Week Ending 25.08.2017
- Central banks face tough decisions this half year. They are likely to play out a very cautious set of moves designed to test the water rather than create a storm.
- France moves over to take on Germany’s role in driving European growth.
- The inflation (or lack of) debate looks to the traditional relationship with labour markets.
- Australian data will emerge from a very quiet patch with important indicators on investment spending.
After a long hot summer, the northern hemisphere returns to the work schedule of the second half of the year.
First up will be the Jackson Hole Conference over the coming days, with investors looking for pointers on monetary strategy. Second is the US debt ceiling, almost certain to find some, if messy, partial solution. Then, tax reform and infrastructure spending may come into play. But it all has to fit together and, in reality, it is unlikely to please the ambitious aims of the early days of the new administration. Recent US data can best be described as middling; home sales fell in July, unemployment claims have levelled off and manufacturing trends are patchy. The latter may be due to the volatile auto sector, where lease cars have flooded the second-hand market. But a meaningful move in investment is far from evident, placing the reliance on consumption.
European momentum appears to be going from strength to strength. The French business survey (INSEE) hit a 10 year high, driven by the manufacturing sector. Capacity utilisation is above its long-term average and investment spending is therefore moving ahead at a reasonable clip.
Manufacturing capacity utilization rate
Handily, it comes at a time when the German growth rate is expected to weaken due to a slump in the auto and chemicals sectors.
If one reflects on the predictions made for 2017 at the beginning of the year, the most puzzling aspect that have been disproven is that inflation would tick up and take interest rates with it. The logic was clear – labour markets were rapidly tightening and wage growth would come through as it had always done in past cycles.
Instead, there is now endless analysis on why this pattern has not emerged. The basis for the case lies in the so-called Philips curve, the relationship between unemployment and prices, or in concepts such as the NAIRU – non-accelerating inflation rate of unemployment. In practice, such relationships always have their variations and may be better in the long term rather than short term outcomes. If so, is it possible that the long-awaited wage movement may surprise when just about everyone has convinced themselves that global influences, part time and informal work arrangements and the predominance of low wage service jobs will hold labour costs down for ever.
A number of observations challenge some of the proposition. The wage and inflation link is working in some countries. In the Czech Republic, the fall in the unemployment rate to below 4% in recent months has triggered a 5% year-on-year acceleration in wages. In turn, it was the first country in Europe to raise rates two weeks ago. Germany has seen some of the same but without the mechanism to respond in monetary policy.
On the other hand, the country at the pointy end of this relationship is Japan. Low inflation, low wage growth and low unemployment is taken as evidence that this trinity can cohabit for a long time. But it bears watching, as the trends have now reached a more extreme level. Unemployment is down to below 3%, its lowest in 20 years. Meanwhile, the ratio of job openings to applicants is also at 25-year highs. Yet, wage growth has been flat.
Japanese Unemployment and Average Monthly Earnings
While the usual factors noted above can lie beneath this delinked trend, the devil is in the detail. Full time skilled wages have accelerated at a much faster pace than part time. With the economy now expanding at its fastest rate in years (growth now ahead of the US and Europe), this could filter into wages. Notably, Japan has the lowest minimum wage rate in the OECD, and this is expected to rise by 3% to US$7.64/hour. Consumption growth has started to rise and companies are suggesting they are likely to put through price rises. Maybe Japan, of all places, is going to set the inflation trend.
Local economists will also be back to work after a few weeks with barely a data release. Coming up this week are some of the early indicators of Q2 GDP growth. Private sector credit growth and updated capex estimates may be more important in terms of what lies ahead.
Fixed Income Update
- The ECB is widely anticipated to wind back its QE program as finding bonds to purchase becomes problematic
- Bank loans in the US extend out, increasing interest rate risk for the lenders should the Fed continue to raise interest rates
- The new Tesla bond in the US trades below par in the secondary market
- ANZ confirm the margin on their new ANZ capital notes 5
The ECB president Mario Draghi has signalled that the central bank will be deciding on its QE programme in the ‘fall’ (September or October most likely), but market participants will still be listening closely for any hint of a tapering at the Jackson Hole symposium meet this weekend. QE bond purchases have already been scaled back from €80 to €60 billion, with a further reduction to €30 or €40 billion broadly expected. It is also possible the ECB may extend the time frame for bond purchase at this lower level.
While some point to the unresolved financial circumstances of some of the European banks as a reason not to wind back QE, others talk to the fact that the ECB are running out of eligible bonds to be able to buy under the current mandate and therefore a change is inevitable.
Under the current guidelines the ECB can only purchase up to 33% of outstanding German bunds. Statistics from the International Monetary Fund indicate that the ECB already owns more than €400bn of the €2.1tn issued by the German government. Continuing the same trajectory, the ECB is expected to reach the 33% cap by February 2018. Purchases of Dutch, Irish and Portuguese debt are also approaching their limits. Unless the ECB manages to make changes to the bonds they can buy, the likelihood of a tapering of QE is almost a foregone conclusion.
The ECB’s bond holdings
Many expect that this will lead to a rise in bond yields as the biggest buyer of these securities retreats from the market. Others predict economic conditions will keep yields low regardless of the unwind, which include low long term inflationary expectations, below trend growth and demographic changes supressing interest rates.
A counter intuitive dynamic is playing out in the US bank loan market. With the Federal Reserve Bank raising interest rates, one would expect that banks would be wary on the length of the term over which they lend. Recent data shows that the percentage of bank loans over 5 years reached new highs in the second quarter of this year. Understandably borrowers are terming out their loans to lock in these lower rates. but the surprise comes in the banks willingness to oblige.
Bank assets with terms greater than five years as a percentage of total assets, quarterly
In a recent publication, we noted the new 8 year Tesla bond that came at a very tight margin compared to other single B rated corporates issuing in the high yield market. The notoriety of Tesla’s founder and CEO, together with the worlds desire for a mainstream battery run driverless car to become a reality, is thought to have influenced the demand for these bonds. The enthusiasm for this bond has somewhat waned since it began trading two weeks ago, with it falling below $100 in the secondary market. It highlights that investors should make investment decisions based on the pricing relative to the risk of the company’s balance sheet as opposed to emotional drivers.
In the Australian listed debt market, the order book for roll overs from the ANZPC’s into the new ANZ capital note was completed. The margin for the 9.5 year mandatory convertible preference share with a call date in 7.5 years was officially set at 90 day BBSW + 3.80%. This came at the tighter end of the price guidance. The overall size if the deal is yet to be determined, but is to be capped at $1 billion.
- BHP Billiton missed on its earnings, although continues to evolve into a more shareholder-friendly entity after putting its US shale assets on the block.
- Oil Search (OSH) has progressed slowly on its LNG expansion plans.
- Star Entertainment’s (SGR) year was held back by capital works and the contagion following the arrest of Crown employees in China.
- Sydney Airport (SYD) has lifted its full year distribution guidance on the back of excellent international passenger growth.
- Amcor’s (AMC) steady growth profile remains unchanged.
- FY18 looks to be one of consolidation after a challenging year for Brambles (BXB).
- Reporting season was disappointing for insurance companies, with IAG guiding the market lower for FY18.
- Health insurance affordability is a key issue for both Medibank Private (MPL) and Healthscope (HSO).
- Woolworths (WOW) likely growth got a reality check.
A relatively weak reporting season is now largely complete and has been characterised by downgraded earnings estimates for FY18. Aggregate profit growth has been robust, although largely driven by the rebound in the resources sector. Dividends have held up well, despite the high profile casualty of Telstra’s distributions. We will provide a more detailed wrap of results in coming weeks.
BHP Billiton’s (BHP) US shale mea culpa diverted the attention of investors from an impressive rebound in profitability, which though fell short of expectations. The expansion of its petroleum division into the US shale industry has proven to be a disaster for the company, with its large capital outlays (upwards of US$30bn on acquisitions and capital expenditure) primarily occurring at a time when oil was trading at circa $100/barrel. The collapse of the oil price over 2014/15 left the unlikely prospect of an acceptable return on this investment.
BHP is exploring various options to exit its shale business, and while a trade sale is the preferred option, other possibilities include a demerger or IPO. The sale may only realise US$10bn as a best case outcome. However, it is difficult to mount a case that the assets be considered core to the broader BHP entity and fit with its low-cost mantra, with returns clearly inferior to the company’s other key business units.
BHP: Return on Capital Employed
While BHP’s earnings were boosted by stronger commodity markets in FY17 (which in itself lifted EBITDA by 2/3rds), this cannot be relied on for the next 12 months, given that commodity prices are expected to be softer (on average) through this time. Iron ore remains key, although coal, copper and petroleum are all important. In the event of greater stability in commodity markets, it is likely that the shareholder-friendly capital management and investment decisions (increasing dividends, reducing capex and paying down debt) will find support among investors.
Oil Search’s (OSH) half year result was sound and the company’s assets demonstrated operational consistency. OSH’s interest in the core PNG LNG project (which nearly increased its production four-fold) has been the primary driver, with production consistently running ahead of nameplate capacity.
Progress on expanding the project (which will likely again double its production) has followed a slow and steady pace; a reasonable strategy given the current state of global energy markets and the anticipated growth in LNG supply as other projects are completed in coming years. Currently OSH is pointing towards a startup of sometime into the next decade when markets may be more favourable.
Global LNG Supply Demand Balance
Developments over the last 12 months have been quite positive for the expansion. In particular, there has been recognition by the joint venture partners for a greater level of cooperation in its development and the recent return of the PNG Government has created a relatively stable political backdrop. Supported by strong cash generation in the current environment and high-quality growth options, OSH is our preferred holding in the energy sector.
The next twelve months looks more promising for casino operator Star Entertainment (SGR), which will be cycling two factors which provided a headwind for its FY17 results. Normalised (that is, adjusted for normal casino win rates) earnings fell 11%, in line with expectations. As was widely anticipated, the key swing factor was the decline in its high roller VIP business (which is typically much more volatile on a year to year basis), with all Australian casinos suffering following the arrest and conviction of Crown employees in China. High roller turnover was down 20% on the year, partly attributed to a higher than usual win rate as front money was actually higher. Additionally, an increased focus on targeting high rollers outside of the North Asian region paid off, with turnover from this subgroup doubling.
Star Entertainment: VIP Turnover Growth vs pcp
The other key drag on Star’s result was the disruption caused by capital works at its Sydney and Gold Coast properties, although the company was still able to record domestic gaming revenue growth of 2%. Following completion, the trends in the second half were more promising and thus show good momentum into FY18. Given a reasonable earnings outlook, sound balance sheet, growth opportunities, leverage to strong inbound tourism and a valuation in line with the industrials sector, we remain comfortable holding SGR among our recommended direct equities.
Sydney Airport (SYD) has a natural dependence on inbound tourism growth and this was reflected in another period of excellent operating performance in its first half results. EBITDA growth of 8% was underpinned by valuable international passenger growth (and has outpaced domestic growth for some time) and increases in aeronautical charges, with international agreements locked in at ~4% p.a. out to 2020.
The growth in passenger numbers translated into improved revenues across each of SYD’s business units: retail (+14% on the opening of new stores), property and car rental (+3%) and parking (+2%). By nationality, the fastest growth was from the South-East Asian region.
Sydney Airport: Fastest Growing Nationalities in 1H17
The solid result allowed SYD to raise its full year distribution guidance to 34.5c an increase of 11% over 2016 and a key element in providing share price support. While the operating outlook for SYD remains sound, outside of a large disruption shock that could cause a decline in global air traffic, the longer-term risk revolves around the impact of the opening of the Western Sydney Airport, although this is well into the next decade. In the interim, interest rate risk is important to monitor given the benefit that a declining rate environment has given to its cash flows and valuation.
To highlight its leverage (which is not unusual among infrastructure companies), if one were to translate its 6.5% average debt charge of five years ago against its current debt burden, this would be equate into an approximate 15% decline in operating cash (and likely distributions). While a sharp upward rise is unlikely and would not be immediately reflected in an increase in interest costs (given the maturity profile and hedging in place), the experience of the latter half of 2016 is an indication of the potential downside to its valuation, with a ~20% share price decline as the stock was de-rated by the market.
Amcor’s (AMC) full result was predictably uneventful, with underlying earnings growth of 9%. The result was generated by a typical mix of stable organic and bolt-on acquisitive growth, the latter of which has been a key to its success over the last decade. After being primarily driven by growth in emerging markets in recent years, developed markets picked up the slack in FY17, helping to offset softer trading conditions across its Latin American operations.
The outlook for next year was for much of the same (without providing a specific growth target, AMC forecast “solid” and “strong” profit growth across its two divisions). The company also outlined an expected $100m increase in earnings contribution (about 9% of its FY17 base) over the next three years from recent acquisitions and a restructuring of its flexibles division. While remaining a solid core industrial stock holding with good defensive characteristics, the investment case is tempered by a relatively full multiple for a company that is exposed to benign underlying demand factors.
FY17 was one that pallet pool operator Brambles (BXB) would prefer to forget, with underlying earnings flat on a constant currency basis. Early this year the company issued a surprise earnings downgrade on the back of issues in its US pallets business which led to softer margins, some of which appear to be cyclical in nature and some structural. The cyclical factors highlighted were the higher costs associated with the investment made in the prior year to support better growth and a level of customer destocking in the second and third quarters of the finanical year.
However, around half of the margin pressure was attributable to an increased level of price competition, particularly from its key competitor PECO, which is not expected to abate in the near term. Volume growth in the business improved in the second half, although this has clearly come at the expense of price.
Brambles: US Pallet Revenue Growth
While the company remains confident of its longer term target of mid-single digit sales growth and profit growth in excess of this from the operating leverage in the business, FY18 is still expected to contain some headwinds (including the loss of a domestic reusable plastic container contract with Woolworths) and is thus likely to be a year of consolidation. A more rational pooling market in the US would provide scope for a return to margin growth, although this is no longer the base case assumption by most analysts and the near term risk clearly revolves around further pricing pressure.
Proving the value proposition is a key challenge for the new management team, as would an end of the deflation seen in the recycled pallet alternative to pooling. On its current multiple, investors are no longer paying a premium price for a company that has an attractive asset base with a scale network advantage over new potential entrants to its markets.
IAG rounded out a poor reporting season for Australia’s three key listed insurers, with a result that met investor expectations, although was poor on quality and with softer guidance for FY18. The group’s underlying insurance margin deteriorated in the second half of the financial year, with the group highlighting three key reasons: an adverse outcome from higher than expected natural perils (with three events that saw $100m+ in claims), claims inflation in motor insurance and an increased level of large losses in its commercial business.
The first of these was well known by the market, as the insurers flag the expected cost of natural hazards as they occur. The high frequency in which perils have exceeded expectations, however, has been recognised by the industry and insurers are taking on a greater level of reinsurance protection into next year, causing a margin headwind.
The motor insurance issue has recently been a problem for the industry, with premium rates rising in response, although the lag has potentially been underestimated by the market. Lastly, a few large one-off losses in its commercial business could simply be put down to poor luck (given the higher contribution from single claims) and so this may possibly reverse in FY18.
A more positive view on IAG would note that the rate of premium growth in the Australian market has improved, potentially fixing issues around elevated claims and capital management in coming periods is a possibility. Some investors, however, will be sceptical of this outcome given the recent inconsistent delivery of the insurers. Despite its pullback this week, we note that IAG continues to trade at a reasonably high P/E premium compared with its closest listed peer, Suncorp (SUN).
Medibank Private (MPL) is an insurer that should have a more predictable growth profile than IAG and SUN given its exposure to short term claims and, notionally, better top line performance from an ageing demographic. Its recent primary issue has been arresting the decline in membership of its core Medibank brand, which has been losing market share to lower value products without the bells and whistles (including its own lower margin AHM brand).
A cost out story has been the key driver of better profitability since it listed and this has now morphed into better investment income returns (MPL’s earnings would have declined in FY17 if not for a lift in investment income), both of which cannot be relied on as a sustainable source of profit growth.
Medibank Change in Market Share
Woolworths’ (WOW) better than expected supermarket sales for the second half of the year failed to inspire interest. Even management cautioned that, at over 6% growth in the last quarter, that this could be the best run rate for some time. The most likely outcome is now for slower growth, assuming Coles accepts market conditions and achieves its aim of a modest pickup in sales momentum. In those circumstances, these two groups should see supermarket EBIT margins of circa 4.7% for WOW and low 4% for Coles, with revenue growth 1-3% ahead of food inflation, depending on population shifts, new stores and product assortment.
Big W could be an enduring problem, reporting a large $150m loss and little conviction that profitability is to emerge. As we have noted in the past, there are too many department stores in Australia and short of a major reconfiguration, the outlook for the big three will remain problematic.
Two components in the group’s cost of doing business will be notable in the coming year. Wages growth has rarely troubled supermarkets, though in FY2017 WOW has had an outsized wage bill as it paid bonuses and higher training costs to incentivise the sales recovery. There is an uneasy calm in the low-end wage rate and penalty clauses for this sector which may become problematic if there is a push to lift incomes for the lowest quintiles. The second is energy costs, with estimates these will raise costs by 10-20bp for WOW in 2018. While this may not seem much, its in the context of the lower margins that are now in the sector.
The stock is trading at 22X earnings, on a skimpy yield (for a low growth company) of just over 3%. It would not be surprising to see the share price roughly at the same level in a year’s time.
Ultimately, the issue is one of health insurance affordability, with rates growing at inflation plus, resulting in slow industrywide policyholder growth in an environment of tight household budgets. The issue has also been acknowledged by the private hospital operators, including Healthscope (HSO), which dropped sharply following the release of its results this week. The lesson for investors is that a strong underlying demand theme (ageing population) does not always translate into positive outcomes for companies exposed to that theme.
Reporting season concludes next week, with a limited number of companies still to report:
Monday: Japara Healthcare, LendLease
Wednesday: Ramsay Health Care