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WEEKEND LADDER

A summary of the week’s results

19.06.2015

Week Ending 19.06.2015

Eco Blog

Greece and the Federal Open Market Committee (FOMC) meeting dominated global news in the week. With the inevitable end point to the discussions between Greece and its European counterparts looming, commentators range from those that believe a Greek exit from the Euro is priced in, to those that believe it will set in train a chain of disruptive events. The reality is that it is hard to predict, while we have to take comfort that European authorities are likely to be as prepared as they can be. Another ‘whatever it takes’ from the ECB head, Draghi, may well be repeated.

In the US, the FOMC statement said all the expected things. The economy is described as ‘healing’, while it noted the job market, housing and consumer ,spending was acceptable, business investment and exports were a little soft; likely due to the rise in the $US, the fall in energy prices and the port strike earlier this year.

The inevitably of at least one rate hike this year is essentially confirmed, while the rate of subsequent rate hikes is flattening off.  Janet Yellen will clearly be the key decision maker, and some analysts entertain themselves trying to guess which of the dots she may be within the chart below. Process of elimination implies she is in the one to two rate hikes dots for this calendar year. As the expectation is that, once the US rate cycle commences, it will be at 25 basis points per quarter, the first date may then be December rather than September, and this would imply two rates this year.

Source: FOMC
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In a flurry of data releases for the US economy, the path to a decent growth rate in Q2 seems set. Indicators such as the Philadelphia Manufacturing Index (which is in fact a broad-based survey rather than a city one) and the Conference Board Leading Index, were both stronger than expected. Inflation too popped up, both in the US and in Europe. Cycling the lows in energy prices is already adding to inflation and there are indications of pricing capacity in some service sectors such as travel, with airfares in both regions up some 5-6%. As we have noted before, the services component of inflation has been steady for some years and due to complex pricing structures, the ability to hold these is often greater than for goods, so readily comparable these days.

Aside from the US rate outcome, one of the other important and related determinant of investment markets this year has been exchange rates.

Over the past year, the trade weighted $US has increased by 17%, one of the sharpest moves in recent times due to a combination of US economic strength and forecast rates versus monetary easing elsewhere. Of the US trade weighted index, the Euro makes up 58%, the Yen 14%, British pound 12%, Canadian dollar 9%, with Swedish krona and Swiss franc at 4% each. As trade with China is still largely in USD, it does not make much of an impact on the US trade index, albeit the Yuan/$US exchange rate has been remarkable stable for some time.

Nominal Trade-Weighted Exchange Value of $US vs Major Currencies

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The question is whether the currency has pre-empted the rate and economic environment in full, or possibly even over stepped. This is in contrast to the consensus opinion that the $US will strengthen further this year. Comments by the Bank of Japan’s Kuroda that the Yen is already cheap based on its purchasing power parity (PPP) highlighted that, even the most likely major currency candidate for further weakness may well find stability at this time. Others also believe the Euro is under its purchasing power parity, as evidenced by its current robust export competitiveness.

If the US decides to pace its interest rate moves more slowing than some anticipate, the $US may have overshot, at least in the near term. Some are further of the view that a Greek exit could see the Euro strengthen, compounded by the recent move in European rates towards what is now considered fair value.

We have noted that forecasts for exchange rates are generally inaccurate, as currencies have a habit of under and overshooting their estimated fair value. With respect to the A$, the balance of probabilities is still skewed to the downside; indeed an overshoot to 70c against the US$ or even lower is not impossible. Two rate rises in the US, coupled with a possible rate cut in Australia later this year, paint a possible set up for renewed $A weakness.

The charts below illustrate the PPP for the $A and the Euro against the $US. The $A is indicatively still some 6-7% overvalued, whereas the Euro is now about 13% undervalued. However, it is easy to observe how long these misalignments with PPP do in fact last.

Source: GavKal
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Source: GavKal
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Fixed Income Commentary

We continue to closely monitor the increased levels of volatility in the global bond markets. The main causes have been the divergence of central-bank policies, whiffs of inflation emerging, the ongoing Greek negotiations, and new regulations reducing banks’ balance sheets and therefore their ability to provide liquidity.

As an example, since the end of April, the yield volatility on 10-year German bunds has climbed to nine-times its average during the past 15 years. These moves have led to notional losses of $640 billion in sovereign debt worldwide over this period.

The divergence in central bank policies remains intact, despite what appears to be a united front in the direction of bond yields. The Fed is still on track to deliver rate rises this year, yet, in contrast, the RBA retained their easing bias in its minutes this week. It is therefore surprising, given such divergence in monetary policy, that bond yields are moving in unison. The chart below shows the upward movement in rates in the US and Australia in the last two months. Domestically, yields have followed the global upward path despite the fact that the RBA has cut rates by 25 basis points over this time.

Australia and US Yield Curves

Source: Bloomberg, Escala Partners
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Concerns regarding the Greek crisis continue, with contagion spreading to the peripheral European bond markets.  Widening in Spanish and Italian bond yields have outpaced the rest of the European market. The spread of 10 year Spanish bonds over 10 year German bunds is now at 159 basis points, the highest since July 2014.

Reduced liquidity in fixed income markets remains topical. Constrained bank balance sheets is only one part of the equation. The market has also experienced significant growth in issuance levels over the last few years, driven by corporates and governments looking to issue larger volumes and longer dated securities to lock in the unprecedented low levels of interest rates. The result is an increase in the amount of debt outstanding, which is evident in the Bank of America Merrill Lynch’s Global Broad Market Index, which has ballooned to more than $41 trillion from about $26 trillion at the end of 2007. Larger supply levels and less room to facilitate balance sheet warehousing by the intermediaries is cause for liquidity concerns.

Credit has held up quite well to date, which has helped cushion the blow from recent losses in interest rate markets. However, recent withdrawals in the US high yield market may put upward pressure on credit spreads across all sectors; $2.5 billion has been withdrawn in the last week, which is the largest outflow this year.

Company Comments

Westpac (WBC) this week announced the partial selldown of its shareholding in BT Investment Management (BTT), reducing its stake in the fund manager to approximately 35% from its current 59% holding. The sale could be viewed as well timed, with listed fund managers recording strong share price gains since late last year. Despite a recent pullback over the last two months, BTT shares are still more than 50% higher compared with October last year, and have more than doubled over the last two years.

The sale is a demonstration of one method that the banks will likely use to improve their capital positions over the next few years. While the quantum of additional capital that will be required by the industry is yet to be spelt out by APRA, Westpac has taken the decision to get ahead of the curve through this sale (which will improve its capital ratio by around 15 basis points), along with an underwritten dividend reinvestment plan (DRP) at its most recent result.

At this point, the expectation is that no significant capital raisings will be required by any banking institution, but earnings per share will be diluted over the next few years through issuance from DRP’s. The return on equity across the industry should fall as a result, and dividend growth will be much more limited in this environment.

This weaker earnings growth outlook is beginning to be reflected in reductions in earnings per share by analysts. The chart below illustrates that three of the four major banks had their earnings downgraded following their results last month, in contrast to the previous trend of flat to slightly up. While the share prices of the banks have fallen much more than these revisions would suggest, the sector still remains reasonably fully valued, particularly given the multiple headwinds in the medium term.

Major Banks: FY16 Earnings Per Share Revisions

Source: Bloomberg, Escala Partners
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The association of Warren Buffet’s Berkshire Hathaway saw Insurance Australia Group (IAG) get a lift this week as it unveiled a strategic relationship with the famous investor. The deal will see Berkshire Hathaway effectively gain access to 20% of IAG’s business for the next decade in exchange for a $500m investment in the company. As part of the agreement, Berkshire Hathaway will have the option to increase its stake in IAG to up to 15%.

IAG will now have a much stronger balance sheet with a greater level of flexibility as it will reduce the company’s regulatory capital requirement by approximately $700m by next year. The potential for higher dividends or capital management initiatives has thus increased; a fortunate position given current investor preferences. A path with a higher risk/reward would be to pursue acquisition opportunities into Asia. The trade off for IAG is reduced earnings per share, however a more stable income stream (which should be valued more highly by investors) as a result of a higher level of commissions and lower exposure to reinsurance rates.

While the Buffet tick of approval would provide many with confidence as to the quality of the company, the fact remains that Buffet is rarely on the side of a bad deal and hence he may be the real winner in this instance. IAG also gave guidance for FY16, which appeared to be relatively soft (after discounting the benefits of this deal), particularly with regards to its insurance margins, reinforcing the view  that the industry is at a cyclical high on this measure. 

Monadelphous (MND) fell this week after it emerged that a claim had been filed against a joint venture in which it was a participant for the construction of a coal export terminal in Queensland. With the project subject to a number of changes to its scope over time, the Monadelphous joint venture has filed a counter claim against its customer to recover these associated costs.

Monadelphous has had an excellent track record over a long period of time with regards to issues such as these, noting that it had not been involved in a legal dispute in the last 25 years. Nonetheless, it highlights that no company in the industry is immune to these types of risks which will perhaps be chased more vigorously now given the revenue pressure felt across the resources industry.  

As is often the nature in the engineering and construction industry, the size of individual issues such as these can be quite material (particularly relative to the profitability of the company as a whole) and place considerable pressure on balance sheets. In this case, Mondalephous’ $100m share of the potential liability is equivalent to approximately one year’s worth of earnings. Monadlephous has been one of the standout performers in the mining services industry over the last decade, however we have largely avoided stocks in the sector given an increasingly challenged revenue outlook.

Ten Network (TEN) completed a necessary capital raising this week, through a pro-rata entitlement offer and placement of up to 15% of new equity with Foxtel. The size of the discount of new shares placed relative to Ten’s share price (43%) gives an indication as to the urgency Ten had to strengthen its balance sheet. A loss of commercial network advertising revenue share has in recent years led to significant problems for Ten, which has subsequently deprived it of the capital it requires to invest in appealing programming content to improve its ratings.

The new arrangement with the pay-TV group gives Ten given the option to become a shareholder in the subscription TV streaming service, Presto (currently a joint venture between Foxtel and Seven Network). The advertising divisions of Ten and Foxtel will be merged, providing scale advantages for the two groups through lower costs. Despite this week’s deal, Ten remains the most vulnerable of the three commercial networks (it’s overall market share is only around half that of the leader, Channel Seven) from the structural transition of consumer entertainment consumption over time, with free to air’s slice of the overall advertising pie expected to decline gradually over the next decade. The stock is at best a deep value play for those who believe that it can restore some of its lost ground in the medium term.

Woolworths’ (WOW) CEO, under pressure due to weak operating performance in the past year, will depart his role after November this year in an arrangement with the board. The weak comparable sales momentum in supermarkets has continued and indeed has become progressively worse in recent months. It is clear that management will have to undertake a major shift in direction to recover from this pattern. For many years, Woolworths was adept at cutting costs and reinvesting in the business. Arguably lulled into the belief its cost structure was optimal, gross margins drifted up as it sought to demonstrate even higher profit margins. By early this year it was clear that customers were all too well aware of the lack of attractive pricing in store, with Aldi and Coles moving to ‘Every Day Low Pricing’ for core items, only adding to the pain.

Acknowledging this issue, management claims to have addressed its comparable pricing, though it would appear to be through deep discounts on a few lines while holding the higher priced product lines where it could. Time and again, these largely deceptive pricing strategies fail to change the consumer’s perception of value. 

The underlying profit growth guidance has been revised to flat for FY15. However, the company is taking a number of writedowns, some of which is more operating than one-off. $180-200m will be incurred to achieve $500m in cost savings; $40-50m of redundancy costs will be paid out and even the property portfolio is taking a $30-40m writedown. Investors should recognise that expectations of improved profits in the future are being paid for today and that this year’s real profit is down 13%.

The market initially took heart that a change in direction may redeem what appeared to be an increasingly dire outlook. However, the key will be a recovery in sales momentum, something which may be some time away, and the cost to profit margin has yet to be established. With an even sharper fall in sales at Big W (down 12% to date in Q4) and continued large losses at Masters, the new CEO will have plenty to consider in the first few years.

In the same sector, Metcash (MTS) reported its result for the year end April 2015. EBIT declined by 17% predominantly due to a 26% fall in the core food distribution business. The sale of its auto division to Burson (BAP) for $275m will stabilise the balance sheet, but also takes away one of the better and more defensible growth options. The pressing question is now whether Metcash can make headway with its grocery retail customers. Profit margins have halved in the space of two years in an effort to improve its pricing, yet even this may not go far enough. As noted, Woolworths will also be looking to recover ground, Aldi is expanding into new regions where Metcash has some strength and Coles too is working even harder to adapt its offer. The apparent low P/E of around 10X may appeal to deep value investors, but confidence in the ‘E’ (earnings) is very low, and there is no dividend support until at least 2017.

 



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