Week Ending 13.02.2015
The small business survey in the US delivered a similar message on government policy to that we cited last week on the NAB business outlook, but had a number of important distinctions, indicative of the relatively robust US growth. Financial conditions and interest rates barely rate a mention, with only 2% citing this as a problem. Inflation comes in at 3%. The difference to Australian conditions, however, is stark, with steady improvement in sales momentum and an increasingly tight labour market.
NFIB Small Business Optimism Survey
The pattern leading to a US rate rise later this year remains in place. While retail sales data in January was weaker than expected, it appears that consumers are banking some of the savings from lower fuel prices and are being more discrete on what they want to buy. Notably, similar to Australia, households are more than happy to entertain themselves through higher spending in restaurants and the like (with this segment showing a double digit rise in sales) rather than overindulging in goods.
Any positives from European data is being undermined by the ongoing ramification of the government in Greece. The debate has turned to the increasing probability Greece will have to restructure its debt again. At present, debt/GDP in Greece is 170% and any refinancing this year looks unlikely. The realistic potential for the full repayment of debt (even after the maturity extension of three years ago) is low under virtually any scenario and some further face-saving compromise between Greece and her creditors will have to evolve. The summary view seems to be that Europe is in a better position to cope with a Greek exit than it was in 2011, if for no other reason than it has had plenty of time to plan. Greek debt represents some 3.5% of total Eurozone debt; not insignificant, albeit not substantial. The bigger issue will be if this outcome plays its way into Portugal, Spain or Italy. None of these countries face such a dire situation as Greece, yet austerity measures are seen to be causing hardship that does attract a large vote. With the ECB now a big buyer of Eurozone bonds, it may be able to dampen the outcome, but one should expect asset prices to take a hit if no acceptable outcome is reached.
In Australia, the major economic data point was the unemployment rate, which hit a 12-year high at 6.4%. This temperamental data set, however, is due for another recasting in March, with possible revisions emerging once again. Seasonal shifts in employment, regional sampling inconsistencies, realignment with population data and the move to online rather than physical interviewing, have somewhat undermined this important indicator of economic health.
Perhaps the most worrying trend is the fall in hours worked. Businesses may hold onto labour in anticipation of better times to come, but at some point there may be excess labour capacity in a business and jobs cuts become more broadly spread.
Australia: Employment and Hours WorkedEnlarge
With this release the dollar duly weakened in anticipation of another rate cut this year, an idea not dispelled by Governor Glen Stevens’ address to the House of Representatives Standing Committee on Economics.
Cochlear (COH) spruiked a solid increase in its half year profit, although in reality, earnings only returned to levels of two years ago. An uplift in gross margins and contained costs were the key drivers of improvement for the company, which was delivered on the back of high levels of unit upgrades as well as a higher proportion of growth in more profitable developed markets. COH has a high leverage to movements in the $A, given much of its costs are incurred domestically but earned in international markets. To smooth its earnings, it employs a currency hedging policy, and thus the impact of the depreciation of the $A was restricted for the half year.
For a company ascribed a high earnings multiple by the market (on a forward P/E of 30X), COH’s lack of unit growth is a concern. Since the company had a voluntary recall of one its products in September 2011, it has struggled on this measure, which highlights the risks of what is essentially a single product company. While it remains the market leader, COH has appeared to have lost share to its competitors over this time period. COH also finally rebased its dividend lower, a necessary step to bring its payout back in line with its stated 70% policy target.
Cochlear: Unit Sales
Commonwealth Bank’s (CBA) result was largely faultless, although growth is evidently beginning to slow like its peers. Credit growth is tracking at a mid-single digit level, while its net interest margin was flat. This reflected a reduction in funding costs for the six months, although this has been passed on through tighter pricing as a result of increased competition. Cost containment could be a point of difference in the sector in the current environment. CBA scored well here, achieving positive margin ‘jaws’ in the half, with income growing at a faster pace than expenses.
Falling bad debts, which have provided a big boost to the sector’s profitability over the last few years, edged even lower still in 1H15, with an impairment expense of just 14 basis points. Most credit metrics continue to move the in right direction and will be helped by the recent cut to interest rates by the RBA, although remain at risk should the domestic economy experience any further slowdown. For the time being, the most important number for investors will be the bank’s dividend, which increased by 8%; in line with profitability. We recognise the quality of CBA’s business with the strongest domestic retail franchise and highest return on equity, however we believe that is more than priced in though its significant premium to its peer group.
Suncorp’s (SUN) result revealed some emerging competition issues and the effect of a slowing domestic economy, affecting its core general insurance business (which accounted for just over 60% of earnings for the half). Gross written premium was flat for the six month period. Margins, however, remain strong despite claims of $250m related to the Brisbane hailstorm in November. Investment earnings were again assisted by a further fall in interest rates, lifting returns from its fixed income portfolio. Its insurance margin remained robust, up to almost 15%, and ahead of the company’s through the cycle target of 12%. A normalisation of this in future years will likely, at some point, become a headwind for the company.
Of its other divisions, the Suncorp bank reported a solid result despite a decision to take a more conservative lending approach, targeting mortgages below an 80% loan to value ratio (LVR). In the face of potentially lower top-line growth across its businesses, SUN’s simplification program will become even more important in maintaining its current momentum. SUN expects this to deliver a further $40m in benefits in FY16, bringing the cumulative (annualised) total to $265m.
We believe that the other key factor that will underpin SUN’s share price in the medium term will be the prospect of further special dividends. The yield on its ordinary dividend payments is over 5.5% and higher than the major banks. Its solid capital position has it well placed to pay out further special dividend payments at its full year result in August, and potentially in FY16 as well.
Ansell (ANN) lifted its profit by 34% for the half, although this was driven by a large acquisition made in November 2013. Organic growth, however, has remained elusive for ANN for a few years now. A rate of 2.6% for the six months was a slight improvement on last year, but remains at risk of weakening given the soft conditions in key markets, particularly Europe. Part of this is also attributable to the ongoing brand rationalisation that ANN is currently conducting. This may eventually be a longer term positive, lifting returns from its higher-returning segments, but will impede growth in the interim. A drop in raw material prices will provide ANN with a short-term benefit through lower costs, however the company is also approaching a currency headwind. If the strength in the US dollar continues through this year, ANN’s euro earnings (which account for approximately a quarter of overall sales) could also decline as its current hedges roll off.
Growth in mobiles was the standout of Telstra’s (TLS) result, although this was only enough to drive overall EBIT growth of just 2%. Lower interest costs led to a 7% increase in net profit, allowing a marginal increase in the company’s interim dividend to 15c. As we have highlighted before, TLS is paying out close to all of its underlying earnings, limiting the prospect of meaningful dividend increases in the absence of overall profit growth. The company is also activating a DRP in response to shareholder demand, although this is not expected to be dilutive to earnings as the company will buyback the equivalent shares on market.
Mobile services revenue was up 7.4%. The rise was through a combination of average revenue per user (ARPU) growth of 4% along with customer growth of 4%. TLS’s mobile business has been a star performer over recent years, although its ability to maintain the current momentum in this division will be dependent on further market share gains. This could prove difficult in the face of better execution by its competitors, particularly Vodafone, which has given TLS a free kick due to internal issues. For the time being, the market appears to be acting on a fairly rational basis, although TLS noted that its own churn rate has ticked up a little. We remain of the view that the rollout of the NBN will result in TLS losing market share in fixed broadband and threaten its margins as it loses the revenue from its legacy copper network.
As was widely expected, Rio Tinto (RIO) announced a US$2bn buyback with its results as well as raising its final dividend by 10%. With the majority of its shares listed on the London Stock Exchange, the ASX component of the buyback will be limited to $US500m. The ASX-listed buyback will be conducted off-market, with a $9.44 per share capital component and the balance a fully franked dividend, providing an attractive investment proposition for investors on a low marginal tax rate. While RIO had previously talked of a sustainable capital management program, whereby it would conduct buybacks over a number of years, it appears to have backed away from this commitment and this instead will be assessed on an annual basis.
Of RIO’s result itself, underlying earnings fell 9% to US$9.3bn. The result was commendable given the commodity price headwind that RIO faced over the year, as illustrated in the chart below. Lower prices subtracted US$4.1bn from earnings over the course of 2014, while the controllable components of earnings (being volumes, costs and exploration) added US$2.6bn.
Rio Tinto: Underlying Earnings 2013 vs 2014
This year is shaping up as no easier for RIO, with the iron ore price already down over 10% since the beginning of the year. The oversupply situation in the market is expected to deteriorate further before it gets better. By RIO’s own estimation, 100 million tonnes of new capacity will be added to the iron ore market in 2015, while growth in demand will be just 20 million tonnes. With this difficult outlook, we have recently removed the stock from our model portfolios.
CSL tarnished its solid track record on beating its guidance as it cut its FY15 forecast from 12% growth down to 10% (on a constant currency basis). With share price appreciation of 30% in the second half of 2014, any earnings miss was likely to be punished by the market and the stock was subsequently sold off. Lower margins than expected were the chief cause of concern, with CSL highlighting an increase in competitive behaviour over the period. CSL still was able to record double-digit volume growth for the six months, ahead of overall market growth. EPS growth continues to run ahead of profit growth thanks to CSL’s ongoing buyback program.
Like other companies with multi-national operations, currency movements are also having a large influence on profit figures. Of note was the 2% negative impact (on an annualised basis) that the recent appreciation of the Swiss franc will have if sustained. Of course, for Australian investors, the depreciation of the $A is more significant for the purposes of valuation as well as dividends. With CSL’s dividend up 9% in its reporting $US dollar currency, this translates to 26% higher in $A. We hold CSL in our model portfolios, although acknowledge that the stock’s valuation looks relatively full at present.
Transurban’s (TCL) portfolio again delivered strong performance in the first half, with growth driven by a mix of better traffic figures, higher tolls and contained costs (see chart below). Following its acquisition of Queensland Motorways (as part of a consortium) it now has a solid network of toll assets across Sydney, Melbourne and Brisbane. TCL also lifted its FY15 distribution guidance to 39.5c per security, which would represent a 13% increase on FY14.
Transurban: Network Performance
While TCL continues to perform well operationally, the key source of upgrades from the analyst community in recent months has been a reduction in interest rates, with yields across the curve at, or close to, all-time lows. Given the large levels of debt that infrastructure companies like TCL carry, the effect that this has on the sector is greater than most of the broader market. With the upside from further yield compression arguably reduced from here, so is the potential for TCL to continue its recent outperformance of the market. In terms of its debt, TCL has limited refinancing commitments remaining this year. Should the current low interest rate environment continue through FY16 and FY17, however, there is the potential for these savings to incrementally improve distributions to shareholders over this time.
Interest rates have a large influence over the performance of Computershare (CPU) as well, although in the opposite direction to most of the market. CPU earns an interest margin on the US$15bn it holds in client funds under management. While this entire balance is not exposed to interest rate movements (given they represent a fixed margin or have hedging in place), movements in short-term interest rates nonetheless can play a big part in CPU’s earnings on an ongoing basis. The chart below illustrates the key currency exposures, with the majority made up of US dollars, British pounds and Canadian dollars. Short-term rates remain low in each of these markets, although the Fed in the US is likely to start hiking its rates in the second half of this year, potentially providing a multi-year tailwind for CPU.
Computershare: Interest Rate Exposure by Currency
After growing successfully by acquisition in its core registry business over many years, CPU now acknowledge that “limited opportunities” remain in this space. In a relatively low-growth environment, acquisitions remain central to its strategy. It has, however, had mixed success branching out into new areas. After underperforming the market over the last six months, CPU now is starting to emerge in a number of value screens, although it appears too early to call a turnaround in its end markets.
Some might suggest that Australia’s best performing IT company is Domino’s Pizza (DMP), where management have arguably been one of the most successful in adapting digital media and the internet to what otherwise would be construed as an unexciting product. Net profit for the half year increased by 44%, off double digit sales store sales in Australia and good progress in its European and Japanese operations. Part of the product success has come from a moderately-priced pizza, but the same cannot be said of the share price, which now reflects a fine dining valuation of 47X FY15 earnings. The key and difficult question is therefore how long the company can sustain its high growth and pattern of raising guidance on future earnings. If there is any disappointment, the sell-off is likely to be severe.
Retail property REITs give a good indication of some of the sales trends for the listed retailers. The news was not good, with Shopping Centres Australasia (SCP) painting a picture of a worrying fall off in supermarket same-store sales. This data point does not bode well for Woolworths, which is a key tenant of SCP. In the previous week, Federation and Novion also reported soft supermarket momentum.
On a brighter note, BWP Trust (BWP), as the major holder of Bunnings sites, conversely gave a ‘steady as she goes’ outcome. This trust’s capacity and willingness to rework the sites to suit Bunnings’ business model is a picture of a symbiotic asset and operator relationship that is somewhat rare in the REIT landscape. There is a near uniform view that this trust is expensive, with the implied cap rate over 1% higher than its current 7.4%. The run up in most of the REITs is arguably the iconic expression of the interest rate trend with the combination of the distribution yield, the falling cost of debt for REITs and the support provided to property prices. While we do not see this giving way in the near term, we point out that when rates eventually do turn, the downside risk for the REITs sector is leveraged more than many investors would appreciate.
Next Week’s Reporting Schedule
Monday: Aurizon, Bendigo and Adelaide Bank
Tuesday: Asciano, Amcor, ANZ Bank, Coca-Cola Amatil, Challenger Group, Dick Smith, Fortescue Metals, Iluka Resources, Invocare, Monadelphous, Pacific Brands, Seek, Sonic Healthcare
Wednesday: Arrium, carsales.com, Dexus, Fletcher Building, IAG, Novion Property, Primary Health Care, Recall, Toll Holdings, The Reject Shop, Woodside Petroleum
Thursday: AMP, Crown, Federation Centres, Fairfax, iiNet, IOOF, Origin Energy, Platinum Asset Management, Super Retail Group, Tatts Group, Wesfarmers
Friday: DUET, Santos