Week Ending 06.02.2015
The big economic news is now out of the way, at least for the time being. Surprising most economists, the RBA elected to cut rates by 25bp and left open the potential of another cut later in the year. Most commentators concede that the direct impact on business credit growth is likely to be modest at best, but the RBA may well be more focused on the exchange rate rather than credit growth at this stage.
After a sharp initial downward move against the USD, the currency bounced around for the rest of the week, driven by volatility in commodities. Nonetheless, talk has been followed by real action; the AUD/USD exchange rate is 10c lower than two months ago. The RBA would be aware of the potential for the AUD to hold up given the easing in Europe and Asia and needs to remain on the front foot in terms of interest rates. Further rate cuts may therefore be in the wings to exert the required pressure, depending on the US Fed and the rate outlook there. For the RBA, the perfect world may be a hawkish stance to come from the Fed and relieve it of using rates to leverage the AUD down.
Turning to the fundamental issues, was there compelling evidence for the RBA to have cut rates regardless of the currency dynamic? The subsequent release of the NAB Business Conditions Survey shows that the persistence of weak demand is the primary issue; indeed interest rates barely rate a mention.
NAB Business Conditions Survey: Response to Business Constraints
The terms of trade has deteriorated further since the RBA’s last meeting and, more importantly, the expectation for commodity prices is more subdued than before with little sign of a sustained recovery in prices.
We are not suggesting the RBA has turned to exchange rates as its primary goal. It does, however, fill a gap and is arguably a necessary factor as part of overall financial conditions. Low lending rates, stable and high asset prices (including equities) are in place and at this point it is difficult to suggest the RBA could do more.
The release of building approvals data for December was marginally in favour of the RBA move. The volatile multi-density approvals fell back sharply, offset by a small pickup in free-standing housing. Non-residential building approvals was very weak, at a near 10 year low in nominal dollars. While the run-off of mining construction is expected, the lack of approvals in other segments reinforces the lack of confidence businesses have on demand growth.
Retail sales for December were also below expectations. For the RBA, this has to be balanced against the changing pattern of seasonal sales, with consistent indications that traditional December spending is being shifted into January. However, there is little indication that households are yet transferring savings from lower inflation, or bank savings into spending.
China joined the growing number of central banks to ease. The path there is through the Reserve Requirement Ratio (RRR) which sets the capital structure of the banks and implicitly the amount of credit they can extend, rather than the price of credit (as is the case elsewhere). The People’s Bank of China (PBoC) has been working on the stability of the exchange rate and through that had indirectly drained liquidity from the system. This cut in the RRR alleviates some of the constraint during Lunar New Year when liquidity demand is high.
While the nuances of the Chinese economy differentiate much of it from developed world dynamics, there are a number of inescapable determinants which underpin any economy. The growth in money supply is usually closely aligned to financial conditions and corporate investment strength. As can be seen in the chart, the rate of growth has been falling away, even taking into account a look through the extreme easing in monetary conditions at the time of the financial crisis.
China: M1 and M2 Growth
Most China commentators take the view the authorities will play a cautious hand on providing support and that credit growth will be carefully managed rather than let loose. Even this cut in the RRR was not uniform across the banking sector, with regional banks and those that meet lending targets to small and medium businesses given greater leeway. Nonetheless, the direction of growth in China is unquestionably somewhat worrying and unless there is a pickup in coming months, it is more than likely reported GDP will ease into the 6-7% zone by year end.
A glimmer of hope has emerged from European data. As we have noted in past weekenders, the services sector is holding up reasonably well and the recent PMI survey supports further improvement. With the PMI, an index based on 50 as neutral, the services component across Europe showed a reading of 52.7 for January compared to 51.6 for November. France continues to be the laggard, with its index component below the 50 required to show expansion. Spain is making considerable progress with a reading of 57.5 for its manufacturing sector and Ireland is at a heady 62.5. The UK also gave a firm reading after a softer tone at the end of 2014. Into the end of the week the euro therefore rose, indicating the sensitivity to any possible change in pace.
European stocks have done relatively well in the past quarter and if the PMI is an early indicator, the economic momentum is improving, albeit at an overall low pace. Greece may still prove a fly in the ointment, with protracted and messy discussions on what to do with its participation in the Eurozone. It seems inevitable that any arrangements to accommodate the new government will go down to the wire and have a host of ‘ifs’ and ‘buts’ in providing further support. Broadly speaking, EU members are looking for a commitment to structural reforms in return for some flexibility in the primary balance on the budget and extension of debt maturities. Over this weekend, the Greek government meets to represent their legislative agenda and on Thursday the EU leaders meeting will be an important date for signs of some compromise. The hope that economic conditions in Spain and the UK continue to improve may prove critical for their elections this year.
JB Hi-Fi (JBH) was first off the market this week with its interim profit release. Net profit for the half year was up only 1.9%, but the indicative sales data for January at 7% comparable growth was a vast improvement on the -0.7% for the first half of the fiscal year and gave some hope that the second half would see a pickup in trend. We have been buying iPhones, fitness gadgets and games, while the tablet market is soft without any product releases. Headline growth is required as the cost of doing business is rising faster than gross income and net profit margins have been edging backwards. In 2010 the company was in a sweet spot, having grown from 10 stores in 2000 to 141 (see chart below), achieving double digit comparable sales and headline growth of around 30%. The stock price peaked at $23 late that year. The outlook now is vastly different. Stores are growing at a rate of 3-4 per year, there is efforts to gain share in other product segments through the HOME business division and competition is increasing from online, as well as improved local operators. At times the market will reward short to medium term momentum but, in our view, longer term investors face the prospect of continued tough revenue growth and tight profit margins.
JB Hi-Fi: Store Growth over Time
An interesting development in the broader retail sector was the announcement of a friendly share based merger of Federation Centres (FDC) (which emerged from Centro) and Novion (NVN) (the recently rebadged CFS Retail Trust). The fundamental premise for this arrangement is clear; some costs can be saved from operating overheads and there is the potential for lower interest rate funding costs. These are mostly one-off and while the funding rate can be lowered, it does come with a sizeable offset to re-establish debt at the reduced rate, suggested to be 4.1%. Most analysts therefore took these net benefits to be a modest contributor to the overall value enhancement of the deal and instead focused on the leasing and development prospects of the combined entity.
Retail, as we noted in our economic section, has been experiencing slower growth for some time. The likely cause is the uncertain economic climate, preference for experiences over goods, online spending and demographic changes, including the nature of household formation. More recently, the entry of global retailers to the key clothing and apparel segment has affected the profitability and growth aspirations of local apparel groups. Net rental income for retail assets has fallen from around 5% to 2%. On aggregate, the retail trust sector has become increasingly reliant on supermarket sales as well as food courts. With rental growth to supermarkets generally a slow burn, the smaller stores have been pushed up from mid-double digit rent/sales to where the commercial returns for the retailer can become questionable.
The emphasis has therefore moved to redevelopment potential. For example, tenancy mix, the question of poorly performing department and discount department stores, the growth in services and the ambiance that these require all likely require capital investment. The proposed combination of FDC/NVN is therefore likely to be in response to these trends, which should give greater flexibility on developments, potential clout with retailers and lower cost of capital. In the short term. the market has judged that NVN is getting a better deal as it has a more difficult redevelopment path. In time, the merits will be judged by the reconfiguration of the asset base and the ability to grow income as a combined entity.
National Australia Bank (NAB) announced its quarterly trading update, with earnings growth of 6% for the first quarter of FY15. Top line momentum is still benign, with a 4% growth figure enhanced by the sale of a portfolio of loans in the UK. Underlying expense growth was also 4%, while bad and doubtful debts were flat. NAB has been gaining market share in the Australian mortgage lending market, at 1.4x system. Business lending, traditionally its strong suit, has lagged in recent times and NAB highlighted increased competition.
The requirement to improve capital ratios will be a key issue for the banking sector in coming years, as recommended by the Financial System Inquiry. While the banks will likely be given an extended period of time to make this adjustment, NAB’s decision to effectively retain two-thirds of its final dividend payment (through its dividend reinvestment plan (DRP) and the partial underwriting of the DRP) could be a sign of things to come. EPS figures will be lower than underlying profit generation in this environment given the dilutionary impact of additional shares. NAB’s share price has appreciated materially since mid-December, however this performance is largely in line with its peers and it remains at a discount to the sector. We believe that the potential for it to exit its UK business and thus focus on its higher-returning domestic operations will be key in a potential re-rating of the company’s earnings.
FlexiGroup’s (FXL) half year result was sound and the company reaffirmed its full year guidance, allaying some fears that some investors may have had after the company had pointed to soft trading conditions at its AGM. A 10% increase in receivables led to a 9% increase in cash profit after tax, with profit growth across each of its business divisions. A highlight was the turnaround in its core leasing divisions, which had been a drag on profitability in recent years. FXL has successfully diversified its business away from these operations via a number of acquisitions.
Trends remained consistent with what FXL has typically delivered, including a further reduction in funding costs and its cost to income ratio, and impairment losses remaining well contained, underpinning a return on equity in excess of 20%. Other highlights included consistent solar volumes despite reduced government subsidies and a growing level of repeat customer business – an outcome of its strategy of becoming a more customer-centric company. We have FXL in our model portfolios.
Downer EDI’s (DOW) result again reflected challenging markets, although the company performed quite well with this backdrop. The group’s mining exposure remains the biggest cause for concern as it faces lower capital investment in response to lower commodity prices, increased competition for a reduced pool of work and customers that are also looking to restructure their cost bases. Margins were generally lower across the board, although this was offset by its rail division which benefited from lower restructuring costs. The division has been transitioning to a more integrated, full service life cycle offering to its customers.
A lower interest and tax expense translated to a smaller decline in profitability (4%) than revenue (9%). Despite the result, DOW also reaffirmed its full year guidance and was able to record a slight lift in its half year dividend, while work in hand slipped almost 10%. For companies that have mining services exposure, DOW is better placed than most, with a solid balance sheet and a greater level of diversification across its business (see chart below). Until there is more stability in its end markets, however, it is hard to see what the catalyst will be for the company to re-rate from its single-digit P/E multiple.
Downer: Work in Hand by Division
Tabcorp (TAH) delivered a 20% increase in EPS, led by an improvement in turnover in its wagering division. The breakdown of this distribution reveals the current trends with customers increasingly likely to place their bet via digital mediums (particularly via mobile phones as smart phone penetration has grown) as opposed to at retail TAB outlets or over the phone:
Tabcorp: Wagering Turnover by Division
The competition is obviously greater in the online market, given several new entrants over the last few years. TAH is still the leader in this space, however, and appears to be reaping the benefits of a more rational market which has experienced a degree of consolidation. Other factors are also favourable, such as the increasing popularity of multi-bets and greater penetration of fixed odds betting.
In keeping with the current thematic of increased shareholder returns, TAH also paid a special dividend for the half of 30c (releasing excess franking credits) for a total dividend payment of 40c, although its capital position remained largely unchanged given it was accompanied by a similarly-sized equity raising. It is arguable whether the special dividend may have been more accretive to EPS given the current low cost of debt, however will likely be supported by local investors.
Also in the gaming sector, Echo Entertainment (EGP) produced a solid result, with ongoing momentum from its NSW and Queensland casinos. Normalised (that is, adjusting for expected win rates on its various games) profit grew by 78% on the back of rises in both its high-roller and mass-market businesses, while its dividend was raised by 25%. Its flagship property, The Star in Sydney, had underperformed for a number of years, although now is finally responding to the significant investment that the company has made. Market share gains have been made as a result of better marketing and progress made with its loyalty offering.
EGP’s VIP (or high roller) business performed particularly well in the half, with turnover almost doubling last year’s figure. The lower-margin VIP business is typically quite volatile, so we would caution against extrapolating this current trend. However, it may have been a beneficiary of the clampdown of corruption in Macau, resulting in regional market share gains. Crown’s (CWN) result will reveal whether this has been more of a company-specific or industry-wide trend.
In the medium term, EGP should continue to do quite well as the turnaround in its casinos appears to have further room for improvement. Over a longer time frame, however, the threat of competition looms in the Sydney (via Crown’s Barangaroo development) and Brisbane markets (through the development of the Queen’s Wharf precinct). EGP is part of a consortium that is on the Queen’s Wharf shortlist of two, with CWN involved in the other bid. The Queensland government is expected to announce their preferred design in coming months, and this may be a short term catalyst for the stock.
REA Group (REA) again produced a solid result, with a 34% increase in EPS as well as dividends, despite lower listing volumes across the industry. The company is moving away from a subscription-based model with real estate agents to market-based pricing that more resembles the health of local conditions. This has the potential to see REA’s revenues eventually follow a more cyclical nature, depending on housing market activity. While it has a dominant position in its market, the need to continually innovate and listen to its customers is ongoing for REA in order to repel any potential competitor from emerging, as well as to appease its customer base. Recent developments include the acquisition of 1Form, an online rental application service; an automated utility connection service; and last year, an agent profile section to aid in brand awareness and promotion. For investors, the structural opportunity for REA to take revenue away from print media remains, however the stock continues to trade on a relatively full valuation.