Week Ending 24.02.2017
- Economic momentum continues to improve; Europe being the standout at the moment. Talk on monetary policy in that region is likely to become pronounced if these trends continue.
- Local wage growth slipped again. This is increasingly pointing to a structural rather than a cyclical phenomenon. Japan provides a good insight into the mix of full time and part time roles as industries evolve.
In a busy two weeks of corporate profit results with much light and colour, the economic news has been subdued, mostly reinforcing the momentum we have noted over the past few months.
The US purchasing manufacturing index (PMI) is suggesting a slowing rate of growth, but still at a respectable clip. The PMI for February measured 55.9, with a number over 50 indicating expansion. A degree of caution has come through the corporate sector as businesses digest higher wages and the impact of the strong dollar. The implication is that jobs growth will edge lower in coming months and likely lead investment markets into a heated debate on the timing and extent of rate rises.
Of relevance to the equity market was a slowing in producer prices, while selling prices rose. This suggests that profit margins may hold or even expand.
Europe continues to surprise on the upside with a strong run in PMI indicating that GDP will rise at around 0.6% in Q1. Inflationary pressures are also rising and, here too, the discussion will inevitably turn to the stance taken by the ECB on further QE. Bond markets have taken these trends on board, with European rates rising over the past months. While exports are key, employment growth in services is the highest in nine years, implying that there is broad spread growth across the economies of the region. To cap the news, France’s PMI edged above Germany.
Market Eurozone PMI
Locally, wage pressure has taken another step downwards. Private sector wage growth fell to a record low of 1.8% year-on-year and the cut to penalty wages may reinforce that trend.
Low wage growth is, on balance, good for company profits, but for the moment this is being outweighed by the reluctance of consumers to lift spending outside the interest rate-supported housing market.
Private sector capex intentions and construction work done both showed disappointing trends. While the drag from the resource sector has passed, there has been little lift in other investment spending.
The domestic labour market has become a debating topic, given the significant trend to part time employment in the past couple of years. The implication is that if employment growth picks up, this may reverse the pattern. However, much is structural and due to the sectors where part time employment is entrenched.
In Japan, which is experiencing a very tight labour market, the government provides statistics on the level of part time down to industry level. These sectors are unlikely to be able to reduce labour ratios as much as the industries that use robotics and mechanisation, a theme Japan has long embraced.
Japan: Weight of Part Time Employees by Industry
If anything, Australian economic growth is leaning on education and tourism, both of which have an emphasis on part time roles.
Finding a supportive path for our labour market is far from easy - mechanisation and robotics will find its way here too - the reliance on high paying construction and mining roles is likely to be curtailed for some time and even the services sector is stretched to get sufficient margin to support employment growth.
Fixed Income Update
- Tight credit spreads on US high yield bonds have some market participants calling the end of the cycle.
- Issuance and demand for floating rate bonds is on the rise.
- CBA have announced a new bank hybrid to replace the maturing Colonial subordinated bonds.
Outside of a default scenario and periods of illiquidity, the two main drivers of performance on a bond portfolio is interest rate changes and credit spread movements. In terms of the latter, the spread movement on riskier securities, such as high yield, is nearly always more pronounced, resulting in significant price volatility compared to safer investment grade securities. As a reminder, high yield securities are originated from issuers that are below investment grade or unrated by rating agencies, and are therefore considered to be of poorer credit quality.
Bonds in the US high yield sector performed exceptionally well in 2016 as investors poured into these securities, driving up the price as credit spreads contracted. This trend has continued into 2017 as investors bet on the US president delivering on his pledge for a stronger economy, lower taxes and less regulation. Strategists argue that lower corporate taxes will aid these companies in meeting their coverage of interest payments and a more accommodative regulatory environment will help improve profit margins.
$US10bn has flowed into funds that invest in this asset class since the start of December. Issuers are taking advantage of this, with high yield companies raising $41 billion in the US so far this year, which is the highest volume of new issue for that period in four years. Notwithstanding the new supply, spreads continue to contract as bonds rally.
Concerns are emerging in various research publications regarding the sustainability of this trend, and whether spreads are starting to bottom out. Franklin Templeton asset management have produced the following chart, which illustrates the lows of previous cycles, which is very close (in terms of credit spread) to where the market is currently priced. While few Australian investors are likely to have a significant direct exposure to this sector, the flow on effect to other spread product is the concern in the event of a large correction in high yield.
Staying in offshore markets, the recent rise in bond yields (and expectation of further rate rises by the Fed) together with a surge in new bond deals in US markets, has led issuers to alleviate rate risk for investors by issuing more securities with floating rate coupons. The strong appetite for floating rate bonds has seen new issuance by investment grade companies hit three year highs. These bonds account for 17% of the new issue market year to date vs an average of only 8% in the two years prior. On the face of it, this increase appears mostly demand-driven, as one would question why issuers would want to lock in funding in a floating rate format given the likelihood of further rate rises. However, with the steepening of the yield curve, the differential between the short rates and long end are significant, giving issuers the benefit of a lower funding rate; at least in the short term. Further, tight credit spreads give issuers the opportunity to take advantage of the demand for floating rate product and lock in this lower margin. The chart below illustrates this changing trend.
Issuance of Floating Rate Investment Grade Bonds
As expected, this week CBA announced a new tier 1 bank hybrid in the domestic listed bond market to replace the maturing Colonial Subordinated Bond (CNGHA). CBA fully owns Colonial, and rather than issue out of the same entity, chose to issue a replacement bond further down the capital structure out of the parent company. Holders of the maturing CNGHA are said to receive a priority allocation of the new mandatory convertible bond that has a call after 5.15 years and is paying a margin of BBSW +3.90%.
- Woolworths’ (WOW) result was highlighted by the improving sales in its supermarkets, however a highly competitive sector is likely to restrict its recovery.
- BHP Billiton (BHP) reported in line with expectations. Increased shareholder returns remain on the table over the next 12 months.
- Oil Search (OSH) confirmed its positive long-term growth opportunities in PNG.
- WorleyParsons (WOR) and Monadelphous (MND) reported weaker earnings, with a stabilising environment yet to be reflected in results.
- Brambles (BXB) confirmed a weaker outlook for FY17, largely driven by competition issues.
- Vocus (VOC) reported in line, which was enough to give the stock support after a difficult six months.
- Flight Centre (FLT) continues to be impacted by airfare deflation despite respectable operational performance.
- Costa Group (CGC) upgraded its full year guidance again and has a strong medium term outlook.
Woolworths (WOW) got a welcome fillip from a better than expected sales trend, but more importantly, its capacity to grow its gross margin, attributed to a sharp reduction in shrinkage (stock loss). Store like for like sales gained 3.1%, though the increase in sales per sqm was less pronounced.
Nonetheless, it is clear that sales have turned the corner from a concerted effort to rebase its pricing proposition and reinvest in store based staff. This seems to have encouraged loyal Woolworths shoppers to buy more at the store, while management concedes that it is not yet increasing customer numbers.
Woolworths: Comp Sales Growth
The debate on the merits of investing in WOW (and by default Wesfarmers (WES)) rest on the degree of competition in the supermarket sector. Woolworths bulls expect a ‘rational’ market where neither major participant excessively disturbs the balance of power. Small scale guerrilla tactics will always be in play, but a wholesale price war is clearly not in the interests of these parties. However, if one group finds its sales growth measurably below the other, it is more than likely to react.
Given this somewhat uneasy scenario, the dispersion in estimated net profit for FY2018 (FY2017 is still seen as a rebasing year and affected by write down of assets) amongst the analyst community is wide, ranging from $1550m to $1830m. At the lower end the stock trades on a high 22X multiple and if the top estimates prove right, a more acceptable 19X would support further upside to the share price. That said, the prospect of regaining its previous highs is many years away.
As the bellwether stock for the resources sector, BHP Billiton’s (BHP) result is closely followed, although the half contained few surprises. Illustrative of the leverage in the industry and the company’s relentless ongoing focus on reducing its cost base, revenue growth of 20% translated into a 65% increase in EBITDA for the half year. Of the US$3.9bn increase in EBITDA for the period, $US3.5bn was attributable to improved prices, with the residual balance (such as foreign exchange movements or changes in volumes) relatively minor in nature. Prices were better almost across the board, from a relatively modest 7% average improvement in oil to the 118% jump in hard coking coal.
BHP Billiton: HY EBITDA Change
BHP’s improved profitability allowed the company to increase its interim dividend to US40c in line with its new payout ratio policy. While a large jump on last year’s US16c, it was still well below the US62c of the previous year.
While BHP has enjoyed a material improvement in its operating environment over the last year, the way it is deploying this excess cash gives a good indication of its priorities and outlook, with its commentary relatively cautious in nature. It was therefore unsurprising that almost three quarters of its excess cash for the period was used to repay debt and little in the way of new investment that would support volume growth in the business.
With the balance sheet strengthened, the next logical step will be a step up in shareholder returns (via increased dividends or share buybacks), although this, of course, is conditional on a degree of sustainability in the recent commodity price rebound. BHP is a step behind Rio Tinto (RIO) in this regard in the short term, although still has a more even commodity mix to fall back on, particularly if copper and energy markets are more supportive in the long term.
Oil Search’s (OSH) full year report was largely as anticipated, however the longer-term growth potential for the company was confirmed. The company’s profit for the 12 months was naturally impacted by a weaker average oil price, however progress on reducing costs and the rebound in through the year, capped off with a production cut agreement from OPEC, has given further confidence on the expected expansion of its existing asset base in PNG.
Recent developments for OSH have been relatively positive. ExxonMobil’s takeover of InterOil has meant that linking this primary gas field into PNG LNG is more likely (which could potentially double the capacity over time); recent discoveries has led to reserve upgrades for the company; and PNG LNG continues to operate at above-nameplate capacity. OSH remains our preferred exposure among the major energy stocks due to its existing low-cost operations (a total cash flow break-even price of $US/boe) and attractive long-term expansion opportunities.
Contrasting fortunes of WorleyParsons (WOR) and Monadelphous (MND) showed that the resources services sector is not out of the woods just yet. WorleyParsons has ridden the value/cyclical recovery over the last 12 months, with a share price recovery that has tracked the rebound in oil prices. The underlying earnings outlook for the company has no doubt improved over this time, however, it has more been due to a stabilisation in its markets as opposed to a sharp uptick in activity, as illustrated by the capex spending of its key customer base – the oil and gas majors.
Select Oil and Gas Majors: Global Capex Year-on-Year Growth (%)
In light of this backdrop, WOR has focused on reducing its cost base – as a services business, this essentially means cutting staff numbers – in order to improve staff utilisation and hence margins. To this end, the company has done a good job, with a higher underlying EBIT margin for the half despite a 30% drop in revenue and it increased its total cost reduction target to a $450m run rate by the end of this financial year.
While it has made good progress here, attention has again turned to WOR’s balance sheet after a poor cash flow performance for the period. Debt rose more than expected after the company noted that it had experienced delayed payments from a number of large state-owned entities who are likely experiencing their own budget problems in the current environment. Resolving this emerging issue and greater evidence of increased capex spend across the energy industry will likely be required for the stock to push higher from here.
Monadelphous has some parallels with WOR and is also viewed as a best-in-class contracting company, but with more of a domestic focus and greater exposure to other commodities, such as coal and iron ore. Earnings for first half were down 24%, although an increase in maintenance work (which should be more recurring in nature) was encouraging. MND also pointed towards stabilising conditions in the domestic resources and energy sector, however, a return to the high investment of previous years is an unlikely scenario.
From a balance sheet perspective, MND is in a strong position, with the company holding no net debt. With the recovery in its markets likely to be gradual and somewhat reliant on the recent commodity price rebound being sustained, its FY18 P/E of 22X would appear to more than factor in the potential upside over this time.
Pooled pallet operator Brambles (BXB) confirmed the worst fears of investors as it provided further clarity on its full year guidance after issuing a profit warning last month. In the space of a month, the company has shifted from initial underlying profit growth (at constant currency) of approximately 10% to a new expectation of flat year-on-year; not a disaster, but certainly against the expectations of what has been a fairly predictable growth pattern over several years.
The group’s core North American pallets business was central to the earnings downgrade, with the other parts generally performing quite well. While last month’s update primarily pointed towards what would be viewed as a temporary cyclical issue of customer de-stocking (which now appears to have been confined to one of its larger clients and went against any external evidence of an industry-wide problem, distorting the overall picture), a broader structural factor may also be emerging, which would be cause for greater concern.
BXB noted a couple of factors that led to weaker margins in the half. The company’s primary pooled pallet competitor in the US, PECO, has been competing more aggressively on pricing, leading to lower revenue growth. Secondly, one-way whitewood recycled pallets (the alternative to a pooled solution such that BXB offers) have become cheaper, also leading to fewer conversions.
Brambles: Drivers of Lower US Margins
While BXB has faced challenges and has overcome competitive pressure in the past, the current range of issues may take time to work through. The new management team will now be tasked with again proving the value proposition to new and existing customers and thus the short to medium term expectation of low organic growth, coupled with incremental customer wins and cost leverage is, to a degree, impaired.
Longer term, a key issue that the company will face is remaining relevant within the delivery value chain as more businesses go direct to customer; although its fast moving consumer goods focus somewhat insulates it from this development. Nonetheless, the stock is likely to tread water at best until its outlook becomes clearer and it is thus unlikely to return to its historic market premium valuation in the near future. We have held the stock in our direct model equity portfolio and will review this position at the next review.
After a tumultuous six month period with board and management change following a string of company-changing acquisitions, Vocus Communications (VOC) got a tick for delivering on expectations and maintaining its full year guidance. Integration synergies are the key short term driver for VOC and management confirmed that its targeted savings form Amcom, M2 Group and Nextgen remain on track, with benefits realised primarily over the next two years.
While VOC’s cash flow for the half was poor, on a more positive note there was evidence of better organic sales momentum. On the consumer side, the company’s NBN market share is a key indicator, increasing from 5.9% to 7.0% over the 12 months and notably, customer churn rates were less than half of that on the new network; a key factor in what should drive better customer retention. As we have previously pointed out, the NBN transition remains a significant opportunity for VOC to win additional market share and it does not have the same expected margin contraction of its two key listed competitors, Telstra and TPG Telecom. While the integration risks are likely to remain with the stock for a period of time, we believe that this is more than factored into a current forward PE of 12X.
Flight Centre (FLT) reported a result that was in line with guidance, although a further downgrade to its expected earnings for FY17 was disappointing. The customary criticism of the FLT model is that it is structurally in decline, with travel spend (as like other retailers) transitioning from bricks-and-mortar retail shopfronts to a more competitive online marketplace. To a degree, this is true, although the evidence would suggest that FLT is still holding its own in the market. While Australian outbound travel growth was 5% in the half, FLT’s ticket sales growth was 10% in the period, indicating market share gains.
The primary issue that has been affecting FLT in the short term has been the high level of airfare deflation; even higher than the long-term established trend of airfare affordability. Rapid airline capacity growth over the last 12 months has accelerated this issue, with overall seat numbers increasing at a faster rate than international travel. A further issue for the company is the rise of low-cost carriers, on which FLT typically generate a lower margin. This has coincided with an increase in investment spend across the business (with better sales figures evidence that benefits are being realised), with a contraction in margins the inevitable outcome.
As airline capacity normalises through this year it would be reasonable to expect that the level of airfare discounting occurring to ease and, in turn, translate into a better outlook for FLT. Some stability on this front, however, will likely be required in order to have a more constructive view on the stock, particularly considering the company’s rising cost base. A reasonably attractive valuation and strong balance sheet will likely provide support for the patient investor, although the risks would appear to remain on the downside in the short term.
Fruit and vegetables producer Costa Group (CGC) continued its strong recent momentum with an additional upgrade to guidance, three months after upgrading at its annual general meeting and underlying earnings growth of 36%. An upgrade was somewhat anticipated by analysts following the company’s acquisitive expansion into avocados late last year, however the quantum surprised on the upside.
There is inevitably some volatility from year to year in any agriculture business, and while CGC has insulated itself to a degree with protected cropping environments (which limits volume variability), pricing and overall supply across the industry will still influence the company’s earnings. To this extent, the company’s berries and tomatoes businesses produced a better result, as they were cycling a number of challenges from the previous year
Costa Group: Revenue Growth and Mix
The benefits from Costa’s growth projects also contributed to the expansion. Berries is central to this program, and the ongoing growth its supported by 30%+ annual category expansion in blueberries and raspberries. Costa also has expansion projects internationally (which is still in its early stages of investment) and in mushrooms, while its avocado business will now give it a greater level of diversification and a fifth core division. While Costa’s share price has appreciated significantly over the last six months, this has been underpinned by earnings expansion, and so the stock’s valuation has not become stretched.
Reporting season concludes next week, with a handful of companies scheduled to release results on Monday and Tuesday. We will provide a detailed summary of trends and takeaways in next week’s publication.
Next week’s reporting schedule:
Monday: Harvey Norman (HVN), LendLease (LLC), QBE Insurance (QBE), Spark Infrastructure (SKI), Japara Healthcare (JHC)
Tuesday: Spotless Group (SPO)