Week Ending 19.08.2016
A week of sunshine makes the weather a starting point. The Bureau of Meteorology reports that the negative event in the Indian Ocean Dipole, which peaked in July as the strongest in 50 years and results in higher than average rainfall, has weakened into summer. In turn, the La Nina conditions have mitigated to around neutral and if it does develop, it is likely to be weak. La Nina rainfall is usually well above average.
Australian Winter-Spring Mean Rainfall Deciles (La Nina Years)Enlarge
Weather can have a meaningful impact on investment markets. The primary factor is, unsurprisingly, food inflation. A La Nina brings drought to the grain growing regions of the Americas, while floods across Asia can be problematic for many essential commodities such as palm oil. Other impacts can be in iron ore and coal if high rainfall inhibits movement from Australian ports. Finally, insurance companies are often exposed to extreme weather and which is correlated with high claims followed by a rise in premiums.
From a regional perspective, India is a major beneficiary from La Nina trends. In La Nina years, agricultural output has increased by 7.8%, compared to a 2.3% average in other years. Higher rural incomes have a substantial impact on the Indian corporate sector.
In the US, the CPI has not budged from its low reading. With the release of July data, headline inflation registered 0.8% year-on-year and ex-food and energy, 2.2%. The trends that have held back inflation since 2012 remain in place. Goods inflation has weakened, while services have edged up. Medical services, rent and recreational services all rose by more than 3% year-on-year, while on the goods side, only apparel and fruit and vegetables showed any increase, and minimal at that.
As we have frequently noted, it is wages growth that will determine the critical path of inflation. Private sector compensation has improved from a rise of 1.9% in June 2015 to 2.4% by June 2016. Government sector employees have seen a more modest pace of wages growth, registering only 1.7% in the year to June, though benefits (mostly healthcare) took the total compensation increase to 2.3%.
Locally, the same picture is playing out, with the latest wage price index coming in at 2.1% for the quarter and 2% for the year. With part time and casual employment rising as a proportion of the total, it is likely wages will be stuck at this level.
That paints the picture for the overall economy. Housing investment appears to have peaked, though the unwinding will take time. The worst of the terms of trade is over and as we annualise the slump in resource investment, the drag on growth is passing through the data. Without another influence, the forecast of 2.5-3% GDP growth for 2017 looks baked in.
After the heat of earlier this year, China has been off the news pages for some months. Weak credit growth was attributed to seasonal effects and some deleveraging. The central authorities appear willing to slow lending given the relatively benign financial conditions and reduced capital flight. The data for Q3 is likely to be soft as a consequence of this pull back in credit and the impact of the G20 summit in September. This meeting is being held in Hangzhou and industries in the surrounding Yangtze River Delta have been shut down to improve air quality. With some 10% of China’s GDP from this region, the impact will be felt that month.
Fixed Income Update
The London Interbank Offered Rate (LIBOR) is defined as ‘the average of interest rates estimated by each of the leading banks in London that it would be charged were it to borrow from other banks’. The widely used 3 month LIBOR rate is they key benchmark from which floating rate corporate bonds, commercial paper (short term debt securities issued by banks and corporates) and collateralized loan obligations (CLOs) are referenced off to determine their coupon yields. The LIBOR setting will therefore directly affect the return that investors receive and the funding costs for the issuers of these debt securities.
In contrast to the LIBOR rate, the US Overnight Indexed Swap rate (OIS) is a measure of the risk free rate (the US government funding rate) and moves in line with actual and expected Federal Reserve Bank policy rates. The spread between the two is a measure of the ‘spread’ that banks pay for funding over and above the risk free rate.
Recently, the spread between these two rates has increased, driven by regulatory changes affecting money market funds. These funds invest in short term debt instruments and are often used for liquidity purposes by corporates running surplus cash on their balance sheet. A change in the regulatory framework due to take effect mid-October, includes the halting of redemptions in certain circumstances and liquidity fees on redemptions.
Rather than face these constraints, many investors have withdrawn from these funds, with further outflows expected. Shrinkage in the size of money market funds has led to a fall in the participation rate for commercial paper, pushing up the short term borrowing rates of the banks as they pay up to entice limited demand. The US 3 month LIBOR rate vs the US 3 month OIS is illustrated below.
LIBOR and OIS
While many will be puzzled why this matters to Australian investors, it has widespread repercussions. Amongst others, US banks are potential
beneficiaries due to their ability to price up short term paper and could see stock prices improve. On the other hand, currency carry trades into the US (which affect hedging) may have a negative impact. Secondary issues, such as the flows into short term debt instruments, the pricing of US treasurys and the currency repercussions are likely to impact critical markets in coming months. For example, investment banks are now of the view US investors may finance through European and Japanese credit markets and change the weighting of regional indexes.
In last week’s publication we discussed how the ‘search for yield’ and the recent surge of inflows into credit markets, high yield and emerging markets has increased the price of these debt securities. The resulting contraction in credit spreads since mid-February this year has raised concerns as to how low they can go. However, for investment grade corporate bonds, these spreads are still wide by historical standards. The Moody’s BAA bond yield spread index is at 2.70% (down from 3.70% in February) which is higher than nearly 80% of the time since 1920. This index is charted below. While corporate bonds have rallied significantly, the technical analysis favors further spread contraction (price rises) to come.
Domestically, this week saw the launch of a new ANZ bank hybrid for the ASX listed market. This deal is a replacement for the soon to mature ANZPA securities, which will soon mature. The structure was like its Basel III predecessors, including a capital trigger, maximum conversion ratio and non-viability trigger. The new hybrid is a capital note that converts to equity in 9.5 years unless called in 7.5 years. The spread offered is yet to be confirmed, but will be in the range of bank bill swap rate (BBSW) plus a margin of 4.70-4.90%. The issue size is $1bn plus, with expectations that it won’t exceed $1.25bn. (The maturing ANZPA securities have an issue size of $1.9bn).
Given the mixed retail trends of the past year, JB Hi-Fi’s (JBH) solid result was well rewarded given sales growth of 8.3%, or 5.4% on a comparable store basis. The group benefited from the closure of Dick Smith stores, along with the strength in the housing market, which supports the appliance sector. The momentum will inevitably ease, but the key support for JBH comes from the consistency in its gross margins and cost of doing business. Gross margins have been held between 21.5%-21.9% over the past four years. While the product mix has had an impact, the group has been careful to maintain its perceived value rather than grab margin when demand is strong. This is in notable contrast to other retailers (such as Woolworths) where a rising gross margin was considered a merit. In the same vein, costs have been steady at 15.2% of sales for some time and implicitly EBIT margins are stable too. This relatively predictable pattern is valued, though for most the upside is now factored in the share price.
It was hard to contain the superlatives that flowed from the Treasury Wine Estates (TWE) result. Very patient shareholders, who had seen the share price halve in 2014, have been rewarded with a threefold increase largely due to the reasons that attracted those investors back then. In simple terms, the cost of holding inventory in the premium price bracket is now reaping the profit that previously was realised by retailers.
On the downside, revenue growth was soft, estimated at 3% for the year, excluding the acquisition of Diageo assets, though partly attributable to the sale of volume market brands. At some point the higher margins from inventory and low ongoing headline growth may compromise the potential to surprise. Trading at 27X 2017 earnings, it’s a fine wine stock to be reserved for special occasions and trading well above global peers.
That Domino’s Pizza Enterprises (DMP) has got the kudos as the 20th most innovative global growth company (according to Forbes) may be a source of pride or despair, depending on one’s view of fast food as our one as a great company. The case, however, is that DMP has gone well beyond providing just food and now a service makes a credible argument. Delivery though e-Bikes, on time cooking and a 3/10 project aiming for 3 minutes in store and 10 minute delivery times, has maintained a robust pace of same store sales growth in Australia, this year at 14.3%. Replicating these systems across all regions, extending the menu, rolling out stores and a willingness to trail other new technologies such as auto delivery (driverless), supports the heady P/E multiple of over 50X 2017 forecast earnings; enough to cause many investors indigestion.
BHP Billiton (BHP) reported a significant 81% drop in underlying profit, which was broadly in line with what the market was anticipating. Adding to the woe was a number of previously foreshadowed, large ‘one-off’ charges taking the number to a net loss for the year. This included a writedown of its investment in the Samarco iron ore mine (which suffered a disaster late last year when a dam was breached), provisions relating to ongoing costs of the disaster and an impairment of its US shale energy assets. Consistent with the company’s new revised dividend payout policy, BHP’s final dividend was cut to US14c, down from US62c last year.
Of the factors within its control, BHP performed well, with US1.4bn in costs taken out over the 12 month period. Similar to RIO’s recent result, however, this was not nearly enough to offset the impact of weaker commodity prices, which were responsible for an almost halving in EBITDA.
While BHP is now in a somewhat more comfortable position following a recovery in many commodity prices since early this year, the near term outlook is more complicated. At the centre of these is a commitment to reduce its net debt levels, balanced with a desire to increase returns to shareholder off this year’s low base. BHP’s ability to achieve the former will be made easier if this recent commodity price recovery is sustained; CEO Andrew Mackenzie noted that free cash flow in FY17 would more than double that of this year based on spot prices.
Other factors that cloud the outlook for the company include the lower forecast production from its US shale assets (BHP has given guidance for an approximate 25% decline in FY17) which should lead to lower overall group production, as well as further potential liabilities to arise from Samarco. Slated growth projects that are currently on the table are only incremental in nature (unsurprising given the limited free capital available) and instead the company is focusing on smaller brownfield developments and releasing latent capacity.
The more positive view would note the strength of BHP’s position in petroleum and copper, the two core commodities that are closer to a demand/supply balance and thus are expected to benefit from an element of pricing support. Notably, iron ore, which is more important to peer Rio Tinto, is the furthest away from reaching this balance.
BHP: Commodity Market Outlook to 2025
Staying on the resources sector, Origin Energy (ORG) and Santos (STO) both succumbed to the new lower oil price environment by cutting their dividends completely. With higher cost coal-seam gas LNG operations compared with the conventional oil companies, net debt reduction and cash flow optimisation is the priority, even following the recent oil price recovery. ORG managed to reduce its debt over the 12 month period, however this was only achievable following asset sales and an equity raising late last year. STO wrote down the value of its Gladstone LNG business by over US$1bn while reducing its expected free cash flow oil breakeven price to US$43.50/barrel. Both stocks have higher leverage to a recovering oil price compared with our preferred energy exposure, Oil Search (OSH), however with longer-run consensus forecasts now reduced, the expected cash flows at the latter appear more comfortable. For those seeking energy utilities, AGL Energy (AGL) is an alternative to ORG with low leverage to oil prices.
QBE was one of the more disappointing reports this week. Earnings were broadly in line with analysts’ expectations, though somewhat questionable in composition, boosted by higher than expected reserve releases. QBE also reduced its full year top line guidance while maintaining its forecasts for margins. The group’s new margin indication also included the aforementioned reserve releases and this guidance was therefore viewed as a soft downgrade.
QBE’s issues reflected a relatively challenging global insurance environment and, in particular, some of the problems that the two domestic-focused insurers (Suncorp and IAG) have highlighted. The company’s underwriting margin has been hit by increased claims inflation (including higher repair and replacement costs) and pricing pressure given high levels of competition.
The weak results from QBE’s domestic operations overshadowed the ongoing improvement that the company has made in reducing its cost base. QBE’s investment earnings were also ahead of expectations and this remains a key source of difference to the domestic insurers, with leveraged exposure to a tightening Federal Reserve. The discount that the stock trades at to other listed insurers is likely to remain given the company’s history of negative surprises, however we note that its issues are certainly not company-specific and are being felt across the sector.
Sydney Airport’s (SYD) half year EBITDA growth of 9.5% was underpinned by solid passenger growth for the six months. SYD reported international passenger growth of 9.3% for the six months, while domestic passenger growth was solid at 5.3%. New capacity increases and growing load factors led to the increases in international numbers, which are more valuable to SYD than domestic passengers. By country, passenger growth from China was strongest by absolute number, with more than an additional 100,000 passengers for the half. The exposure to rising consumer wealth in Asian countries is evident in the nationality growth listed below.
Passenger growth is the key metric that SYD focuses on, given fixed costs and as a driver of ancillary revenue across each of its businesses – aeronautical services, retail, property and parking.
Sydney Airport: Fastest Growing Nationalities in 1H16
Like many other infrastructure stocks, SYD has benefitted greatly from falling global interest rates and the company has taken advantage of this environment to extend the maturity of its debt. The second half of 2016 looks promising, with a tailwind to returns provided by a 4.8% aeronautical price increase (which came into effect from the beginning of July) and the company indications growth will continue based on reported good numbers for July. SYD also lifted its full year distribution guidance for FY16, corresponding to greater than 20% growth year-on-year. While this is expected to be fully covered by operating cash flow it does, however, leave little margin for error should the positive tailwinds that is subject to subside. SYD remains an attractive play on domestic and international tourism, however a stretched valuation tempers the investment case.
Mantra Group (MTR) also is leveraged to the tourism theme, although the stock’s more recent performance perhaps does not reflect the positive tailwinds to which the company is exposed. More recent investor concerns include the sudden departure of its CFO, a possible divergence from its strategy with the acquisition of a property in Hawaii and the structural challenge from the emergence of Airbnb. A strong cash flow performance for FY16 addressed the first of these issues, while we are less troubled by the latter and believe that Airbnb threat is overplayed, particularly with regards to MTR’s resorts division. The company’s FY16 earnings was in line with guidance with a mix of organic growth and new properties added contributing to earnings.
MTR has focused on growing its resorts business and the buoyant conditions were evident the company’s result. The company increased its total rooms available by 24% in the year, while a lift in occupancy and a 9% increase in average room rates underpinned solid earnings. The group’s CBD properties were mixed, reflecting the different economic conditions across the states; demand was weaker in Brisbane, Darwin and Perth, while Sydney, Melbourne, ACT and Tasmania performed better.
MTR’s outlook commentary also had a positive tone, with the company expecting growth across both of its key segments. While the company is guiding towards almost 15% earnings growth in the next 12 months, this appears to be just short of consensus expectations. Nonetheless, the stock is now screening as good value on a similar P/E to the broader market.
Tatts Group (TTS) reported a solid result at the upper end of its guidance, with its core lotteries division the primary driver of growth. Lotteries, which accounts for 2/3rds of the group’s earnings, recorded double-digit earnings growth and was assisted by a larger number of large jackpots through the year. TTS’s wagering business had a tougher year, which represented the first full 12 months of its relaunched brand, UBET. After declining in FY15, TTS was able to record turnover growth through FY16. However, similar to what competitor Tabcorp (TAH) had noted in its recent results, high levels of online competition in the wagering sector have led to margin contraction.
The migration of customers to online channels has positive and negative outcomes for TTS, although the benefit from the margin uplift in its larger lotteries division would outweigh the more competitive environment from online in wagering. In FY16, digital sales represented 13.5% of TTS’s lotteries revenue; up from 11.1% last year, although continuing a well-established trend and leading to further improvement in margins. We remain attracted to TTS’s defensive growth characteristics.
Tatts Group Lotteries: Margin and Digital Sales
Brambles’ (BXB) met expectations for its upgraded guidance, with 9% growth in constant currency earnings and flat on a reported basis (the company reports in $US). The company’s core pallets division continues to be a story of respectable organic growth combined with incremental market share wins, with high marginal returns from adding additional customers. Sales growth remains higher at its smaller divisions and in emerging markets, although are typically lower margin and have been boosted by acquisitions in recent years.
BXB also announced the current CEO, Tom Gormon, would be retiring early next year after seven years in the job. While the announcement was anticipated at some point in the near future given the length of his tenure, the timing maybe somewhat surprising given that the company is also searching for a new CFO. BXB retained its longer term target of 20% return on capital invested by FY19, and though only modest progress was made on this measure, improving returns will add to the organic growth story. FY17 guidance of ~10% profit growth would imply a continuation of the recent momentum and would help to justify the P/E premium that the stock trades on relative to other large cap industrials.
The Real Estate Investment Trust (REIT) sector has been the star of the year. The fundamentals have barely budged, but the demand for yield and consistent compression of cap rates saw the sector drag in fund managers which did not typically invest in these stocks. In the past month the sector has eased back given that the premium to NTA that many stocks trade on is well above historical norms. The results season also contributed to this with a sober assessment of income growth and valuations.
For the retail REITs in particular, the picture was less than compelling. Supermarket sales growth is near flat, discount stores revenues are falling on aggregate and the only source of revenue growth is from mini-majors and speciality stores. Woolworths’ closure of select supermarkets and reduced footprint for discount department stores have exposed the risk of overbuilding formats. Indicative cash flow growth of 2-3% and payout ratios of near 100% imply that distribution growth will be contained. Distribution yields of around 5% are far from compelling given the risks implicit in the sector.
Lend Lease (LLC) reported earnings growth of 13%, driven by a 30% improvement in development earnings, while construction and investments were largely flat. The delay between booking development earnings and actual cashflow receipts led to a higher increase in operating cashflows relative to profit growth this year and this is expected to underpin increased shareholder returns in coming years.
One of the primary concerns with LLC’s business has been with the settlement risk from its apartment developments. With a high proportion sold to Chinese investors and the restrictions that China has imposed on capital outflows, it was thought that this might result in defaults from this group of investors. Pleasingly, LLC reported that the non-settlement rate across its 1,203 units settled across FY16 was less than 1% and below the 3% historical average that LLC has experienced. Across its book, mainland China accounts for 23% of its apartment presales, with other offshore markets at 18% and the balance from domestic buyers. We have LLC in our model portfolios as a preferred exposure to more passive REITs, which are experiencing fairly benign rental growth and have been bid higher primarily by falling interest rates.
Medibank Private’s (MPL) profit result for FY16 was ahead of expectations, but with a weaker outlook, the share price retraced on the release. Health insurance margins were slightly better than forecast at 8.3%, but policy growth fell by 2.5% as market share gave way. The expense ratios in insurance businesses tend to be sticky and the prospective loss of revenue will likely mean insurance markets are at best flat into 2017. In turn, the 20X P/E multiple more than prices in the premium of ‘health’ versus ‘insurance’ whereas mainstream insurance stocks trade at mid-double digits.
Next week’s reporting schedule:
Monday: BlueScope Steel, Fortescue Metals, Japara Healthcare, Seek
Tuesday: Caltex, Greencross, Healthscope, Monadelphous, Oil Search, Scentre Group, Vocus
Wednesday: Alumina, Boral, Charter Hall Retail, Link Administration, Qantas, Wesfarmers, Westfield, WorleyParsons
Thursday: Amcor, Flight Centre, Iluka, Nine Entertainment, Perpetual, South32, Woolworths
Friday: Regis Healthcare, Super Retail Group