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WEEKEND LADDER

A summary of the week’s results

18.07.2014

Week Ending 18.07.2014

Eco Blog

Domestically, economic news was fairly light, and thus July’s RBA Minutes captured much of the attention. The minutes reaffirmed the view of the Board that we are in for a period of interest rate stability. Various subtleties were again picked up by a number of analysts, in particular a slightly softer view of the labour market. The most recent problem to emerge that has threatened the transition from mining investment to other parts of the economy has been a decline in consumer sentiment following the Federal Budget. This has come at a time when the Australian dollar has remained high and hence failed to provide the assistance that was hoped to a number of parts of the economy.

The market, however, is beginning to make up its own mind on the direction of the cash rate, with expectations of a rate cut towards the end of the year increasing over the last month – markets are now implying a 66% chance that the cash rate will still be 2.5% following November’s monetary policy meeting, down from 90% four weeks ago, with the chances of a rate cut increasing.

RBA Cash Rate Implied Probabilities - November 2014

Source: Bloomberg, Escala Partners
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The other worry for the RBA is that it does not wish to stimulate house prices if it were to cut interest rates further. While Australia’s high housing prices were highlighted in a recent speech by the Governor, a research paper released by the central bank also looked to address the matter. Titled Is Housing Overvalued?, it assessed the opportunity cost of owning a home against renting. The authors’ conclusion was that the housing market is only at around fair value if one was to assume that historic rates of pricing growth were to be replicated in the future. The RBA will be hoping that such analysis will encourage investors to exercise a degree of caution before entering the market.

NAB’s Quarterly Business Survey again showed a marked difference compared to consumers in response to the budget, with the index declining only slightly from the first quarter, but remaining in positive territory. Business conditions continue to show steady improvement, and importantly, there are tentative signs of growth in non-mining capex.

The June quarter’s reporting season starts earlier in the US, and early indications have been quite encouraging. The banking sector has been in focus this week, with Goldman Sachs, JP Morgan and Citigroup all posting numbers that were well received by the market. After rising fairly steadily since the depths of the GFC, the US market is increasingly looking towards underlying earnings growth to support current valuations. The current low interest rate environment is certainly playing its part in assisting earnings per share growth, which has allowed companies to improve this metric through a high level of share buybacks, along with improving the economics of various M&A activity.

Janet Yellen’s semi-annual testimony to Congress touched on the sharemarket, highlighting the stretched valuations for a number of industries, including those in the social media and biotechnology sector. The Fed believes, however, that valuations measures for the overall market are not far above their historical averages.

On the economy, Yellen again reiterated a relatively dovish tone, justifying the central bank’s current stance. A comment that the path to higher interest rates could be accelerated if the labour market improves more quickly than expected was viewed as slightly more hawkish by the market.

While employment figures have been encouraging in recent months, with a fifth successive month of 200k+ jobs growth recorded in June and an unemployment rate that has dropped to 6.1%, the amount of slack in the labour market has been highlighted by the Fed as an ongoing issue, and a key reason why many believe that it will still be some time before it begins to raise rates. The chart below tracks these various measures, with the blue line representing the traditional measure of unemployment, as well as including those who have given up looking for work (‘discouraged workers’) and those that can only find part-time employment. Anaemic wage growth (2.25% over the year to March end) has given further support to the central bank’s view.

US - Measures of Labour Undertilisation

Source: Federal Reserve
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This slow wage growth is also being reflected in US retail sales, which failed to match expectations in June, rising by 0.2%, when the market had been looking for 0.6% growth. While this was the weakest reading since the weather-induced slump in January, the read-through appeared to paint a better picture, with much of the disappointment attributed to volatile categories such as auto sales. May’s figure was also revised upwards, however a significant consumer-led recovery is still yet to emerge in the US.

Fears over a hard landing in China were further dispelled this week as it released its GDP figures, showing that the economy had expanded by 7.5% in the 12 months, ahead of expectations for a 7.4% reading. The country’s reform agenda has taken somewhat of a back seat in recent months, with a mini-stimulus, including spending on infrastructure, helping the economy to track back towards its 2014 growth target. Some relaxation of the tight credit conditions previously imposed also led to solid expansion in lending. 

China GDP Growth (Year on Year)

Source: Bloomberg, Escala Partners
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Company Comments

While July is otherwise a fairly quiet period leading up to reporting season in August, quarterly production reports from the resources sector provide further clarity to the market on what to expect from these companies next month.

Rio Tinto’s (RIO) quarterly confirmed a previous notice to the market which announced that it had reached its targeted 290 mtpa iron ore production run rate two months ahead of schedule. The group’s iron ore production rose 10% on the first quarter of this year, while shipments grew at a faster rate as the company drew down on stockpiled inventory that was built up ahead of its infrastructure expansion. Iron ore is still clearly the main game for RIO, despite the dominance of the commodity on its existing portfolio and overall profitability. The company is looking to increase its Pilbara production by more than 10% again in 2015 to 330 mt as part of its plans to achieve a rate of 360 mtpa by 2017. While this additional supply has had a detrimental effect on the price of iron ore, particularly in the first half of this year, it is easy to see why it is pushing on with these expansions – at a capital intensity of US$120 - $130/t, the payback on this investment, even in this lower iron ore price environment, is still attractive. The ability to leverage existing infrastructure through brownfield expansions gives the company an advantage over smaller players.

Outside of iron ore, performance has been much more mixed, reflecting adjustments made to adapt to changing market conditions (lower semi-soft coking coal and titanium dioxide feedstock), as well as other marginal gains from projects reaching their completion or ramping up (the Oyu Tolgoi copper mine in Mongolia) or recovering from disruptions (Kennecott Utah Copper was impacted by a pit wall slide in April of last year). The table below highlights these varying fortunes compared with last year:

Rio Tinto - 2Q14 Production Summary

Source: Rio Tinto
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The major miners screen as good value at present in a market that otherwise appears to be fairly fully valued, although weakening commodity markets could continue to overshadow any positive catalysts in the short term. A persistently high Australian dollar is also leading to some downgrades of earnings forecasts at the margin. Sentiment will likely improve in the upcoming reporting season should either of the majors announce capital management initiatives, although the expectation of the size and timing of these has been dialled back in recent months in the wake of the weak iron ore price.

Fortescue Metals (FMG) also released its quarterly production report, although much of the key data points were announced to the market in an update last week. Of interest was its disclosure on iron ore pricing, with the company achieving a price at a 20% discount to the 62% Platts index benchmark. This was greater than the 14% discount achieved on average over the course of FY14. What this highlights is that an important part of the margin equation of the iron ore miners is not just on the cost side, and that pricing can also differ quite materially depending on the quality of the product. The iron ore price itself has dropped considerably in 2014 and will thus provide a difficult starting point for FY15 as companies will be cycling a higher price and thus earnings from FY14. The commodity appears to have found a bottom in the last month, however, rising back to US$98/t after dipping below US$90/t in the middle of June.

Woodside Petroleum (WPL) surprised with a production upgrade for the 2014 calendar year. The company narrowed the range of its production target for the year, with the midpoint of the new guidance around 2% higher than previously indicated to the market. With a lack of any significant growth from new projects reaching the production phase, however, production surprises such as these will be limited to improving the performance at its existing operations, and thus are likely to be more marginal when compared with the other large-cap names in the sector. These include Oil Search (OSH), Santos (STO) and Origin Energy (ORG), who will all benefit from various LNG projects reaching completion in the coming years. Our preference in the sector remains with these stocks that will have more opportunities available to them as these projects come on line, with their cashflows improving at a better rate than earnings due to the highly capital intensive nature of LNG construction.

Santos’ (STO) quarterly production showed the benefits of the commencement of production at the first of these LNG projects in the current wave of expansion, with PNG LNG adding 5% to the group’s production compared with the first quarter. The ramp up at PNG LNG has been strong, and the benefits from this will contribute to further growth over the next 12 months with Gladstone LNG, which is currently over 80% complete. What was perhaps a little disappointing from STO’s announcement was a lack of any upgrade on the company’s full year production guidance given the better-than-expected performance at PNG LNG (which has seen Oil Search upgrade several times) – while this indicates that the rest of its portfolio has been performing a little below par, this will begin to become overshadowed by the growth in its portfolio in the medium term.

AGL Energy (AGK) appeared to be the biggest loser from the repeal of the carbon tax this week, with updated guidance to the market for FY14 and FY15. While FY14 is expected to come in at the low end of its previously stated range, its forecasts for FY15 took some by surprise, with the removal of the carbon tax expected to reduce its operating earnings by $186m. In short, the impact will be felt from two sources – reduced earnings from the company’s Loy Yang power station, and a lower contribution from its renewables portfolio as a result of a decline in wholesale electricity prices. Loy Yang had been receiving assistance from the government to help it transition to the carbon tax environment, however these payments were greater than cost of the tax itself.

Renewable energy generators will also face lower margins given the lower revenues following a decline in the wholesale electricity price, but unchanged costs. This will affect AGK to the tune of $80m in FY15, given its substantial wind and hydro portfolio. Origin Energy (ORG), which we have in our model portfolio, will also be impacted as a result of this, however not nearly to the same extent due to the fact that its renewable portfolio is a much smaller size.

The major banks made headlines with the release of the interim report from the Financial System Inquiry. While not alluding to any recommendations as such, the report appeared to favour the smaller regional banks over the big four. Policy options that have been put on the table include increasing the D-SIB capital buffer (i.e. the additional capital required to be held by the four major banks which APRA deems to be systemically important), adjusting the risk-weighting for mortgages to level the playing field with smaller borrowers, along with addressing the notion of the majors being “too big to fail” by looking at ways to lift the burden on the taxpayer in the event of a bank collapsing. The chart below shows the capital buffer required for systemically important banks in Australia compared with around countries and regions around the world, with shows us at the low end of the scale:

Capital Ratio Add-ons for Systemically Important Banks

Source: Financial System Inquiry - Interim Report
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While the final recommendations of the report are not due until November, the proposed options in the report point towards higher capital requirements for the banks and thus a reduced capacity to lend, lower dividend growth in the medium term, and lower returns on equity for shareholders, in an environment that is presently showing limited credit growth. We are underweight the banking sector in our model portfolios.

Sector Focus - Earnings Updates

With a few downgrades beginning to filter through the market in recent weeks, we have reviewed the list of S&P/ASX 200 companies that have provided an update on their expected FY14 earnings over the past two months. For the purpose of this review, we have looked at all companies, excluding the resources sector, where guidance largely refers to production figures and thus is not affected by an external market environment.

The table below summarises these earnings announcements. While there has been a number of downgrades, on the whole the ‘confession season’ has been relatively benign compared to previous years, indicating that most companies are expected to deliver on their guidance in the upcoming reporting season. Also of note:

- downgrades have outnumbered upgrades by a factor of 2:1 (9 downgrades against 4 upgrades)

- the retail sector has been the primary source of downgrades, with Kathmandu, Super Retail, Pacific Brands and The Reject Shop all reporting lower sales through a combination of the warm start to winter and in response to the budget

- outside of retail, the only sector to feature more than once is mining services, with minor downgrades to Cardno and Bradken

- impairments or one-off costs that will be taken below the line will reduce the profit figures of several companies, although ‘underlying’ figures that most analysts focus on will not be impacted by these.

S&P/ASX 200 Earnings Updates - last two months

Source: IRESS, Escala Partners
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The table on the previous page has looked at updates provided by companies in the last two months, and thus it is still possible that companies may have had their earnings forecasts trimmed by sell-side analysts. This will likely be evident given a number of influences that have provided a more cautious outlook for the market in recent times, including the continued strength of the Australian dollar, weakness in commodity prices (in particular iron ore) and the fall in consumer sentiment and spending post the budget.

For companies that are able to meet their guidance, more important in the reporting season will be outlook statements, many of which will address these various issues. At present, forecasts for high single-digit earnings growth for the market do not look unrealistic, however these figures are likely to be revised as we progress through reporting season.

 

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