Week Ending 15.08.2014
Given the focus on profit results at this time, we will restrict our economic commentary to a few topics rather than present the roll of data out during the week.
In a generally upbeat tone, even bad news can become good news. Weak economic data, such as the low level of wages growth (annual 2.6%, the lowest in nearly 15 years) in Australia, could be considered good for the corporate sector’s capacity to restrain cost increases. Weak US retail sales and inventory data resulted in bond yields edging back and equities rising on the assumption this could potentially delay the interest rate cycle.
In our view, the key will be the labour market, with less emphasis on some of these other measures, which can be prone to seasonal and short term factors - for example, influenced by weather or holidays. One suspects the Fed is watching the unfolding employment pattern, rather than the obsession of financial markets on short term indicators. It is therefore useful to take in what Fed members are saying on this issue, and a recent report from The Federal Reserve of Kansas therefore makes interesting reading.
The extracted chart indicates that, alongside the fall in unemployment, Fed participants are watching the wage rates carefully. If there is any sign of a rise in earnings, this is likely to be an important determinant in a decision to raise interest rates, or at least indicate that they will rise at a predetermined time.Enlarge
The report notes that in the early stages of the recovery, wage rates apparently fall as employers introduce new workers at lower than average wages – they can do both due to labour market slack, as well as the structural effect where existing employees tend to have worked their way up the pay scale over time.
If the chart above runs its course, US interest rates could be firmly on the Fed agenda later this year, assuming employment growth continues at around 200k per month.
An important event is, therefore, the Jackson Hole economic symposium on 21/22 August. Notably, the headline title is ‘Re-evaluating labour market dynamics’. This is not a formal FOMC meeting, but in the past this event has set the agenda for the Fed’s approach to monetary policy decisions.
The flip side is inflation. With US CPI at an underwhelming 1.5%, dovish economists lean towards a restrained Fed, waiting to see tightening labour markets before any interest rate hike is required.
As we are likely to note for months to come, the nature of the interest rate cycle from here can be expected to have the greatest impact on financial markets.
To summarise other relevant news flow, Chinese credit growth for July was well below expectations, with overall loan expansion of 10% compared to 14% over the previous three months. Contributing factors to this were the authorities’ efforts to reign in risky lending and credit used to facilitate capital flows, a seasonal lull, and some payback on recent resilience in data. Chinese growth dynamics will be closely monitored over coming months and more than likely GDP expectations revised down.
Japan produced very weak Q2 GDP, down 1.7% in the quarter. Some blame can be rightly attributed to the rise in consumption tax in April, but in reality there is no clear evidence of a successful restart of this economy. Europe also disappointed, with Germany weakening as export and industrial production fell back. The problems in Eastern Europe are likely to again impact Q3 GDP growth for Europe, given the weight of Germany in the data and the now long-standing underperformance of France.
JB Hi-Fi (JBH) kicked off reporting season on a soft note. Sales growth in the final quarter and new financial year to date (July like for like sales down 5.5%) has been well below expectations. The premise that lower growth in products such as tablets is going to be temporary is difficult to substantiate. It does indicate that JBH is, in good part, dependent on product releases out of its control to pull in customers, who then buy higher margin ancillary products. The outlook for the group hinges on a combination of a general uplift in spending, product launches and the success of its HOME stores. These are conversions of existing stores to a new product assortment of household whitegoods and appliances. We have some reservations on the success of this initiative and note a big jump in working capital which we believe is associated with these stores.
On the positive side, gross margins and cost of doing business have been very well managed. Gross margin for FY14 at 21.7% is marginally below that of three years ago (22.0%), a commendable effort in light of tough trading. Costs as a percentage of sales have crept up a little; no surprise given the sticky rise in rent and wages. In all, JBH’s EBITDA margins came in at 6.5% for the year.
The certainty in the outlook has diminished. Unless there is confidence that retail spending it about to recover, we recommend standing aside. That said, in our view, JBH is a potential retail portfolio stock with a much better track record than most in the sector.
Woolworths (WOW) delivered the unsurprising news that its Masters stores would lose substantially more than originally forecast and would be unlikely to break even until at least 2018. With much fanfare, Woolworths commenced this store format in conjunction with the US retailer, Lowes, to take Bunnings head on. At face value, it has some rationale – Bunnings was making consistently strong comparable sales growth and incremental margin expansion in a product category well attuned to our housing obsession. Second tier players were disjointed and the potential of a fresh new brand, in a product segment WOW otherwise had little to offer, made some sense. The reality has been another salutary lesson on the challenges of competing with an entrenched business in the relatively narrow Australian market.
Sites have proved expensive and hard to come by as WOW rushed into opening as many stores as it could in a short time span to accrue economies of scale. The exact source of the pain is hard to identify. WOW claims cannibalisation, an inauspicious outcome given its relatively small store numbers to date; it believes its range needs refining – for a start-up this is quite normal, but should not result in such substantial operating losses and instead implies it is unsure of its customer proposition; it blames weak consumer sentiment, which Bunnings seems to have overridden. The reality may be that it has little to offer against the incumbent. Good Australian supermarket operations don’t necessarily transfer elsewhere - WOW has only had modest, patchy success in NZ and its discount store, Big W has not escaped the pressure on the sector overall.
WOW has been, for good reason, a commonly held stock in private investor portfolios. While it is unlikely to cause near term grief, we caution against assuming that supermarket profit margins and valuation will be sustained in the longer term. Globally food retail is under a state of flux and the entrenched participants that have assumed customer habits cannot change have come astray. There is some risk this could also happen here.
Domino’s Pizza Enterprises (DMP) is the best performing stock on the ASX200 over the past 12 months, up a heady 107%. Domino’s has 600 outlets in Australia/NZ, 401 in Europe and 320 in Japan. In both Australasia and Europe, 90% are franchised, whereas in the recently acquired Japanese business, 80% are in corporate hands. As DMP beds down this region, it is likely that most will move into franchisees. For the 2014FY the operating performance could hardly be faulted, but at least as impressive is the way management continue to innovate product and are totally on top of marketing though social media, ordering and tracking on line, paying through new platforms and other changes coming through digital trends. Those with more refined culinary habits may gag at the high growth (the company is expecting 20% p.a EBITDA growth over coming 5 years) from a fast food business, but the bigger hurdle to investing is the estimated 33X FY15 P/E. Nonetheless, the company is a rare example of an Australian business which has been able to evolve with the times both in terms of product and technology.
A number of REITs released results. Amongst them, Dexus (DXS) and Goodman Group (GMG) created some commentary with a pickup in property trading activity. In short, the underlying operations for both are relatively sound, arguably a little better on the industrial side for GMG, whereas office demand is still somewhat fragile. Capitalisation rates have continued to tighten and balance sheets are not stretched. The lack of recent interest in these REITs has been due to the acceptable but unexciting distribution yields of around 5-6% and the low growth outlook. These trading activities do add a bit more flavour, yet many would be hesitant to rely on them year in, year out, and they are unlikely to therefore add much to the rating of a stock. In general we are comfortable with the well-known REITs, but take the view their yields are unlikely to narrow further and with low growth, other equity investments are more appealing.
G8 Education’s (GEM) first half result beat expectations, with earnings per share rising by 26%. While GEM’s acquisition strategy is utilising significant capital, the group has still been able to lift its dividends over the past 12 months by over 50% (the company pays a quarterly dividend). GEM has continued to produce solid outcomes from several key indicators, with margins, occupancy levels and costs all moving in the right direction.
Most encouraging from the company’s earnings release was the news that it had acquired a further 25 childcare centres. Importantly, the company’s stated acquisition pricing discipline has returned, with the transaction completed at 4X forward EBIT. GEM had deviated from this discipline earlier this year when it acquired a key competitor, Sterling Early Education Group, however based on subsequent deals, this appears to be opportunistic and one-off in nature.
Although the company’s growth rate should slow as each acquisition is added to a larger asset base (see chart below), the pipeline of opportunity for GEM is still significant given the highly fragmented nature of the market.
G8 is also exposed to regulatory risk, given the significant support from the government that the childcare industry receives. A recent development has been the release of a draft report from the Productivity Commission, providing recommendations for improving the childcare system. While the final report is set to be published in late October, the proposals in the draft appear to be relatively favourable, which include means-testing of various rebates and subsidies that are currently in place. G8 is one of our preferred small cap stock exposures.
G8 Education Portfolio Growth
Carsales.com (CRZ) had a slight miss with its result, with profit growth of 14% for the period. The main issue investors appeared to have with its announcement was a softer margin outlook, particularly as it integrates its recent acquisition of Stratton Finance and the growth in its tyresales business. This is a typical problem faced by companies who look to expand outside of a core business that generates high returns – venturing outside of this core will more than likely result in lower incremental returns (although shareholder value can still be created by doing so).
CRZ’s multiple sources of growth were evident again in FY14, with higher revenue generation through dealers, private sales, display and data services. A considerable proportion of CRZ’s results presentation was dedicated to its various international investments (it has a presence in Latin America, South Korea and South-East Asia), with further clarity on the opportunity available to CRZ and the current profitability in these various businesses. The group’s ability to replicate the success of Seek (SEK) with its international investments will be a key driver to its expected mid-teens EPS growth over the next few years.
Commonwealth Bank’s (CBA) annual result was essentially faultless, however it wasn’t enough to excite investors, reflecting the bank’s premium valuation compared to its peers. On most measures, CBA is outperforming the other majors – it produces a superior return on equity, its top line growth is relatively good, its bad and doubtful debts expense is low, it has shown leadership on the technology front, and its capital position remains sound.
For the full year, CBA’s cash profit rose by 12%. In keeping with the current dividend hungry nature of investors, the group raised its final dividend by 9%. The bank’s operating performance again showed positive ‘jaws’, with income growth of 7% outpacing expense growth of 5%. The contained expense growth looked to be a good outcome, particularly in light of its aggressive policy in writing down its technology investment. The half-on-half figures reveal, however, a slower growth rate in the second half, and the bank will take this momentum into FY15.
While CBA has performed well over an extended period of time now, the outlook for the company still appears to be more challenging. We have highlighted the headwinds that it is likely to face in the medium term, but will restate them here for those who may not be aware:
• Bad and doubtful debts are at cyclical lows (and actually increased slightly for CBA in the 2H)
• Credit growth in the economy remains soft (particularly in business lending) and households already have high levels of debt
• Capital requirements are becoming more onerous, with policy options from the recent Financial System Inquiry Interim Report including an additional capital buffer for the four major banks
CBA arguably has less upside than the other majors given its relative weaker position in business lending (which has greater scope for improvement), it has perhaps less opportunity to cut costs, its dividend yield remains lower and P/E higher.
A soft revenue trend was also confirmed by ANZ when it released its third quarter trading update, with the group guiding towards full year revenue at the lower end of its range. The market interpreted an 8% rise in profitability for the nine months as marginally negative. Another factor important in driving the banking sector’s profitability – net interest margin – was slightly lower. Put simply, funding costs, whether they be from the wholesale market or retail deposits, have been trending down (investors may have noticed term deposit rates falling despite no change to the cash rate). These savings, however, have been largely passed on to the bank’s customers, as well as the changed mix in lending to lower margin mortgages.
Suncorp (SUN) surprised with a 30c special dividend. Combined with the interim and final dividend payments, SUN shareholders have received a 40% increase in dividend income over the last 12 months. SUN is making good progress on its strategy to de-risk and simplify its business. The company is forecasting further benefits to be recognised from this program over the next two years, extending the forecast positive impact that it will generate to $265m in FY16.
SUN is more of an insurance business with a bank attached, and hence its fortunes should be more closely tied to that of the more volatile insurance industry. As recently foreshadowed by its key competitor in the general insurance space in Australia, its result in this division was strong, assisted by a lower claims experience (see chart below). Its underlying insurance trading ratio rose to 14.3%, keeping in line with an improving trend and a marked improvement on the sub-10% it recorded four years ago. Investment income on its insurance funds was higher – despite a low yield environment, gains from a narrowing of credit spreads more than offset this impact.
We have recently downweighted SUN in our model portfolios. The stock remains an attractive story, with better performance expected over the next two years. We have come to this conclusion following recent share price strength and an insurance division moving closer towards the peak of the cycle.
Suncorp - General Insurance Claims
While Crown’s (CWN) profit growth is being driven by its investment in Macau through Melco Crown (MPEL), it was its Australian casinos which provided the upside surprise in the second half of the financial year. After CWN’s first half result showed that its VIP revenue at its Australian casinos was down 26%, solely attributable to a poor result at Crown Melbourne, there were some concerns its Australian growth was questionable. For the full year, however, this decline was just 2%, indicating a significant turnaround in the last six months, and perhaps highlighting the sometimes volatile nature of this earnings stream.
All up, CWN’s casinos (ex-MPEL) produced a 3% increase in EBIT. This refers to its ‘normalised’ result, which effectively takes out the volatility that can arise from CWN or its customers reporting better than expected win rates. In FY14, this was much more in CWN’s favour (i.e. gamblers lost more than would be expected given their turnover), which added an additional $96m to its EBIT line.
The MPEL result is the most important in CWN’s figures, as this is exposed to the high growth market of Macau compared to the more mature domestic industry. MPEL’s profit almost doubled in FY14, and was the key reason for CWN’s overall profit growth of 35%.
Recent weakness in the Macau market has also been the main reason for a decline in CWN’s share price over the last few months and has been the catalyst for several analysts to downgrade their expectations for the region. Earlier this year, the Chinese government’s crackdown on corruption was primarily responsible for weakness in the high roller market, however July’s gaming data has shown that this has extended somewhat to the mass market, with a growth rate of 16% year on year. The mass market is the key for MPEL, as it is higher margin revenue and its City of Dream casino occupies a strong market position. Despite the downgraded forecasts, growth in the mass market is still expected to remain in the mid-teens in the medium term. While we have recently downweighted CWN in our model portfolio, we believe that the stock still represents good value in a market that is reasonably fully valued.
Echo Entertainment (EGP) is another stock in the gaming sector, however its current market outlook and position are starkly different to that of CWN. The EGP investment case is more about a turnaround at its underperforming domestic casinos. The company is starting to see the benefits of a significant capex investment program, which was particularly evident in the second half of the financial year at its Star casino in Sydney. In the short to medium term, EGP could receive good investor support should these trends continue, however longer term its outlook is more difficult, with casino competition increasing in Sydney (CWN’s Barangaroo development) and Brisbane (which is yet to be awarded).
Telstra’s (TLS) result was boosted by one-off gains on asset sales, including its stake in the Hong Kong mobile business CSL (not to be confused with ASX-listed healthcare stock CSL). As a result, the headline 9.5% growth in EBITDA was reduced to 4.7% growth on an underlying basis, in line with the group’s forecast for ‘low single digit growth’. With a higher cash balance post these asset sales, TLS decided to conduct an off-market share buyback of $1bn – the size of the buyback (compared to TLS’s ~$70bn market capitalisation) combined with the stock’s relatively high P/E ratio means that earnings per share accretion that shareholders will enjoy will be limited.
The outlook for TLS remains challenging. Mobiles, which has been the key driver of earnings growth in recent years, has largely grown from market share gains – while in part this has been a reflection of the superior mobile network of TLS, it has also been a function of poor execution by its key competitors, Optus and Vodafone. With effectively no growth in total mobile subscribers in Australia in the last 18 months, it is difficult to see TLS maintaining this momentum through the next few years, given recent evidence that competition is starting to intensify and with TLS’s market share sitting at a high 50%.
Of the group’s other divisions, revenue from fixed products fell 1%, with a 6% increase in broadband offset by a 7% drop in fixed voice. One of the problems that TLS faces is that fixed voice is amongst its highest margin businesses, and this is being replaced with earnings growth from lower-margin mobiles. Network Applications and Services (servicing large businesses and government) recorded good growth (boosted by a large contract win), but remains a much smaller part of the overall business. The chart below outlines the revenue change across TLS’s businesses:
Telstra: FY14 Revenue Growth by Division
TLS is an underweight in our model portfolios. The stock now trades on a forward multiple of around 17X and with a muted earnings outlook, we believe that there are better options available in the industrials sector of the market.
CSL has a history of exceeding its earnings guidance and the company again delivered in FY14. While 8% profit growth in constant currency was only slightly above its 7% guidance, this included a litigation settlement in the US, hence its underlying growth was 11%. Despite a reasonably competitive environment developing in the plasma industry, CSL was able to outpace the growth of its competitors as well as growing its margins. The company is guiding towards 12% profit growth in FY15.
We believe that CSL should be a core stock in an Australian equity portfolio and we recently took advantage of some weakness in its share price to increase its weighting in our model portfolios. Continuous product development, a long track record of successful performance, ongoing capital management, a strong market position and robust underlying demand growth all amount to a solid investment proposition.
Next week’s reporting schedule:
Monday: AAD, ANN, AZJ, NAB, NCM, SGP
Tuesday: AMC, ARI, BHP, CDD, GWA, IAG, IOF, IVC, MND, OSH, QBE, SHL, TOL
Wednesday: AGK, APA, BXB, CCL, CQR, FBU, FMG, SEK, SRX, TME, TRS, WES, WPL
Thursday: AIO, AMP, ASX, AWC, BRG, CAB, CFX, IIN, IRE, MGR, ORG, PNA, SAI, SGP, SUL, SYD, TPI, TTS, TWE
Friday: DUE, FDC, IFL, ILU, QUB, SGM, STO, TEL