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WEEKEND LADDER

A summary of the week’s results

21.08.2015

Week Ending 21.08.2015

Eco Blog

The brightest news on a dour week was from the US where a series of data releases indicated that the manufacturing weakness has abated (Philadelphia Feb business survey). Notably, the employment component was particularly strong and the average work week rose sharply. On the other hand, the pricing index fell to a three month low. This is in part likely to be due to the US$ strength and does indicate goods inflation is unlikely to surface any time soon.

US housing starts, at eight year highs, may well gain ground into 2016.  The improving employment picture, a small pickup in wages and low inflation are fertile ground for those that avoided household formation in the past few years to enter the market. The US demographics are such that there will be an increase in the number of people entering the typical time of housing activity in coming years, that is, there are more 20-35 years olds than 35-49 year olds. 

US Demographics

Source: US Census
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Sales of existing homes are also strong, up 11.7% year on year, with the median price registering $234,000. The inventory of unsold homes at 2.24m represents 4.8 month’s supply compared to 11.9 months at the peak, April 2010.

However, the troubling outlook for China weighed on the market, with the PMI reading of 47.1 the lowest in six years. There was little glimmer of any turnaround and the pressure on authorities is mounting.

The composition of the PMI and the trends in each component are shown below:

China PMI Composition

Source: Caixin Purchasing Managers Index
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The repercussions from China’s unexpected currency devaluation is still reverberating across the region. Other Asian currencies will inevitably ease to align their competitiveness to that of China. The sharp pullback in trade is already putting pressure on some countries in the region. Their relationship to China varies from some such as Hong Kong, essentially totally interrelated, while Korea and Taiwan have a high level of exports to China. On the other hand, countries such as Vietnam do not have a large export exposure but compete with China for trade with others. Those least affected include India, Indonesia and Singapore, which do not have China as a dominant export partner not the same products.

Over time, emerging economies are rather diverging economies, as their destiny is increasingly unique to their own circumstances.

Global growth expectations are very likely to be revised downward as the decades-long engine room of Asia takes a step back.

Elsewhere, there was little economic news that influenced investment markets. The keys will remain with US employment trends and the looming Federal Reserve meeting on 16/17 September. Possibly some early indication will emerge from next week’s annual Jackson Hole Economic Symposium, though Janet Yellen is a notable absentee.

Fixed Income Update

Bond markets have had a volatile couple of weeks on the back of deflationary concerns following the depreciation of the Chinese yuan. Yields initially fell on both the US Treasuries and Australian government bonds before rebounding and finishing the end of last week pretty much unchanged. This week has seen some further weakness in yields, off a few points across the curve.

The depreciation of the yuan last week and a cautious tone in the FOMC minutes this week has markets speculating that the Fed might delay raising rates. Despite this, a recent Bloomberg survey of economists showing that 77% expect the Fed to hike in September, only 36% of market participants are predicting lift off that early (admittedly, this is down from 48% two days earlier).

The implications of events in China are likely to be weighing on markets, as US investment grade bond funds saw US$1.1bn of weekly outflows; the highest since 2013. In addition, credit spreads are also at their widest in two years. The Australian credit market has also weakened, with spreads (as measured by the Australian 5 year Itraxx Index – see below) pushing through the highs of January this year and not far off the elevated levels during the Greek crisis. 

Source: Bloomberg
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All CBA listed securities were on trading halt last week as the bank entered the market with a $5billion equity raising. Once this lifted on Monday, there was aggressive selling of the CBAPD (Perls VII) whilst CBAPC (Perls VI) and CBAHA (senior bond) posted gains with all three securities trading above average volume. While this increased subordination (from the equity raising) is theoretically good for hybrids, it appears that investors were selling out of the longer CBA hybrid to fund the new shares.

Apple Inc is entering the Australian bond market with the issuance of an inaugural AUD denominated ‘kangaroo bond’. After gauging investor interest earlier this week, the US based company has announced a four and seven year bond in the OTC market with both fixed and floating tranches.

Corporate Comments

FlexiGroup’s (FXL) result was pre-announced, so there was little to move the dial when it reported on Monday. The detail showed a very much mixed result across its various divisions, with robust volume growth across its interest free credit cards and Certegy businesses, while disappointing figures were posted by its SME and commercial leasing. High competition and the disruption that resulted from the departure of some key executives were blamed for the latter.

On a number of measures, FXL continues to perform quite well. Return on equity remains high at 23%, the group’s funding costs fell further in FY15 and impairment losses are also quite low (despite rising slightly through the year).

FXL’s FY16 guidance implies a weaker rate of growth for the company compared with what investors have been accustomed to, despite a further contribution from recent acquisitions that the company has made. The general consensus amongst analysts at present (and a view that we would share) is that the current share price implies an overly negative earnings outcome in the medium term. The realisation of a positive turnaround, however, may be some time off, given a weakening organic growth profile and the current vacancies that the company has in its CEO role and a new Chairman, it is probably that the stock may simply tread water during this period.

Asciano Group (AIO) reported a 10% increase in underlying EBIT for FY15, in line with its guidance of “>5% EBIT growth” but comfortably ahead of analyst expectations. Consistent with recent results, the key driver of the improvement in earnings was the company’s ongoing cost out and efficiency program, which allowed it to record earnings growth despite a 4% fall in revenue across its various businesses.

Overshadowing the result, however, was the confirmation that AIO had agreed to a takeover bid from a consortium led by Canada’s Brookfield Infrastructure Partners. Investors may recall that AIO initially confirmed media speculation that Brookfield had made an approach to the company in late June and subsequently granted it the opportunity to conduct due diligence.

Brookfield has now offered a combination of $6.94 cash and 0.0387 Brookfield Infrastructure units per Asciano share. The cash component of the deal is expected to include a fully franked special dividend of 90c, thus giving the opportunity for shareholders who are able to capture the full benefit of these franking credits a further 39c of upside. Excluding the franking credits, the offer is currently valued at $8.88 (and will fluctuate based on the Brookfield unit price and currency movements), a slight premium to AIO’s last traded price of $8.66. The discount can be explained by the time frame before the deal is expected to be completed (mid-December, following a shareholder vote in November) as well as perhaps the reluctance of some investors to receive scrip for their AIO shares. While AIO shareholders can elect to receive all cash or all scrip, Brookfield have indicated that there will be an aggregate cap on both options, limiting the certainty for investors. The timing of Brookfield’s offer looks to be quite opportunistic, with a sharp improvement in AIO’s free cash generation as it completes a significant capital expenditure program (see chart below), however, the 30%+ premium to AIO’s share price prior to the approach should see it get across the line. Given the higher probability of a transaction for AIO, we will look to replace the stock in our model portfolios at the next review.

Asciano: Free Cash Generation

Source: Asciano
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Sydney Airport’s (SYD) result was solid as it demonstrated good revenue growth across its four businesses – aeronautical, retail, property and car parking – leading to total EBITDA growth. The half was notable for the new five year international aeronautical agreements that SYD had announced with the various airlines, with an annual escalation of 3.8% on the charge per international passenger. This week, SYD also announced that it had reach an agreement with Qantas to take control of the airport’s domestic terminal 3, four years before the airline’s lease was due to expire. SYD expects the deal to be EBITDA and cash flow accretive in the first full year.

Chinese passengers continue to be an important part of the airport’s overall passenger growth, while other Asian countries also featured heavily in total passenger growth of 2.1% for the half. SYD also lifted its full year distribution guidance by 0.5c to 25c, which is backed by the company’s cash flow growth. Over the next 12 months, a catalyst for the stock will be the decision on the construction of a new airport in Western Sydney, in which SYD has first right of refusal. We hold SYD in our model portfolios.

Sydney Airport: Passenger Growth 1H15

Source: Sydney Airport
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Seek (SEK) surprised the market with forward guidance for FY16 that was 10% weaker than analysts had expected. The company appears to be taking a long term approach to its strategy by stepping up its investment over the coming 12 months. As a result, SEK is expecting EBITDA growth across its business of 5-8%, much lower than the revenue growth expectation of 15-18%. Investors were not so convinced with the approach, marking the stock down as it effectively delivered its second downgrade in the last three months.

For FY15, the result was mixed, with strong ongoing growth in SEK’s international investments, a reasonable result from its domestic business (considering the weak employment market) and the previously highlighted weakness in its online education division. The difficult environment faced by SEK in the latter is unlikely to abate into FY16, suggesting a further earnings drag on next year’s result. We took SEK out of our model portfolios earlier this year based on valuation grounds and with the stock still trading on a forward P/E of 21X despite two downgrades in recent months, we are not tempted to reconsider this position.

The result of Brambles (BXB) met expectations, which was at the low end of the company’s guidance of 10-13% growth in constant currency operating profit. The strength of the $US over the last 12 months meant that earnings growth was reduced to just 3% in BXB’s $US reporting currency. Forward guidance for FY16 was for a slower rate of growth (again on a constant currency basis). A higher rate of sales growth was again evident in businesses that the company has acquired in more recent years, while pallets posted respectable figures.

Brambles also reiterated its long term return on capital invested (ROCI) target of 20% (prior to the impact of acquisitions made since 2014), with only a slight improvement recorded in this measure in FY15. If it were able to achieve its stated ROCI target, this, in combination with a respectable level of ongoing sales growth across the business, would lead to a sizeable earnings uplift opportunity for BXB. The company’s ROCI trend across the group in recent years would suggest that this goal may look to be overly ambitious, however, with only the core pallets division currently meeting this return objective. Having fallen from a share price of close to $12 in early April, BXB is now trading at around the $10 mark. The stock now trades on a more attractive forward P/E of approximately 17X; a fairly typical valuation level for a medium-growth industrial stock.

Brambles: Return on Capital Invested by Division

Source: Brambles
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The downturn in oil markets hit energy stocks this week as Woodside Petroleum (WPL) and Origin Energy (ORG) reported results. A further dip in the oil price over the last few weeks has come at an inopportune time for ORG as it revealed that the APLNG project will now cost the company an additional $550m as a result of lower oil prices, a later commencement of sustained production (previously noted by ORG) and additional costs that have been brought forward to take advantage of additional LNG production capacity. What was largely overlooked in the company’s result was the announcement of a project that is targeting an annualised figure of $200m in cost savings from FY17, with ORG following the recent lead of AGL Energy.

Despite the diversity and relative stability provided by its utility business, Origin still has significant leverage to the oil price given the high operating costs of the APLNG project. The company estimates that the project will deliver free cash flow to shareholders where the oil price is above $A55/barrel (note the denomination in our domestic currency). Every A$10/barrel change in the oil price will result in a change of approximately A$200m in distributable cash flow from APLNG for ORG. As a result, while ORG may have been expecting to receive approximately $900m per annum when the oil price was at $A100/barrel, with the price now at $A65/barrel, this distribution would thus fall to $200m.

The inevitable outcome for ORG shareholders is that the much higher dividend stream that was initially expected to result from APLNG cashflows will now be much lower and perhaps delayed somewhat, with the initial priority likely to be a deleveraging of the company’s stretched balance sheet. While this may be the case, ORG appears to have a reasonable amount of flexibility when it comes to raising capital with the potential for further asset sales following its recent divestment of its stake in Contact Energy. ORG’s valuation looks relatively attractive despite this weaker outlook, however the shorter term outlook will continue to be dictated by the ongoing weakness in the oil price, with our conviction in a sustained recovery waning somewhat in recent months.

Woodside has fared better than other large-cap energy stocks over the past year, largely a function of its relatively low-cost operations and safe balance sheet. With a low immediate capital expenditure profile and low cash costs of its existing operations, the company has been well placed to weather the current market conditions.

WPL was able to limit the damage from the weaker oil price due to a further incremental uplift from improved contract terms from its Pluto operations, which came into effect in the first half of 2014. Investors who had been holding WPL shares for its high dividend yield would have been disappointed with the 40% cut in the $US-denominated dividend payment; an outcome that was inevitable given the fall in profitability of the company and its steady 80% payout ratio. The dividend is expected to fall further in the second half as a full six months of lower oil prices is factored into earnings.

 While WPL has outperformed the sector in the current downturn, if anything, the low oil price only exacerbates the company’s key problem of a lack of organic production growth. Browse is still slated as the project most likely to become WPL’s next big-ticket project, however the weak economics of this project can only have become more difficult under lower oil price assumptions.

AMP met expectations with a half year result that showed a 12% rise in underlying profit, with a positive contribution from the majority of its divisions. The issues that the company faced with its insurance division now appear to be largely behind it, with a third consecutive half of consistent results. The company continues to work towards ensuring the longer term sustainability of the division.

The performance of AMP’s wealth management business remains key to that of the overall group and the division was able to record solid earnings growth despite the ongoing margin pressure due to the transition of clients to MySuper. This heightened level of margin compression is expected to continue through to June 2017, indicating that it will remain a headwind for earnings over the next two years. Combating this has strong retail fund flows and the company’s ongoing savings from its business efficiency program, which is expected to deliver further cost savings over the next 18 months. With a respectable forward earnings profile and a P/E similar to that of the broader market, AMP remains one of our preferred investments in the financials sector.

AMP: 1H15 Underlying Profit Movement

Source: AMP
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Following on fairly strong results in the gaming sector last week, Tatts Group (TTS) also reported an impressive 13% rise in profitability for the full year. The company’s lotteries business, which is responsible for 60% of group earnings, was able to record earnings growth of 6%. This was despite a slightly weaker year for large jackpots, which typically result in an uptick in ticket sales.

Offsetting this division was a lower profit contribution from TTS’s wagering division. In the second half of the financial year, TTS launched a new wagering brand (including a refreshed website), which it is rolling out across its retail outlets in Queensland, South Australia, Tasmania and Northern Territory. The benefits of the investment that TTS has made here should begin to pay off over the next two financial years.

As we noted last week with Tabcorp, the trend for consumers to purchase through digital channels (and the overall expansion of the market as a result) was also evident in TTS’s sales. In FY15, digital sales accounted for 11% of the company’s lotteries business and 26% of all wagering turnover. The higher-margin nature of this channel, coupled with the relatively predictable top line growth of the overall business that predominantly contains monopoly assets, leads to a sound investment proposition.

Wesfarmers (WES) is likely to prove to be one of the few large cap stocks where the FY15 result and forward expectations did not trouble investors. EBIT rose by 5.4%, and net profit was up 8.3% based on a continuing business. It did disguise, however, the divergence between the retail divisions, with profits up 10%, versus the 57% fall in the combined industrial divisions. These chemical, resource and industrial product operations now account for only 9% of group EBIT.

Management’s focus on return on capital as the primary measure to achieve shareholders returns results in capital allocation to the high performing divisions and it should come as no surprise that the group has aggressively defended the home improvement division against Woolworths’ Masters effort. 

Wesfarmers Home Improvement Return on Capital

Source: Wesfarmers
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This result suggests they have every intention to maintain the pressure with margin from operating leverage ploughed back into sales and store opening to continue apace. The possible closure or downsizing of the Masters format would become a further bonus. The correlation to the housing cycle nonetheless suggests investors would be unwise to assume the rate of growth in this division can be sustained.

Coles supermarkets also had a productive year, once again at the expense of Woolworths. Fourth quarter same store sales at 4% is well ahead of its competitor, though achieved through flat margins as competitive pressures in food retail remain intense.

Kmart did well, too, while Target, after years of pain, eked out a small growth in EBIT. The question is what price to pay for a well delivered execution against its major retail competitor in the bulk of its business. Woolworths likely requires a reset of its profit margins and if a new CEO decided upon this path, the outlook for Wesfarmers would take on a different shape. For the moment it’s the large cap retailer of choice, trading at forecast 17.8X FY16 and an anticipated yield of 5.2%. We note that the 93% payout ratio leaves little room for movement where earnings to soften.

While the FY15 results for Super Retail Group (SUL) were soft with EBIT down 8.7% excluding restructuring costs, the trading pattern over the last few weeks is strong, setting the tone for a potentially better FY16. The strategy appears to be a measured transition for each of the three divisions (auto, leisure and sport) to create communities through club membership, targeted marketing and rejigging of the supply chain. Within the corporate business, there are also a number of small fledging investments which are at early stage development. The last couple of years have been tough for SUL shareholders, however, in our view the management is highly credible and taking a sensible approach to shifting the operations towards a productive platform. For patient investors, FY16 promises to be a much better year for EPS growth forecast to be around 12%.

Coca Cola Amatil (CCL) reported a flat first half profit, but with encouraging volume growth, the share price was one of the few in the black at the end of a difficult week for markets. A concerted marketing effort, new products, price investment in supermarkets and traction in the route trade with premium products appears to be paying off. The company still expects full year net profit to December to be flat on FY14, with mid-single digit growth thereafter. At 17X FY15, it is not a bargain, though if the predictability in earnings and cash flow could improve, the stock could once again find favour as a low risk investment.

Reporting season concludes next Friday, with another fairly busy week of results. So far, results have been slightly disappointing (overall the market has missed expectations by ~2%), however the key concern for investors has been the downgrades that are filtering through for FY16, with many companies issuing relatively soft guidance. A renewed bout of commodity price pressure has also clouded the picture further for the resources sector. We will provide a more comprehensive wrap up of results in two weeks’ time.

Next week’s reporting schedule:

Monday: Caltex, BlueScope Steel, M2 Group, Lend Lease, Spark Infrastructure, Japara Healthcare, Fortescue Metals, South32

Tuesday: BHP Billiton, Amcor, Oil Search, Healthscope, McMillan Shakespeare, Pacific Brands, Scentre Group, Spotless Group

Wednesday: WorleyParsons, APA Group, Westfield Corp, Orora, Pact Group, Steadfast Group

Thursday: Perpetual, Flight Centre, Ramsay Health Care, Boral, Nine Entertainment, Veda Group

Friday: Woolworths, IOOF, Northern Star Resources, Slater and Gordon, Regis Healthcare


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