Week Ending 24.06.2016
Britain’s decision to leave the European Union sent a wave of selling into equity markets and caused major movements in currency and bond prices. While it will take some time for the implications to become clear, the most widely expected outcome is that central banks will revisit their easing and possibly intervene in currency markets. The Bank of England has been dealt a difficult hand as it needs to support the domestic economy yet is faced with a fall in Sterling, already one of the weaker currencies this year.
Draghi at the ECB had for some time been signalling that policy could become more accommodating and today’s event does provide the trigger for the asset purchase programme to be extended and widened. Europe has to see through a Spanish poll on Sunday following the inconclusive election six months ago from which no government emerged. The likely inclusion of the anti-austerity Podemos presents another risk for Europe. With a constitutional reform vote due in Italy and the German and French elections looming next year, the machinations of the political overlay are a headache for any central banker already struggling with low inflation and volatile currencies.
The Fed has already shifted to a dovish stance. While the direct impact from Brexit on the US economy is small, the Fed does take into account financial market instability and rates are likely to stay on hold at this stage.
A strong yen puts paid to any efforts in Japan to spark growth and inflation. Given that the Bank of Japan has already undertaken widespread asset purchases to little effect, it may well decide it has nothing to lose by going even further and currency intervention cannot be excluded.
Locally, the RBA will be unable to ignore these movements and the likelihood of another rate cut is high.
The financial sector is expected to experience some short term pressure. Wholesale funding will more than likely rise and credit demand will slow given corporate uncertainty.
While there have been sharp swings in the lead into the Brexit vote and so far on Friday the reaction has been harsh, given the time it will take for the UK to leave the EU (at least 2 years), the market can be expected to return to its path of trading along views on fundamental valuations and reaction to the next event or newsflow.
Elsewhere, however, mixed signals from global economic trends continue to befuddle the direction of financial markets. US existing home sales reached their highest level since 2007, with the median price up 4.7% in the year to US$239,700. New home sales dipped 6% in May but remain up 8.7% over the year. For both new and existing homes, the inventory levels are low, at around four months of supply. Based on these trends, the housing industry in the US looks solid but with a diminishing contribution to growth.
A similar pattern is unfolding in Europe. Employment growth is sound, particularly in Germany where the recent business confidence survey belied gloomy predictions of a slowdown. Nonetheless, the outlook is clouded by weakening consumer confidence in light of the political uncertainty plauging much of the region. Inflation is also showing no signs of emerging. Surveys indicate that firms are reducing prices to match competition, with profitablity therefore looking subdued.
Fixed Income Update
The last couple of weeks has seen some volatility in bond markets as the changing predictions on ‘Brexit’ swung sentiment in favour of ‘risk off’ then ‘risk on’. Now that Britain has made the decision to exit the EU, markets will take a few days to digest the result and reset yields and credit spreads across the fixed income universe accordingly. With that in mind, we will observe the reaction bond markets next week once all global markets have opened and had time to respond.
While traditional long duration bond funds have performed well in the last few years, as global yields have been tumbling, credit spreads have been rising over this period creating a challenging environment for short duration credit funds. As a reminder, as credit spreads widen the price of corporate bonds fall (assuming no change in government yields). This is obviously from a mark to market perspective, and only realised if the bond is sold, but it does erode the performance results of the managed fund. However, a recent snap back in the spreads for most of the fixed income market has boded well for those funds that took the opportunity to buy more product when spreads were at their widest.
The chart below tracks the movement in spreads over the last two years of the CBA 5 year CDS (Credit Default Swap – a measurement of the risk in terms of spread paid above government bonds for an issuer), the iTraxx index (basket of 5 year investment grade CDS), and on AAA RMBS (Residential Mortgage Backed Securities). However, interestingly the RMBS market has remained at wider levels and has not contracted in line with other corporate bonds in the last couple of months. See chart below.
One reason that perhaps explains this disparity is the lower levels of liquidity in the RMBS market vs the CDS and cash bond market for banks and corporates. In addition, recent negative sentiment and commentary on the housing market in Australia may be responsible for an additional demand for spread on these products.
In the domestic listed debt market, the Crown hybrid notes have taken on a bumpy ride in the month of June. These securities came under pressure earlier in the year when rumours circulated about a potential privitisation for the company. More recently the company announced a restructure involving a demerger of some of its offshore assets into an international company, while Crown resorts retains the Australian investments. In addition they announced a new dividend policy and a proposal for a property trust IPO of their Australian hotels.
The initial response to this was deemed positive for the hybrids, with the CWNHA’s rallying from $92.50 prior to the announcement and peaking at $96.80. However, subsequently S&P and Moody’s have placed Crown Resorts on negative watch citing a number of concerns on the proposal. In turn, Crown have expressed in an investor call this week that they are committed to maintaining their investment grade rating. The result has been a price fall in the CWNHAs, where they currently remain range bound between $93.70 and $94.30. The price action of this security is depicted below.
Crown Hybrid Securities (CWNHA)
Wesfarmers’ (WES) strategy day did not surprise, with few new facts, yet plenty of opinions and a note of caution emerged. Representing a microcosm of the equity market, WES’s 10 year history contains the hubris of acquisitions from the global financial crisis, a recapitalisation after excess leverage, a strong profit cycle from lower funding costs and better execution and now a challenge to find another leg to its strategy.
Management believe they can extract more from supermarket retailing, notwithstanding the recent weak trend in food inflation. However, the strategy appears to be defensive rather than innovative. Store refurbishments protect market share gains, unless there is a successful new format. Growth in produce has long been the aim of the supermarket sector but the consistency in product standards has kept the independent sector well entrenched and while Coles is achieving volume growth, it is largely due to sharper pricing. Coles has also clearly been the beneficiary of Woolworths’ and the independent sector’s problems. Both of these corporations are fighting to re-establish their share and likely curtail the pace of Coles’ revenue growth. The next few years are more likely to therefore see Coles make mid-single digit profit gains, and a strong rise in margins should instead be viewed as a dangerous development signalling a repeat of the issues that have led to Woolworths’ current problems.
Investor focus is therefore likely to shift to the potential for Target to return to stable margins and the growth in the home improvement sector. Target has taken a large writedown of assets and inventory, clearing the slate for a new product range over the coming year. The outstanding question is therefore whether its traditional consumer base returns for well-priced, reasonable quality basics or whether this gap has already been filled by other retailers.
Bunnings’ potential revenue is tied to the home refurbishment cycle, which seems everlasting in the housing-obsessed Australian market. Post the demise of Masters, this position has been reinforced. The risk lies in the expansion of the product range into ancillary product that may not resonate with shopper expectations. The recent acquisition of Homebase in the UK inevitably carries high risk, albeit that the cautious approach in changing and expanding this business suggests management is well aware of the low success rate in global retailing.
Along with the weak outlook to the resource and industrial businesses, this all points to single digit earnings growth for the foreseeable future. From an investor’s point of view, the question is therefore how to value the lower, but relatively reliable rate of profit expansion. To add to the complexity, the dividend may to be cut back as the group seeks to protect its A- credit rating. Once again, this highlights the excess payout prevalent in the Australian equity market. WES is a stalwart for investors in the big cap space. We foresee nothing like the problems that face Woolworths, but with a view that earnings are likely to creep rather than kick along, an index weight appears to be the appropriate position for most portfolios.
Metcash (MTS) earlier in the week released its full year result. The core food distribution EBIT fell 17% and the weak cash conversion (implying the seasonal impact of working capital is much higher than apparent from the annual statement) saw the share price fall some 14% in the week. Few believe MTS can combat the rise of others in the supermarket sector, but had been attracted to the low multiple (P/E of 10X) and prospect of a return to stable dividends. The outlook is now evenly balanced between further pressure on revenue given the rise in competition, versus some stabilisation in margin from cost reductions and the potential acquisition of Home Timber and Hardware.
BHP Billiton (BHP) held an investor day this week focusing on its coal division, putting forward its best case for the longer term prospects for the commodity. At the peak of the commodities boom, BHP’s coal division generated earnings of close to US$4bn, however, a collapse in pricing over the last five years saw this division only breakeven in FY15, with little improvement expected this year.
BHP has significant operations in both metallurgical (or coking) coal, which is used in steel making, as well as thermal (or energy) coal, which is used in power generation. While this results in a different demand profile for both, the high prices of a few years ago incentivised a large step up in supply, much of which is continuing to depress the current market.
Metallurgical coal demand has dropped with slowing steel production, particularly from China as it transitions away from an investment-led economy. The fall in demand from China has been particularly pronounced given the country’s domestic supply - it is the seaborne market which has worn the consequences. While growth in global steel consumption can still be expected in the long-term, particularly from developing economies, increasing use of steel scrap clouds the outlook for coal.
The longer term outlook for thermal coal remains more challenged. Electricity demand from developing countries continues to grow, but coal’s proportion of overall electricity generation is expected to decline over many years as countries look to reduce carbon emissions. BHP’s base case assumption is that thermal coal demand will increase by 10-15% in absolute terms by the mid-2020s, however the risks to this forecast are clearly to the downside.
The shape of the cost curve for commodities plays a large part in explaining why prices and profitability have fallen so sharply across the industry. The steepness at the right end of the cost curve (i.e. the relative cost of higher cost operations) means that incremental new low-cost production (or a slight decrease in demand) can reduce marginal costs, and hence commodity prices, significantly. BHP is better placed than the majority of its peers with its low cost operations (see charts below), however the cost curves across coal have flattened, leading to low margins across the industry.
Coal Cost Curves
In this benign demand/oversupply environment, cost cutting is the most likely source of profitability upside for coal operations. BHP has managed to reduce its units costs by 56% in its Australian metallurgical coal operations and 29% in thermal coal, with labour, lower oil and more favourable currency markets all contributing. Further progress is expected in the next 12 months, although if similar measures are made by BHP’s competitors, then the benefits will ultimately accrue to its customers.
Coal should remain one of BHP’s four key commodity pillars (the others being petroleum, copper and iron ore), and while it has high quality operations, it is unreasonable to expect any significant rebound in pricing in the medium term that would be materially positive for the overall group’s earnings. Nonetheless, the benefits from a diversified portfolio will be evident in the company’s upcoming full year result given the turnaround in other commodity markets, particularly oil and iron ore. While we have a preference for BHP relative to Rio Tinto in our model portfolios based on a higher exposure to petroleum and copper, the medium term investment thesis for the diversified miners presently is one of participation in global commodity demand growth as opposed to leverage to rising prices.
Stock Focus: Costa Group (CGC)
Costa Group is an integrated horticultural company that is involved in the farming, packing and marketing of fresh fruit and vegetables and is the leading producer in the Australian market. The company’s operations are split across four key categories – berries, mushrooms, tomatoes and citrus.
While Australia’s domestic fruit and vegetable market is relatively fragmented, Costa is the number one domestic producer across each of their four categories and is the largest fresh produce supplier to Woolworths, Coles and Aldi. Costa also holds a dominant market position in the berry market (a market share of 77% in blueberries and 91% in raspberries) and is responsible for a large market share in mushrooms and glasshouse-grown tomatoes. Costa’s large footprint allows it to achieve better economies of scale than its peers.
Costa is well placed to benefit from robust demand growth in berry consumption. While overall fruit and vegetable demand growth in Australia is in the low single-digit range, certain categories have a much stronger expected demand growth profile. In recent years, consumption of raspberries, blackberries and blueberries has grown at rates of greater than 20% p.a., driven by the associated health benefits and their recognition as a ‘superfood’. Despite this recent growth, berry consumption levels in Australia are still much lower than that of the US (where demand growth also remains strong), which points towards latent demand potential. Over many years, the company has built considerable intellectual property (IP) in the development of blueberry varieties and likewise shares in the IP that US-based company Driscoll’s has in raspberries through a joint venture. Costa’s size, import restrictions on the import of berries to Australia and IP in berries have led to high barriers to entry for potential competitors.
Costa’s new projects are aimed at tapping into this demand growth in berries. Its three year expansion program is forecast to lift its planted hectares by 40% and is designed to cover seasonal and geographical production gaps across Australia. The company also has expansion projects in tomatoes and has an interest in two international berry joint ventures with Driscoll’s, both of which are at an early stage of maturity and are expected to contribute materially to earnings growth in the next few years.
Like many agricultural companies, the greatest risk for Costa is weather events, which can result in poor yields and limited supply in any given year. Compared to many in the industry, however, Costa is less exposed to adverse weather conditions. Approximately three quarters of its earnings are derived from produce that is grown in protected cropping environments, including those grown under cover, indoors or under permanent tunnels. This also reduces seasonality risk across its business and allows it to achieve better pricing and margins in off-season periods.
We like Costa for its leading market position, demand growth in key categories and attractive growth projects that it is undertaking to meet this demand. The stock currently trades on a forward multiple similar to the broader industrials index, with above-market expectations for earnings growth. We recently added the stock as a smaller position in our extended portfolio.