Week Ending 20.02.2015
This week we will restrain economic commentary to absorb the large amount of local corporate reporting and activity.
A summary of selected economic releases gives colour to the ongoing trends we have noted in recent weeks.
Malaysia’s CPI registered an annualised 1% in January. Excluding ‘volatiles’ such as food, fuel etc. the rate was 1.7% p.a. The key issue is that inflation is low even in countries without major structural problems, unattractive labour and poor demographic trends. Those concerned about Europe’s low inflation should possibly cast their eyes wider to understand the global issues that are causing prices of goods and services to be so contained.
Indonesia unexpectedly cut their deposit interest rate (25bp to 5.5%), while Korea is experiencing quite different dynamics and held rates at 2%. Diverging issues for emerging market economies is likely to see some unique investment opportunities within that group of countries.
Indonesia has a current account deficit and needs to tread a fine line between undermining its ability to fund this deficit as US rates rise. Yet inflation in Indonesia is also low and the general confidence in structural changes supports an easing that aligns its currency towards a better current account outcome. Korea, conversely, is experiencing relatively subdued growth but does have a very high level of household debt and a strong housing market; not dissimilar to Australia. A weaker currency would be helpful, but the risk is a further rise in consumer leverage.
Emerging countries can be vulnerable to funding issues (as was the case in 2013) if they run a current account deficit. Recently, the majority have been able to manage the outcome better and the likelihood of being swept up in unstable financial conditions that might emerge from elsewhere is much lower than before.
Some European countries are well into negative rates – Switzerland and Denmark perhaps the two most recent examples. These low (or zero) rates in part are there to push savings into the economy, but also due to the risk of capital flows seeking safe havens. Eurozone instability, the problems in Russia and trouble in the Middle East had seen significant pressure on Switzerland as capital sought this traditional safe haven. However, the cost of defending its currency fix was overwhelmed by the extent of demand for francs. The mechanism has therefore turned to rates.
The US appears headed down the same path. The FOMC comments noted low inflation and implicitly a possible deferral of the expected interest rate hikes. Many economists believe the US is concerned that the rise in the $US will harm the growth trajectory and that a dovish tone on inflation keeps a lid on the flows into this currency.
Most, if not all, countries are grappling with the interchange between capital flows, currency movements and incentives to invest rather than save. Perversely, this seems to be pushing many to save more, given the complexity and uncertainty they face. Low, or even negative, rates have to date appear to have made little difference to household spending.
Possibly the most compelling piece of evidence on consumer attitudes will be any eventual lift in consumption due to the fall in oil prices. Some commentators suggest the halving of gas (petrol) prices is equivalent to the largest cut in personal taxes ever experienced by the US consumer.
Japan’s Q4 GDP came in at 0.6% or 2.2% annualised. After a tough period post the introduction of a consumption tax, the weaker Yen and suggestions of improved vigour in the corporate sector, growth has been underwhelming given the extraordinary level of quantitative easing. While a bounce in data and probable equity performance is likely, the sustainability of the path being followed is questionable.
Locally, there was little economic data of importance. The RBA minutes confirmed the relatively dovish tone with the forward market pricing in a rate cut. The Westpac Melbourne Institute Leading index suggests the low growth rate will persist in the near term and all eyes will now move to the RBA meeting on 3 March. While some have a rate cut on this day, others believe the RBA will want to see the Q1 CPI data and a recasting of labour statistics from the ABS before making its move.
Westpac-Melbourne Institute Leading Index
As has been the issue with many companies this reporting season, Asciano’s (AIO) half year result was notable due to the lack of underlying top-line growth in its business. What remains on track, however, is the company’s business improvement plan. This cost-out program has to date delivered $172m of savings (with $57m in 1H15), with the company targeting $300m by the end of FY16. The integration of Pacific National’s coal and intermodal rail divisions accounted for a large part of these savings in 1H15. In a reasonably weak operating environment, the magnitude of these savings relative to AIO’s profitability levels is material. The chart below illustrates the drivers of profit growth in the first half for AIO.
Asciano: Underlying EBIT Bridge
Increasing coal volumes had been a key driver of earnings improvement in FY13 and FY14, however this positive effect has now evaporated. Weakness in coal prices has, to date, not caused any noticeable drag on overall volumes. While some smaller mines have been put on care and maintenance, this has been offset by increasing utilisation from the larger miners. For AIO, the investment thesis of improving free cash flows remains, as its capital expenditure profile rolls off over the next two years. Despite the market conditions the company has faced, management’s confidence in achieving its targets is evident in its 43% lift in its interim dividend (although noting that this is coming off a low base), which is now at the top end of its target payout ratio.
Carsales.com’s (CRZ) half year result showed good revenue growth, however this failed to translate into the profit expectations of investors. The profit miss was largely attributable to the company’s recent expansion into vehicle finance business Stratton, as well as the growth in tyresales, both of which are lower margin than its core business. While the company has a good core structural thematic, it still retains an element of cyclicality in its business. Growth would typically be lower in a benign economic environment, while display advertising on CRZ’s website would also be impacted.
Of its domestic business, CRZ’s inventory levels were down slightly on last year, although this was largely explained by the decision by a number of car manufacturers to remove internet listings. Offsetting this, however, was higher turnover figures – the time taken to sell fell, increasing the value proposition of CRZ’s site. The company is always mindful of competition in its market place, although the figures below show that presently this threat is not great. We have CRZ in our model portfolios.
Carsales.com: Market Position
Seek (SEK) probably has even more cyclicality in its business than CRZ, which makes its performance in recent years impressive, particularly considering the weak domestic jobs market. In conflict with the rising unemployment rate, however, there is evidence that conditions are starting to improve. SEK’s new job ads index has now risen by 11% over the past year. SEK’s volume growth of 7% for the half caused it to miss analysts’ expectations.
While the success of its domestic business is still important for SEK, it is its portfolio of international job website investments that provide the greatest opportunity over the longer term. Typically in less mature and developed markets than Australia, the structural change that has occurred domestically is still in its infant stages in most of these countries. Look-through EBITDA growth from these business was 25% for the first half, and will receive the tailwind of a lower $A into the second half. SEK currently trades on a relatively high forward P/E multiple, although this appears justified considering its 15%+ p.a. EPS growth forecasts over the next three years.
Amcor’s (AMC) result built on the momentum in the business in recent years, with EPS growth of 6.8%, or 10.4% on a constant currency basis (the company reports in $US), which was slightly above expectations. As is the flavour of the month, the company announced a US$500m on-market share buyback (unlike Rio Tinto’s buyback announced last week, AMC does not have excess franking credits on its balance sheet in which it can distribute to shareholders). The buyback is expected to add 1-2% to EPS on an ongoing basis. Despite this additional return to shareholders, AMC has retained a relatively strong balance sheet, leaving it with further capacity to complement its growth via selective acquisitions. The company increased its interim dividend by 9%, which translates into a 25% increase in $A.
Growth in emerging markets was again key for AMC in the half, with 10% organic growth offsetting a flat performance from developed regions. Lower raw material prices should also provide a short-term boost to margins, although these will inevitably be passed on to its customers. While AMC’s share price has appreciated significantly over the last six months, its valuation is now only on par with many other core industrial stocks on around 18x forward earnings. We believe AMC is a sound portfolio stock with attractive characteristics; a defensive growth profile, strong cash generation, exposure to faster-growing markets and a recent sound track record of execution of its strategy.
iiNet (IIN) continued the recent progress that it has made in organic broadband growth. Net additional subscribers over the last six months maintained the run rate of 2H14 at 25,000, as shown in the chart below, representing an annualised growth rate of 5%.
iiNet: Broadband Net Adds (000's)
The chief cause of concern in its numbers, however, was the failure to turn this into profit, which rose just 1%. IIN has stepped up its investment in staff in a bid to reduce its customer churn rates even further. The benefits of this spend will be realised on an ongoing basis going forward, and the company expects its cost base in the 2H to reduce. As such, we are not overly concerned about the earnings miss in this half and instead look at the medium-to-longer term picture of market share growth through the disruptive industry event of the NBN rollout. As IIN highlight, under the Coalition Government’s revised multi-technology plan, the rollout is expected to accelerate over the next 18 months. Over this time, the number of connected premises is expected to rise from the current 0.6m to 2.5m. Expressing confidence in its future, IIN lifted its interim dividend by 17%. IIN remains our preferred telco stock and its valuation (on a forward P/E of 13.5x) is particularly undemanding compared to Telstra (TLS) on 19x and TPG (TPM) on 22.8x.
The leverage of the smaller and mid-tier iron ore miners Fortescue Metals (FMG) and Arrium (ARI) was clear in their interim results this week. Despite a 12% reduction in cash costs (in $US) over the half, FMG’s underlying EBITDA halved and net profit declined over 80%. Like the other major Pilbara operators (BHP Billiton and Rio Tinto), FMG has done a fantastic job at reducing its costs over the last 12 months, but the fact remains that its margins lag by approximately US$20/t to these peers, a function of lower pricing and higher costs. While it had been paying down its (not insignificant) debt when the iron ore price was high, the ability for FMG to do this in the current environment is much more limited. Perhaps surprisingly, FMG decided to pay out a 3c interim dividend, well below last year’s distribution of 10c.
ARI is also addressing its cost base in a hurry, a necessity borne out of its even more marginal cost operations (relative to FMG). An underlying net loss for the period was compounded by a pre-announced $1.3bn impairment charge as a result of lower iron ore pricing. With an oversupplied iron ore market and its core steel division returning another loss for the half, the outlook for ARI remains challenging.
Each of AMP’s key business lines grew earnings at a double-digit rate for its full year result, helping to achieve overall underlying profit growth of 23% and ahead of expectations. Most impressive was the ongoing recovery in its wealth protection division, with a further improvement in 2H profit. The leverage to rising investment markets showed in its wealth management division, with improved revenues flowing through on a flat cost base, while inflows onto its platforms were robust. The market’s performance in the early part of this year will see the company well placed to capitalise on this momentum.
AMP’s top line growth is currently being complimented by an ongoing cost out program. The benefits from this are expected to ramp up over the next two years, as illustrated in the chart below. We recently added AMP to our model portfolios, and though the long-term outlook for the company is attractive, in the short term it is susceptible to any short term pullback in the market after the remarkable rally over the last month.
AMP: Business Efficiency Program Savings
Origin (ORG) is a company in transition, with its APLNG project in Gladstone now 90% complete and approximately six months away from first production. Concerns still remain over its energy markets business, which has suffered a drop in profitability over recent years due to high levels of competition. In the first half, ORG benefited from the availability of cheap wholesale gas prices as a result of the ramp up of production ahead of the commencement of Queensland’s various LNG projects, providing a margin uplift for the company. While electricity margins also rose, the overall retail market still remains difficult, as evidenced by the customer losses experienced by ORG in the early part of the financial year when it reduced its discount offers. ORG has responded by increasing these discounts again (see chart below); a positive for customer numbers, but this will likely be a negative for margins into the second half.
Origin: Average Discount Offers for Electricity and Natural Gas
We believe that the market’s focus over the next 12 months will centre on the progress of APLNG. While there were some indications by ORG that the budget for the project may be stretched (partly a function of the recent depreciation of the $A), this does not appear to be material. We have retained ORG in our model portfolios as a relatively low-risk play on an expected medium-term recovery in energy markets, with a step change in cash flows as APLNG commences production.
G8 Education (GEM) disappointed with its full year result, which came in at the low end of expectations. The company reported underlying profit growth of 88% and 58% growth in earnings per share as a result of equity issuance. Cash flow was strong, the company’s return on its investment remains robust and occupancy rates improved (albeit a slower rate compared to previous years). Along with its full year results, GEM also announced the acquisition of a further 12 childcare centres from various vendors at a price of 4X forward EBIT, consistent with its acquisition strategy target.
Despite what appears be a relative solid set of figures, a number of issues have emerged that are concerning analysts and investors. Firstly, there is a risk to funding levels for the industry at present, with the Federal Government to respond to the Productivity Commission’s report on child care, which was released earlier today. While the report has recommended improved assistance to lower-income families, those on higher incomes are likely to be worse off. The demographics of GEM’s centres will thus be important in determining the effect that these changes are likely to have.
Secondly, estimates are divergent on a key driver of profit growth, that being the acquisition pipeline for the group over the next few years. GEM recorded a jump in its growth last year when it took out a key competitor in the market, Sterling Early Education, and it added over 200 centres to its portfolio over the course of the year. The company has been employing an acquisition arbitrage model (whereby its own stock trades on a large premium to that of its acquisition targets), however the effectiveness of this strategy is reduced at present given the relative weakness of its share price. While more optimistic growth targets may not be reached, we believe that the opportunity remains large in what is a highly fragmented industry.
In much the same way that Echo Entertainment demonstrated in their profit announcement two weeks ago, Crown (CWN) showed that when it comes to the high roller market, Macau’s loss has been Australia’s gain. With CWN’s casino’s interest in both regions, it has provided an effective hedge for the company in the last six months given the crackdown on corruption in Macau. Also helping CWN is the fact that its Australian casinos are 100% owned, while it only retains an equity stake in Melco Crown Entertainment of 34%. Crown Melbourne was able to grow EBITDA by 26% for the first half, led by an 86% jump in VIP (high roller) turnover. Crown Perth showed more modest growth of 8%.
The normalised net profit contribution from Melco Crown was down 21% on the previous corresponding period. While the Macau market is yet to emerge from the weakness seen over the last 12 month period, Melco Crown has offset its decline to a degree via taking market share in the mass market table game segment. CWN itself has no shortage of investment options that it has either committed to or looking at, including at Barangaroo in Sydney and as part of a consortium in Brisbane. How it finances its ambitious plans is likely to be an ongoing question mark for the company given an already stretched balance sheet. While the stock is not without its risks, CWN’s valuation is undemanding, particularly compared to its peers and the upside opportunity should Macau recover.
Super Retail’s (SUL) first half results could be described a respectable under the circumstances. Headline sales growth of 5.7% eased back to a 7.0% fall in EBIT due to tighter gross margins and higher depreciation expense. Reported net profit fell 45% after one-off restructuring. Investors looked through these numbers to the much better sales for the second half of the year to date and the restructuring of the leisure division, with the prospect of higher profits from this attractive product segment. Over the past two years SUL has been de-rated due to lower growth expectations and costs associated with distribution centres. While the strong trajectory of some years back through new store openings and acquisitions is unlikely to reoccur, we believe the discipline and focus of the management supports its position as our preferred discretionary consumer stock.
Wesfarmers’ (WES) result should put the question back on the table; why does the group persist with its conglomerate structure? The premise is well known, with its head office seeing itself as an allocator of capital, not a manager of individual businesses. Yet when the retail divisions are doing well, the overall profit is dragged down by a sharp fall in the chemical, energy, resource and industrial divisions. Total retail EBIT was up 7.3%, whereas the other divisions profit fell by 25%.
Wesfarmers: Divisional EBIT
The sale of the insurance division took reported net profit down 3.7% for the half year, or up 8.3% for continuing operations. While there was clear logic to realise the insurance operations, it does highlight that the group struggles to reinvest these proceeds. We have supported an investment in WES to capture the upside from the retail improvement and as an exposure to a relatively stable industry sector. These merits are less prevalent now, especially given the valuation with the FY15 P/E forecast at 20x.
Medibank Private’s (MPL) maiden half year result showed profit growth of 11%. As expected, this was driven by cost reductions, with its management expense ratio improving from 9.2% to 8.0%. For a company trading on a similar P/E multiple to many other established health care stocks with an established track record, we believe that it has more headwinds and faces a greater level of regulatory risk than its peers. One particular concern is the affordability of health insurance and how this continues to impact MPL’s core premium brand. The Medibank brand again lost market share in the half, while the strong growth in its more value-focused (and lower-margin) ahm brand led to total policyholder growth of just 0.5%.
Woodside Petroleum (WPL) and Santos (STO) both reported an increase in their full year profit, although the effect of lower oil prices is yet to be fully realised for the two companies. LNG accounts for a large part of their respective portfolios and this is typically priced with a three month lag to oil. With the sharpest declines in oil coming in the last few months of the year, this will flow through during 2015.
Of the large cap oil companies, WPL is still our least preferred due to its lack of growth options, which have reduced further in the current low price environment for oil. The company’s big potential project, Browse, is unlikely to be approved under these conditions, although WPL is still targeting a mid-2015 date for front-end engineering and design. The group’s production is expected to fall in 2015 (the mid-point of its guidance assumes an 8% decline), and with profitability much lower, the high dividend payments that investors have been receiving will likely be cut significantly.
STO has already responded to falling cash flows through reduced capex and cost cuts in recent months, so the new detail at its full year result was limited. While the company has adequate liquidity on which it can draw as it nears completion at Gladstone LNG, the key concern has been over its credit rating. Of note was a flat final dividend (although a reduced value from its full year result) when some had feared that it would be cut altogether. The successful navigation of the next six to 12 months along with some recovery in the oil price would likely see a positive outcome for shareholders, however the stock is not still without its short term risks.
Next Week’s Reporting Schedule
Monday: BlueScope Steel, Brambles, Caltex, GPT, Lend Lease, M2 Group, Spark Infrastructure, UGL
Tuesday: BHP Billiton, Breville Group, Flight Centre, Genesis Energy, Healthscope, McMillan Shakespeare, Orora, Oil Search, QBE, Qube, Scentre Group, Spotless
Wednesday: APA Group, Austbrokers, AWE, Henderson Group, Veda, Westfield Corporation, WorleyParsons
Thursday: Adelaide Brighton, Alumina, IOOF, Nine Entertainment, Perpetual, Qantas, Ramsay Health Care, SAI Global, Sydney Airport
Friday: Harvey Norman, Treasury Wine Estates, Woolworths