Week Ending 19.09.2014
With the release of detailed labour force statistics, the cumulative growth in employment across various industries can be illustrated, also removing the noise from short term data.
The chart below shows the changing nature of work over the medium term. An instinctive reaction is the concern that the jobs in services are by nature public sector roles and therefore funded by tax receipts rather than private enterprise. While the specific data to establish whether that is correct is not readily available, it is unlikely to be that simple.
Change in Employment by Industry: 3 Years to August 2014Enlarge
We are far from alone. As can be seen below, the US is following a similar trend, yet government job growth has been slightly negative.
US Industry Employment Growth This Decade
The same timeframe data based on the size of business supports the role of small business. It therefore implies that many of these jobs in health, training and services are in fact private sector jobs paid for by individuals rather than governments.
US Jobs Created this Decade by Company SizeEnlarge
These trends support the contention that Australian household spending has moved further away from goods, or traditional retail, to services, as we have noted for some time. It also implies that the reaction of financial markets to retail sales and other such indicators of household behaviour are largely missing the point, and that households are spending more than they appreciate; in turn, supporting the relatively resilient labour market.
Global economic data through the week reinforced the moderate pace of growth. In the US, the Philadelphia manufacturing data edged back after a very strong month and remains in growth territory. Weak housing was somewhat balanced out by lower jobless claims. A middle-of-the-road GDP growth of 2.5% for Q3 looks increasingly likely.
The FOMC language hardly changed, but the short end of the rates curve moved up in anticipation of changes within the coming months. While the ‘dots’ from the Fed show median expectations of a 2.75% Fed rate by the end of 2016, the financial market is only pricing in 1.75%. It would also appear the Fed is progressively tightening liquidity in money markets. For example, it has been offering reverse repurchase agreements (reverse repos) to the financial sector. In short, the Fed takes in cash at a low interest rate, which serves to create a floor for interest rates, manage liquidity flows, and over time, increase the yield on money market products for investors. This programme could go some way to lift rates towards the 25bp that would come from the first move in the official Fed Funds rate.
On the other side of the Pacific, the People’s Bank of China (PBoC) is doing the opposite. This week it offered 500 bn renminbi for 1-3 month loans to banks. In line with the efforts to manage credit growth, this would help provide short term credit for working capital into the business sector, in a time liquidity can be tight at quarter’s end. It also means banks would not have to pull back on longer term loans to fund these short term capital requirements.
While at the margin, it may provide some upside to commodity demand as inventory funding becomes available. The chart of the funds in this programme shows the size of the current offer, compared with the lack of funds mid-year at the time when commodity prices weakened.
Outstanding Balance at the End of each Quarter for the Standing Liquidity Facility (SLF)Enlarge
Following the news today that Scotland has voted against independence and hence will remain in the UK, the attention in Europe will turn to its increasingly sluggish growth. The trends in Germany have been particularly weak in recent months, in good part affected by the geopolitical strife. But it has also been a salutary reminder on the fragile and export dependent economies of Europe. Another round of monetary easing by the ECB may well be on the cards to keep the global liquidity engine moving.
Specialty retailers Premier Investments (PMV) and Oroton (ORL) released their full year result in the week. In both cases, their stock prices jumped with the much better trend in the second half. Sales momentum picked up from the dismal pace of FY13 and the first half of FY14 to register a decent comparable store sales outcome in the second half. In their post result presentations, Premier made much of its Smiggle brand’s potential to grow the business overseas, as well as the possibility of taking Peter Alexander into those markets. Oroton has also established stores in Asia, but is emphasising its relationship with the Gap and Brooks Brothers stores in Australia.
Barring occasional issues, both these business have generally managed their operations well over the years, but face a struggle to achieve growth. Premier’s seven retail brands have grown sales from $866m in FY11 to $888m this past year. Oroton’s sales appear to have come by sacrificing gross margin. Exacerbating the maturity in the domestic market has been the entry of differentiated global brands that have garnered the attention of fashion seekers. We are very cautious of the global rollouts – this has been the graveyard of so many Australian companies and especially consumer brands. In our view direct small cap investment should have a compelling thesis on medium to long term growth, rather than a trade, and these companies do not meet that mark for us.
Macquarie Group (MQG) had a small upgrade to its FY15 guidance this week when it forecast its earnings to be ‘slightly up’ instead of ‘broadly in line’ with FY14. Given that the company’s FY14 result included a large contribution ($228m) from the gain made on its stake in Sydney Airport (SYD) securities, on an underlying basis the guidance implies a strong result. First half profit is expected to approximately 25-30% higher than last year.
While it derives a large part of its earnings from its more annuity-like businesses, including funds management, corporate and asset finance, and banking and financial services, it is the company’s capital markets facing operations that are likely to provide the upside leverage in the medium term. This is evident in MQG’s estimates of the return on equity of these two broad groups in FY14 compared with their respective averages over the last eight years. In FY14 these annuity-like businesses achieved an ROE of 20%, in line its historical average, while the capital markets businesses recorded an ROE of 11%, well below the 15-20% range of the last eight years.
A large part of this uplift is expected to be realised in coming years through the performance fees that MQG will receive as a number of its unlisted infrastructure funds reach maturity. Encouraging trends in M&A activity and equity capital markets deal flow through this year help to underpin an optimistic outlook for the stock. More recently, the depreciation of the AUD could potentially provide another tailwind for the company, with international revenues accounting for over half the group’s total.
Arrium (ARI) surprised some, doubling its number of shares on issue through a discounted equity raising, with the proceeds intended pay down debt. The raising appears to be a pre-emptive move against a further potential deterioration in the iron ore price, which would likely leave the company’s mining operations in a marginal situation. The chart below details the break down in cash costs for ARI’s mining in FY14 – which equates to around US$66/t. This figure would be closer to US$80/t if other ongoing costs, such as sustaining capex, were added to the equation. In recent years the company had enjoyed healthy margins from this business, however this is not expected to be the case for the foreseeable future.
Perhaps most worryingly for investors was the fact that the equity raising came so soon after the company’s full year result last month, where the company indicated a more promising outlook. ARI’s steel business continues to face challenges, with the company indicating that profitability has failed to improve in recent months despite some recovery in volumes.
We have long preferred our exposure to the iron ore market through the lower cost diversified miners (which have cash costs of around US$40/t) rather than companies such as ARI, and this week’s events has reaffirmed this view. The stock will be one of the more leveraged beneficiaries of any short-term rebound in the iron ore price, although the chances of this being sustained for a more extended period of time are debatable.
Arrium: Iron Ore Cash Costs
Australia’s thermal coal industry made headlines this week following China’s ban of imports of low quality coal from the beginning of next year. The move is designed to curb a worsening pollution problem (and has little to do with global warming) across a number of the country’s major cities, particularly those on the eastern seaboard, which will enforce even more stringent requirements. The restrictions relate to the sulphur and ash content of the coal.
Various estimates have stated that up to half of Australia’s thermal coal exports would not meet this most stringent requirement, and are therefore at risk. In reality, it is not quite as straightforward as this. Firstly, only around 20-25% of our thermal coal exports end up in China, and of this, only part will be subject to the tough requirements. Secondly, other coal exporters to China will also face the same restrictions, along with Chinese domestic production. Further to this, if part of China’s domestic production is unable to meet the new hurdles, this could actually result in an increase in the country’s overall imports, and possibly higher prices to match this increased seaborne demand. It should be noted that coal that does not meet China’s new specifications could also possibly be directed to other markets.
In summary, there are several moving parts to the equation, with many coming to the conclusion that there will be minimal impact for Australia’s domestic producers. Rio Tinto (RIO) stated as much during the week, although any negative effect may be lost in its large, diversified earnings base. The other major domestic thermal coal producers include BHP Billiton (BHP) and UK-listed Glencore, following its acquisition of Xstrata. Of greater concern for the industry perhaps, is the persistently weak coal price (as shown in the chart below), a function of strong supply growth in recent years. This supply growth has resulted from the large capex investment made when pricing was much higher three to four years ago. While in the medium term, prices are expected to recover as the market adjusts, the longer term story is more difficult, driven by environment concerns and the rise of alternative sources of power. We have been conscious of this change with our recent downweighting of Asciano Group (AIO) in our model portfolios, however note that this is only part of its overall business.
Thermal Coal: Historical Pricing and Consensus Forecasts
Market Focus: Stock Overhangs
In a week where we have seen two sell downs by large shareholders in ASX 200 companies (Ramsay Health Care and Dick Smith), it is worthwhile reflecting on other companies that may have a stock overhang. An overhang situation can emerge when an investor that is not considered a long-term holder of a stock builds or holds a substantial stake in a company. The risk for other shareholders (and also those considering an investment in the stock) is that this investor decides to sell their stake, adding further liquidity to the market and putting pressure on the share price.
In practice, the existence of a stock overhang will generally put a ceiling on a company’s share price – as a stock’s price rises, it will increase the probability that the investor creating the overhang will consider selling their stake.
Several of these overhang situations have arisen over the last 12 months as a result of the large number of initial public offerings that have come to the market, many of which have been floated by private equity groups. In the majority of these floats, the private equity investor has retained a stake in the business post the float, with the shares able to be sold after a prescribed period of time. The motivation for such a clause for new investors in a float is clear – their interests will be aligned with the private equity group (even if it is for a short period of time), giving them some form of assurance that they are not getting a raw deal. The escrow period, however, is essentially a two-edged sword – it also creates the aforementioned stock overhang, particularly given that private equity will generally have a short investment time frame and hence will utilise the earliest opportunity to exit the stock. Recent floats that fall under this category are listed in the table below.
A longer term example of stock overhang that has recently played out has been Shell’s stake in Woodside Petroleum. Shell sought to reduce its 23.1% stake in the company in June, partially via a placement to institutional shareholders, and partially via a selective buyback. When the buy-back was voted down by WPL shareholders, Shell was left with a 14% stake in the company.
Many other companies have large investors that have been long term holders of the stock, either from a founding member of the company or a family member thereof. In most cases, these investors are unlikely to be sellers of the stock in the short term, although a change of ownership, generally to the following generation in the family, can trigger such an event. Companies that would be included in this category include Crown (CWN), Ramsay Health Care (RHC), Harvey Norman (HVN), Fortescue Metals (FMG), Westfield (WFD), TPG Telecom (TPM), Premier Investments (PMV), Magellan Financial Group (MFG), Platinum Asset Management (PTM), WorleyParsons (WOR), Computershare (CPU), Seven West Media (SWM), Seven Group Holdings (SVW) and Primary Health Care (PRY).
Investors should be conscious where there is existence of a stock overhang when considering a particular investment. While in itself it does not give reason to preclude investing in a stock, it is one of many factors that should be taken into account.
On the following page we table a (non-exhaustive) list of notable stock overhangs in the Australian market.
Stock Overhangs on the ASX