Week Ending 15.05.2015
Bond markets remained uneasily in the spotlight, with daily movements larger than normal. Commentators reflected on the causes and repercussions. An overextended starting base, with negative interest rates in parts of Europe, arguably distorts the apparent change to a small positive yield. For example, German 10 year Bunds are trading at around 0.65%. European GDP data out this week showed 0.4% growth for the first quarter, supporting forecasts of 1.5% growth for the year; in turn, this should not imply negative interest rates. The contributors to this much-improved first quarter were Spain, with a galloping 0.9% quarterly growth, and the surprise packet of France; at long last stepping up to the mark. Germany was below expectations, largely due to much stronger import growth netting off against its traditional high contribution from exports. Given the weakness in the euro, this was an additional surprise and arguably suggests that the German economy, specifically the household sector, is even more robust than the headline rate would suggest.
The key now for Europe is to make a dent in its high unemployment rate, though this is likely to come with a significant lag. In the meantime, the rise in productivity supports private sector profitability and, in turn, there has been a recovery in business credit growth. Fiscal conditions are also expected to ease off as most governments have exhausted their political capital.
The risks with respect to investing in Europe remain elevated. Political issues trouble many of its members and the regions around it; the sustainability of the Eurozone is an open ended question; and structural reform is lacking. This last issue is hardly unique to Europe though. On balance, fund managers have retained a positive bias to European stocks over their previously high exposure to the US. With better potential for an earnings recovery, this theme is expected to persist for a few months yet.
US data is proving highly variable. After weak first quarter GDP data, retail sales were below expectations – essentially flat. Given expectations of rising spending due to the fall in oil prices, decent employment and solid wealth growth, consumers have been far from encouraged to shop. Some point out that this data only covers some 25% of household spending, with services making up the bulk of the outlays. As we have noted before, the lack of measurement of services consumption will limit economists’ ability to interpret household behaviour.
Reasons for this slowing spending have stumped most analysts. Few are prepared to blame the inevitable – the weather – and most simply hope that the data will bounce back, as it has before. Maybe there just was nothing exciting to buy. Increasingly, the trends indicate that consumers do prefer to concentrate their purchases around events (such as the November Black Friday and Super Monday sales), but also that the change in emphasis by demographic cohorts may confound those that expect historic patterns to persist.
Other research shows that 65% of Millennials get parental support, roughly double what the same age group – 18-30 years – got a decade ago. Further, the burden of student loans in the US has increased dramatically and rents are going up. Given that this generational group is often the swing factor in discretionary spending, it is perhaps not surprising that the outlays are less than before.
US Retail and Food Services, Total Monthly Change (%)
Locally, the budget dominated the headlines and we assume our readers have had sufficient commentary on the consequences. An important read will come from consumer and business confidence surveys in coming weeks, with the latter group’s reaction to the small business tax incentive critical.
The wage price index hit a fresh low at 0.4% for Q1 and an annualised rate of 2.3%. Private sector wages actually fell 0.4% in the quarter and even NSW, the state that has been particularly strong of late, was soft.
Annual Wage Growth (Private and Public)
Services wages are generally holding up. As they are lower than the median, however, they are not adding to the average. This trend is good for corporate earnings and some will argue a necessary development in the Australian economy, but will also dampen household spending ,especially given that rents and other regulated costs are front of mind.
The movement in bond rates referred to earlier engendered suggestions that the interest rate market is front running a possible lift in inflation. As we have noted before, US wages are the most likely trigger for a turn in the inflation data and the rise in oil prices in recent weeks also has given cause to suggest that commodity prices have bottomed and are on the upward trend.
Some of that has been deflated by the build in inventories, which could well cap any further movement in the oil price. The chances of anything but a mild lift in inflation still appears low.
Myer (MYR) reported its third quarter sales, with little other commentary prior to a strategic review underway by the new management. Sales growth was reasonable at 2.4% and like for like at 1.7%. The benefit of refurbishments and clearance sales, however, probably covered a much weaker core result. Analysts remain sceptical that Myer can sustain any real momentum given the weakness in the format in recent years and the pattern of unproductive strategic reviews.
The bounce in the share price will therefore need to be confirmed by a credible path to prevent margin deterioration over time as costs and price pressure outweigh the potential for improved sales. Nonetheless, the outlook for the retail sector is somewhat better than it has been for some time, particularly for stores which may benefit from the small business sector. We would, however, be careful about the likely persistence and that this tax-driven pattern may disguise the longer term poor business outlook for some in the industry.
Resmed (RMD) provided an unexpected shock when it announced the results of a clinical trial that it was conducting to expand the market for its product that is primarily used to treat sleep apnea. The company believed that it could be used in the treatment of patients who had suffered from heart failure, however its trails instead came to the conclusion that its products instead increased the risk for patients.
At face value, the immediate earnings impact to RMD appears to be low. In the 12 month period to 31 March, the devices that have caused the issue represent less than 7% of RMD’s total revenue, and less than 2% of the cumulative number of devices that the company has sold. Of the 7%, RMD estimates that approximately a quarter of these were prescribed to patients who will be affected by the outcome of this trail. While this may be the case, the potential for RMD to open up this new market for its products has essentially been eliminated from the earnings forecasts for the company. While few analysts had ascribed much value for success in this market for RMD, some of the more lofty valuations in the market had incorporated this as a solid driver of top line growth.
Nonetheless, the reputational damage to a device maker can often be quite severe in these circumstances, and while there may not be any issues with its primary product and the rest of its portfolio, the sentiment that will now be associated with the company may well be prolonged. A parallel could be drawn with the problems that Cochlear (COH) have endured since it instigated a product recall 3 ½ years ago. The market has largely made a similar assessment of the way forward from here for RMD following yesterday’s announcement, with the stock trading down 15% since Wednesday’s close. In light of this week’s announcement, our recommendation on the stock is under review.
BHP Billiton (BHP) presented at a global mining conference this week, outlining a consistent strategy following the demerger of South32 (which will trade on the ASX on Monday). The company revealed that it expects to cut its capital expenditure budget by a further 29% in FY16; a necessity borne out of its dual commitment to a progressive dividend and protecting it’s A+ credit rating. Analyst had previously been forecasting a capex level of in excess of US$11.5bn, a figure which would have represented an approximate 10% fall from FY15 levels.
Despite the large amount of operating costs already taken out of its business, the company is targeting further savings into FY16. In the case of iron ore and metallurgical coal, this would suggest a reduction on a per unit basis of approximately 50% on FY12 levels; in part aided by the decline in the $A over this time.
Much of BHP’s presentation was devoted to its efforts to simply its portfolio further as it trades independently of South32. It therefore demonstrated how, with its reduced capital budget, its future capital investment will be more directed towards cooper and petroleum. These two commodities are generally cited as having more attractive supply/demand characteristics than most others and this shows the benefits of a diversified portfolio where capex options are greater. BHP still expects that this pipeline of projects will generate an average return in excess of 20%, however this is obviously subject to the volatility inherent in commodity price forecasts.
BHP Billiton: Forecast Capital Expenditure, FY16-FY20, %
Orica’s (ORI) half year result was met with some enthusiasm by investors, with the stock gaining 5% over two days. In a difficult market, limiting its net profit decline to just 3% was viewed as a respectable outcome. This was, however, assisted by lower interest and taxation expense, with the company reporting a larger 9% fall in underlying EBIT. The company’s cost cutting/transformation program also helped to limit the damage from the weak trading conditions, delivering $79m in savings for the half.
A pressing issue for ORI is its search for a permanent managing director, a position that was vacated after Ian Smith left the company in March. The longer term problem is the fact that the mining company customer base (coal is its core exposure) is looking to protect earnings by addressing costs. Its primary ammonium nitrate explosives product is faced with surplus capacity. This is not only evident in the Australasian market, but also at a global level (see chart below). The rebalancing of this market is expected to take several years and will limit the group’s ability to achieve pricing growth during this time. Having divested its chemical business (the last of its non-mining exposure) earlier this year, ORI is now also more exposed to the commodity cycle. This difficult outlook is reflected in the group’s forward P/E of 13.5X.
Ammonium Nitrate: Oversupply as % of Demand
One of ORI’s competitors in the ammonium nitrate (AN) market, Incitec Pivot (IPL), also reported half year results. It faces the same challenges as ORI, however there are a few key differences between the two companies. IPL’s AN business has a much larger exposure to the US, where the demand drivers are different to the Australian market. North America’s coal market is largely thermal coal, used in the generation of power plants. This market has been in decline for several years now, with low gas prices encouraging the switch to this alternative energy source. A smaller proportion is used in quarrying and construction markets, which have picked up (although failed to offset the losses from coal) as the US economy has recovered.
Aside from its differences in the AN market, IPL also has a fertiliser division, and earnings here can be quite variable dependent on the demand and volatility in this market. Conditions have currently been relatively favourable, with the diammonium phosphate price rallying in the latter part of 2014. A growth driver for IPL in the medium term is the ammonia plant that the company is constructing in Louisiana in the US. The project is at present 75% complete, with first production expected in the third quarter of 2016. In a sense, the project is somewhat of a hedge to the difficulties that the company is facing in the North American explosives market, caused by low gas prices. Low gas input prices are a competitive advantage for the Louisiana plant, helping the project’s economics. For the time being, the mixed outlook for its products and future potential appear to be reflected in the stock’s premium valuation rating compared to its peers.
CSR is another on the March/September reporting period time frame, with the company posting its full year result. CSR showed improvement across the board, with each of its four divisions growing profitability year-on-year. Building products has benefited from the current boom in domestic housing, although its returns from this division perhaps don’t reflect a cycle nearing its peak (see chart below). Its Veridian glass division was marginally profitable after three consecutive years of losses, while its aluminium business was assisted by better pricing and weakness in the $A. Recent building approvals data remain supportive of CSR extending its recent rally, although the company’s ability to generate a satisfactory return through the cycle is still questionable.
Residential Construction Pipeline
This week’s budget had fewer negative surprises for individual equities compared with previous years. Threats to superannuation and the possibility of a bank deposit tax did not materialise, while the retail sector look to have been the biggest beneficiaries. Consumption and investment by businesses received a boost from the decision to allow immediate deduction of expenses up to $20,000. Increased childcare rebates also resulted in this sector performing relatively well this week. Compared to the austerity theme of 2014, the more positive tone should also be helpful to confidence in the broader economy, which will be a positive for our equity market.