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WEEKEND LADDER

A summary of the week’s results

13.11.2015

Week Ending 13.11.2015

Eco Blog

Sceptics supped on humble soup as the Australian labour force data beat expectations by a mile. In October, full time employment rose by 58.6k and the unemployment rate dipped below 6%. There had been growing indications that employment conditions were far from as dire as the general economic tone would have suggested. Job ads have been picking up, the NAB business survey was more upbeat, retail sales (outside of supermarkets) were acceptable and clearly housing activity has been robust.

It should not be a surprise therefore that NSW accounts for most of the gains in the past six months, though Victoria had the largest improvement in October; according to the data, the largest decline in unemployment in nearly two decades.

Six Month Change in Employment

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Even with a very likely revision in coming months, the trend is unlikely to be disrupted: unemployment is past its highs and the impact of accommodative monetary conditions (i.e. housing) as well as the lower A$ have worked their way into the economy.

The unanimous conclusion was that the RBA would now sit pat well into 2016; there is simply no trigger for a rate cut.  In sequential speeches RBA members have talked about their major concern: lending standards and household leverage. Lower rates always ran the risk of fuelling this very issue and clearly played a role in the RBA’s decisions. The other side is the currency, with the RBA keen to keep a lid on the exchange rate. Based on the Trade Weighted Index, the RBA appears to be of the view a further fall in the A$ would be preferable, but is unlikely to use interest rates to get it there.

It may find the assistance of the Fed, with a December rate rise now considered a near certainty. Notwithstanding occasional patchy data, the US labour market is pointing in the right direction. US economists believe the Fed watches the JOLT - job openings and labour turnover – more closely than the standard labour market data, as it indicates the expected rate of jobs growth and the willingness of employees to move jobs. With the view that skills are the main handicap to closing the unemployment rate, this survey gets around that structural issue. The charts reinforce the strength in job openings over hires, symptomatic of this feature. The other factor is the robust strength in the private sector.

US Employment: JOLTS Indicators

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The subdued government sector is a function of the persistent budget deficit which will undoubtedly fill the newspapers in advance of the US election next year. The October deficit was marginally ahead of expectations, and while as a % of GDP it is arguably a manageable 2.5%, there is no sign the US can get to a surplus in the foreseeable future.

The table shows the arithmetic. While the US corporate tax rate is relatively high, the bulk of revenue comes from individuals and social insurance. Of the groupings in the outlays, services such as education and training form the smallest component, not a great sign of changing direction on the skill gap referred to above.

Source: Haver Analytics
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The debate on funding the big ticket items of healthcare, pensions and social services is a global phenomena. The European Commission gauged the opinion across its member states on where they thought the deficiency would be most problematic.

Source: Bruegel Economics
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When asked how they would rank priorities, healthcare edged out elderly care and childcare came in last, bar in Poland where it was the most important.

The funding dilemma found a middle path; cynically one can suggest that everyone wants someone else to pay. Portugal was biased in favour of spending cuts, while Finnish citizens implied they were willing to pay up. GGS refers to the general government debt to GDP.

Source: Bruegel Economics
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There are constant reminders that observations on the Chinese economy, or for that matter most developing countries, should be seen in the context of its own behavioural features rather than assuming it will resemble a western style.

Readers may have seen the Singles Day in China, which now gets the headlines, rather than the US Black Friday sales. While there is some scepticism on the data, Alibaba is used as the benchmark, though also supported by ancillary releases from transaction tracking. Alibaba states that sales were up 60% over last year, taking its total to US$14.3bn.

The day was originally for singles to reward themselves with a gift. Instead it has grown into a shopping frenzy in which many young people participate regardless of their partnership status. Xiaomi mobile phones is the largest seller, followed by the Huawei equivalent. Apparel features prominently, with a Japanese brand taking the honours for both male and females

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Global retailers noted as beneficiaries according to Sina Tech were Costco (all products), pillows from Nittaya (Thailand), health and beauty from Kirindo (Japan), Huggies from the US and, yes, pharmaceutical products from the Chemist Warehouse of Australia.

Retail sales in China have held up well, notwithstanding the discouraging trends in other sectors. For example, Singles Day saw a 100% increase in the sales of home appliances, and home decoration products featured heavily. The desire for better product quality is a key feature. Consumption growth in the region is a key theme of a number of fund managers. Increasingly unfamiliar company names are in these portfolios rather than the traditional ones that were the case some years back.

Corporate Comments

BHP Billiton (BHP) shares have been sold off in the last week after it reported the collapse of a dam wall at an iron ore mine in which it is a joint venture partner with Vale in Brazil. The loss of human life that the accident has caused is tragic and the financial and reputational damage to BHP and Vale could be quite significant. While the overall contribution to BHP’s earnings is not material, some analysts have estimated a clean-up cost of circa US$1bn, in addition to the opportunity cost of the joint venture sitting on an inactive mine for several years. The inevitable outcome from this is greater pressure on BHP to meet its safety obligations to its employees (an important consideration given the greater weight that investors give to ESG issues today) and a further hurdle for the company to help it meet its progressive dividend policy; an issue that we have previously highlighted as unsustainable.

Despite the fall in BHP’s share price this year, the forecasts of BHP’s earnings have actually been falling at a faster rate than its share price, resulting in a near-doubling of its forward P/E ratio and now higher than it has been in the last decade. Often a high P/E on a cyclical company is an indication of a marked improvement in its trading environment in the near future. This prospect remains in certain parts of its business (most notably its petroleum exposure), however our conviction that this will materialise across its broader operations is, in this instance, low.

BHP Billiton: Forward P/E Ratio

Source: Bloomberg, Escala Partners
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Companies with a September or March financial year end continued to report their financial results this week. DuluxGroup (DLX) is an excellent example of a company prospering as a demerged entity operating it its own right. DLX was demerged from Orica in 2015. Since then, Orica shares have declined by a total of 35%; a commendable outcome given its leverage to the mining sector. Shares in Dulux, however, have more than doubled over this timeframe, with the Australian housing market proving to be a more reliable environment for earnings growth. The somewhat defensive nature of its market exposure (approximately two-thirds is related to maintenance and home improvement markets) has also helped its shares re-rate to a higher earnings multiple.

In FY15 DLX reported EBIT growth of 5%, with its core paints and coatings division driving the performance. The quality of this business is high, with DLX’s strong brands enabling the company to price its products at a premium to the market. As is the alliance that DLX has created with the Bunnings network, with these products not stocked in the struggling Masters chain. Other markets that DLX has expanded into via acquisition have not replicated this success, with a decline in earnings from its garage doors and openers division for FY15.

While DLX’s exposure to new housing is not high, on the balance of probabilities Australia is approaching a peak in the current cycle, and this will likely weigh on the momentum of the business in coming years. As we noted, the company’s low but predictable earnings growth trajectory has been rewarded by investors with a re-rating of its earnings, hence the upside may be capped from here. James Hardie (JHX), which is more reliant on the US market and is in our model portfolio, reports next week.

Foreign-exchange payment service provider OzForex (OFX) reported a 3% increase in underlying profit for the half year, a result which, at face value, appears light for a high-growth company. On most of its key top line metrics, OFX continues to perform well; active client growth of 16%, average transaction value growth of 15% and overall transaction growth of 17%. The ongoing organic growth in its customer base is important for the company as this is the key element in its overall fee and commission income growth.

OzForex: Fee and Commission Income by Customer Base

Source: OzForex
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OFX’s profit growth didn’t reflect this outcome in the half largely due to a previously flagged step up in costs in the period. OFX is undertaking an ambitious growth strategy, in which it aims to double its revenue over the next three years (and more than double earnings). To provide this platform, the company has made a substantial investment in the last six months, including in areas such as IT and risk and compliance. OFX is a credible alternative investment to more established players in the financials sector of the market as it takes market share with a better and cheaper operating model.

Santos (STO) finally announced the outcome of its strategic review which it has been undertaking over the last few months. As was widely expected, the process of balance sheet repair has been achieved through a combination of a large $2.5bn capital raising, a $500m placement (which was priced at a premium) to a China-based private equity group Hony Capital and $520m in asset sales. STO also took the opportunity to change its dividend policy to a more suitable payout ratio model and announced the appointment of a new CEO, Kevin Gallagher, who is currently the CEO of engineering services group Clough.

While the placement to Hony was an important piece of the total measures taken, it has also undoubtedly taken away some of the takeover premium that had built into STO’s share price following the recent approach from Scepter. The earnings dilution is also large, with an approximate 70% increase in STO’s share count as a result of the capital raising. While the raising has removed the immediate risk of a credit rating downgrade, what does remain a possibility is the potential for asset impairments at its upcoming full year result. Its previous impairment analysis used a US$70/barrel price of oil for 2016, US$80 in 2017, US$90 in 2018 and US$90 long term price and the indicative writedowns that it would face under revised assumptions is illustrated below.

With relatively high cost operations compared to others in the energy sector, the immediate focus for STO will remain on the costs side of its business instead of possible growth opportunities. Among large-cap energy stocks, STO has the best leverage to an oil price recovery, although investors should expect this path to be volatile. We remain comfortable gaining energy exposure through the safer option of Oil Search (OSH).

Santos: Potential Impairments

Source: Santos
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The battle for Asciano Group (AIO) continued this week when the Qube Holdings (QUB) consortium lodged non-binding indicative proposal to the company. The terms of the offer are quite similar to that offered by Brookfield Infrastructure, both in terms of the cash component of the consideration (representing ~75% of the total) and the value of the scrip component. Under the QUB consortium proposal, AIO shareholders would also receive QUB shares; a prospect that may be more favourably received with shareholders compared to the alternative of Brookfield units.

While competing bidders is a good outcome for AIO, we note that the ACCC has already raised competition concerns with the Brookfield offer and may also do so for QUB, potentially knocking one or more parties out of the race. The preliminary view of analysts at this stage is that the QUB offer will encounter less regulatory resistance, although there still may be some time before this is all played out. The knowledge of the AIO assets by QUB chairman Chris Corrigan (who is a former managing director of Patricks, an owner of some of AIO’s assets prior to their takeover by Toll Holdings), could be an important trump card to sway the favour towards the QUB offer.


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