Week Ending 26.02.2016
While the RBA does not specifically note wages in its deliberations, it may be encouraged by the low growth in labour costs, combined with the fall in the currency to date, in addressing the relative competitiveness of Australian industries. Q4 wage growth was a subdued 2.2% on an annualised basis, with private sector wages rising at below 2%.
However, to match OECD labour costs the currency would have to fall below 65c/USD, or wage growth will have to edge down even more.
Labour Cost Comparison and Currency Impact
Low labour costs are likely to keep inflation in check for some time, allowing the RBA to contemplate the interest rate trigger. The recent flurry of commentary on the housing market may also be helpful in a perverse way, in that lending constraint to property investors is necessary if interest rates are to fall further.
Locally, there is consensus that the banking sector is in a reasonable position to weather a fall in home values. While that won’t stop sentiment from holding back the performance of the stocks and a rise in bad debts is inevitably at some point, there is agreement that a major issue for the banks will not arise from housing unless unemployment is over 8%. Of course, under such conditions, bank equity will be far from the only trouble spot. Recent analysis by The Federal Reserve of New York shows that in the US, the 2008 crisis was not a function of the absolute level of mortgages, but the number of defaults. In the US, the incentive to default is clearly higher due to the non-recourse nature of lending and while here housing investors are more likely to walk away from mortgage debt than owner-occupiers, the consequences are still a lot less problematic than in the US.
The US housing market appears to be holding up without causing concern of overheating. Interest rates are tied to long term bonds and therefore the fall in bond yields has reduced the effective interest rate. An average loan size of US$289,200 also leaves US housing within affordable boundaries.
Early indications from other data, such as durable goods orders, suggest that discussion on a possible recession in the US is premature. A broad-based recovery in activity has emerged post the slump in December.
Headlines of ‘Boris Backs Brexit’ spoke as much to the unusual set of names that hold sway in public debate in many countries, as it does to the question of the UK leaving the EU. While the perception is that exiting the EU will be bad for the business sector, many others are of the view the outcome is finely balanced. At first blush, the risk alone means the BoE will hold rates for now, which did result in a sharp downward move in the GBP. The other arguments are somewhat convoluted. If Britain were to leave the EU, both consumer and investment spending are expected to take a short term hit until its clear what repercussions there will be. Trade arrangements present downside risk, while greater flexibility on business regulation may work in the UK’s favour. A big picture issue is whether Brexit would result in a change in the EU itself to deal with the disparate attitudes and requirements of the members.
The fall in the GBP, however, raises another issue. Even a small currency appreciation, along with the global widening in credit spreads, implies tightening financial conditions, and again that leans towards easing interest rates in many domains.
Fixed Income Update
Fixed income markets remained orderly this week, with limited movements in rates and credit spreads. The only issue of note was increased funding costs for Australian banks after spread widening on their credit default swaps (CDS). As a reminder, a CDS is a contract that investors buy if they want to ‘insure’ their portfolios on the credit risk of an issuer. The CDS spread is closely linked to the premium an issuer pays for funding over the risk free rate. The CDS on our bank debt vs banks in the US is at its highest spread in 10 years.
As a guide, NAB issued a senior unsecured 3 year deal last week, which at a credit spread of 98bp over BBSW, is 10bp higher than where ANZ issued for a similar tenor last month. CBA also issued a 3 year deal in October last year at BBSW + 78bp.
The rationale cited for the spread widening in Australian banks relative to the US is firstly, the perceived risk in our housing market and secondly, hedge fund shorting Aussie banks against a downturn in China and commodities.
As discussed last week, CBA brought to market a new bank hybrid deal, Perls VIII to replace the maturing Perls III. The issue size was $900m (below the expected size of $1.25billion) for a 5.5 year capital note that converts to equity in 2023 if not called. The price was set at BBSW + 5.20%. Only 17% of holders of Perls III are said to have rolled into the new deal. While the pricing was at the tighter end of CBA’s range, we believe expectations were for a higher capital raising (issue size) through a greater conversion rate from existing holders of the Perls III.
Also this week, Westpac issued a 5 year non-call 10 year (5NC10) subordinated bond at BBSW + 3%. With a coupon that is 2.2% lower than that of the CBA bank hybrid discussed above, we thought it a good idea to once again highlight the differences between a banks subordinated bonds and hybrids. These differences in risk are the reason for the price differential.
In theory, subordinated debt is ranked further up the capital structure than hybrids. However, under Basel III, all new subordinated bond deals and bank hybrid deals have to include a ‘non-viability’ trigger, which will come in to play if APRA deems the bank at risk. At this point the bonds will be converted to equity, therefore ranking equally in the event of liquidation. This begs the question as to the benefit, in terms of capital preservation, of owning a subordinated bond over a bank hybrid security? And is this enough to compensate giving up the higher return?
The devil is in the detail, and the below table highlights the main risks that exist between these bonds and explain the pricing differential.
Differences Between Bank Subordinated and Hybrid Bonds
Spotless Group (SPO) made its first steps in restoring investor confidence, following its surprise earnings downgrade late last year, as it reported earnings in line with this guidance and reaffirmed its full year outlook. With no new issues uncovered by the company’s recently appointed CEO, management expressed confidence that the integration problems of acquisitions that led to its earnings downgrade will be resolved by the end of the financial year.
Spotless’ presentation also addressed a number of ongoing concerns that have been raised in the last six months. The company’s margins were largely maintained, despite the fact that acquisitions have generally been lower margin than its core business. Additionally, new contract wins have been on comparable margins to historical rates and its win and renewal rate on contracts has also been relatively steady. SPO outlined its longer term opportunities across its various sectors in the table below.
The key criticism of SPO’s update this week was a poor cashflow for the half, although this appeared to be influenced by several one-off factors which should reverse in the second half. Achieving this, as well as successfully addressing its integration issues, would see SPO well placed to deliver solid earnings growth into FY17. With the ongoing solid performance of its core business, a greater contribution from higher-margin PPP contracts and better outcomes from its acquired businesses, the stock remains good value on a P/E of less than 10X.
In a widely anticipated move, BHP Billiton (BHP) became the last of the major diversified miners to drop its progressive dividend policy when it announced its half year results. The company has instead adopted a more appropriate payout ratio, with a minimum of 50% of earnings to be paid in dividends. In the medium term, the notion that BHP could retain some appeal as a yield stock has been quashed, with its trailing yield of in excess of 10% likely to be cut to less than 2% on a forward basis. There has been a rapid shift in BHP’s fortunes over the last two years, from the possibility of additional capital returns to this week’s announcement. Many in the industry have been caught out by this transition, including BHP, which noted that the “rate, magnitude and correlation of decline in commodity prices has surprised”.
BHP’s dividend announcement overshadowed a result that fell short of expectations. With asset impairments pre-announced, underlying earnings dropped by 92%, highlighting the challenges for the mining sector, even for those that have the lowest-cost assets in the industry. BHP’s petroleum division, once a positive distinction with its global diversified mining peers, has turned into a negative point of difference (at least in the short term) following shifts in OPEC’s policy and decreasing relevance in global oil markets.
BHP’s credit rating remains the strongest in the sector, yet in the short term the company will have to continue on its path of capex and cost reduction in order to maintain its single A S&P credit rating. Ultimately, while the company has made good progress as it has adapted to the changing market conditions, a turn in the commodity cycle will be required in order to see earnings growth again restored. Lower demand growth and resilient supply has combined to drive commodity prices lower in recent years and the hope rests with supply cuts, which would be expected to occur at some point given the high proportion of loss-making supply at current prices.
Proportion of Industry Supply Loss-making at Current Prices
Other results across the resources sector were similarly weak. South32 (S32) again reported a solid outcome on the aspects of its business that it can control. The company’s ability to achieve cost savings has been ahead of forecasts (to date is has effectively under-promised and over-delivered) and this program will continue over the next 18 months, with more extensive detail released with its results. For a miner with a weaker suite of assets than the majors, S32’s debt reduction in the last six months has also been impressive, placing the company well to withstand the current volatility across markets and capitalise on opportunities when the cycle improves.
Oil Search’s (OSH) full year result contained no new information of note, although was solid given the circumstances. Production was higher following a full year of contribution from its interest in the PNG LNG project, which continues to operate above its nameplate capacity.
Oil Search noted that it is cash flow positive at an oil price of US$20 per barrel, or approximately US$30 a barrel once interest and sustaining capex costs are considered. The company thus remains less stressed compared with some its listed peers and is aiming to consolidate this position further in 2016.
Meanwhile, OSH’s still has had funds available to progress its development pipeline, particularly the option of an expansion of the PNG LNG projects. OSH targets a further doubling in its production levels by the early 2020s.
Pointing to the strength of this opportunity is the ongoing spend on proving up the asset base, while expenditure around the world by energy companies has plummeted. In 2015, five major projects were sanctioned, compared with 50 in 2014. Exploration budgets are down 60-70% globally, while around a third of employees in the industry have been made redundant.
Should OSH and its partners proceed with an expansion of PNG LNG, they will likely do so in a cost environment that is far more favourable compared with the boom years across the resources industry. While we note that OSH’s share price has held up comparatively following the sharp drop in the oil price, it remains a preferred exposure for the dual reasons of comfort in riding out the current environment and future optionality.
Brambles (BXB) upgraded its earnings guidance for the first time in several years with a result that showed mixed performance across its key divisions. The company’s core pallets division had an excellent first half, particularly in the US, through a mix of organic growth, new contract wins, pricing and operational leverage. Earnings growth in Europe was more subdued, although BXB’s profit was boosted by better margins.
The similarities of the market’s reaction to BXB and Amcor (AMC) are worth highlighting. Both have a defensive growth profile in which investors have placed a premium on in the current equities environment; both reported ahead of expectations, despite some fears of slowing global economic growth; and the share price reaction to results was much better than what the implied earnings upgrade that would otherwise have been implied.
The key difference between the two companies likely comes down to the relative success of acquisitions over the last few years. Amcor has built considerable value, first with its purchase of the Alcan packaging assets, and then with several smaller bolt-on opportunities. On the other hand, Brambles has had less success in growing outside of pallets into other pooling equipment services, such as reusable plastic crates (RPCs) and bulk containers.
Brambles also reiterated its longer-term FY19 target of a return on capital invested (ROCI) of >20%. While the guidance excludes acquisitions that the company had made in the last two years, the group ROCI improved in the first half when adjusted for the impact of currency movements. The target suggests an EBIT for Brambles of US1.4bn in FY19, which would equate to an approximate US$400m increase from FY16, or a 12% p.a. growth rate. Further progress on achieving these targets (particularly an improvement in the lower-returning RPCs and containers divisions) should give Brambles a healthy premium to the broader market, although the stock may be marked down without any realisation in the second half.
Brambles Return on Capital Invested
Regis Healthcare (REG) reported a strong result, with 15% earnings growth for the six months. Underlying profit, however, excluded a known Federal Government taxation change that has affected the sector, with the removal of the Aged Care Payroll Tax Supplement, which was previously received by for-profit residential aged care providers. The ongoing tailwinds and otherwise strong conditions in the aged care sector has been somewhat overshadowed in recent months by further government funding risks, with a review of the current arrangements expected to take place later this year, although arguably this is now reflected following share price weakness across the board.
Operationally, REG performed well in the half. Occupancy levels edged up to nearly 95%, revenue/occupied bed also increased and staff costs were contained. REG also recorded growth in its average refundable accommodation deposit (RADs) from new residents, reflecting the quality and location of the company’s asset base. Growth in the RAD base is important for REG, as it helps to provide the capital to fund its growth strategy, which is a mix of brownfield and greenfield development and acquisition of existing facilities. We remain of the view that REG is a suitable investment for growth-orientated investors and believe that it is the highest quality of the three listed aged care stocks.
QBE Insurance (QBE) reported a solid result in a challenging global insurance market. After adjusting for currency movements and the disposal of its problematic Argentinian workers compensation business, premiums were effectively flat year-on-year. Despite this backdrop, the turnaround story is on track, with further cost out again helping the bottom line, along with the company’s best underwriting result since 2010.
The journey, evidently, has further to go, as the company’s expense ratio is still some 2% to 3% above its global peers. Management are targeting bridging most of this gap over the next few years and the confidence in achieving this was reflected in a significant increase in the final dividend. Margin guidance for 2016 appeared at first glance to be relatively flat, although excludes any reserve releases which have been a feature of the last three halves.
QBE’s investment income was lower again in 2015 and with yields down again in the early part of 2016, the prospect of much improvement for this year appears low. Nonetheless, the company’s leverage to higher short term interest rates remains and the stock thus provides an attractive hedge to the large number of ASX-listed stocks that would be negatively impacted by such an event. We prefer QBE for insurance exposure in portfolios for this reason and its more attractive earnings growth profile compared to domestic-focused peers of Suncorp (SUN) and IAG.
Flight Centre’s (FLT) result was respectable considering the headwind of a stronger $A. While the company is building its presence in international markets, the domestic business is still key. Outbound travel by Australians has slowed in the last 12 months, although pleasingly for FLT, total transactional value (TTV, or the value of bookings through the agent) grew at nearly twice the rate. Outside of more cyclical elements, ever-lower airline ticket prices (see table below) remain the primary longer-term driver of demand. Margins, however, were lower in most regions, with FLT pointing towards higher investment in sales and marketing.
FLT continues to evolve with its changing market and has perhaps defied some critics that suggested it would struggle under the weight of online competition. Investment in acquisitions, new brands and increasing interchangability between booking mediums (in store, phone, online) has helped to arrest a perceived structural decline against its traditional format. With guidance maintained of ~6% earnings growth, a debt-free balance sheet and relatively attractive valuation, we have the stock in our model portfolios.
Airfare Changes Over Last Year
Wesfarmers (WES) net profit was in line with estimates, but masked a more difficult outlook. At a headline level a 5% revenue growth resulted in a somewhat skinny 3% EPS rise. Coles and Bunnings contribute around 70% of earnings with some divisions, notably resources, a drag on the group. We have for some time held the view that the conglomerate structure of this company is no longer a benefit and that even if the capital allocation discipline from head office is a core attribute, it is now overwhelmed by the underlying conditions for the divisions.
Coles supermarkets did well at a headline level with revenue growth of 6% and unquestionable market share gains. There was however considerable commentary on the flat margins. Coles has focused on getting its prices right, with a broard programme of Every Day Low Prices (EDLP), home brand and special offers in fresh produce. It may be that higher margins in supermarkets are unrealistic. The combination of Aldi and the ever-possible resurgence of Woolworths suggest Coles should stay focused on giving up some margin to maintain its competitive pricing. Inevitably there will be pressure on costs to achieve higher profit. The key will be to manage that without compromising service standards and stock availability.
Margins at Bunnings were also tight, albeit at relatively high levels. Disruption from clearance activity at Masters may cause some shorter term volatility, but otherwise this business should be able to capture most of the incremental housing-related spending. The oversight of Kmart and Target now falls under one executive. Kmart’s profitability is three times that of Target, driven by its success at direct sourcing, but both operate in a difficult segment. Reducing costs through sharing of functions may protect it against some of the risks it faces.
With the resources division in the red for the foreseeable future and tough trading in chemicals, industrial and safety, WES earnings growth rests on consumer spending. The stock has retraced its recent rally off this report and we would expect a soft patch until a catalyst emerges. This could include a view on a shift in direction at WOW post appointment of the CEO, internal restructuring or a change in fortunes for one of its divisions.
Woolworths’ (WOW) result did little to engender confidence a turnaround was emerging. Food and liquor edged up 0.7%, with most of that from its liquor division. Comparable sales fell 0.6%. Unsurprisingly, as the numbers show below, operating leverage put pressure all metrics. Margins are expected to fall again in the second half.
Woolworths Earnings and Margins
None of the strategies aiming towards a better outcome are a surprise – stock availability, promotional effectiveness, product price structure, customer experience and loyalty programmes, amongst others. Elsewhere there was little to please investors. Big W EBIT slumped 39% and hotel earnings fell 7% due to the rise in rental costs post asset sales.
The spotlight was also on the appointment of the current head of supermarkets, Brad Banducci, to CEO. This comes some nine months after O’Brien announced his intention to retire mid-2016. The market is likely to have preferred an external candidate to add fresh management to the group and make hard decisions unencumbered by allegiances to existing senior staff. It became clear, however, that good global candidates where not interested enough in the WOW CEO role and that an internal appointment was less risky than a non-retail local. The reality is that there are no easy solutions to pursue and investors face a tough path ahead.
A trifecta was not in the making for Super Retail (SUL). Its Auto and Sport businesses did well, but the Leisure division saw a sharp fall in margin. The stock price was duly punished. Hindsight is proving that the Ray’s store group (acquired some years ago) had poor locations, pricing and a dated product assortment. The potential from a store group focused on outdoor activities still holds true, however. Head office costs included unused distribution facilities, a combination of redundant space yet to be rolled off and new facilities that are not fully utilised. Costs associated with online have also been expensed.
In the trading weeks this calendar year the sales momentum in Auto and Sport has, if anything, picked up even more. Sales in leisure now appear to be heading in the right direction, but margins are expected to fall again in H2. SUL has been a less-than-stellar performer in recent times, yet has managed to hold its head above the ASX200 over the past year. While some may lose faith, we are inclined to hold through to mid-year to see if the recent momentum can be sustained.
A 30% increase in net profit was not enough for Harvey Norman (HVN) shares to rally, though the stock has done well over the past year, absorbing the housing recovery. Many investors, however, remain skittish on HVN due to the potential profit share swing in favour of franchisees and the investment adventures outside of the retail business. A reminder of these activities is the writedown of mining camp accommodation and the equity loss from the recently acquired interest in farming. While relatively small in the context of the business, it does reflect the few growth options the group has in its core domestic operations. Store closures make HVN the only Australian retailer reporting higher comparable than headline sales growth.