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WEEKEND LADDER

A summary of the week’s results

07.11.2014

Week Ending 07.11.2014

Eco Blog

Australian retail sales edged up in September, with household goods leading the charge. The iPhone release and flow on effect from housing activity underpinned momentum in this segment. With little new on the horizon in terms of other high profile product launches and the lower rate of approvals for housing, this momentum is likely to fade into 2015, yet other sectors are also starting to show improved trends.  

The data below illustrates the volumes and assessed price movement in retail sectors. It contradicts supermarket claims of price deflation, due to their judgement of their own promotional activity, rather than shelf pricing. Clothing sales volumes are respectable, but prices are still falling, notwithstanding the retracement of the A$. As has been the case for some time, eating out is gaining share of pocket in both price and volume terms, reinforcing the view that the weaker goods retail pattern is at the expense of those preferring to spend on services. 

Australian Retail Sales

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Indications from the retail REIT sector also suggest a patchy, but relatively broad pickup in retail spending in the past weeks. Scentre, the previous Westfield centres, for example, reported September quarter comparable specialty sales up 3.6% against 2.7% in the June quarter, with segments such as jewellery and footwear leading the charge.

Given the unlikely source of melodrama surrounding the labour market statistics in recent times, there was both attention and scepticism on the release this week.  The summation appears to be that measured unemployment is 6.2% and that employment growth has been weak for some months. Private sector surveys give a slightly more upbeat tone, implying that this may be the low ebb in labour demand. But less frequently mentioned is the participation rate which is some 1.5% below the rate 2 years ago. The predominant influence on the participation rate is the decline in males presenting as looking for a job or in a job. If these potential workers reappear as the job market tightens, unemployment may well take longer to move in the right direction.

On a broader definition, and arguably more meaningful from an economic point of view, is the number of people employed relative to the total population over age 15. This steady decline implies a higher dependency ratio and supports the contention that household spending will remain restrained. 

Source: ABS
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Confirmation of the Republican majority in the US Senate caused US equities to rally with the assumption policies would more likely pass into legislation given the previous bottleneck. Backing the move in equity prices was a decent labour data release, supporting monthly employment growth of 200-250k, and the persistence in low fuel prices, an indirect boost to income, much needed at this point. The US$ saw support from all sources as pressure builds for Europe to join Japan in asset purchases. Market commentators have largely taken the view that the ECB is unlikely to do anything until early next year, though Draghi has clearly indicated the willingness of the ECB’s Governing Council to expand asset purchases.

European business surveys highlighted the fragile momentum in those economies. Business confidence fell to a 16 month low, weak orders saw final prices in deflation, with the only glimmer of light from a relatively resilient services sector.

First past the post are a few investment houses detailing their expectations for next year. In general, they paint a tone of below par growth, subdued inflation due to weak demand and therefore the incapacity of companies to raise prices. A gently humming US is subdued by a sluggish improvement in growth in Europe and matched by a declining momentum in China. Central bank policy will still rule the roost for another year.

The surprising outcomes for 2014 have been bond yields, which were unanimously expected to rise in anticipation of the end of US easing.  While most had therefore expected the US$ to trade up against other currencies, this factor has been less pronounced, yet the speed and extent of the move in the US$ has taken many by surprise.

What has become evident is that the regions dependent on global trade have not done as well as the self-generating engines, particularly the US and even the UK. In that context, the differential growth between New Zealand, where construction activity, consumption and immigration are likely to produce annual GDP growth of 3.7% this year, stand in contrast with the perceived weakness in Australian domestic demand, with exports making up nearly half of the growth in GDP.

Company Comments

The major banks’ reporting season concluded this week. While Westpac (WBC) delivered good revenue growth (in which it had underperformed its peers in recent periods), its expense growth ran ahead of this top line rate, limiting overall profit growth. With the lowest cost to income ratio amongst the majors, there appears to be less scope for WBC to generate profit growth through a positive movement in ‘jaws’. Its wealth management arm, BT, delivered 16% year on year growth, highlighting its value in a rising market environment. A 4bp reduction in bad and doubtful debts to just 12bp for the year now has impairment charges at close to all-time lows across the sector. WBC lifted its final dividend by 4.5% on last year, however total dividends were lower after it paid two special dividends in FY13.

Low bad debts were also a feature of Commonwealth Bank’s (CBA) quarterly update, helping driver another positive quarter and some minor earnings upgrades by the market. While more detailed disclosure on revenue and expense trends is not evident in its release, CBA did report a fall in its cost to income ratio. Generating the highest ROEs of the majors, CBA and WBC also remain the two most expensive banks, either when viewed on a P/E multiple or price to book ratio.

The growth outlook for the sector is tempered by several factors; low credit expansion, a potential normalisation of the bad and doubtful debt cycle and the risk of high capital requirements in the near future. We remain underweight the sector in our models, largely on valuation concerns, however recognise that in a continued low interest rate environment the stocks should retain solid support from investors who are looking to boost their income. The near term catalyst for the sector is the release of the final report from the Financial System Inquiry and subsequent response by the Government sometime in the next month.

UGL, now without its property services business DTZ, highlighted the risks in the engineering and construction sector when it warned of a $180m blowout in costs on its 50:50 joint venture contract to construct a power station for the Ichthys LNG project in the Northern Territory. Corporate governance issues were also raised, after its joint venture partner, CH2M HILL, had disclosed in August reservations over the successful completion of the project, something which UGL had failed to do until now. In the context of its FY14 EBIT of $84m for its engineering division, the single project impact is significant to say the least, particularly without earnings from DTZ to cushion the blow. UGL fell 21% in the two days following the announcement, however its current share price also includes the value of an upcoming capital return from the sale of DTZ. Despite relatively attractive valuations following share price declines over the last few years, we believe that contractors with a large exposure to the mining sector face difficult conditions in the medium term. We previously held Downer EDI (DOW) in our models, which has broader exposure beyond the mining sector, however the stock had failed to re-rate despite solid execution over the last two years.

Brambles (BXB) provided an update on its first quarter results, and also upgraded its full year guidance. With the increased guidance largely accounting for the acquisition of specialist containers business, Ferguson Group, the investor response was rather muted.

While BXB has diversified its earnings base through RPCs (reusable plastic containers) and containers (through Ferguson), pallets remain core to the overall success of the business. First quarter revenue growth was fairly consistent across the board (see table below), despite some weaker conditions 

Brambles Pallets: Q1 Sales Revenue

Source: Brambles
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BXB’s profitability over the next five years is expected to be boosted from its target of a 20% return on capital invested by 2019. As the chart below illustrates, the returns of recent acquisitions of IFCO, IBC and Ferguson are well below this rate, largely a function of the goodwill paid upon acquisition. If goodwill is excluded, however, it would appear that returns are much closer to this target, implying that organic growth in these divisions should translate into improving returns across these businesses.

Brambles: ROCI Across Operating Divisions

Source: Brambles
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CSR’s six month result showed an underlying 72% increase in profit, driven by a turnaround in its aluminium division, along with the tailwind of a healthy domestic housing market for its building products business. Quality exposure to Australian housing is difficult to find, and CSR is symptomatic of this, with the investment case for the company weighed down by its lower-quality aluminium and glass divisions. While aluminium recorded a positive result in this half, the longer-term profitability of its aluminium smelter near Newcastle is clouded by an expected uplift in energy costs once its existing current supply contract expires in 2017. The Viridian glass division recorded a break-even result, which was a substantial improvement on losses reported last year.

Woolworths (WOW) reported its first quarter sales for FY15.  The key was the weak comparable sales trend of 2.1% in supermarkets, though there was barely a business segment where sales momentum met expectations. 

A debate has ensued on the cause and cure for the malaise in Woolworths supermarkets, with many ominously noting the impact discounters have had on the UK food retail sector. Parallels between the two can be a little stretched, but the overarching message is that consumers are significantly more sensitive to price than retailers would like to believe. Woolworths has let shelf prices creep up, mostly in products it considered low profile, while restraining promotional activity. In a Coles presentation day this week, this group suggested it will strive to sustain its better trend in comparable sales through pressure on grocery prices, which are intended to attract consumers in store to participate in fresh food sales.

While WOW did not change its profit guidance of mid-single digit growth for this fiscal year, profit margins may well prove to be tighter than originally expected. WOW remains a very resilient company in a two-horse sector. However, the competitive environment has evolved and the valuation rating that applied when WOW determined the direction of supermarket retailing has been undermined by this loss of leadership.

Sector Focus: Oil and Energy Stocks

Last week we touched on recent changes in the oil market, which has experienced a turbulent few months. This week we have revisited this issue (given some may have missed it due to Cup week), and tied this back to the ramifications for listed stocks.

There are a number of reasons for the decline seen in the oil price, not least a weakening in demand. Since mid-year, the International Energy Agency (IEA) has made a number of downward revisions to its 2014 forecast of global oil demand, with the third and fourth quarter run-rate lowered by 0.5 mb/d (million barrels per day). With a number of economies experiencing a deterioration in economic conditions over this time, these downward revisions are not overly surprising. Weaker demand has been forecast for Europe and China, in particular, along with some weakness in Japan. For 2014, the IEA is now forecasting global oil demand of 92.6 mb/d, which would represent a 0.9 mb/d increase on 2013 levels.

Compounding this weakness in demand has been robust growth on the supply side. Through its shale revolution, the US has been adding to global supplies at a rate of approximately 1 mb/d each year. This supply growth, however, is essentially an expected outcome. What has perhaps surprised is the recovery in supply from Libya. Despite an ongoing fragile environment, Libyan supply has strengthened in recent months, with recent production levels showing that the country has recovered almost half of the 1.2 mb/d of production lost following unrest through 2013. Despite several sources of geopolitical tensions around the world, including in Iraq and the Ukraine, little supply disruption has so far eventuated from these regions.

In recent weeks the attention has turned to the response by OPEC to recent price declines. OPEC has historically acted to support periods of weak pricing by cutting its own production levels. Recent commentary, however, from various OPEC members has been less than encouraging. Within OPEC, Saudi Arabia is the largest producer, accounting for a third of OPEC production, and has often acted as the swing producer in periods of price weakness. While Saudi Arabia did cut its production in August, its willingness to extend this further has been questioned over the last few weeks, and it appears that it wishes other OPEC members to share the load when it comes to production cuts. One theory suggested is that it may use this opportunity to attempt to pressure some marginal US shale production which may be struggling to make a profit under current prices, as well as slowing the rate of production growth. This view was reinforced this week when Saudi Arabia cut its export prices to the US.

These recent developments set the stage for an important OPEC meeting later this month, whereby the possibility of production cuts remains unclear. At this stage, there is no clear consensus among OPEC members on how to handle the current situation.

A further reason for oil price weakness has been the strength of the $US. The $US has rallied with a more hawkish outlook from the Fed over the last few months, the end of QE3, ongoing positive data points and relative economic strength compared to other developed economies. The majority of commodities are priced in $US, hence strength in this currency often corresponds with weakness in commodity prices.

While this short term downturn in pricing may persist for some time yet, there still remains a number of reasons to remain optimistic on the longer term outlook for the oil price. The demand growth trajectory has reduced a little over the last few months, however still remains supportive of longer term expansion, driven by emerging economies, particularly China. Oil fields continue to be depleted around the world, and thus need to be replaced by new supply, which requires high prices in order to be economic. The capex holiday currently implemented by many of the international oil companies will likely lead to lower supply growth in the medium term. A lower oil price will only intensify the current predicament that these companies are in, reducing cash flows and their ability to enhance shareholder returns via higher dividends.

Finally, it is often argued that many OPEC countries require a high oil price (generally estimated at $90/barrel or higher in some cases) in order to balance their budgets, many of which expanded materially following the revolutions in Arab countries in 2011 and 2012. This may be true over the long term, however there would also be a number of countries that could withstand lower prices for longer. Another important consideration (as discussed above) is that the strength of the $US could mean that OPEC countries could now withstand a lower oil price than previously expected if their own currencies have depreciated.

Combining all these factors, the chart below illustrates the movement in Brent oil futures over the last six months. As the chart shows, the weakness is expected to be relatively short term in nature, with the forward curve now moving into contango (i.e. higher prices are expected in the future). Earlier this year, there was already the expectation that prices would move lower over time. What is also notable is the fact that, despite lower prices expected over the next three years, the futures price is implying higher pricing beyond this date than what was expected earlier this year.

Brent Oil - Forward Curves

Source: Bloomberg, Escala Partners
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Tying this back to the Australian equities market, the natural question is: what effect should this have had on valuations in the energy sector? Not all of the major ASX energy companies provide earnings sensitivities to movements in commodity prices and currency markets, but we will use Santos (STO) as an example (NB: there will obviously be differences in sensitivities across various companies based on the margins of their respective assets, location, debt levels etc.). STO indicated at the beginning of the year that a US$1/barrel movement in the oil price would impact its net profit by around 2.5%. The company also indicated that a 1c movement in the $A/$US would impact its net profit by a similar amount.

From the chart on the previous page, we can estimate that oil prices are now expected to be, on average, around $10/barrel lower than what was previously thought earlier this year. This alone, if assumed into perpetuity, should indicate that STO shares are now worth around 25% less than before. Mitigating this is higher prices beyond 2017, and so the 16% fall in STO’s peak price this year to current would appear to be appropriate. Offsetting this, however, has been the fall in the $A, which has depreciated nearly 10% this financial year, improving the returns for domestic investors. Since their recent peaks, Oil Search (OSH) has declined 12%, while Woodside Petroleum (WPL) is down 8%.

As a result, we can conclude that recent oil price movements are largely reflected in the change in the prices of energy stocks. However the fall in the $A may indicate that the selloff has been overdone. The exception to this conclusion may be WPL, which has performed relatively well compared to its peers. Predicting the short term movements in commodity markets is fraught with danger, but we remain confident of the longer term fundamental position of the sector, along with the good progress that is being made on the various LNG projects to which the stocks are exposed. The table below summarises the earnings forecasts and P/Es of the major stocks in the sector. Our preferred stocks remain OSH, STO and ORG.

Earnings Growth and Valuation of Major ASX 200 Energy Stocks

Source: Bloomberg, Escala Partners. Data as at 31 October 2014.
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