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WEEKEND LADDER

A summary of the week’s results

17.08.2018

Week Ending 17.08.2018

Eco Blog

- One week in, Turkey’s relatively unique issues are evident. Emerging assets have, however, all been dealt much the same hand, whereas the differentiation is the opportunity.

- The pattern of domestic data reinforces rather than changes the outlook, while the US expansion could well be prolonged.

- Europe is, not yet, back in the basket case. GDP growth has recovered from Q1 lows and there is plenty that can be done to lift it further.

Turkey’s problems bubbled over, triggered by what would otherwise have been an annoyance of tariffs on its steel exports to the US. Its problems have been building for some time and the meltdown was a textbook case of what will happen when conditions are pushed to the edge. These are rising inflation (last measured at 15%, though some believe it is closer to 100%), a politically influenced central bank that has not raised rates in response (holding the cash rate at 17.75% against an expected rise), and a long-standing problem with both fiscal and current account deficits that require external funding. Two countries stand out with rising or persistently high deficits; Argentina and Turkey. This week, Argentina has raised rates to 45% and sold USD to support the peso. These are tough decisions as they will hurt the domestic economy in the short term, but are necessary to prevent an even greater issue in the future. Elsewhere in emerging economies the deficits are far less problematic now than 5 years ago and point to the differentiation in the outlook that is far from evident in the wholesale sell off in the classification.

Emerging market current account balances (% of GDP)

Source: IMF, Escala Partners
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The flow on effects from Turkey to others in emerging economies is essentially via the financial channel, as trade and banking cross exposure is low. Focus on any unsustainable imbalance will find its way into a reaction at some point. Notably, Asian countries with current account deficits – Indonesia, Philippines and India - have seen their currencies underperform the others in the region year to date.

While emerging markets have been dealt a heavy hand by investors in equities and bonds, the response from a monetary policy perspective has been measured and mostly judged appropriate. These have been quite different, from easing in China to rate hikes elsewhere. 

  • With valuations now at a near historic relative high for developed markets compared with emerging, we continue to recommend investors stay with their emerging market investments. Adding to allocations may be somewhat premature but for long term investors is expected to pay off.

Most economic data this week was benign in terms of influence, reinforcing the trends of the past few months. Locally, the weaker employment outcome (-3.9k in July) looks like payback for the atypically strong June (+58k). The trend growth in employment of 25k a month is still spot on. Low wage growth at 2.1% in Q2 continues to suppress domestic demand.  The housing retracement gathered momentum, though the trend is still relatively mild. Unsurprisingly, the consumer sentiment measure (Westpac/Melbourne Institute survey) also eased, though the cause is arguably a misreading of the outlook for economic growth, which is on the up. Households are unlikely to be aware of the impact that state-based infrastructure spending and the trade balance will have on GDP.

RBA Governor Lowe summarised the above data in his appearance before the House of Reps, noting the impact of risks from the outlook for our trading partners in Asia, the modest growth in wages and the welcome ‘adjustment’ to housing and related credit growth. Rates are mostly likely beholden to wage developments to allow the household sector leeway in the costs of servicing debt.

The AUD/USD inevitably felt the emerging market impact, yet the trade weighted index (TWI) is at around its average level of the past two years.

US data had much the same pattern. The housing sector is relatively weak, but the consumer is buoyant. Retail sales for July were above expectations. Discretionary segments did well, with apparel store sales up 5.4% year-on-year, building materials and garden stores up 5.8% and the category that usually is the most cyclical, restaurant and drinking establishment sales, up 9.1%.

  • The US economy is evolving in a balanced way, supporting the potential for the cycle to be more prolonged that many, wanting to be seen calling the next downturn, expect. Domestic demand investment is proving fruitful.

Germany’s Q2 GDP was a touch higher than expected, with domestic demand reasonably strong. Confidence indicators have held their ground, notwithstanding some of the difficulties – trade, Italy, Brexit – of the past few months. Fiscal policy is generally expansive and financial conditions are accommodating, despite the reduced asset purchases from the ECB.

Subject to the usual caveats on political instability, the prospects for Europe are far from as dire as some assume. Exports matter a lot for the region, yet the impact of trade tension is relatively modest at this stage. The fall in the Euro helps corporate cash flow, though inevitably will not endear itself to the US government. The key would be reform – particularly on labour markets and pensions, as well as tax cuts where they can be afforded – Germany being the standout.

  • Investment in Europe is centred on equity options, given that fixed income is uniformly judged as unattractive. The lack of high profile growth stocks has instead shifted the focus to yield companies such as infrastructure, as well as safe haven consumer staples.

Focus on ETFs

- After reaching just shy of $80 per barrel, Brent crude oil prices have fallen back to its lowest price since April. The impact on energy companies depends on where their operations fall within the sector. 

The energy sector (as defined by the MSCI) comprises of companies that are involved in exploration and production of energy, as well as equipment and service companies required by the industry.  As such, the supply and demand for energy can have a different impact depending on a company’s role within the production of energy. While the producers of oil and gas are leveraged to the price of the commodity, the profit margins of oil refiners can increase if the input product, be it gasoline or diesel fuel, drops. Currently equipment and service companies that supply the rigs and other services to producers have lagged as companies have been relatively constrained in their capital programmes. 

Performance of energy sector, energy industries and oil price

Source: Bloomberg, Escala Partners
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There are limited ways to gain exposure to the energy sector through ASX-listed ETFs with the only two energy related ETFs. The BetaShares Global Energy Companies ETF – Currency Hedged (FUEL) tracks the NASDAQ Global ex-Australia Energy Hedged AUD Index, a modified market capitalisation index of global energy companies. Nearly 50% of this fund is allocated to US companies with the biggest stock weights to Chevron and Exxon Mobil. The largest sub-industry exposure for this ETF is Integrated Oil and Gas, consisting of companies such as Total SA, BP PLC and Royal Dutch Shell. As the name suggests, these companies have combined their upstream businesses of the exploration and production of oil, with downstream operations such as refining, marketing and transportation. This can reduce the impact on changing oil prices on their profitability.

Investors can also get exposure to the hedged price of crude oil through BetaShares Crude Oil Index ETF – Currency Hedged (synthetic) (OOO). This is a synthetic ETF, which utilizes derivatives to track the price movements of oil. An investor is exposed to the risk of tracking error if the oil futures differ from the spot price, as well as counter party risk. OOO has outperformed FUEL over the past year, albeit volatility has been much higher.

Performance of energy ASX-listed ETFs

Source: IRESS, Escala Partners
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  • Investing in single-commodity ETFs gives an investor a concentrated exposure of the underlying commodity and returns can be highly volatile. The current spread between the equity and the commodity index suggests that the former could catch up with the rise in the oil price.

Fixed Income Update

- We examine the contagion into other fixed income risk assets as the spotlight shines on Turkey.

- Further flows expected into US pension funds over the next month, supporting demand for US treasuries.

As one would expect, the recent crisis in Turkey has caused increased currency volatility in the Lira and a sell-off in Turkish sovereign bonds. Most Australian investors are unlikely to hold any exposure to Turkish bonds, or it will be via a small exposure within a global bond fund and will make up a very small percentage of an overall portfolio. It is not direct exposure that is the concern, but rather the effect to other risk assets that has attracted attention.  

The Turkish Lira and bonds prices fall

Source: M&G, Bloomberg
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The impact has spread to other risk assets, with emerging market currencies caught up in the crossfire.  The Indonesian rupiah fell hard, prompting the Indonesian central bank to intervene by buying rupiah. Argentina’s central bank lifted interest rates by 5% to 45%, in an effort to support the falling Peso. South Africa, Brazil, Uruguay and Mexico similarly affected as currencies depreciated and bond yields rose. The Indices that track this sector in local currency inevitably followed the pattern with the JP Morgan EM local currency bond ETF down -3.5% over the last 6 weeks, taking it to its lowest level since inception in 2010.  

A sell off in Chinese credit and Italian bonds have also been part of the risk off moves over the week.

  • For those with an appetite for risk, a tolerance for volatility and a 5-year time frame, select emerging market bonds present a good buying opportunity where bond prices have fallen in the sentiment rout. We use the Legg Mason Brandywine Global Opportunities Fund to allocate to these securities as a part of their portfolio. 

US treasuries are often well supported during periods of uncertainty as investors flee to safe-haven assets. Of late, this has kept the US 10year bond yield below 3%. Adding to demand for treasuries has been buying from pension funds which buy treasuries to match their long-term liabilities. The tax reform changes where the US corporate tax rate fell from 35% to 21% is partly the cause of the flow as companies have until September 15 to top up pension fund deficits under the old higher tax rate. Large US corporates such as GE and FedEx have been taking advantage of this incentive. Experts estimate a further $40bn to $60bn of Treasury buying from pensions funds in the coming month.

  • It is unclear whether this increased demand from pension funds will be enough to offset other counter moves in yields which include the Federal Reserves’ unwinding of its balance sheet and interest rate rises. Our view is that yields will rise over the next 6 months, although this buying may slow down the timeframe of these moves.

Corporate Comments

- JB Hi-Fi countered the short-sellers with its result. Addressing the issues at the Good Guys and negotiating a weakening housing cycle are the key risks.

- The environment for CSL remains buoyant, with valuation a secondary consideration.

- Cochlear (COH) has also reported solid trends, but is also the most expensive within its sector.

- IAG has been the standout performer from an operational perspective in the insurance sector, while QBE has lagged. The room for improvement in the latter has translated to a discounted valuation.

- An accounting adjustment for Origin Energy (ORG) triggered downgrades to its forecast earnings. Balance sheet repair continues and should allow a dividend in the coming year.

- Telstra (TLS) continues to face challenges on several fronts. The light at the end of the tunnel is provided by cost out, 5G and a possible infrastructure spin off.

- The growth path from here for Wesfarmers (WES) is not clear despite a solid FY18.

- The premiumisation of Treasury Wines’ (TWE) product range and share price has underpinned the profit growth.

After downgrading its guidance in early May, the hurdle for JB Hi-Fi (JBH) was relatively low, with the stock’s recovery this week reflecting its earnings delivery ahead of expectations and its large short interest. Earnings per share growth of 9% led to a profit figure that was only 1% short of the company’s initial guidance prior to May, accompanied a 12% increase in the dividend.

JBH’s two key divisions had contrasting fortunes in FY18. The core Australian JB Hi-Fi business reported another solid year of growth, with margins maintained on a sales rise of 9%. The performance of this business remains the key driver of JBH’s overall earnings, accounting for over 80% of overall profit.

The Good Guys has been problematic and JBH would arguably be better positioned today had it not undertaken the acquisition. Sales have been poor, compounded by the loss of some franchisees in the ownership transition, while price discounting at a Harvey Norman has been matched to help maintain market share, leading to a contraction in margins. The much-hyped entry of Amazon into the market, however, has not yet appeared to have much impact on JBH’s business.

JB Hi-Fi Australia EBIT

Source: JB Hi-Fi
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The read through from FY19’s guidance is that JB Hi-Fi Australia will moderate, while initiatives to improve the Good Guys, the cycling of low comps and synergies will flow through to the bottom line. The key risks to the outlook are macro in nature, given the potential impact of a slowing housing cycle. Nonetheless, the stock has and attractive valuation (P/E of 12X) and yield (5.3%) in what is a somewhat expensive market.

CSL’s result was again solid, with a 29% increase in earnings driven by a mix of double-digit top line growth and margin expansion and ahead of the group’s own guidance. The environment for CSL remains very favourable. Underlying demand is robust, new products coming to market are typically higher margin, previous investment in collection centres is paying off and its acquired flu vaccine business is now on the path to profitability.

If there was a negative point to be highlighted in the commentary, it was rising plasma collection costs and a broader industry-wide investment response to strong demand, although it will take some time before the latter has a discernable effect.

Given the above, it was unsurprising to see CSL outline plans for a further step up in capex and maintain a high level of R&D spend (around 10% of revenue), with a preference for investing compared to its track record of supplementing investment with share buybacks.

Guidance provided for FY19 indicated ~12% earnings growth, although this has not deterred more optimistic forecasts given the company’s history of conservative forecasting. Following the stock’s extraordinary run over the last 12 months, whereby solid earnings trends have been accompanied by a leap in P/E expansion, its valuation is become harder to justify in an expensive sector. Growth managers with preference to qualitative factors, incorporate an element of momentum into their process or include the optionality value of its R&D pipeline, are more likely to stay the course.

CSL: Capex Profile

Source: CSL
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Cochlear’s (COH) rise over the last year has parallels with CSL, although CSL is typically favoured due to its more consistent track record, higher growth profile, broader product range and better relative valuation. COH’s full year result was in line with its guidance, although forecasts were revised downwards. What was perhaps more surprising was further share price gains after an initial negative reaction by the market.

Regionally, Cochlear reported good revenue growth in the US and Europe, while its Asia Pacific numbers were held back by a lower contribution from the typically volatile and unpredictable sales from Chinese government tenders. What appears to have been key in the company’s guidance for the next 12 months was for a similar margin outcome, which could be interpreted as a lack of operating leverage. Instead, however, scale efficiencies will be used to invest further into sales and marketing, helping to at least maintain COH’s high market share.

While the outlook for the next year remains sound and the weaker AUD is positive for domestic investors, value-orientated investors will remain on the sidelines. 

IAG reported a solid result, however a share price retracement followed given elevated expectations (reflected in its premium valuation to its closest competitor Suncorp) and what was judged as weaker guidance. As is typical with reported results from the insurers, there was a multitude of underlying earnings drivers.

Premium growth was relatively good at 4.3%, although almost half of this rise was offset by absorbing the impact of the reforms in the NSW compulsory third party market. IAG got a margin uplift from announced quota sharing agreements with three reinsurers, while reserve releases were higher than expected and a benign year of extreme weather events meant that natural perils costs were below its allowance. The latter two have a high degree of cyclicality and hence would expect to be a drag on profit growth if normalised. Finally, investment income was lower given softer equity market performance over FY18, while its ‘optimisation’ programme is yet to contribute to a lower cost base given the implementation costs.

IAG Insurance Margin Trends

Source: IAG
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Offsetting some of these concerns is the strength of IAG’s balance sheet, with the company announcing a further return of capital (equating to 2.4% reduction of shares on issue) and the possibility of further initiatives in coming periods. IAG’s quota sharing agreements have effectively reduced its earnings volatility (allowing the stock to trade on a higher multiple) and freed up regulatory capital. Given its high relative quality in the sector along with a reasonable yield, the stock has been a core part of our SMA portfolios.

Despite also operating in the insurance sector, QBE is quite a different investment proposition, as the company is a turnaround story after several years of disappointing performance. With a new CEO implementing a strategy of simplyifying the business, including the exit of volatile and loss-making units, the initial assessment of the plan got the tick of approval from the market. Meeting guidance (after adjusting for a low tax rate) was sufficent for a share price bump given the company’s history of negative surprises.

Assisting the management through this period has been the much better premium pricing environment among global insurers, with QBE noting a 5% growth in the second quarter and rate increaes across all divisions. Providing support to the share price will be the recommencement of a share buyback scheme and a weaker AUD, while the company’s link to higher investment earnings from rising interest rates in the US is well understood. QBE will likely need a further period of delivery to help close the valuation gap on its Australian-focused competitors, although it continues screen as the value option in the sector.

Insurance Sector: Forward P/E Ratios

Source: Bloomberg, Escala Partners
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A reasonable result for Origin Energy (ORG), with earnings more than doubling year-on-year, was overshadowed by the disclosure of an accounting change that has given cause for a reassessment of the company’s underlying profit base. ORG provided additional transparency around the accounting of electricity hedge premiums, which were previously tucked away below the line into a single item that included other more volatile components. Given the recurring nature of these costs and the transition of this cost from ‘statutory’ to ‘underlying’, the negative revisions to ORG’s future earnings (and thus valuation) were relatively significant, at around 10%.

As with AGL’s result last week, the benefit from rising electricity prices was visible in its integrated energy business, although the real leverage is from its interest in APLNG. APLNG recorded an uplift in production and the oil price-linked nature of LNG led to a material rise in revenue and profitability. The company’s efforts to strengthen its balance sheet continued, with net debt falling following the rise in operating cash flows and the proceeds from asset sales. Despite this, ORG is still not yet in a position to recommence dividend payments, with its preferred debt/EBITDA measure still above its target range of 2.5-3.0x. The company’s outlook has been clouded by the recent rise in competition in the retail energy market, although a supportive oil price is expected to allow dividends to return in FY19. The stock looks decent value on 12x FY19 earnings, with the key risk that its two core divisions are both approaching peak profitability.

Given Telstra’s (TLS) recent history of downgrading profit guidance, the stock rallied after it reconfirmed its expectations for FY19. This was not unexpected, although reflects the current pessimistic view of the analyst community. The earnings challenges are well known and illustrated in the chart, which shows the performance of its continuing business (11% decline in EBITDA), partially offset by the one-off nbn connection payments (which are being utilised to support special dividend payments).

Telstra: EBITDA bridge

Source: Telstra
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Aside from the nbn transition, it has been rising competition in the mobile sector which has recently provided a challenge for TLS. Its mobiles division was previously a reliable source of growth, however earnings have now been in decline for several periods. This is predominantly driven by lower revenues per subscriber as the various providers compete for market share. A source of optimism was provided in this set of results with a sharp rise in subscriber growth in the fourth quarter; how this translates into profitability is less clear given declining margins and the phase out of excess data charges. The next 12-18 months will present a new set of opportunities and threats. TPG Telecom’s entry into the market is likely to further highlight the price disparity between TLS and the rest, while the rollout of 5G will give TLS a chance to reassert its network superiority.

The value argument for the stock typically focuses on the prospect of cost out (TLS has set itself a $2.5bn productivity target) to help arrest the core earnings decline and/or what value may be realised via a spin off of its infrastructure assets. The more immediate problem for the company will be the likely prospect of an additional dividend cut into FY19, with no guidance given as of yet. Notably, sell-side analysts have already accounted for this; consensus currently sits at 17.5c per share.

Wesfarmers’ (WES) last result as a combined entity was rock solid. That is now history as shareholders will need to focus on the prospects for the Coles supermarkets separate to the remainder of the group, dominated by Bunnings. The disastrous foray into the UK has dealt with (though management and the board got away with taking responsibility) and the disposal of resources assets and Kmart Tyre and Auto are in place, leaving a structure that is likely to be the base case for what comes next.

Operationally Coles showed a modestly better second half, as sales lifted in Q4 to 1.9% versus 1.3% in Q3, 1.1% in Q2 and 0.4% in Q1. The Little Shop promotion will likely deliver another decent sale uplift for this quarter and then the question will be whether those shoppers stick with Coles absent any such incentive. Suppliers still suggest Woolworths is doing a better job than Coles where it counts. The new CEO (ex Metcash, private equity, Coles Myer) starting in the next month will be key, with potential shift in emphasis towards private label and lower reliance on price promotion.

Within the remaining Wesfarmers component, Bunnings was the predominant contributor, though Kmart also maintained its dominance in discount store land. The question is whether Bunnings is past its peak as sales growth in Q4 faded to 4.9% after consistently tracking at 8%+ for some time. The judgement is that this is reflective of market conditions rather than a one off, as the housing cycle fades.

The split of the group will have Coles reflect circa $20bn in enterprise value and $34bn for WES group. The combined P/E of just under 20X is high given mid-single digit growth, while the dividend yield is an acceptable 4.5%. We view the stock as expensive, but rationally held as a big cap anchor with relatively reliable earnings. The longer term question is growth. For both divisions this will be challenging within Australia, while overseas adventures will be frowned upon.

Treasury Wines (TWE) joins global high end beverage companies with a 34% rise in net profit, now compounding four years of growth via a doubling of EBITS margin (the ‘s’ relates to accounting standard on vine depreciation). Net sales revenue (NSR) per case has been the key as TWE moves to ‘premiumisation’ and away from wines bought largely on price (the infamous two buck chuck). This shift has though seen volumes slow, with revenue growth of only 1% this year.

Treasury Wine: Revenue Per Case Trends

Source: Treasury Wine Estates
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Cash flow was weaker with a large inventory investment, a cost that is inevitable if vintage wines are growing, though exacerbated this year by port delays. Luxury (+$20 price bracket) comprises 56% of inventory and 76% of non-current working capital. It is also a function of the change to the distribution system in the US where TWE takes control of the supply chain from its distributors.

For the moment, a 20-30% growth rate is still on the cards, reflecting the higher margins in the US once the supply chain is reconfigured, margin growth in Asia and a currency tailwind. But the focus is on the balance sheet costs of this growth. The 30X forward multiple is higher than comparable global high end companies which typically trade at around 22-25X. This valuation is in good part a function of the lack of similar companies within  the ASX 200, but is a limit to further upside for the share price.

Next week’s reporting schedule:

Monday: Ansell, Woolworths, Fortescue Metals, Seven Group, NIB Holdings

Tuesday: BHP Billiton, Seven West Media, Scentre Group, Amcor, Super Retail, Oil Search, Monadelphous

Wednesday: Fletcher Building, Sydney Airport, APA Group, Newcrest Mining, Lendlease, a2 Milk, Carsales.com, Spark New Zealand, Vocus, WorleyParsons, Coca-Cola Amatil, Trade Me Group, Cleanaway Waste Management, Bapcor, Adelaide Brighton

Thursday: Platinum Investment Management, Stockland, Qantas, Qube, Webjet, Nine Entertainment, Santos, Flight Centre

Friday: Sims Metal Management, Automotive Holdings, Mayne Pharma, Star Entertainment, Brambles

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