow this progress over the next few years, however it should be noted that the returns still look attractive even under much lower oil price assumptions. OSH is the best option for investors looking for an energy stock with good prospects for production growth over time.

Origin

Origin’s situation has some parallels with that of Santos in the fact that it has a large stake in one of the higher-cost Queensland coal seam gas projects, with the project six months or more away from first production. While the value of this project to the company is impaired under low oil price assumptions, ORG’s power generation and retailing business provide a higher level of diversification for investors than the pure oil and gas companies.

Similar to Santos, Origin has significant undrawn debt facilities (a position of $5.1bn as at 30 June 2014). As a result, unless there is a material cost overrun at its APLNG project, its funding position is well covered. The company’s credit rating will thus be keenly watched in the current environment, which could face some pressure should the oil price slide further. This week, Standard and Poors reiterated its BBB credit rating for ORG, although it came to this decision after reducing its assumptions for Brent crude to US$80 a barrel for 2015 (around US$10 a barrel higher than the current price) and US$85 a barrel for 2016.


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