Week Ending 26.08.2016
In the everlasting search for some formula to push economic growth higher, old ideas and new thought bubbles emerge. The oldest idea is fiscal spending. A universal view that much of the developed world’s infrastructure is dated inevitably leads to a call for governments to invest given the low cost of debt. This argument is perhaps most applicable in the US where the practical experience for many would support a strong case to improve infrastructure. The evidence is in the low share of spending as a proportion of GDP.
US: Real Government Non-Defence Investment as a Share of GDP
The bulk of these outlays are on water and transport and while the decline does not look that terrible, the fall has essentially been all in new investment, as the cost of maintaining the old infrastructure has risen. Both sides of politics have stated that they want to increase spending. Unsurprisingly, Trump has indicated he would double any amount Clinton put forward. Either way, it should be a boost to growth, though it may take a few years to flow through.
Over the weekend, the prognostications from the Jackson Hole symposium will hit the financial cyberspace. Yellen is lined up to talk Friday 10am Wyoming time. Befuddled economists have grumped about the apparent changes in communication from the Fed this year. Post the wobble in financial markets in February 2016, the language turned dovish, by April it had taken on a neutral stance and with better than expected labour trends went hawkish in June. Cum Brexit, a neutral stance returned and at this time that is exactly what markets are saying – it is a 50/50 call on a rate rise this year. Given the subject matter for this year is the Federal Reserve’s monetary policy toolkit, it may well be that the focus is on the increasing inability of rates to move the economy, rather than provide much of a signal.
Different solutions to a slow economy, aside from fiscal and monetary, receive mention. Concepts such as nominal growth targets or minimum income levels have gained airplay and then are shot down due to a lack of any supportive evidence. Locally, fiscal stimulus gets a mention too, in an effort to compensate for the slump in construction and mining spending, or a retracement of housing activity. As in the US, it may make sense given low rates and some areas where spending can improve productivity, but the need is not as pressing as in the US. Instead, others suggest Australia would be better served from a change in labour regulations, tax structures and regulation.
Much to the amazement of many long standing cynics, France’s labour laws are set to change. Restrictions on the implementation of hours worked have been relaxed and agreements can be formed at a firm level rather than a branch level. This means different parts of a business can adapt to their own set of circumstances. Unionisation in France is notably lower than other European countries and for the private sector averages below 5%. The previous legal procedures, however, gave an indirect coverage to agreements of around 90% of the workforce.
Unionised Ratios Across Countries
France has suffered a highly uncompetitive wage rate for some time, currently sitting at approximately double that of Spain or Portugal. Whether these changes can change that trend or lift productivity to German standards where the wage rate is about the same, is the bigger challenge.
So far, Europe has mostly stepped over the Brexit outcome. The production index for August indicates a continuing expansion, pointing to GDP growth of 1.2% for the year from the Eurozone.
Eurozone Economic Growth and PMI
Fixed Income Update
The order book for the new ANZ bank hybrid closed on Tuesday this week. As discussed in last week’s publication, this is a replacement of the ANZPA security due to mature in December. The structure is a capital note that converts to equity if not called in March 2024 (7.7 year). The issue size is ~$1.3 billion at a price of BBSW + 4.70%. This is expected to be the last bank hybrid to come to market this year, and given the issue size is lower than the maturing ANZPA securities ($1.9bn) supply is restricted. The demand for this new issue (code ANZPG) is said to have been high, with holders of the maturing hybrid and new money orders scaled back.
The pricing of ANZPG securities was broadly in line with where similar types of securities are trading in the secondary market. Despite this hybrid being longer dated than most of its peers, investors were paid a higher ‘yield to call’ for the extended maturity. Pricing in the secondary market is constantly changing, but the below chart shows the relative value and comparison of this new hybrid to others in the market at last week’s pricing.
Grossed Up Yield to Call Date of Listed Bank Hybrids
Elsewhere in the domestic listed debt market, Origin Energy Notes (ORGHA) continue to trade close to their par value of $100. The price on this security traded down to $90 in February this year as oil prices troughed and equities tumbled. However, the price has grinded higher since March as Origin have publically announced their intention to call this bond. The company reiterated its intention to redeem ORG Notes (ORGHA) by the first call date in December 2016 in its results presentation last week. The chart below illustrates the price movement of the bond over the course of 2016.
Origin Energy Notes in 2016
Similarly, Crown Subordinated Notes (CWNHA) are now trading close to par following Crown Resorts’ earnings report last week. Many market participants have voiced their concerns on Crown being able to maintain its investment grade rating, on speculation earlier this year of a potential privitisation of the company. Rating agency Standard and Poor’s has made no revision to its rating on Crown (BBB, stable outlook) following its results and stated that “performance of the core Australian assets, particularly Crown Melbourne, was solid and continues to underpin the group’s credit quality.”
Moody’s also affirmed Australia’s sovereign rating at Aaa/stable last week, but revised the Australian major banks to a negative outlook. This is in line with S&P’s negative outlook on major bank ratings.
In offshore markets, China has been making efforts to integrate more fully into the global financial system, leading to a relaxation of rules in financial markets. Although it is the third largest bond market in the world, sales of onshore bonds by foreign organisations – known as panda bonds – remain limited, accounting for less than $3bn of the $7.4tn market. Poland is planning to become the first European country to issue debt into China’s mainland bond market with a sale of renminbi-denominated bonds this week.
Global credit spreads have contracted slightly over the week (prices up) as corporate bonds continue to perform. Demand for bonds in riskier sectors has also remained, with emerging market debt funds receiving a record $20bn in flows over the last seven weeks. The index for US high yield bonds (i.e. below investment grade bonds) has risen 15% this year, despite the huge sell-off in this market in January and February. While default rates in this sector have risen to a six year high of 4.5%, they are notably still below the historic average.
Wesfarmers’ (WES) group EBIT before abnormal items fell by 4%, mostly due to the drag from its resource division and a loss at Target. This headline number however, plays second fiddle to the specifics of its two predominant divisions of Coles supermarkets and Bunnings.
Wesfarmers: Divisional Returns on Capital
Disconcertingly, Coles’ comparable sales growth eased to 3.3%, its lowest rate in some years. Food inflation has been low for some time, but the strong gains in market share appear to be abating. As important, margins were weaker in the second half. The cost of pricing to an ever competitive market may well weigh on profit growth in the coming few years. Coles has tapped up its price points on lines less subject to scrutiny and this could well bite back when or if Woolworths finds its way forward.
Both its hardware and discount operations face new challenges. The acquisition of a UK-based homewares retailer will provide some evidence on whether Bunnings’ success is due to its local dominance, or whether it has a transferable retail format. Kmart sales growth has continued, though the lower AUD has resulted in a small fall in margin. The debate turns to Target and if there is to be any renaissance there it will be at the expense of Kmart.
The retail outlook for WES is not getting better and its other businesses present a mixed and unpredictable bag. The small cut in its second half dividend aligned the payout to earnings, yet is still an uncomfortable 94% of earnings.
It is hard to build an interesting upside case for WES. The businesses are mostly mature with competition and cyclical headwinds. Resource earnings may bounce in 2017, yet as these are so variable it is difficult allow for in the valuation. While some earnings growth is still likely, it is expected to be in the low single digits on a rolling 2-3 year basis and some de-rating of its 20X P/E is probable in coming years.
In the meantime, Woolworths (WOW) is extracting itself from its painful effort to gain a foothold in the hardware and homeware sector. The cleanest part of the deal is the sale of the majority of the smaller Home and Timber Hardware to Metcash for $165m. Metcash is, in turn, undertaking a placement to cover some of the capital outlay. Masters’ store inventory will be underwritten by GA Australia, a specialist organisation in realising inventory. The freehold stores will, in part, be sold to Home Consortium (Spotlight, Chemist Warehouse and Aurrum) while some sites will be retained by Woolworths, presumably unattractive to the consortium. The bottom line is likely to be net proceeds of $500m, which has to be shared with its joint venture partner, Lowes of the US. WOW and Lowes have found little to agree on in recent months and the resolution of the final outcome may take time. WOW is unlikely to end up with much more than $200m after taking into account the residual assets. While the finalisation of Masters will be a relief to management, the capital that went into the business, cash losses and management distraction at great cost to shareholders.
This preceded a sigh of relief which came with WOW’s full year result, as it appears the worst is behind the group. In the last few weeks, supermarket sales have turned positive, albeit by only 0.8%. Nonetheless, investors seem to be reassured that the work being put into improving the in-stock availability and refurbishment of the stores would continue to support some sales momentum. The question is the pace and cost to margin and on this front, the management gave qualitative rather than quantitative guidance. That leaves scope for further share price swings either way as the outcome moves ahead or behind expectations in coming reporting periods. WOW’s supermarket profit margin is about 87bp below that of Coles. The case can be readily made that there should be little difference between the two and that WOW should have a small advantage given a larger footprint as well as what is judged to be a geographic advantage, particularly in NSW.
But the pressure on the sector overall through low food inflation, changing habits and Aldi suggests the stable duopoly dynamic of the past is less certain. The underlying value of the business is therefore vulnerable to small changes in assumptions. As a company, WOW also has limited potential outside its existing businesses, none of which have much more growth than nominal GDP + 1-2%. In the near term, a 21X P/E for 2017 and thin dividend after a cut to a 3% yield may restrict any further upside. However the probability is now that any good news see off investors with negative views.
It was a case of two out of three for Super Retail’s (SUL) earnings for FY16, with excellent performance across its auto and sports segments and a disappointing outcome in leisure. The latter resulted in an impairment and restructuring costs incurred in the year, leading to a net profit decline. On a like-for-like basis, SUL’s auto division achieved 4.4% growth in sales while its sports business generated 6.3% growth. Margins were also higher across the two, with improved gross margins and cost control impressive.
The drag, as expected, was the earnings in its leisure business (Ray’s Outdoors and BCF). Leisure has proven to be a challenging product segment for SUL, however the restructure of the division is now well underway and has involved some store closures and others converted to a new format. While legacy Ray’s Outdoor stores again delivered a poor sales figure outside of clearance activity, the performance of the converted stores and BCF business was more promising. Continuing this turnaround and the ongoing good momentum in the company’s other two divisions provide a solid base from which to grow in FY17.
Given the challenges presented by the fall in the oil price, Oil Search’s (OSH) half year result was commendable. Production was lifted again in the six months thanks to the ongoing strong output from the PNG LNG project, while cash margins were protected by a reduction in unit costs after a 33% decline in sales revenue. For the period, OSH reported an operating cash flow breakeven oil price of $US28/boe (which includes operating costs, interest expense and principal repayments, and sustaining capex). While this approximately was equivalent to the low oil price point in early February, the subsequent recovery meant that the average realised price for the half was above US$40/boe.
Oil Search: Cash Flow Break-even Analysis ($US/boe)
OSH also provided further clarity on the likely path forward for further LNG development following ExxonMobil’s successful bid for InterOil (having outbid a combined Oil Search and Total offer). While the InterOil gas fields could potentially be developed as a stand-alone, greenfield LNG project, the likelihood of integration with the existing PNG LNG project is high, given the savings that would accrue to all partners (including OSH). Following completion of the deal, OSH plans to participate in discussions around a cooperative development later this year and thus this will be an important catalyst in the next six months. With low cost operations and the most attractive growth options among the large cap stocks in the sector, we continue to recommend OSH as our preferred holding in the energy sector.
Vocus Communications (VOC) produced a strong result this week for FY16, in contrast to the more challenged status of its larger competitor, Telstra. The year was one of significant transition for VOC as it built itself up into a viable competitor to the larger telcos, with acquisitions of Amcom, M2 Group and (subject to regulatory approvals) Nextgen. The three acquisitions have enabled VOC to become a vertically integrated telco covering both the consumer and corporate sectors of the market.
While it was difficult to get an accurate read on the level of organic growth across the business due to the scale of VOC’s acquisitions, growth in consumer broadband subscriber numbers was a positive and the company noted that it had increased its market share of NBN connections and reduced churn levels. While top line growth opportunity for VOC is large over the next few years, the predominant driver of earnings growth for FY17 will come from the substantial acquisition synergies that the company is targeting.
We continue to believe that the VOC and TPG Telecom are better placed to benefit from Australia’s changing telecommunications market. On a forward multiple of 21X, VOC may look fully valued, however this would appear to be more than justified if it can deliver the 28% p.a. earnings growth as forecast by analysts in the next two years.
After a disappointing year, all eyes were on Spotless Group (SPO) to deliver on its downward-revised earnings guidance, with the company receiving a pass mark. The key positives to come out of the result were a resolution of the integration issues from recent acquisitions in its laundries business that were responsible for the company’s earnings downgrade late last year and a good pace of revenue growth, up 11% over the year.
SPO also informed the market last week that it was no longer going to proceed with a potential divestment of its laundries division after it received a number of unsolicited proposals for the business. A divestment would have been viewed favourably by the market, as it would have cut off the most capital-intensive part of SPO’s businesses, paving the way for more corporate interest in the group given its cheap relative valuation to its global peers.
With a new CEO, SPO outlined its strategy going forward, which included a priority of organic over acquisitive growth (unsurprising given the recent performance), prioritising high return, low capital intensive sectors and increasing contract win rates by focusing on fewer but larger opportunities.
The last measure was somewhat disappointing for SPO in FY16 as, while its win rate on bids was consistent with its recent history, by value it underwhelmed, missing out on some of its larger bids. Cash flow generation was also below expectations and this will be a key metric that will be watched for evidence of a business turnaround. Cycling this difficult period for SPO should result in a better result in FY17 and the company will also be aided by a number of high-margin public private partnerships (PPPs) ramping up in the year. For the time being, SPO continues to screen as good value for what should be a ‘GDP plus’ business, particularly given elevated valuations across the market, although delivery over the next six to 12 months will be critical.
Spotless: Public Private Partnerships (PPPs)
Amcor (AMC) reported one of the better large-cap industrial results of reporting season to date, beating expectations after hitting a hurdle in recent months when it revealed problems with its business in Venezuela. The stock has re-rated over the last years on the back of its defensive growth characteristics, which were again evident in FY16. Relatively modest 4% revenue growth (on a constant currency basis), with an uplift in margins increasing net profit to 7% growth, complemented a share buyback, which left earnings per share growth at 11% for the year.
AMC’s earnings was again a mix of organic and acquisitive, while 8% growth from emerging markets (which account for approximately a third of AMC’s sales) dispelled some of the fears that had been raised recently. The outlook for FY17 was one of confidence, with its core flexible division expected to “deliver particularly strong profit growth”. A larger number of bolt on acquisitions made through FY16 will support this outlook. We have AMC in our model portfolios as a core industrial company.
Amcor: Recent Acquistions
Star Entertainment (SGR) edged above consensus for the full year, with a mixed bag of trends contributing to a 14% increase in EBITDA. Gaming revenue at the company’s casinos increased by 7% over the year, although would likely have been higher if not for the disruption of some capital works across its properties. Revenue from high rollers also increased at a similar rate, despite cycling a tough comparable figure from FY15, and SGR’s win rate was higher in the second half after it experienced a run of bad luck in the first half. Good cost control allowed the group to expand its margins over the year.
After receiving a significant boost from its previous investment in improving its casinos (particularly the flagship Star casino in Sydney), SGR’s capital investment is set to be higher in coming years as it expands its Sydney and Gold Coast casinos and it commences the development of its new Queens Wharf project in Brisbane (as part of a consortium). Each of these projects plays into the favourable investment theme of increasing tourism, underpinning the expected demand profile going forward.
Fruit and vegetable grower Costa Group (CGC) reported its maiden full year result after listing 12 months ago, recording earnings growth of almost 30% for the year. Earnings were better than prospectus forecasts, with mostly positive performance and conditions across its key produce, offset by price deflation in the banana and tomato categories. Fruit and vegetable pricing can be variable year on year and can be largely dependent on weather conditions. With yields strong in the past year for tomatoes and bananas, the industry has endured a period of oversupply, reducing prices and margins for growers. Of these two, only tomatoes is considered a core CGC category, while more favourable conditions were experienced across CGC other key divisions.
Expansion in CGC’s berry business (blueberries, raspberries and strawberries) was a key plank of the top line growth of the business, and this will feature in the next few years as the company looks to profit from a fast-growing demand profile in Australia, with several projects in place. The contribution from its international berry joint ventures also stepped up in FY16 and this is set to be a significant longer term growth platform for the company. CGC is guiding towards 10% profit growth in FY17, which makes the stock look quite attractive on a below-industrial P/E of 16X.
Costa Group: Fruit and Vegetable Price and Industry Volume Growth
The share price of Regis Healthcare (REG) has been particularly volatile over the last 12 months, with swings largely driven by the changing government funding profile for the aged care sector as opposed to the better operating performance of the listed stocks. Despite the uncertainty, REG managed to deliver a 24% increase in underlying earnings in FY16. Earnings were boosted in the second half by an acquisition made in the second half of the year (acquisitions accounted for approximately a third of REG’s earnings growth), however the operating performance across REG’s existing portfolio was solid. Occupancy levels were higher over the year, revenue per bed increased by 5% and staff costs (as a percentage of revenue) were steady.
REG’s outlook for FY17 was relatively robust, with EBITDA growth of at least 15% expected for the year and ongoing high accommodation bond inflows supporting its capital expenditure profile. Importantly, REG noted that it expects minimal impact to earnings resulting from the recent government funding cuts announced, although these will be more of a challenge over FY18/FY19. This should give REG (and the other operators) ample time to mitigate the impact, and REG would appear to be in a strong relative position to deal with the changes given its centres cater to a higher socio-economic demographic. We remain attracted to REG, given its status as the highest quality of the aged care providers with a demand tailwind driven by the ageing population.