Week Ending 27.06.2014
Local economic news was light. A number of labour force indicators did nothing to move the dial, suggesting employment conditions were stable, yet largely uninspiring. The stalemate on securing certainty in policy is arguably more important than small movements in the data.
For the second time, the US revised its GDP for Q1 this year. From an initial read of 0.1% growth, it then was recast at a 1% decline, to now a 2.9% fall. The source of the revision was essentially due to healthcare, with the Affordable Health Care Act failing to contribute as initially estimated. As an aside, if this scale of revision was forthcoming from, say, China, many would suggest data there was unreliable, yet it is clear that growth measures are probably somewhat unreliable in most countries.
In other circumstances, this downward revision would cause much comment and concern, but given the data since the first quarter has been ‘back to normal’, the revisions have been discounted. This week US single home sales, for example, were up 18.6% in May and the Consumer Confidence Index came in at 85.2, up from 82.2, adding to the relatively encouraging recent trends.
Nonetheless, it clearly puts more pressure on the forthcoming quarters to achieve their expected growth levels, with Q2 expected to bounce back at around 4%, and then two sequential quarters of 3%, to take annual GDP to 2.5%. In turn, it means any misstep, or adverse reaction to monetary policy, could be problematic.
An uneasy calm in financial markets reflects these issues. For nearly 50 days the S&P 500 has traded without a 1% move either way, a pattern not seen since 1995. In looking for something to break this pattern, one can simplify the outlook. Higher economic growth, employment and inflation would be welcomed by the Fed and the corporate sector, yet signal interest rate rises. On the other hand, weaker data delays that outcome, but implies low profit growth.
The divergence of economic growth in Europe is reflected in the probable recession in France, offset by a strong bounce from the south - Spain in particular - and steady if somewhat uninspiring pace from Germany. This leaves the ECB in a somewhat awkward position where further monetary support may well find resistance from Germany. At the very least, it is likely interest rates in Europe will be the last of the economies to move up.Enlarge
As we have noted in previous editions, the UK is lining up to be the next to raise rates. The Bank of England released its Financial Stability Report (FSR). For financial market geeks, this report makes for good reading. Commentary on the conditions of the global financial system are followed by UK-specific issues.
While somewhat technical, the presentation on the following page (extracted from the FSR) is a good guide to investment markets (and importantly not from investment banks). It shows the valuation being applied to asset segments relative to the risk free rate, or appropriate benchmark, based on the average over the past 10 years. The crisis saw a major rise in premia in credit through a fall in security prices – as the coupon payments remained intact. In equity the adjustment was also a fall in prices, but largely due to the sharp decline in earnings which takes longer to rebuild than the yield applied to a coupon.
We are now back to pre-crisis risk valuations across these assets, with segments of fixed interest arguably somewhat overvalued. If equity risk premia are now at fair value, the inevitable rise in bond yields has to see corporate earnings match that move. For example, based on a global 10 year bond yield of 3% and a 4% risk premium, a 1% rise in bond yields required EPS to grow at 14% to maintain the same risk premium just to hold equity values. While this is clearly a simplistic method, it does illustrate that equities are now dependent on solid profit growth, or should be bought with valuation upside.
A further chart from the FSR is a segue into comments on our banks. Globally, banks have been restructuring to meet capital ratios required by the regulator. In many cases this has meant banks have been forced to or chosen to sell assets, and close down divisions where the capital required to support those activities is deemed too high. The intent is to make banks far less likely to require government support. Our banks, having gone into the crisis with relatively high quality assets, have been able to avoid any major restructure. Nonetheless, they are required to hold more capital, which will hamper their capacity to improve their return on capital.
Over and above regulatory capital, the Bank of England is sufficiently concerned on housing to impose some restrictions on mortgage lending. New mortgagees have to be stress tested to a full 3% rise in rates and banks must limit the amount of lending to loan to income ratios above 4.5 times.
The report goes into detail on the liquidity risks in credit markets, concerns on investor understanding of risk, the ranking of debt securities (with reference to hybrid and other loss-absorbing issues), household debt and efforts to sustain financial stability. Given its wide circulation amongst financial participants, it would be interesting to see if our RBA also chooses to become activist in bank lending, a domain it has largely left to APRA.
The four major banks presented at a conference this week. Given most, if not all, Australian investors hold banks, the question is whether it is important to distinguish between them, and if so, why.
From a performance point of view, there has been a difference, with the CBA substantially outperforming the laggard, NAB for some time. However, for those who trade there have been many opportunities to switch, which can have a meaningful impact on a portfolio’s performance. Active fund managers may be able to capitalise on these ebbs and flows in relative performance, whereas direct holders are less likely, given tax consequences and low appetite to trade. High weights in a bank portfolio may therefore show a divergence from the index simply due to the relative bank holdings.
Why have the four major banks performed differentially and what are their prospects going forward?
Over the past decade, CBA has delivered a virtuous cycle of stable growth and controlled costs, which supported a high ROE, cash flow and therefore capital position. Its sticky retail customer base and broad reach has, in our view, substantially contributed to its revenue growth as, unlike the other banks, it does not seem to have to resort to price driven campaigns to maintain its market share.
More recently, Westpac (WBC) has also achieved much of the same, and currently has the lowest cost ratio. While not quite at the elevated status of the CBA, its equity performance has been good.
ANZ and NAB have been less productive in portfolios. ANZ has chosen to battle for growth in Asia, which has taken up capital and strategic attention. Consequently, its local market share has been variable. A smaller bank branch has also meant it has to use mortgage brokers to get its product to customers. NAB has been distracted by the overhang of its UK operations but also seems to have lost its firm hold on small business customers, once its stronghold.
As the large companies now go direct to credit markets, lending to households and local enterprises are the battle ground. ANZ gives a snapshot of its small business lending book, showing the skew to retail and property. APRA is closely watching the exposure banks have to non-residential property.
The outlook for the banks is muted at best. The fall in bad debts, as noted before, has been a major contributor to profit, but is not a growth avenue. Lending to small and medium business is tough, given the patchy local conditions and aversion to debt, and banks themselves seem to be intent to restrain their mortgage book (arguably before the regulator makes them do so).
Differentiation between the banks has become harder. There is little to distinguish CBA from WBC in our view. ANZ does have the Asian strategy, which may limit its local growth (and possibly constrain dividends) due to capital requirements, but at least there is some prospect for longer term growth above the Australian financial system. NAB may be able to exit the UK as conditions there improve, yet we are cautious that this will improve the outlook; instead it may cast more of a light on the struggle it is having to compete locally.
With banks, the major proportion of most equity portfolios, we will tend to spend a disproportionate time on them to be aware of any potential changes in their outlook. At this stage, they present as expensive, but supported by high relative yields. Capital growth is likely to be low and if interest rates rise, may be negative. CBA and WBC are priced for stability, whereas ANZ and NAB have higher risk and lower valuations. Investors’ portfolios can reflect their risk appetite in the balance across these.
The retail sector once again came under pressure with a profit warning from Kathmandu (KMD), with weather again called out as the major cause. Though this is likely to have a temporary impact, it is a reminder that discretionary retailers are not entirely in control of their destiny and that their profitability can be substantially impacted by loss of sales in a small time frame. While some in investment circles have warmed to JB Hi-Fi (JBH) as their preferred discretionary retailer, our first choice still lies with Super Retail (SUL). Relatively stable demand for auto parts and sports gear, as well as growth options are, in our opinion, a better option than electronic goods with their deflationary pressure and tight price points.
A market update from Lend Lease (LLC) was initially received poorly by investors, although the stock had recovered some of these losses the following day. The company’s statement included news on the sale of its interest in the Bluewater Shopping Centre in the UK (at a price that was better than analysts had been anticipating), along with upgrading its FY14 guidance as a result of this sale and confirming that it is comfortable with current expectations for FY15.
The criticism of the announcement largely came down to the fact that, excluding the profit on the Bluewater sale, the profitability of the overall business looks to be short of expectations in FY14. As the company explained in a follow up conference call, however, was that other transaction profits (excluding Bluewater) that were slated to occur in FY14 had been deferred until the next financial year, as LLC had instead focused its resources on the Bluewater sale. Transaction profits typically account for around one fifth of LLC’s earnings, although this year it will obviously account for a much larger proportion.
The announcement highlights the sometimes lumpy nature of LLC’s profitability, and that investors should not become accustomed to a smooth, upward progression in earnings, year on year. With LLC looking to pay out half of this year’s earnings in dividends, in the short term, investors will benefit from a substantially higher final dividend. The company’s medium term outlook also looks to be sound – with a good development and construction pipeline that will underpin earnings over the next few years.
LLC is listed in the Real Estate Investment Trusts section of the market, despite generating most of its profits from development and construction projects. This is true of several other companies that have been given the same classification, as they have chased the higher returns that are potentially available to them by undertaking these activities.
Following the recent Westfield restructure, which sees the new entities now trade as Westfield Corporation (WFD) (the international businesses) and Scentre Group (SCG) (the Australian and New Zealand operations), these two securities still dominate the overall weightings in the domestic listed property trust index (see chart on following page); combined they account for nearly a third of the index.
For asset allocation purposes, we prefer to include listed property trusts within the Australian equities component of portfolio holdings. There are several reasons for this – they no longer account for a significant part of the broader index (at around 6%, compared to over 10% prior to the financial crisis), there are few that are truly passive real estate portfolios, and their structures mean that they will often behave quite differently to unlisted property investment.
Santos (STO) had an investor site tour of its Gladstone LNG project, with the company sticking to its previously guided timeframe and budget. While the project’s returns are not as attractive as PNG LNG (in which STO and Oil Search (OSH) has a stake), these recent updates have been encouraging, and the project will still deliver substantial cashflows for the company. More details on expected operating costs etc. are gradually being revealed for GLNG, however, one of the more unresolved issues is the level of third party gas that will be required to supplement its own resource. Further progress on this front is a potential near-term catalyst for the stock.
UK-listed BG Group will be the first of the Gladstone LNG projects to commence production, expected later on this year, and the successful delivery of this should provide further investor confidence in the sector. STO’s recent underperformance compared to its other large-cap peers has provided a more attractive entry point for new investors.
Sector Focus: Online Technology
In light of Flight Centre’s (FLT) soft earnings downgrade issued a couple of weeks ago, it is worth reflecting on other listed companies that are well-established and generate a large part of their earnings from online transactions. Within the online travel sector, Wotif.com (WTF) and Webjet (WEB) look to be two obvious candidates that could be caught up in the recent softness in consumer sentiment and spending. With share prices that have approximately halved over the last 12 months, the issues facing these two companies are clearly more significant than any short-term cyclicality in trading conditions. Both have been exposed to increasing competition from overseas operators that have entered the Australian market and the financial clout that these large companies wield.
Expedia and booking.com are two such companies that have ramped up their advertising spend in Australia, which shows the low barriers to entry in the industry and difficulty that incumbents can face if they do hold a dominant market share in a category. As WTF and WEB’s share prices have declined over the last year, there has been several reports highlighting the possibility that they may become takeover targets for one of these larger international players. There is no certainty in any transaction taking place, however, particularly given the capital-light nature of the business and the takeover premium that would likely be required.
Flight Centre’s key differences to WTF and WEB lies in two areas – the added complexity of its transactions, and the dual channels in which it operates, with an online offering complemented by a large ‘bricks and mortar’ presence. FLT should further consolidate its position as it rolls out its ‘blended access’ model, whereby its customers will be able to switch a transaction at any point between in-store and online.
Seek.com (SEK) is another stock that we currently hold in our model portfolios. One of the bigger threats that has emerged in recent years to its dominance has been the rise of LinkedIn. Seek has, to date, successfully negotiated the increasing usage of LinkedIn – in job placements, its market share is around 12x the combined share of other online competitors, while on the job ads side, it accounts for over 80% of website visits. The company has also been successful in growing outside its core business, with expansion into online education and international online employment ad websites.
Carsales.com (CRZ) is also held in the model portfolio, and, like Seek, is the clear leader in its industry. The company is not simply reliant on the number of car listings on its website and has multiple avenues that are driving revenue growth, including display advertising and dealer and data services. The group’s high dealer penetration (over 80% of dealers) and highly fragmented nature of its customers (both at the dealer and individual customer level) again makes it difficult for a new entrant to challenge its position.
REA Group (REA), operator of the realestate.com.au website, is the other dominant listed online player in the Australian market. With its large market share, REA has a lot going for it, particularly when you consider the structural shift of real estate advertising from print to online, the still large disparity in pricing between the two mediums, and the low relative cost of such advertising compared with the value of a property. REA, too, lives with the constant threat of new competition potentially eroding its dominance, with news just this week that a number of real estate agents are looking to join forces to create a new property portal. It will likely require this sort of cooperation amongst REA’s fragmented customer base to put pressure on pricing and its market-leading position. While the company has an attractive growth profile, its valuation remains quite demanding.
In an industry that undergoes change at perhaps a faster rate than any other, it is important for even the larger players to continue to innovate and adapt their business model as the industry evolves. Failure to do so will result in a fast erosion of their market position. The stocks that we hold in our model portfolio have generally been quite successful at this – whether it be carsales.com and its introduction of more premium categories and listings, or Seek’s online education offering and international expansion.
Below we show a summary of consensus forecasts for earnings growth over the next three years, along with the current forward P/E multiple for each stock. REA looks to offer the most promising growth profile, however it also trades on the most expensive multiple. WEB and WTF are at the other end of the scale, with valuations reflecting the more challenged outlook for these two companies.