Week Ending 08.08.2014
As human nature dictates, any data that reinforces a view is naturally spot on, whereas if it does not, the data must be at fault. The unexpected rise in the Australian unemployment rate, jumping to 6.4% or a fall of 300 people in employment, caught all off guard. In the lead up to this release, the indicators suggested employment growth of some 10-20k in the month and stable unemployment of 6.0%. Hours worked have been rising, business surveys suggested improving labour market conditions and job ads were solid. What was the cause for the surprise? Blame the data – the ABS changed its sampling. The Bureau samples a number of groups in regions which it believes is a representative mix. At times it has acknowledged that this process can pick up outliers where a proportion of people in the sample have sufficiently different metrics to influence the overall number. This rotation, the ABS reports, accounted for about one third of the change in the number of unemployed. The other side of the case is that its previous sampling rotation appears to have overstated the strength in the labour market in the past months.
Economists are, on balance, of the view this will prove to be a temporary lull, and that employment will pick up through the year, or at least be measured as such. A divide however is emerging. The halo days for WA are over, though it still registers the lowest level of unemployment at 5.2%. NSW is proving rock solid with a 5.9% rate. Conversely, Victoria is now at the upper end near 7.0%, but perversely due mostly from a rise in the participation rate.
Employment by StateEnlarge
Nonetheless, it certainly puts paid to the notion the RBA will do anything but wait for real signs of some activity in domestic demand outside housing before interest rates move. The A$, in turn, responded by ending on a softer note.
Economic news elsewhere was light and did not have much of an influence on markets. The predominant external impact came from the intensifying political and real conflict in Eastern Europe. We will leave comment on the events there to others, but assess the potential investment market repercussions.
The German DAX index is down 10% since early July, in small part due to a mild softening of German economic momentum, but in large part to due to the impact Russia will have on the German economy and corporate sector. Already companies such as Adidas have noted a sharp reduction in inventory demand from that region, which could well get worse as the sanctions bite. In turn, German 10 yr bunds, with the flight to safety, are yielding their lowest since mid last year at just over 1%.
Emerging market debt has been a good investment year to date given the lack of yield worldwide, with an index return of 5.3%. For those that judged their regions well, the returns could well have been much higher as the index was dragged down by the relatively high weight of Russia at 8% (only Turkey at 9% and Mexico also 8% are as big in their representation in this index). Argentina, as we noted in previous weekend notes, is not big enough in bond market to have caused any meaningful impact.Enlarge
These flows in bond markets in particular can have an impact on currencies and any sell off from emerging markets tends to find its way to developed markets such as Australia, which would then drag the currency up with it. Compared to the dislocation in May last year, when the US first indicated its intention to cease easing, this time the impact had been contained to countries directly affected and Asia for example appears to have been a beneficiary of the selling of Eastern Europe bonds.
Staying with this topic, many would be unaware that high yield debt (below investment grade) has been a strong performer until recently. The risks with high yield lie clearly with the quality of the issuer – usually highly leveraged, often in risky sectors or industries, generally smaller companies with low diversity and likely to have an uncertain profit outlook. But with low interest rates and few defaults, income seeking investors have been buying into this segment of debt securities with some abandon.
Credit markets can act as the proverbial canary in the mine for financial markets and any sell off in credit is carefully analysed for its cause and extent. The chart below shows the flow into European high yield with the reversal in recent weeks causing the spread to rise sharply. The case was readily made that the problems emerging in the Portuguese banking sector were a reminder risks in credit have been too finely priced, and therefore the further impact of this sell down in high yield has abated.
European High Yield Investment FlowsEnlarge
We have elaborated on these possibly unfamiliar parts of the investment market, as this is where something unexpected can emerge and cause a large scale sell off. At this stage these are on watching brief, but there is, in our view, no evidence of any systematic issue.
The recent soft spot in equities more likely has an old fashioned reason. Valuations are toppy, and the earnings season both globally and here, while far from problematic, does not support any further extension of those valuations.
Downer EDI (DOW) announced a 6% increase in net profit for the year, in line with the company’s guidance. While the result was assisted by lower interest charges, in line with lower debt on its balance sheet, management did a commendable job in reducing operating costs in the face of some difficult end market conditions. DOW was successful in achieving an improvement in margins despite a 15% drop in revenue for the 12 month period. The company’s cash flow generation was also strong, through work in hand declined by 7% over the year.
DOW provided guidance for FY15, indicating that it expects full year profit to fall to around $205m, which would represent about a 5% decrease on this year’s figure, and not too different from analysts’ forecasts. Some investors were disappointed by its final dividend, however DOW also announced an on market share buyback program, taking advantage of the company’s undemanding valuation and solid balance sheet. As a result, while the company’s earnings may decline in FY15, earnings per share is unlikely to fall to the same extent (and may even rise) depending on the timing and size of shares bought back by the company.
DOW still screens as good value, on a forward P/E of 10X, which is at a discount to its peers and even more so compared to the broader market. While concerns over the company’s medium-term earnings profile have some foundation, given its exposure to the mining sector (and following the loss of a key coal mining contract in June), management have so far navigated this environment well. However, it is difficult to see what the catalyst will be for the company to re-rate. On a more positive note, DOW believes that the outlook for government related capital expenditure is more promising, and so this should offset some of the impact from other markets. The market’s reaction to its result typified this confusion in assessing its outlook – while the stock fell 4% on the day of its result, it subsequently recovered all of these losses over the next two days, rising 7%.
After experiencing large fluctuations in its share price in recent months, FlexiGroup (FXL) delivered on its guidance, with an 18% increase in underlying cash profit. While the stock had recovered well leading into its result, over the year it appeared to be impacted by its association with the retail sector, as a number of retailer downgrades filtered through the market. A slight dampener was impairment expenses that were related to legacy IT systems that are currently being upgraded.
The chart below shows the group’s performance across each of its divisions, with growth recorded in each, with the exception of its traditional core business, its rental arm. This outcome was largely expected, with the company reducing its dependence on this segment in recent years through a number of acquisitions in higher growth segments of the market.
FlexiGroup - Profit Growth by Division
On most key metrics, FXL is tracking well – impairment expenses were flat at 2.7% of the receivables base; the group’s receivables book recorded 13% growth; funding costs declined by 1.1%, reflecting improvements made in diversifying its funding base; and the company’s overall cost to income ratio fell further on an underlying basis.
Management’s refined focus on its end customers was evident in the growth in repeat business in its interest-free financing division, Certegy, and this is an important development in the company’s development of a more recurring revenue earnings base. The company is forecasting mid single-digit growth in FY15 before returning to a higher growth rate in FY16, and with an attractive valuation, the stock remains one of our preferred small-cap picks.
Cochlear (COH) was one of the more impressive sharemarket performers this week after improved profitability in the second half of the financial year allowed it to deliver at the low end of its guidance. With most analysts expecting the company to fall short of this outcome, and considerable short interest in the stock, the stock rallied on the day.
One of the key issues for COH at present is that it is losing market share, with sales growth falling short of its peers. This has been a problem since it announced a product recall nearly three years ago (see chart below), and has contributed to a decline in underlying earnings in each of the last three financial years. For FY14, unit sales fell 3%, although excluding the impact of the more variable China tender sales, unit sales rose slightly. COH has an improving product release cycle, which should assist sales growth for FY15, however the recent evidence has been that these have not been providing the positive boost to sales that it has enjoyed historically.
Cochlear - Cochlear Implant Unit Sales
Another criticism that the company has faced has been a high contribution to earnings from an extensive currency hedging book – this effectively means that it benefits from these when the Australian dollar is appreciating, however a falling dollar won’t be fully realised in its earnings should this outcome eventuate. With the stock still trading on a hefty forward multiple of 26X despite these issues, there looks to be better value elsewhere in the market.
Rio Tinto (RIO) beat expectations with a 21% increase in underlying earnings for the first half. They key was the realisation of its cost reduction target ahead of schedule – the company had been targeting US$3bn in operating cash cost savings by the end of this year. RIO reported that it had so far achieved US$3.2bn in ongoing savings, and has now increased its target by a further $US1bn by the end of next year. The result allowed the company to raise its half year dividend by 15%.
While the cost reductions were a feature, the other important controllable contribution to the company’s profitability, being volumes, added US$911m to underlying earnings. As a result, despite weaker commodity prices for the half, the group was able to achieve solid earnings growth. This volume growth impact, however, was almost exclusively limited to its high-quality iron ore portfolio, as the following chart demonstrates:
A feature of the change in strategy by the big diversified miners in the last couple of years has been the increased importance attached to delivering higher returns to shareholders through not only ongoing dividend payments, but where possible, capital returns through share buybacks. While the aforementioned cost savings had a positive impact on further strengthening RIO’s balance sheet, the company continues to reduce its capital expenditure program, with forecast capex for 2014 reduced to US$9bn, $2bn below previous guidance. The trade-off will obviously be lower volume growth in the future, but in keeping with lower return on investment given the new pricing environment.
Capital management was not expected at this result, however the company’s performance in the first half sees it well placed to potentially undertake a share buyback at its full year result. As we have mentioned recently, the diversified mining companies screen as good value at present compared to most other sectors of the market, and they should receive good investor support in the medium term through these increased returns to shareholders.
Orica (ORI) failed to excite investors given an unsurprising outcome from a strategic review of its chemical business, with plans to separate the division through either a demerger or sale. Presently, the division accounts for less than 10% of the company’s overall earnings base. Therefore, a separation would probably not have a material impact on the core ORI business, which would be left entirely exposed to the mining industry. While ORI has been a poor acquirer of companies in recent times (which led to an impairment charge in 2012), the demerged Dulux business has been one of the sharemarket’s better performers since it was separated four years ago, with its share price more than doubling in this time – this could be a positive omen for the chemical division if it were spun off.
Tabcorp’s (TAH) net underlying profit rose by 7%, with margin expansion enhancing its subdued top line growth. In a wagering market that is seeing consumers move their betting preferences to a more competitive online market, TAH has done a good job in retaining its share of overall wagering turnover. The company’s retail network will still provide it with a distinct advantage over the international players that have entered the online market in Australia.
FY14’s result received a slight boost due to the World Cup– given that this event crossed over the financial year, it will contribute to FY15 as well. This year appears to be a more difficult one for TAH, given that it will face increased race fees in Victoria and Queensland that came into effect on 1 July. TAH has a relatively defensive earnings base, however its earnings profile is low growth and the company still trades on a premium to the market, despite the ongoing risks to its various wagering licences.
Crown (CWN) had a difficult week, with disappointing gaming growth figures in the Macau gaming market for July following the revelation that the company had, in partnership with asset management firm Oaktree Capital, acquired a vacant site in Las Vegas. To date, CWN has spent US$280m on the site, however the full development costs would like run in to the billions. Investor concerns over the potential return from such an investment appear to be relatively well-founded, particularly given CWN’s poor pre-GFC acquisition history in Las Vegas, which subsequently led to significant writedowns. Prices were, of course, much higher then, so at the very least this current investment would look to have a higher margin of safety. We will expand further on trends in Macau (which is still the primary driver of CWN’s valuation and share price) next week following the release of CWN’s full year result.
The coming week has a raft of high profile companies reporting results. While too early to come to a fulsome conclusion we note three features to date:
· All management feel obliged to talk to capital management, be that the dividend prospects, buybacks or any plans which may enhance short term shareholder returns without taking operational risks.
· Cost cutting is highly in vogue and in line with the first point, most companies are keen to ‘prove’ their costs cutting credentials.
· Headline growth is weak and few companies want to discuss investment or spending plans.
It is quite likely that these will be the summary of the reporting period. Companies appear to be guiding, on average, to a modest increase in profit due to the issues above. Few are indicating any improvement in underlying demand and any emergence of better business conditions could provide a useful fillip on the upside.
Next week’s reporting schedule:
Monday: BEN, JBH
Tuesday: BKN, DMP, GPT, UGL, WTF
Wednesday: CBA, CPU, CRZ, CRZ, CSL, EGP, GFF, OZL, PRY, SKC, SKE, SUN
Thursday: CWN, DXS, ENV, FXJ, GMG, SGT, TLS