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WEEKEND LADDER

A summary of the week’s results

16.12.2016

Week Ending 16.12.2016

Eco Blog

-  The Fed has lifted interest rates for the just the second time in the current cycle and is now forecasting an additional three hikes in 2017.

-  The unemployment rate in Australia rose in November, although an increase in full time jobs was positive.

-  The NAB Business Survey revealed ongoing softness in business conditions over November, however confidence has remained resilient.

With this week’s interest rate hike by the Federal Reserve viewed as an all but certain outcome leading into the event, all focus was on the forecast path of expected hikes in coming years as illustrated by the ‘dot plots’, which represent the individual projections of all Fed members (without identifying individual members). To this end, Fed members have become more hawkish over the last few months and the median forecast for 2017 is now for three hikes instead of two.

This represents a turnaround from the more recent trend over the last few years of higher expectations being reduced. Through this time, markets had taken a less constructive view on the pace of rate hikes (as illustrated below by the futures line). While this remains the case, the gap between the two has narrowed over the last few months with futures expectations also lifting meaning that both are now closer to the same page.

FOMC: Change in Dot Plots

Source: FOMC, Bloomberg, Escala Partners
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While the dots were raised, there were only modest changes made to the Fed’s economic forecasts. All, however, were consistent with the Fed’s changing stance, including an edge up in GDP growth and inflation expectations and a further decline in the unemployment rate. Notably, chair Yellen’s comments about the labour market approaching full employment with limited slack in itself could be sufficient to explain a more aggressive rate hike path.

A large swing factor for 2017 is expected to be the fiscal policies of the new Trump administration. At this stage, any proposed policy is largely speculative in nature and thus is yet to be incorporated into the Fed’s thinking. A large fiscal stimulus package would likely trigger a faster pace of rate hikes by the Fed, acting as a handbrake on the effectiveness of such a policy. Conversely, the introduction of the tariffs threatened by Trump would have the opposite effect. In the short term, the developments this week give further fuel to the current momentum in themes across investment markets – a stronger US dollar and upward pressure on interest rates.

Domestic economic data this week was mixed. While the headline unemployment rate ticked up to 5.7% in November, the composition of the data was much more encouraging. With an increase in the participation rate the primary reason for the rise in unemployment, jobs growth in the month was stronger than expectations. In addition, the increase was entirely in full time jobs, with 39,300 jobs created in the month, while part time employment was flat and measures of underemployment also fell. The figures give additional support to the notion that the decline in 3Q GDP will prove to be a blip.

While full time employment has now recorded two strong months, this has followed a sharp fall in September and is counter to the longer term growth of part time work at the expense of full time. This has been a key factor in contributing to the weak inflationary outcomes experienced in Australia. While the participation rate rose in November, this is also counter to a structural issue of lower participation as the population ages.

Australian Employment Market: Participation Rate

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Meanwhile, NAB business conditions were weaker in November, falling to the lowest level since early last year and continuing the trend of recent months. Most indicators were softer, including employment, profitability and trading conditions. Despite the weaker conditions, confidence has been fairly resilient over this time and remains at its approximate long run average. The chart below shows the contrast across various industries. An improvement in mining conditions over 2016 has now left the industry in a position that is less worse than before, while a number of services industries and retail are showing signs of easing; the latter a concern as we enter the Christmas trading period.

Source: NAB
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Fixed Income Update

-  Global bond yields rallied again (prices fall) on the back of hawkish comments by Fed chair Janet Yellen following the FOMC meeting.

-  Reduced demand for US treasuries from offshore buyers since July this year.

-  Australian listed hybrid securities have performed well, with the spotlight on the recent ANZ deal

The hawkish tone of Janet Yellen was unexpected and moved bond markets, as prices adjusted to reflect the likelihood of three more rate rises in the US next year, and a further three more in 2018. Yields on US treasuries jumped (the chart below illustrates the movement in the yield curve following the FOMC statement). In percentage terms, the move was mostly felt in the belly of the curve, which is maturities of 2-5 years.  US 2 year treasury yields rose to their highest level in two years. The Australian market also responded to the move with domestic yields rising across the curve.

US Yield Curve: Change after FOMC Meeting

Source: Escala Partners, Bloomberg
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An additional factor contributing to the downward pressure on US treasuries has been reduced demand from foreign central banks. The four biggest owners of US treasuries are China, Japan, Saudi Arabia and Belgium, who collectively owned ~43% of the market in July this year. Each of these countries have been reducing their holdings for varied reasons:

-  China to defend its currency

-  Japan has been swapping treasuries into cash and T-bills

-  Saudia Arabia has been a seller of treasuries to fund its budget deficit following the decline in oil prices

-  Belgium acts on behalf of other countries, and speculation is that it has been selling on behalf of China

Reduced offshore demand, rising rates and increased supply to fund the proposed infrastructure spend of the new US government could see a further lift in yields as we head into 2017.

While most long-dated fixed rate bonds are expected to have headwinds over the next few years, some market participants are suggesting buying 10-year German bunds as a bet on a break-up of the Eurozone.  At a current yield of 0.3% p.a. for 10 years, the trade is relying on significant capital appreciation if this event was to occur. The logic is that a German single currency and debt would appreciate, given its strong relative economy compared to the rest of Europe.

Australian listed subordinated and hybrid securities have continued to perform well in current market conditions. These floating rate assets are an attractive alternative to fixed rate product and money has been flowing into the market over the last few weeks. On Thursday, ANZPA securities officially matured, although many holders had already rolled into ANZ’s new longer replacement deal in September. The new security started trading two months ago (despite the December maturity of the existing deal) and has rallied strongly since inception. ANZPG securities, which were issued at $100, are now trading above $104.

ANZPG Securities Since Listing

Source: Escala Partners, Bloomberg
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Corporate Comments

-  Tatts (TTS) received a competing takeover offer from a consortium that includes Macquarie and private equity. While the bid includes a cash consideration for the group’s lotteries division, there is less certainty over the value of the residual gaming and wagering operations.  

-  The two large outdoor media stocks, APO Outdoor (APO) and oOh!media (OML) have agreed to a merger. 

-  Santos (STO) has come back to the market to raise additional equity in what appears to be at an opportune time following the recent OPEC deal. 

-  Crown Resorts (CWN) has abandoned plans to demerge its international assets and has instead sold down a little over half of its stake in Melco Crown.

It was a busy week in corporate activity, with several M&A deals in the news.

After agreeing to a merger deal with Tabcorp (TAH) several weeks ago, this week Tatts (TTS) become the subject of a bidding war, with a consortium that includes Macquarie and private equity group KKR putting forward a takeover proposal. The consortium’s interest is in TTS’s core lotteries business, which it is prepared to pay $3.40 in cash per share. Under the proposal, TTS’s other businesses, being its smaller wagering and gaming divisions, would then be either spun out into a separate listed entity or sold to another party (most likely another wagering operator) that could realise the substantial synergies that TAH and TTS have identified. TTS’s lotteries assets are viewed as attractive in their own right due to their defensive characteristics and long-term monopoly licences, leading to predictable recurring revenues.

The consortium’s offer has some appeal considering that it would not be subject to the same ACCC scrutiny that the currently tabled TAH offer will. However, the full value realisation for TTS shareholders would be dependent on the consortium finding a party that would be willing to pay a premium for these assets. As a result, the consortium has estimated a value for the TTS gaming and wagering business at $1.00 per share as a standalone business and up to $1.60 per share if it were to be acquired by a strategic party (which may indeed end up being TAH).

Notably, the consortium’s estimates of the gaming and wagering business may prove to be somewhat optimistic. As a standalone business, the estimate has assumed a forward EV/EBITDA multiple of 11.7x, a healthy premium to TAH’s current and historic multiple (illustrated in the chart below). Given the underperforming nature of this division compared with the TAH business, a strong case could be made that it should trade at a discount to TAH.

Tabcorp: Forward EV/EBITDA Multiple

Source: Bloomberg, Escala Partners
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As such, while there is a potentially a considerable premium associated with the consortium’s proposal, the fact that there is a large unknown (being the range of valuation outcomes for gaming and wagering) may lead the TTS board to continue to recommend the more certain outcome of the TAH offer. An additional complicating factor is the equity swap deal that TAH entered into last month for 10% of TTS’s equity on issue, which could help the company block a competing proposal.

In the event that the TTS board switches its preference to the consortium’s offer, TAH may well come back with a higher bid; it would be expected that the company could afford to offer more than other bidders given potential synergies it could realise that would not be available to other bidders.

The outdoor media sector had been a happy hunting ground for small cap managers until several months ago when APN Outdoor Media (APO) disclosed a surprise profit downgrade. The key driver underpinning a positive outlook for the sector was the transition from static to digital advertising billboards, with a significant revenue and margin uplift to the operators as this occurred.

APO’s downgrade in August, however, shifted the focus from this structural transition to the shorter term, cyclical driver of the advertising market, along with the lack of revenue visibility beyond the next few months. While the latter point was confirmed when APO subsequently upgraded its guidance last month, the de-rating which occurred on its downgrade and across the sector has been symbolic of what has occurred among high growth/high P/E stocks that have disappointed this year, particularly among small caps.

Both of the two large operators in the space, APO and oOh!media (OML) have supplemented their earnings growth over the last few years with bolt-on acquisitions in what has been a relatively fragmented industry. This week the two companies agreed to a merger, estimating cost synergies of $20m from combining the two groups. The upside is forecast to be shared between the shareholders of both companies, with an EPS uplift of double-digits (before transaction and implementation costs) over two years. Upon completion, the merged group would become the fifth-largest listed media stock on the ASX.

ASX Media Stocks Market Capitalisation ($bn)

Source: APN Outdoor/oOh!media
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Competition concerns may be raised from the deal given that the combined group would control approximately 60% of the outdoor media market in Australia. Key will be how the ACCC defines the as the market for the companies, as the share of total advertising spend across all mediums is much smaller. A broader question for shareholders may be whether the merger is a sign of maturity within the outdoor media sector itself (with the sector making significant advertising market share gains over the last decade) and if it is thus being made to help cover a slower forward earnings profile.

Just 13 months after undertaking a $3bn capital raising, Santos (STO) came back to the market this week seeking a further $1.5bn. The raising has been viewed as relatively opportunistic in nature, with a recent spike in the energy company’s share price following OPEC ‘s recent agreement to cut production levels. It is also relatively surprising in its timing, following the positive comments that the company made last week on the progress that it has made in taking costs out of its business this year.

While having the effect of further diluting equity holders, the raising provides additional support for STO’s balance sheet, which was still viewed as susceptible to any oil price weakness and a possible credit rating downgrade should the oil price weaken again. The raising will also introduce new shareholders to the register who are now more comfortable with the balance sheet risks that have hovered over the company. The timing may also send a signal to investors over the company’s expectations for the oil price in the near term; while the recent spike is welcomed, cycles are likely to be shorter and a sharper going forward given the shorter time frame in which the global swing producers in the oil market (being US shale operators) now operate.

After deciding earlier this year to split its domestic and international casino businesses into separate listed companies in order to unlock shareholder value, Crown Resorts (CWN) this week altered these plans. CWN instead announced a sell down of just over half of its holding in Melco Crown (which is primarily focused on the Macau region) as well as the pay down of debt and capital management initiatives, including a buyback and a special distribution to shareholders.

While not fully extracting itself from Macau, the plan will still have the effect of reducing the company’s exposure to a region that has experienced a much more fluctuating operating environment over the years and has more recently been impacted by China’s crackdown on corruption. In addition, the sale will alleviate the balance sheet question marks that were hanging over the company, particularly with several capital-intensive growth options that it had in the pipeline.

One of these, being its proposed project in Las Vegas, is now off the table, which may please investors given it was potentially viewed as a low-returning investment. Its other major project, Barangaroo, also faces a challenging future given its focus on high rollers and the recent arrest of CWN employees in China. Highlighting this was the trading update that CWN also provided the market with this week; high roller turnover for the first 23 weeks of the financial year is down by approximately 45%.



 


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