Week Ending 25.09.2015
Outside of financial markets, the data represents as quite settled. For some time now, the US trends hint at a weakish manufacturing sector, partly attributed to the oil sector, seasonal impact on defence and airlines, with a possible overlay of the stronger US dollar limiting new investment. On the other hand, employment and housing have barely flinched in their solid pattern of improvement. As always, the aggregate data can disguise what’s happening under the hood.
August new home sales were up 5.7% over July, taking them to the highest level since 2008. The regional strength is evident from the table below, where the south and west overwhelm north and midwest.Enlarge
A notable feature is the well-behaved price momentum, stabilising at a median of just below US$300,000 for single family homes; following the recovery in prices since 2011.
Similarly, household spending, while more muted than previous cycles, is hardly cause for alarm. These two activities are likely to continue to support a modest repair to the labour market. In apparent efforts to clarify the confusion post the FOMC meeting, Yellen commented on employment, a more critical determinant than inflation:
“The labour market has achieved considerable progress over the past several years. Even so, further improvement in labour market conditions would be welcome because we are probably not yet all the way back to full employment. Although the unemployment rate may now be close to its longer-run normal level – which most FOMC participants now estimate is around 4.9 percent – this traditional metric of resource utilization almost certainly understates the actual amount of slack that currently exists.”
Judging the labour market has become increasingly complex. Those espousing weakness point to the fall in participation, underemployment (as measured by part time) and low average wage growth. The counter argument is that participation is a function of demographics, with more young people studying longer while older workers are choosing informal work or self-employment. A survey conducted by the Kansas City Federal Reserve reports that 76% of people in part time employment are there by choice due to family circumstances or lifestyle decisions. Average wage growth understates the rise in wages in industries as measured by the employment cost index.
One notable feature of the US labour market has been resilience in jobs for those with degrees. For the 70% of the population aged over 25 that does not have a college degree, employment conditions and wages are much lower. In a combined study by four of the Federal Reserves, they assessed that this was slowly shifting. So called ‘opportunity occupations’, which do not necessarily require a full degree, include all levels of nursing, office, admin and sales staff, heavy truck drivers, supervisor retail workers, maintenance and repair trades and computer support. Higher pay rates and availability of workers with degrees was encouraging employers to take on less qualified staff. The survey found that once that trend took hold in a region, it tended to occur in all job categories and become entrenched.
Europe’s economic momentum appears to be chugging along at a modest pace. Decent momentum was registered in segments such as Italian industrial orders (up 10.4% year-on-year), positive French business confidence and German IFO measure of business climate (though that might take a hit following the events at Volkswagen). Conversely the jobs market and household sector is still relatively weak.
The most troublesome part of the economic world remains China. Efforts to lift activity to date have been in vain, such as was evident in the Caixin Index survey of mid-sized manufacturing activity. The question is what the authorities can do to change the pattern. The developed world solution of easing monetary policy has so far been a handicap rather than a benefit. The devaluation of the currency in August has destabilised capital flows. To prevent pressure on the currency and excess outflows of capital (which would tighten monetary conditions in China), the government has been accessing its foreign reserves. The numbers are, as always, muddy, but it appears that there was a capital outflow of USD85-100bn in August used to prop up the currency. The chart shows the persistent pattern of outflows and recent acceleration in the downward trend.
China's Foreign Exchange Reserves
While it holds FX reserves of some USD3,500bn, China clearly would not want to continue to leak at this rate. Its options are therefore:
- High level statements about the appropriateness of the present exchange rate. Most economists believe another 5-10% devaluation would align with fundamentals, such as purchasing power parity. That said, there is no reason to think the currency is handicapping the Chinese economy. And any devaluation is likely to be matched across Asia, reducing any potential benefit. A messy devaluation would be massively counterproductive, likely to overshoot and cause much anxiety across markets.
- It could control outflows, and has made it more difficult in recent weeks. But given the attempt to control the equity market, few would be confident it could now execute on capital flows. Raising interest rates is also clearly highly unlikely given it would be entirely counterproductive.
There is therefore no easy way, bar a respectable improvement in economic momentum. The rationale for a cyclical uplift, however, is harder to discern. Household spending has remained stable, but has nothing to underpin an acceleration. The ‘old’ sectors of fixed asset investment, property and exports are still moving down rather than staging a recovery.
Under these circumstances, the government is likely to have to use further FX reserves to prevent devaluation and offset that tightening with a broader easing of monetary conditions through interest rates and other mechanisms. China will then have joined the quantitative easing party.
In turn, other countries will hold to the same bias, with Norway, Taiwan and Ukraine cutting rates this week. No wonder the possibility of an RBA cut is still on the cards.
Locally, economic news was light this week. A moderating housing market was noted, along with the longer term relevance of weak population growth.
NAB’s economists, back from a trip to Europe, made comment that bearish sentiment towards Australia was as high as they had seen in a long time. The usual culprits of falling mining activity, weak commodity prices, extended housing cycle and overflow from China were highlighted. As buyers of Australian bonds, overseas investors would be sensitive to the potential for another cut or two to the cash rate, offset by the perceived risk of a fall in Australia’s credit rating and the path of the current account. This paints a somewhat difficult number of months ahead.
TPG Telecom (TPM) reported another solid result, with a 30% rise in earnings per share in line with consensus expectations. The result was to the end of July, so did not incorporate its recent acquisition of iiNet (IIN). The group’s profit was enhanced, however, by a full 12 month contribution from AAPT, which was acquired in the FY14 financial year.
While TPM has successfully acquired and integrated a number of businesses over the last several years, the group’s ability to maintain a high level of organic subscriber growth through its price-led strategy has been a key driver of its earnings growth. This continued through FY15 and importantly, growth in NBN subscribers was a feature of the result with its growth in this market above its overall broadband market share. Only 5% of its overall subscriber base is currently on an NBN plan, and this is clearly a multi-year option for the company to gain market share as consumers are switched off the legacy copper network.
TPG: Consumer Broadband Subscribers
TPM’s guidance for FY16 was limited, with the company pointing towards further organic growth for the year. The timing of the IIN acquisition would have played a part in this decision given the uncertainty that would come with its forecast profitability and synergies. TPM have said that they will maintain IIN’s call centres; an important decision given the high service levels its customers have become accustomed to.
TPM’s ability to leverage of its existing fibre network for IIN’s customer base will likely be a key source of margin protection for the company given the higher wholesale access costs of the NBN. TPM’s share price has run up against the market over the last four weeks and the stock is certainly not cheap on around 25X forward earnings. We believe that its expected earnings profile (20% earnings per share growth p.a. over the next four years) and track record justifies this premium valuation.
BHP Billiton (BHP) this week announced that it was considering raising a multi-currency hybrid capital instrument to the institutional market. The additional funding will be used for “general corporate purposes” as well as the refinancing of upcoming maturities. The debt is expected to be treated with a 50:50 weighting split between equity and debt by the ratings agencies.
BHP also announced that it was looking to transfer shareholder reserves from its Australian arm to its UK arm given the fall in its UK reserves following the spinoff of South32 (S32). While this would result in a cancellation of franking credits (which could not be utilised by its UK shareholders), it is unlikely to impact on the company’s ability to continue to frank its Australian dividend payments given the size of this existing balance.
For the proposed hybrid issue, the trade-off for BHP is that it will provide a level of balance sheet flexibility for what would likely be a higher level of interest cost. While this adjustment in its balance sheet may be favourably viewed by ratings agencies (and follows a recent decision by S&P to cut its credit outlook to negative), in our view it simply highlights the current difficult situation that BHP finds itself in, brought about by its two key strategic objectives of protecting its A credit rating while maintaining a progressive dividend for its shareholders. The two can be at odds with one another when a sharp correction in commodity prices occurs (such as the last few years) and led to the situation whereby the company paid out all of its earnings in dividends in the last financial year. The prospect of the company effectively borrowing to maintain its dividend in FY16 is very real and is unlikely to receive much support if a sustained recovery in commodity prices is not realised in the medium term.
In the energy sector, Santos (STO) announced that its Gladstone LNG project had started producing its first LNG and was on track for its first cargo to be shipped to Asia in the coming weeks. The news is amidst a strategic review that the company is undertaking, which it recently initiated in response to the persistently low oil price. Santos is currently evaluating offers for its assets in order to repair its balance sheet, with final bids reportedly expected to be received by the end of next month.
While the timing is clearly not ideal for Santos given the lower price of assets in the current environment, going down this route would likely be more palatable than undertaking a large capital raising. Santos’ share price has suffered more so than its ASX-listed large cap peers over the last 12 months as a result of this fear of a capital raising, and its current share price is more than likely discounting a much lower oil price compared to these companies. While few energy companies are looking to expand given these current conditions, the attractiveness of buying compared with developing or building assets within the industry has recently been highlighted by Woodside’s (WPL) pursuit of Oil Search (OSH).
During the week, we hosted a presentation from CSL, a company which has been a core healthcare holding for many domestic investors. In a relatively concentrated market (CSL is one of three companies that have a dominant market share in the plasma industry), the major companies have generally been quite disciplined with regards to growing capacity over the last decade, ensuring solid returns in a market that shows reasonably consistent demand growth. While the intellectual property is limited for these companies, restrictive capital, regulatory and time hurdles create a high barrier to entry for potential new entrants to the market.
CSL enjoys a margin advantage over its smaller competitors due to its scale advantage and cost-efficient operations. While CSL may now struggle to achieve the type of earnings growth rates that it has achieved in the past due its much larger size, there is the potential for a margin uplift should new plasma products be developed, as the marginal costs would be low.
The company has encountered few hiccups since it listed over 20 years ago, yet CSL is not immune to the development of alternative treatments for which blood plasma is currently used. One such example is a recombinant haemophilia product that is currently being developed by Roche.
The other side of the coin is the potential from its R&D investment. The unknown optionality of this expenditure is typically given little value by analysts in the market, although it has been given more attention by the company’s institutional shareholder base.
All companies face threats to their market position and an investment in CSL should recognize that risk by limiting the weight in any portfolio.
Stock Focus: Regis Healthcare (REG)
Regis Healthcare is one of the largest for-profit aged care operators in Australia. The company’s portfolio of facilities are primarily located in metropolitan areas and is geographically spread across NSW, Victoria, South Australia, Western Australia and Northern Territory. The company listed on the ASX In October 2014, being one of three aged care operators to list last year.
Australia’s aged care sector is underpinned by long-term structural growth, driven by an ageing population. Increasing life expectancy and the retirement of the baby boomer generation are two important tailwinds for the industry that will provide support for a relatively predictable demand growth outcome. On the supply side, the industry has reasonably high barriers to entry given the level of government regulation, which awards licences for new places every year. This oversight helps to keep occupancy levels across the industry high, an important driver of profitability.
Regis’ growth strategy is based around a mix of acquisitions, greenfield and brownfield expansion. While the industry has experienced a reasonable level of consolidation over the last few years, the opportunity for growth via this method is significant given the high level of fragmentation that still exists. Brownfield expansion (that is, expansion of existing facilities) is typically highly value-accretive to an aged care operator as it allows the company to leverage off existing infrastructure, while greenfield projects (new facilities) complement the group’s overall growth.
The structure of capital funding in the aged care industry is an important element that encourages expansion, allowing the operators to earn an attractive return on their investment. Refundable Accommodation Deposits (or RADs) are paid by many incoming residents, which is refunded when the resident departs with zero interest attached. While RADs have some correlation with housing prices, supply and demand of aged care places and the quality of facilities has led to consistent growth in average value over the last decade. Aged care providers are able to use RADs for capital expenditure purposes and hence rising RAD levels have provided an additional level of balance sheet capacity for the operators. Recent aged care reforms by the Australian Government have also encouraged incoming residents to pay a RAD, which also allow aged care operators to pay a high proportion of their earnings in dividends.
Of the aged care operators, we believe that Regis is the highest quality. The company has a solid management team, as evidenced by the group’s high return on equity, margins relative to its peers and track record of expansion. Regis’ facilities are among the best in the industry, located in high socio-economic areas, which are typically associated with higher RAD values and residents who opt for “extra services” places (these attract a higher margin for the operator). Since Regis acquired Retirement Care Australia in 2007, it has made a considerable investment in its IT systems and thus does not have the potential implementation risk that the other two providers may carry.
Regis recently reported a solid FY15 result, easily beating the forecasts in which it set out in its prospectus last year. The company showed ongoing improvement in its occupancy levels, a lower staff cost ratio and higher revenue per bed. Regis has a large pipeline of expansion opportunities over the next few years, which is supported by ongoing increases in RAD cashflows. We recently added the stock to our model portfolio as a higher-growth small industrial company.