Week Ending 12.02.2016
Economic news and data releases were smothered by the moves in bank debt markets. We elaborate on those in our fixed income section.
The economic pain is centred on weak industrial production, pretty much in every region. The causes are put to the fall in energy and resource investment, lower global trade and China, the source of much investment spending in recent years.
Many will point out that traditional sectors of economies, such as manufacturing, are a relatively small component of GDP, but that misses the bigger point that the economic multiplier from asset production is much greater than that of services.
The judgement on whether a sharp fall in industrial activity is an indicator of troubled growth ahead is offset by the stable spending currently exhibited by consumers. Indeed, there are many that believe consumption spending will progressively pick up due to the ‘oil bonus’, growth in employment and early indicators of a possible rise in US wages.
GDP tends to be a backward looking and often-revised measure. Nonetheless, it does provide the basis of what underpins an economy. The best board indicator of the mix of sectors that contribute is the value add. Inevitably, many of these industries are interdependent. The US contributions are shown below and suggest the focus on energy is overdone.
From the most recent GDP data, Australian real gross value add is shown below.
Herein lies much of the quandary on the current direction. Without an easy-to-measure anchor, such as housing investment or production of goods, the assessment of economic health lies in a mix of services which are harder to measure, which have large interdependencies and are, in part, reliant on government spending. Certainly, few believe such a mix can achieve the rate of expansion most financial analysts would like to see.
We have now introduced unsettled credit and banking markets, which underpin the two sources of capital, without which, investment spending may well be further dampened.
The most obvious escape route appears to be a set of fiscal packages that address many of the world’s requirements, such as transport assets, water resources or pollution controls.
A range of commentary from central banks reinforce the need for a new direction. Further monetary easing, as evident from the negative rates in Europe and Japan, appear to be largely impotent and financial markets now see such moves indicative of concern rather than stimulating growth.
Fixed Income Update
Who said bonds are boring? While one might think that the recent sell off in global equities is all about the slowdown in China, falling oil prices and the US yield curve, the chink in the chain is the corporate bond market. This week the focus has been on the banks.
While there has been many reasons for the banking sector to become stressed, the most recent jitters relate to the risk that Deutsche Bank (DB) would not have adequate reserves to pay coupons on its outstanding AT1 (hybrid) securities. It comes down to a ‘trigger’ that is incorporated into the terms and conditions of these securities, which states that they must have sufficient available distributable items (ADI’s) at the end of 2015 to pay coupons due before April 30, totalling around €340m. In the event that coupons cannot be paid, the deferred interest is non-cumulative.
This has caused a fierce sell off in DB bonds and equities, with the lower ranked AT1 securities (also called hybrids and coco’s) trading down to 70c (where redemption is $1). Following a DB announcement on Wednesday that the bank would be able to pay its coupons, together with speculation that the ECB will expand its QE asset purchases to include subordinated debt, the AT1 bonds recovered to 75c. However, pricing still remains weak and other similar securities have been taken for the ride (particularly peripheral European banks).
Considering the blowout in the European AT1 market, Australian bank hybrids are holding up reasonably well. Any weakness here is possibly more a function of a falling equity market and lack of liquidity than contagion from European peers. The structures and terms and conditions in Australia are different to European securities, our banks are better capitalised (e.g. comparable CET1 of CBA at 14.3% vs DB 11.1%) and profits in the majors remain strong.
Australian banks have reduced their reliance on offshore wholesale funding, instead bolstering their deposit base and issuance of listed subordinated debt and bank hybrids. While the risk of deferral of coupon interest is a risk for our domestic securities, we think this is a minor one given the reputational risk and reliance on this funding source. Our hybrids also have a dividend stopper, which the European banks don’t have, reducing the likelihood of coupon deferral.
The DB hybrids are just one casualty in what has been a difficult time for banks. There are a number of other reasons that have led to the issues in corporate bond markets and pressure on bank profitability, which has had contagion worldwide. These include:
- Central banks pushing interest rates into negative territory (ECB and BoJ), tightening net interest margins for banks. One quarter of the global government bond market is now in negative territory.
- Despite US Treasury’s offering positive yields, the flattening of the US yield curve has impacted on the profitability of the banks. With the Fed lifting interest rates, market expectations are that this tightening will intensify deflationary pressures and has caused a narrowing of the gap between short and long term bond yields (long term bond yields anticipate the market’s forecast for growth and inflation). This reduces bank profitability, as banks make their money from borrowing money in the short term, while lending out at higher long term rates. The difference between the US 2 and 10 year treasury yield has slipped to about 100bp, the narrowest in 8 years.Enlarge
- In December last year, foreign investors suffered losses when senior bonds in Portugal’s Novo Banco were ‘bailed-in’ under new regulations that prioritised losses of senior bond holders over capital injections of public money.
- Increased capital requirements by the regulators has reduced bank balance sheet capabilities. A fall in trading activity has put additional liquidity pressures on the bond market. This has led to a ‘liquidity premium’ being priced into corporate spreads of bonds.
- With spread widening in corporate debt, this further increases the cost of funding for banks and other issuers. Spreads on 5 year senior unsecured debt has moved from +80bp to +120bp, whereas spreads on subordinated debt is 100bp higher than a year ago.
- Falling commodity prices has put pressure on energy companies, with corporate defaults in this sector forecast to rise significantly. The market then looks to the banks to see what exposures they have both through loan assets and derivatives contracts.
The sell-off in risk assets worldwide this year highlights the importance of including an allocation of longer dated fixed rate (duration) government bonds within portfolios as these are often negatively correlated to equities and credit. Prices on these securities have risen across the curve, cushioning the falls from the equities and credit. The chart below shows the price rise of the 5 year Australian Government Bond in 2016.
Australian 5 Year Government Bonds
Commonwealth Bank’s (CBA) result was given the tick of approval by investors, more likely due to the fact that there were no negative surprises hidden in the numbers. Profit growth for the half was 4%, with a more modest 1% increase in EPS due to the bank’s larger capital base following its equity raising. This has also had an effect on CBA’s return on equity, which fell from 18.6% to 17.2%. With some market concerns over the bank’s dividend and its sustainability in the current environment, CBA elected to keep it steady for the half. Notably, this was the first reporting period post-GFC where CBA’s dividend has not increased. Net interest margins were also flat, with rising funding costs offset by the round of mortgage repricing undertaken by the sector last year.
Asset quality is the other key area of concern for the banks at present, with the issue at the forefront of investors globally given the high probability of future losses stemming from energy and emerging markets. Domestically, the credit cycle remains favourable for the banks and CBA’s loan impairment expense for the half remained low at 17bp. The composition of this was interesting, however, as consumer impairments fell, while corporates rose off a low base. The latter category will face further scrutiny in coming quarters and has the potential to disrupt expected dividends from one or more of the banks.
CBA has historically traded at a premium to its peers given what is perceived to be a safer loan exposure, dominated by the Australian housing market. With lower levels of business lending compared to the other majors (the area most at risk of rising in coming periods), this premium has expanded further over the last few months. While we recognise the quality of the franchise, our current model portfolio is more weighted towards ANZ and Westpac given the relative value.
Commonwealth Bank: P/E Premium to Peers
Suncorp’s (SUN) banking result was relatively strong compared with CBA’s, although the bulk of the company’s profitability is generated by its insurance arm. Earnings for SUN dropped 16% in the first half, which was driven by a 29% decline in profit from general insurance.
The problems arising in general insurance were flagged to the market in mid-December and, as such, were of no real surprise. Coming soon after the appointment of a new CEO, it would be reasonable to expect that the downgrade was in part a rebase of expectations. SUN did provide additional detail on the cause of the issues which cut its insurance margin from 14.8% to 10.1%, unravelling much of the progress that it had achieved in improving this in recent years.
The primary reasons cited were increasing costs associated with home (a sharp rise in average claims costs) and motor insurance. Natural hazard costs again were in excess of SUN’s allowance (a recurring feature of its results), while its investment income was also a drag on profitability.
Claims in home insurance were impacted by high building costs from a skills shortage in builders, while SUN blamed a weaker $A in driving up the costs of car parts. Evidence that SUN is able to remedy these issues (probably through a more appropriate pricing structure) may be required to restore investor confidence in the stock. In the interim, SUN’s dividend should continue to provide good support and there remains the expectation of an additional special dividend in August this year given a strong balance sheet.
carsales.com (CAR) again produced a relatively solid result, with earnings growth of 10%. CAR has navigated a tricky period in the last few years through emerging competition and some reluctance from car manufacturers to advertise new cars on its site.
Pleasingly, each of its domestic divisions – dealer, private, display, data and finance – all recorded growth through the half. The standout was the 15% revenue growth from private listings. CAR successfully continued to differentiate its listing fees into various segments as it lifted the price for premium ads while introducing a free option for cars under $3,000. A rebound in dealer new car listings also augers well for the year ahead.
The key criticisms of the result centred on the slower growth from its domestic core business (5% revenue growth and 8% EBITDA growth), along with the earnings arising from its various international investments. Domestic growth was driven by performance of a number of acquisitions that the group has made in recent years, which are lower margin in nature, including Stratton Finance and Tyresales.
As CAR’s domestic business matures, the company will be more reliant on acquisitions such as these and the growth in its international portfolio (which can be quite variable from year to year) to sustain a level of earnings growth commensurate with its P/E rating. While CAR’s days of very high earnings growth may now be past, we remain attracted to the still-respectable expansion in its domestic business coupled with the longer-term option of its international expansion.
Cochlear (COH) shares jumped after it lifted its full year guidance, although this was driven primarily by the weaker AUD. With local manufacturing and research and a global sales base, the stock is one of the more leveraged to fluctuations in the currency, and this proved true again in the December half. Aside from currency, COH benefited from the rollout of new product and unit growth was assisted by success in a large tender in China.
While COH is a global market leader in its product and its market opportunity is clearly significant (it estimates less than 5% of the world’s population with hearing loss have a hearing device), in the past it has struggled to maintain a consistent level of growth (see chart below). Moreover, its sales effectively dominated by a single product, which puts it at risk should any issues arise with this product (as was evident when it was forced into a recall in 2012). These two characteristics should result in a more modest valuation yet the stock currently trades on a forward P/E of ~30X, limiting its investment appeal.
Cochlear Implants (Units)
Transurban (TCL) lifted its distribution guidance for the year, although the share price rose only slightly. TCL’s operating result was in line with expectations, with strong traffic growth across its portfolio (particularly its Brisbane and Sydney networks), leading to group EBITDA growth of 15%.
TCL’s growth projects are key to the ongoing distribution growth. The company outlined its current pipeline out to FY22, including committed and possible projects. Most of these are existing enhancements or upgrades of its existing network, which are lower risk. On the other hand, this strong pipeline raises the possibility that TCL will again call on investors at some point for funding purposes, with its estimated capital contribution of $8.2bn over this time.
TCL’s defensive growth portfolio has been valued highly by investors, which has helped the stock to again outperform the market in the most recent bout of volatility. While it provides a good balance to sectors with a more uncertain earnings outlook, we recommend a reduced holding in portfolios with more value emerging in other parts of the market.
Transurban Project Pipeline
Rio Tinto (RIO) finally bowed to the inevitable this week when it scrapped its progressive dividend policy from 2016 forward. The sharp deterioration in commodity markets (the extent of which was clearly not anticipated by the miners themselves) had led to the policy becoming unsustainable and highlighted the inappropriateness for its application to a company operating in a cyclical industry. While RIO’s situation was not as dire as that of BHP, warnings by ratings agencies over potential credit rating cuts in recent weeks may have been the final trigger for change.
RIO’s new dividend policy is effectively a payout ratio, with a target of 40-60% of earnings paid out “through the cycle”. With 2016 a transition year, RIO has promised a dividend of at least US$1.10 for the year, in comparison to its total dividends of US$2.15 for 2015. The change in RIO’s dividend yield highlights the folly of investing in the company for yield. On a trailing basis, the stock’s yield is 7.4%. If the company were to introduce its payout ratio policy in 2016 (instead of guaranteeing a US$1.10 dividend minimum), based on consensus earnings estimates, its yield would be approximately 2.4%.
RIO’s result itself was in line with expectations, with underlying earnings dropping in excess of 50%. Lower prices reduced receipts by over 80% for the year (see chart below), with the main offsets more favourable exchange rates and cost reductions. Despite the fall in the iron ore price in 2015, the commodity again dominated RIO’s earnings mix, accounting for 87% of earnings. Even in the current environment, the group’s iron ore margins remain solid, with cash costs of under US$14/tonne in the December half.
Rio Tinto: Underlying Earnings 2014 vs 2015 ($USm)
Going forward, the cash preservation strategy is unchanged, with further cost out targeted and more cuts to capital expenditure. The former should result in pushing commodity cost curves lower (putting additional downward pressure on prices), while the latter will go some way to a slowing of industry supply growth and balanced markets at some point in the future. We retain a preference for BHP over RIO given a more balanced commodity mix and a lower reliance on iron ore.
Fund manager Henderson Group’s (HGG) result was hard to fault, with EPS growth of 17% and a 14% increase in dividends for the year. The key indicators for a funds management company – investment performance, net flows and performance fees – all moved in the right direction. Net flows for the 12 months were +£8.5bn, a 10% increase on HGG’s starting FUM base, although flows slowed in the second half of the year. The bulk of this was in higher margin retail funds, where management fees have been 2-3X that of institutional FUM. With nearly 80% of its funds outperforming in 2015, HGG was able to sustain a good level of performance fees. While all of this resulted in a strong top-line performance, earnings growth was limited by an inability to cap the growth in staff expenses.
All of the above is generally positive for HGG, however, the share price of the company has been weak of late following the decline in equity markets (particularly in Europe, which is a large part of its equity exposure). HGG is obviously leveraged to investment markets and the weakness in equities has in turn led to fund outflows across the region. As a result, while HGG is executing well on its strategy and the factors that it can control, the shorter outlook is difficult. Focusing on the longer term, we believe that there is value beginning to emerge in HGG, with the stock now trading on a forward P/E of 13X.
Henderson Group: Asset Mix
With many reports of higher spending on gadgets and the demise of Dick Smith, expectations had been set for JB Hi-Fi to deliver a decent result. Sales were up 7.7% for the half year, with comparable sales up 5.2%, though this includes conversions and online. The slow decline of software (music, movies and games) continued, with these categories representing only 16% of sales, down from 25% in 2012. The business now relies on product launches in fitness, telco, accessories and home appliance to drive the top line. Gross margins have remained in a tight range at just under 22% for some time, reflecting the competitive nature of the product range. Similarly, the cost of doing business is tightly controlled and therefore JBH’s earnings increase reflected the growth in gross income of 7.5%. In the coming 12 months, JBH should further benefit from the closure of Dick Smith stores.
JB Hi-Fi (JBH) has been recognised as one of the better managed domestically-oriented companies for many years. An estimated net cash position by this financial year end and steady hand on capital investment into new stores is another positive feature. Some may expect a dividend increase or special dividend, though a share buyback is more likely in our view.
Notwithstanding our positive take on this result, we have not included JBH in our models as we do believe the group is close to maturity in its potential growth, beholden to new product launches (such as fitness gadgets) which are out of its own control and the company is likely to experience consistent pressure on margins from online.
Reports from retail REITs, such as Shopping Centres Australasia (SCP), provided evidence that supermarket retailing is a divide between a poorly-performing Woolworths and the beneficiary, for the moment, Coles. These assets, however, are dependent on specialty stores, which contribute around 40% of the rent. A weak anchor is not a great outcome and SCA may find its speciality tenancy rotate more frequently than one would like. Retail property assets have held up remarkably well given the changing pattern of spending and widely varying fortunes of the retailers. Globally, there is a view most countries have excess retail space. While zoning and tighter control here appears to have prevented this outcome, there are pockets, such as discount department stores and appliance retail, where the appropriate square metres for these segments is likely to be considerably lower than today.