Week Ending 27.02.2015
Wages growth in Australia is annualising 2.5%, the lowest nominal rate in 16 years, but still comfortably positive in real terms. Low wage momentum would naturally be welcomed by the corporate sector with cost reduction the saving grace of profit margins. Logically, however, spending is consequently likely to be more restrained in this economic cycle, as has been the case to date. The economic kicker from the household sector is proving elusive, which will inevitably mean GDP growth will remain below par.
Australian Wages and Inflation
A number of releases this week reinforces the low level of investment commitments outside the housing sector. Construction work totals around $210bn per annum. Of that, 60% is engineering work, whereas the remainder is roughly split between residential and non-residential building construction. Clearly, residential work is important, but insufficient to be a major lead to higher economic growth. The chart below shows the stark fall in work related to large projects, which is expected to halve in coming years. The drag from the very elevated levels of the final stages of the commodity investment cycle are yet to play through and are essentially unavoidable.
Major Project Works: Historical and ExpectedEnlarge
A glimmer of hope came through the latest PMI release from China, touching back in positive expansion territory with a reading of 50.1 from 49.7. It would appear momentum in China is levelling out, but most are of the view that risks are still skewed to the downside without greater government effort. The central authorities continue to tighten controls on local governments in an effort to reign in shadow banking, specifically the LGFV’s (local government funding vehicles). No longer can they provide implied guarantees with respect to these loans, which will result in higher funding costs and require other sources of capital. The important repercussions will likely be a further reduction in interest rates to limit the cost of capital and support for a wider range of private funding sources such as municipal bonds. In the longer term, this will be an important and probably positive development in China’s financial system, albeit with short term downside and uncertainty.
In the US, January’s CPI fell 0.7% at a headline level and even without the swing factors of energy, eased a touch to an annualised 1.6%. As before, services inflation where many households focus their sensitivity to prices, remained steady at around 2.4%, while goods prices have been deflationary for a number of months now. The rise in the US$ is a key driver of that outcome. Other data from the US was mixed. The jobless claims number was higher than expected, durable goods orders conversely were better than forecast and housing indicators steady. The interpretation of Janet Yellen’s address was that, while an interest rate rise was not imminent, it was likely in the second half of the year. Of the main determinants, the labour market was on track, CPI was less than desired but possibly temporary, while the US$ strength is the one component that is troubling and may be the reason to wait until late in the year.
With Greece possibly (hopefully!) taking more of a back seat in coming months, the fundamental picture of Europe may gain greater focus. Trends are improving; for example Germany’s employment growth is rock solid, even France appears to be showing signs of life and the lower oil price is translating into export orders. Crucially, the demand for money has picked up. The chart shows that all indicators of private credit and money growth are now trending up strongly implying further investment spending may be underway. If it were not for the politics, Europe would likely be a uniform contender for investor flows.
Euro Area M1, M3 and Loans to Private Sector
For Australian investors, the coming RBA decisions are key – easing will be welcomed by financial markets but also indicate that the RBA views the outlook with an increasingly pessimistic tone.
Looking further ahead, May is lining up to be an interesting month in many ways. Our budget will coincide with the UK election. In both cases, fiscal privileges are likely to be a big feature and have repercussions on saving and therefore spending behaviour. Implicitly, that involves investment markets given household spending is proving to be much softer in this economic cycle than most had forecast. Overall this leads us to guide towards a low return environment with potential disruptive periods of volatility.
Similar to Rio Tinto (RIO), BHP Billiton (BHP) this week revealed that it has been tracking ahead of expectations on its cost out and productivity program. For the six months, savings from these two measures added US$2.3bn to earnings before tax, with the company targeting a US$3bn saving for the full financial year and a further US$1bn in FY16. This failed to offset the $6.1bn impact from lower prices in the half; a situation that is not expected to improve in the short term, with commodity prices beginning the year from a lower base.
BHP lifted its dividend by 5% to US62c and committed to retaining this current dividend level post the demerger of South32. With a dividend payout ratio of 62% in the half and falling commodity prices, this would imply an increasing payout ratio in coming years. The chart below shows how this is being sustained - with a falling capital expenditure profile, which will decline further over the next 18 months.
BHP Billiton: Sources and Uses of Funds
While the iron ore market remains well supplied for the foreseeable future, BHP is more optimistic about the longer term prospects for a price recovery in two of its other key commodity exposures – copper and petroleum. By BHP’s estimates, more than half of the potential future supply of copper requires a price of US$3.50/lb or higher to induce investment (around 35% higher than current pricing). The company also expressed its confidence in oil prices recovering, through a combination of long-term demand growth, the higher prices required to induce new production and the supply response that is already underway. It is these two sources of longer-term upside that currently differentiates BHP from RIO.
WorleyParsons (WOR) pointed towards difficult times ahead in its first half result, as its customers fully digest the impact of the recent slide in oil prices. Underlying profit for the half was up 4% on last year, with margins protected through an extensive restructure and cost out program that was implemented last year. As the sharpest falls in the oil price have occurred in the last two months 2014, the extent of cuts to investment budgets across the energy sector remains to be seen.
The charts below suggest that these cuts may be modest, although sustained oil price weakness could see them revised sharply lower. Given the quality of the company, WOR currently screens as good value, trading on a forward multiple of 10X. We would caution, however, that there are considerable downside risks to these current earnings estimates.
Capex Forecasts for Oil Majors and National Oil Companies
Spotless’ (SPO) first half result indicated that it is on track to meet its prospectus forecast for the full year. The group recorded top line growth of 5%, with profit growth enhanced by further margin improvement from cost savings and efficiency programs. The health and government sectors drove this organic growth, while the win rate on new contracts has been running ahead of expectations. The company is supplementing its growth through a number of small bolt-on acquisitions and the strength of its balance sheet will allow it to continue this strategy in the medium term.
The other significant opportunity available to Spotless is in the Public Private Partnership (PPP) sector. PPPs are increasingly popular among governments for the delivery of social infrastructure projects, given the partial transfer of financing to the private sector. SPO is one of the leading operators in this field, which typically offer it integrated contracts across several services, higher margins and lengthy contract terms (on average 27 years). We have recently added SPO to our model portfolios as a relatively defensive industrial stock, trading on a relatively attractive forward P/E of 15X.
Oil Search (OSH) surprised with a special dividend of US4c to go with a final dividend of US8c, four times higher than its 2013 final dividend. The additional payment to shareholders highlights the strong position of the company compared to its large peers, with the large investment in PNG LNG complete and now contributing high cash flows, even in the present low oil-price environment. OSH retained its full year production guidance of 26-28 mmboe, which would represent a 40% increase on 2014 levels as a result of a full year contribution from PNG LNG.
Oil Search: Production Forecast
Similar to other companies in the sector, OSH has decided to also focus on cost reductions in the short term. Production cost cuts of 20% are targeted for 2015, with exploration and evaluation spend also expected to be reduced by around 25%. While this may inevitability result in some slowing in the progress of expansion opportunities of PNG LNG, they remain attractive investments, even under lower oil price assumptions. Shorter-term options also remain for OSH, with debottlenecking of the existing facilities likely to be targeted, given the high return on this investment. We have OSH as our preferred energy exposure given its attractive asset base and ability to weather the current volatility in oil markets.
Brambles’ (BXB) first half was reasonably solid, with 6% growth in underlying profit, or 10% growth in constant currency terms (the company reports in $US). Organic growth of 6% was supplemented by a number of small acquisitions for 8% total sales growth. Of these, the most questionable appears to be its purchase of Ferguson Group, a container solutions provider to the global offshore oil and gas industry. While the recent oil price weakness is unlikely to have a significant impact on this business given its customers are typically conventional oil operators at the lower end of the cost curve, the longer term trajectory looks more difficult. Of concern is its large exposure to the North Sea, which has been in structural decline for some time now. The size of this business, however, makes it relatively immaterial to BXB’s overall results (at less than 2% of sales).
In BXB’s core pallets business, most surprising was the contribution mix. Despite recent economic weakness in the region, Europe produced a solid result, while the North American business underwhelmed. Increased costs in this region led to an overall drop in profitability as the company increased its investment in order to improve the quality of its pallet pool. While the benefits from this have not yet been evident, over time this should result in a longer replacement cycle for its pallets. We have BXB in our model portfolios, although like many other high quality industrial stocks with a defensive growth profile, further share price gains in the short term may be limited given a relatively full valuation.
The market’s response to Flight Centre’s (FLT) result indicated that many investors had been anticipating a further downgrade after it lowered its guidance in December. The stock rose 12% after reiterating its full year guidance and first half results that were in line with its recent update. The group’s domestic business was impacted by a downturn in consumer confidence over the half. To counter this, FLT reduced commissions to stimulate demand while also stepping up its investment, resulting in a lower margin outcome.
After a relatively weak first half, FLT noted that it starting to see signs of a recovery in trading conditions. What may hold this back in the short term is the recent weakness in the $A, which would discourage consumers from travelling overseas. FLT noted that, to date, this has not had any noticeable impact on its product mix. Of course, the weak $A will also help FLT’s international operations (which again produced a solid result for the half), although they still remain small relative to the size of its core Australian business. FLT’s balance sheet remains in good shape and it has a large franking balance which may well be distributed to shareholders in the future through special dividends or a share buyback.
Iress (IRE) was sold off after it produced a solid result for the full year, however disappointed on its guidance for FY15. Underlying profit rose 28%, although earnings per share growth was limited to 13% as a result of an equity raising conducted at the time of its acquisition of Avelo (UK based wealth management software provider) which in turn was the key factor in the group’s overall growth. Excluding its UK businesses, earnings growth across its operations was 3.4%.
IRE’s products generate fairly predictable, recurring earnings and cash flows. Within this, it is facing contrasting trends in its two key focus areas. Its traditional financial markets division (which accounts for approximately half of its earnings base) has faced some pressure over the last few years amid weaker trading activity and as its customers have sought to rationalise their cost base. Its wealth management arm, however, has a tailwind of an increasing regulatory burden on the industry, adding to the demand for its products. Post the successful integration of Avelo, which added considerably to its EPS growth, IRESS arguably needs to show better organic growth to justify its high valuation.
Showing predictable growth, Sydney Airport (SYD) guided towards a 6.4% increase in distributions for 2015. For FY14, the company benefited from revenue growth across each of its four revenue sources – aeronautical, retail, property and car parking, leading to overall EBITDA growth of 6.1%. Increasing passenger numbers underpin each of these individual divisions. For the year, domestic passenger numbers grew by 1.2%, with international at 2.8%. After a lull mid-year, international passenger numbers again picked up towards the end of the year. Unsurprisingly, Asian markets remain the fastest growing for international passengers, with China (+16.4%), India (+11.9%) and Malaysia (+11.6%) leading the pack.
Sydney Airport: International Passenger Growth
Like many other companies, SYD has taken advantage of more accommodative fixed interest markets over the last year to refinance its debt and improve cash flow. The company’s growth is incrementally driven by many small, low-risk capital expenditure projects. SYD is guiding towards $1.2bn in capex over the next five years, with no single project accounting for more than 5% of this total cost. While the long term investment case for SYD remains sound, we have recently reduced its weighting in our model portfolios, with the stock having appreciated significantly over the past few months on the back of declining interest rates.
Qantas (QAN) has also been ‘flying’ recently and the airline finally has a multitude of concurrent tailwinds, allowing it to swing to a profit for the half year. Oil prices have been falling, its cost cutting/transformation program has been delivering benefits at a rapid rate and the overall airline market has started to act in a more rational manner, with a moderation in capacity growth at both a domestic and international level. The last of these is supportive of further yield enhancement across the industry, a key driver of the profit margins of airlines. Each of these factors may carry QAN higher in the short to medium term, although we remain unconvinced on the longer term investment case from a fundamental perspective.
After some months of uncertainty, Woolworths (WOW) confirmed investors’ worst fears announcing a disappointing result for the half year and guiding to a lower growth target for the full year. In carefully worded terms, management conceded that the credibility of the supermarket offer had unwound and promotional campaigns had failed to convince consumers. A swath of management changes have been brought about across a number of important roles, with some key positions yet to be confirmed. Meanwhile the group says it will reinvest any operating savings into its supermarket business, implying another period of price competition as well as higher costs through in store service.
In terms of financials, the relatively soft sales growth in supermarkets (Australia 3.4%, New Zealand 1.1%) came with a small increase in profit margin (up 41bp in Australia, 10bp in New Zealand); itself an uncomfortable outcome given that management have now confessed to the lack of investment in the consumer. Big W also faced the strong headwind of the discount department store sector, with sales falling 3.5%, margins easing, but more importantly taking a large $148m provision to clear inventory. The investment market is taking an increasingly cynical view on these writedowns where they are operational in nature and should be treated above the profit line rather than called out as ‘significant items’.
We judge the malaise at Woolworths as much deeper than just a temporary hiccup. In our view a cultural shift will be required to return to the roots of its success, that is that financial wellbeing cannot come at the expense of the consumer. While selling a holding based on the sharp reaction of the share price on the day may be the best move, we continue to encourage investors to reduce holdings over time. As we indicated last week, Wesfarmers is also under some pressure as the supermarket sector has now clearly flagged that difficult times lie ahead.
Elsewhere in retail, Harvey Norman’s (HVN) result gained favour, making it one of the better performing industrial companies of the past year on the back of the strength in the housing market. As always, the group’s profit reports are hard to interpret as they combine franchise operations with corporate stores across a number of countries and a large property asset. Franchise sales have been rising at between 2-3% for some time now, but the store footprint has been modestly reduced, a feature many other retailers may want to take on board given likely excess space in their segment. HVN supports franchisees at times through additional payments or reduced rental. This does make it less of a pure franchise and the level of support can be hard to judge. In this half, unsurprisingly, there was reduced pressure at a P&L level but a significant rise in working capital for the franchises in anticipation of the improved trading conditions. Global operations (New Zealand, Ireland, Singapore and Malaysia) were generally strong in the half. HVN has worn a highly volatile return from these investments and it will take some time before one can reliably predict their contribution.
Notwithstanding these cautious comments, HVN can be expected to retain investor favour at this time given the lack of alternative attractive stocks in the retail sector. It does have a robust balance sheet with low debt (debt/equity of 22%), a solid franking balance (though reticent to pay out special dividends without raising capital, as occurred in December) and an asset buffer through its property portfolio, which it clearly has no intent in realising. For more trading-oriented portfolios, HVN has been, and is likely to be a good way to participate in the housing theme. The dividend yield is around 5% fully franked while the P/E at 17X is higher than history. We do not see the stock as a long-term investment, however, as the predictability of its profits are low.
Ramsay Health Care (RHC) again delivered on its high expectations, with EPS growth of 20% for the half. Its Australian business remains central to RHC’s success and the region showed EBIT growth of 12.6% on the back of an 8.8% increase in revenues. The company is looking to replicate its success in international markets and has now built a significant presence in the UK and France. RHC’s long term growth is underpinned by ageing populations across its key markets and its growth is typically low-risk given the high proportion of additional capacity sourced from brownfield (i.e. expanding existing assets) investment. While further acquisitions (if funded via its expensive equity) are a source of upside for the company, the stock now trades at one of the highest forward P/Es across the ASX 200 at 30X (see chart below for how it has traded historically). The possibility of a retracement in this multiple is the key source of risk for investors.
Ramsay Health Care: Forward P/E Multiple
After relatively disappointing performance since listing in December 2013, Nine Entertainment (NEC) found investor support by announcing a $150m on-market share buyback; sizeable relative to the company’s $1.9bn market capitalisation. The group’s half year profit decline of 7% was in line with the updated guidance reported at its AGM in November. Channel Nine accounts for approximately three quarters of NEC’s earnings, with profitability falling in a weak free-to-air advertising market, despite the network gaining market share. Ticketek is NEC’s other key business, which saw lower sales reflecting the weak consumer environment.
With entertainment media consumption trends changing at a rapid pace, NEC (in partnership with Fairfax) has entered what is likely to be a highly competitive streaming video on demand (SVOD) market through the launch of “Stan” last month. Foxtel and Channel Seven’s “Presto” is also up and running, while the local launch of Netflix is imminent. Stan has been described as a successful launch, with subscriber numbers tracking ahead of expectations. Notably, the service is free for the first month, and so it remains to be seen what level of support it will receive from consumers once all options are available. In any case, the winners will likely be determined by who has the highest quality and quantity of content. We believe that success in SVOD by the existing free-to-air networks may simply be a cannibalisation of their current revenue streams.
As one of the few stocks in the market with leverage to rising interest rates (along with the positive impact from a lower $A), QBE Insurance (QBE) is a tempting investment. Shareholders who endured successive downgrades and impairments in recent years as a result of questionable international acquisitions over time are unlikely to return in a hurry, however the company may be turning a corner. QBE is looking to move towards a more stable level of earnings through higher levels of reinsurance (taking advantage of lower reinsurance rates), which would reduce the potential impact from the volatility that often results from various catastrophes.
The flip side to this action is a reduction in net premiums (as QBE gives more of its earned premiums away to reinsurance companies), although there is the prospect that an improved capital position could lead the company to a higher dividend payout ratio. Helping sentiment towards the stock was the announcement that it had agreed to sell its Argentine workers’ compensation business (which was partly responsible for a profit warning issued by the company last August). In the sector, the choice for investors are the two large domestic insurers (IAG and Suncorp (SUN)) which are showing benign growth vs the turnaround story of QBE, which operators in more competitive international markets. We have favoured SUN, which has the capacity to distribute further special dividends to investors in the near term.
Westfield Corporation (WFD) posted its first results since restructuring in the middle of last year, with its numbers coming in line with its guidance. To recap, WFD now represents the international Westfield assets, which are spread across the US (71% of total assets) and Europe (29%; predominantly London). The quality of this asset base is undoubtedly high, although the primary reason for WFD’s premium valuation to the broader real estate investment trust sector is the group’s ability to recycle capital through its development pipeline. At present, WFD has a US$1.8bn share of current development activity, with another US$4.5bn of future projects in the pipeline; significant numbers compared to the US$17.7bn carrying value of its total assets.
Income growth across its portfolio was a reasonably solid 5.3%, lifted by its prime flagship assets, which grew by 6.2%. Occupancy levels ticked up a little and remain high at close to 96%. Further corporate activity remains a possibility for WFD as well as converting its listing to a different stock exchange. Like most other REITs, WFD looks to be fully valued as it has received the tailwind of falling bond yields over the last six months, and it has little appeal from its relatively low forward (unfranked) dividend yield of just 3.3%.