Week Ending 17.10.2014
The noisier sections of the media like to suggest that the current malaise in investment markets is due to geopolitical ructions or even concerns on Ebola. While these are distressing and troublesome, they have not, in our view, influenced markets beyond adding to negative sentiment. The trigger for this sell down has largely come from poor trends out of Europe and, to some extent, China and Japan. Even modest ‘under expectations’ data is taken as a sign growth rates are deteriorating.
There seems to be little question that Europe has entered into another challenging period. It is important to distinguish this from 2011, where the possible collapse of financial institutions and the risk of a disintegration of the Euro had major implication for the global financial system. Weak, even negative, growth in Europe will impact on investment valuations, but is unlikely to trigger a specific event.
While the powerbrokers in the European Union did a commendable job to allay fears in 2011, the reality is that the structural changes required have been mostly pushed aside. Indicators are that Europe will avoid a recession, but seems destined to grow at a slow pace of perhaps 0.5-1.5% for some time. Upside may come from the fall in the value of the Euro, given the high export dependency of the key economies and, for financial markets, the prospect of monetary easing coming out of the next meeting of the European Central Bank on 6th November.
Data out of the US in the past week is best described as mixed. Retail sales were a little weak and producer prices edged down, yet other indicators such as lower jobless claims and the Fed Beige book, which reports on conditions across a number of districts, imply ‘modest to moderate’ expected growth, the same as in Q2. A significant change in US economic conditions does not appear to be on the cards at this time, but the combined impact of the higher US$ and the current unsettled financial markets may take the edge off growth over the coming months. The flip side is that the US consumer historically is highly attuned to energy costs and low inflation may see consumption spending picking up.
The chart below shows the contribution to GDP in the US economy in Q2 this year. The focus is often on housing and investment spending, whereas the consumer is clearly critical.
China is sticking to its path of trading off higher growth for continued reform. In past reports we have noted the changes to the financial sector, where market forces are increasingly allowed to set the pace and price of credit and the currency. The shadow banking segment, much in the news earlier this year, is gently reducing in scale.
China: Off-Balance Sheet Financing as a % of Total Social FinancingEnlarge
China’s monetary base is now rising at roughly the rate of nominal economic growth rather than the elevated levels of 2013. While this inevitably limits the near term economic momentum, it does reduce concerns of leveraged stimulus. China may well be a precursor for other economies to spend differently, rather than always more.
Locally, households have for some time expressed confidence in their own financial circumstances, but take a less upbeat view of economic conditions. The ANZ – Morgan survey out this week has the response to ‘economic conditions next year’ registering 8% below its average since 2001.
The NAB survey data on business conditions further indicated that any investment spending was not imminent, yet once again businesses felt reasonably comfortable about their specific circumstances.
NAB Business Survey
The question of growth in the Australian economy is testing many economists. Most agree on the support from dwelling construction activity, which is expected to fade during 2015, minimal support from fiscal policy as budget constraints remain tight, and no visible emergence of business investment to compensate for the end of the resource phase. The biggest swing factors will come from the terms of trade, that is, the value of exports versus imports and any marginal shift in household consumption patterns. The counterbalancing influences of improved wealth (from investments and house prices), decent levels of population growth and the likely easing of cost pressures from service inflation, such as energy and utilities, is offset by patchy employment conditions, low wage growth and what appears to be a systemic change in savings as a precautionary measure in light of global uncertainty. The consensus appears to be shifting towards lower interest rates for longer and a below-par period of economic momentum.
Rio Tinto (RIO) this week was the first of the major resource companies to release its quarterly production figures. The group had a mixed third quarter, with solid figures from its iron ore and copper division offset by the slow performance of its alumina assets. Quarterly figures invariably show a high degree of fluctuation based on various disruptions, such as the effects of weather or maintenance conducted, however the nine month figures give a better picture of the business growth over time:
Rio Tinto: 3Q14 Production Summary
Similar to BHP Billiton, RIO is pushing ahead with further iron ore expansion and is showing no sign of pulling back its rate of growth, despite the weakness seen in the iron ore price over the course of this year. The group is expected to produce 295 million tonnes this year, with a target in excess of 330 million tonnes for 2015. Beyond that, the plan is expand its Pilbara capacity to 360 million tonnes, with the infrastructure to support this already 75% complete.
While this growth strategy has been questioned by some, given the underlying market conditions, companies that are more affected by RIO’s actions are those that occupy the top half of the iron ore cost curve. Several of these ASX listed companies have suffered significant share price losses in recent months, highlighting their underlying leverage to commodity prices and the inherent risks in their businesses. Our thesis for investing in the low-cost, diversified miners is more a play on a longer-term demand thematic, particularly from emerging Asian economies, which continues to evolve. At present, despite pricing headwinds, RIO still screens as reasonable value, and should receive some share price support given Glencore’s recently disclosed interest in acquiring the company.
Fortescue Metals (FMG) is one of these more marginal producers, although it sits between BHP/Rio and the rest. The grade of its ore is closer to 58% (as opposed to the 62% benchmark price that is often quoted), and hence its realised price closely tracks this index (see chart below). This 58% grade price is currently at an 18% discount to the 62%, although this discount has closed in recent months. Any ambitious growth opportunities that the company may look to explore are likely to be contained in the current environment, when one considers the likely returns it would achieve and its relatively highly geared balance sheet.
Iron Ore Pricing
AGMs are often the first opportunity that companies take to give an update on their trading conditions following their results in August. This week we have had AGMs for Telstra (TLS), Cochlear (COH), Crown (CWN), Ansell (ANN) and Orora (ORA). We will limit our comments to companies that have had something to say which has a market impact.
Crown’s valuation broadly sits as 50% in its domestic casinos business (at present, Melbourne and Perth) and 50% in its shareholding in Macau Crown (MPEL), which owns casino assets in Macau. The domestic casinos are relatively mature, and have delivered a solid underlying income stream over several years. Earnings volatility here is more a function of the variance seen in the win rate of their customers. In the early part of this financial year, Crown Melbourne and Perth has shown 2% growth in main gaming floor revenue, reflective of the weakness in consumer sentiment. A recent agreement with the Victorian Government to extend its Melbourne casino licence to 2050 (previously it expired in 2033) which also allows for an increase in its gaming operations is a positive, removing a level of regulatory uncertainty that often hangs over the sector.
The key driver that has led to the group’s poor share price performance this year has been a fall in gaming turnover in Macau. This has largely been felt in the high-roller section of the market, following a crackdown on corruption in China, and more recently, the introduction of smoking bans. While there may be a structural element to this decline in the VIP market, the higher margin mass market continues to tick along at double-digit rates. Crown’s asset base has likely been a beneficiary of this weakness seen in the Macau VIP market, as some of the market share would have been captured by its Melbourne casino, as reflected in its H2FY14 figures. With consensus forecasts still reflecting above-market EPS growth on a below-market P/E, Crown looks attractive from a risk/reward perspective.
CSL maintained its FY15 guidance of 12% constant currency net profit growth, and extended its capital management program further by announcing that it would buy back a further $950m of shares over the next 12 months. The buyback was largely anticipated by the market, given the strength of CSL’s balance sheet and the fact that it has conducted a buyback of a similar value over each of the last three years. Despite its premium valuation to the market, CSL’s current low cost of debt should ensure that the buyback is EPS accretive to shareholders.
Woodside Petroleum (WPL) upgraded its full year production forecast, with the mid-point of its new range representing a 2.7% uplift. WPL is getting a temporary tailwind from two sources – higher production as a result of better performance of its producing assets (and after a maintenance outage at its Vincent oil field in 2013), along with better LNG pricing following the rollover of some legacy contracts.
As we have highlighted before, however, the growth outlook for WPL is muted, with few near-term development options for the company. This is made more difficult by the natural field decline in its existing asset base, and now, following recent weakness, a sliding oil price, which has recently hit its lowest level in two years. This decline, however, will not have been fully reflected in the September quarterlies, given the relatively high base in which the price started the quarter. A falling $A will partially insulate the earnings of WPL (and others in the energy sector) when converted into domestic currency.
Santos’ (STO) production, meanwhile, is on an upward trajectory, with 9% quarter on quarter growth. PNG LNG, which shipped its first cargo just under five months ago, is now operating at full capacity. The next three to four quarters will now be focused on the Gladstone LNG project, in which it is the operator and has a 30% interest. The milestone boxes continue to be ticked on GLNG, with STO reporting that it is approaching 90% complete.
Ten Network (TEN) is well off the radar of most investors given its decline over the last four or five years, and its full year result demonstrated why this is the case. The headline of its result trumpeted its “strong audience growth since May 2014”, however its bottom line was an underlying loss of $115m, with revenue declining 4.2% and cost growth of 7.0%. Ten has been squeezed out of the three-player free to air market, losing close to a third of its overall industry advertising share over the last four years. It is difficult to see significant improvement in the next 12 months, particularly with a lack of key sports offering. The quality of its new shows for 2015 also fails to enthuse, and most may question whether new titles such as I’m A Celebrity… Get Me Out of Here! will change this landscape. The television industry is likely to experience considerable change over the next decade, with the lines between the traditional delivery of the media and online video becoming blurry. While this will create opportunity for the free to air networks, the threat of new competition looms large, particularly for those who hold better content.
Company Focus: Amcor and Brambles
Amcor and Brambles are two industrial companies that we hold in our model portfolios that share a number of characteristics. Both have divested businesses in the past 12 months which have gone on to perform relatively well trading as separate entities on the ASX. The companies have defensive earnings streams, deriving a large proportion of their revenues from fast moving consumer goods segments of the market, with reduced exposure to more discretionary consumer spending. Amcor and Brambles also are amongst the global leaders in their respective fields (packaging for Amcor and pallet pooling for Brambles), and thus are amongst the leading industrial companies on the ASX with a diversified global earnings base.
Despite these similar characteristics, Brambles has historically traded on a P/E premium to Amcor, and there could be several reasons for this outcome. Brambles has generally been the higher margin business, with better cashflow conversion and a higher return on equity. Brambles’ business also, arguably, has higher barriers to entry given the scale of its network. Amcor, however, has been closing the gap in recent years, with the company’s improved earnings being driven by the successful integration of the Alcan packaging business. Brambles’ returns, meanwhile, have been diluted through the company’s expansion via acquisition into new market segments.
In terms of geographic exposure, the two companies are remarkably similar, with European and American revenues dominating the mix. Amcor has a higher weighting towards emerging economies, which is seen as key to the group’s overall growth in the medium to longer term. Amcor separately discloses that 11% is derived from Latin America. While Brambles does not make this same distinction, it is likely that its ‘Americas’ revenue is dominated by the US and Canada. In total, emerging markets accounted for 30% of revenues for Amcor in FY14, while for Brambles, this figure was around 10%.
Amcor and Brambles: Revenue by Geography
In the following table we have outlined where consensus earnings expectations currently sit for the two companies. From a valuation perspective, the gap between the two stocks has closed in the last two months, with Amcor performing particularly well (relative to the market) over this time and following its August result. At present, forecasts are showing a better earnings profile for Brambles, and the stock looks to be better value than Amcor. The recent weakness in the $A, however, may have inflated this difference to a degree. We have listed the earnings growth for Brambles in $A and $US separately (Brambles reports in $US, while Amcor does not), given that the depreciation in the $A may not yet be reflected in the forecasts for Amcor.
In terms of guidance from the two companies, Brambles is indicating high single digit revenue growth, consistent with the five year targets that the company has set out. The company is also aiming for margin expansion in the medium term, with a 20% return on invested capital target by FY19 to be achieved through a combination of reduced overheads, improvements in asset efficiency and control, and scale efficiencies from revenue growth. This alone, if achieved, would contribute 4% earnings growth p.a. over this time frame.
Amcor is more ambiguous with its guidance, pointing towards “higher earnings” across its key divisions. Growth in emerging markets will continue to be key for the company, which showed 8% organic profit growth in FY14 compared with a flat result for developed markets. For FY15, a key risk for both would be further deterioration in the European economy.
Amcor and Brambles: Consensus Forecasts