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WEEKEND LADDER

A summary of the week’s results

22.02.2019

Week Ending 22.02.2019

Eco Blog

- Exchange rates are a complex barometer of risk, interest rates and investment flows. Currency forecasting requires judging both sides of the equation correctly and invariably results in unexpected moves. The AUD movement in recent months has been a small additional benefit for investors.

Currencies as a topic have been off the radar for the past few months. With plenty of noise on global economic growth, trade, interest rates and policy, cross rates between the major currencies have ambled along. Soft economic data and rate uncertainty have held back the AUD and Euro, while EM and the Yen have found some support.

USD versus Euro, Yen, Yuan and AUD based to Oct 2018

Source: Bloomberg, Escala Partners
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Calling the movement correctly in the USD can not only add to global investment returns but is also a bellweather for the relative performance of the US market against the rest of the world.

The go-to metric on currency views is the yield differential, on the basis higher yields will attract flows into bonds and cash instruments. This underpinned the AUD for many years until the RBA also joined the rate cycle. However, the appetite for higher yield currencies is tempered by two aspects, namely the cost of hedging and the impact of large external debt burdens. As noted in recent fixed income comments, the cost of hedging USD exposures results in a negative return for European and Japanese investors, notwithstanding the interest rate differential that would otherwise exist. The impact of rates alone has been muddied by the structural changes in bank regulation that limit some of the participants in currency trading, and the impact of stress periods predominantly as a function of policy.

External debt loads can have an outsized influence in risk sentiment if they are denominated in foreign currencies. Turkey was the iconic story of 2018, having built up a large external debt position due to low domestic savings and reliance on global capital.

Going into 2019, the consensus was that the USD should weaken as other countries also tightened their financial conditions. In a reversal, the view is now that a dovish tone is prevalent across the board, while country-specific issues such as Brexit have had a bigger role.

The key turning point, however, has been the prospect of a truce, even if temporary, between the US and China. Emerging market currencies have therefore rebounded relative to the US.

Yield differentials and year-to-date currency perofrmance versus USD

Source: Blackrock Investment Institute
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The AUD sits between its status as a G10 currency and traditionally with correlation to EM currencies given the commodity and China link. The tone from the RBA and global opinion on the housing risk has pushed the AUD down against the bullish sentiment to EM financial assets this year. Indeed, we read that shorting the AUD is a way to de-risk exposure to EM as it is easy and cheap to do so.

Nonetheless, the consensus forecast at this stage is that the AUD will remain in the low 70c/USD range. The instinctive view is that the relative strength in the US economy should find a parallel in the USD. Exchange traders, however, work on real effective exchange rates (REER), that take into account purchasing power, inflation and other factors. On these criteria, the USD is still considered somewhat overvalued.

  • At this point we are neutral on hedging against G10 exposures that predominate global equity portfolios. For EM, the relative strength in their currencies against a muted AUD could be an additional bonus to an already attractive valuation backdrop.

Fixed Income Update

- A more dovish tone from the US Federal Reserve bank supports corporate credit as spreads continue to tighten.

The Fed minutes this week drew attention to rates and the balance sheet. Perhaps the biggest take-away referred to the latter with the statement “Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year…such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet.” This refers to the reduction in the Fed’s balance sheet which has been underway since 2018. Under Quantitative Easing (QE), the central bank’s balance sheet rose from $900bn in 2008 to $4.3tn by 2014. Following recent policy, it contracted to $3.85tn and was on track to fall below $3tn by late 2020. The minutes have been interpreted as an explicit signal that the Fed is keen to pause its balance sheet reduction.

The comments on rates was more balanced. On one hand the rhetoric indicated that some officials will be voting to raise rates should economic growth remain firm, while others will only vote to tighten policy if inflation rises. A slow-down in growth and failure of inflation to emerge will likely see the Fed pause indefinitely. No rate cuts were indicated.

Given the pause (or perhaps end in this cycle) in monetary tightening in the US, and now tapering the balance sheet run off, what are the implications for fixed income assets? The answer is clear in the swift repricing of credit spreads and rates this year.  Credit spreads have come in off their highs after widening in-line with the equity sell off in December. Rates have shifted lower (bond prices up) resulting in strong performances across our recommended fixed income funds in January (and so far in February). 

US Investment Grade Spread Moves (USD iTraxx)

Source: Bloomberg, Escala Partners
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In a meeting this week with JP Morgan asset management, they highlighted the strong conditions of US credit markets, which they expect will continue this year. They note the more dovish nature of the Fed and other central banks (including the RBA and ECB) which they believe will push out recession risks. They also emphasised that in the US, top line corporate revenue growth, consumer cash flows, tax reforms and low default rates will support US credit markets. Further, they expect a resolution on the trade discussion between China and the US as both parties are incentivised to stave off a recession and restore economic growth.

While we agree with supportive conditions for credit, we are mindful of:

  • The strong pull back in valuations this year which has credit spreads not far off their lows of March 2018 - which marked the lowest margin since before the financial crisis.
  • The high weighting in the Investment Grade (IG) index to BBB rated credits.
  • The high leverage in the corporate bond market (ex-financials).

On balance, we still view investment grade credit as a safe fixed income option, offering a decent pick up over government bonds. Investment timing and security selection are key to mitigating some of the above-mentioned risk. While we don’t recommend selling holdings despite the credit rally, for new money we suggest waiting for the Fed’s minutes to wash through markets and await a better entry point once spreads settle down.

Corporate Comments

- BHP’s half year was impacted by operational issues, although a lift in iron ore prices provides support for the second half.

- Oil Search (OSH) has catalysts in the next 12 months as it moves closer to LNG expansion.

- Trends for WorleyParsons (WOR) continue to be positive, while a large acquisition will add to the growth profile in the medium term.

- Casino operators Crown (CWN) and Star Entertainment (SGR) recorded mixed fortunes in the December half.

- Managing cost inflation is the immediate issue for Brambles (BXB).

- Cochlear’s (COH) recent successes have been halted by market share losses from a competitor’s new product launch.

- Travel-related stocks are facing slowing growth as consumers become more cautious.

- Structural headwinds continue to impact Coca-Cola Amatil (CCL), while A2 Milk’s (A2M) profits track higher.

- With a maturing domestic market, Domino’s (DMP) success hinges on replicating this internationally.

- Valuations appear full for the supermarkets cohort of Coles (COL) and Woolworths (WOW), along with Wesfarmers (WES).

A number of operational issues overshadowed BHP’s result, with unplanned outages at assets that included its Pilbara iron ore and Olympic Dam mines. Profit was relatively flat year on year, with mixed commodity price performance in the period. On the more important metrics in which shareholders are currently focused – balance sheet, operating cash flow and dividends – BHP performed well, with the current respectable ordinary dividend yield supplemented by a buyback and special dividend in the period. The second half is panning out to be even better for the company, particularly following the rally in iron ore prices and the recovery in oil markets. This underpins the resumption of an earnings upgrade cycle for the stock (a spot price scenario would lead to higher earnings again) and shareholders should stand to benefit further given these developments.

BHP Free Cash Flow

Source: BHP Group
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As usual with Oil Search (OSH), the focus on the company’s result was more about the progress towards its expansion as opposed to the numbers from last year. The company has a few catalysts through this year, including front-end engineering and design for its expansion of PNG LNG before a likely final investment decision next year. While this has been pushed out somewhat from the initial timelines proposed given the negotiations with the PNG government and following Exxon’s InterOil acquisition, the positive for OSH shareholders is management’s view that the large capex bill will be funded from operating cash flows and existing debt facilities. This will, of course, be largely dependent upon the path of an unpredictable oil price over the next several years. OSH remains our preferred energy exposure given its value-enhancing expansion options in its portfolio.

Oil Search: LNG Development Timeline

Source: Oil Search
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WorleyParsons (WOR) often trades like an energy stock given its dependence on capital expenditure in the sector. The company’s outlook is not too different from six months ago, despite the wild oil price swings through this time, with a period of catch up in capex spend across its customer base. Underlying profit for the half was up more than 20% on the back of double-digit revenue growth and margin expansion. Most observable trends were also positive, including increased employee numbers, high staff utilisation rates, a large number of significant contract wins and a growing backlog of work. The medium-term growth profile is underpinned by the synergies from the recently announced acquisition of a division of Jacobs Engineering, which should help to reduce the volatility in the underlying core earnings base. On a forward P/E of 16x FY20 earnings, the stock is one our preferred cyclical exposures.

WorleyParsons: Staff Utilisation

Source: WorleyParsons
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Domestic casino operators Crown (CWN) and Star Entertainment (SGR) reported contrasting fortunes in their respective half year numbers. Crown’s high roller numbers continue to be quite variable, with turnover down 12% in the half. SGR also experienced a sharp decline in turnover, although a high win rate by the casino played a large part in this outcome. Main gaming floor revenue was the key differentiator between the two; SGR’s casinos in Sydney and Queensland recorded mid-single digit revenue growth, while CWN’s Melbourne (+2%) and Perth (-2%) properties were much softer. Despite SGR’s superior performance, the stock trades at an approximate 25% discount to CWN, which appears to be some unjustified despite the support that CWN has enjoyed on the back of a more shareholder-friendly capital management program.

Star Entertainment: High Roller Win Rate and Turnover History

Source: Star Entertainment
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Brambles’ (BXB) result was relatively soft as expected, with underlying profit flat year on year. At a glance, top line growth of 7% (in constant currency) appeared to be a reasonable outcome, although the greater focus was on the cost line. Ongoing high cost inflation again reduced the group’s margins, with BXB noting that only 75% of increased transport and lumber costs recovered through pricing. BXB management is guiding towards a 2-3% margin uplift by FY22 on the back of cost out, procurement, automation and higher pricing. These benefits are perhaps already captured in a forward P/E of close to 20x and the stock has held up much better over the last six months than much of the market, indicating that there are better value options elsewhere among core industrial stocks. Nonetheless, the stock has an upcoming catalyst, with the demerger of its IFCO (reusable plastic container) business slated for later in year.

Cochlear’s (COH) half year contained several positive elements, including solid emerging markets growth and cash flows, although a lofty valuation left little margin for error for any issues raised. The focus for investors was COH’s implant sales growth, or the lack thereof, which was impacted by the launch of a new product from one of COH’s key competitors, Advanced Bionics.

While COH’s services revenue (from upgrades) continues to grow at a good clip as the installed base grows (revenue growth has averaged in the mid-teens in recent years), the immediate term growth for the company will be predominantly driven by its ability to claw back these market share losses. In short, the competitor’s new product launch was a well-known headwind and, while it has often been a short-term cyclical issue in the past, the impact was much greater than feared. COH undoubtedly has high quality characteristics, with leadership in a large untapped market, although the stock may now be sidelined by growth investors until it has proven that the market share losses are only a short-term issue.

Sydney Airport (SYD) reported a typically solid full year result, although there are clouds on the horizon as cyclical elements come into play. A 9% increase in cashflows translated into a similar increase in the distribution, however the company’s forward guidance was below expectations. Slowing passenger growth is the primary reason, which underpins each of SYD’s revenue lines. Domestic growth is being hampered by increased rationality in terms of capacity and a yield focus by the key airlines, while a recent increase in the oil price is unhelpful for demand. International customer growth is also slowing (though still the key driver) and forward indicators are for capacity reductions by airlines through 2019. Distribution guidance for FY19 now stands at just 4% growth, well below the 10% CAGR enjoyed by investors since 2012. With fundamental factors working against SYD, the recent recovery in SYD’s share price has thus been yield-driven in nature.

Sydney Airport: Distributions and Growth

Source: Sydney Airport, Escala Partners
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Several other travel-related stocks also posted variable conditions this week. Flight Centre’s (FLT) growth focuses on the company’s international expansion, with these businesses now accounting for over half of group profit. However, the domestic network has been hampered by a systems upgrade in its stores, wage inflation and a more cautious consumer, which has translated into softer margins. A special dividend was declared to appease shareholders and will release some of the company’s large franking balance. The outlook is driven by the strong overseas momentum, but with domestic volatility, while the stock’s large derating over the last several months (from a mid-20’s P/E to 14X) is somewhat of a representation of the extremes in sentiment that can drive valuations in the short term.

Slowing passenger growth will also be problematic for Qantas (QAN), although, for the airline, restricting capacity can protect the downside via improved yields. Managing fuel price volatility, however, remains the biggest challenge for the company and the ability to recover a higher oil price in a weaker market will likely prove difficult. Ongoing capital management (an additional $305m on-market buyback was announced) buffers the downside, although this alone should not be reason to invest in the stock. Ultimately QAN is only a viable option for investors willing to make a call on the short term cycle.

Coca-Cola Amatil (CCL) confirmed that 2019 will be another year of “transition” for the company. A higher investment spend in order to boost volumes has, to date, not had the desired result. The table below infers that CCL itself is doing a good job having gained market share, although the market itself is in decline, including in what have recently been higher growth segments (such as water). CCL offers a strong dividend yield of circa 5.5% and a quality defensive brand, although a lack of underlying earnings growth and structural headwinds appear to be more than captured in a mid-teens P/E.

Coca-Cola Amatil Australian Beverages Volumes

Source: Coca-Cola Amatil
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Not all food-related stocks are challenged by the same headwinds as CCL. A2 Milk (A2M) has been a small cap success story over the last several years, having considerable success in expanding into the large Chinese market, while the US is the next frontier. Navigating a dynamic regulatory environment for imports into China has been important to the A2M’s growth, with these risks mitigated somewhat by a multi-channel sales approach. Valuation has been the key hurdle for many small cap investors, while some are wary of the non-insignificant risks such as its concentrated supply contracts. A comparison with CCL’s valuation is somewhat instructive; A2M’s sales are approximately ¼ of that of CCL, profitability is ¾ of that of CCL, while its market cap is around 70% higher. We have left judgement on the investment merits to small/mid cap managers, many of who have generated material attribution from the stock over time.

Once-market darling Domino’s (DMP) has had its fair share of critics over the last few years, largely stemming from a slowing growth profile, mixed performance in its international expansion and addressing what was an unhealthy balance between corporate and franchisee profitability. The disruption brought to a halt the impressive sales growth story driven by its well-recognised leading technology platform. Attention is now turned to replicating the success in international markets, with a strong presence in Europe and Japan. While the latter has had variable success, the December half showed a good turnaround. With the stock now trading on a more palatable P/E of 23x, several growth-focused managers have held faith in the outlook.

Domino’s: Australia/New Zealand Same Store Sales Growth

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After a prolonged period of passing the baton on market share and stock performance both Coles Group (COL) in its inaugural report as a stand-alone entity, and Woolworths (WOW) reported slow sales and more importantly, rising costs. The new enterprise award added to labour costs and there was little in the way of other productivity gains. These are likely to require capital spending on distribution centres and instore efficiency. In the meantime, consumers are clearly price sensitive. The outlook therefore is muted in both cases. The dividend provides some support but the P/E valuation in the high teens looks rich for the expected growth. Defensive stocks are only such if they do not come with a high price; in this case the promises both make on how they can improve their consumer offering and contain costs will have to be delivered.

Wesfarmers (WES) is now Bunnings in disguise with the division contributing more than half of EBIT and the market essentially focused on the outlook for this business. This half year result was solid in terms of profit, though, the 4% like for like sales growth is a notable moderation from the 8-10% that was the feature of the past years. How this division shapes up as housing deteriorates and consumers remain skittish will determine the equity performance. The valuation at 19X FY19, as with WOW and COL, leaves little room for error.

Reporting season wraps up next week, with a handful of stocks yet to report.

Next week’s schedule is as follows:

Monday: Lendlease, Harvey Norman, Boral, Reliance Worldwide, BlueScope Steel

Tuesday: Caltex, Spark Infrastructure, Afterpay

Wednesday: Rio Tinto, Costa Group, Viva Energy, OZ Minerals, National Storage REIT, Trade Me Group, Vocus, Seek

Thursday: Inghams, Adelaide Brighton, Atlas Arteria, Ramsay Health Care

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