Week Ending 12.08.2016
A week of messy and largely directionless economic data gave little sense of any change in pattern.
US productivity is struggling, with real output per hour declining for the third quarter in a row. This is a tough measure to assess, as the concept of output in a services-dominated economy puts undue emphasis on indirect data, rather than the observed physical output of the manufacturing sector. On the other hand, while some will quibble that higher unit costs are good news, the trend in compensation per hour implies that wage growth will edge up, supporting the contention that inflation has to rise into 2017.
However, the direction points to a soft outlook for the US economy, dependent on the consumer rather than the business sector. There is good evidence that the household sector remains in good shape to maintain its contribution. Mortgage applications are up 7% year on year, with an effective interest rate on a five year loan of just 3%. Adjustable rates are at 2.9% and the overwhelming majority elect the fixed rate.
The National Federation of Independent Business survey gives another lens on business attitudes. The data is from a sample of the 24m small businesses in the US, reporting an average of 10 employees and revenue of $500,000 per annum. They claim to create 80% of the jobs in the US.
In its July report, small businesses are troubled by the lack of pricing power and therefore real sales levels. The overall economic outlook is challenging, though somewhat more benign than before. On the other hand, employment intentions and a tight skills market again point to the labour market as a key issue in the economy.
National Federation of Indpendent Business Survey
Locally, the NAB surveys around 230 real estate organisations on a quarterly basis, gathering views on commercial property. Sentiment is falling, though different sectors may surprise the casual observer. Retail is considered the most promising, notwithstanding falling retail sales momentum based on ABS data. Similarly there is a particularly negative view coming through on CBD hotel capital values in contrast to the robust tourism data and business travel.
Funding is reported as becoming tighter, a message that has also come through from the banks as they seek to limit risks in exposure to any sector. The average required pre-commitment reported by developers is up to 57% from a low of 48% and is expected to rise over the coming year.
Housing finance approval growth has also moderated to +1.2% in June and is now tracking at +6.7% for the year. Notably, approvals in NSW and Victoria have slowed substantially following many reports on oversupply in the apartment sector.
Both commercial and residential construction activity is showing clear signs that it could turn into a growth headwind into 2017. That then raises the question of what part of the economy can take up the baton.
European economic data continues to muddle along. Manufacturing indicators are mixed, with Italy and Spain making progress, Germany tracking sideways and France still slumbering. Nonetheless, equity markets have rebounded, pushing aside any concerns on Brexit. The corporate sector is supported by imbedded monetary policy and the improvement in the household sector.
It does though reinforce the low correlation between equity market performance and economic growth. This is at its most stark in the emerging world. The chart shows that there is, in essence, no correlation for these countries.
Real GDP Growth and Stock Returns 1970-2015Enlarge
Fixed Income Update
The listed debt market continues to trade tighter, led by tightening across the ‘Over The Counter’ (OTC) wholesale market for senior debt. The iTraxx Index (measuring credit spreads of 5 year senior debt) has contracted from a peak of 140 at the end of June to 104 today (therefore leading to higher bond prices). The chart below illustrates this trend over the last two months.
Australian iTraxx Index
On the listed market, the short dated ANZPA securities have been one of the strongest performers, with demand increasing as investors seek to guarantee an allocation into the new deal when they mature in December 2016. As previously discussed, ANZ issued an inaugural USD tier 1 deal into offshore markets earlier this year. With this additional $1bn of funding already obtained, the expectation is that ANZ will not roll over the full $1.9bn ANZPA maturity value. It may well be only the holders of the maturing bond that gain much access to a new deal given the likely limited supply.
With other Australian banks potentially also looking offshore, the success of the most recent deals by CBA, Westpac and NAB, and the search for yield from investors, the whole bank hybrid market is very likely to continue to trade tighter.
Some caution has been noted by a couple of fixed income fund managers regarding the record low global yields that we are witnessing. Bill Gross from Janus Capital (which also has ownership in Kapstream in Australia) stated last week that he didn’t see value in sovereign bond yields and that they are too risky given the capital loss should yields rise. Joining the discussion, Vimal Gorr from BT also publically questioned the role of central banks in controlling asset prices and questioned whether the resulting low global yields were actually causing more harm than good.
While it is clear that participants are worried about record low bond yields, any significant increase in yields in the short end of the curve should be capped. Central banks, including Australia, have an easing bias, and the ECB, Japan and now the UK are all undertaking further accommodative measures.
In response to the fallout from the Brexit vote, the UK commenced their £70 billion program this week. This new measure includes the purchase of corporate bonds. The result has been a rally in UK gilts (UK Government bonds) and yields on the 10 year benchmark bond fell to an all-time low of 0.56% this week. These bonds were trading at 2% at the beginning of the year.
US 10 Year Gilt Yields
The search for yield continues to benefit emerging markets (EM) with more than $16bn flowing into mutual and exchange traded funds invested in EM debt since June. Taking advantage of this, Mexico sold nearly $3bn of debt at record low rates, rolling over a deal that is due to mature next year. The deal was priced at a 145bp to US 10 year treasurys. Ten year Mexican bonds were trading at a 256bp premium to US treasurys in January this year.
High yield managers have also been receiving significant inflows, causing downward pressure on yields. The average US high yield corporate bond dipped to 6.58% this week, its lowest level in more than a year.
carsales.com’s (CAR) result was solid, meeting consensus expectations for 10% earnings growth for the year. The result was fairly consistent across the board, with the exception of its acquired vehicle finance arm, which was weaker in the fourth quarter as a result of a temporary volume capacity reduction at a major lender. Revenue from private listings was the highlight, with advertising volumes up by more than 10% in the second half and were accompanied by a shorter time to sell. Inventories also lifted for the year, reversing the trend of the previous two years. Listings for new vehicles from dealers expanded as well, despite some recent reduction from some manufacturers.
carsales.com: Domestic Revenue by Division
CAR also has several international investments in more developing countries, including Brazil, Chile, Mexico, Korea, Indonesia, Malaysia and Thailand. While much smaller in nature than the now relatively mature Australian business, as a group they reported revenue growth of in excess of 50% for the year. This is expected to be key in generating ongoing double digit earnings growth in the medium to longer term and to help justify what is now a relatively full valuation (a forward P/E of 26X) after strong share price growth this year.
Other growth-orientated stocks that reported followed a similar share price pattern through the week, initially sold off before subsequently quickly recovering. Cochlear (COH) fitted this description, with the stock losing 7% following its result before eventually closing the week 8% higher. More so than usual, the premium that investors is applying to above-average earnings growth has continued to expand.
For FY16, COH’s result was solid, with the company hitting the top end of its guidance range. Two factors have emerged in recent reporting periods that have improved the outlook for the company. The first is more consistency with unit sales growth (+12% in FY16), a measure in which the company has struggled to achieve following a product recall several years ago. New product releases have led to market share gains for COH. The second is an increasing proportion of revenue derived from upgrades and accessories, with the opportunity for growth in this division expanding with a broader installed base.
The year was also characterised by a large benefit from a weaker AUD. COH has a greater leverage than most other ASX-listed international stocks given his high domestic cost base and a high proportion of overseas revenues. COH employs hedging to smooth its earnings profile, hence if the AUD settles at a lower level then this will flow through to the bottom line over a number of years. While COH’s outlook is quite promising (the company is guiding towards a 10-20% increase in earnings for FY17), the principal hurdle for investment consideration is its lofty P/E multiple of 35X; high even for the relatively expensive health care sector.
REA Group (REA) and Fairfax Media (FXJ) both missed expectations, with a similar theme emerging from both companies. While REA has international investments and FXJ is still dealing with its declining print media assets, at the core of the valuation for both companies is their respective domestic online real estate classifieds businesses. Both companies noted that new listings volumes had fallen in July and blamed the uncertain environment brought about by the lengthy federal election campaign. Domain reported that volumes had declined by 25% in Sydney and 11% in Melbourne, highlighting that while there may be a sound long-term structural growth proposition to its business, the cyclicality of the property market cannot be discounted in influencing short term returns. The key investment thesis for FXJ remains the ongoing emergence of Domain within its earnings base, its market share gains and thus the stock’s relative discount to REA. A demerger by FXJ may be one option to realise this value.
Transurban’s (TCL) result was in line with forecasts, with EBITDA growth of 15% for the 12 months. The result was achieved through ongoing solid growth in traffic across its three key networks (Sydney, Melbourne and Brisbane), boosted further by increases in toll levels. Margins were slightly lower after a higher contribution from lower margin networks, notably its recently acquired Brisbane assets. TCL still has an attractive pipeline of future development opportunities which the company estimates its share at approximately $9bn. The largest of these is the Western Distributor project in Melbourne, with financial close expected by late next year.
The greatest risks to most infrastructure or utility stocks like TCL is a normalisation in interest rates, given the high levels of debt that these companies typically carry. TCL has insulated itself to a certain degree from potential interest rate rises in the future by extending the tenor of its debt, with the weighted average maturity across its debt funding now nearly nine years. This has had the effect of trading in a higher benefit from lower short term rates for a more stable long term profile.
TCL’s ability to increase its distributions is likely to be critical to help the stock justify its elevated valuation. The company is guiding towards a further 11% growth in FY17, although recent history would suggest that this initial guidance may prove to be conservative. While TCL is typically viewed as a core high-yielding stock, this status has been diminished somewhat over the last few years through strong share price appreciation. The following chart illustrates the yield contraction over this time, relative to the broader market.
Transurban and S&P/ASX 200 Forward Yield
Of large-cap industrial stocks, Telstra (TLS) rarely surprises with its results and this proved to be case again in FY16, with earnings growth of just 1%. This outcome is a function of its entrenched status as the country’s dominant telecommunications company and trends which typically remain in place for several years. The most recent driver of the company’s improved profitability over several years was the gains that it had made in the mobile market, as it took market share through missteps from its rival telcos (particularly Vodafone) and through a more competitive approach to the pricing of its plans. Competition in the mobiles market, however, has been increasing, reflected in pricing pressure (TLS’s average revenue per user fell by 2% for the year). The ability to monetise the sharp rise in mobile data (TLS notes that mobile traffic data has grown nine-fold over the last five years) has proven to be a difficult task in this environment, with the telcos trying various strategies to attract new customers in a mature market, including increased data allowances, lower prices or unique content (e.g. Optus with its recent rights deal for the English Premier League).
The argument for TLS that it can charge a premium for its superior mobile network has also been dealt several blows this year, with a succession of network outages in recent months. Management have effectively acknowledged this issue by stepping up proposed capital expenditure spend over the next three years to 18% of sales, the highest level since it finished its 3G network in 2009. This will likely result in a lower free cash flow profile in coming years, limiting investment options for the company to help plug the looming earnings hole as its copper network is switched off.
Telstra: Capex to Sales Ratio
TLS also announced a share buyback of $1.5bn, returning the capital to shareholders from the recent sale of its 48% stake in Autohome (a Chinese online car sales business). With TLS’s weak forward earnings profile that is currently being supported by NBN transition payments, we continue to believe that the prospects for the smaller telcos of TPG Telecom (TPM) and Vocus (VOC) remain more attractive over the medium to longer term.
Commonwealth Bank’s (CBA) result confirmed the sluggish environment for the banking sector, with cash earnings growth of 3% for the year and flat on an earnings per share basis. After reporting dividend growth every year since the peak of the financial crisis, CBA’s dividend was flat for the year. Home and business lending growth for the year were both in the mid-single digit range; a similar pace to broader system growth.
With the top line slowing in the second half, the result was achieved through solid cost control, allowing the bank to record positive ‘jaws’ (i.e. the difference between revenue and expense growth) for another year. Net interest margins were slightly down, with increasing competition for home loans offsetting the mortgage repricing that occurred across the sector in the second half of 2015.
As expected, the key drag on earnings was rising bad debts, which have primarily been attributable to a few large single-name exposures across the resources and dairy industries. With no further large bad debts arising in the fourth quarter, CBA’s impairment charge fell in the period, although the risk remains of further normalisation with bad debt charges still quite low.
The strategies of the major banks are converging somewhat (following NAB’s demerger of Clydesdale and ANZ pulling back from Asia) and so is the return on equity (ROE) across the four. With CBA’s ROE premium to its peers typically cited as the key reason for its higher relative valuation, any further erosion in this ROE premium would likely lead to relative underperformance of the stock. While CBA’s capital generation has been superior to the other banks (helping it to at least maintain its dividend), it is still exposed to the same sector-wide drivers of earnings and higher bad debts and capital requirements are more than likely in coming years.
The high yield that each of the banks trade on is the most attractive factor from an investment point of view. However, with dividends perhaps less secure than other sectors, we believe that an underweight position remains appropriate for equity portfolios.
AGL Energy (AGL) met the upper end of its guidance with its result, although some weaker commentary on its short term outlook and a lack of any capital management may have disappointed investors. AGL’s balance sheet is now in a good position, however the company is keeping its options open with regard to potential acquisitions, with a bid for Western Australia gas network owner Alinta Energy thought to be a key target. If AGL were successful with a bid for Alinta, this would be expected to account for much of its capacity to take on additional debt.
AGL is progressing well with its targeted operating costs savings, having achieved $122m to date and ahead of its schedule. Further progress is expected to result in an additional $50m in savings in FY17, helping to underpin earnings in the next 12 months.
The key driver, however, of AGL’s expected earnings growth in the medium term is higher wholesale electricity pricing, which will gradually flow through to the bottom line as existing hedges in place roll off. Higher electricity prices would appear to have sustainability as well. The primary factors that have led to this have been higher electricity demand and lower gas availability for the domestic market as various LNG export projects in Queensland ramp up, as well as a degree of rationalisation across the market over the last few years with some withdrawal of capacity.
Wholesale Electricity Market Forward Curve
AGL expressed some caution over its outlook for FY17, noting that the start to the year had been challenging given the unseasonably mild weather in July and the previously cited lower gas margin that it expects to achieve. Nonetheless, the company looks to be well placed to deliver respectable growth over the next few years and with the stock trading on an earnings multiple similar to the market, it would appear to be fairly valued.
Reporting season is busier again next week, with the following companies releasing results:
Monday: Ansell, Aurizon, GPT, National Australia Bank, Newcrest, Orara
Tuesday: BHP Billiton, Challenger Financial, Invocare, Mirvac, Shopping Centres Australasia
Wednesday: CSL, Crown, Dexus, Fletcher Building, Primary Health Care, QBE Insurance, Stockland, Sonic Healthcare, Vicinity Centres
Thursday: AMP, ASX, Brambles, Investa Office Fund, Spark Infrastructure, Sydney Airport, Tatts Group, Treasury Wine Estates, Webject
Friday: Automotive Holdings, Amaysim, Cover-More, Duet, IAG, Lend Lease, Medibank, Mantra