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WEEKEND LADDER

A summary of the week’s results

19.02.2016

Week Ending 19.02.2016

Eco Blog

Trend setting economic news remains light. Locally, labour force data showed a fall in employment in January taking the unemployment rate up marginally to 6%. Many continue to debate the accuracy of this data series given the sharp swings in recent months. The RBA seems to believe that while the specific month on month numbers are questionable, the trend of lower unemployment can be explained through the growth in the services sector.

The lack of trigger there turns the question to whether the RBA has the appetite for another rate cut to fit in with easing cycles in many other countries along with the possibility that the US Fed holds back on its intentions. Any timing on such a decision is complicated by the budget, where the RBA would want a perspective on possible fiscal easing or tightening, and the elections, most likely set for the second half of the year. Governor Stephens’ impending retirement in September is also likely to rule out action at that time. In these circumstances, a short window of opportunity now and possibly mid-year are there for the RBA.

Recently, the RBA highlighted the lower cost of capital the business sector now enjoys and that the hurdle rate for investment should reflect these conditions. In response to a survey, companies state that they rarely adjust their hurdle investment requirement, presumably on the assumption that conditions will return to where they were in the past. Additionally, the equity market puts pressure on companies to protect their return on capital based on its historical level. The majority of companies are looking to invest at well above a 10% hurdle rate which the RBA estimates is now 3-4% above the weighted average cost of capital for most organisations.

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This explains the frustration of the central bank, with households reactive to a rate change while the business sector shows little appetite for a monetary policy nudge. Instead, the business sector appears to have embraced the fall in the AUD as the major benefit of easing. The RBA decision may therefore depend on how much the central bank believes the AUD can fall, rather than the flow-through impact on lending rates, with banks likely to retain a proportion of any cut.

The US picture is arguably even more complex. If the Fed did decide to delay another rate rise, it would once again introduce uncertainty on its intentions. One assumes that the members will skew their deliberations on the underlying economy rather than financial markets, albeit the upward movement in credit spreads is a de facto rate rise. Industrial production data shows no sign of recovery from the slide into contraction late last year. On the other hand, the labour market is unquestionably sound. Even the mix of new jobs, 2.7m in the past year alone, has been balanced, with growth in higher wage sectors such as legal services, computing, engineering and business as well as across the lower paying service segments. 

The Atlanta Fed constructs a set of data it believes will match economic growth. The most recent release suggests a stable-to-rising rate of expansion. Residential investment spending, intellectual property production and private consumption, in their view, offset the fall in non-residential construction (largely oil related) and weak equipment spending, as indicated by the industrial production trends. With the market now pricing in only one US rate rise this year and the bond market implying lower growth, the divide between this relatively solid outlook and these financial markets is wide.

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The coming months will likely determine which of these is wrong. In turn, this is likely to have implication for the direction of the USD. And with so much of financial markets directly or indirectly associated with the strong USD, much could still change. Examples are commodities, emerging market bonds and currency-sensitive equities.

Fixed Income Update

Bond markets appear to be a lot calmer this week than last (or are we just in the eye of the storm?). With talk of central banks coming to the rescue, oil production being cut and Deutsche Bank reassuring the markets with an offer to buy back some of their EUR and USD senior bonds, credit markets are back open for business.

New issues in all markets have been scarce this year and now some high quality credit names have been the first to dip their toe in the (muddy!) waters. This week has brought Apple, Toyota and IBM to the US bond market. Apple sold $12 billion in bonds over 9 structures, IBM $5 billion and Toyota $1.75 billion in two parts. 

Like our overseas counterparts, the Australian listed bank hybrid market is also being tested for the first time this year. CBA have announced the rollover of its maturing Perls III deal, with a new Perls VIII offering. This is a mandatory convertible perpetual note that converts to equity in 2023, unless called in 5.5 years. The issue size is expected to be $1.25 billion plus, with price talk of BBSW + 5.20%-5.35%.

Buyers of the last CBA deal (Perls VII) have seen mark-to-market losses since its inception. The large issue size ($3 billion) and skinny pricing was initially to blame for the poor performance, but a general risk off sentiment across markets has continued to put downward pressure on these bonds. Given the poor performance of Perls VII, it is somewhat surprising, in our view, that the new CBA deal is not offering a higher coupon; particularly one that is in line with other bank hybrids that can be found in the secondary market. The chart below shows the current pricing of existing bank hybrid securities compared to the expected pricing of the new Perls VIII. Despite this, we are told that the book is building well.

Relative Value of New CBA Deal vs Secondary Bank Hybrid Market

Source: Bondadvisor, Escala Partners. Pricing as at 18th February 2016.
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Staying in the Australian listed debt market, this week also saw support for the unloved Crown and Origin subordinated notes. Following Origin’s profit results it confirmed its intention to call its subordinated notes in December this year. Consequently, the securities rallied back towards par, trading at around $97.50 at week’s end. Crown (CWNHA and CWNHB) securities were also up about 13% over the week. While there has been no new information out regarding a privatisation of Crown (or its intention or otherwise to call these bonds) the securities were looking oversold based on potential returns.

Corporate Comments

Half yearly reporting season continued this week, with approximately 2/3rds of companies now having reported results. The share price reactions of companies reporting would, at the very least, suggest that results haven’t nearly been as bad as some may have feared, providing a welcome relief to investors after a difficult start to the year. Domestically-exposed companies appear to have performed quite well, while the weakness in resources-related sectors has been well anticipated. With several large-cap stocks still to report next week, we will provide a more detailed assessment of results at the conclusion of the month.

Amcor (AMC) kicked off the week with another solid result, with constant currency (the company reports in $US) earnings growth of 7%. EPS growth was higher at 10% following a US$500m share buyback through the period. The result was again achieved through a mix of organic (5%) and acquisitive (2%) profit growth.

Fears around its emerging market exposure have also been allayed somewhat, with growth from these countries ahead of that from developed markets, although somewhat lower than longer term trends. While there was an element of demand pulled forward in its tobacco packaging business as a result of customers building inventories in anticipation of tax and regulatory changes, the result saw slight earnings upgrades by brokers.

In the current volatile equity environment, AMC continues to provide relatively predictable, defensive growth (its end market exposure is illustrated below) and a consistency in its strategy which has yielded solid results for investors. Offering a respectable level of earnings growth and a forward P/E of 17X, we believe the stock remains a good core industrial holding for portfolios.

Amcor: Sales by End Market

Source: Amcor
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Casino group Star Entertainment’s (SGR) (previously Echo Entertainment) underlying result was excellent and well ahead of expectations. On a ‘normalised’ basis, that is, after adjusting for the expected win rates on its table games, SGR recorded earnings growth of 26%. The result was impressive, considering that in the prior corresponding period high roller turnover had doubled, leaving a high hurdle rate for this half.

Unfortunately for SGR, high rollers took the casino to the cleaners in the half, having considerably more success at its table games than probabilities would suggest. The relative success of SGR’s high roller customers can often have a large influence on the group’s results. SGR has been criticised in the past (probably fairly) for using a higher win rate assumption than its peers, although it has now reduced this to be in line with other casino operators. The chart below shows how its high roller win rate has varied over time. A win rate of 1.35% indicates that the casino is collecting $1.35 for every $100 bet.

Star Entertainment: High Roller Win Rate

Source: Star Entertainment
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The company’s flagship Sydney casino, the Star, was the standout performer again across its portfolio of assets, as it continues to reap the rewards of investment and a good trading environment. On its main gaming floor, electronic gaming machines and table games both showed double-digit revenue growth and cost containment enhanced profit further.

Star Entertainment is performing well operationally, is exposed to a strong cyclical theme in tourism and a longer term structural trend of increasing Chinese tourism. Compared to other stocks with a good earnings growth outlook, SGR’s valuation still is relatively undemanding on a forward P/E of 18X.

Also in the gaming sector, Tatts Group’s (TTS) 5% increase in earnings met expectations. Tatts’ earnings base is more stable and less leveraged to cyclical factors compared with SGR (and other casino groups), with lotteries and wagering holding up in most economic conditions. Tatts’ lotteries division (which accounts for nearly 2/3rds of its earnings base) had a particularly good six month period. The number of large jackpots across its games can influence its revenue in any given financial year. With 24 jackpots of $15m or greater (more than any other six month period in the last four years), the December half was favourable for Tatts, driving an 11% increase in EBIT. 

Tatts Group: Jackpot Run

Source: Tatts Group
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Tatts’ wagering division is in a transitionary phase as it rolls out a new brand, UBET. A change in its fiscal arrangements with the Queensland Government led to lower margins in the half, although turnover growth was respectable. Tatts’ retail stores that have converted to the new UBET brand have demonstrated double-digit growth so far in 2016, leading to confidence in the future profitability and returns for the group.

A risk for TTS in the short term is a decision by the High Court on its pokies compensation from the State of Victoria after the company lost its duopoly licence (along with Tabcorp) to operate poker machines in Victoria. TTS is having its $541m claim challenged by the State and, if successful, intends to distribute the after tax proceeds to shareholders. An outcome is expected before the end of the financial year.

With forecast margin expansion across its business as it moves more transactions to online, the benefits of its wagering investment still to materialise and ongoing solid contribution from lotteries, we remain comfortable with TTS as a holding within our model portfolios.

Telstra’s (TLS) result reflected its evolving environment and its net profit growth of just 1% was enough to match expectations. At a top line level, the company produced growth of 9%, although the changing mix of its earnings base and shift to a more competitive landscape has led to margin erosion. As has been the trend of the last two years, TLS was able to edge up its dividend to 15.5cps.

Mobile subscriber growth has been at the centre of Telstra’s success over the last few years, as it has taken market share through a combination of competitor missteps (Vodafone with its network problems) and a reduction in the ‘Telstra premium’ on its plans. This subscriber growth has begun to slow in more recent periods and aggressive pricing with increased data allowances is now translating to lower mobile margins. Telstra’s fixed broadband showed a better result in the half, although this growth was not enough to offset the ongoing decline in fixed voice services.

Telstra: Mobile Subscriber and Revenue Growth (YoY)

Source: Telstra, Escala Partners
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Telstra’s NBN payments from the Federal Government stepped up again in the first half, although the question mark for the company is how these funds are reinvested in order to arrest the trends across its other divisions and will likely involve a higher level of risk. Telstra remains in a relatively strong position as the incumbent telecommunications operator. Although its valuation has improved following a share price decline in the last six months, we believe that investors will ultimately be better rewarded in the smaller, faster-growing operators in the sector, such as TPG Telecom (TPM).

A lift in its 2016 distribution guidance (which would represent an 18% year on year increase and a jump on its recent trajectory) boosted Sydney Airport (SYD), helping the stock after its result slightly missed consensus. Increasing passenger traffic is central to the earnings growth of Sydney Airport, as this feeds through its various divisions – aeronautical, retail, property and parking. For the 12 months, SYD reported 3%-8% growth across each of these divisions, all ahead of the underlying passenger growth recorded.

Sydney Airport Distributions

Source: Sydney Airport
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SYD’s confidence in 2016 is underpinned by several factors. Seven new international airlines are commencing over the next year; an additional 1.5m new seats. New international aeronautical agreements will result in a 4% increase in pricing. SYD is also expanding its car parking capacity by 10% and is constructing two new hotels.

The latter two are relatively low risk capital investment, supporting the growth in cashflows required to fund SYD’s progressive distributions. The better growth rates in international vs domestic passengers is also a factor; SYD notes that these passengers are approximately 7x more valuable to the airport. SYD is one of our preferred holdings among defensive stocks, although we acknowledge that its valuation is not cheap having held up well in the last period of volatility in markets.

Accommodation operator Mantra Group (MTR), a stock which we added to our extended portfolio this week, reported a solid first half report and upgraded its guidance for the full year. Underlying earnings for Mantra grew by 27% for the six months through a mix of organic and acquisitive growth. Among stocks exposed to the domestic tourism industry, MTR has greater leverage than most, particularly with its resorts properties.

Mantra’s resorts proved to the be primary driver of earnings growth, with a 45% increase in earnings. New properties added by the group led to an additional 22% of total rooms available. The key metrics that are critical to the profitability – occupancy (+4.7%) and average room rates (+9.2%) – were both pointing in the right direction, with the company highlighting the strong conditions in the Queensland market.

Mantra’s CBD properties, which are more stable in nature and less exposed to cyclical market conditions, nonetheless made a solid contribution to earnings on organic revenue growth of 9%. Profit from the company’s central bookings division also improved, continuing the trend of a higher proportion of bookings through this higher margin channel.

Mantra’s balance sheet is in good shape, which will allow it to take advantage of the growth opportunities and expand its portfolio in the current supportive environment. With good momentum in its business expected to lead to strong medium term earnings, our view on the stock remains unchanged.

Lend Lease (LLC) also comfortably beat expectations with its half yearly earnings growth of 12%. The highlight of the result was a jump in earnings from its property development operations, which more than offset some weakness in other areas. Lend Lease’s property development pipeline remains strong, it has a high level of apartment pre-sales and, to date, no flags have been raised on settlement default. The company’s settlement default rate of <1% for the half was much lower than historical rates of ~3%; an impressive result given the high proportion of settlements with offshore investors.

Successful execution of its development pipeline will lead to considerable cash inflows over the next few years and thus the potential for increased shareholder returns. Across its four divisions, LLC continues to expect all to be cash positive between FY17 and FY19:

Lend Lease Indicative Major Project Cash Flows

Source: Lend Lease
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With a high level of earnings visibility in the next few years, we believe that, on a P/E of 10X, Lend Lease remains good value.

Following Commonwealth Bank’s (CBA) half year result last week, ANZ and National Australia Bank (NAB) posted quarterly trading updates. As with CBA’s report, the lack of any negative surprises from ANZ and NAB led to both being well received by investors. ANZ’s bad debts faced the most scrutiny, particularly with its larger Asian portfolio compared with the other majors. While its impairment expense was in line with expectations, ANZ noted that it expected this to tick up somewhat in the second quarter, although below more pessimistic forecasts. Other factors were mixed for ANZ in the quarter; a slight decline in net interest margins, market share gains in housing lending and revenue growth ahead of expense growth. With ANZ trading at a large discount to the other majors, it is our preferred holding in the sector.

NAB’s result was boosted by a very low bad debt charge of just 6bp (which be unlikely to be sustained into the next quarter) and was the main reason for its earnings beat. NAB’s underlying revenue grew 4% in the quarter (now excluding its Clydesdale Bank spinoff), although its costs were also ahead of expectations. Along with ANZ, NAB has the more question marks than the other majors over its ability to sustain its dividend payments going forward following the divestment of Clydesdale.

Among smaller financial stocks, FlexiGroup’s (FXL) half year report raised several question marks over a number aspects of its business. At the headline level, the result was broadly in line with expectations with earnings growth of 4% and reaffirmation of its full year guidance. There was several positives in FXL’s result. The company’s cost to income ratio again tracked lower, indicating that progress is being made on the integration of acquisitions. Funding costs were also lower, a consistent trend over the last four years as FXL diversified its funding sources. Growth in its interest free cards division was also a positive and the company expects the impact of Dick Smith (one of its retail partners) to be immaterial.

Several points from the result, however, overshadowed these positives. Volumes from Certegy, which provides point of sale interest free financing, fell, raising concerns over the organic growth profile of the division going forward. An increase in impairment losses from 3.0% to 3.5% was also a worry. Funding costs, while falling again in the period, are also expected to potentially be an issue for FXL going forward given tighter credit markets. The resolution of each of these issues may take time, and patient investors may be rewarded given what appears to be a fairly compelling valuation and attractive dividend yield. At this stage, we hold FXL in our extended portfolios, but we will reassess our position in the next portfolio review.

CSL’s result also featured a mix of positive and negative outcomes, although the company appears to be well placed to deliver excellent growth post FY16. The current financial year has been described as a transition year for CSL and its underlying earnings guidance of 5% constant currency growth (a level below which shareholders have become accustomed) would appear to reflect this. The key piece of negative news was the expectation of higher losses in the current financial year from its recently acquired Novartis flu vaccines business. More promising was ongoing solid demand from its core plasma business.

With the expected release of high margin products in the next two financial years, ongoing contribution from its core operations and profit realisation from flu vaccines, earnings across FY17 and FY18 are expected to return to strong growth and EPS should again be supported by share buybacks. Much of this would appear to be reflected somewhat in CSL’s P/E premium to the market, something it arguably deserves given its long track record of delivery.

Next week’s reporting schedule:

Monday: Brambles, Oil Search, UGL, Scentre Group

Tuesday: BHP Billiton, Caltex, Healthscope, Qantas, QBE

Wednesday:  Flight Centre, Fortescue, Qube, Wesfarmers, WorleyParsons

Thursday: Crown, Iress, Nine Entertainment, Perpetual, Ramsay Health Care, South32, Seek

Friday: Harvey Norman, Link Administration, Regis Healthcare, Super Retail, Woolworths


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