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WEEKEND LADDER

A summary of the week’s results

12.06.2015

Week Ending 12.06.2015

Eco Blog

After a week of grumbling on house prices and falling confidence, the labour market stepped up with a much better than expected May unemployment rate of 6% compared to consensus of 6.2%, with 42,000 new jobs in the month. The participation rate remains stable at 64.7%, but it is some way off its peak of 65.8%, implying that there are some within the potential workforce that have walked away from the job market altogether. While the cacophony of commentary on the unreliability of this data series inevitably arose, the persistence of, let’s say, adequate employment growth confounds those with a bearish outlook.

With most states showing solid results, it would appear that the combination of housing activity and the service sector has offset the fall in mining-related employment. Wage growth supports this contention, in that the job growth is skewed towards lower paid roles and has brought down the median wage rise that troubled the corporate sector for some time.

Both Korea and New Zealand cut their official rates by 25bp to 1.5% and 3.25% respectively. These are different economies, but with some notable parallels to Australia. New Zealand is also facing a shift in its terms of trade, albeit dairy prices are more volatile, yet less prone to long term overproduction compared to our commodity complex. Secondly, the house price rise in Auckland compared to other cities has been a matter of much debate. Pre-empting the move on interest rates, the RBNZ has co-opted the regulator. From 1 October, Auckland residential property investors will have to stump up a 30% deposit, while banks will be restricted in their lending to owner occupiers with deposits of less than 20%.

South Korea faces high household debt levels with a similar debt/disposable income ratio to Australia at circa 160%, as well as a rise in mortgages, even though house prices have been relatively flat. In this case, there are some country-specific nuances, such as households buying small business with mortgage debt and a rental system where the tenant borrows on behalf of the owner, while living rent free. Another feature is the very high level of interest-only loans and the Bank of Korea has provided incentives to increase the repayment of the principal component. The point is that housing genies are very hard to rebottle, yet central banks are at pains to restrain this sector as it limits their monetary policy options. 

Locally, this is translating into a clear direction from APRA in conjunction with the RBA to restrict investment housing credit growth.  How far they will go is going to have a meaningful impact on the mortgage market and banking sector. Presumably, when some success has been achieved on this front, further interest rate cuts may well be on the cards.

In that context, the comments by RBA governor Glenn Stevens that ‘households have the least scope to expand their balance sheets’ implies the burden of growth has to come from the corporate sector and fiscal policy. With budget discipline welded into the political language, it is hard to see a new beginning on government investment and the case can be made that without this as the starting base, corporations will remain resistant to higher investment levels themselves. A clear path to economic growth has yet to emerge.

China is coming to terms with its debts, with the problem areas largely in the local government and state owned enterprise sectors. In March, the Ministry of Finance undertook its first CNY1tr debt swap with local government, followed by a second tranche this week. This serves to reduce the interest rates for local governments as well bringing these debts well under control of the central authorities. The rapid fall in property activity as the main source of revenue for local regions has put pressure on their finances and the government is probably taking the best course of action to manage the outcome by reducing the cost of debt while not entirely turning off the debt tap at this time. 

Activity indicators in China remain weak. Industrial production is running at 6%, fixed asset investment continues to soften, while retail sales growth is steady at 10%. These figures would be good enough at face value, but overall suggests the aim of a 7% GDP growth rate this year may be hard to achieve.

China Indicators

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The US consumer showed welcome signs of life, with a solid May lifting the annual rate of retail sales growth to 2.7%. Auto is the predominant driver, but other sectors also did well enough, barring the inevitable result from department stores. As evidence that we are not alone, the persistent negative trends in sales (excluding licensed departments) is highlighted in the chart below. Conversely, apparel stores are maintaining a decent positive trend, indicating it’s the format which is the problem, not the product categories as such.

US Department Store Sales (ex Licensed Departments): Year-on-Year

Source: US Census and Barclays Research
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Over the past 10 years there has been a 92% correlation between retail sales and GDP growth, even though measured retail sales only comprise 25% of consumption spending. Household balance sheets have improved considerably and, as at the end of the first quarter, net worth was 639% of disposable income, the highest level since Q3 2007. In part, this is due to the low appetite for debt, as the US Financial accounts show. Conversely, the corporate sector has been less shy about leverage; hardly surprising given the low cost of borrowing.

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It is unfortunate that the Australian Bureau of Statistics does not go further in sampling the services sector. The US provides a range of data which clearly highlights the growth in services versus goods. The release is based on 5,000 service businesses which report their revenue to the Census Bureau. This would also be a good indicator of where employment growth is concentrated.

Source: Haver Analytics
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Company Comments

Nine Entertainment (NEC) delivered a blow to media companies when it downgraded its FY15 earnings guidance last Friday evening. The company cited a weaker than anticipated free to air advertising market in the second half of the financial year, particularly over the last two months. This was somewhat contradicted by an earnings update from Seven West Media (SWM), as it reaffirmed its own full year guidance. SWM’s market release pointed towards market share gains for the network, suggesting that Channel Nine’s programming has underperformed over this time.

While this case may simply be a rotation in market share between Nine and Seven, the fact remains that consumers are faced with an increasing number of ways to consume digital entertainment. This is highlighted by the recent successful launch of Netflix in Australia, along with other subscription video on demand services, including Stan (backed by NEC and Fairfax) and Presto (Seven Network and Foxtel). The high fixed cost nature of the television broadcasting industry will mean that small advertising share losses to other mediums will likely result in a larger impact on the earnings of these respective companies. While this structural thematic may take a while to play out, over the longer term it is reasonable to expect that further pressure will be felt by the free to air networks.

Following on from AGL Energy’s (AGL) investor briefing two weeks ago, Origin Energy (ORG) this week conducted its own investor day, with the focus on the energy markets side of its business. Compared with AGL, ORG will benefit in the medium term from a wholesale electricity market that is in oversupply, as it is the least vertically integrated of the major generators (see chart below). The strength of its gas position, however, is a key differentiator, with a large part of its contracted gas supply locked in at a low fixed price. It thus stands to benefit as Australian domestic gas prices move towards export parity prices as the various Queensland LNG projects come on line, allowing it to expand its margins over the next few years.

Electricity Generators: Level of Integration (TWh)

Source: Origin Energy
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Like AGL, ORG is now pushing its own solar installation product, with a goal of becoming the largest installer of rooftop solar panels. Purchase power agreements are expected to be a key part of this strategy and would appear to be the preferred sales outcome for energy retailers, as they influence the disruptive nature of the technology through the long-term contracts associated with these.

On the retail side, however, a weak demand environment and ongoing high competition levels have hurt the company’s profitability. To deal with this outcome, ORG is targeting cost savings and efficiency improvements achieved through several measures. Some of these include reducing bad debts, better communication with its customers (which reduces complaints and inquiries), increasing the proportion of customers using electronic billing and direct debit, and reducing the reliance on expensive external channels to grow its customer base.

Given the high level of competitor discounting in the market, these actions undertaken by ORG may simply be required to maintain its existing margins in this division, with consumers predominantly choosing a retail provider based on price. As we have previously highlighted, ORG remains our preferred stock in the sector due to the step up in cashlfows once APLNG is online in coming months, its superior gas portfolio and leverage to a recovery in oil prices. The option to demerge its LNG business from the core operations will also be a potential catalyst for the stock in future years.

Global managers and investors are inevitably interested on where the flow of investment funds are heading at any time to pick up on any developing trends. There are a number of providers of such data, tracking long only mutual funds and ETFs. While the data is backward looking, it does indicate how convinced the investment community is on where to place their money.

The table below shows the annual trends over the past 10 years based on the percentage of total assets.

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The data below shows the total assets in the sample and the change in assets based on flows for the last year and four weeks to 6 June.

Source: Deutsche Bank, EPFR
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As a broad statement, the long-anticipated shift out of bonds into equities has been muted at best. Instead, most fixed income assets have moved within the asset class. Unsurprisingly, US bond flows have been weak in anticipation of the first rate rise, with the barbell alternatives of high yield and European bond funds.

Within equities, the feature of the past year has been the move out of the US and into Europe and Japan. This is in response to the better valuations many managers found within those markets, as well as a higher opportunity for earnings growth compared to the US, where the recovery in corporate profits is already extended. Japan has gained even more attention in recent weeks, as some companies appear to be on the cusp of reforming their passive balance sheets.

Emerging markets have been mixed. Notably, Asian flows have been relatively weak, as most of the money within the hot Shanghai market has come from within China, or is funds moving within Asia, rather than new money. We are of the view this will change over the longer term as more companies list and more managers initiate funds in the region.

Conversely, Latin America has seen major outflows in equities, but inflows in bond funds. The broader logic is that the difficult conditions facing those economies and therefore the corporate sector will result in lower interest rates and therefore a profitable trade in bonds.

The ETF participation can also be distinguished in general terms. In developed market equities, ETFs persistently outperform mutual fund flows, whereas in the more volatile emerging markets, active funds have in the past year clawed share back from ETFs. The rationale for this is to us obvious; country, sector and stock selection is likely to result in a better outcome within emerging markets than index participation.  

Stock Focus: ALS Limited

ALS is an operator of a global network of laboratories, providing analytical and testing services to a range of industries and is the fifth largest testing, inspection and certification (TIC) company in the world. These include minerals (servicing the mining industry), life sciences (including environmental, food, pharmaceutical and biotechnology) and energy markets.

ALS’s life sciences division is its largest, and has been the source of a consistent level of earnings growth over the long term. Organic growth across these sectors is typically non-cyclical in nature and in excess of underlying GDP growth rates. Within the life sciences sub-sectors, ALS is the global market leader in environmental testing (water, soil and air), is a large player in the food sector and a smaller player in the pharmaceutical and biotechnology sector. The markets in which ALS operates are quite fragmented and the company has taken advantage of this industry structure through a series of bolt-on acquisitions.

The division is exposed to a number of favourable structural trends. Increased outsourcing of laboratory testing activities by its customers should continue given the cost savings it can achieve and the fact that typically it is a non-core activity. Increasing regulatory requirements is also a positive for ALS, ranging from environmental and sustainability concerns, to health, safety and quality control issues in the food and pharmaceutical industries. Rising globalisation of trade and the growing middle class in emerging economies also benefits ALS, with increased testing required with international trade and higher standards demanded and enforced as living standards improve.

ALS has faced earnings pressure in recent years as a result of its exposure to the mining industry. The company’s minerals division is largely dependent on exploration activity by its mining customer base and hence has a high correlation with commodity prices. While this provided a strong tailwind for the company during the years of the mining boom, the sector has been in a cyclical downturn over the last three years. Unsurprisingly therefore its revenue and margins have fallen over this time, but recent commentary from the company and its peers has been encouraging, suggesting cautious optimism in the market and more limited downside to the current depressed conditions. This falling demand trend has since stabilised and was evident in the company’s recent full year results, which showed consistent revenue levels over the last three halves.

A more immediate concern for ALS would be its energy division, which provides quality, assurance and laboratory testing services for coal, oil and gas clients. ALS increased its presence in the industry upon its acquisition of Reservoir Group nearly two years ago. Given that the fall in the oil price has been much more recent than that of other commodities, there is a risk that the market could experience similar conditions to that seen in its mineral division, although we believe that this scenario would be well anticipated by many analysts. While this may well be the case, we note that the division is a much smaller part of the company’s overall earnings, at around 10%.  

We view ALS as a quality company that has managed difficult conditions in one of its key divisions relatively well over the last few years. Management has a strong track record of execution of its growth strategy, successfully adding several bolt-on acquisitions to complement the defensive organic growth in its life sciences division.

ALS generates solid cashflows, is geographically diverse and has a high proportion of overseas earnings, which will aid the company should the $A depreciate further. With the risks of further earnings disappointment from its minerals division beginning to dissipate, we have recently added the stock to our model equity 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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