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WEEKEND LADDER

A summary of the week’s results

13.03.2015

Week Ending 13.03.2015

Eco Blog

Economic trends out of China continue to worry analysts. Given that the Chinese New Year can fall in either January or February, it is customary to look at the combined months to assess trends. Industrial production in the two months slipped to 6.8% year-on-year, the lowest rate in six years and points to a weak Q1 GDP growth rate – likely below the 7% annual target set by central authorities, indicating that a pickup in activity will be required through the year.

The range of complex debates facing China sequentially bubble through. A recent release of transcripts from Federal Reserve meetings highlight that issues raised in 2009 are still much the same as today. US concerns on the ability to ‘retool China’s economy from one dependent on exports and investment to one driven primarily by domestic consumption’ are even more relevant now than first expressed by the Fed five years ago. It also expresses admiration for the way China had dealt swiftly with the consequences of the 2009 downturn, while already highlighting the risks within the banking system. In their discussions with China’s central bank, back then it already expressed concern on the US’s quantitative easing and the Fed’s capacity to successfully withdraw liquidity when appropriate. Finally, Bernanke notes that while China’s data may require ‘disclaimers’ on accuracy, the strength in its economic achievement was credible.

The two charts below show the current momentum in retail sales and the breakdown by type. The spiking effect in Jan/Feb is typically associated with the New Year pattern and should be discounted.

On balance, however, the momentum in growth is troubling, while also showing signs of a greater degree of discrimination in spending. Recent interaction we have had with financial market representatives from China focused on the nature of household spending where around 300m people already consume much the same as developed economy households. 

Source: Barclays Research
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On a positive note, early indications are that the easing of monetary conditions in China was starting to have an impact, with an unexpectedly sharp rise in loan growth and a welcome fall in off balance sheet (or shadow banking) activity. There may well have been a shift from off to on balance sheet accounting for some of the rise in loans, but even that is to be welcomed with the greater supervision of credit across China.

The combination of January/February was also relevant in the Australian statistical releases. The all important employment data came in at a 6.3% unemployment rate, reversing January’s rise, though net new jobs were effectively zero over the period. A glimmer of hope came from a rise in hours worked, now up 1.8% yoy. For the corporate sector, this is a good development; a weak (but not abysmal) labour market supressing wage growth, yet a decent number of hours on offer which suggests productivity gains are possible.

Labour markets are the lead into interest rates and, in turn, the currency. While we are always careful of charts which show an apparent causality, this one has some logic. The potential path of employment implies that the $A can ease further against the $US. As often noted, the predictability of the exchange rate is low, yet there are longer term signals on its trend. The exchange rate also has a persistent habit of overshooting its expected range and being sticky at low or high levels. The skew to the $A is still more down than up, but the bulk of the transition is over, and we expect to encourage investors to hedge part of their global exposure over the course of the year.

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In an address ‘Australian economic growth  - the how, what and where’, the assistant governor of the RBA, Christopher Kent, noted the challenge towards higher productivity outside the mining sector, focusing on greater competition both domestically and through free trade as a primary driver. Another supportive factor was monetary policy, but according to Kent, it could only “guide imprecisely through the blunt tool of overnight rates”.

Other means towards growth came from adjustments in the exchange rate, with the RBA still hoping for more broadly based depreciation of the $A and from a moderation in wages, it pointed out that the impact is negative in the short term due to lower growth in household income, but that it does improve the potential for growth in the longer term.

Turning to the sources of growth, the RBA presented the data shown in the chart below:

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The major shift in the consumption of services rather than goods is a phenomena we have noted a number of times in our weekend reports, as well as referring to the lack of exposure one can get to service companies within the ASX. Education, health and recreation stand out as areas households need to or want to reallocate their spending. Communication also is notable, although arguably this is more due to the growth in ways to consume over the 20 year period, rather than necessarily the growth itself.

Given the fall in commodity prices, service exports (predominantly tourism and education) have now edged ahead of iron ore. We are back to the 90’s!

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The numbers employed in services is much higher than in mining, albeit at lower average wages. It may well then be that, with a lag, employment in these service sectors does pick up (and contrary to our earlier comment on the direction of the $A), though at lower aggregate income compared to the commodity cycle.

US data did little but muddy the water. Retail sales were weaker than expected and were possibly weather-related. But there are some indications households are reluctant to splash out on the savings they have enjoyed from lower fuel prices and the employment pickup. First quarter GDP is lining up to be below par once again, in contrast to the strength in the labour market. Next week’s FOMC meeting will be even more carefully micro-analysed to glean any hint on the timing of a rate hike.

Another feature of the US economy is the notable slowing in the rate of healthcare costs. Most concede that after a messy start, Obamacare has reduced medical costs, in good part by limiting unnecessary procedures and tests. The healthcare sector has been a stellar performer for some time. If these apparent constraints on spending feed their way into healthcare corporates,  greater discrimination will need to be exercised on stock selection in the sector.  These trends reinforce to us our focus on investment managers with whom we can debate such issues and also our aversion to using sector-specific ETFs where all stocks are lumped together without any identification of winner and losers.

Company Comments

With the iron ore price this week hitting multi-year lows, one could imagine a fairly sombre setting for a global iron ore and steel conference in Perth over Tuesday and Wednesday. BHP Billiton (BHP) and Rio Tinto (RIO) both presented at the conference, with the two companies reiterating their iron ore strategy of ploughing on with further production growth despite the falling price. The market-leading low cost position of the two will mean that both will survive any environment. Their margins are also being protected to a degree by the cost out programs currently being implemented, which have been assisted by the decline in the $A.

Essentially, the argument from the two large diversified miners is that if they are not the ones to add to capacity, then someone else would be filling the gap. RIO maintains that, despite the large additional capacity that it has brought online over the past decade, its share of overall seaborne supply has been relatively stable at around 20%. Of the three large Pilbara iron ore producers, Fortescue has actually been responsible for the largest volume increase over the last three years (RIO estimates FMG has added 43% of incremental tonnes among the large miners).

With iron ore demand growth slowing (particularly in China) and further tonnes to be added by BHP and RIO in coming years, the outlook for the smaller high-cost miners remains bleak. The highest-cost Chinese supply has been slowly exiting the market over 2014, although the fact that many of these mines are integrated with steel mills and are state-owned (where profit may not be the primary incentive for production) will likely limit a full exit. Further price downside, however, may be limited by the fact that the cost curve for iron ore has flattened out over the last couple of years. This could indicate a more stable price environment in the medium term, although this outcome could do little to save the current marginal producers. Given the inherent risks of these smaller producers, we believe that the only ‘safe’ way to participate in the sector is through an investment in either BHP or RIO.

Iron Ore Cost Curve

Source: BHP Billiton
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TPG Telecom (TPM) today announced that it had reached agreement with iiNet (IIN) to acquire the company for a consideration of $8.60 cash per share. The price represents a 29% premium to the stock’s closing share price as of yesterday. The acquisition will grow TPM’s broadband subscriber base to 1.7m and an approximate 25% market share, making it the clear number two player behind Telstra (with around 3m) and ahead of Optus. While a merger between the two telcos has long been discussed, the timing by TPM does appear to be a little opportunistic after the recent weakness in IIN’s share price after its poorly-received first half result. The two companies have been effective in consolidating the smaller end of the telcos industry in Australia for several years now, with the focus now turning to growth by more organic means.

One key difference between the two companies that was viewed as a hindrance to a merger was the distinct market segments that each targeted and hence the culture of the respective organisations. TPM has successfully achieved organic growth via its low-cost value offering to consumers, while IIN has delivered a more premium offering based on, in its view, customer service. TPM has indicated that it intends to retain IIN as a separate, premium-based brand. Nonetheless, the financial reward for combing the two companies is seen as quite significant. This was reflected in an atypical 18% rise in the acquirer’s (TPM) share price on the day, indicating that the (substantial) synergy benefits from the group’s larger scale will be shared between the two companies. While not quantifying this benefit, TPM stated that the deal would be “immediately EPS accretive” for its shareholders.

Following the announcement, IIN has traded inline- to-slightly below the offer price. While the necessary regulatory and competition approvals are still to be gained, the natural question for IIN investors would be whether or not another bidder will emerge. Optus would appear to be the most likely candidate from this perspective, and the fact that there are few remaining consolidation opportunities in the sector would likely increase its interest. From an investment perspective, we have liked the thematic of the smaller telcos taking market share from the incumbent (Telstra), particularly as the NBN rolls out and results in a more level playing field. While recognising the quality in TPM’s business (including the advantage it has from its fibre to the basement network), we had preferred IIN based on valuation grounds.

Over the past five years, Telstra has no doubt been a solid investment, with its share price doubling while delivering a consistent dividend. Despite this, as the chart below illustrates, it is the smaller telcos (without the structural issues that Telstra faces) that have performed better. These companies have been more driven by earnings growth as opposed to an expansion of their P/E multiple, whereas Telstra has been assisted by the preference of investors for yield. We remain more optimistic of the outlook of these smaller companies in the medium term.

Telecommunications Sector: Relative Performance over Past 5 Years

Source: Iress, Escala Partners
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Stock Focus: Spotless Group (SPO)

Spotless Group is the leading provider of outsourced facilities management, laundry and linen, catering and cleaning services in Australia and New Zealand. The company services four broad sectors, being health, education and government; commercial and leisure (including sports and entertainment); base and township (defence and resources); and laundry and linen (primarily hospitals, aged care and hotel laundry services). Spotless recently re-listed on the ASX after two years where it was under the ownership of private equity group Pacific Equity Partners.

Spotless’ markets are relatively mature and underlying growth shows a high level of correlation with GDP growth. However, it is the trend of its customers to outsource an increasing level of non-essential services (which Spotless performs) that provides the company with a positive long-term structural change tailwind. The outsourcing of these services allows its customers to achieve cost savings and instead focus on their core competencies. Total outsourcing penetration in Australia is currently estimated at around 50% and is below that of many other developed economies, hence there is considerable upside from current levels. The budgetary pressures that many of Spotless’ customers are facing (both commercial and governments) only accelerates this trend as they become increasingly focused on costs.  

Spotless' contracts result in a high level of visibility in its revenue stream. They are typically multi-year and hence recurring in nature, the company has a strong track record of contract retention and overall, Spotless has relatively low customer concentration levels (no single customer accounts for more than 4% of revenue). Almost all of its contracted revenues have embedded price escalators (such as CPI or labour increases), protecting its margins against rising costs in its business. Its cost base is also predominantly variable, with labour and sub-contracting costs accounting for approximately two-thirds of its total costs.

Spotless is the largest participant in its industry with approximately 12% market share. However, in Australia the market is highly fragmented, with a large number of smaller competitors. Spotless is the market leader in three of its four sectors (health, education and government; commercial and leisure; and laundry and linen) and is in the top three for base and township. It has a larger scale and breadth of service offering compared to its peers, enabling it to compete with few others on integrated, multi-service contracts and providing it with a competitive advantage.

Integrated contracts are becoming more popular due to the growth in private-public partnerships (PPPs) and are hence a growth source for Spotless. PPPs utilise a combination of government and private sector funding to design, construct and operate infrastructure and facilities that were historically serviced by governments only. They generally offer higher margins and have much longer duration than Spotless’ core contract base. A good example of one of these is the contract that Spotless won to act as the facility manager of the Royal Adelaide Hospital (which is to be completed next year) with a contract term of 35 years.

Small bolt-on acquisitions provide a further growth opportunity for Spotless. The company completed four of these in the first half of FY15, adding to its overall service offering. The strength of Spotless’ balance sheet should result in further capacity for growth via this avenue in the medium term.

Outlook

For FY15, Spotless expects to see further benefits realised from the cost saving initiatives introduced by the company’s previous owners through a reduction in headcount, procurement savings and exiting contracts that were unprofitable. The company has good cash flow conversion, is relatively capital-light, a 4.9% dividend yield and generates a solid return on equity. With the stock trading a fair discount to the broader industrials sector, we believe that it represents good value and have recently added it 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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