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WEEKEND LADDER

A summary of the week’s results

17.02.2017

Week Ending 17.02.2017

Eco Blog

The Australian labour market is a key reason for the subdued domestic outlook. Part time work is rising and limits household spending. 

The US housing market is potentially reaching an inflection point. The big growth in apartments appears to be coming to an end, with single units to take over.

The Australian labour market once again reinforced its character in this stage of the economic cycle. Unemployment is range bound between 5.6-5.8%, though this is still off a relatively low participation rate. But the trend to part time wages remains pronounced. Over the year to January 2017, full time jobs have fallen by 56k, while part time has increased by 159k.  It is no wonder that overall income growth is soft and consumer spending restrained.

A robust measure of consumer spending itself is increasingly difficult to achieve. ABS retail sales form a diminishing part of the pie, with the absence of services, ecommerce and a restricted sampling of smaller store groups colouring the data. NAB compiles spending based on the domicile of their account holder. It captures all spending on cards, direct debt, paypal, bpay etc. It does have incomplete data on utility spending, insurance and excludes tax or government transfers and mortgages. It does however provide a different lens to spending patterns. The state trends are unsurprising. Spending growth in WA is negative year-on-year, QLD is below par, while SA, VIC and NSW are all average. Tasmania, or rather Hobart, is the surprise packet, running at 4.1%, compared with countrywide metro growth of 2.9%. Regional spending is far from downbeat at 3.5% and even in nominal terms does not fall far behind city dwellers at $1949 per month compared to metro of $2117.

Of the sectors, there is one standout. Spending on accommodation and eating out is up 13.5% year to date.

The Westpac Consumer Confidence Survey is a telling pictorial of the household sector in the past two to three years. Households are, on balance, neither positive or negative.

Westpac Consumer Sentiment Index

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Within the context of the survey, consumers have for some time been bearish on their short term financial circumstances, while persistently expressing some confidence that this will improve over the coming five years. Economic conditions for the country are, however, viewed to be below par, a realistic assessment. Yet households remain upbeat on potential purchases, responding positively (as they have for a long time) to the capacity to buy a large item. The most pronounced change has been towards the housing market, where the consensus no longer believes it is a good time to buy a house.

US housing growth is also moderating. The series is very lumpy and prone to revision, but in the medium term has been on a steady growth pace of circa 10% per annum. The concentration on multi- units appears to be waning in favour of single unit homes. There has been debate on the reasons for the changing pattern of household formation and home ownership. One easy argument is that uncertain economic times restrict the capacity of the younger cohorts from home ownership and result in them staying at home or renting.

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The US housing sector is far from a uniform market. Not only is economic growth very different, but planning approvals differ vastly. In this upturn, about half of new home starts have been in the south west (Texas, Florida, etc), where zoning is rarely a problem. This has driven a strong market in apartment building, which in some areas is likely to be ahead of demand.

Conversely, in California and cities such as Denver and Seattle, restrictions are much tighter. Overall, the boom/bust cycle is influenced by the countervailing pressures, but given elevated levels of building in the south west, a sharp downturn appears underway.

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The question now is whether the rise in mortgage rates, linked as they are to the bond market, will stem housing activity. On the other hand, if wage growth can compensate and the single unit sector picks up, the flow on effects are strong, given the spending on household goods and inevitable increase in family size that usually follows. 

US retail spending is solid already, running at a 4.9% headline rate and 3.8% excluding auto and gasoline. Akin to trends here, it is the services component that is outstripping goods. Most store sales in sectors such as furniture or clothing have been range bound at monthly growth of between -1% to 1%. Conversely, restaurant sales are up 3.4% year-on-year, while health and personal care is growing at 9.4%. US e-commerce sales are partially included in the data and are increasing at 14.9%.

These changing patterns in household formation and consumption are inevitably reflected in corporate results and underpin much of the stock selections in these sectors. For example, pet spending is growing rapidly, driven by older demographics but also a wide range of other factors. The US pet sector goes to great lengths to assess who is their target market and their outlook. Single homes is likely to be a major component. Australians outstrip the US, spending over $1000 per annum on their dogs and $745 on cats.

Source: The Pet Business Professor
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Fixed Income Update

NAB completed a successful new listed subordinated bond issue.

Margins in the listed hybrid market have had peaks and troughs in the last two years.

Australian bond yields have lifted higher again, following the lead of the US 

In the domestic listed debt market, the NAB subordinated bond issued last week was welcomed as the first bond in this part of the capital structure that has been brought to market in three years and offering relative value to the OTC market. Holders of the maturing NABHB securities were given a priority allocation, while bonds for new money were scaled back considerably. The order book was said to be two times oversubscribed, and the final issue size was set at $800m.

The market now looks to the next trade, which is expected to be a new tier 1 bank hybrid to replace the maturing Colonial subordinated bonds (CWNHA securities). The hybrid market has had an interesting few years in terms of credit spreads, with CBA issuing one bond at the peak and another at the trough in margins. CBAPD securities, which were issued in September 2014 at BBSW +2.80%, marked the bottom of the range in terms of spread for a new issue. The $3bn issue size was also larger than expected and the resulting oversupply gave way to poor performance in the secondary market. In February 2016, at the peak in spreads, CBA issued CBAPE securities at a margin of BBSW +5.20%, which, unsurprisingly, has had strong secondary market performance, reaching a high of $108. The upcoming new issue is likely to come at a margin of BBSW +3.80 - 4%, given current secondary market pricing for comparable listed bank hybrids.

The chart below depicts the trading margins of bank hybrids (for a given call date) in 2016 compared to 2017. While spreads have tightened in the last 12 months, they are still above that of 2014.

Source: Cuffelinks
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Globally, yields on government bonds have lifted again following hawkish comments by Fed Chair Janet Yellen. Yellen commented that "waiting too long to remove accommodation would be unwise" and that delaying rate hikes now could result in the Fed having to raise rates at a faster pace later, "which could risk disrupting financial markets and pushing the economy into recession". Strong US CPI data also gave yields a boost, with the 10 year US Government bond trading back above 2.50%.

Rates on Australian domestic government bonds also moved quite dramatically on the back of the US. Surprisingly, the short end of our yield curve (< three years), which one would expect to be quite well anchored to movements by the RBA and less so by global factors, has been quite volatile in the last few months. The 3 year Australian government bond has been moving directionally in line, and with similar pace to yields on the longer end (5 and 10 year maturities), rising to the high of its recent trading range.

Australian 3 Year Government Bond Yield

Source: Iress, Escala Partners
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Corporate Comments

Amcor’s (AMC) result beat expectations with results driven by better developed markets demand. 

Commonwealth Bank’s (CBA) half year was again determined by its market-leading retail division. 

- Receipts for the NBN transition propped up Telstra (TLS), with declining earnings in its core businesses. 

CSL reaffirmed its positive outlook as it capitalises on strong demand conditions. 

Cochlear’s (COH) result was good, although supported by fx hedging gains. 

- The uplift from a recovering global economy was tempered by rising input costs for Ansell (ANN). 

Medibank Private (MPL) reported a further decline in policyholder numbers and is now investing to stem these losses. 

Star Entertainment (SGR) missed expectations, although noted more promising trends in early 2017. 

Tatts Group (TTS) also reported a soft result. The focus remains on its proposed merger with Tabcorp (TAH).

Wesfarmers’ (WES) result was dragged down by Coles.

Consumer market darlings Domino’s (DMP), Treasury Wine (TWE) and JB Hi-Fi (JBH) all reported well.

Amcor (AMC) shrugged off softer expectations leading into its result following the downgrade by Brambles (BXB) with a solid half year report. Profit growth of 1% looked weak at the headline level, however this was impacted by the strength of the $US and previously disclosed issues in its Venezuelan business. Excluding these two effects and accounting for the benefit from the company’s share buyback, underlying constant currency EPS growth was 12%.

Compositionally, AMC’s result was somewhat different to the historic drivers, with strength in developed markets offsetting more modest growth from emerging markets. Latin America, in particular, was quite weak, with volume declines reflecting a challenging economic environment.

Amcor: Profit Before Interest and Tax Growth

Source: Amcor
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AMC has a higher than usual level of earnings visibility over the next few years, with the company identifying in excess of $150m in EBIT growth from the restructuring of its flexibles business (which includes optimising the company’s plant network) and the benefits from its recent acquisitions. AMC’s balance sheet is in good shape and thus it has the capacity for further bolt on acquisitions in coming years. With an excellent track record on this front, any further announced deals are likely to be viewed favourably by investors. AMC is currently trading broadly in line with the industrials sector, although remains relatively attractive as a core stock holding with its defensive characteristics and a respectable medium term earnings profile.

Commonwealth Bank’s (CBA) first half was solid given the prevailing lower-growth domestic banking environment. The bank’s core retail banking business was again the key driver, with profit growth of 9%. Softer performance across other divisions, however, limited group earnings growth to a modest 2% and was in large part an outcome of excellent cost control. A 0.5% lift in the first half dividend was a small reward for shareholders; a respectable outcome given the higher capital requirements that the sector has had to absorb, although much lower than historic growth rates.

Commonwealth Bank Dividends

Source: Commonwealth Bank
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Of the key indicators for CBA, home loan growth of 7% was above that of the market, although the trade-off was lower net interest margins, which declined by 4bp. Loan impairment expenses remained at similar levels to the last three financial years and close to historic lows at just 17bp. A gradual normalisation in coming years still presents as an earnings headwind risk for the sector.

CBA’s return on equity contracted a further 1.3% to 16.0% in the half and the transition to increased risk weights for mortgages will continue to be a challenge in the short term. The high relative premium that CBA has traded on compared with the other majors could thus be expected to contract further, given CBA’s above-average residential mortgage exposure. Taking this into consideration, at this point in time we have a preference for the other major banks.

The reality of the new National Broadband Network (NBN) operating environment for telcos was noticeable in Telstra’s (TLS) result, with EBITDA growth of 1.7% for the half, or 2.4% if two adverse regulatory decisions were included. The result scraped into the company’s full-year guidance run-rate, although management now expect FY17 to be at the low end of “low to mid-single digit EBITDA growth”.

While at face value Telstra still appears to be growing its earnings, a look at the composition reveals a different picture. A slight decline in revenue was assisted by an additional $370m in one-off NBN earnings, with the bulk of these from payments received as connections from its copper network are switched to the NBN. While these will continue for the next few years as the transition continues (currently the NBN reaches approximately 20% of all connections), the focus will increasingly turn to the performance of TLS’s core businesses.

Telstra Income Waterfall

Source: Telstra
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Results in these were broadly weaker. In the half, income from fixed broadband data failed to offset the ongoing decline in fixed voice. Further, revenue from mobiles, once a key source of strength, declined despite a 3% increase in customer numbers. The maturity of the market and high ongoing levels of competition have combined to keep mobile pricing in check, with average revenue per user declining by 3%. Customer churn rates also ticked up in the half, perhaps unsurprisingly given the network outages that have recently afflicted TLS customers and the improving network coverage of its competitors.

Our view remains that TLS is likely to continue to be used primarily as a dividend income stock in the short to medium term, which will likely prove unsustainable once its NBN receipts begin to decline and in the absence of investment in new revenue streams. TLS’s primary two listed telco competitors, TPG and Vocus, are not immune to some of the challenges in the transition to the NBN, however we believe that, following a de-rating in the second half of 2016, are more appealing options from a risk/reward perspective.

Several healthcare stocks also reported during the week, with mixed reaction from investors. CSL consolidated the share price gains that it made last month following its full year earnings upgrade, despite limited new information. After a pause in earnings growth in FY16, the company’s profit is forecast to grow at between 18-20% this year (in constant currency terms), with EPS higher again supported by its perennial share buyback.

There are two key drivers in CSL’s positive outlook. The first of these, robust industry demand growth, has CSL well placed due to the investment it has made in its plasma collection centre network. This has been critical in capitalising on these conditions, with the company having opened 70 centres in the last three years, three times the growth rate of the rest of the market. With the market tight and collection centres taking two to three years to be optimised, the conditions are likely to be quite supportive for CSL.

CSL: US Plasma Collection Centres

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Secondly, the turnaround of the acquired Novartis flu business is a further driver. Breakeven is not expected until the next financial year and then the company is targeting a 20% margin on US$1bn of revenue by FY20. Both of these factors support CSL’s expected double-digit growth rates over the next few years and it would appear that there is upside risk in the current cycle. This is arguably almost a necessity given that the stock has returned close to the high end of its P/E trading range, now on a forward P/E of 28X.

Also trading at a healthy premium to the market and its sector is Cochlear (COH), which reported 19% growth in its first half profit, although supported by foreign exchange hedging gains (the company employs a rolling foreign exchange hedge strategy). After underwhelming sales growth for several years, COH has lifted its game in recent times, reporting unit growth of 10% for the half, with similar growth levels from developed and emerging markets.

COH appears to have put behind it the issues that afflicted the company following a product recall in 2011 (which served as a reminder as to the single-product risk of the company), with steady improvement in sales on the back of product launches in the last few years helping to lift its overall market share. While it has consistently cited a global unpenetrated market of just 5%, low levels of awareness among consumers and bottlenecks across the industry has limited growth to the high single-digits. This may be an excellent rate compared with many industries, yet it is a level that perhaps does not warrant the elevated premium valuation attached to COH.

Ansell (ANN) is also notionally listed as a healthcare company, although its demand profile primarily determined by the economic environment, with exposure to a wide range of industries. These more cyclical elements mean that analysts often look to industrial production projections, more so than other measures, in forecasting the expected demand for its products.

Ansell Market Exposure

Source: Ansell
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Trading conditions should thus be improving for ANN, however an emerging issue is escalating raw input costs, including natural rubber and latex, which have accelerated in recent months. The lag between this flowing through to cost of goods sold implies a margin drag in the second half, the extent of which will be determined by ANN’s ability to pass these on to its customers. Falling costs had previously been a tailwind for the company over a multi-year period and perhaps had masked soft organic growth figures, which improved to a still-low 1.4% in the half. Despite missing expectations with its half year earnings, ANN maintained its full year guidance range, implying that a better second half is now forecast. While the downgrade cycle for the stock has largely abated, a better demand environment balanced against risks to costs leaves the stock fairly priced on 15X earnings.

Medibank Private (MPL) also straddles the healthcare sector, although is more comparable to general insurers. Its underlying growth should be higher than the general insurance industry, yet a high level of regulatory oversight tempers the investment case. With rising health insurance costs, MPL’s key challenge remains customer retention for its premium Medibank brand, which experienced an additional 4% loss in policy holder numbers in the half. Its smaller, lower-cost ahm brand grew at 8%, although not sufficient to offset a combined 2% contraction across the group.

Since listing, one of the primary drivers of profit growth for MPL has been cost reduction, as indicated by the drop in the group’s management expense ratio. Of concern was that this measure rose in the December half, with management investing to improve customer service and ultimately retention. Earnings were rescued in the six months from a pick up in investment income due to strong equity market returns. With this unlikely to be replicated in coming periods, evidence that its investment in customer initiatives is translating into a better top-line performance will be required to have a more constructive view on the stock.

Investors were prepared to look through a relatively weak first half for casinos operator Star Entertainment (SGR) and into what should be an improved second half. Star’s earnings from its high roller business were forecast to be softer following the fallout from the detention of Crown employees in China. As expected, the impact has been significant for CWN (and was also material for SkyCity), however SGR has stemmed the loss of business (from what is typically a volatile source of earnings) to a 12% decline in turnover. On a better note for SGR, the win rate of its high roller business was much higher than it allows for, although this is clearly not a factor that can expected to be replicated in the future.

Star Entertainment: High Roller Win Rate

Source: Star Entertainment
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Secondly, SGR has recently been undertaking a refurbishment of its Gold Coast and Sydney casinos, which has caused some disruption to the activity on its main gaming floor. With these works nearing completion, the expectation is that the second half of the year will show much better trends. This was confirmed with SGR’s trading update for the first six weeks of the year, with the company noting an 11% growth in revenue (excluding its high roller business). We believe that the investment case for SGR remains attractive, with a good level of expected earnings growth in the medium term and with the stock currently trading at a similar multiple to the broader industrials market.

A soft result from Tatts Group (TTS) also materialised as was anticipated, a somewhat unhelpful outcome with the company in the midst of a takeover battle. The performance of TTS’s lotteries business (accounting for nearly 2/3 of group earnings) is the key driver for the company and in the short term performance is typically driven by the number of jackpots in any given period. For the December half, TTS was cycling a particularly strong run of jackpots in the previous year (24), with five of these for $50m or more. Earnings from lotteries were thus 11% lower in the half, slightly higher than what TTS had forecast in December.

Earnings from wagering were also softer, with TTS struggling with its refreshed UBET brand in a competitive market place. This result may prove to be somewhat inconsequential given the key catalyst is its impending takeover by Tabcorp, with a high level of projected synergies to result and an increased scale in wagering. Nonetheless, it likely reduces the chances of an attractive counter offer from the Macquarie consortium (which failed to gain TTS board approval). The next important date for shareholders is the ACCC’s determination on the TAH combination, which is due in early March.

As expected, Coles proved a drag on the Wesfarmers (WES) result and detracted from the performance of the other business in the group. While Bunnings has been a long-standing workhorse for WES, other divisions such as resources, Kmart, Target and the Industrial operations are cyclical by nature, or have to prove that they can withstand the changing conditions in their markets. Therefore, the valuation does largely rely on the future of Coles within the increasingly tense supermarket sector.

History shows that there is always one loser. Over the past 20 years either Coles, Woolworths or the independents have experienced a sharp deterioration in profit, while one participant has been the outright winner. This time we add Aldi into the mix. Most commentators assume it will be the independents that once again feel the brunt of the pressure. Given Aldi’s move into their strongholds in South Australia and Western Australia, the assumption has solid ground. But that is unlikely to be the only impact. For the moment, investor attention is on the sales and operating leverage battle between Coles and Woolworths and Aldi is seen as a gnawing presence.  Much rests on the notion that competition will prove ‘rational’.

There seems little doubt that WES is entering a much lower growth phase than achieved the past few years. Possible rationalisation of the portfolio through the sale of the resources division and Officeworks add a different dimension and may in turn open the door for investment into new businesses. WES has key metrics of a 16.3X forward P/E and a 5.4% fully franked yield, yet with EPS growth in the low to mid single digit range; this suggests the stock is fully valued and not without risk. 

Three other consumer market darlings, Dominos Pizza (DMP), Treasury Wine (TWE) and JB Hi Fi (JBH) all reported solid results.

DMP has come under scrutiny regarding franchisee labour conditions, but this is yet to affect its local sales, with revenue up 17% in the first half. Conversely, the European and Japanese business were both weak, though apparently attributable to specific issues in each – taking burgers off the menu in Europe and a seasonal impact in Japan. The bulls believe these will prove temporary issues in what has mostly been exemplary execution by management to date. It will have to be, as the stock trades on 40X forward earnings, an expensive price for a cheap pizza. Valuation is based on the assumption EPS growth of 30% can be achieved for 3-4 years. The one thematic factor strongly in its favour is the persistence in shift towards casual eating, as highlighted in the economic section.

TWE’s result was a fine vintage with circa 20% organic growth supplemented by the acquisition of Diageo. Asia was the standout region, but the management focus appears to be on the US with a significant change to the product positioning taking place. The group is willing to forego sales in Australia to shift product into regions such as Asia, where longer term growth is higher. The view on TWE can be formed from judging the success of its branding strategy and the associated balance sheet costs.  The reduced exposure to commercial brands has taken some of the price pressure of the product range, but it comes with capital costs, as the higher price brackets stay on the books longer. While that provides high margins, the return on invested capital is stuck at well below 10%.

Treasury Wines: Inventory at Book Value Split by Segment

Source: Treasury Wines
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TWE is on a 28X forecast P/E, arguably somewhat rich given the risks in execution and competition. Inevitably forex translation and accounting can move this headline P/E around by some measure, requiring a careful analysis to assess the cash profit growth. For the next year or two the US is expected to keep profit growth in the 20% range, though in the longer term TWE will require another new dimension.

JBH has possibly pulled off a feat the previous two companies have yet to prove they can emulate. From its origins as a retailer of DVDs and CDs, JBH has consistently transformed its product offer such that, even with e-commerce, it remains relevant. Underlying profit growth in the JBH stores of 20% was supplemented by the acquisition of The Good Guys, lifting the overall result to 32% for the half year. While it has unquestionably benefited from the demise of Dick Smith, it has been the mix of sales to appliances and its willingness to back up and coming brands, such as Oppo in mobile phones, that is the driving force of momentum. The key telling positive for the group has been the tight control of working capital, with barely a misstep over many years, and the source of the demise of many others in speciality retail. The risks to the outlook are, however, ever present, including the entry of Amazon and the housing cycle given the increased exposure to that sector through The Good Guys. At 16X P/E, the stock is in line with its historic multiple and remains a favoured consumer play.

Reporting season continues next week, with a similar number of companies scheduled to release results.

Monday: Brambles (BXB), Bellamy’s (BAL), BlueScope Steel (BSL), WorleyParsons (WOR)

Tuesday: BHP Billiton (BHP), Altium (ALU), Caltex (CTX), Monadelphous (MND), Oil Search (OSH), Seek (SEK), FlexiGroup (FXL), Aconex (ACX)

Wednesday: APA Group (APA), Stockland (SGP), Blackmores (BKL), Coca-Cola Amatil (CCL), Fairfax Media (FXJ), Woodside Petroleum (WPL), Healthscope (HSO), IAG, Fortescue Metals (FMG), Vocus (VOC), Qube (QUB), Fletcher Building (FBU), Bega Cheese (BGA), Pact Group (PGH), APN Outdoor (APO)

Thursday: Alumina (AWC), Adelaide Brighton (ABC), Perpetual (PPT), Iluka Resources (ILU), Qantas (QAN), Flight Centre (FLT), Webjet (WEB), Ramsay Health Care (RHC), Ardent Leisure (AAD), Platinum Asset Management (PTM), InvoCare (IVC), Nine Entertainment (NEC), Crown Resorts (CWN), Estia Health (EHE), Scentre Group (SCG), Spotless Group (SPO), Costa Group (CGC), Reliance Worldwide (RWC)

Friday: Super Retail Group (SUL), Westfield (WFD), Regis Healthcare (REG), Mayne Pharma (MYX), Automotive Holdings (AHG)

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