Week Ending 16.10.2015
Another few surveys show that our spirits are lifting into summer. Business confidence picked up, with the expectations of improved government outcomes offsetting the dislocation in financial markets. Unsurprisingly, the financial and property sectors saw some deterioration in confidence in the month, but services in general are outperforming other industries. Labour costs are registering subdued levels, suggesting the fall in wages growth in the past year will be sustained. On the product cost side, there are some signs that the lower AUD is adding to input costs, while not all selling prices are rising, indicating a potential margin squeeze for some industries.
Australia’s labour market data release verified the soft employment conditions, with a fall in the participation rate resulting in a flat unemployment rate of 6.2%. A worrying trend is the persistent low rate of full time employment growth, though total hours worked indicates that part time employees are picking up additional work time. The insecurity and likely lower wages in this segment, however, would restrain major spending decisions.
Australian Full and Part Time Employment Trends
The RBA stepped right into the middle of the fray on housing, clearly stating that ‘the risks surrounding housing and the mortgage market seem higher than average at present’ and specifically noting inner city apartments as oversupplied. Even the commercial sector got a serve, with comments on the divergence in office vacancies compared to valuations in some cities a cause for concern.
In the US, the Fed’s Beige Book, which is a qualitative assessment of business conditions in the 12 Federal Reserve districts, makes frequent reference to ‘modest’ and ‘moderate’. The positive side of the ledger is residential and commercial real estate activity, with particular reference to multi-family homes, healthcare facilities and senior living accommodation. Services such as marketing, logistics and accounting were also in an expansionary phase. On the other hand, energy continues to drag and the higher USD is hurting manufacturing confidence.
Labour markets are noted as ‘generally tightening’, particularly in specific industries – construction, IT and even trucking. This week, the WSJ reported that the shortage of truck drivers has pushed wages in that sector up by 17% since 2013.
US Trucking Industry: Wages and Employment
Payroll data in the US remains a critical measure to signal a possible rate rise. Recent trends have been somewhat softer. However, the Job Opening and Labor Turnover Survey (JOLTS), which gives a better reading of the rate of new jobs available (some of which cannot be easily filled due to skills), and ‘quits rate’, which signals employees’ confidence in finding another job, both suggest a persistence of good labour conditions.
Complicating matters, however, is the very weak CPI print and the sloppy retail sales data. The two are somewhat correlated, with weak price momentum impacting on headline sales. The tricky part is whether the CPI is now lulling at a seasonal low, rolling through the fall in energy costs and taking on board the impact of the rise in the USD. On the other hand, spending on auto, restaurant meals and housing is still solid. As we have frequently noted, services prices remain rock solid, rising 2.7% in the year to September, driven by rental, education and medical care. Inflation is in the eye of the beholder, where the data may significantly misrepresent individual spending patterns. In the US, the cost of occupying a house accounts for 42% of the weight, followed by transport and food at 15% each.
The cumulative inflation in the eight core components of the US CPI are shown below. Medical costs in the US have soared, though have levelled off in recent years. Apparel prices have essentially not increased in 15 years, with a similar outcome in Australia, though have a natural seasonal bias. The most volatile by far is transport, due to fuel prices.
US Inflation by Industry
Flat inflation is a global phenomenon. UK inflation is practically zero, with the Bank of England Chief Economist attracting headlines by suggesting that “if downside risks were to materialise, there may be a need to loosen monetary reins”.
Economists fret about falling inflation expectations. Recent surveys suggest households understand that short term inflation will, to some extent, mean revert, but are also winding down their expectations of longer term inflation; an unhelpful signal. At the end it will come down to wages, without which, inflation is more than likely to remain subdued.
It was only a few years ago that many fretted about the potential for inflation to race out due to monetary easing. The opposite outcome has taken the wind out of that argument and is largely due to the low growth in monetary turnover or the velocity of money; that is, a lot of the additional supply is not chasing up the price of goods and services. An eventual reversion to higher inflation, most likely due to energy, will see this debate reappear and potentially change the colour of investment markets.
Westpac’s (WBC) capital raising was the key news item of the week, as it followed in the path of the other major banks. The $3.5bn raised was hardly a surprise and widely anticipated, with new regulations set out by APRA enforcing the banks to hold additional capital against the residential mortgage books (note that these apply to the four major banks only).
The offer is structured as a 1 for 23 entitlement at a price of $25.50; this represents a 14% discount to the last price adjusted for Westpac’s upcoming final dividend (of which the new shares will not be entitled). Retail shareholders will have the option of taking up their entitlements or selling them on the market from next week. As the chart below shows, the capital that Westpac has raised this year (including $2bn from a DRP and $0.5bn from the partial sale of BT Investment Management) has improved its capital ratio in excess of the increased requirement of APRA’s new rules.
Westpac: CET1 Capital Ratio (%, APRA basis)
Westpac also released its preliminary FY15 results, which were largely in line with the market’s expectations. Cash earnings per share grew by 2% for the year, dividends are up 3%, while its cost to income ratio ticked up somewhat and net interest margins were flat. Loan growth of 7% is approximately in line with credit growth across the economy, although an expected slowdown in investor lending may limit this core driver over the next few years.
In response to its higher capital requirements, Westpac has become the first to move on repricing its owner-occupied lending rates. We have previously noted that the ability of the banks to achieve this would play a large part in their ability to offset the earnings per share and return on equity drag from these higher capital levels. The banks have already made some progress on this front in recent months, increasing the rates on investor loans. This was an obvious starting point given APRA has also been looking to limit the overall growth in this market segment.
It is highly probable that the other banks will follow suit by raising their own mortgage rates now that the precedent has been set by Westpac. The upcoming RBA rates decision in the next few weeks is the obvious time that this may be implemented (should the RBA decide to cut the cash rate further they would not pass it on in full).
What this would mean is that the additional costs on the system imposed by APRA will effectively be passed on to borrowers, thus preserving the net income margin of the banking sector. If this level of repricing were to occur across the sector then the EPS drag from the additional shares raised would be approximately offset and hence give further protection to the high dividend payments of the majors. A downside, however, may be lower overall housing lending, which has been critical for overall credit growth in the economy. We note that, while the current domestic regulatory requirements have now been met by the majors, there remains the possibility that new international Basel IV standards, which are expected to be released in the next six months, may trigger a further round of equity raisings.
Brambles (BXB) released first quarter sales figures, which were on track with the company’s full year guidance despite some recent concerns emerging on global economic growth. In a way, the reported sales growth of -2% is illustrative of the currency challenges facing US companies this reporting season (Brambles reports in $US). On a constant currency basis, however, Brambles reported growth of 8% for the quarter, with new business wins underpinning this performance. We have Brambles in our model portfolios as a reasonably-priced industrial with a good medium term earnings outlook.
AGM season continued this week, with a number of large companies updating the market. Telstra (TLS) reaffirmed its guidance of low single digit growth in EBITDA, although noted the negative impact from a recent ACCC decision that would see a drop in access costs that operators pay to use Telstra’s copper network; a revenue line that was falling for the telco as customers migrate to the NBN.
CSL provided some additional colour to its guidance at its AGM, with its forecasts for the recently acquired Novartis flu business somewhat weaker than expectations. Management, however, reaffirmed its longer term revenue and profit guidance for the business. FY16 is shaping up as a transitory year for the company, with a forecast 5% earnings growth rate in constant currency expected to be weakened by the strength of the $US. The sporadic release of new products (few for CSL this financial year) means that earnings growth is often not as smooth as other industries, while the integration of Novartis will add to the challenges for the year. Nonetheless, we continue to hold a positive view of the stock and its longer term prospects, with a recent pullback in its share price improving the investment case.
Lend Lease (LLC) conducted an investor day, with the company dispelling some investor fears over the settlement risk on its large $5.2bn pipeline of apartment pre-sales (the majority of which is due to settle in the next 3-4 years). In particular, concerns have been raised over the company’s exposure to Chinese investment, which represent 20% of this apartment pre-sales book. With slowing economic growth in China and the potential for additional capital controls to limit outflows from the country, the risks to this investment is somewhat understandable.
Lend Lease noted several points to address these concerns. Firstly, the historic default rate on its apartment projects has been a low 3%. Secondly, it typically will retain a 10-20% deposit on these sales, limiting any losses that would result. Finally, the default incentive is particularly low at present, given the price growth in the housing market as well as favourable currency movements for international investors.
Lend Lease: Apartment Pre-Sales
We have added Lend Lease to our model portfolios this month, with the stock underperforming the market over the last six months on some of the concerns highlighted above. A high level of earnings visibility in the medium term, possible upside from a higher level of infrastructure spend in Australia and an attractive forward P/E of 11X, points to the stock again presenting as an attractive investment opportunity.
One of the market’s more successful mid-cap stocks, Domino’s Pizza (DMP) further expanded its international presence this week when it announced the acquisition of Pizza Spring, an 89 store chain operating in Western France. The acquisition will take its store count in France to approximately 330 and will contribute to the company’s overall target of 3,250 stores by 2025, an approximate doubling from current numbers.
Domino’s is forecasting that the deal will be 4% accretive to earnings per share. With the share price rallying 18% this week since the deal was announced, investors are clearly giving the company significantly more credit than what the expected earnings impact would imply. The Domino’s model has been hugely successful over several years now, with a combination of impressive organic growth, acquisitions, and innovation with its menu and digital ordering system. Its valuation, though, is the major sticking point for investment. A FY16 forward multiple now of 50X looks very rich, even considering a high level of expected earnings growth in the medium term.
Brookfield Infrastructure’s bid for Asciano (AIO) hit a speed hump this week with a release from the ACCC outlining a number of competition issues that could arise from the merger. Brookfield already has an existing presence in Australia, with the manager operating a major coal export terminal in Queensland and a rail network in Western Australia under long-term leases. Combining these with Asciano’s operations would result in a higher level of vertical integration across these networks, potentially leading to a lessening of competition in these markets.
At the very least, the deal, which was expected to be closed by mid-December, will be delayed somewhat. The ACCC expects that it will announce its final decision by 17 December, so that the implementation of the proposed merger would likely be pushed into January. With the stock now trading at an approximate mid-point of its price before the Brookfield approach was announced ($6.65) and the implied offer price ($8.71 based on the current unit price of Brookfield and prevailing exchange rates), the market is indicating only a 50% chance of success. On the balance, competition issues such as these are often resolved with asset disposals that appease the regulator, although those with a more risk-averse outlook may prefer to realise some of their holdings at the current price.
Woodside’s (WPL) quarterly production figures were strong, although its production growth was due to better performance of its existing asset base rather than from new resources. Revenue for the quarter was 45% below the corresponding quarter of last year; reflective of the decline in oil prices since then which will then flow through to Woodside’s final dividend payment.
No news was provided on its development opportunities. The concern remains that its primary development project in its portfolio, the Browse floating LNG project, is likely to face significant economic challenges in the current environment.
It has been speculated in the media this week that Woodside was looking to increase its offer for Oil Search (OSH) after its initial proposal was rejected by the target. We note that such action would be in contrast to the disciplined M&A process that the current management team has been keen to put forward, with the initial offer viewed as dilutive to Woodside shareholders. Oil Search is still our preferred way of participating in the energy sector.
Treasury Wine Estates (TWE) has acquired a number of US and UK brands and assets from Diageo for USD552m, paid for through a 2 for 15 entitlement issue and debt. There is general agreement that the price is a good one (~7X EV/EBITDAS) and that most of the US brands are a good addition to their stable. Diageo clearly used the transaction to exit some less attractive UK brands, most notably the rather unappealing label of Blossom Hill. TWE is expected to save costs through merging its overheads in the US and also potential capital expenditure down the track, as it utilises the combined bottling facilities. Post a messy few years and takeover approaches, TWE is back to making the most of growing wine consumption across Asia, while managing a competitive market in other parts of the world.
Most analysts are forecasting a decent uplift in earnings in FY16 due to this acquisition and 15-20% profit growth in the following year or two. However the forward P/E of 22 times captures this upside in a company that has been troubled by consistent delivery.