Week Ending 24.04.2015
Few countries indulge in weekend financial market events as much as China. After a late Friday scare on possible margin lending restrictions, the regulator appeased most with a gentler take on Saturday. This was followed by a cut in the lending bank Required Reserve Ratio (RRR). China has tended to control credit growth through this volume mechanism rather than the interest rate price signal. The RRR had been progressively raised in 2011 as the property sector got overheated. It still remains a long way from the ratio some years back and further easing is probable.
If capital flows were to accompany such moves, the outlook for China would be even more complex. But as the chart below shows, the currency has been held relatively stable (due to intervention by the PBOC) when there are sharp changes to the RRR; again implying that central authorities will balance out the mechanisms they use to manage financial conditions. China’s intent to make the renmimbi one of the global reserve currencies is clearly stated; it will make every effort to create a stable exchange rate, though with regard to global rates rather than just the US$. This is an important dimension, as currency depreciation by China could derail efforts by other countries to lift activity through their easing policies.
China RRR and USD/CNY Fix
Weak China growth for at least the first half of this year is almost a given. The Markit/HSBC PMI, which is skewed to smaller enterprises, shows a weakening in activity in April, with production and new orders softening the most. These efforts to stimulate domestic demand in China and support the business sector appear yet to have been rewarded.
Before leaning too much on the bearish outlook, Chinese spending trends are taking off again in Europe. The chart shows a data series that tracks VAT refunds by tourists. After the self-imposed austerity on the back of the corruption crackdown in China, coupled with the big fall in Russian tourism (the second largest spending group in Europe), the past few months have seen a sharp recovery. China alone typically accounts for 40% of this luxury good spending, with watches and jewellery the stand out product categories. The pattern suggests that the response to the lower euro is indeed significant and only now emerging. Secondly, it implies that while China is slowing, the overall wealth and willingness to spend is still growing rapidly.
Greece’s issues are at this stage unresolved. Within months, Greece will run out of money to pay local obligations, such as government wages and pensions. While there is much focus on the levels of debt, we understand the sticking points are about reform of the labour market, the pension structure, privitisation and value added tax. All are politically very difficult for the new government. In June, Greece has to repay €1.5bn to the IMF, and in July, €0.5bn to the IMF and €3.5bn to the ECB. Dancing around June may happen, but July is almost certainly insurmountable given obligations.
What can happen? Greece can elect to default. That sounds extreme, but is not. Many small countries have previously defaulted. Europe is probably well prepared. Expect a short, sharp rattle in markets, an open ended liquidity provision by the ECB for any counterparty impacts and then we move on. The Greek government can capitulate to demands. It can attempt to do so behind closed doors to prevent a political backlash, yet this is unlikely. The conditions it would have to impose would soon be evident.
The option a few commentators raise is the possibility of a capital controlled dual exchange rate system for a period. Cyprus is an example, with capital controls to prevent flows out of Greece and a currency aligned to the euro. In time, it could be brought back into line. This would give Greece the chance to devalue within, but without being tied to the euro. If so, it could change the way the euro is managed in the future. Currency unions have had low success in the long run. The balance is still that the Eurozone goes the path of all the others, but if there is this option of rebalancing when in stress, it may well extend its life.
A host of data releases across the globe and PMIs coalesce to a subdued recovery in the US and Europe. Almost universally, fund managers headline their macro outlook around a globally low growth environment, and therefore low interest rates. At this stage, the data is in furious agreement, and soft inflation only reinforces that. European CPI came in at -0.1% headline for March and 0.6% core (that is, without food and fuel). This is far from a European issue. Singapore has registered its fifth consecutive month of negative headline inflation. Bearing in mind that inflation in Singapore was running at 5% only two years ago, there is clearly more to global pricing than just fuel and other volatile categories. Pricing power is weak, as can be deduced from the low revenue growth facing corporations around the world. From an investment point of view, it is therefore even more important to retain active managers which can seek out the companies able to gain share or grow their product category. In both cases there will be a losing side.
Australian inflation remains above that of most other developed nations essentially due to the non-tradeable (or services) component. We appear to have embedded administered price rises in health, education, utilities and excise that continue to increase at around 5% per annum.
This pattern has two repercussions. Household spending is incrementally skewed away from goods and discretionary spending to these regulated items. For the economy as a whole, this is an unhealthy trend. Secondly, due to our higher inflation, our interest rates will be higher than elsewhere. Near-zero rates in many developed regions reflect their near zero inflation rather than any view the Australian economy is stronger. In short, real rates around the world, including Australia, are not that differentiated.
All eyes will turn to the RBA on that front as we enter May. From a near-certain pricing of a cut, the rate crystal ball has become murky. The lack of reaction from the business sector (outside property) to lower rates, the converse reaction from housing investors and the already-strained household balance sheets are an uncomfortable backdrop for the RBA members. Recent comments with respect to Australia’s level of debt by rating agencies acknowledge the low Government debt/GDP while noting that it should be lower than for many other countries due to its dependence on commodities. Additionally, there is an indirect reference to tax income to service debt, which is sensitive to the household sector and therefore its obligations cannot be ignored. At over 150% debt to income, we are the highest in the developed world. The sensitivity of domestic households to higher interest rates goes without saying.Enlarge
The market’s narrow focus on iron ore meant that Rio Tinto’s (RIO) March quarter production report was viewed as weaker than expected, with lower production from its Pilbara iron ore operations. The company’s other core commodities, however – copper, metallurgical coal and aluminium – were largely in line, or slightly better than, forecasts and hence earnings revisions across the market were limited. RIO’s iron ore production was affected by wet weather over the course of the quarter, leading to a 6% quarter-on-quarter decline. Reflecting the longer-term expansionary trend, however, production was 12% higher compared with the first quarter of 2014. Iron ore sales were 2 million tonnes lower than production as a result of a train derailment at one of RIO’s two exporting ports. The release of this inventory build over the course of the year will be incrementally better for RIO’s cash flows, but this will be a further slight drag on the iron ore price. Total shipments for the year are still expected to be approximately 350 million tonnes, up 17% on 2014 and a further demonstration of a saturated market.
While RIO maintained its production guidance for the bulk of its divisions, BHP Billiton (BHP) made a number of revisions to its full year, with iron ore and metallurgical coal up, while coal is now expected to be lower. While BHP didn’t appear to be plagued by the same issues in its iron ore division as RIO, the bigger news was its announcement that it was deferring some capital expenditure in iron ore. BHP is effectively aiming to generate additional production growth in the next couple of years by working its existing asset base harder, leading to slower progress towards its 290 Mtpa capacity target. Given the recent sharp decline in the oil price, developments in BHP’s petroleum division will also be keenly watched in coming months. With drilling rigs already cut in the early part of this year and lower expected capital spend in the final quarter, it is anticipated that lower production volumes will flow through at some point in the near future.
Even though the iron ore operations of BHP and RIO remain profitable in the current pricing environment, free cash flow will be severely constricted in upcoming years. With the companies bound by progressive dividend policies (and a commitment to maintain a strong balance sheet), the residual to balance the equation is further cuts to capital expenditure. In that respect, this week’s announcement by BHP may well foreshadow a more significant capital expenditure reduction in the next reporting season.
Fortescue Metals (FMG) got somewhat of a reprieve this week when it announced that it had refinanced US$2.3bn of debt. The company has now bought significant time in dealing with the current market conditions, although it appears to have come at a significant cost compared with a refinancing option that it walked away from last month, with an interest rate on its new debt of 9.75%. The contrast with a bond announcement from BHP earlier this week couldn’t be starker, with BHP pricing bonds of a similar term in European markets at 0.75%.
Fortescue Metals: Debt Maturity Profile
Oil Search’s (OSH) first quarter production was lower quarter-on-quarter as a result of scheduled maintenance at its PNG LNG project. After taking this into account, however, the performance at PNG LNG continues to be strong, with the project running ahead of its nameplate capacity. With its low cost operations that allow it to weather the current market conditions and high optionality in its asset base to expand the existing PNG LNG facility, OSH remains our preferred stock in the energy sector.
Spotless Group (SPO) announced that its CEO, Bruce Dixon, had decided to retire at the end of the year. Dixon had been well regarded, running the company under private equity ownership and into the relisting of the company on the ASX almost a year ago. While Dixon may have been instrumental in the success that SPO has enjoyed over this time, the 8% decline in the company’s share price since Wednesday appears to be an overreaction by the market. The 20% increase in the company’s share price since January could have led some investors to the conclusion that now is a sensible time to take profits in their investment. We added SPO to our model portfolios at a time when it was priced at an attractive discount to the broader industrials index, although we note that this gap has closed following this recent outperformance.
Asciano Group (AIO) gave a third quarter update on the volumes across its network of rail and port assets. There was some marginal improvement in container port volumes, which was a positive given the disruption caused by the redevelopment occurring at Port Botany. Coal volumes were weaker over the quarter, although this appeared to be more attributable to some maintenance activities occurring in NSW. The tailwind that AIO received from higher coal volumes in recent years (as the miners improved their utilisation across the network) looks to have dissipated, although a flat profile should be considered a more than satisfactory outcome given depressed coal prices. AIO also reiterated its full year guidance, with earnings growth continuing to be driven by its large business improvement program. Importantly for investors, it expects to be in a position to deliver an uplift in dividends at a much faster rate than underlying earnings growth in the medium term as its capital expenditure profile rolls off.
The third quarter trading update from Brambles (BXB) was slightly disappointing, particularly from its key Americas pallets business. As some may recall, the corresponding quarter in the last financial year was affected by the severe weather conditions experienced in the US and hence investors may have been expecting a much better performance in the most recent quarter. While this did not materialise, underlying revenue growth of 8% (on a constant currency basis) across its entire business is still a commendable result in a market where many other industrial stocks are struggling to grow their top line. A summary of BXB’s revenue growth is shown in the table below.
Brambles: Nine Month Revenue Growth to March 2015 vs pcp
Resmed (RMD) today reported its third quarter result, which was slightly below the market’s expectations. One of the current themes of this US reporting season is the revenue impact that is flowing through from the strength of the $US dollar and RMD was similarly affected. Top line growth of 6% was therefore a solid result given this headwind, with this translating to 13% growth on a constant currency basis. Some weakness in pricing (which was partially explained by the mix of sales) led to lower margins, however, appears to be the core reason for the fall in the share price today. RMD has rerated considerably in the last six months and now trades on a rather lofty forward multiple of 24X. This valuation is currently not uncommon among the healthcare sector of the market, indicating that investors are paying more the high earnings growth that the companies within it have, and are expected to produce, going forward.
Stock Focus: Origin Energy (ORG) and AGL Energy (AGL)
ORG and AGL are often considered alternative investments for one another given the similarities they possess with their integrated energy operations. Below we discuss some of the key differences between the two.
AGL is the more vertically integrated of the two companies, with a larger portfolio of internal power generation. In FY14, AGL covered 75% of its internal electricity requirements from its portfolio. Following its recent acquisition of the Macquarie Generation assets (which included two large-scale coal fired power stations), AGL has significantly increased its generation capacity and thus has little exposure to wholesale electricity prices. Coal is the dominant source of electricity generation for AGL. In the six months to 31 December, coal accounted for 81% of its generation, oil and gas 7% and 12% renewables, including wind and hydro sources.
In FY14, ORG had just under half of its load covered by internal generation and thus has to source the rest of its requirements from the wholesale market. ORG’s internal generation is more skewed towards fossil fuels, with coal making up 69% of its generation, gas 30% and renewables approximately 1%.
ORG’s larger exposure to fluctuations in the wholesale electricity market is not an issue at present, as prices remain low as a result of excess capacity in the system. This situation may become more of a risk to ORG in coming years as Queensland shifts from being a net exporter to a net importer of electricity following the start-up of the LNG projects in the region. The impact for ORG will be dependent upon the hedges that ORG has in place.
ORG’s 37.5% interest in APLNG is the most obvious difference between ORG and AGL. APLNG is a US$20bn, 9mtpa, two train LNG project that is currently under construction in Gladstone in Queensland. The project is underpinned by 20 year supply contracts to Sinopec and a Japanese utility company, with revenues linked to the oil price. The project is currently around 90% complete, with first gas expected in the third quarter of this year.
This point of differentiation is one of the key attractions to an investment in ORG. ORG estimates that from FY17 onwards, its share of distributable cash flows from the project will exceed $900m p.a. The shift from the high capital-intensive construction phase to these cash flows from production will be material for ORG’s financial position and should allow it to provide a step up in its dividend returns to its shareholders. While the economics of APLNG have obviously been affected by the recent weakness in oil markets, ORG believes that free cash will be available for distribution to shareholders at an oil price as low as US$40-45/boe. The forward curve for oil still suggests that oil prices will recover over the next few years and a weaker $A is also beneficial for the company.
AGL and ORG require gas for their retailing businesses as well as a supply for their gas fired power plants. Gas requirements are generated from internal sources and through third party deals with large gas suppliers. With respect to their gas portfolios, ORG is in a better position than AGL.
The respective gas portfolios of AGL and ORG are quite different. ORG has a stronger position with respect to the development of its own gas resources and is thus better placed to benefit from the expected increase in east coast gas prices in coming years. While AGL has a similar level of gas reserves to ORG (excluding the latter’s interest in APLNG), the monetisation of these assets has been more difficult given that they are predominantly made up of coal seam gas acreage in NSW. In recent years the NSW government has cracked down on coal seam gas drilling, weakening AGL’s internal gas position.
The retail market has been difficult in recent years, with falling electricity demand (due to several factors, including the decline in the manufacturing sector and the take-up of solar panels on homes) and high competition. AGL and ORG have a similar size retail and business customer base (almost 4m accounts) to which they sell electricity and gas. Australian retail energy markets are among the more competitive in the world, with customer churn rates of approximately 20% p.a. AGL and ORG both score better than the market on average on this measure. Both companies have averaged churn rates of around 14% in recent years, indicating that their customers are less likely to switch providers.
Customer churn rates also differ between the states. Among the major states, Victoria is the most competitive, with average discounts and churn rates higher than the rest of the country. Queensland is at the other end of the scale, while NSW and SA sit in between these states. From this perspective, ORG has an advantage over AGL, with a lower proportion of its customers from Victoria and a higher percentage from Queensland.
We have ORG in our model portfolios, with the company looking relatively attractive with APLNG now largely de-risked and the earnings and cashflow uplift to follow in the medium term. ORG currently trades on a premium to AGL, however we believe that this is more than justified considering its superior expected earnings profile.
AGL and ORG Valuation Summary