Week Ending 22.08.2014
RBA Governor Glen Stevens’ appearance at Parliament confirmed the likelihood that interest rates would be on hold for quite some time. The economy has not achieved what the central bank would have liked, but the governor also noted that monetary policy could not be the only, or even primary tool, to achieve the outcome. The headlines focused on the AUD and the possibility the bank could intervene in foreign exchange markets rather than push an interest rate string. In practice, financial markets know the hurdle for intervention in currency markets is high, though it may serve to limit the risk of a rising AUD.
The overriding concern in financial markets remains the timing and extent of interest rate rises. Those with slightly longer memories may be considering the reaction to the 1994 rate rises. We hasten to add that, in our view, the chances of a repeat of those events is extremely unlikely.
From a low point of 4.75%, the RBA rapidly increased rates to 7.5% within 8 months. The rate was then held for 18 months before an eventual easing.
The market reaction was, both in bonds and equities, unsurprisingly intense. The chart below shows the rolling 12 month returns for the indices aligned with the same time frame as above.
Equities and Bonds: Rolling 1 Year Returns
The key is that the bounce back was quick, and in tune with the improving economy. This time is different, in that the current economy is highly unlikely to warrant anything more than a cautious incremental approach to rates for a considerable time. While it would be wrong to suggest that a rate rise will be benignly accepted in financial markets, our view, at present, is that it limits the overall returns through the cycle, rather than likely to cause a severe sell off.
A final comment on Stevens’ response to parliament is that the Australian interest rate cycle is almost certain to lag that of the US. The attention therefore is still firmly on the US and specifically employment and wages growth. If the US defers its rate cycle, or moves first towards other forms of tightening, it may put the RBA in an awkward spot. In September we will hit 12 months of a 2.5% official rate, by April the RBA will break its record of no rate move if it holds, and at this stage it looks highly likely it will do that. Economists will have to continue to find other things to write about.
The HSBC Flash PMI for China edged back down again suggesting the economy was flat-lining rather than picking up momentum. This survey, as opposed to the official one, is skewed to smaller businesses and judged to be a better indicator of private sector growth, which in the larger survey can be swamped by public sector activity. The chart shows the trend in both PMI’s. The NBS official survey will be available on 1 Sept and will be keenly observed to judge the overall or divergent strength in the Chinese economy.
China Manufacturing PMI
As this year progresses, the chances of ‘managed’ stimulus may come through, likely to be in rates and the reserve requirement. In time we believe there will be a greater focus on the potential growth rate in China into the coming years. It would be unsurprising to see a firming of the view that the trajectory is likely to ease more quickly than most currently allow for, given that government intervention is required today to achieve the goal of 7.5%.
Intuitively a company seems more complex than necessary when the result presentation requires 8 divisional heads, as well as the CEO and CFO. While investors gave a thumbs up to Wesfarmers’ (WES) capital management, the skew in contribution to profit is increasingly extreme. The Coles supermarket operations and Bunnings made up almost 70% of the EBIT in FY14. Coles and Bunnings together grew their EBIT by 8.5%; the other 6 divisions together saw EBIT fall 5.7%. For shareholders, EPS rose by 6% and forecasts for the coming year range between 2-6%. As noted, a 10c ‘centenary’ special dividend and a $1/share capital return sweeten the distribution stream for retail investors.
Current management hold to their view that they efficiently allocate capital across a range of business to justify the maintenance of the corporate structure. We believe, however, that shareholders would be better served by the market move to a narrower, coherent set of assets through demergers.
Nonetheless, a holding in WES is justified as a relatively benign exposure to improving consumer spending. The Coles operations are likely to grow profit at slightly above revenue as the combination of sales/sqm and cost control add to margin. That said, this division also holds more risk than in past years, as price competition cranks up, given the regulator has limited petrol discounting as a tool and further store growth may find itself in conflict with the ACCC. A consumer staple company (or at least one that is priced in the market as such) is generally expected to achieve long term growth in line with food inflation + population growth + product innovation and addition; within Australia this is likely to be about 6%. Its cash flow should be relatively stable over a cycle and therefore it should pay out a respectable dividend stream. Globally, this is being challenged by changing competition and consumer spending patterns and we will remain mindful that those transitions could well emerge here in coming years.
Coca-Cola Amatil (CCL) reported its first half results with ongoing net profit down 19%, and a useful reminder again that companies that may have been viewed as stable, secure investments can lose their way. CCL’s new management gave a sobering assessment of the outlook. The diagram below points to the combined pressure from all sides on the business leaving unsaid that the group had allowed its prices to drift upwards over years in the assumption consumers would always be prepared to pay a premium for their brand, a salutary lesson for all.
High hopes for the Indonesian division came apart, with high costs and currency translation, and the company is now dependent on cost cutting and support from the US brand parent to restart growth. CCL is likely to find the valuation premium it enjoyed for many years has been eroded for the foreseeable future and we have no temptation at this time to revisit the stock as an option for portfolios.
Other consumer stock results met with a mixed reaction. We were pleased to see Super Retail (SUL) deliver a respectable FY14, which was well received. Group sales growth of 4.6% worked its way through to a 5.6% rise in NPAT. Tough trading conditions, a feature all round, was in the past year coupled with a messy implementation of SUL’s IT platform. The Auto division’s consistent performance was undermined by repositioning in Leisure, where product categories such as barbeques have been taken out. Sport (Rebel and Amart) had a slow year, though the sales momentum appears to be picking up. We recognise that retailers such as SUL have, and will, come under pressure from a range of issues – rising costs in wages and rent, competition from new channels and competitors and selective consumer spending. SUL, in our view, has a better than average capacity to manage these – its product suite, on balance, does not lend itself to online (sport is perhaps the exception); own brand can work (again sport may be harder); and it has shown a willingness to invest, unlike some retailers which cut when faced with tougher times. We are comfortable with SUL as our selected discretionary retailer.
Dick Smith scraped into its prospectus forecast and cast a small cloud over JB Hi-Fi as it managed to out-promote its competitor. We foresee a period where these two groups go head to head and the profit consequences may not be attractive. The Reject Shop (TRS) is a lost opportunity in retail where the group dwelt on its high margin and possibly assumed the demise of its competitors (Crazy Clark, Go Lo) would give it a free lift. Globally, these formats are doing well, but are highly attuned to the low price offer. At some point, the combination of discount department stores and these smaller formats may be reconstructed in the Australian marketplace.
Toll’s (TOL) business offers a look back up into the supply chain. The group has made substantial efforts to diversify from its consumer logistics business into resource and government contracts, yet none are easy businesses with recontracting tending to tighten margins at each point. Having been distracted by its efforts to expand globally (return on capital there achieved less than 10%) and therefore allowing its domestic business to lose focus, the recent results have demonstrated a greater resolve to lift performance. For the three years to now, TOL’s net profit has been flat and the outlook is at this stage for low single digit growth. The stock is cheap at face value, trading at estimated 13.5X FY15 with a franked yield of just over 5%, but the growth outlook remains very tight and dependent on economic activity. There are other stocks with greater leverage to that upside, though we can foresee value oriented investors placing TOL on their radar.
With the market’s obsession with yield and capital returns, it was no surprise to see BHP Billiton (BHP) sold off after it failed to deliver the buy-back that many had been expecting at its full year result this week. The company’s result itself was not too bad – largely in line with consensus expectations. BHP has delivered ahead of its own guidance on its cost-out program – in FY14 it realised US$2.9bn in savings via a combination of reduced operating costs and increased productivity (driving unit costs lower). This took the two year embedded savings to $US6.6bn p.a. The company, however, still has more to go, with a further US$3.5bn savings targeted over the next three years.
For all of the company’s efforts to reduce its cost base, underlying EBIT was actually flat year-on-year, highlighting the drag on profits from lower commodity prices. The primary drivers of this price effect were copper, and, in the first half of this calendar year, iron ore and coal. Commodity forecasts currently expect a rebound in the coal price, however the consensus on iron ore is that it has rebased at its current US$90-100 range, impacted by the wall of supply that has hit the market. BHP’s 10% profit growth for the year was thus largely a function of a lower taxation expense.
The main focus of BHP’s profit announcement was its confirmation that it is planning to demerge the vast majority of its assets that sit outside of its core divisions (or its five ‘pillars’ as it refers to) of iron ore, petroleum, copper, coal and potash. With the working name of ‘NewCo’, the assets to be held in this listed vehicle will be relatively strong in their own right, occupying positions in the first or second quartile of their respective cost curves. The majority of these, however, are exposed to commodity markets that have faced, or are currently experiencing, more difficult conditions than most. Their small relative size and profitability of these assets compared to the five pillars, along with the sharp pullback in BHP’s capital expenditure plans, has meant that they have rarely featured in the company’s spending in recent years. Listing the assets in NewCo would likely see more growth options explored by the new entity.
NewCo will house assets across nickel, metallurgical and energy coal, silver, manganese, alumina and aluminium. With the majority of assets in Australia and South Africa, the new company will be listed on the ASX and Johannesburg. The impact to what is left of BHP is unlikely to be as significant, certainly not sufficient for a re-rating of the stock – valuations of NewCo have centred on a value of around $15bn, compared to BHP’s current market cap of close to $200bn. The chart below from BHP shows the potential upside for the new entity, with the underlying profitability of the group over the last decade on average 80% higher than what it delivered in FY14. With a listing of NewCo not expected until mid next year, we will have plenty of time to assess the relative merits of the new company.
BHP: NewCo Underlying EBITDA
Oil Search (OSH) started to show the benefits from the start up at its PNG LNG project, with net profit growth of 34% for the six months to 30 June. Demonstrating the project’s significance to the company, OSH expects it to add approximately 21 mmboe to its production levels in 2015 (the first full year of operations), which is three times the company’s total production in 2013. OSH also provided a slight upgrade to its full year production outlook, raising the bottom end of its guidance range.
While the initial development at PNG LNG has performed above expectations, the next catalyst for the company (and its project partners) is likely to be an announcement on expansion opportunities. An update on this is expected at the company’s full year results in February, however OSH is well placed to participate in brownfield developments through its strong resource position.
While the company’s dividend in this period was unchanged at US2c/share (as it has remained for a number of years), it indicated that it intended to increase this, commencing with its 2014 final dividend in six months’ time. Presently, consensus forecasts show that that analysts expect dividend payments to be US24c/share in 2015, which would represent at yield of 2.7% based on the current share price. Further clarity on this dividend policy will be announced in October as a part of the strategic review that OSH is currently undertaking, as it seeks to find a balance between its growth options and returning capital to shareholders.
Santos (STO) too, has an interest in PNG LNG, although this is less than half that of OSH. Thus, it also saw the first incremental increase in profit growth from the various projects in its pipeline, which allowed it to raise its dividend for the first time in six years, and ahead of the market’s expectations. The more significant step-growth in its production levels will come from the impending start up at Gladstone LNG. GLNG is now 85% complete and within budget; each successful progress report until first LNG should be well received by the market as the risk of budget overruns subsides. Slightly disappointing from STO’s update was a lack of any refinement of its broad “2015” first LNG forecast for GLNG.
Woodside Petroleum (WPL) also recorded a growth in profit in the first half, up 33% on last year. The story for WPL, however, is much different to that of OSH. WPL was able to increase production by 11% during the period, however this was driven by an improved performance at its existing assets, rather than new sources of growth. Also key in its profit growth was a positive impact from the repricing of some of its legacy LNG contracts. In recent weeks WPL failed to gain sufficient support to undertake a buyback of a large portion of Shell’s remaining stake in the company, and hence the company’s remaining investor base had been hoping that this opportunity might be extended to them. A decision on this was not forthcoming in the company’s result, however this may be made in coming months.
While WPL should receive further benefit from Pluto LNG repricing in the 2H, the lack of growth options beyond this year leads us to prefer OSH and Santos (STO) in the large caps energy sector. WPL now has a solid balance sheet and has an attractive dividend yield, however the risk for investors will be if it compensates for a lack of organic growth in its portfolio by overpaying for acquisitions.
Sydney Airports’ (SYD) relatively predictable earnings stream was again evident in its half year result, with mid-to-high single digit revenue growth across each of its four revenue sources. Passenger growth is the most important metric to focus on with SYD, as all other ancillary revenue stems from this. Total passenger growth in the first six months of the year was 4.7%, ahead of the longer term trend, and largely due to increased international numbers. The take-off of low cost international carriers is important in driving the international business, making international travel affordable to a wider audience. The increased seat numbers on these services also leads to a more efficient use of SYD’s infrastructure.
SYD’s investment in improving its airport facilities can be viewed as relatively low-risk brownfield capital spend, however the longer term project that could have an impact on its asset is the proposed second airport to be developed in Western Sydney. Mitigating this risk to a degree is the fact that SYD has first right of refusal to build the second airport. We have SYD in our model portfolios as a defensive industrial with the capacity to grow its distributions over time.
Brambles’ (BXB) result was a slight miss to consensus, however its outlook was fairly encouraging. Without the divested Recall (REC) business, the company is now a pure pooling solutions logistics company with a global presence and market-leading positions. With its exposure to the relatively defensive fast moving consumer goods industry, organic growth rarely deviates significant year on year, with new business wins supplementing its top line. Economies of scale as the business expands and improving asset control are the other important pieces that add up to FY15 guidance of 7-10% profit growth (at 30 June’s exchange rates).
Brambles: FY14 Revenue Growth
BXB’s price looks reasonably full at 19.7X FY15 earnings, however its medium term growth profile is arguably better than many other similarly-price industrials. The company also has better upside prospects than most given its high weighting of revenues from recovering developed economies and also the prospect of a weaker AUD.
Amcor (AMC) is in a similar boat, it too having divested a division in the last financial year – essentially the Australian arm of its business. For FY14, the group recorded 9% EPS growth on a constant currency basis. With AMC reporting in Australian dollars, some investors may have been misled by the company’s reported 25% profit growth, as it benefited from much more favourable exchange rates over the period. Having executed well on its acquisition of Alcan packaging, acquisition-led growth remains a key part of the company’s strategy, accounting for around half of profit growth in FY14. Good cashflows through the year and a solid balance sheet see AMC well placed to continue with this over the next few years. More recently, these have been smaller in nature, and while each one individually adds only incrementally to overall earnings, as a group the benefits are more significant.
The other half of its profit growth was primarily from emerging markets, which account for just under a third of its overall sales. This is perhaps the core thematic driving AMC’s earnings growth at present, assisted by limited pressure from input costs, allowing the company some modest margin expansion.
Asciano (AIO) gave an indication of its confidence in achieving its targets that it has provided to the market with a 36% increase in its final dividend. AIO has been able to increase these returns to its shareholders due to two factors – the progress that is making on its cost out program (the company recently doubled its expected benefits from this to $300m by FY16), along with a capital expenditure profile that shows a material decline over the next two years, allowing the company to increase its payout ratio over time. The chart below shows the dividends paid out by the company over the last two years, and what consensus forecasts are for FY15 and FY16:
Asciano: Dividend Forecasts
AIO’s recent results have shown robust growth in its coal haulage business, offset by relative soft conditions in its freight rail division – an outcome of a weak domestic economy. With the coal market unlikely to provide the same tailwind to earnings in FY15, recent market share gains in its terminals divison and a better performance in its rail business will be relied on for further profit growth. The stock remains attractively priced, trading on a P/E below that of the market.
Origin Energy (ORG) rose after releasing its results, however this was more likely related to the fact that it is no longer planning to raise equity to pay for its recent purchase of a gas field in the Browse Basin off the coast of Western Australia. With good progress being made at APLNG (which is expected to commence production in mid-2015) the requirement for this additional capital was short-term in nature, and hence the company’s decision to instead issue a hybrid security in the European market makes a lot of sense.
ORG’s current profitability continues to be affected by the weak conditions in the electricity market. There are various factors at play here, but they include: the increased take-up of solar panels, a relatively warm winter, and competition remaining relatively high in the retail market. The Australian Energy Market Operator’s (AEMO) forecasts show that per capita usage is expected to slow further over the next few years, but thereafter at a reduced rate.
While investors with a shorter investment timeframe may have focused on the weakness in this division, looking out beyond 12 months, the picture looks more promising. Earnings (and cashflow) growth from APLNG, rising gas prices and a stabilisation in the retail market all point towards a positive outlook for ORG.
National Electricity Market: Mass Market Electricity Consumption per Capita
IRESS (IRE) provided one of the better results of the reporting period, with its earnings growth fuelled by a large acquisition in the UK, which was announced 12 months ago. For many companies, acquisitions do not necessarily lead to growth in earnings per share, but IRE has proven itself to be capable of achieving its integration goals, with underlying EPS growth greater than 20%. IRE’s wealth management division again performed well in the six month period, while its core financial markets business showed resilience in difficult conditions. IRE trades on a relatively high P/E multiple, however results such as these help to justify this premium rating.
Seek’s (SEK) current growth is also been led by its international investments, which it has required given the subdued domestic labour market. Despite a higher unemployment rate during FY14, yield improvements in this division were more than able to offset weakness in volumes. The ability for SEK to raise pricing by 5-6% p.a. in a difficult market to us is demonstrates both its value proposition to its customers and the strong market position that it occupies. SEK is keen to highlight the cyclical leverage that the company has for when we see improvement in the labour market – in FY11 the group was able to achieve a 43% increase in EBITDA based on a 15% rise in its job ads index. The structural migration of revenue from print to online remains a value driver in this division, with Australia still lagging the progress made in the US.
SEK’s profit contribution from its international division has more than doubled over the last three years, and this trend is forecast to continue in the medium term. The investments are at various stages of maturity, however the structural trends that have played out in developed markets are expected to be replicated in many of the emerging markets in which SEK is now exposed to:
Next week’s reporting schedule:
Monday: BPT, BSL, CTX, MMS, MTU, ORA, REC, SFR, SPI, SKI, UGL
Tuesday: AWE, CVO, PBG, SXY, VRT
Wednesday: BLD, CHC, DLS, FLT, HZN, LLC, PGH, SDF, SWM, VED, WHC, WOR
Thursday: ABC, PPT, QAN, RHC
Friday: HVN, PDN, TSE, WOW