Week Ending 26.09.2014
Economic news was relatively light this week, allowing the RBA to again put the housing market in the headlines with the release of its biannual Financial Stability Review. A robust housing market (particularly in the key cities of Sydney and Melbourne) has been one of the RBA’s primary concerns over the last 12 months, particularly given that it has been largely fuelled by investor demand, as opposed to owner-occupiers. Spots of weakness in other parts of the economy, including on the consumer side, coupled with the ongoing strength of the $A, has seen the central bank sit on its hands with regard to monetary policy, and instead resort to warnings over property speculation.
The RBA noted that recent house price growth had in turn encouraged further activity by investors. While it downplayed the credit risks associated with investors compared to owner-occupiers (and hence any issues related to the stability of financial institutions), concerns were raised over the impact that this could have on the property cycle, leading to a potential correction sometime in the future. Should this situation play out, it would clearly have implications for the broader economy and the household sector.
Instead, the RBA has now raised the prospect of working with APRA to introduce constraints on lending for investors in an attempt to take some heat out of the market. These constraints could include higher capital requirements for investors (or limits on loan to value ratios) or more stringent stress tests for borrowers’ ability to service their loans. The charts below would suggest that the former is not an issue at present, with LVRs greater than 90% trending down over the last few years. The serviceability of these loans, however, is likely to be more stretched, given the rise in the house price to income ratio, and the fact that we are at a low point in the interest rate cycle.
Australian Banks: Housing Loan CharacteristicsEnlarge
Banking stocks declined after the release of the report, unsurprising given that housing lending for investors has been one of the few bright spots in overall credit growth in the past 12 months. The possibility of the introduction of lending constraints to housing investors adds to the already challenging outlook for the banks, who face the prospect of additional capital requirements in coming years. The RBA’s comments this week reduces the chance of any interest rate hikes in the near term, given that these other policy options could be used to combat this specific problem.
The quarterly job vacancies figure, showing a 0.7% decline over the three months to 31 August, was a further employment data point that contradicted the extraordinary jump seen in the employment figure for August. Other indicators, such as wages growth, support the notion that the trend in unemployment is tracking sideways.
China’s Flash HSBC Manufacturing PMI reading of 50.5 for September released this week was viewed as a positive, with expectations for a figure of 50.0 exceeded. To refresh, a reading of above 50 indicates expansion in manufacturing, below 50 indicates contraction, and 50 indicates no change. The chart below shows that the index has fluctuated around 50 for the last few years now, well below the recovery seen post the GFC.
HSBC Flash China Manufacturing PMI
Despite ongoing weakness in its property market and recent softness in other data points, China still appears on track to deliver GDP growth for 2014 of somewhere close to, if not a little below, its target of 7.5%. After last week’s liquidity boost provided by its central bank, this week has seen the removal of some restrictions on property purchases, with buyers who have fully repaid their mortgage qualifying for first home-owner status. In the current environment, whereby the Chinese government has been taking a measured approach to stimulus measures such as these, a PMI of above 50 is seen as a good result.
The Australian market suffered its fifth consecutive weekly fall this week, and the ASX 200 remains a little over 5% off its recent peak. As we have commented before, equity valuations look to be fairly full, but not excessively so. The catalyst for this mini correction in September has been the rise in bond yields in anticipation of interest rate hikes by the Fed in the US. This has put pressure on the yield trade and hence the $A has weakened. The buffer provided by a weakening $A, if sustained, will be beneficial for the domestic economy and domestic stocks with overseas earnings exposure. Given the topical nature of the currency, we expand further on what this means for company earnings at the back of this week’s note.
TPG Telecom (TPM) reported another solid result this week, with earnings growth of 15% for FY14, slightly ahead of its own guidance. The telco’s low cost model has been effective in helping it achieve organic subscriber growth over the last few years – this was evident again in FY14, complemented by a contribution from its acquisition of AAPT earlier this year. TPM also provided guidance for FY15 of 25% growth in EBITDA on FY14 (around half of this would come from a full year of earnings from AAPT). TPM had a win a few weeks ago when the ACCC gave it the green light to continue to connect apartments to its Fibre to the Building (FTTB) network. A successful rollout of the FTTB could lead it to pose direct competition to the NBN. Further hurdles remain, however, with the federal government yet to decide on whether they would push TPG to functionally separate their wholesale operations.
We believe that the smaller telcos have a brighter earnings outlook compared with Telstra (TLS), which faces the biggest challenges as Australia transitions to the NBN (notwithstanding the compensation that the company will be receiving). In the broadband market we have highlighted the more level playing field that will result from the NBN, and the opportunity for others to take market share from TLS, particularly in regional areas. The investment case for TPM is quite attractive, with a superior track record of organic subscriber growth, high margins and potential upside from its FTTB network, however we feel that this is captured in the current share price, with the stock trading on a FY15 earnings multiple of 26X. We have recently added iiNet (IIN) to our model portfolios, as a similar play on this thematic with a more compelling valuation.
Boral (BLD) and James Hardie (JHX) conducted investor tours of their US operations during the week. BLD trumpeted its leading market positions - #1 in brick, clay tiles, concrete tiles and stone veneer – however it has clearly had an issue turning this into a profitable outcome for investors. The charts below detail the story. Up until early 2006, US housing starts had been on an upward, unsustainable trajectory (see chart below), which came undone over the next few years as questionable lending practices helped to trigger the GFC. From the trough, starts have made a steady recovery, although still remain well below the long term average of around 1.5m p.a., suggesting there remains considerable upside.
BLD’s US division is only just returning to a breakeven level, however, demonstrating the fixed cost leverage that this business has to the housing cycle. Unfortunately this result is despite a focus on pulling costs out of the business in recent years. Pricing trends have not been favourable, with considerable excess capacity across the industry. The other key trend which has worked against BLD has been the mix of housing, with free-standing homes making up a smaller proportion of new housing compared with apartments. The growth in housing starts is thus of a lower quality, given less building materials are required per start for apartments.
US Housing Starts and Boral USA's EBITDA
JHX will also be a beneficiary of this US housing recovery and is more closely tied to this market given the concentration of its earnings base. It is the better performing company of the two in this market, and has still managed to generate solid margins, even throughout the downturn. For JHX, the story is as much structural as cyclical, with its aim to grow to 35% market share of the siding market, and 90% category share of the fibre cement category. With fibre cement currently at approximately 15% of the siding market, the opportunity is large.
JHX has faced some challenges in the last 12 months in the form of an increased competitor response, particularly from other siding material suppliers (whose product is generally cheaper but ofinferior quality). Also clouding the picture is its asbestos liability, which has risen through an increase in claims. The stock’s valuation is looking relatively more appealing following a recent correction, although it is not without its risks.
ALS (ALQ) provided a further profit warning to the market this week, highlighting the ongoing fragility of its end markets and lack of immediate earnings visibility in the business. This was effectively the third downgrade provided by the company in the past six months, with its FY14 guidance issued in February well below expectations, along with its initial first half forecast provided at its AGM two months ago.
The decline in profit experienced by ALS in its FY14 result was largely due to the fall in revenue and margins in its minerals division, driven by reduced capital expenditure by the mining sector globally. Its core Life Sciences division, which provides analytical testing for a range of sectors, including food, pharmaceutical and environmental, also experienced a smaller degree of margin pressure, and this appears to have extended further into FY15. The group’s acquisition-led growth in the energy sector also appears to have come at an inopportune time, with the company pointing towards lower profitability despite a doubling in revenues in this division.
As we have commented before, ALS is a good business that is currently being overcome by a difficult trading environment. A key catalyst that would reverse its fortunes would be a recovery in commodity markets, giving the mining sector more confidence to invest in exploration. The weakness seen this year in the majority of commodities, combined with the higher priority given to improved shareholder returns by the sector, means that this outcome may be some time off. Trading on a FY15 P/E of 15X with downside risks to earnings, the stock is not offering sufficient reward for this risk.
Market Focus: Australian Dollar Sensitivities
After remaining at elevated levels for a couple of years, the decline in the $A in May and June of last year was a welcome relief for not only the Australian economy, but also a large number of ASX-listed companies. With the currency reset in the low US90c range, and trading within this band for the majority of FY14, this provided a tailwind for earnings growth (in $A terms) for companies that have significant offshore earnings.
Earlier this year, many economists had predicted the readjustment of the $A to continue over the next couple of years, drifting closer to its longer term average of around US75-80c. Most of the key drivers of the $A seemed to point towards this scenario playing out. Commodity prices (and in particular, iron ore) had fallen well off their cyclical peaks recorded in early 2011, and most were expected to experience further pressure through a combination of supply additions and a slowing demand growth profile. The growth of the domestic economy was at risk from the adjustment away from the unprecedented capex in the resources sector, while other developed economies around the world were expected to continue their recovery from the GFC, with potential interest rate hikes from the emergency settings that were implemented during this time.
Since then, commodity prices have fallen perhaps more than expected, including our two largest exports, iron ore and coal. Around the world, the European economy has stalled in recent months, while the US recovery was temporarily impacted by severe weather conditions in the early part of the year. The decline in commodity prices had failed to have much impact on the $A over this time, with the currency also showing resilience to any disappointing data from China. Expectations, however, have been building the last couple of months that the Federal Reserve in the US is moving closer to interest rate hikes. The $A has thus declined by around 5% against most major currencies in this time, in what could be the start of the unwinding of the yield trade.
With the $A remaining above what many would consider as fair value in the first half of 2014, reasonably steady currency forecasts had been factored into most Australian equity valuations for FY15. Currency movements over the last few weeks, if sustained, will likely cause some reassessment of this view. In the table on the following page we have shown what the impact would be on earnings forecasts if we were to assume the $A/$US were 10% lower (compared with current forecasts) over the course of FY15. While the estimate is not perfect in the sense that it simply translates the earnings change for companies that report in $US, it nonetheless gives a good indication of the sectors that would benefit most from a weaker currency. Overall, this currency depreciation would add around 2% to overall earnings growth, however this is driven by three sectors in particular – materials, energy and health care.
Sector Sensitivities to Lower $A
Below we list some larger-cap stocks that derive a significant proportion of their revnue from overseas:
ASX 200: Percentage of Revenue From Overseas
The list contains mostly high-quality names. This is perhaps not suprising, as the companies are generally those that have had considerable success in expanding in international markets, which are generally more competitive than the oligopolistic nature of many industries in Australia.
Health care is best represented amongst the group, with ResMed, CSL and Cochlear all amongst the leaders in their respective fields. Amcor and Brambles are two of the larger industrials that are on the list, with both increasing this international leverage over the years via various acquisitions and divestments.