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WEEKEND LADDER

A summary of the week’s results

21.11.2014

Week Ending 21.11.2014

Eco Blog

Following on from our comments last week on Asian economies, Indonesia announced a significant change in its fuel subsidies which has been growing in terms of fiscal outlays. The timing is near perfect as the impact on the consumer is dampened by the recent fall in the oil price. The key takeout, however, is that these newly elected politicians appear to be willing to take some early pain in the interest of the longer term outcome and if other programmes do follow through, the potential growth in Asia may indeed reach the optimistic targets.

The most unattractive part of the China-Australia Free Trade Agreement is arguably the resulting acronym of ChAFTA. To be implemented over about 11 years, there will reductions in tariffs for agricultural products and resources, while service industries may be able to extend their offer into China as well as being on a number of approved lists or registries. While there was some cautious commentary on the impact of labour mobility (up to 5000 people on temporary work visas) and the potential for domestic agricultural prices to rise due to demand from Asia, the general view is positive though acknowledging the long term impact of such agreements.

Forward indicators such as this weeks’ HSBC PMI reading would imply that China will run on its soft economic tone until at least early next year. Indeed it is hard to see any trend that is pointing in either direction at this stage.  While this sounds bearish, an economy ticking along at near 7% GDP growth is hardly problematic. During 2015 however, the risk is that this eases back further which would introduce risks to global growth and potentially result in accelerating bad debts in the shadow banking system.

Given the recent uncertainty in the key ABS labour market data, other indicators of employment conditions are been keenly observed. The chart shows a number of job vacancy surveys indicating the labour market is likely to have bottomed and may well improve into 2015.

Job vacancy surveys

Source: ANZ
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On an industry basis, both hospitality and construction stand out with good improvements in trend, though the big employment sectors of professional services, retail and even health are still weak.

Attention to the US FOMC minutes of their last meeting was a touch more dovish than the market would have expected given the reasonable resilience in US growth momentum. One of the challenges facing the Fed committee is how and to what they alter the language that has accompanied releases for some years now, that is ‘interest rates remain low for a considerable time’.  In order to avoid dislocating markets as rates inevitably rise, forthcoming releases will be even more attentive to the words used by the Fed members.  The fundamental influences are firmly anchored on the labour market, where the committee acknowledged the recovery, though noting a mild amount of ‘underutilisation’, and on inflation where the recent fall has not changes inflation expectations. Consensus for the first rate rise sits in the third quarter of 2015.

The early hopes for the Japanese economy have dissipated into an early election and weak growth. While the current government is almost certain to be re-elected, the proposed rise in GST will therefore be delayed until 2017 and limit the fiscal flexibility for now. The export sector has found support from the weak Yen, but there is little flow through into domestic activity at this stage. Nominal wages have not risen to compensate for the initial GST and consumption spending has therefore been very weak.  Whether a weak Yen can also result in higher inflation and subsequent change in household behaviour has yet to be tested.

Real wages and consumer confidence

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It would appear that all hope now rests on the Yen, or perhaps more appropriately phrased, the fall of the Yen. Currency battles can cause friction as there are obvious counterparties. Other Asian currencies such as Korean Won or Taiwan dollar are most likely to be affected and could distort their interest rates as they seek to avoid the counterparty effects from Japan.

The US $ is currently bearing the bulk of the burden in currency adjustments and is arguably the best place for that to take place, given the level of commodity and trade pricing that still takes place in US$. But the tension between competing interests in currency may become a bigger issue into 2015.

Company Comments

AGM season continued this week, and an update from iiNet (IIN) was well received by the market. After several years where the company’s growth has been driven by acquisitions and consolidation in the industry, IIN’s focus is turning to organic growth. IIN has shown a positive trend in winning new customers over the last two years and this momentum has been maintained into the first few months of FY15.

Key to this growth has been its success in new NBN connections, where its market share has been greater than that of the legacy copper-based ADSL network. Superior customer service is a differentiator compared to other telcos, and IIN has been investing in this further (as illustrated by a growing net promoter score), helping to reduce the churn of customers to other providers.

iiNet: Net Promoter Score

Source: iiNet
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James Hardie (JHX) reported half year results that were ahead of expectations, despite its primary US market performing below what the company had expected for FY15. Nonetheless, volumes and prices are moving in the right direction, with second quarter sales rising 12% on the corresponding period from last year. Its US margins were slightly down as input costs, particularly pulp and gas, rose materially over the last 12 months. Views on the stock are largely determined by opinions about its ability to achieve its stated target of fibre cement growing to 35% of the North American exterior cladding market (around double current levels), with JHX targeting a 90% share within this category (implying it retains its current share). Growth in US housing has slowed a little in recent quarters, but most still expect this to remain a tailwind for a few years yet, with the long term trend of starts closer to around 400,000 per quarter:

US Housing Starts

Source: James Hardie, US Census Bureau
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While the group’s underlying result was positive, the ongoing specter of its asbestos liability is sufficient to turn some investors away. JHX makes an annual contribution to the asbestos fund based on 35% of its operating cash flow. However, its recent move to change the payments to asbestos victims from this to from a lump sum or instalments over time highlights the potential for a shortfall in the fund, and claims were again higher than expected in the second quarter.

The payment of special dividends by JHX (the company has made three of these in the last 18 months) may be limited given these circumstances. JHX remains the best ASX-listed exposure to the US housing market. However, its end markets are much narrower than other stocks which we have preferred, such as Brambles (BXB) and Amcor (AMC).

Woolworths (WOW) has changed its joint venture with Caltex, reducing by 27 the number of outlets where it offers fuel discounts under the Caltex brand. While insignificant in the context of the group, it may indicate that Caltex, now a retail and distribution business rather than a refiner, is aiming to grow its own retail footprint and not rely on Woolworths as a partner.

Adding to the negative tone for WOW was the release of its hardware store joint venture partner’s first quarter result which implied that the losses at Masters remained higher than expected. Masters sales, as reported for the first quarter, suggested that its sales per store may have edged slightly ahead. Higher losses indicate that these sales are coming from tighter margins rather than an uplift in customer acceptance. WOW share price has been under pressure in recent times as the supermarket sector becomes more competitive, while its efforts to garner growth in other formats looks less successful. Wesfarmers (WES) will not escape any heightened competition in the retail sector, but we feel WES has more levers to pull to achieve its expected growth at this time.

Orica’s (ORI) full year profit was up slightly on last year. However this was largely aided by low interest costs, with underlying EBIT falling. A well supplied market for ammonium nitrate explosives in Australia (coal and iron ore being the two key commodity exposures) is beginning to hurt the company and it has faced a degree of pricing pressure, with this expected to increase over the next 12 months.As it foreshadowed in August, Orica also announced the sale of its chemicals division, leaving the company a pure mining services company. While its chemicals division only accounted for a small part of the overall group’s earnings, the timing is perhaps questionable, given the difficult outlook across the mining services industry. ORI previously divested DuluxGroup (DLX) in 2009 (although this was via an in-specie distribution), and the two companies have had vastly different fortunes since then, as illustrated in the following chart. ORI currently trades on a forward P/E multiple of 11X, which is appropriate given its current environment.

Orica and DuluxGroup since Demerger

Source: IRESS, Escala Partners
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Monadelphous (MND) has performed better on a relative basis in the mining services sector, although its sharp growth trajectory has also stalled as the boom in mining and LNG construction has tapered. At the group’s AGM this week, it guided towards a 15 to 20% decline in revenues for the first half, slightly more than what the market was anticipating. Despite its strong performance and execution in recent years, the stock is weighed down by this large exposure to start up mines. An ability to transition into a higher proportion of maintenance work, generally more recurring in nature, will be important to see the stock re-rate from its current single-digit P/E multiple.

Also at its AGM, FlexiGroup (FXL) reaffirmed its full year guidance for underlying profit. However, two aspects of its announcement saw the stock sold off. The company disclosed a $2.5m provision relating to a commercial leasing contract, whereby the salvage value of the assets (photo printing equipment) had fallen below expectations. FXL also noted that trading conditions so far this financial year had been tough, elevating the risk of an earnings miss for the full year. While the announced provision was disappointing, we believe that the stock has fairly sound valuation support at current levels and are comforted by the high level of short-term earnings visibility in the business.

Market Focus: Yield and Growth Stocks

In our model portfolios, we look to strike an appropriate balance between stocks that are relatively defensive in nature (and generally higher yielding) and those that are held more for their potential to grow their earnings over time. This week we have viewed these two baskets of stocks (taking the ASX 100 as our universe) through some common valuation measures.

As we have previously discussed at length, high yielding stocks have performed particularly well over the last two years as investors have sought to increase their income from equities as fixed interest yields fell. If, or when, the interest rate environment normalises at some point, it is likely that these stocks will come under some pressure as the yield gap closes.

In this environment, it will be important for these high dividend paying stocks to demonstrate the capacity to grow their dividend. There are two limiting factors to dividend growth. Firstly, earnings momentum across the market is expected to slow this financial year. Secondly, many stocks are already paying out a high percentage of their earnings, and thus have little capacity to lift this further.

Below we have charted the highest yielding stocks from the ASX 100 against the expected compound growth in their dividend over the next three years. Stocks towards the bottom half of the chart are those whereby dividend growth is expected to be low, or even decline. Stocks with a direct or indirect resources exposure are most at risk here, including Woodside Petroleum (WPL), ALS (ALQ) and WorleyParsons (WOR). Monadelphous Group (MND) (not shown on the chart as it is outside of the scale) also falls into this category, with a current forward yield of 9.7%, but with a forecast 9.4% p.a. decline in dividends over the next three years. Stocks that look to be well placed on this measure include IOOF (IFL), Bank of Queensland (BOQ), Sydney Airport (SYD) and Suncorp Group (SUN). Each of these are expected to show 6%+ p.a. growth in dividends over this time frame.

DPS Growth (3 Year CAGR) and Dividend Yield

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The ‘earnings growth’ chart below illustrates the companies in the ASX 100 that are trading on the highest forward price to earnings ratios. Compared to our ‘yield’ chart, the outliers on the ‘earnings growth’ chart are fewer, with a higher correlation between P/Es and earnings growth. For these stocks, delivering on, or maintaining this growth trajectory is important, as the failure to deliver on earnings expectations will often see individual stocks de-rate from a P/E perspective, resulting in a much larger impact to its share price.

The companies featured on this chart are generally high-quality in nature and typically have an extended record of double-digit growth in earnings. Stocks that would fit this description include the three major online companies (REA Group (REA), Seek (SEK) and carsales.com (CRZ)), CSL and Ramsay Health Care (RHC).

Stocks towards the top-left of the chart below are amongst those that, at face value, would appear to be good value compared to the rest of this ‘growth’ basket of stocks. For a number of these stocks, however, there is a higher cyclical element to their earnings, and thus the longer term sustainability of this growth is more questionable. Aristocrat Leisure (ALL), James Hardie (JHX), Newcrest Mining (NCM) and Graincorp (GNC) would all fall under this category.

Stocks that perhaps do not justify their above-market earnings multiple would include all those expected to deliver single-digit growth in earnings. In this list would be Recall (REC), Tabcorp (TAH), Tatts Group (TTS), Transpacific (TPI) and Westfield Corporation (WFD).

EPS Growth (3 Yaer CAGR) and P/E Multiple

Source: Bloomberg, Escala Partners
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