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WEEKEND LADDER

A summary of the week’s results

23.01.2015

Week Ending 23.01.2015

Eco Blog

The long awaited event of ECB easing is upon us at last. Rather than debating the ‘if, what and when’, it is now the consequences that will come under scrutiny. In summary, the ECB will buy €60bn of legible sovereign bonds and asset backed credit over the coming eighteen months. This is larger and more condensed than most had expected.  Various accommodations have been struck towards peripheral country debt, specifically Greece, on the eve of its election weekend.

Some economists believe the ability to execute this programme will be difficult. For example, the value of German Bunds would be large compared to that on issue, particularly considering that the maturity of bonds must be greater more than 2 years.

The stated aim is ‘a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. Inflation should be the consequence of higher demand, or in other words, growth. For any central bank, an inflation target (or more correctly, inflation expectations) makes more sense than a growth target, which captures the complex interaction of fiscal and monetary policy and is a lagging indicator.

As we have noted on a number of occasions over the past few weeks, inflation is low because goods prices, including food, are flat to falling. Low price rises for consumer goods have been entrenched for some time as lower production costs out of Asia, in particular, and product development have driven comparable unit costs down. Of course, that does not mean consumers repurchase the same item every time. The best example is of communications products, where the replacement price may be higher than the previous purchase, but the features are vastly enhanced.

Retail goods spending has therefore comfortably exceeded underlying inflation for most of the decade. Along with the fall in oil prices and hard commodities, this development adds to the complexity central banks have to deal with. Food inflation across Europe and the UK has been barely in positive territory for most of 2014, in good part due to the fall in input costs as can be seen from the movement in agricultural commodities (shown below).

Agricultural Commodities: Returns over Year to 16 January 2015

Source: Bloomberg, Deutsche Bank
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Service prices, by contrast, have been remarkably resilient, rising at near 1.2% p.a in both Europe and the UK for the past 2-3 years.

It is not clear QE is therefore going to shift the dial on inflation. The most likely development is a weak Euro, which serves to increase import prices and encourage exports and tourism; in turn, adding to GDP. Over the coming months, the impact of oil prices will slowly work its way into the system – first reducing inflation through secondary effects, such as a reduction in the price of goods through lower transport costs, and in plastics and other chemical products. By late 2015 it may well be that this impact is over, along with a cyclical impact from food prices. The ECB could get closer to its aim without QE necessarily being much of a contributor.

On the basis that QE is a lubricant, rather than the engine to recovery in Europe, its major impact will be in financial markets which have warmly embraced the arrival of such solid support. Quite simply, with the ECB taking hold of a large pool of financial assets, other institutions and investors will look elsewhere and drive prices higher.

China’s Q4 GDP release showed the continuation of moderating growth, but there is a case to be made that the quality has improved. Property construction slowed sharply and could put the outcome for 2015 at risk. As derivatives of the property cycle, most heavy industrial sectors now also have low growth. But it was not all bad news. Manufacturing held up well, which also showed up in decent export growth, and consumption spending both in goods and services was relatively strong.

The press in China have reported what at face value looks like extraordinary salary increases for public servants of 62%. Though unconfirmed, it would apply to a relatively small cohort of circa 7m strictly-defined public administration workers, not all employed by the government. Further, the last adjustment to their salaries was in 2006. If this takes place, the consequences are twofold. Firstly, it is a signal to other employers in China to offer higher wages and therefore consumption spending. Secondly, it is an effort to remove the incentive for officials to engage in corrupt practises. If this succeeds, China may well revert to exporting inflation in forthcoming years, turning the low to negative tradeables inflation almost all countries are experiencing at present.

The Bank of Canada surprised markets with a 25bp rate cut to 0.75%, stating it was in response to lower oil prices. While economic growth has slowed though 2014, core inflation has remained around 2%. Similar to Australia, the central bank has expressed concern on house prices and consumer debt. However, it appears the BoC is maintaining its relatively activist stance and will support the economy at a time its energy sector faces major challenges. Indicatively the banks new GDP forecast is for 2.1% growth, down from 2.4%.

In the meantime, the Bank of England, headed up by a Canadian, unanimously agreed to leave rates on hold. Previously, a small number of committee members had voted for a rate rise. Low inflation and wages now appear to have deferred a rate rise, possibly into 2016. The UK is caught between the weak Eurozone and the relative strength of the USD, with the euro impact outweighing the USD and an implicit tightening of financial conditions as the sterling strengthens.

Maintaining the inflation barometer, New Zealand had a headline CPI print for Q4 2014 of -0.2%.  Unsurprisingly, fuel played a major role, but food prices eased as well. Low food inflation is unwelcome for retailers which struggle to adjust their gross margin to support gross income. This will impact Woolworths, with its New Zealand food retail operations having struggled for some time against a well-structured independent, Foodstuff.

The chart below also illustrates another global phenomena in CPIs of widening price momentum between goods and services. Local reports suggest health insurance premiums may rise in the order of 7%, and a similar pattern in Australia is likely to be reinforced.

New Zealand CPI

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Next week reveals a key data point for Australia with the release of our CPI along with the indicator of business confidence. Many are now suggesting the RBA will be forced to reduce the cash rate given the global dynamics of this week. If it does not, it risks a rebound in the A$ and a rise in the bond rate, neither of which would be welcomed at this stage of the economic cycle.

As one investment house rather gloomily pointed out, we face high business costs (labour costs compared to our competitors and structural issues given the lack of scale in many industries), the A$ is still too high on a trade weighted basis, there is excess reliance on housing to drive the economy, household debt is high and the budget has structural weaknesses which will cause further pressure on confidence if, and when, addressed.  

Company Comments

December quarter production reports were released by BHP Billiton and Rio Tinto (RIO). BHP’s production was largely in-line with expectations, with overall growth across the group of 9% for the half year. The company’s guidance for FY15 also remained unchanged. This shows full year expectations of an 11% increase for iron ore, 5% for petroleum, 5% for copper, 4% for metallurgical coal and flat production for energy coal. The chart below highlights the challenges presently facing the mining sector, with price declines across almost all commodities.

BHP Volumes and Realised Prices: December HY14 vs December HY13

Source: BHP Billiton, Escala Partners
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With little to surprise from the production numbers, the key takeaway from the announcement was BHP’s response to the sharp decline in oil prices over the last six months. What was previously a point of distinction for BHP Billiton relative to Rio Tinto, its petroleum business has become problematic for the company. BHP built a significant presence in the US shale energy industry following a number of large acquisitions made around four years ago.

In October last year, BHP cited returns of 25%+ across its shale portfolio based on the prevailing pricing environment. Returns will clearly be much lower in the medium term, and as such it has decided to reduce the number of operating drilling rigs by 40% by the end of the current financial year. This will not result in an immediate drop in expected production, although the company’s guidance will likely be lowered for FY16 onwards. The magnitude of cuts to capital expenditure in this division will be a large determinant on the impact to free cash flow projections. The trade-off facing BHP is one of increased (or even maintaining) shareholder returns against production growth over the longer term.

Following earnings downgrades over the last two months, an expected dividend payout ratio of 73% (based on consensus figures from Bloomberg) in this financial year points to a reduced investment outlook for the company. A further complicating factor for BHP will be the impact that the spinoff of non-core assets into new entity South 32 will have on its business.

Rio’s production report likewise met expectations. The company’s cash flow will be boosted by an inventory drawdown of approximately 3mt from its Pilbara iron ore operations over the quarter. With a lower dividend base and large cuts to its capex budget already implemented, several analysts are predicting Rio to initiate a buyback when it announces its results next month. Following the sharp re-basement of the iron ore price over the last 12 months, however, any increased capital returns to shareholders is likely to be modest in size.

Macquarie Group (MQG) upgraded its FY15 guidance (the company’s financial year runs to 31 March) from “slightly up” to earnings growth of between 10 and 20%. MQG cited improved trading conditions and the lower Australian dollar as the primary drivers of the upgrade. The company appears to have erred on the side of caution with its guidance over the course of the year, with several slight upgrades at each trading update.

MQG’s international exposure is perhaps undepreciated by some investors. It derives around two thirds of its earnings from overseas markets, including Europe, the Americas and Asia. Volatility in investment markets is also positive for MQG, leading to increased activity across its trading divisions. We have MQG in our model portfolios and believe that its valuation is undemanding on a forward P/E of 13X.

Resmed (RMD) is even more so leveraged to a weakening Australian dollar and its quarterly result was ahead of expectations. Revenue growth of 12% in the Americas was a welcome rebound from recent periods, while 8% from other international markets was consistent with recent years. Some margin pressure remains evident in the business, leading to 7% growth in earnings per share. After a period whereby the company faced several headwinds, notably pricing pressure from the competitive bidding structure introduced in the US for Medicare and a lack of product launches, RMD is beginning to cycle these weaker comparable periods. Following a strong rally in recent months, RMD’s valuation now clearly offers less upside than previously, although its positive earnings momentum is somewhat of an uncommon feature in the current market.

Stock Focus: Telstra

Telstra has been among the better performing large cap stocks over the last four years, with the share price more than doubling in value, while also paying a consistent dividend over this period. However, as we have previously highlighted, this share price growth has far outpaced that of earnings growth. From earnings per share of 26c in FY11, forecasts for FY15 currently sit at 33c, a rise of just 27% (representing a compound growth rate of just 4.2% p.a.).

While management have done an excellent job in growing profits with the backdrop of declining returns from its fixed line business, the overriding factor driving the share price has been the re-rating of high yielding equities with predictable cash flows as bond yields continue to drop to record lows. TLS is now trading on a FY15 P/E of almost 19X; admittedly on par with many industrial stocks, however without the expected earnings growth of its peers. Below we detail the positive and negative views on the company from an investment perspective.

Positives

- TLS has the strongest brand name in the market, it has a dominant market share and is the default option for consumers who would not necessarily shop around for the best deal.

- The company’s mobile network is superior to its peers. The coverage of this network is a key point of difference for consumers in regional areas.

- The company will receive significant cashflows from the government as consumers transition to the National Broadband Network (NBN). The recently revised NBN deal with the Federal Government provides a level of regulatory certainty going forward. TLS will be able to deploy this capital into opportunities to replace the earnings from its copper network.

- The Federal Government is committed to protecting the interests of the NBN, as evidenced by the recent decision to ensure other retail providers gain access to TPG’s fibre-to-the-basement (FTTB) wholesale network. TPG has currently been force to suspend sales of its FTTB product before it adjusts to new regulations.

- Growth in data, particularly in mobiles, remains a revenue opportunity for telcos globally.

- Overall broadband penetration in Australia has continued to rise in recent years, with the trend expected to remain in the medium term.

- TLS has a strong balance sheet, as evidenced by the buy-back that it was able to undertake following its FY14 result.

- The decline rate in fixed line retail telephone connections has been arrested in recent periods, with this earnings drag falling each year from what is now a smaller base level.

- Bond yields remain in a downward trend, with the Australian 10 year rate recently at all time lows. Australian yields are high compared to other countries around the world, with downward pressure in most regions. Safer equities that have been acting as bond proxies therefore could retain their premium to the market for some time yet.

Negatives

- Fixed line is TLS’s highest margin business, and its earnings from line rental access to its copper network (both telephone and broadband services) will accelerate as the NBN is rolled out.

- The NBN will increase the opportunity of smaller telcos to compete with TLS and take market share, particularly in regional areas.

- The mobile market in Australia is mature, with little net subscriber growth over the last two years.

- TLS is paying out almost all of its earnings in dividends, which has limited its ability to increase its dividend payments. The stock’s yield has declined as its price has risen, with dividends stagnant until the last 12 months. TLS’s yield is now only in line with the broader market at 5.0%.

- While TLS has competed more aggressively in the pricing of its plans, these remain at a premium to its competitors. Increasing pricing competition has become evident in mobile and broadband markets over the last 12 months. Margin pressure is a potential outcome should it pursue a strategy of protecting or growing its market share.

- TLS’s earnings growth is expected to be low over the next few years and the stock is currently trading at a premium to the valuation of many analysts.

In our view, we believe that prospects of the smaller telcos is greater than that of the incumbent provider of fixed line services, TLS. While the company has reasonably defensive characteristics, we believe that its valuation remains full and it is unlikely to raise dividends materially in the medium term

Telstra: Valuation Summary

Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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