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WEEKEND LADDER

A summary of the week’s results

26.06.2015

Week Ending 26.06.2015

Eco Blog

The US economy looks likely to register close to 3% annualised GDP growth for Q2. Any signs the rate of momentum is fading may see the Fed’s rate rise expectations shift to December rather than September. While the labour market and consumer continues to report acceptable data, other indicators are less supportive, though this may prove to be due to the volatile energy and transport sectors.

In the early part of the year, retail spending had been patchy against expectations there would be a lift from the fall in energy costs. However, the release of May personal consumption data suggests spending is back to normal, running at 3% growth to date in the quarter.

A key component, housing, has been on a steady recovery post 2010 and could well pick up further into 2016. Mortgage applications are running at some 11% above last year. Purchase applications are up 18.1%, while refinancing is up 4.3% year to date. The average mortgage size was $290k for purchases, while for refinancing it was $233k. US house prices registered a decent improvement as well, with the average now at $337k (median at $283k).

The chart shows the unfolding pattern in the US mortgage market, with the refinancing component relatively steady while purchase loans have edged up faster than house prices (as measured by Case-Shiller) recording a 28% increase in loan value over five years, compared to a 17% increase in home prices. With the history of 2008 still imprinted in most minds, this may be concerning at face value, but it rather reflects the lag in price momentum in some of the more depressed areas of the US, such as New Jersey.

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First home buyers now make up a third of home sales, indicating that the job market itself is seen as solid. The share of 18-34 year olds living with parents had moved up markedly from a steady 26.5% over the decade to 2007, to peak at 31.5% in 2012. Since then, it has stabilised and conversely household formation has picked up. The data indicates that these households, after departing the family nest, initially rent before turning to purchase, as now appears to be the case. That, in turn, tends to flow into a lift in consumption spending, as furnishing and children become part of the cycle.

The tricky part for the Fed will be to judge how sensitive these trends will be to a rate rise. Indications are clearly now, too, that inflation is picking up from its lows. The improvement in household spending is being attributed to the significant recovery in household net wealth. Income and liquidity from investment wealth is naturally not part of the wages measure and is likely to be the predominant factor.  If wages momentum were to accelerate in coming months, the Fed’s job would be easier.

The Australian housing market does not escape the headlines. The table and chart below shows the sharp drop in ownership in the younger cohort and the likely cause: aversion to a high dollar debt (as opposed to the interest cost). In many ways this is quite sensible, as even without the practical experience, many would appreciate that current low interest rates cannot be banked upon.

Home Ownership Rate: 1982-2011, %

Source: ABS Surveys of Income and Housing
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Mean Mortgage Debt to Income Ratio

Source: Digital Financial Analytics
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The fall in home ownership plays out in overall financial well-being.  ABS data shows that net household wealth rose by 9.3% over the year, a combination of housing and investment markets. Inevitably, this is concentrated in those that have the largest net ownership in these assets, as the liability side has increased as well.

In Europe, we still await clarity on the Greek saga, and while 30 June looms as a date for repayment of the IMF loan, it may not trigger default as such. However, it is also increasingly in the interests of the EMU to close this chapter, even if it does open the door for further instability in the Eurozone in the future.

In the meantime, German data has been soft in recent months, while Spain is likely to have the best growth in Europe by some margin. Spain carried relatively high private sector leverage and, specifically, mortgage loans into the financial crisis. The unwinding of these and the easy financial conditions in Europe have been most beneficial to Spain, in contrast to Germany, which did not have the debt burden in the first place. Spain also undertook structural reforms, such as the consolidation of the cajas or savings banks and to the labour market. Whether the population will concede this recovery or hope for more from the ballot box will be evident by year-end given an election is due by December. As noted, it is partly with these issues in mind that the EMU negotiators are treading around Greece at this time.

Company Comments

Bad news was punished severely by investors this week, with Seek (SEK) and Flight Centre (FLT) sold off heavily after both companies provided a trading update. The first take on Flight Centre’s update is that it was a significant overreaction by the market. Flight Centre was previously guiding towards a FY15 profit before tax of between $360m to $390m and has now revised this to between $355m and $365m; a downgrade of 4% based on the midpoint of the ranges.

While Flight Centre’s international businesses have continued to perform well, it is its core domestic division that has been the primary source of its issues (which still accounts for around 80% of the company’s profit). The domestic demand environment has been weak for some time now. The reasons for this are varied, including: the negative consumer reaction to last year’s budget; an unemployment rate which has trended higher over recent times; a household savings rate which remains relatively high; and the overdue depreciation of the Australian dollar. As a result, growth in Australian leisure spend is currently tracking at just under 3%, compared to a longer term growth rate closer to 10%.

While the company could be excused from these broader cyclical problems that have affected the entire market, it has been the possible structural element of market share losses (as described in Flight Centre’s announcement) that has been of greater concern. For many years now, Flight Centre has defied expectations that it would begin to cede share to online-only operators. This has certainly been the case for the booking of products that are more commoditised, such as accommodation or simple point-to-point airfares. It has, however, held its ground with regards to more complex packaged deals, in which the customer typically seeks a more high touch approach.

The market’s reaction to Flight Centre’s announcement (the stock has lost around 20% since its announcement this week) suggests a much more significant extrapolation of market share loss for the company, even though the company pointed towards a narrow range of problem areas, such as domestic accommodation. We have held Flight Centre in our model equity portfolios and, following the sharp share price fall, we will be reviewing this position, noting that the stock is now trading on a relatively undemanding forward P/E of 13x.

Seek’s (SEK) revised earnings guidance implied an approximate 5% downgrade to consensus expectations, highlighting issues related to an IT upgrade undertaken by one of its key clients in its education division, TAFE NSW. The company also noted more moderate earnings growth into FY16 as it steps up its reinvestment across the company.

While Seek’s education division (in which it partners with tertiary institutions to deliver online courses) provides a nice counter-cyclical exposure to its dominant domestic employment classifieds business, it doesn’t share a similarly strong competitive position. Seek’s education business has had a mixed record over the longer term, although its performance in more recent years has been better. With disappointing earnings from this division, a lower margin outcome in future years as a result of higher investment costs and  the stock trading on a premium P/E rating, the 14% decline in Seek’s share price is somewhat understandable. 

FlexiGroup (FXL) also experienced a difficult week after its CEO, Tarek Robbiati, announced that he would be stepping down in the second half of the year to return overseas, just 2 ½ years into the job. Under Robbiati’s leadership, FXL has largely continued its strategy on acquisitive growth, with a more refined focus on the end customer and a higher investment in its information technology platforms. The benefits of this should be further realised over the next 12 months, although there is a possibility that in this transitional period that the company may miss out on further acquisition opportunities. FXL remains one our preferred exposures in the small financials sector, with its market leadership in what is a fairly niche market. The chart below shows that the company screens well on a common metric used to compare lenders – book value vs return on equity.

Financials: Price to Book Ratios vs Forward Return on Equity

Source: Bloomberg, Escala Partners
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IOOF’s (IFL) share price also came under pressure this week, although for entirely different reasons to that of FLT and SEK. IFL fell after a newspaper report with allegations of insider trading, front running and various compliance breaches in one of its equities research divisions. It is difficult to assess the financial impact that this will have on IFL, with any potential penalties yet to be determined from an ASIC investigation which is now underway.

The share price decline this week would imply quite a significant impact from indirect consequences, such as reputational damage to the company, the resulting outflow of FUM and an increased spend on improving its compliance oversight. If the alleged behaviour was limited to just one of IFL’s brands (which may be the case), this highlights the risk of companies that have grown their business via numerous acquisitions over the years and the challenges involved in integrating not only systems, but overlaying the culture of the acquirer. Conversely were there to be minimal impact to earnings, IFL will begin to appear on value screens of fund managers. In our model portfolio, we currently have exposure to the sector through investments in AMP and Macquarie.

Potential corporate governance issues also impacted the share price of law firm Slater and Gordon (SGH) as it emerged that the UK’s Financial Conduct Authority had launched an inquiry into recent financial accounts of Quindell. In March, SGH announced that it had acquired the professional services division of Quindell, which would make the company the market leader in personal injury law in the UK. The issue relates to specific accounting policies undertaken by Quindell, including what appears to be an “aggressive” policy with regards to when revenue was recognised. When SGH made the acquisition, it had restated this revenue lower so that it was consistent with its own (more conservative) revenue recognition policy. To us, this highlights the importance of reconciling earnings with cash flow when undertaking fundamental analysis; further investigation is warranted where discrepancies arise.

Woolworths (WOW) was back in the limelight, with press reports of possible interest from private equity. Many global private equity firms are on the hunt for investment options, having realised many holdings in recent years. Low interest rates and the leveraged loan market play a big role given the typical leverage in these deals.

Those with long memories will recall that Woolworths was subject to such actions back in the late 1980’s. Could this happen again? The question is how a private investor could realise enough value. Closing Masters would almost certainly be a priority. In October this year, Lowes, as a 33% participant in WOW’s hardware holding company, Hydrox, can give notice that it will exercise its right to require WOW to buy out its interest within 13 months. Taking that into consideration, the lease obligations and other closure costs, the investment community estimates it would cost around $1.5bn gross to exit Masters. There would be assets that can be realised, predominantly property, which would pare back the net loss to possibly somewhere in the $750m mark, though there are a host of assumptions within this. However, given forecast operating losses just shy of $200m this year, that might not be such a heavy price to pay.

Some suggest Big W should also be sold, but we see little chance of a buyer for this business and it should be able to return to at least cash flow break even. An aggressive private equity firm may contemplate selling its New Zealand (some 8% of group earnings) and hotel operations (around 6% of earnings). That would leave it to stage a recovery in the grocery business in Australia. Perhaps this also makes the deal less likely, as this is far from an easy task. Woolworths problems are not so much the typical private equity deal of costs out and restructuring, but reconfiguring its consumer facing side. In today’s world, we should never say never, but Woolworths does not strike one as the likely candidate for private equity at this time.

Stock Focus: TPG Telecom (TPM)

TPG is one of Australia’s largest telecommunications companies, with a strong position in the provision of fixed broadband. The company primarily services the retail and small business segments of the markets, with its offering including broadband, fixed line phone and mobile.

As we have highlighted before, we believe that the construction of the National Broadband Network (NBN) over the next decade will change the competitive broadband landscape over the next decade, as customers are forced to transition their legacy copper network-based DSL connections to a new NBN connection. We believe that the more level playing field that will result will see smaller telcos (such as TPG) well placed to increase their market share, particularly in regional areas that are currently dominated by Telstra. As consumers have their copper fixed line switched off, this will trigger a review decision of their telco provider and plan. While Telstra is still expected to remain the dominant telco company thanks to the strength of its brand, we expect that other factors will become increasingly important for consumers with their decisions, including pricing, customer service and the unique content that can be delivered by their provider. The reworked structure of the national Coalition government’s NBN plan should be beneficial to TPG, as it includes a faster rollout of the infrastructure than previously planned.

TPG has a point of difference compared to most other telcos in that it is the owner of a network that will have the opportunity to compete with the NBN in metropolitan areas, called the fibre-to-the-basement (FTTB) network. The FTTB is a fibre network that will cover around 500,000 premises in major metropolitan centres. TPG announced the product just over 18 months ago and was officially released in September last year. To date, there has been some disruptions in the rollout of these plans, with TPG forced to functionally separate its retail and wholesale businesses as a requirement to sell the product. We believe that the opportunity to win market share with this network is significant, which will be priced competitively and allow the company to earn an additional wholesale margin on its assets.

TPG has effectively grown organically and via acquisition over the long term. It has a reputation for being the market leader with regards to the pricing of its plans, which has been key in driving consistent new subscriber growth over time. Of the major telecommunication companies, TPG has the most efficient cost base, and despite its low price point offering, it has enjoyed high margins due to this competitive advantage.

TPG also has had a strong track record of growing via acquisition. Most of these have been smaller in nature, consolidating TPG’s position as one of the primary alternatives to the big telcos. In more recent years, the scale of these has become more significant, with the purchase of AAPT 18 months ago and the current proposal on the table to purchase iiNet. TPG has achieved iiNet’s board support for the proposed acquisition with a superior offer to peer M2 Communications (MTU). While the offer has been placed at a high premium, the synergies involved in combining the two groups are substantial and are expected to be up to 15% accretive to TPG’s earnings per share. iiNet shareholders will vote on the proposal at a meeting in four weeks. 

Outlook

While the iiNet acquisition would be the final major acquisition opportunity for TPG, the purchase has strong strategic merit, lifting it to second place in terms of Australian broadband subscribers. The medium to longer term outlook for the company looks robust, as it leverages its low cost model to drive market share gains from Telstra as the NBN is rolled out nationally. We have recently added the stock to our model portfolios.

Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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Source: Bloomberg, Escala Partners
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