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WEEKEND LADDER

A summary of the week’s results

20.11.2015

Week Ending 20.11.2015

Eco Blog

A dearth of any meaningful economic data or trend in the past week has opened the door for reports on what 2016 holds for the financial world.

More often than not, there is no need to think that a new calendar year will change the pace of activity or market behaviour. This time, however, is a little different. The Fed rate rise is now considered a near certainty for December and on the other hand, some form of easing is widely anticipated by the European Central Bank (ECB).

Are conditions so vastly different across the Atlantic divide? European economic growth and inflation are clearly lower than in the US, but not by such a considerable margin to warrant directionally opposite monetary settings. Additionally, the trend in growth in Europe is on a similar trajectory to that of the US.  The most compelling difference is in employment rates, excluding Germany. Yet, there is far from a direct link between central bank easing and employment levels.

The real intent of ECB easing may rather be to provide enough time for the banking sector to recapitalise and deal with the long legacy of bad debts that are not fully out of the system. Unlike the US, where the corporate sector makes full use of a large credit market, European corporates, particularly the number of substantial small and medium private businesses, stay with bank debt as their source of capital. That makes the imperative to create a robust bank sector all the more important in Europe compared to the US.

Another important feature which rarely gets much airplay is the availability of trade credit. Many of these European SMEs require some financing of working capital, given they tend to focus on goods rather than services.  In short, monetary policy in Europe is smoothing the path for the workings of the financial sector, rather than just addressing a perceived lack of sufficient growth, with more required.

The investment implications are likely to be muted. Financial markets have already factored in both the US and ECB direction.  If yields rise beyond expectations, buyers of these assets are likely to return. The charts below show the capacity of various participants with different requirements which buy Treasuries.  Private investors have sought comfort in bonds as the volatility in equities and credit occurred. On the other hand, as pension schemes move towards full funding, they are likely to shift their bias to fixed income.

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The verdict on inflation for 2016 is that it is likely to tick up, cycling the extended weakness in oil prices, as well as the probable rise in food prices due to supply disruptions in many regions. But there is also a growing opinion that wages may just start to edge upward. Certainly in the US, all the signs are there that it should, though to date the data has been stubbornly resistant to confirm this view. Even here it appears that the public sector, where wage growth in recent years softened to the level experienced in the private sector, is pushing for incrementally higher levels. 

The chances of high inflation are improbable, but with inflation expectations having tipped down over the course of 2015, they may well revert in 2016 and impact on longer term interest rates.

Many commentators are hedging their bets on the oil sector, while remaining bearish on hard commodities.  The inventory levels and supply of oil are still elevated relative to demand. As yet, the fine line between output and consumption appears to be tipped to keeping the lid on prices. A few, however, believe that in the second half of the year supply will contract enough to get markets believing higher prices will emerge.  The counter argument is that costs of production can fall further, as has been the case in hard commodities, restraining the amount of supply leaving the market, and that demand growth from emerging economies is still overestimated.

Given the fall in commodity prices shown below, it is no wonder some are looking to call this bottom.

The investment case is hard to make either way. Those with patience may be tempted to add to energy stocks during the coming year by taking the view the debate is about the time frame rather than the direction.

Two Years of Commodities

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The investment case is hard to make either way. Those with patience may be tempted to add to energy stocks during the coming year by taking the view the debate is about the time frame rather than the direction.

Politics, as always, will be important, but even more so in 2016 due to the elections cycle. First up could well be ‘Brexit’, the promised referendum on whether Britain will stay in the European Union.  Inevitably, wider issues such as refugees will possibly have a greater influence than the issue at heart: is it in Britain’s interest to be part of the EU block, or are the costs of supporting Brussels and compromise on some regulatory structures too high?

The second event of consequence is clearly the US election. At this stage, it appears likely a Republican congress and Democratic president will emerge, though there is still plenty to transpire beforehand.

Finally, both France (May/June) and Germany (autumn) will have general elections in 2017. Even though that is some way further off, these are critical for Europe.

For investors there is possible upside. A small amount of fiscal leeway to induce a more positive view of the incumbents may come through in Europe. The business sector is unambiguously of the view that it is important Britain remain in the EU and are likely to fund a status quo campaign. 

Required (as they are) to form a view on asset classes, the 2016 gazers have a muted positive slant to equities. Most note, however, that there is no obvious pockets or easy gains to be made. Agility will likely be required by those looking to match or beat shorter term trends. The alternative is patience without panic. 

Fixed income has its supporters, notwithstanding the absolute levels of rates. Riskier segments, such as high yield or emerging markets, are hotly debated. The conclusion is to stay away from the distressed elements such as energy, high yield or countries with endemic current account deficits, but that there are also sectors and countries unreasonably sold off in the generic rush to avoid the broader index.

Finally, a telling chart on demographics. Despair over Japan’s anaemic trends has to be seen in this context.  New Zealand has not materially outdone Japan, and the picture for Australia is not entirely different. Population growth and productivity remain the key to higher aggregate GDP.

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Fixed Income Update

Following the events in Paris, the ACGB (Australian Government Bond) curve shifted lower: both 3 year and 10 year ACGB yields were 6bp lower at 2.09% and 2.89% respectively.  However, this risk off trade was short lived, as the domestic market responded to the hawkish comments from the RBA minutes. The yield curve reversed at least half of these moves, with the short end of the curve taking out most of the sentiment of a further rate cut. The Australian futures market is now pricing in a 28% chance of a rate cut in February (the first meeting for 2016), compared to being fully priced in a month ago.

On the supply side, we have previously discussed the global nature of our bond markets. In recent years there has been a large amount of issuance being done by Australian domiciled companies into the offshore markets as well as new global issues done domestically. A recent example of this is the announcement that Intel will be doing a series of investor calls with a potential inaugural AUD denominated deal to follow.

The Australian listed debt market is dominated by the issuance of hybrid and subordinated securities, so it was pleasing to see a new senior unsecured bond issue launched last week. Australian Unity (a diversified organisation specialising in the provision of healthcare, financial services and retirement living) launched a $230m, 5 year senior unsecured bond at BBSW (bank bill swap rate) +2.8%. This offered a good diversifying option for investors both from a credit risk perspective as well as its superior position in the capital structure. For a reminder on the capital structure, the depiction below spells out the ranking.

Source: FIIG Securities
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The window has not yet closed for more hybrid capital raisings in 2015. Reports appear to confirm that Macquarie is still planning on bringing another hybrid deal before year end, with an announcement expected Monday. It will be looking to raise capital in order to contribute to funding the recent purchase of Esanda Dealer Finance from ANZ.

Staying domestically, Standard and Poor’s (S&P) upgraded Qantas to BBB- this week, returning it to an investment grade credit. Following hefty financial losses, the rating agency had cut the airline to junk status back in December 2013.

Liquidity concerns continue to plague global bond markets. According to reports out this week, US and UK swap spreads vs treasuries have become inverted. In simple terms, government backed treasuries are trading at a higher yield to interest rate swaps. Interest rate swaps are the rates that banks exchange fixed for floating in the market, so they effectively have bank credit risk incorporated in them. A higher yield for government vs banks does not makes sense given the lower credit risk of the former vs the latter. However, it goes to show the growing gap in liquidity between the derivatives market, where interest rate swaps are traded, and the physical market, including those for government treasuries.

The main drivers causing this dislocation include:

- The reduced balance sheet capabilities of banks as regulatory changes inhibit their ability to warehouse bonds;

- The increased use of derivatives to alleviate balance sheet pressures of the banks; and

- The move in recent years to central clearing houses which keep the costs of derivatives down.

The AUD swap spread to ACGB is not yet inverted but it is trading at its tightest level ever.

High liquidity buckets have increasingly become normal amongst fixed income funds as portfolio managers look to mitigate this illiquidity risk of holding physical bonds.

Corporate Comments

James Hardie (JHX) disappointed with its quarterly earnings result and downgraded its forecast earnings for FY16 by approximately 6%. Prior to the result, sell side analysts had been predicting the full year profit to be at the high end of the company’s guided range, hence the downgrades to consensus were slightly higher.

For the half, James Hardie’s key US and European division grew their top line by 6% through a mix of modest price increases and 5% volume growth. The Asia Pacific segment also posted solid numbers, with an 11% increase in sales (on a constant currency basis). James Hardie had been able to grow its earnings at a faster pace thanks to the margin expansion; a feature of its results over the last few years now (illustrated in the chart below). Part of this has been as a result of the leverage in its business to higher volumes, some is attributable to the cost and efficiency gains and more recently also come from a fall in its input costs.

James Hardie: USA and Europe EBIT and EBIT Margin

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JHX’s margin outcome has been quite variable over the last five years, and with it now at the top end of its guided long-term range, it is probably unreasonable to expect this to expand much further.

While the margin outcome was below expectations, it appears that the JHX downgrade is more related to weak category growth of fibre cement in the siding market (compared to other materials, such as vinyl, brick and stucco). Fibre cement has been taking market share when viewed on a longer term time frame (and is a key part of the JHX growth story), however this has shown more variability on a shorter term basis.

We remain constructive on the outlook for JHX. With US housing starts remaining nearly 30% below mid-cycle levels and better conditions in the renovations market (a result of improving house prices), the prospect for solid earnings growth in the medium and longer term are good. We have recently added the stock to our model portfolios and the fall in the stock price along with reset expectations represents as a good entry point.

Orica’s (ORI) result gave little indication that the weak environment in mining-related industries is picking up. Profits were impacted by a pre-announced asset impairment charge, with underlying profit falling 26%. This was despite the $52m benefit from more favourable currency markets (to put into context, a 6% boost to EBIT) and $175m of “transformational benefits” delivered over the course of the year. The cost savings that ORI has realised include the renegotiation of supplier contracts, improving its manufacturing productivity and reducing its employee headcount.

In the shrinking mining services sector of the market, ORI has been viewed as providing a higher level of protection to weak conditions due to its leverage to commodity volumes (which have been resilient) as opposed to capital works. While this has some merit, it is not immune to the pricing pressures that are being felt across the industry. The group’s contracts which have been coming up for renewal (contracts are typically renewed every few years) are being priced at a much lower rate. In FY15, this led to a $57m drag on earnings and ORI expects a similar negative impact for FY16. 

Source: Orica
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Adding to ORI’s issues has been a loss in market share in the higher-margin Australian market (which has faced oversupplied issues) as well as a further deterioration in profit at its acquired ground support division, which was loss-making for the half. Orica is a company with restructure potential and the challenge for the company will be to turn its cost savings measures into better profitability for the company. At this stage, however, it appears too early to call a turnaround in its fortunes and further downside risks do not appear to be adequately reflected in a forward P/E of 14X.

We hosted a presentation from Spotless (SPO) management this week, a stock which we added to our model portfolios earlier this year. SPO had one of the better results of August’s reporting season and provided strong guidance for FY16. One of the company’s competitive strengths is the depth of its service offering, which includes catering, cleaning, laundry and facilities management. The ability to offer a multi-service capability is an important factor in its success, with the trend moving towards these contracts which combine two or more of its services.

Within the domestic laundry industry (which services hotels, hospitals and aged care facilities), SPO is the only company with a national presence; an important distinction when bidding for nation-wide contracts. Compared to its peers, Spotless also self-delivers (i.e. utilises its own workforce as opposed to subcontractors) a high proportion of its work and plans to increase this further, enabling to take greater control of its service offering, giving it a better oversight of its business and reducing some risk factors.

The one area of SPO’s business that is at most risk at present is facility services contracts within remote mining communities (accounting for approximately 10% of its exposure). While there has been a higher proportion of contract turnover in this industry compared to others, there remains opportunities in the sector to consolidate several smaller contracts within a region.

Almost all of SPO’s contracts contained embedded price growth mechanisms (such as CPI), thus reducing the risk from covering its largest cost, being employee expenses. Its business model is capital light, ensuring solid cash generation. SPO operates in an industry with relatively defensive growth aspects; organic growth is linked to GDP growth in the economy, while the outsourcing trend in Australia (which is underpenetrated compared to other developed economies) should be a tailwind for the next decade. The ramp up of higher margin social infrastructure Public Private Partnerships (PPPs) over the next few years provides a further leg of growth for the company. Trading on a P/E of 14.5X, we believe that the stock remains a good value option in the market.

Increased corporate activity has been a feature of the Australian market more recently. This week we had a takeover proposal for OzForex (OFX) by Western Union and a possible tie-up between domestic market leaders Tabcorp (TAH) and Tatts Group (TTS). OFX sits among a group of smaller companies in the financial services sector that have been growing through offering a more competitive price or service (in this case, international currency transactions) compared to that of larger financial institutions. 

As we have highlighted, the weak $A has provided an opportunity for international competitors to either increase their presence or gain a foothold in the Australian market. The online currency transfer market has seen a high volume of M&A activity internationally and the Western Union proposal would appear to reflect the potential of this fast-growing market, valuing OFX on a FY17 multiple of 26X.

A merger of TAH and TTS has been raised in the past and this week the companies confirmed that they had held discussions over a nil-premium merger of equals, which have since ceased. The largest synergies that would be on offer from combining the two companies would lie in the wagering divisions. Wagering is the core business of Tabcorp, while for Tatts it accounts for less than a third of its earnings.

Tabcorp and Tatts: Market Exposure

Source: Tabcorp and Tatts
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For TAH, the timing of a transaction could be ideal given the recent investment that TTS has made into its wagering division after a period of lagging performance. TAH had previously made a play for the then-named UniTAB business in 2006 (which was blocked on ACCC competition concerns) before Tatts came in to buy these wagering licences and form an additional operating division for the company. The betting market has changed materially since then, with a rise in international and online competition and consumer preferences moving towards mobiles. This would likely mean that any proposed transaction would have a greater chance of proceeding in today’s environment.

Myer (MYR) followed the path of David Jones with a decent rise in first quarter sales of 3.9% on a same store basis. David Jones, however, is claiming first spot, with over 10% growth since mid-year. Both should be viewed in the context of clearance sales as they undertook a significant shift in merchandise assortment. Nonetheless, speciality store sales, particularly apparel, have been strong in recent weeks and therefore department stores would participate to some extent. This does not change the underlying problems for the format. Very weak recent sales from similar store groups in the US and UK reinforce that whilst they may experience occasional bursts of growth, the pressure from other formats and online is unlikely to go away.

The next step for MYR will be the closure of some 20 stores and the introduction of a larger number of concessions. The modest proportion of concessions at Myer and their success has brought about the view they can improve profit, even though Myer forgoes the apparel gross margin and acts akin to a landlord subletting space. We would be cautious. To date, the concessions have been to those confident and willing to invest in their brand, staff and inventory. The choice of the partnership is more important than the fact that there is one.


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