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WEEKEND LADDER

A summary of the week’s results

27.05.2016

Week Ending 27.05.2016

Eco Blog

Economic data releases were relatively light this week. Domestic construction for the March quarter gave a window into next week’s GDP figures. The fall in construction was weak, as expected, although the decline was greater than what economists had been anticipating.

As the chart below shows, the drag from resources-related engineering construction has continued after peaking a few years ago. Private sector engineering work was down 21% compared to the first quarter of last year, with a sharp contraction in Queensland (following the completion of a number of large LNG projects) the key driver. Residential construction (which includes both the construction of new homes as well as renovations) has been the key offsetting factor that has prevented even weaker data prints over the last few years, however this too has decelerated this year.

It would appear unlikely that the tailwind to GDP growth that residential construction contributed to the economy in 2015 will be repeated this year. Further, the roll-off in mining capex is expected to continue in the medium term. Unfortunately for the RBA, lower rates has failed to stimulate non-mining investment, however the transition to a higher proportion of growth from the capital-light services sector would have also played a part. It is hoped that a lift in exports will help to fill the void in economic growth following the depreciation of the $A.

Australian Construction and Building Work Done ($bn)

Source: ABS, Escala Partners
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In the US, data was more mixed. While manufacturing data was weak, new home sales growth for April was 17% month-on-month, far exceeding expectations for a slight increase, and taking sales to the highest level since the financial crisis. Adding to the positive sentiment was an upward revision of prior months. Housing data can be quite volatile on a monthly basis and, as such, it would not be unexpected to see a pull back in May. However, the trend remains favourable for the US economy as well as for some ASX stocks that have exposure to US housing.

US: New Home Sales

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The UK Brexit vote, now four weeks away, continues to dominate the agenda in Europe. While the ‘remain’ vote has edged higher in recent weeks, most analysts are of the view that there has been no discernable trend either way in 2016, with the ‘remain’ vote holding a slender lead. However, a high number of undecided voters muddy the picture. Interestingly, telephone and online polls are yielding quite different results; online respondents would put the vote at close to a 50-50 contest, while telephone polls give the ‘remain’ vote a healthy lead. Bookmakers are also taking bets on the outcome, with odds suggesting a 1 in 5 chance of a ‘leave’ outcome.

What could make the vote tighter is turnout on the day and this is an important unknown variable. The ‘leave’ camp has greater support among older voters who are more likely to cast a vote. While the broader repercussions of a ‘leave’ vote would play out over some time, the initial reaction is forecast to be a sharp drop in the pound, perhaps as much as 10%, a spike in volatility on financial markets and potentially the resignation of the UK’s prime minister. Beyond this, the stability of the European Union will be raised again among a myriad of issues over the past few years.

Fixed Income Update

After the Federal Reserve increased rates in December last year and indicated a normalised rate path for 2016, the market has had little faith in the Fed’s statements. The shape of the yield curve, which effectively indicates the forecasts of market participants for interest rates, lagged below that of where the Fed dot plots were (which signifies their projections). However, in the last couple of weeks we have seen a shift in the US treasury yield curve as the chances of further rate hikes by the Fed have become more likely.

US Yield Curve

Source: Bloomberg, Escala Partners
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The Fed remains attuned to global markets and will only move if the data lends itself to a rate hike. In addition to domestic economic data, the British referendum and conditions in China will be closely monitored, with the possibility of a ‘Brexit’ being the main reason why the market is skewed to the July meeting over June. The probability of a rate hike according to the futures market is now at 34% for June and 54% for July. This is up from 20% and 34% respectively a month earlier.

Emerging Market (EM) bonds have had strong performance thus far in 2016. Spread widening and falling currencies weighed heavily on this sector last year, but this year has seen a reversal in performance, with the USD denominated Bloomberg EM Index up 7.8% and the local currency Bloomberg EM Index up 5.5% calendar year to April. However, increased forecasts of the Fed raising rates has had negative implications for emerging markets’ local currency debt, as higher rates translate into increased borrowing costs for these countries and the strong USD puts downward pressure on their currencies. Since the re-adjustment in the US yield curve, the performance of the local currency emerging market index has also softened. The chart below shows its recent performance and illustrates the global implications from US monetary policy.  

Bloomberg Emerging Market Sovereign Debt Index (Total Return)

Source: Bloomberg, Escala Partners
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The new Westpac tier 1 hybrid was finalised on Tuesday this week, closing a day earlier than planned. The deal was well received by the market with over $2.30 billion in orders for a $1.45 billion issue size. Indication was that 23% was taken up by institutional clients, with the balance coming from retail clients by way of new money and roll over from WCTPA securities. Given the oversubscription of the deal, new money was heavily scaled back, with most investors only getting 35-40% of their initial application.

Spread widening on these securities in the last 12 months, potential for reduced dividend payouts from the banks’ shares and the recent cutting of rates by the RBA have aided the popularity of tier 1 securities. The search for yield is evident.

On the supply side, regulatory changes have increased the banks’ demand for these products and the 2016 pipeline is buoyant. CBA and Westpac have now both issued this year, with NAB expected to announce as soon as next week and ANZ later in the year. CBA may also try a further raising before the year is out.

The initial introduction of ‘capital and non-viability triggers’ was met with caution when the first securities containing them came to market in October 2012. Since then, the market for Basel III compliant securities has grown to represent over $20bn in issuance, and this is expected to grow further. The chart below illustrates this growth.

Major Bank Additional Tier 1 Basel III Issuance

Source: BondAdvisor
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Corporate Comments

Flight Centre (FLT) downgraded its FY16 guidance this week by approximately 10%, just weeks after cautiously reaffirming its outlook at an equities conference in Sydney. The company cited four factors: increasing uncertainty in some key markets (due to weak business and consumer confidence in Australia and the UK due to the upcoming Federal election and Brexit vote respectively); poor US leisure trading; airfare price wars, which has reduced FLT’s ability to hit supplier targets; and the ongoing investment spend that the company is undertaking, which has resulted in an elevated cost line and reduced margins.

The first two factors are cyclical in nature and a certain degree of softness was expected after Qantas downgraded its outlook a month ago, although the group’s total transaction value (or TTV, which measures the total spend of FLT’s customers on its products and services) growth does not paint as bleak a picture. With FLT forecasting TTV growth of $19bn for the financial year, this would represent 4% growth in the second half; a respectable number, but down on more recent growth rates that have tracked at double-digit levels. FLT’s investment spending plans had also been previously flagged by the company and so some margin pressure was likely to materialise in the upcoming results. 

Flight Centre: Total Transaction Value Growth

Source: Flight Centre, Escala Partners
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Of more concern for investors should be FLT’s reduced ability to hit its supplier targets. The company typically earns attractive commissions from the major airlines for hitting certain revenue targets. This, however, has come under pressure recently as a result of strong competition among the airlines, which has reduced the prices of airfares. In addition, a shift by consumers towards low cost carriers, which often do not offer these incentives, has also impacted FLT. If these low cost carriers are to drive industry growth in the future, this is likely to result in a headwind for FLT’s supplier targets for some time. Ever lower airfares is often listed by FLT as a key long term driver of demand for international travel (and this has proven to be true over many years), however evidently this deflation can hit a point whereby it hinders its ability to achieve these supplier targets.

Those with a positive view of the stock would point towards an excellent long term track record in the face of perceived structural headwinds, a solid balance sheet (the company is net cash) and an undemanding valuation. The more pessimistic view will note three downgrades by the company in the past 18 months, the stronger growth and higher competition in lower margin online bookings and the increased costs and investment by the company to protect its market share. We have held FLT in our model portfolios as a value industrial stock for some time now and while it is now trading at a similar level as last August, we will reassess this position in our next portfolio review.

Wesfarmers (WES) announced asset writedowns of approximately $2bn at its upcoming full year results, although these non-cash charges had little impact on the company’s share price on the day. The writedowns were anticipated to some degree, although it was the quantum that surprised most. The impairments include a charge of up to $1.3bn against the goodwill attributable to Target and up to $850m against the carrying value of its coal assets. Target had previously been written down by almost $700m when WES had reported its FY14 results.

The impairments reflect the challenging conditions across the two businesses, although the stronger performance of WES’s two dominant divisions, Coles and Bunnings, has now meant that there has been perhaps less focus on those under pressure (see the following chart for the growth in EBIT across WES’s various divisions; the group’s retail divisions are in blue, while others are in green). In the case of Target, it is also reflective of a sizeable acquisition that was made close to the market’s previous peak and for an isolated transaction, has tarnished WES’s reputation as a good allocator of capital. Perversely, WES’s future returns on these businesses will now appear much better given the lower capital base for each on the company’s balance sheet.

Investors will be comforted to learn that the impairments will not affect the group’s final dividend, which is based on underlying profit. Nonetheless, with the company already expected to pay out close to 100% of its earnings in dividends, growth in dividends is expected to be limited and the prospect has been raised of a slight dividend cut in the company’s upcoming full year results in August. In this regard, Wesfarmers is far from alone among mid and large cap stocks.

Wesfarmers: EBIT across Divisions ($bn)

Source: Wesfarmers, Escala Partners
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Aristocrat Leisure’s (ALL) first half result was strong, although pre-announced to the market two weeks ago. Earnings growth of 66% followed improved performance across each of its key operating segments and was driven by market share gains, higher selling prices and average daily fee revenue, while the weaker $A was also favourable to the company. ALL has done well in increasing the proportion of recurring revenues from its business, which was boosted by its acquisition of Video Game Technologies two years ago. Digital online gaming is another source of growth for the company, albeit off a low base.

The key factor, however, behind its earnings growth has been the market share gains that ALL has taken from its competitors, which has followed a period of increased investment spend across its design and development. This has come at a time when the overall market has been relatively weak, and so a risk for the company could be losing these gains should its competitors lift their game. In the short term, however, the momentum remains with the stock, although this appears to be fairly reflected in the stock’s forward P/E of 21X.


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