Week Ending 14.08.2015
China’s foreign exchange movements overrode most other financial market news this week. It’s worth briefly reflecting on the background to this event. Prior to 2006, the Renminbi (RMB) had been fixed against the US$ for some time at 8.28CNY/USD. (In a short report on China we noted that the terms Renminbi (RMB) and Yuan (CNY) are akin to the use of Sterling and Pound in the case of the UK). The decision was then made to allow the RMB to reflect a basket of currencies generally tied to the trade weighted index. However, with the onset of the financial crisis in Oct 2008, the RMB was once again fixed to the USD, which was held until June 2010 at a rate of 6.831 CNY/USD. At that point, the currency was allowed to vary again, but within a designated tight range, with this band having been progressively widened as shown below.
RMB Exchange Band
This week, however, the authorities devalued the RMB from 6.209 to 6.396CNY/USD. Had this move been within a free floating environment it would not have attracted that much attention, but given the relatively tightly-controlled China framework, as well as the potential for the inclusion of the RMB in the IMF’s Special Drawing Right (SDR) programme, the timing and lack of signalling from the authorities took markets by surprise. By the end of the week the dust has somewhat settled after the Peoples Bank of China (PBoC) held a press conference and indicated that they believed the required adjustment was now over, given that the RMB had moved towards its valuation range, largely due to the appreciation of the USD.
In the near term the RMB rate is likely to stabilise, or at least be held within its perceived bands through intervention by the PBoC. But, as the band will now be made with reference to the previous day’s close, it could well drift lower over time.
Some will suggest this event was mishandled, as has been the judgement with respect to intervention in the stock market, yet there was an easy case to make that the RMB was overvalued given the direction of the USD versus China’s trade weighted basket and the weak economic data out of China so far this year. Switzerland found itself in a similar boat a year ago as it attempted to prevent the Swiss franc from rising excessively against the Euro, to no avail.
There is a broader lesson that any intervention by central banks, which does not align with economic reality, can have unintended consequences. The US may well find that it has over-extended its zero interest rate policy by the time it wants to return to normal monetary settings.
Capital flows from China (a combination of outward investment, China’s allocation to its fledging Asian development bank and monetary movements in response to falling interest rates as well as the currency) now complicate things for China. It has been attempting to sustain growth through traditional economic easing, but instead these flows serve to reduce the amount of credit available. Other initiatives to encourage lending are likely to emerge in coming weeks.
This easing bias extends beyond China. Low inflation in India, sluggish growth in Malaysia and structural pressures in Indonesia (amongst others) mean that monetary policy across Asia/Pac is likely to ease. Implicitly, their currencies will weaken and competitive pressures across Asia remain more or less the same to what they were prior to the move by China. The AUD moves in sync with these movements. Thus, unlike US investors, unhedged investments in the region, while subject to higher than normal volatility,are at this stage not at risk from exchange rates.
Closer to home, the New Zealand housing market is worth watching. As we have previously noted, NZ is attempting to contain Auckland house prices while reducing interest rates. So far, that has not worked, with Auckland prices up 24% year-on-year, compared to less than 10% in most other regions. Some of the restrictions on lending to Auckland are still to be fully implemented and forthcoming data may well capture the attention of our RBA as it frets in a similar vein over Sydney.
Locally, the wage price index (WPI) showed a weak rise of 2.3% for the year, indicative of the continued adjustment towards globally competitive rates and spare capacity in the labour market. As the WPI is slow to adjust to changes in the composition of the labour force, average earnings growth is even lower due to the shift from high wage resource jobs to lower paid services.
Australian Wage Price Index and Average Earnings
US data watch intensifies as we get closer to a rate decision. Retail sales imply Q2 GDP will be revised up in its second reading, due 27 August. Discretionary spending in July was particularly strong, with its ultimate expression in spending on food away from home, up 9.8% in the month. Notably, general merchandise stores (mostly discount department stores) saw weak sales of 1.5% year-on-year compared to the specialist category stores. For example, sports goods/ hobbies/books grew 7.7% and home furnishing 6.6%.
US Retail Spending
Transurban’s (TCL) result reflected a solid performance across its portfolio of high-quality assets. Its Sydney, Melbourne and Brisbane networks each delivered double-digit growth in EBITDA. The company’s presentation highlighted the numerous growth opportunities that will enable it to leverage off its existing network in each of these cities in the medium term. The integration of its acquisition of Queensland Motorways is also on track, with TCL delivering 3.6% in margin improvement since it acquired the assets 12 months ago, with further improvement forecast for FY16.
While we believe that TCL’s valuation still appears to be relatively full and with its dividend yield only in line with that of the broader market, importantly the growth in its distribution is expected to continue into FY16, underpinning its appeal to investors. The company has given guidance of a 44.5c distribution in FY16, which would represent an 11% increase on FY15. We hold the stock in our model portfolios although down-weighted earlier this year following strong share price gains.
Commonwealth Bank’s (CBA) result was overshadowed by a $5bn equity raising, which was initiated in response to regulatory pressure imposed by APRA. Even though the question of the banks’ overall capital position relative to their international peers has been left without definitive guidelines, each of the major banks have been set a timeline of 12 months to lift the capital which they hold against residential mortgages. This implied a further $2bn - $4bn for each of the banks, of which ANZ covered last week with its raising and CBA has likewise done this week.
The question for the industry in the medium term, is how much of this capital drag will be able to be recovered through a repricing of their mortgage books (i.e. lifting mortgage rates to increase the gap against the RBA cash rate). This has already begun when the majors failed to pass on the full rate cut in May, as well as more recently, with the banks lifting rates for investor loans. Analysis suggests that 20-25 bps will be required to offset the negative impact to return on equity from the increased capital requirements.
The result itself was a slight beat on what was fairly low consensus expectations. In what has been a harder trading environment for the banking sector, CBA’s figures look reasonable on a full year basis although there was a noticeable slowing of earnings growth in the second half. Credit growth was slightly lower than system growth, net interest margins were down over the year and the group’s cost to income ratio was broadly flat year on year. CBA’s credit quality remains sound with bad and doubtful debts holding at low levels (see chart below). As we have previously noted, after being a positive tailwind to earnings in recent years, the most likely outcome in the medium term is this turning into a headwind to earnings.
We have been underweight the banking sector in our model portfolios. This is based on a relatively weak medium term earnings outlook and the aforementioned increasing regulatory capital burden, which will further reduce earnings per share growth. While CBA’s equity raising this week sees it in a much improved capital position, we note that APRA’s recently updated guidelines are in effect only on an interim basis until new international measures are formalised by the Basel Committee, which may not be until next year.
Commonwealth Bank: Loan Impairment Expense
National Australia Bank’s (NAB) quarterly update was solid at a headline level, although the composition could be described as weak, as it was supported by a lower than expected bad and doubtful debt charge of just 13 basis points. With underlying costs rising at a faster rate than revenue, a better performance from its domestic franchise will be required for the stock to rerate following the divestment of its UK operations.
Carsales.com (CAR) reported a slight miss with its result, with earnings per share growth of 7% for the year. A key positive was the continued growth in the dealer segment (the company’s largest source of revenue), with revenue growth of 7% driven by a 4.4% increase in enquiry volumes. Yield enhancement made up the balance with the company’s further success in growing the share of more premium advertising products. The private sector also showed good revenue growth of 8%, although the second half was somewhat weaker than expected. Revenue growth was also recorded in its display advertising and data services segments.
Margins were lower on the first contribution from its acquisition of Stratton Finance, as well as some increase in investment to combat the competitive threats in the market. With CAR’s domestic business showing some signs of maturity, the longer term growth option for the company remains the various international investments that it has made, although the profit contribution from these is currently not overly material, at less than 10% of earnings.
G8 Education (GEM) reported a solid 60% increase in underlying earnings per share for the first half, however some cyclical weakness in certain markets (particularly WA) meant that the result was a slight miss to expectations. The result was driven by a 17% increase in EBIT growth per childcare centre, with margins enhanced by good cost control. Efficiencies and leveraging scale benefits from the acquisitions that the company has made over the years has been core to its success. The chart below shows the progression of EBIT improvement of centres acquired by acquisition year. In the first half of 2015, GEM acquired 21 centres; a lower rate of growth compared to the previous three halves, but nonetheless still consistent with the company’s strategy.
G8 Education: 1H Centre EBIT by Acquisition Year
Last month GEM acquired a stake in one of its rivals, Affinity Education (AFJ) and launched a takeover offer for the company. The opportunistic nature of the offer has reduced the likelihood of the deal being completed, although the fragmented nature of the industry will still see many opportunities available for the company. We have recommended GEM as a small position in our model portfolio, and while the growth expectations of the company have been somewhat reduced over the last 12 months, we believe that it now represents good value, trading on a forward P/E of 12X.
A number of gaming stocks reported this week with mixed results. The turnaround story of Echo Entertainment (EGP) continued as it posted a 30% increase in normalised EBIT (the ‘normalised’ result adjusts the actual figures according to the expected win rates on the high roller or VIP business). With the actual win rate lower than this theoretical rate, realised EBIT increased by 20%. The company’s flagship asset, Sydney’s Star casino, was the key driver in the increase in profit, while high roller turnover growth across the group was impressive.
The outlook for EGP over the next few years remains promising, with good momentum across its portfolio of domestic casinos. The recent win to develop the Queens Wharf project in Brisbane has added to a good pipeline of opportunities for EGP and the stock’s valuation is reasonable, trading on a similar forward multiple to that of the market. Crown’s Barangaroo project (though some years off) remains the longer term challenge for the company as it will signal the end of EGP’s monopoly hold on the Sydney market.
Contrasting EGP’s result was that of Crown (CWN), which has struggled following the well-documented difficulties in the Macau gaming market over the last 18 months. CWN’s Melbourne and Perth casinos also benefited from a surge in high roller activity, as it picked up market share gains lost from the Macau region. CWN’s normalised share of profit from its investment in Melco Crown, however, declined 45% over the course of the year, with China’s crackdown on corruption affecting all operators. Melco Crown has a further large-scale casino that is due to open within the next three months, although given the current state of the market, the timing of this is far from ideal. Of the casino stocks in the Australian market, CWN has now become the value play, although the risk remains on the downside with no improvement in recent Macau gaming trends.
Tabcorp (TAH) again displayed good defensive growth characteristics with its result, with a 15% increase in profitability (although enhanced by a lower interest expense for the year). Wagering is the key division for the company, accounting for nearly three quarters of total earnings. TAH is successfully growing wagering turnover in its digital platforms (web and mobile) despite the increased competition in this segment of the market, as it combats more subdued growth in its retail outlets. With a solid balance sheet, attractive dividend and reasonable earnings outlook, the stock has some investment appeal, although this seems to be reflected in a forward P/E of 20X.
Telstra (TLS) disappointed somewhat with its full year result, with low single-digit growth in revenue and EBITDA and a similar outcome expected for FY16. TLS has been successful in growing its subscriber base in fixed line and, in particular, mobiles, which has been important in the earnings growth that it has achieved in recent years. Notably, however, the momentum across these two divisions has been diminishing in recent halves and this was again evident in the six months to June 30. In the mobile space, Optus has lifted its game and grown its subscribers at a rate almost double that of TLS over the past 12 months, showing the high competitive nature of this market segment. With TLS looking to defend its market leadership position, the risk is this may result in margin compression.
The persistent low interest rate environment and utility-like nature of the company should continue to see the stock get some support in the event of any selloff (this is reflected in the vast majority of analysts with a “hold” recommendation), although we are mindful of the longer term challenges that the company faces, particularly as the NBN is rolled out around the country. We continue to recommend that clients diversify away this risk through a holding in one of the smaller telcos, with TPG Telecom (TPM) currently also in our model portfolios.
Computershare’s (CPU) guidance for FY16 implied that investors had overestimated the positive impact that would result from rising interest rates in the US. While the company’s result met expectations, guidance for a 7.5% decline in $US earnings per share for FY16 undershot expectations by approximately 10% (although part of this was attributed to currency movements). In effect, the benefit of (marginally) higher US interest rates on its funds under management is expected to be more than offset by lower rates in other countries (including Canada and Australia) as well as the roll off of existing hedges that the company had in place.
While the market has focused on this obvious macro driver on CPU’s earnings, the continued poor organic growth of the company has been somewhat overlooked. CPU has also had limited success in the acquisitions that it has made in recent years outside of its core share registry business. CPU now looks to have some appeal from a value perspective, with its forward P/E now at 13X, although the further prolonged and gradual nature of global interest rate rises places an obvious risk on a current investment in the stock.
Computershare: Margin Income
AGL Energy’s (AGL) result came in at the top end of its guidance range, a 12% increase in profit on FY14, although included writedown charges on a number of its gas assets. The result was largely driven by the first contribution from AGL’s acquisition of the Macquarie Generation power stations from the NSW Government (which was announced at its FY14 results last year) which performed ahead of the company’s expectations.
Weak energy demand remains one of the biggest headwinds for the listed utility companies, although there has been some signs of stabilisation in the market after the declines seen in recent years. Retail competition is also still high, although AGL has been outperforming its peers with a lower churn rate. On a positive note, wholesale electricity and gas prices have recently strengthened; important to AGL given its now larger generation asset base. A more critical driver of profit growth in the medium term, however, will be the cost savings it announced as a result of a strategic review. The prospect that these will be passed through to shareholders in the form of increased dividend payments will be a focus for investors over this time.
FlexiGroup (FXL) this week announced a number of changes to its board, confirmed its guidance for FY15 and surprisingly gave guidance for FY16. The forecast profit for FY16 (implying profit growth of 3%) underwhelmed the market and the stock was subsequently sold off before recovering some ground later in the week. With a new chairman and an unfilled CEO position, the level of disruption at the company is unlikely to bode well for investors with more of a short term focus as the company loses any momentum in its business. Further, there remains the possibility that in this transitory period, the company misses out on potential acquisition opportunities which have been key to its growth over the years. We will provide a further update on the stock post the announcement of its full year results next week.
Ansell (ANN) fell short of expectations, with lower than anticipated revenue growth and foreign exchange headwinds. It also joined companies in guiding to lower than consensus FY16 profit forecasts. Organic revenue growth has been circa 1% for the past three years, with acquisitions lifting the headline in constant currency terms. A combination of weak sector demand (e.g. energy), a big shortfall in Brazil and Russia, the drag from the mature product range as new lines cannibalised legacy products and competition provided a tough growth environment for ANN.
The complexity and FY16 impact of FX movement however, saw the stock sell off sharply. ANN does report in USD and while its revenue translation can be estimated with reasonable accuracy, the EBIT outcome depends on the cost in each jurisdiction and importantly for ANN, the USD costs of its commodity inputs.
Management gave a wide FY16 guidance range of EPS (US$) of105-120c/share versus 118c for FY15, highlighting the tricky conditions and uncertain currency and commodity impact. At a forward P/E of 14x, the company is not expensive relative with its comparative group, but without sales growth it is hard to make a case to invest in this stock.
Cochlear (COH) too came under pressure due to a soft rate of unit sales growth of 3.2%. Prior to its product recall in 2011, COH was upheld as a high growth story with a superior product. However, the developed world is largely mature, limited by restrained clinic availability and reliance on professionals for marketing. Emerging economies have greater scope, but are invariably highly price conscious, while hearing implants are arguably not considered to be the highest priority. The P/E of 27x FY16 can only be justified by confidence that sales momentum can be sustained at a higher rate.
After a stellar run to over $100/share, it’s not surprising that CSL gave way in a weaker market. Its reported FY15 result was largely in line with expectations. Revenue growth in (all cited in constant currency taking out the fluctuations in exchange movements) was 7%, flowing through to a 10% NPAT rise, excluding the Novartis vaccine acquisition costs.
Over the years, CSL has broadened its product offer such that it is no longer quite as vulnerable to competitive factors and the risk in production or regulatory issues. Nonetheless, the mature products, specifically IVIG, will become a drag and the maintenance of a high R&D budget with supportive marketing is critical.
CSL: Product Mix
The relatively benign FY15 outcome however was balanced by subdued guidance for FY16 due to increases in spending on product launches, integration of Novartis and currency impacts. Net profit is expected to rise by circa 5%, while EPS edges ahead of that due to a further $950m buyback.
Few would argue that CSL is the champion stock in the ASX200. At this point, however, the forecast FY16 P/E of 23x in a year with integration risk and payback from marketing spend suggest that the share price is unlikely to return to $100 unless we have a broader market rally.
In the consumer discretionary sector, the federal budget did flow through to product demand from small and medium enterprises at JB Hi-Fi (JBH) along with the expected benefit from the housing cycle. Total sales for FY15 were up 4.8% (2.9% comparable) and gross margin also increased by 16 basis points, beating the rise in cost of doing business, to take net profit to $136.5m (+6.4%). Momentum in H2 was the predominant factor with same store sales improving from -0.7% in H1 to +7.4% in H2. More importantly, management believed they had enough visibility to provide expectations of a 6% sales rise for the year, made easier by cycling the low first half of last financial year.
The group has done a sterling job in the face of testing conditions over the past few years, however the key will be continuation of this sales momentum and rational market behaviour. The category in which the company operates has been in deflation for some time, with volume growth through market share and new products critical to success. With the decline of some high revenue categories such as CD’s and associated products, the group has converted to appliances which is likely to introduce another cyclical element to its sales. The stock has outperformed strongly in recent times and trades on a reasonable multiple of 15x forward earnings. However, we are reluctant to chase the stock into what may turn out to be near the top of the cycle.
There can be few less likely market darlings than Domino’s Pizza (DMP), a poster child for taking what many would believe is a difficult product segment – fast food – and turning it into one of Australia’s best growth stories, having delivered 23% compound EPS growth over 8 years. This year’s final result did not disappoint with 19% growth in revenue (8.6% same store sales) and a 35% rise in EBITDA to $127.8m.
Domino's Network Sales Growth ($m)
The success can be oversimplified into an aggressive store growth strategy, both organically and through acquisitions, the most recent the Domino’s operations in Japan. Management have clearly set their sights on further regional acquisitions in the result presentation. The second is a constantly evolving product suite, from ‘design your own’ pizza, to popularising unusual toppings – Gyros is the Netherlands best seller and Europe even sports a sauerkraut version. Finally, as a lesson for all companies, Domino’s has taken pizza digital with ordering, GPS tracking and social media ingrained into the group’s operations.
With management guiding to 20% net profit growth in FY16, the stock will remain a favourite. The investment hurdle, however, is that one has to pay in excess of 45X earnings to participate. Successful global fast food franchises do trade at high valuations. For example, Chipolte Mexican Grill is currently on an estimated 42X, Panera Bread on 32X and YUM! Brands on 20X. DMP is, however, at the upper end, though we would not discourage investors to look for an attractive entry point.