Week Ending 27.03.2015
The RBA Financial Stability Review once again dwelt on the property market, extending its concerns to commercial offices in Brisbane and Perth, in particular. In these markets, secondary property, typically held by private investors, is particularly vulnerable as leasing incentives reminiscent of the early 1990s suggest that cash flow will be severely compromised. Distressed selling would reinforce a downward cycle and therefore today’s apparently safe loan to value ratios may become more marginal.Enlarge
The RBA notes that, at present, the financial risk is relatively low given current interest rates settings. However, the vulnerability of property to changes in economic conditions trouble the bank. This may not stand in the way of another rate cut, with the RBA likely to lean ever more heavily on APRA to restrain bank behaviour.
After accelerating past Australia in 2014, New Zealand is suffering a milk hangover. Current prices for milk solids are weak and on current projections, farmers may find themselves in a loss position on aggregate. Our iron ore chart and vulnerability might look remarkably similar!
Average NZ Dairy Farmer Profitability Before Tax
The RBNZ has been tussling with high housing credit growth, but may choose to drop rates to take some of the pressure off the relatively leveraged farming sector. New Zealand has also been comfortable using macro prudential policies, such as restricting the amount of investor lending by the banks and may therefore give the RBA some comfort on their efforts. It will take a cricket match to define the differences between us and our cousins over the ditch.
Mixed US data sets the tone for a period of weak and sloppy investment markets. Durable goods orders fell 1.4% in February and retail sales were well below expectations. Many will blame the weather, given the cold conditions in February and snow impacting much of the north. Nonetheless, the pattern indicates that there is not an unusual level of pent up demand building in the US economy and that the pace of growth may well level off through the year.
The heightened degree of cyclical impact in economies in recent years may have disguised some of the structural changes and result in a misinterpretation of data. In the US, for example, per capita miles travelled by car has fallen 6% from its peak in June 2005. Some would initially have squarely attributed this to the recession, yet there are other influences which now predominate. Inner city multi-unit dwellings are as much the rage in the US as here and the strength of population growth in big cities is striking. This likely explains a large part of the fall in travel per capita.
Investor confidence in Europe has been improving for some months, with regional performance top of the table in the past quarter. Supporting this was the release of business conditions in Germany and France, both of which were encouraging and point to a steady, if slow improvement in growth. A survey of concerns on European investment now has China and emerging economies at the top, rather than the predominant geopolitical issues of 2014. European reliance on other regions to absorb its trade surplus is sometimes muted by the issues from within the region. Investment managers returning from Europe do comment that they are seeing a refreshed positive tone. Given the issues of the past, Spanish mortgage growth at 11% may worry some. This is indicative of an expanding set of trends that may indicate Europe can indeed surprise on the upside.
The weak PMI for February from China at 49.2 (falling activity in the manufacturing sector given the base line is 50) suggests more easing is likely in coming months. There is a case to be made, however, that financial market participants are overly focused on data such as these, whereas the central government has a much broader ambit to cover, such as improving the quality of life for the average Chinese – healthcare, pollution, holidays, public amenities etc.
There have been many counterbalancing impacts on emerging economies in the past year. In turn, the majority have shown resilience and flexibility in their approach to these challenges. With the widely-held view these economies are highly vulnerable to $US strength and rates, largely due to tenuous current account balances, they have demonstrated their willingness to undertake monetary easing, even risking the prospect of capital leaving the country. The chart on the following page shows the easing against inflation expectations. Only Russia and Brazil, with their unique home-grown problems, have had to raise rates.
Monetary Policy Decisions Since October 2014 vs Inflation Targets
Bank of Queensland’s (BOQ) reporting is somewhat out of line with that of the majors (financial year end of August), resulting in a unique level of scrutiny in its results. A half year result of 19% growth in cash earnings after tax was slightly below market expectations. The group’s profit was boosted by its acquisition of Investec Bank’s specialist finance and leasing business (made 12 months ago), hence the associated equity raising that came with this transaction reduced EPS growth to 6%. The chart below breaks down the contribution to overall profit into the various sources. Underlying profit growth of 7%, bad debts again contributing in a meaningful way at 7%, then acquisitions (+14%) offset by various impairments and one-offs.
Bank of Queensland: 1H15 Earnings Growth
This mid-single digit underlying earnings growth is what is now largely expected by the banking sector over the next few years. What remains unclear for the regional banks (BOQ and Bendigo and Adelaide Bank) is whether or not they will be better off in a relative sense following the implementation of the Murray Inquiry reforms. With these increasing regulatory capital requirements (although this is expected to be phased in over a number of years), bad debts at cyclically low levels and low but steady loan growth, the share price appreciation by the sector has recently been fuelled by downward pressure on interest rates. We believe that using these stocks as a proxy for bonds is fraught with danger given the higher associated capital risk. We remain underweight the sector in our model portfolios.
Computershare (CPU) held an investor day highlighted the new areas that the group is branching into to offset what appears to be a relatively low-growth, mature core business. Mortgage servicing (that is, the management and administration of mortgage loans) is one such area that the company is keen to highlight, with a large opportunity for this business in the US and UK. CPU’s acquisition success has been quite mixed in recent years, which could explain the market’s reluctance to ascribe much in the way of value to future inorganic growth options. Further diversifying away from its registry management division may well dilute the good returns that it has delivered.
A medium term tailwind though could come in the form of higher interest rates, particularly in the US. The ability for the company to generate a higher return from the funds it holds on behalf of its clients is a source of upside, although the now widely-expected slow path to interest rate normalisation (particularly following recent comments by the Fed) will likely put a ceiling on this benefit.
The level of corporate activity has stepped up a notch over the past few months. We have highlighted local merger and acquisition transactions in the telecommunication sector which is also taking place elsewhere. Hutchison Whampoa is purchasing the UK-based O2 from Spain’s Telefonica to add to its Three brand and create the largest mobile group in the US. It follows BT’s acquisition of EE in recent months.
While yet to be consummated, the proposed merger of the cement giants Holcim and Lafarge will change the landscape for that industry. Elsewhere, China National Chemical is acquiring Pirelli from the founding Italian family and reports note that consolidation in the tyre sector is overdue.
These are only small samples of a swath of takeovers that will inevitably change the competitive landscape for a number of industries. The iconic deal announced this week has been the acquisition of Kraft by Heinz, controlled by Berkshire Hathaway and private equity group 3G.
There are a number of common themes that emerge from this deal activity. Reducing costs and gaining scale are hardly new. These transactions, however, seem to suggest that globalisation in many industries has some way to go. By all accounts, the managers of the Heinz business have come to grips with the difficulties facing packaged food companies, yet an annual recasting of its costs has added some 8% to its operating margin over the years.
It is not unreasonable to assume that these trends will become part of the Australian landscape and while many industries here have already consolidated, there are some sectors with high market shares and high profit margins that may find themselves challenged by a different approach from others without entrenched modus operandi.
Stock Focus: Veda Group
Veda Group is the leading credit bureau in Australia and New Zealand, providing information and analysis of data (typically in the form of a credit report) to businesses and individual consumers. The company has successfully expanded its product offering in recent years, branching out into new sectors. Veda listed on the ASX in late 2013 after the sale of the business by private equity group Pacific Equity Partners (PEP). PEP recently sold down its remaining stake and hence removed any overhang issues on the stock.
Of Veda’s core business, credit growth in the economy is a key driver of its revenue growth. Given the high levels of debt that Australian households currently hold (largely related to the strength in housing prices over the past two decades), credit growth in the medium term is likely to be more subdued than the double-digit rates that were common prior to the GFC. In recent years, overall credit growth in the economy has been running at more sustainable mid-single digit rates; sufficient to provide a reasonable level of organic growth for Veda. Competition and customer churn are two further important elements in Veda’s top line. Credit enquires driven by consumers looking to move from one lender to another is a positive for credit bureaus, and current low interest rate settings (expected to remain for some time) provide an ideal environment for new credit growth and for churn rates to remain high. Proposals in the recent Murray Inquiry are seen as a net positive for Veda and the industry, with a key theme to encourage greater competition.
Veda’s extensive historic database of records (built up over its 48 year history) is the source of its key competitive advantage. With the quality and depth of this database difficult to replicate, a high barrier to entry is provided to Veda and other existing credit bureaus. Veda has long-term relationships with its core customer base, particularly major financial institutions, resulting in an entrenched market position. Many of its products are integrated within the systems of these customers, creating a high disincentive to change providers. The markets in which Veda operates are relatively concentrated. Within the consumer credit segment, Veda’s market share is approximately 85% and the company also enjoys a market-leading position in commercial credit data.
The longer-dated growth option for Veda is the recent introduction of Comprehensive Credit Reporting (CR). Broadly speaking, this involves the collection of ‘positive’ data points of a consumer’s credit report, including repayment history and more detailed data on individual accounts, such as opening and closing dates and credit limits. Historically, the Australian system had only allowed ‘negative’ information to be collected, such as defaults. CR is expected to lead to higher rates of credit growth in the economy as it will allow institutions to make better risk assessments of consumers and thus reduce default rates. While it opens the door to increased competition in the sector (as all participants are starting from scratch), the potential for credit growth enquiry has led the incumbents to be supportive of these changes.
In recent years, Veda has become much more innovative, leveraging its expertise in data analytics into other products and sectors, leading to solid levels of organic revenue growth. Veda has complemented this with a number of small bolt-on acquisitions. Non-credit products that Veda now operate include Carhistory.com.au (comprehensive reports on the history of used vehicles), NTD (a tenancy verification and identification service for real estate agents), Verify (for organisations to obtain verification on a potential employee’s background) and a recent partnership where it will provide e-conveyancing products for the property industry.
We view Veda as a company with multiple drivers of revenue and earnings growth over the medium term, with the introduction of comprehensive credit reporting a longer-dated option. The company has a sustainable competitive advantage, has strong market positions and benefits from a concentrated industry structure. Veda generates high margins from its business, solid cash flow and has a relatively defensive earnings stream. We have recently added the stock to our model portfolios.