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WEEKEND LADDER

A summary of the week’s results

16.02.2018

Week Ending 16.02.2018

Eco Blog

The much-anticipated US CPI duly delivered slightly higher headline and core rises for January. A 2.1% annual inflation rate translates into 1.8% core (excluding food and energy), taking the CPI to around its average of the past three years.

US Consumer Price Index

Source: US Bureau of Labor/Haver Analytics
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There is little question that aggregate price inflation has lifted somewhat from the usually low levels of 2016 and 2017. Yet, there is also no evidence that this is due to the strength in the economy or from higher wages. This month, apparel prices jumped 1.7%, vehicle insurance prices rose by 1.3% in January and 8.7% year-on-year, while medical service charges rose more than expected. 

Monthly numbers may well jump around a little, cycling one off factors of 2107, such as the incapacity of the CPI to adapt to unlimited data plans for communication services. The trend is, however, clear that inflation is confirmed at around 2%, supported by a relatively strong producer price index release. These suggest that the CPI may move up to around 2.3-2.4% in coming months.

So far, therefore, the Fed rate rises are being confirmed, rather than changed. Markets therefore took this data in its stride, with spirits somewhat dampened by weak retail sales, probably due to the extreme weather on the east coast early in the month.

· Evidence tthat the sell-off in equities is due to wage growth has yet to find support. Nonetheless, there is no question that the regime of the past ten years has changed with rising interest rates the main determinant of investment positioning.

A somewhat weaker Australian January employment growth does not detract from the improvement in labour conditions that has been a feature of 2017. While employment rose by 16k, full time jobs are reported to have declined by 50k, offset by a sharp rise in part time work. A logical argument for this shift is attributed to seasonal factors, where employees with variable hours fall into the part time category over the holiday season. With female participation in the labour market the main contributor to the decent jobs growth, it is unsurprising that this pattern is emerging.

Australian Employment: Participation

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One of the main contributors has been the roll out of the National Disability Insurance Scheme. Approximately 100k jobs have been added to the health sector, where females represent 80% of the workforce. It reinforces a long-term trend in rising female participation that can be explained by a wide number of issues – educational achievement, delayed childbirth, tax incentives and availability of childcare. Of note is the rise in older female workers, with the participation of woman aged 55-64 doubling in the past two decades. The offset has been variable male participation. There was a notable fall as the mining boom ended and, even now, younger males have not returned to previous levels. Some ascribe this to longer education (gap years?) as well as higher share of disabled workers.

· Domestic conditions are relatively stable. However, household income growth appears to be some way off improving.

Lurking in the background is global trade tensions.  The US still seems intent on narrowing its trade gap, notwithstanding the fiscal stimulus that has already been unleased. Discussion on NAFTA centres on the large trade surplus that both Canada and Mexico enjoy with the US in goods, while the US exports a significant amount of agricultural products to these two countries. The Mexican election (1 July) may also play a role, given the possibility of a populist leading. To add to this mix is a growing view the US administration is intent on wide sanctions against China, particularly in intellectual property and the IT supply chain.

Large global trade imbalances are not sustainable. But if they are politized (for example over the US mid-term elections) rather than negotiated in the interests of growing rather than diminishing trade, this could be a major destabilising influence on the current cycle. While it may not be directly related, the fact that the US is about to increase its issuance of Treasuries, the risk is that those countries that buy US dollars decide to turn elsewhere would only add to tensions.

· If there were to be a destabilising trade battle, equities are highly likely to come under considerable pressure. It will not be isolated to the affected regions.

Fixed Income Update

Strong CPI data in the US has turned the spread differential between US and Australian 10-year bond yields negatives.

- The use of derivatives to hedge credit exposures and limited new issuance are said to have dampened the volatility on cash credit bonds in February.

Bond yields rose sharply in the US this week following stronger than expected inflation data. The yield curve shifted upward, pricing in more Fed rate hikes for 2019. This is the latest catalyst in what has been a weak start to the year for US bonds. Prior to the CPI data, markets have been responding to a combination of tax reforms, fiscal stimulus, near full employment, Fed balance sheet reductions and expected rate rises.  With inflationary pressures now also building, the yield on the US 10 year bond has risen above the Australian equivalent for the first time in 18 years.

The Australian sovereign has a higher credit rating than the US (AAA vs AA), which, in theory, might imply that rates should be lower in Australia than the US given the similar cash rate in the two regions. However, with persistently low inflation domestically and the gap widening in growth between the US and Australia, the consensus is of the view that the RBA won’t be increasing rates until at least November this year. Yields are driven by interest rate forecasts and economic conditions, with inflation playing a significant role in the pricing of long dated bonds.

Australian and US 10 Year Government Bond Yield

Source: Bloomberg, Escala Partners
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Given the often-positive equity-credit correlation, one might expect heightened volatility in credit markets, as was the case in equities in early February. Despite a ‘risk off’ sentiment in markets, credit held up well and investment grade (IG) cash bonds have experienced only a modest widening in spreads since the beginning of the year. One observation is that valuations have been supported by a favourable supply and demand dynamic. Supply of non-financials has been low into 2018, and spreads tend to perform in periods of low supply. By way of example, net issuance of USD investment grade bonds was at $US75bn for of January compared to $136bn last year.

Another theory is that market participants will instead use index derivatives to add protective hedges to portfolios, rather than undertake the physical sale of bonds. By accessing the credit default swap market (using the CDX index), participants can effectively add or subtract credit exposure by buying (reducing credit exposure) or selling (taking on credit exposure) the index. The use of these derivatives is quicker and more liquid than trading bonds. To this point there was a sharper move in the IG Credit Default Swap (CDX index) and the High Yield CDX index when equities sold off.

US Investment Grade CDX Index

Source: Escala Partners, Bloomberg
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Similarly, our internal fixed income trading desk noted some illiquidity this week when trading GBP denominated investment grade bonds. While there was no noticeable mark down in the price, there was a greater lag time to find a buyer and execute on the trade. This is not uncommon during periods of ‘risk off’.  Following the strong CPI print in the US, spreads on investment grade have tightened slightly in response to the generally positive tone across investment assets.

Corporate Comments

Boral’s (BLD) half yearly report was weak, although the company is confident of a turnaround in the second half amid several tailwinds. 

Transurban (TCL) consistent distribution growth continued despite below-trend traffic numbers on CityLink from its expansion. The interest rate outlook remains key to its equity performance. 

- Rising raw material prices were a drag for Amcor’s (AMC) margins, although an eventual pass through to customers is anticipated. 

CSL reported another solid result, with full year guidance appearing to be quite conservative. 

Telstra’s (TLS) core business declined again, leaning on nbn connection receipts to support its profit and dividend.  

Origin’s (ORG) recovery continued on much better earnings in both of its divisions, with the company remaining a deleveraging story. 

- Domestic insurers IAG and Suncorp (SUN) had mixed results. On the positive side, the outlook for the domestic market is picking up. 

Star Entertainment (SGR) low margin high roller business underpinned its earnings growth, with the benefits of main gaming floor capex spend also realised. 

- JB Hi-Fi (JBH) had a solid Christmas trading period. Its margin evolution is critical to its earnings profile from here.

Boral (BLD) produced a slightly disappointing first half result, meeting expectations thanks to a lower-than-expected tax rate. Despite the miss at an operational level, there were several positives in BLD’s announcement.

The performance in the group’s Australian business was particularly strong, given favourable weather conditions and accelerating levels of infrastructure work that more than offsetting a softer housing market. A further positive was the progress on the synergies delivered from its acquired Headwaters business in the US, with BLD on track to exceed its FY18 target of US$35m.

Boral: Headwaters Synergies

Source: Boral
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The key disappointment was the earnings in its North American business, which was expected to reflect buoyant market conditions. While some of the issues were outside of BLD’s control (such as the impact of hurricanes and wildfires), earnings were also held back by poor plant operational issues.

BLD has implied that these are likely to be one-off in nature and a lift in its guidance is supportive of this view, although investors are placing their faith in management delivering on a much better second half. Confidence is supported by growth in the US housing market (with faster growth in detached housing as opposed to apartments, a positive for BLD), along with a pick up in renovations activity (reflecting the rise in house prices). Domestically, the infrastructure pipeline will be strong in the medium term, while US tax cuts and infrastructure spend announcements are also incrementally positive.

BLD currently trades on a forward P/E of 17X (broadly in line with the industrials sector), with forecast EPS growth of 16% p.a. over FY17 to FY20. Notwithstanding the cyclicality of its business, we believe that it is one of the more attractively priced growth companies among large caps in the Australian market.

Transurban (TCL) reported a solid half year, with a 12% rise in EBITDA, while distribution guidance for the full year was unchanged at 56c (representing 9% growth). The result was impressive given the disruption caused by its project to widen the Tullamarine Freeway, which led to a 1% fall in traffic for CityLink. Despite this, TCL’s Melbourne network had the highest earnings growth in its Australian portfolio. Revenue rose 14% on the back of an increase in the toll multiplier applied to trucks, providing evidence of TCL’s ability to extract positive concessions for upgrades to its existing roads.

Having recently completed a capital raising to fund its share of the West Gate Tunnel Project, there was no new announcements from TCL on its strategy or pipeline of opportunities. TCL remains a core income security for Australian equity portfolios (we note that Martin Currie and Investors Mutual both hold the stock), with an excellent track record of growing its dividend on the back of inbuilt toll escalation and the execution of attractive expansion projects.

While TCL has better inflation protection than other real assets, rising interest rates are still the key risk for the stock (and are the primary reason for the underperformance of TCL and other interest rate sensitive stocks over the last two months) given the high levels of debt that these companies carry and the relative yield of the assets compared with fixed income products. TCL has little in the way of debt refinancing for the remainder of this financial year, however this rises sequentially over FY19-FY21. It is likely that refinancing this debt will be at a higher cost, which could begin to impact TCL’s distribution growth.

Transurban: Debt Maturity Profile ($m)

Source: Transurban, Escala Partners
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Amcor (AMC) was largely unchanged following its earnings result despite softening its outlook statement. Constant currency earnings growth for the half year was 4%, while the company raised its dividend by 8%. The result was commendable considering a modest decline in revenue for the six months.

A few key issues emerged from AMC’s result, some of which appear to be transitory as opposed to structural problems. The first is the rise in raw material costs, such as resin and aluminium. AMC typically passes these onto its customers, albeit with a lag (which is more extended in its emerging markets geographies) indicating a margin catch-up in coming periods. This alone was an approximate 5% drag on earnings for the half. A secondary issue was the weak sales performance from one of its key North American customers and a turnaround here carries less certainty.

AMC’s result highlights that, while it is exposed to offshore markets that are typically growing faster than Australia, it perhaps lags the cyclical leverage that other companies are likely to be enjoying to the recent synchronised economic upswing. The stock remains a solid, core defensive holding with a disciplined capital allocation track record over time; characteristics that see it held in the Investors Mutual Core SMA.

CSL’s half year result was one of the most impressive this week, with a 31% uplift in earnings (on a constant currency basis) and a 23% increase in its dividend, leading to earnings upgrades across the board. The result was delivered amid a strong plasma industry demand environment (and additionally so given it was cycling a tough comp), with CSL able to make the most of the conditions from its prior investment in collection centres. A positive sales mix was a further driver, with recently introduced higher-margin products increasing the group’s margin to its highest point in the last few years. Finally, CSL’s acquired flu vaccine business also performed better than expectations, lifting the unit to profitability for the half.

CSL Margin Growth

Source: CSL
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Despite the robust six months, CSL raised its full year guidance by a relatively modest 4%. While the company pointed to higher expenses in the second half (including research and development) which has led to margin variability in the past, at face value the new range appears conservative but in keeping with its guidance history. CSL has already achieved two thirds of its full year profit target in the first half, its flu vaccine business is expected to be supported by one of the worst seasons on record in the US and its core business is likely to remain similarly strong.

As with much of the healthcare sector, CSL trades on a high multiple of around 30X which has expanded in the last 12 months in the domestic rotation back into growth stocks. On absolute measure it thus screens as quite expensive. However, relative to its peers and factoring in its sound history of value creation and earnings outlook (~15% EPS growth p.a. over the next three years), it continues to be one of the higher quality large cap stocks in the market and a core holding for many equity portfolios.

There was sufficient material for the bulls and the bears in Telstra’s (TLS) result, with no change in the company’s guidance for the full year. The positives included a half year dividend that was in line with the company’s lowered guidance (from last August), additional growth in mobile subscribers and a good result in its cloud and network services business. TLS is now also cutting into its cost base aggressively, with a 7% reduction in the six months. Overall, this led to a rise in underlying earnings of 9% for the half.

However, the bears would note that the result illustrated the challenges that TLS faces. Earnings were supported by an increase in the one-off nbn receipts that the company is receiving; excluding this impact, core EBITDA fell a further 8%. This also has implications for the long-term viability of its dividend; the 11c declared in the half included a 3.5c ‘special’ dividend from its one-off nbn receipts (which will not continue beyond the next few years) and the recommencement of a dividend reinvestment plan gives further credence to this view. Notably, the company has, to date, only absorbed $870m of the $3bn earnings gap that the nbn has created.

Telstra: EBITDA Change

Source: Telstra
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Despite growing mobile subscribers, TLS has recently ceded market share to Optus, while monthly pricing plans are falling in a competitive market, crimping margins. The trends support the contention that the growth in mobile data downloads is not flowing through to additional profitability for mobile carriers.

Finally, TLS recently announced a $273m asset writedown to zero value on a US video analytics business that it initially bought in 2012. While this did not restrict the company from declaring its expected dividend, it shows the less certain nature of the investments it is making to cover its earnings lost to the nbn.

Some investors have become incrementally more positive on TLS in the last several months on an attractive valuation (on 10X forward earnings), rebased dividend and what is viewed as a large cost out opportunity, which may be larger than the $1.5bn it has targeted over the next few years. We have a relatively negative view on the stock given the headwinds that it faces while recognising that if it is able sustain its dividends it has appeal from an income point of view.

Origin Energy’s (ORG) half yearly report showed similar drivers to AGL Energy of last week on its vertically integrated energy business, however the real boost was provided by its interest in the APLNG project. APLNG had a full six months of production with the second train in operation and enjoyed the benefit of better pricing (which is linked to the oil price). Production has been consistently above the operational nameplate of the project since it was commissioned, allowing additional gas volumes to be sold into the domestic spot market. With APLNG a relatively high cost operation (operating breakeven is estimated at US$27/boe and US$45/boe including project financing repayments), the leverage to earnings from small changes in the oil prices is material. While it is profitable in the current oil price environment, the company is working on reducing operating and capex costs to help the operation remain cashflow positive through the cycle.

Origin Energy: Gas Supply

Source: Origin Energy
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As with AGL, ORG noted the pickup in competitive behaviour on the retail side of its energy business. Average ‘cost to serve’ rose in the half with higher spend on sales and marketing in an effort to retain market share. The large energy retailers have recently been turning to improving the customer experience via digital investment in online tools, although it remains to be seen how much emphasis customers will place on this compared to pricing structures. While churn rates to other retailers are below that of the rest of the market, the expense base should continue to be elevated with reduced margins.

ORG first half earnings was strong and it provided a slight upgrade to its full year guidance from its energy markets business. What was lacking, however, was any dividend payment, reflecting the high debt levels it has carried through its recent period of investment and subsequent balance sheet deterioration as the oil price dropped. A sustained high oil price will help to accelerate the balance sheet repair it is undertaking (which has also been assisted by asset sales) and the recommencement of dividends, although this may still be 12 months away. On a reasonably modest valuation, we note the stock is held in the IML Australian Share SMA.

The domestic listed insurance companies (which are key positions in our Australian equity SMAs) had mixed fortunes upon reporting this week, confirming IAG’s high P/E premium relative to Suncorp (SUN). IAG reported a 33% increase in EPS, with an 8% lift in dividends, in a sign that the insurance cycle is beginning to improve. Like-for-like premium growth of 4% was better than recent trends and reflected better pricing outcomes to counter claims inflation, underlying insurance margins picked up in the half and natural perils came in below the group’s reinsured allowance.

While the result was strong, the fact that it was also influenced by more cyclical factors tempered the more bullish view of the stock. Part of the margin uplift was due to an elevated level of reserve releases (which could potentially be sustained in the medium term) and tightening credit spreads. Nonetheless, the momentum in the business is sound and there is the prospect of further capital returns in coming years, although this appears to be fairly reflected in its valuation.

IAG: P/E Premium to Suncorp

Source: Bloomberg, Escala Partners
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Meanwhile, bancassurer SUN’s result was softer and missed expectations. The key factors included higher natural hazards costs and those incurred in implementing its ‘business improvement program’, with the benefits yet to be realised from these cost out initiatives. Earnings from its banking division were slightly lower, with the key takeaways being good lending growth, a lift in net interest margins, offset by a rise in bad debts off record lows.

Given its recent poor track record, there is some scepticism around SUN’s ability to improve its insurance margin. However, there is a view emerging that it now represents better value with the cycle improving (as it is exposed to the same positive trends in the Australian general insurance market) and cost out still to come through. SUN itself is quite optimistic of its outlook, predicting a “significant uplift in performance in FY19 and FY20”.

Casino operator Star Entertainment (SGR) retreated slightly after reporting a 12% rise in normalised earnings for the half (i.e. after adjusting to normal win rates). The highlight was the rebound in its high roller business, with Sydney VIP turnover growth of 57%. The business and broader industry had previously been impacted following the arrest of Crown employees in China and while SGR had performed better than most of its domestic peers, the growth in the half surprised to the upside. SGR has worked to reduce its reliance on the China market in this area given its susceptibility to policy changes; to date the strategy has been effective.

Star: International High Roller Front Money ($m)

Source: Star Entertainment
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SGR’s high roller business was the primary driver of the group’s revenue beat, however the translation to earnings was not as significant due to its lower margins compared with its main gaming floor operations. Additionally, the casino’s win rate against high rollers was particularly low, dragging on reported earnings, although this is typically volatile from year to year. Main gaming floor revenue expanded at both its Sydney (+4%) and Queensland (+9%) casinos, with an improvement following recent refurbishment capital works undertaken.

Of some concern was SGR’s update on its trading conditions, which were described as ‘mixed’. However, the variability of trading due to the timing of the Lunar New Year typically makes comparisons difficult to extrapolate. We have the stock in our model equity portfolio with it offering respectable earnings growth, a valuation in line with the industrials sector, a quality asset base and growth linked to the key tourism centres of Australia.

JB Hi-Fi’s (JBH) first half results confirmed the reports of a robust Christmas trading period with 10% comparable sales growth in its key division, helping the company to increase its dividend by 19%. Investors, however, instead focused on several issues that have emerged, with the stock unwinding some of its sharp run up since late last year. This included guidance that fell short of expectations, weak trends at its acquired Good Guys business and a softening in gross margins in its core Australian division.

While the Good Guys is a work in progress and it remains to be seen whether JBH can succeed in this category, much of the post-result analysis homed in on the margin outlook for its JB Hi-Fi stores. Its sales mix played a part in lower gross margins (a higher proportion of low-margin hardware as opposed to software sales), however, more importantly, the company alluded to becoming proactive in preparing for Amazon’s entry through more competitive pricing.

This impact is now largely understood, with the key differences in its earnings profile from here revolving around the extent of price deflation across key categories. Helping it fend off the Amazon challenge is its competitive advantage of a low cost of doing business (relative to other local retailers), which could see it take market share if competitors fall over. While we are cognisant of the risks to the outlook, we believe this is fairly reflected in a forward P/E of 12.5X and a dividend yield of above 5%. JBH is held in the Martin Currie SMA along with the model Escala Australian equity portfolio.

Next week in reporting season is another busy schedule, with the following companies scheduled to release results:

Monday: Invocare (IVC), Domain Group (DHG), Brambles (BXB), Seek (SEK)

Tuesday: BHP Billiton (BHP), Seven West Media (SWM), G8 Education (GEM), Oil Search (OSH), Monadelphous (MND), Super Retail (SUL), Vocus Group (VOC), Bapcor (BAP)

Wednesday: Fletcher Building (FBU), Fortescue Metals (FMG), WorleyParsons (WOR), Coca-Cola Amatil (CCL), Scentre Group (SCG), Fairfax (FXJ), Santos (STO), LendLease (LLC), Wesfarmers (WES), Sydney Airport (SYD), Downer EDI (DOW), Pact Group (PGH), Independence Group (IGO)

Thursday: OZ Minerals (OZL), Bega Cheese (BGA), Qantas (QAN), Perpetual (PPT), Flight Centre (FLT), Crown Resorts (CWN), Nine Entertainment (NEC), Link Administration (LNK), Webjet (WEB), Westfield (WFD), Platinum Asset Management (PTM)

Friday: Woolworths (WOW), Mayne Pharma (MYX), Retail Food Group (RFG)






 

 


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