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WEEKEND LADDER

A summary of the week’s results

22.05.2015

Week Ending 22.05.2015

Eco Blog

US data refuses to consistently align itself with the general view that the economy is tracking along fine. Following on from last week’s fall in consumer sentiment, the NAHB survey of homebuilders also suggested that activity was levelling off. Then, later this week, housing starts and building permits came in above expectations. In turn, given the persistence of low inflation (another reading to come late this week), the FOMC is leaning on the dovish side and the therefore the bond market remains indecisive on the precise timing of the much anticipated Fed official rate movement. A hike in June is certainly no longer on the cards. 

There would be few who would not allow for some rate rise this year, yet the potential extent is arguably much more critical. Here there is a wide spread of opinion, with the infamous Fed dots implying that members of the FOMC assume the historic pattern will largely be repeated, compared to asset managers who are factoring a lower peak in the rate cycle. Ultimately, the valuation of most financial instruments rests on the anchor provided by the longer term bond rate.

With the emergence of domestic demand in Europe, the question is whether this can be sustained or, even better, find its way into business confidence and investment spending. Signs are emerging that the corporate sector is willing to access bank capital again given the fall in lending rates.

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Efforts by the Chinese authorities to re-invigorate its economy have added another dimension through a ‘made in China’ strategy aimed to support manufacturing industries to advance their technological prowess. The release of the HSBC Flash PMI (which tracks the momentum in activity in medium to small businesses) was weak once again. A pressing question is whether the root cause is the quicker than expected loss of momentum for the Chinese economy overall (and hence requires a revision of GDP growth forecasts), or whether there are structural issues within the Chinese economy which can be addressed by reform.

China has studied the German ‘Mittelstand’ (medium to small business) phenomena for some time and appears to be trying to replicate that through this latest plan. Given the still entrenched position of state owned enterprises on one hand, and the entrepreneurial ambitions of the millenniums in internet and information technology, it may struggle to gain traction. 

But one cannot argue that China is lacking in initiatives to regain its growth rate. The One Belt, One Road initiative is also underway, with grand ambitions to create land and sea trade routes. For those that have not focused on this plan, the belt is a rail, road and pipeline infrastructure ‘silk road’, while the road rather awkwardly refers to the maritime route encompassing ports and related infrastructure.

Source: Businesskorea.co.kr
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The observation can also be made that China is still leaning heavily on global trade to drive its economy. Many economists prefer a greater focus on domestic issues and services such as health, tourism, pollution controls and professional services, rather than expectations that industrial activity can continue to be the primary area of government support.

The RBA minutes were carefully perused given the reaction of the market to the last rate cut. This time the RBA’s language was more benign, stating that even though no further guidance on the possible direction of rates would be given, this did not limit the Board’s ability for further action. The market is modestly skewed to another rate cut, but has largely pushed that out as a possibility later in the year.

Perhaps the key lies with the lift in consumer confidence (the Westpac/Melbourne Institute consumer sentiment index rose 6.4% in the month) and whether that translates into household spending. The forthcoming data may be hard to read given the tax break for small business, widely reported as finding its way into some of the retailers. In this case, it is less likely that any investment spending would follow, and once again frustrate the RBA.

Fixed Interest Commentary

The upward movement in global government bond yields has been the main focus of fixed income markets over the last week. The short end of the curve has remained anchored given that no rate rises are expected in Australia or Europe in the near term, but the mid to long end of the curve has been volatile. Short duration funds and bonds have only been mildly affected by the back up in yields, whilst long duration bonds and funds have seen some capital losses. 

High yield and emerging market debt securities have conversely performed well, with the recent lift in the price of oil aiding some of these markets. Spreads on high quality corporate bonds have also remained stable, however the domestic listed tier 1 market has seen some weakness. Long dated tier 1 securities have been hit the hardest, with spreads getting close to 4%, which equates to a fully franked yield to maturity (YTM) of above 6.8% for the majors with a maturity greater than 6 years.

Listed Hybrid Securities

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In contrast, the OTC market has held firm, with only some slight slippage on the recent AMP tier 1 deal, which has widened by about 10 bps. This stability boded well for Bank of Queensland, who this week announced a $150m Tier 1 deal to be issued in the OTC market as opposed to the listed market.

This week also saw talk of a new ‘green bond’ by one of our major banks. Despite this market gaining traction abroad, it will be the first of its kind in the domestic market. The proposal is for a 5 year fixed rate bond that will be ranked alongside all the bank’s other senior unsecured debt instruments and rated AA-/Aa2. The proceeds will be used to finance assets that contribute to developing low-carbon industries, technologies and practices, such as wind farms, solar energy projects and green buildings. Pricing is expected to be in line with other 5 year senior unsecured securities by this issuer.

Company Comments

James Hardie (JHX) reported its fourth quarter results, with its full year profit coming in at the top (but within) the company’s full year guidance. The share price reaction to the announcement (+11.6%) appears to have been driven by two things in particular; a solid cost performance in its key US business, along with the announcement of a US22c special dividend.

The company is benefitting from the economies of scale as the US housing market gradually recovers, which has more than offset a number of its input costs, including pulp. Past history may suggest that further margin growth from here will be more difficult, with the fourth quarter margin result at the top end of the company’s target range and above all but two quarters since 2009 (see chart below). Earnings growth from here will likely be more dependent on JHX’s ability to grow its top line, something which should have further legs given that the US housing market is still yet to return to an expected mid-cycle figure of approximately 1.5m starts (starts are currently at a run-rate of 1.1m p.a.). JHX expects further gradual improvement over the next 12 months, with the company planning for 1.1 – 1.2m starts in FY16. After experiencing a strong recovery in 2011-13, US housing starts have recorded more modest growth in the last 18 months and this trend is expected to continue. 

James Hardie: US and Europe Quarterly EBIT and EBIT Margin

Source: James Hardie
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Shareholder capital returns remain the flavour of the month in the current environment and JHX ticked two boxes here by announcing a special dividend as well as plans to buy back up to 5% of its issued capital over the following 12 months. JHX remains a higher quality investment proposition compared to its more domestically-focused building materials peers, although the primary challenge for investors is the company’s relatively full valuation. Despite the inherent cyclicality in its business, the stock currently trades at a healthy P/E premium to the broader market.

DuluxGroup (DLX) disappointed with its half year result, which showed underlying EBIT growth of just 4%, despite the favourable impact of the earlier Easter holiday period. Investors were perhaps looking for better leverage from the strength in the Australian housing market. As DLX highlights, however, less than 20% of its end market exposure is new housing. This compares with a 62% exposure to maintenance and home improvement markets. As a result, its earnings base will typically show more stability and have more defensive qualities than others in the sector; clearly a benefit as we approach a peak in the current housing cycle.

DLX is currently facing the challenge of turning around its garage doors and openers business (part of its acquisition of Alesco), with earnings declining by 27% as a result of the transitional impacts as it launched a new product range and adopted a new distribution strategy. The company also recently announced that it will be spending $130m (net) to construct a new paint factory in Melbourne, which is expected to result in cost savings through automation and better raw material utilisation. The benefits from this, however, are relatively long-dated, with a targeted completion date of late 2017. We also note that all of this spend is not ‘growth’ capex, as part of this new capacity is replacing its existing operations.

Mid-May appears to be a popular time for companies to give a more detailed account of their current strategy and longer term plans, more so than can typically be covered in results season. This week we have had investor briefings from several companies, including Wesfarmers (WES), Woodside Petroleum (WPL) and WorleyParsons (WOR).

Wesfarmers had a strategy update with 261 pages of accompanying charts and material. At the end there was little news to drive the share price, bar downgraded guidance to its chemicals division.

The supermarket business remains on the front foot at this stage, showing confidence in its price stance and ready to challenge for a greater share of online and click and collect sales. Nothing suggests that this business is finding it difficult to deal with Woolworths’ efforts to regain market share. A similar tone of measured confidence came from Bunnings, Officeworks and Kmart. Target was at pains to present its efforts to improve profit, but acknowledges that while the customers are trickling through and buying incrementally more product, with volumes up some 4%, prices are on aggregate down 6%, suggesting the EBIT improvement is some way off. The other divisions – coal mining, chemicals, industrial distribution - as always are a mixed bag, with aggregate annual EBIT highly variable, though overall small enough (circa 10% of earnings) to be somewhat irrelevant.

Analysts are keen to spot potential capital management or any hint of acquisition bias. The presentation gave little away, with a sense the group was unlikely to do much as this stage, particularly given recent capital management and a high gross payout (an average 86% since 2009). Capital expenditure has been pulled back somewhat, with Coles and Bunnings the recipients of the majority. Wesfarmers’ head office considers itself primarily as an allocator of capital based on hurdle rates. While this does create some discipline towards higher return options, it could also disadvantage the business units which will persistently struggle in a relative sense. It may be unlikely in the near term, but we remain of the view investors (and the divisions) are likely to be better served by coherence in the operating entities. 

If Wesfarmers were to purchase a business, it is more likely to take on as much debt as it could while maintaining its credit rating. The chart shows the impact of falling interest rates, with the financing bill falling by more than half in the past six years. Investors should however note that the non-cancellable operating leases represent 75% of Wesfarmers’ fixed obligations.

Wesfarmers' Funding Costs

Source: Wesfarmers
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WES trades at around 19X FY16 P/E, based on expectations of a mid-single digit EPS growth. Under these forecasts, the stock is likely to mark time at best. Upside from much better sales at Bunnings and Officeworks may be offset by tight margins at Coles, as Woolworths seeks to reassert its position.

Woodside reiterated its intention to pay out 80% of its earnings “for the foreseeable future”. This is reflective of the current lower oil price environment (notwithstanding the recent recovery) and a lack of investment opportunities available to the company. WPL paid out US$2.55 per share in dividends for FY14 (it has a 31 December financial year) and on current broker estimates, this could be as low as US$1.00 per share. This would represent a current forward yield of approximately 3.6%, with the stock quickly disappearing from the list of high yielding Australian equities.

While WPL may be in sounder shape (balance sheet wise) compared with its large listed energy peers in the Australian market, low oil prices are still not conducive to resolving the company’s issues of a declining production profile and few near-term investment options. Reduced cashflows will limit the number of opportunities that the company can explore in the short term and investment hurdles will be harder to meet under these lower oil price assumptions.

The company’s Browse project illustrates the challenge facing WPL, which is the next big ticket project for the company. It is expected to have marginal economics (particularly in the current environment) and has undergone several changes over the years as WPL and its partners decide on the most appropriate development concept (currently a floating LNG development). Target dates for the project have been pushed out several times over the last few years, with the current schedule showing front end engineering and design to commence mid this year, with a final investment decision in the second half of 2016. Commissioning of the project is expected to be a further five years beyond this date, indicating that it will not be a few years into the next decade that this could provide an uplift to its production.

WorleyParsons’ (WOR) investor day was relatively more sombre than those conducted in the past, with the company’s operating environment deteriorating following the decline in the oil price over the last year. While there will be an inevitable lag between the actual capital expenditure conducted by energy companies and the path of oil, the results are already beginning to show in the company’s trading. Third quarter revenues fell 6% in the March quarter and a margin crunch resulted in underlying EBIT falling 17%. This would be partly explained by an underutlised workforce through this period (WOR’s largest individual cost) and adjusting this in coming months will, to a certain degree, offset the impact of a sharper cost focus by its customers.

WorleyParsons: Hours Charged and Utilisation Rate

Source: WorleyParsons
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While we recognise WOR as a quality business, the industry in which it operates will most likely be challenged for at least the next 12 months. Current analyst estimates of global oil and gas capital expenditure show an approximate 25% decline in 2015. Similar to that of the global diversified miners, many of the large international oil majors also have placed a priority on maintaining progressive dividend policies. Thus, with lower oil price settings, cash flows will be balanced by cuts to capex as opposed to shareholder returns, leaving risk to the downside for WOR’s earnings. In the interim, the best outcome for shareholders is potential takeover interest in the stock, with some recent M&A activity in the sector. While this is a possibility, we would not advocate an investment based on this thesis.


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