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WEEKEND LADDER

A summary of the week’s results

24.03.2017

Week Ending 24.03.2017

Eco Blog

Healthcare costs are a universal issue. As governments and individuals grapple with the options, a host of new investments can be expected to be an alternative to the traditional companies. 

- Somewhat featureless economic data will, for the moment, leave the focus on US policy initiatives and European politics.

Another week of benign economic data was destabilised by other issues.

In the US, healthcare spending is centre-stage this week. The issues are global and complex. Specific to the equity market is the question of what happens to pharmaceutical prices. Drug price inflation has been averaging about 5% per annum for a decade, already a high number, but exacerbated by a spike after 2014. The cause is inevitably multi-dimensional, with a fall in the number of patent expiries alongside a host of new products and price increases in patent-protected product.

Contribution to Growth in Drug Spending 2011-15 ($USbn)

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Specialty conditions make a big dent in the overall spending on drugs and have been the predominant cause of growth in expenses. The top four of inflammatory conditions (rheumatoid arthritis, psoriasis etc.), multiple sclerosis, oncology and hepatitis C -  vastly outweigh other treatments. Conversely, in traditional drugs, diabetes stands out as a high proportion, but others ranked in order of spending - pain/inflammation, cholesterol, attention disorders, high blood pressures and ulcers – are more or less even in cost contribution.

Aside from the question of the efficacy of some of the speciality drugs, there are many examples of US costs of 50-300% over that in the second most expensive country. Given that the US does less than others to regulate pricing and restrict access to these products, the claim is made that the US is in effect subsidising other countries. Unlike trade, it is unlikely that the US administration can do much about this disparity except to bring down prices in the US. Suggestions to allow imports from Canada (where prices are commonly well below those of the US) would open up a can of worms for the pharmaceutical industry. Drugs only account for 10% of total healthcare spending, but 19% of employer insurance, and are highly visible to the buyers.

The US stands out, not only in its per capita spending on healthcare, but also in terms of the private versus public split. Shifting the burden to the individual may alleviate the persistent pressure on the budget, yet inevitably means that consumers will need to account for these costs in their household budget, thus restraining other forms of spending.

Source: Peterson-Kaiser Health System Tracker
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It is also frequently observed that the high expenditure in the US does not result in above average health outcomes. Countries with high spending and good outcomes are mostly in Europe. Studies suggest this is due to a robust primary care sector that works harder on improving health rather than just treatment and therefore avoids some hospital spending. The other key trend is the use of IT, where countries such as Singapore and Israel lead the way. 

Another trend is health tourism. The fall in the value of the Mexican peso has put even greater focus on the much lower costs there compared to the US and has seen an industry evolve for those willing to cross the border to accredited facilities. When the US consumer faces large out of pocket costs, a lab test at less than a third of the price in Mexico is an attractive saving. Malaysia and Thailand have also cottoned onto this theme, with US accredited hospitals in those countries showing 100% growth over 5 years.

The best investments in healthcare may therefore lie outside the equity sector, which is 70% weighted to pharma, biotech and life sciences, with service and equipment providers the remainder. This latter segment is likely to be more resilient to much of the cost pressure. Outside this traditional definition, companies such as Siemens, Fujitsu, GE Healthcare and Oracle all have dedicated divisions in IT solutions. In Asia Pacific equity funds, hospitals for the ‘tourist’ and increasingly domestic health companies aiming to become local champions rather than the global multinationals are arising as investment opportunities.

Economic data from across most countries can be described as ‘give and take’ with some positives (such as a continued upturn in business momentum) partially offset by moderating consumer spending. Indications are that growth trends and therefore GDP over the period may level off. In turn, exchange rate movements have generally been passive. The attention is therefore likely to remain on policy and political events. As noted, the US administration’s efforts to get its agenda rolling is inevitably being challenged and the French elections will hit the front pages in late April.

Fixed Income Update

Global bond funds have the advantage of a wider and more diverse product suite, along with the opportunity to earn an FX ‘carry’.

- US institutional investors have been reallocating funds from traditional fixed income sectors and into equities and alternative credit.

- NAB Subordinated Bonds commenced trading above par, while Villa-World announced a new senior unsecured bond issue.

In the last few years, interest rates in Australia have been considerably higher than those in other developed countries, despite the rate cuts by the RBA in 2015 and 2016. While this still holds true when compared against Europe, the recent rate rises in the US has narrowed the gap between the US and Australia. The futures market is currently pricing in three rate rises by the Fed this year. If this eventuates, then the US Fed funds rate will become higher than that set by the RBA (assuming it remains on hold).

Regardless of the low rates offered offshore, there has always been a compelling argument to participate in global bond funds, given the FX ‘carry’ that was achieved when overseas bonds were exchanged back into AUD (to hedge the currency exposure). This ‘carry’ represented the interest rate differential between the two countries, and added around 1-1.5% to the return of the underlying bond. However, now that the Australia/US interest rate gap is closing, this pick up in return through the FX swap is also diminishing. As compensation, local bond holders in offshore markets will get less in terms of the ‘carry’ trade, but more in terms of coupon return, given the higher rate environment in the US.   

Source: JP Morgan
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Global bond funds also have a wider and more diverse product suite to choose from within the fixed income asset class. In many cases, higher yields are on offer compared to domestic securities. The chart shows recent yields on the different sectors denominated in local currency (which does not take into account the FX carry when hedged back into Australian dollars). High yield and emerging market bonds offer greater rates of return, which is reflective of their heightened level of risk. While we only recommend exposure to these riskier sectors as part of a diversified portfolio, the important thing to note here is the accessibility that global funds have to this opportunity set.

Current bond yield returns reflect the interest rate environment that is consistent with low growth and low inflation and, in absolute numbers, many of these sectors seem unappealing. In a search for yield, many investors have withdrawn money from safer investment grade bonds and reallocated into equities and alternative asset classes in the last year. High yield and emerging markets have also been the recipient of some of this money, but the biggest inflow has been into private debt transactions.  An optimist may view this simply as private investors filling the gap left by traditional lenders (banks) given lending restrictions under regulatory change. Others may draw similarities to the inflow of funds (often without proper due diligence) into complex CDOs and CLOs which triggered the financial crisis. The onus on due diligence is in the hands of the buyer and can require specialist knowledge, again pointing to fund managers with extensive experience in these sectors.

Net Cashflows by US Institutional Investors

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Domestically, this week saw the commencement of trading in the recently issued NAB Subordinated Bond (NABPE). These bonds traded above par on their opening, reflective of the credit spread tightening that has taken place since the bookbuild. Also in the listed market, Crown began its on-market buyback of CWNHA Subordinated Bonds and Villa-World announced a new senior unsecured bond issue.

Corporate Comments

TPG Telecom’s (TPM) half year result was lifted by iiNet synergies and organic growth. Margin pressure is expected in coming years as the NBN transition continues.

- Downer EDI’s bid for Spotless (SPO) received a lukewarm response from Downer shareholders and is conditional upon SPO meeting its earnings guidance.

TPG Telecom (TPM) received a favourable response to its results this week, meeting expectations with a 13% increase in underlying EBITDA for the first half. Despite the solid result, the company’s FY17 guidance, which initially disappointed investors when issued six months ago, was retained. Earnings were supported by an additional three week contribution from the acquired iiNet business and realised synergies. Organic subscriber growth continued, particularly in the company’s core TPG brand, although at a slower pace compared to history.

TPG Consumer Broadband Subscribers

Source: TPG Telecom
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The margin outlook for TPG remains a key point of debate given several moving parts. For this six month period, margins actually rose; with the primary short term positive influence the synergies that are being realised from its iiNet acquisition (which were responsible for approximately three quarters of the earnings uplift in the division). This will soon be fully reflected in the company’s profitability, and so the attention will turn to the longer term picture, which is less clear. Over time, higher network access costs and a competitive market are expected to crimp the broadband margins for all in the telco industry as the NBN is rolled out. 

TPG, however, has an offsetting factor, in its own fibre to the basement (FTTB) network, with these assets expected to attract a significantly more attractive infrastructure-like margin (although this is not specifically disclosed by TPG). The reach of this network does have its limitations, although TPG have forecast a total market opportunity of 500,000 apartments, which covers its footprint within a 1km radius. To date, TPG has 24,000 subscribers on this network, although this is expected to grow over the next few years.

A risk to the FTTB is proposed legislation that would restrict the network to a 50m radius, resulting in a much lower footprint. Presently, this is only in its draft stage, although further progress would likely be a drag on potential earnings for TPG and hence its share price. An opportunity to increase its market share is another earnings lever that TPG can lean on to help ease these NBN pressures.

TPG has had an excellent track record of profit growth over many years, driven by a combination of good execution on acquisitions and organic growth that has been supported by its low-cost model. The primary headwinds that the company faces from here are lack of acquisition opportunities in the domestic market and the NBN migration challenge, risks which were largely unappreciated by the market until the second half of last year. Having experienced a large PE derating as this news developed, the stock is now trading at a discount to the broader industrials index. While participation in the sector should not be a necessity for all investors, we remain of the view that the outlook for the smaller telcos is more attractive than that of Telstra (TLS).

Downer EDI (DOW) this week sprung a surprise with a hostile takeover bid for Spotless Group (SPO). The bid has been pitched as an all-cash offer of $1.15 per share; a healthy premium to the stock’s market price prior to the offer (72.5c), but in line with its trading of six months ago. Prior to launching its bid, Downer acquired a 20% stake in SPO, and has this week conducted a $1bn equity raising to fund the deal.

While there is some merit in diversifying further away from Downer’s mining customer base, there would appear to be limited overlap between the two businesses, reducing the merger motive of realised synergies. Downer has assumed a $20m - $40m run rate of synergies once the business is integrated; this number may prove to be optimistic.

The bid also looks quite opportunistic in nature following the problems that SPO has faced over the last 18 months, including a number of earnings downgrades and the emergence of broader margin pressure across its business at its recent half year result. Looking at the recent direction of the relative PE ratios between the two stocks, it would be hard not to argue that DOW is simply capitalising on its recent strong run to issue high-priced equity to expand. DOW shareholders also took a dim view of the deal, with only two thirds of institutional entitlements taken up, despite the 20% discount of the entitlement share price.

Downer EDI and Spotless: Forward P/E Ratios

Source: Bloomberg, Escala Partners
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So, how does the transaction progress from here? The Spotless board will soon respond with a recommendation for shareholders, although the deal would appear hard to reject given the problems that the company has faced and attractive premium on offer. Another bidder may also emerge from the fray, which would likely be one of Spotless’ global peers, such as Sodexo or Compass. This probability, however, does not appear high, given that the likely suitors have not expressed any interest to date in SPO despite its recent weak share price.

The greatest risk threatening the deal may lie in the performance of SPO itself. The bid is contingent on SPO maintaining its full year guidance for FY17. This is no certainty, particularly following the company’s weak first half and the improvement required in the second half in order to meet this guidance. As such, our view for shareholders would be to sell their shares into the offer, given the considerable downside risks to SPO’s share price should the offer fall over. 


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