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WEEKEND LADDER

A summary of the week’s results

12.09.2014

Week Ending 12.09.2014

Eco Blog

With the iron ore prices drifting away, the coming months will be important to see if this is seasonal or secular. China’s August iron ore imports were reasonably strong, up 8.5% compared to last year at 75m tons. Based on published stockpiles, it would appear most of the volume is being absorbed into the steel industry. The concern is that China is becoming increasingly reliant on steel exports, into what is broadly considered to be a sector with substantial overcapacity. September data on iron ore imports is therefore considered pivotal, coming ahead of the October holidays and the onset of northern winter Chinese mine closures.

The recent China Iron Ore Summit held by the local industry gave a subdued outlook for iron ore, pointing to the now inevitable rise in supply from Australia and Brazil and the large cut in Chinese production that would be required if this volume growth is to find a home. Within China itself, mines are working hard to reduce costs; it will be some time before potential supply is better balanced. While this all appears bearish for iron ore prices, there is little debate that BHP and RIO are best positioned out of all major producers due to their lower costs. The impact on our terms of trade and national income, however, may still present as downside risk to economic growth.

China’s trade balance itself, while high in dollar terms, shows that falling imports are now making a bigger contribution than rising exports. This likely reflects the natural maturing cycle from a high growth export-oriented economy, but for the moment places upward stress on the currency and lifts the required contribution from domestic demand.

China Trade Balance

Source: Barclays Bank
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Other data from China reinforced the ongoing slowdown in activity. The Producer Price Index fell by 1.2% in August and the CPI registered a below expectations 2% rise. Financial commentators are suggesting the Chinese government should proactively now stimulate demand, yet the authorities appear to believe there is sufficient credit growth and are reluctant to contend with higher debt as a path to economic transition.

While wages form the majority of the CPI in developed countries, commodities are much more important in inflation of emerging economies.

Virtually all commodity prices are lower this year, and certainly the key energy and agricultural sectors have fallen, as can be seen from the year to date commodity index moves:

Energy Index Returns: Year to Date

Source: Deutsche Bank
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Agriculture Index Returns: Year to Date

Source: Deutsche Bank
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Low commodity prices are generally correlated with weak economic growth. The present soft trends however are a likely to reflect seasonal elements in agriculture, but for other commodities a nuanced picture of production increases (e.g. US oil and globally traded iron ore and coal), reduced demand due to changing consumption and commodity-specific issues such as for nickel at present. The usefulness of commodities in signalling economic trends therefore may well be over.

After an uneventful period from China, it may well be that the economic growth once again becomes a talking point. In the meantime, however, the Chinese stock market is in the news due to the commencement of trading through the newly established Shanghai-HK Share Connect, which will allow for equities in Shanghai and Hong Kong to be traded without the previous restrictions. To date, the lack of a large scale institutional sector participating in the Shanghai exchange has clouded the oversight and resulted in a pattern of sentiment swings rather than fundamental valuation. This relaxation of restrictions is part of the progressive shift towards a market based and global financial sector evident in recent times.

The British Pound took fright at the potential ‘yes’ vote for Scottish independence. With ‘no’s clearly ahead until recently, the uncertainty given recent polling has many trying to determine the consequences of separation. It goes without saying that the GBP and UK investment markets are likely to experience a sharp sell-off should devolution prevail.

Fortunately the rest of the year appears to be light on for elections. Sweden goes to the polls this weekend and may well see a set of unrelated bedfellows in a coalition. New Zealand is also due, with the current PM, John Keys, highly popular, but his party not necessarily without some risks. Brazil’s first round elections are due on 5 October and highly relevant for that country, but unlikely to have global repercussions. The mid-term US elections on 4 November are possibly the most important post the Scottish ballot. The shifting balance of power in the US has been unhelpful to the economic revival of recent years.

Australian labour force data was met with incredulity given the extraordinary apparent lift in part time employment. As presented, there was 121k new jobs in August, as much as the total for the previous 12 months, of which 107k was part time. The measured unemployment rate therefore fell to 6.1%, back to its level of earlier this year.

The consensus opinion of economists is to put aside these actual numbers and rather look at other indicators that suggest the rate of unemployment is probably levelling out, but that wages growth is weak. What it did highlight was that any data set can be subject to distortion due to changes in method and sampling. For this one, the ABS uses the guidelines of the International Conference of Labour Statisticians. The sample covers 26,000 dwellings or 0.32% of the population over the age of 15. Households are in the survey for 8 months and then rotated. At times this causes sampling issues as different demographic cohorts move in and out of the sample. The definition of employment is any form of paid work for at least 1 hour a week and also unpaid work on farms or family business. Full time employment is based on 35 hours or more in a week. Part time employed, that is below the 35 hour threshold, work at an average rate of 16 hours a week.

Frustratingly, US labour data has also had a weakish tone recently. Jobless claims were a touch higher than expected at 315k for last week. The rate of improvement in employment appears to be levelling off. Whether this is temporary, a result of diminishing capacity to find the right skills as has been reported in a number of surveys, or whether this is a sign of sluggish underlying growth, will play out over the coming months and be critically important for the interest rate cycle.

Company Comments

Brambles (BXB) this week acquired Ferguson Group, a provider of container solutions to the offshore oil and gas industry, for US$545m. Given that it will extend BXB’s coverage into a new sector, it would appear that the transaction will deliver few synergies to BXB’s existing business. However, BXB’s expertise and knowledge in running other pooling solutions will no doubt help it deliver the promising organic growth outlook and margins that the company expects in the medium term.

Ferguson has recorded double-digit top line growth over the last four years, however this rate has slowed a little in recent times. The key criticism that BXB will face is that it dilutes its exposure to the high returns that the company makes on its CHEP pallet pool. In FY14, the company achieved a return on invested capital of 21% in its pallets segment, 8% in reusable plastic crates, and 9% in containers, bringing the company average to 16%. With a target of achieving a ROIC in excess of 20% by FY19, such acquisitions will make the task of achieving this aim difficult. Nonetheless, the fact that the deal will be entirely funded by existing low-cost debt facilities will mean a low hurdle rate for it to be accretive to earnings per share in FY15.

WorleyParsons (WOR) also announced an acquisition this week, purchasing MTG, a US-based hydrocarbons management consulting company. With few details provided on the transaction, it is unlikely that the deal will be material to WOR’s earnings. WOR has had a successful track record in growing via acquisition, particularly prior to the financial crisis when global spending on hydrocarbons projects took a hit. While the company did a commendable job in integrating these various acquisitions, at the same time WOR was assisted by strong growth in capital expenditure by its key customers, fuelled by a rising oil price, as illustrated in the following chart:

Energy - Exploration and Production Upstream Capex Investment

Source: WorleyParsons
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After an initial bounce back in spend in 2010-11, growth has since tapered, and expectations for the next couple of years remain low. This is despite more recent strength in the oil price, with the majority of the oil majors instead focusing on improving their returns to shareholders. While we can appreciate the quality of WOR as a company, we are more concerned about this current outlook, although the stock is starting to look more attractive following the decline in its share price over the last couple of months.

Funds flow is a key determinant for a number of companies in the diversified financial sector. Retail funds under management data for the June quarter has shown a weakening trend in flows. Net inflows had picked up materially around mid-last year, providing an additional tailwind to the industry leveraged to rising investment markets, particularly in equities. The growth in flows is now close to those seen in the middle of a cycle, rather the bull market conditions of the last few years, and overall FUM growth across the industry will thus be driven more by market movements.

The news comes after the Federal Government last week dealt a blow to the wealth management industry when it decided to delay the previously agreed increases in the superannuation guarantee rate. Under the previous legislation, employer super contributions were to rise from 9.5% to 12% by 2019. The 12% rate will now not be achieved until 2025, which will reduce the FUM growth that industry would have been expecting over this time. We have preferred to gain leverage to market activity via Macquarie Group (MQG), where there is exposure to other sectors such as industry infrastructure management as well.

Myer’s (MYR) final year results suffered from the combination of flat sales, a fall in gross income and a problematic rise in the cost structure. Comparable store sales edged up in Q4, but not enough to shift total sales over FY13. Given the capital spending and efforts in the online channel, this stands as a poor outcome. The gross margin fell back 57bp resulting in a 1.4% fall in gross income. The company suggests that the lower A$ and competitive market had reduced its ability to hold product gross margin. Given the growth in own brand, at a high gross margin, and the proportionate fall in low margin audio visual sales, the cost of moving inventory in a slow sales growth environment is telling. Cost of doing business rose by 3.3% due to wage costs and investment in online. The group’s cost of doing business ratio to sales has been rising steadily since FY11 from 28.8% to 32.9% this past year. With costs to rise another 3% again in FY15, the profit outlook is problematic.

Net profit fell by 22% and the final dividend was cut to take the full year payout to 14.5c/share compared to 18c/share in FY13. MYR often finds its way into stock screens looking for high yields. This now presents as a cautionary tale that without confidence in the profit outcome, the yield support can quickly fall apart.

Stock Focus: iiNet (IIN)

iiNet is Australia's second largest digital subscriber line (DSL) broadband provider. The company's primary market is in retail, where it also offers fixed line and mobile services, wireless broadband and IPTV. iiNet has a smaller presence in the government and corporate markets.

The broadband market in Australia continues to grow, and doesn't appear to have reached maturity. Estimates put broadband penetration of households at 65-70%, with many predicting a saturation point of around 80%, ensuring further overall market growth in the medium term.

The construction of the National Broadband Network (NBN) is to change the competitive broadband landscape over the next decade, as customers are forced to transfer their legacy copper-network based DSL connections to a new NBN connection. The NBN is expected to see some reduction in overall industry returns, as it will give more opportunity for competition to enter the market. The more level playing field will see smaller telcos well placed to increase their market share, particularly in regional areas that are dominated by Telstra. As consumers have their copper fixed line switched off, this will trigger a review decision of their telco provider and plan. While the strength of Telstra's brand will ensure that it remains the dominant telco company, other factors will become increasingly important for consumers with their decisions, including pricing, customer service and the unique content that can be delivered by their telco provider.

We believe that iiNet is well placed to capture its fair share of this overall market growth. The company's plans are priced attractively compared with the other major broadband providers; it is a well known brand name in the market and it has amongst the best customer service in the industry, which has ensured much lower churn rates compared to its peers. Early evidence of market share from new NBN connections support this thesis, with the company capturing 20-25% to date, well above its approximate 15% DSL market share. Overall, iiNet has shown an increasingly promising trend in organic growth over the past five reporting periods. With the NBN, iiNet also has less to lose from a margin perspective (and could potentially increase its margins) compared to the majority of its peers, with about a third of its subscriber base currently using Telstra's infrastructure - this will provide it with more incentive to shift its customer base onto the NBN. iiNet also has an IPTV service - 'Fetch' - although this does not appear to be a key selling point given its low subscriber base at present.

Historically, iiNet's growth has been driven by the various acquisitions, particularly over the last five years, however further opportunities here are limited given the more concentrated nature of the current market. Over this time this has included Netspace, AAPT, Internode, and more recently, Adam Internet and the realisation of operating synergies from the various acquisitions has helped the company lift its margins. With the more recent acquired brands yet to be fully integrated, further benefits should be realised in coming years, supporting the forecast earnings growth. A smaller part of iiNet’s operations is corporate accounts and mobiles, where it utilises Optus' network. Given the relative size of these divisions, both represent an upside opportunity for the company.

Outlook

With the NBN opportunity to play out over several years, we believe that the medium to longer term outlook for iiNet is robust, particularly compared to the incumbent operator, Telstra. The company is forecast to achieve double-digit earnings growth over the next three years, and looks to be reasonably priced on a forward multiple of 16X. We have recently added the stock to our model portfolios.

Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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