Week Ending 09.01.2015
As is often the case, the bond market summarises the evolution of the Australian economy over the past two months. Bond yields have fallen to all-time lows as the commodity cycle continues to deteriorate, consumer traction fails to grip and inflation looks likely to be low for some time.
A thin set of data releases gave few indicators on near term direction. Trade data for November was better than expected and the numbers for the prior few months were revised sharply up. Despite this, a deficit was recorded for most of the year due to falling iron ore prices and the import of capital equipment for LNG projects. The ABS appears to be struggling to adjust data for the variable value and volumes in commodities. In coming months, LNG exports will start to exponentially accelerate from here on and should result in a much smaller deficit over the course of 2015. The question then arises whether export LNG prices hold on to their current levels.
Building approvals followed the pattern of the past few months with apartment approvals sharply up, housing flat and non residential still falling away. This uncomfortable pattern where low interest rates is fuelling housing investment and little else will continue to challenge the RBA this year. Many economists, while on aggregate betting on a rate cut, take the view that the fall in the oil price and the A$ (in effect a rate cut) may see the RBA sidelined for the foreseeable future.
At a headline level, retail sales for November were in line with expectations. Within that however, there were some interesting changes. After a strong period, spending in restaurants and cafes has pulled back, indicating this renewed lack of confidence emerging from households surveys. Turnover in food sales remains higher than one would expect given the low inflation, suggesting retailers have been slow at passing through lower prices. In discretionary goods, the iPhone impact lingers in the data along with decent growth in homewares. However, the previous uplift in clothing sales faltered, possibly as consumers held back spending in anticipation of the year-end sales. Indications are that after a soft period, consumers have been willing to spend in the seasonal sales period. What remains to be seen is whether this is the beginning of a better period of retail spending, the effect of lower fuel prices or simply the readjustment of sales as consumers narrow their spending window to the discount periods.
European data shows little signs of life. On one hand, German employment remains rock solid at a globally comparative unemployment rate of 5.0%. However, business activity is weak, as is clear from the composite PMI chart below. Germany and Spain are positive but easing, while Italy and France are making no contribution to growth within the Eurozone.
Inflation is low everywhere and edging into negative territory in Europe due to the impact of oil prices. Ex-fuel, goods prices are flat while services prices have been moving up at a stable 1.2% p.a. for some time. Once the oil price cycles through the data, inflation is likely to be back to a small positive figure, but the call for action by the ECB from the financial market has gone up a notch. Cynics may suggest that self-interest from investment participants is the primary motivation as it is not clear that a rise in the ECB’s balance sheet will have any direct repercussion for the economic issues facing Europe. The secondary effect of a weak Euro is perhaps the more important consequence as it is likely to stimulate exports and raise import prices.Enlarge
Economic releases from China in the coming two weeks are likely to get close attention. The rate of credit growth will be a key data point, supported by direct efforts from the central bank. However, weak trade data may be a precursor to a soft Q4 GDP figure as it would reflect the likely easing in industrial production and investment. In contrast to recent years, this year there has been no early indication from the government that it intends to undertake a major stimulus and will rather persist with its reform programme in the interests of longer term outcomes.
In the meantime, some may have noted reports on the performance of Chinese equities. As with most things associated with this country, it is not that simple.
Chinese stocks are represented in a number of listed markets under an alphabet soup of designations. The establishment of the Shanghai-Hong Kong Stock Connect in November 2014 has eased some of the restrictions between A share and H shares.Enlarge
The A share market, with participation mostly from locals, has a reputation for a high level of trading and volatility. While this is likely to change as the Stock Connect programme matures, historically individuals, who own 26% of the shares, account for some 78% of trading activity. Another large component is held by ‘insiders’, that is, executives and directors of the companies. Little attention is paid to fundamental valuation criteria. Global investors, with limited access to date, have been cautious on their participation and generally stayed with the H shares.
Of the CSI300 (the Shanghai and Shenzen stock index of the largest 300 companies), 43% is represented by financials, which reinforces the caution that investors should apply to using ETFs in these markets as the sector and stock concentration tends to be high. Many global funds prefer to access China through Hong Kong’s Hang Seng index. Companies with their geographic base in China make up 54% of this index, global companies 23% and Hong Kong-resident companies the remaining 23%. Based on consensus data (Bloomberg) the forward P/E for the MSCI Asia Pac ex Japan is 12.3X. The highest valuations are in India and Philippines while Hong Kong and Korea screen with the lowest weighted average P/E’s. The Shanghai Index sits almost exactly in line with the regional average.
The Renminbi (RMB) cross rate with the US$ has been remarkably stable in light of the vigorous moves elsewhere. With the currency increasingly being used in trade, some believe it is only a matter of time before the RMB is considered a reserve currency and will form part of global central bank holdings. As that comes about, monetary policy in China will become part and parcel of global financial markets.
Reports this week suggested that Rio Tinto (RIO) is on the verge of announcing a share buyback when it reports its 2014 results next month. As we highlighted late last year, chances of any significant increases in capital returns were coming under pressure due to the continued decline in commodity prices. Accounting for the bulk of its earnings, the iron ore price is particularly significant for RIO and thus the 47% drop in 2014 changed the assumptions on the timing and extent of capital management. This more recent speculation has come from a more stable iron ore price environment since mid-November and a declining $A (which is expected to remain low).
Despite this higher reliance on iron ore compared to its other large diversified peer, BHP Billiton (BHP), RIO looks to be the more likely to commence a share buyback in the near term. There are several reasons that support this view. Firstly, relative to its level of profitability, its capital expenditure commitments over the next few years are lower than that of BHP. Secondly, the company has already achieved its net debt target of “mid-teens” and its gearing is at the low end of its 20-30% target range. As a result of the resetting of its dividend throughout the financial crisis, RIO’s current payout ratio is also lower, providing it with more flexibility. Finally, despite the aforementioned drop in commodity prices, a key message from RIO management at their investor seminar held in late November was to “materially increase returns to shareholders”.
Based on current consensus forecasts, RIO should have generated approximately US$2.0-2.5bn in free cash flow after dividends in 2014. In the absence of a recovery in commodity prices in 2015, this figure could well be lower in 2015. A modest increase in the company’s gearing levels may be required to help fund the proposed buyback. A buyback of any size should be well received by investors who in recent years have called for a greater level of capital discipline by the diversified miners. Providing further share price support in the short term (and also possibly influencing RIO’s decision to accelerate its capital management plans) will also be Glencore’s interest in acquiring the company. RIO rejected an initial approach from its rival in July of last year, however Glencore cannot make another approach until April.
Perhaps lost through the holiday season was the news that Skilled Group (SKE) had received a takeover approach from Programmed Maintenance Services (PRG). Both companies provide contract labour services to primarily blue-collar employment industries and the share prices of both had been under some pressure in recent times as a result of the subdued domestic labour market and lack of any meaningful wage growth. Comparatively, SKE had been impacted to a greater degree due to its larger exposure to the offshore oil and gas and mining industries (see chart below).
With a share price decline of over 50% between September to just prior to the announcement of the takeover approach, it is hard to disagree with SKE’s assessment that the bid is timed rather opportunistically. Adding to this proposition is the fact that SKE is in a period of management transition, with a new CEO starting the role this week. Nonetheless, the synergies on offer look to be substantial and thus resulted in the rare occurrence of an increase in the share prices of both the bidding company and the target. Although SKE is yet to formally respond to the proposal, the company’s stock is currently trading at a slight premium to the valuation, suggesting some level of investor confidence in a transaction taking place. Further consolidation in the mining services sector is a distinct possibility over the next couple of years as companies adjust to a weaker revenue outlook and pressure on margins, although picking potential investment targets is an exercise fraught with danger.
Skilled Group and Programmed Maintenance Services: Revenue by Sector
Stock Focus: AMP
AMP is the largest listed wealth management company in Australia. The company is vertically integrated through its funds management, financial advice and funds administration platforms. While the company generates the bulk of its earnings from its wealth management division, it also has a retail bank and an insurance arm giving it a higher level of diversification compared to the listed pure fund managers.
The key structural driver underpinning the long term growth in AMP is the expansion of the Australian superannuation industry. The ideal of self-funding of retirement for Australia’s aging population has long been a goal of successive Australian federal governments over the last two decades. System growth is thus mandated by the regulatory framework that sees compulsory superannuation contributions of 9.5% of employees’ salaries. Recent changes to this will see this rate rise again early next decade until reaching a 12.0% rate by 2025. Investment market growth is the other key variable on a year-to-year basis. Short term fluctuations can obviously be quite material, however the longer term trend of rising equity markets (the primary asset class) is a further positive. With this background, the key for those in the fund management industry is capturing their share of this FUM growth. Pleasingly, recent FUM flows for AMP have been positive.
In Australia’s wealth management industry, AMP is a large-scale and low-cost operator, giving it an advantage compared with its smaller competitors. The company’s brand name is particularly strong which was enhanced through the downturn as it avoided any specific events that caused reputational damage to many of its peers. AMP was further transformed by its acquisition of AXA in 2011. It has been successful in delivering substantial synergies which gave it a more vertically integrated business covering the entire financial services’ value chain through AXA’s retail platforms.
AMP is currently 18 months into a business efficiency program with a target of $200m in recurring run-rate savings by the end of 2016. The majority of these savings are expected to be delivered in 2015 and 2016, helping to underpin the group’s earnings growth over this time. AMP is targeting savings from the rationalisation of product duplication and construction, automation of operational areas and improving efficiency in back office operations.
The company’s investment management business, AMP Capital, has the largest scope to record growth outside of the domestic market (in particular through Asia), which is one of the core planks of its strategy. Over the past couple of years, FUM growth and investment performance have both been strong. AMP recently strengthened its Asian commitment through a 20% investment in China Life Pension Company.
AMP’s wealth protection division provides a range of individual and group term, disability and income protection insurance production. The division has been a disappointing performer for the company in recent years. The business has been impacted by a number of cyclical and structural issues which have resulted in a poor claims experience and lapse outcome for the group. Importantly, AMP have looked to address these issues and the division reported a much improved result in the first half of 2014. While AMP’s assumptions in this unit have been rebased lower, the stabilisation of these problem areas provide a greater level of confidence in the outlook for the overall group in the medium term.
AMP has sound underlying long term structural growth drivers and is a relatively defensive investment option among funds management stocks due to the size and diversity of its operations. While regulatory change remains an ongoing risk for the company, AMP has to date successfully managed the changing domestic landscape, including the transition of some clients onto its lower-margin MySuper offering. On a forward earnings multiple of 15X and a yield of 5.1%, the company’s valuation is undemanding. We have recently added the stock to our model portfolios.