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WEEKEND LADDER

A summary of the week’s results

18.08.2017

Week Ending 18.08.2017

Eco Blog

- Increasingly, the probability is that Australian economic conditions are similar to the low growth of the developed world. Investment markets still need to fully adapt.

- China is back on the radar with the US flagging an overview of trade. This comes at a time China has moved back to top slot as a holder of Treasuries.

- Debt is another worry spot for China. In a positive development, the government added outside shareholders to one of its indebted state enterprises, while on the other hand, household debt has unexpectedly spiked.

Current economic data and trends can become normalised is a way that sits at odds with many of the commentators on financial markets, who still expect historical conditions to resume.

This week a few on the Australian household sector stood out. Unemployment is sitting at 5.6% and this level causes neither anxiety or joy. But it remains well above countries such as the US, UK Germany and even Japan. Similarly, very high household debt levels are constantly noted by the RBA and bears on the outlook for the Australian economy.Surveys show that households themselves, however, see their debt as a simple fact and expect it to remain high. The main point of interest to them is debt servicing, not the repayment of principal.

In the context of low income growth (with the ABS release this week of the wage price index at 1.9%) perhaps that is rather a realistic assessment of circumstances.

A paper from Capital Economics makes the case that Australia’s financial trends will become similar to other developed nations. Inflation is likely to be sticky at 2% or even below, given the global influences from trade and lack of high skill paying jobs such as in IT, and the shift to less secure part time jobs. Further, with the ABS reweighting the mix in the CPI later this year, this will structurally move the CPI down, as the impact of falling tradeable prices and services such as communications will be accentuated. Deflation is not impossible in such a scenario. Without the regulated or one-off price rises from education, utilities and health, the current inflation rate is already closer to zero. 

Interest rates may devolve from the inflation target to financial stability, as appears to be the case at present. Investment markets may therefore react to different signals to those typical of today.

There are many direct implications on financial markets. Assets priced off inflation (REITs, infrastructure) often have a ‘higher of CPI or 3%’ formula in their income stream. When the CPI tended to be around 3%, that differentiation was largely irrelevant. If the inflation rate is 1.5-2%, it might be only a matter of time before such formulae adjusts and results in lower returns for the investors. 

Permanently low interest rates, well below the RBA’s recent 3.5% neutral rate, also changes the sustainable price/earnings ratio, as we discussed in our recent Asset Allocation quarterly. The bad news is that earnings will be lower too, and the net result may not imply that equities are now good value.

For rate markets, a flat outlook puts reliance on spreads and opportunistic trading of patterns that inevitably emerge.

Trade tensions are never far away given the attitude of the US and the need to conclude new arrangements for Brexit. Invariably, the US skirmish focuses on China, with the chief strategist Bannon talking about an ‘economic war with China’ in an interview this week. The administration paralleled that by initiating a one year review of China’s trade and investment practises.

This comes at a time China is once again the largest holder of US Treasuries, as it rebuilds reserves after defending the currency last year.

Foreign holders of US Treasuries

Source: US Treasury, Bloomberg
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China accounts for roughly two thirds of the US trade deficit, largely unchanged over the past five years. Aside from some basic goods, such as steel (where the US has already taken action) it is hard to point to major components of the trade that should cause alarm. It would appear the focus is on intellectual property and access to markets; arguably a valid issue but far from unique to China.

The concerns on China debt’s also do not fade. This week Unicom, a state-owned enterprise (SOE), was restructured to ‘mixed ownership reform’ with the introduction of other shareholders comprising not only a number of financial and industrial companies, but also the China internet giants. After muted success in a similar structure for Sinopec, the oil company, in 2013, this transaction will be watched to see if it changes the financial management of Unicom. China’s corporate debt to GDP is high, largely due to the SOEs, which hold account for about 65%.

Many have argued that the government should formally nationalise the SOE debt, while others have suggested the government will look to shift the burden to the private sector as the example now implies. Investors often shy away from China financial stocks for that reason, as they could be obligated to take on bad debts. Instead, the Unicom reform may show that the government will also introduce commercial shareholders in an effort to change the management style.

It does, however, not remove the overburden of high debt and large bad debts. Few believe the official number of 5.3% of loans either in default or one notch above. Most estimate that the real level is likely to be in the mid-teens, with one prominent economist taking the high road at 34%, though also with the caveat that this is the level if economic growth were to fall sharply.

Unhelpfully, there is a new debt cycle emerging in the household sector, where short term loans have risen by over 30% in the past few months. What these loans are for is unclear (as the household sector includes small businesses) while there is no evidence mortgage lending has broken any trend. It points to is the difficulty the government has in controlling credit in the absence of an appropriate pricing signal and alternative avenues for saving.

China’s consumer credit growth, year on year

Source: Deutsche Bank, PBOC, CEIC
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China, quite reasonably, remains firmly in the top three concerns that investment managers nominate in surveys.

Fixed Income Update

- RBA minutes were released, with most market participants forming the view that the central bank will remain on hold for the remainder of 2017.

- Credit spreads remain tight in the domestic market, while offshore markets drift upwards.

- The CDS for NAB trades tighter than CBA as its money laundering scandal unsettles investors.

- ANZ make an announcement on a new bank hybrid and a buyback of option for ANZPCs securities.

The RBA minutes were released this week, with a few slight variations from previous statements.

The key take-aways included:

- The recent rise in the AUD, and the potential for this to compress consumer prices and weigh on the outlook for growth and employment.

- The “ongoing low wage growth and the high levels of debt” and “the possibility that consumption growth could be lower than forecast’’.

- The RBA is not yet fully convinced the macro prudential changes by APRA on residential loans is going to be effective enough, and therefore house price growth is not moderating to a satisfactory degree.

There was no notable movement in the bond market following the announcement. It appears that the RBA is not considering raising rates anytime soon, largely due to the burden of household debt, currently at 190% of disposable income. Futures markets are still pricing in the probability of rate rises from next year on, with a 20% probability in February and building to 45% by mid-2018.

Investment grade credit spreads in the domestic market remain tight.  The Aussie iTraxx (spread index) is at now at 75bp, which is the lowest it has been since December 2007. To add context, before the financial crisis this index traded as low as 23bp and remained close to that level between 2004 and 2007.

iTraxx – Australian investment grade credit spreads

Source: Bloomberg, Escala Partners
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Australian markets are often slower to respond to changes in directions offshore. As credit spreads push lower in the domestic market, the US has recently seen some weakness in investment grade and high yield products. Spreads on investment grade bonds in the US have widened by about 7bp in the last week in response to growing geo-political unrest and increasing market supply.

US high yield is also showing signs of weakness with the market suffering its deepest sell-off in months at the end of last week. Similarly, the cause is a combination of a risk-off tone and new supply. Spreads in this market have increased from 355bp to 389bp in the last month. As spreads had compressed across most sectors of the credit spectrum since the beginning of the year, and these reversals may open up opportunities for deployment of cash at higher yields.

A credit default swap (CDS) is a contract between two parties, whereby the buyer seeks to eliminate a possible loss arising from the default of the issuer of a bond. It is akin to taking out insurance in the event of a bond default of a corporate, sovereign or bank. The price of this ‘insurance’ moves around, and is reflective of the credit risk of a counterparty. It is also a good indicator of the cost of funding (in terms of its spread premium over a benchmark) that the issuer would need to pay if it was to issue a senior debt security. While the CDS market is very thin in Australia, it is very active in offshore markets, albeit name dependent.

The money laundering allegations within CBA have been well documented. As markets wait to see how this plays out (lawsuit costs, regulation etc) the CDS market for CBA has reflected the caution of investors. Historically, CBA CDS has traded slightly tighter than its Australian banking peers. The bank has therefore been able to issue debt at tighter spreads and receive premium funding levels to the other majors. Now the CDS on CBA is trading wider than that of NAB. This index is a key barometer to investors sentiment on credit worthiness of an issuer.

Spread differential between CBA and NAB CDS in the last 5 years

Source: Bloomberg, Escala Partners
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As expected, ANZ have announced a new bank hybrid and a buy-back option for ANZPC securities.  Holders of these securities have the option to:

- Reinvest proceeds from buy-back of ANZPC securities into the new ANZ Capital Notes 5

- Receive the Buy-Back Price ($100) in cash

- Take no action, in which ANZPC case securities will remain outstanding subject to the original terms and conditions of the ANZPC security. These can still be sold anytime on the ASX.

A summary of the details on the new offering of ANZ capital notes 5:

Source: ANZ
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Corporate Comments

- The outcome from Telstra’s (TLS) capital management review was worse than expected, with a significant dividend cut from next year.

- Cochlear (COH) reported well, although the key hurdle remains  valuation.

- CSL tempered expectations for FY18, with the company electing to increase capex at the expense of a continuation of its buyback programme.

- Seek’s (SEK) result was sound, however there is uncertainty on the return of its increased investment spend.

- Origin’s (ORG) balance sheet continues to improve, although the stock is still a riskier proposition compared to competitor AGL.

- Woodside (WPL) has made good operational improvements in its business, although continues to lack attractive growth options.

- QBE disappointed with its guidance, with the negatives overshadowing a few positive trends.

- Challenger (CGF) has been supported by robust demand for annuities, although there are risks around its margin outlook.

- Wesfarmers (WES) result showed the impact of competition in supermarkets, with hints it would reduce that into 2018.

- JB HiFi’s (JBH) met expectations though the newly acquired Good Guys missed and the Amazon challenge once again become the talking point.

- Domino’s Enterprises (DMP) had an unappetising mix of weak Australian margins and messy European result while Treasury Wines (TWE) toasted to success in its higher end product range.

Telstra’s (TLS) full year result missed the mark, however it was the release of its capital allocation strategy review that captured the attention of investors. Telstra announced last November that it would conduct a review given the uncertainty of its medium to long-term dividend profile, with a range of factors contributing to the lack of clarity: a core base business that is facing earnings pressure and the permanent loss of margin as the NBN transition is complete; the one-off payments received as each address is connected to the NBN; and lastly, the recurring revenue from NBN access to its infrastructure.

While TLS’s large retail investor base would have been largely unaware of the looming potential for a lower dividend stream, the prospect has been well flagged among sell side analysts and institutional investors alike. Despite this, however, the results of the review were considerably below the negative forecasts in the market; dividend cuts are coming sooner than expected and the quantum of the cut will be greater.

Having paid out around 100% of earnings in dividends in recent years, TLS is now moving towards a target 70-90% payout ratio, while additionally returning three quarters of one-off NBN receipts. The end result is that the company is now forecasting an FY18 dividend of 22c (a decline from this year’s 31c), which notably includes the special dividend from one-off NBN payments. With earnings declining in the former and the latter peaking within the next few years, the prospect of further dividend cuts in the future remains a real risk for income-seeking shareholders.

Telstra: Dividend Payout Ratio and New Policy

Source: Telstra
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Stripping out the impact of the various revenues and costs of the NBN transition, TLS’s core earnings declined 3% for the year. After driving earnings over several years, mobile profitability fell. Fixed voice and broadband data again saw revenues and margins decline as expected, with the division yet to absorb the majority of the $3bn hit once the NBN is fully rolled out.

As opposed to capitalising the current net earnings of the business, our view is that TLS should be valued on a multiple of its recurring earnings with an additional value ascribed to the one-off NBN payments. Looking through this lens, a forward P/E of 16x (as opposed to a reported P/E of 11x) looks to be fairly full value from a company that may see further earnings decline in coming years.

The momentum in hearing implant manufacturer Cochlear (COH) continued as it delivered a full year result at the top of its guidance, with 18% profit growth. The result demonstrated the benefits of an increase in sales and marketing spend, along with product upgrades It was particularly good considering that sales to China (which are more variable year to year as they are conducted on a bulk tender basis) were lower. Guidance for next year resulted in marginal upgrades, although this has been made with a conservative AUD assumption of US80c.

COH has had a more consistent pattern of sales growth over the last few years which has resulted in solid earnings growth given the operating leverage in the business. An increasing installed base over time has also led to an increasing level of revenue from upgrades and accessories, which have recurring revenue characteristics. The stock is not without its risks, however, given the potential for a competitive response from its peers or product issues (such as those that have resulted in recalls in the past). The biggest near-term risk is likely one of valuation; despite a sound outlook, most struggle to reconcile the stock’s elevated valuation, which is now ~35X earnings on a forward basis.

CSL was a victim of its own success, with the company required to temper the bullish FY18 growth forecasts. Its FY17 result actually exceeded its guidance of 18-20% constant currency earnings growth, although fell slightly short of analysts’ expectations. The result was underpinned by solid organic growth across much of its portfolio and was boosted by new product releases, with the company executing well in a high demand growth environment. A slight negative mark was attributed to the slower than expected trajectory of restoring to profitability its acquired flu vaccine business.

The mid-point of guidance for FY18 is for a further 13% increase in earnings; an impressive figure given its size, especially from a company that is typically conservative with its outlook. Of some disappointment to investors was the lack of extension of the company’s perennial buyback, although this is now less beneficial given the stock’s valuation. However, given a step up in growth capex expected in the medium term (including significant spend on expanding its collection centre network), the priority of investment over shareholder returns should be somewhat encouraging, particularly given the company’s excellent long term track record.

Retaining its status as the core large cap healthcare stock for investors, the quick share price recovery this week is likely more a function of a lack of alternative attractive growth options among the ASX 20.

CSL: Sales and Capex

Source: CSL
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Seek (SEK) was another high P/E, high earnings growth company that is investing for the future, but disappointed with its result and outlook. FY17 was characterised by ongoing solid performance in its core Australian employment classifieds division. Earnings growth of 11% was attributable to a healthy combination of volume growth and price increases, while a mix benefit was gained through a shift towards higher value premium products.

Seek’s international investments are now just as important to its domestic business in terms of size and contribution to group earnings, although the outcome for FY17 was more variable. A stake in Chinese market leader Zhaopin was again the standout, while Seek Brasil faced a difficult macro environment. Elsewhere, the evolution of its education division continued after regulatory reform of recent years led to the decision to cease its vocational education and training (VET) operations and concentrate on online services. At this stage, education is a rather peripheral consideration in group earnings.

The key talking point, however, of SEK’s result was guidance that implied that revenue growth would remain robust into FY18 (20-25%), although earnings expansion will be slower. The crux of the issue is that the group’s development and investment spend has increased materially over the last few years (and took another leg up in FY17) and the question becomes to the payoff on the spend and versus how much is simply defending its position from interlopers such as LinkedIn and Indeed.

An investor with a longer-term time frame may well see the rewards through a patient approach, although the earnings visibility is less clear than high growth companies to which it is typically compared. On a near-term view, the stock, does not look attractive, trading on a P/E in the high 20s.

Seek: Production Development and Investment

Source: Seek
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Origin Energy’s (ORG) result was well received, although the reported profit number was burdened by a large write-down of its interest in the APLNG project (previously disclosed to the market). As with AGL last week, the company’s earnings were supported by the rise in wholesale electricity prices, while APLNG earnings lifted on the ramp up of the second LNG train (which started production last October) and a better pricing environment (domestic gas as well as its oil price-linked export revenues).

Reflecting the balance sheet pressure that the company has faced, no dividend was declared for a third consecutive reporting period, with only a possible chance of a dividend resumption in the next 12 months. Instead, the company’s priority continues to be the reduction of its still-significant level of debt, which may be accelerated should it achieve the successful sale of its oil and gas arm (with an IPO also being considered for these assets).

To a large degree, ORG’s ability to achieve its debt reduction targets will be dependent on a supportive oil price, as this will help it with its asset sales as well as providing higher cashflows from APLNG. APLNG is a marginal producer in the current oil price environment; ORG disclosed guidance for a US$30/boe operating breakeven cost (assuming a 0.75 AUD/USD rate), with an additional US$18/boe of project finance costs.

From an investment perspective, the best way to view ORG is as a leveraged energy play, combined with its core integrated electricity and gas business. While the latter has a positive outlook following the recent rise in wholesale electricity prices, ORG’s electricity generation position is inferior to that of AGL, with the company only supporting just over half of its electricity sold from its internal portfolio. As with AGL, the regulatory risk that could potentially cap returns for utility companies is expected to be an ongoing point of discussion for the medium term.

Woodside Petroleum (WPL) also reported well and ahead of expectations. Over the last few years WPL has done an excellent job of reducing its production operating costs, giving it a degree of protection in a soft oil price environment. With a low cost asset base, its margins remain healthy – a 48% gross margin in the first half – although this also means that there is less positive leverage for those that have a constructive view on energy markets going forward.

While the company has a sound balance sheet, a key issue for WPL remains the lack of attractive growth options in its portfolio, which is reflected in its relatively stable production profile over the last five years. An investment in the Wheatstone LNG project (operated by Chevron) will help in the near term, although this is only expected to replace natural field decline across its portfolio over the next few years. The stock is still the most defensive option across the sector, with strong margins, little development risk and most of its value captured in its existing assets. Our preferred option in the sector is Oil Search, which has a better balance between growth and quality of assets.

Woodside Petroleum: Annual Production (MMboe)

Source: Woodside Petroleum; 2017 is midpoint of company guidance
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QBE Insurance’s half year result was one of the more disappointing of the week, with the company guiding to the lower end of its forecast insurance margin for the full year. Most of the issues that led to its guidance were flagged in June, particularly across its Emerging Markets business, where its underwriting performance has been hurt by a higher frequency of mid-sized claims. Compounding the soft outlook was a lower level of expected reserve releases, which can be somewhat cyclical in nature.

While overall QBE’s outlook was soft, there was some positives to be gleaned. Premium growth rates have improved in the half, particularly in North America and Australia. Investment returns should also be better this year, although forecasts have been tempered by bond yields that have paused following the sharp rise in late 2016.

QBE has been a persistent underperformer for some time, though a positive view can be put together from its undemanding valuation, with an attractive P/E and book value support. Additionally, the company is about to commence is previously announced buyback, which should provide further support to its share price. We have held the stock in our concentrated model from late last year, where it enjoyed a strong rally given its leverage to rising interest rates. This remains the case, although its operational performance has been below par. We will review the position post reporting season.

Challenger Group (CGF) is a diversified financial company that has attracted investor interest on the back of the high demand growth environment for annuities, in which it is the domestic market leader. This trend was evident again in FY17, with sales growth of 20%, although the net growth of its book was lower due to a high level of maturities (a persistent drag given their short-term nature). CGF has successfully grown its distribution footprint in recent times via new relationships with the big players in Australia’s superannuation industry, along with a partnering with a Japanese insurer to sell into that market.

The key earnings risk for CGF is with its ability to maintain its margin levels (it essentially makes a spread on the assets that it invests in and the annuity rate it pays its investors). This is particularly high given the lower domestic interest yield environment and its ability to reinvest maturing assets into securities that generate an adequate spread to cover its annuity rates. With a reasonably high level of leverage to this change, we do not agree with the more bullish views on its outlook.

Wesfarmers (WES) result was met with surprising ambivalence given the notable profit deterioration in the supermarket division. Coles’ profit margins fell by 100bp in FY17, mostly in the second half of the year, to reach a low of 4.1%. The company is signalling (probably as much to competitor Woolworths as to investors), that it will level off its price reinvestment and that it expected food inflation to edge upwards. The basis for this contention is not clear, but given the duopoly nature of the two mainstream participants we assume this is an effort to contain a disruptive price tit for tat.

The Bunnings business goes from strength to strength, with only a pull-back in housing spending possibly disrupting its steady growth path. The losses ($89m) in the fledging UK business were in line with expectations. At this point this operation is small, yet to make profit WES will need to invest a relatively substantial sum. The risk is that it is misjudging replicating the Bunnings formula into this market.

Kmart joins Bunnings in it consistency at this point. On a positive tone, Target should, too, return to profitability in 2018, notwithstanding the 15% fall in sales in 2017. However, the discount department store sector in Australia still looks too large to cope with competition from low prices specialists in apparel and online.

The other divisions, industrial and safety, and chemicals and coal, all had a big upward movement in profit in 2017. History shows that investors cannot rely on these for steady earnings and cash flow.

As the remaining true conglomerate that reflects a good part of Australian activity, the difficulty is valuing WES. A sum of the parts is based on comparable companies for each division, regardless of whether they are overvalued or not. Trading at 16.5X 2018 earnings, at a yield of 5% and forecast growth in the mid to low single digits, the stock is far from compelling, yet is a safe enough spot for investors to anchor a holding given the lack of reasonable alternatives in the top 20 stocks.

JB Hi-Fi (JBH) beat its earnings expectation, yet investors were somewhat discomforted by the mix and returned to the theme that Amazon would poise as a large threat to the business. The core JB Hi-Fi operations delivered a stellar 11% growth in sales and 19% in profit. On the disappointing side was the deterioration in the New Zealand division, slipping into a loss and with a restructure on the cards. Given it represent only 5% of the sales in the JB Hi-Fi brand, its significance is low. More importantly was the below par result for The Good Guys, acquired in the year. Management will have to prove that this business can complement the JB Hi-Fi store base in focusing on big ticket items. If successful, it may also go some way to resist the online challenge.

With the stock is trading at 11.5X FY18 forecast earnings with a yield of 5.7%, we feel shareholders are not taking undue risks, notwithstanding the clear challenge ahead. JBH has, to date, managed much of the volatility and changes in market conditions better than most in the retail sector. Amazon will inevitably entrench low prices for product that is bought without advice. But there is enough complexity in electronic and related product for a service orientated store format to hold onto a decent share of the sector.

Two market favourites have had quite different assessments of their fortunes. Domino’s Pizza (DMP) was hit, notwithstanding a 29% lift in its FY17 profit. Expectations had been for even more after years of beating guidance. Australia was weak, with early indications the format is maturing here. Added to that is the question of the share between DMP and its franchisees, given the problems with wages and other disclosures through this year. The European operations, particularly in France, were also not quite up to scratch, highlighting that simple translation of success from one region to another is not the case. Trading at a still hefty 25X forward earnings, investors are likely to satiate their appetite for growth stocks elsewhere.

Perhaps Domino’s needs to take a leaf out of Treasury Wines’ marketing, as investors celebrated its 30% profit growth. The overarching strategy has been to move towards premium product, where competition is based on status (and of course quality) rather than just price points. Management therefore start their result presentation with slides such as the one below.

Introducing TWE’s Luxury French Portfolio – Maison de Grand Esprit

Source: Treasury Wines Estate
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It would be wrong to suggest that TWE could be affected by similar issues that have come to plague DMP, but the 27X multiple needs most things to go right and any disappointment will invariably result in a sell off. 

Reporting season continues next week, with the following companies scheduled to release results:

Monday: BlueScope Steel, Brambles, Fortescue Metals, G8 Education, Goodman Group

Tuesday: Aconex, Amcor, BHP Billiton, Corporate Travel Management, Monadelphous, Oil Search, Sydney Airport

Wednesday: Charter Hall, Cleanaway Waste Management, Healthscope, IAG, iSentia, Qube, Star Entertainment, Sirtex, Vocus, Woolworths

Thursday: Bapcor, Boral, Costa Group, Estia Health, Nine Entertainment, Perpetual, Scentre Group, Santos

Friday: Flight Centre, Medibank Private, Qantas, Mayne Pharma, Regis Healthcare, Sims Metal Management

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