Week Ending 28.08.2015
With the noise from the reaction to trends in China abating as the week progressed, market attention turned back to the US. We are always mindful that our opinion on both China and the US is based on a wide array of reports and interpretations to which we have access. Nonetheless, while we are as bold as to suggest the bulk of the recent volatility in market can be attributed to news from China, the real source of near term unease lies with when the US Fed will move and what the reaction in markets will be. It is notable that many clamouring for the Fed to hold off until ‘well into 2016’ benefit from the support from the current monetary settings. The suggestion that the short term behaviour of financial markets should determine the decision on rates does not make a lot of sense. For one, the week appears likely to end somewhat benign with weekly performance nothing out of the ordinary. The other implication would be that the Fed should only move in a period of solid equity and bond market performance, an unlikely criteria. Slowing global growth as China works its way through its current impasse is nothing new.
With the next FOMC meeting now within eyesight (16/17 Sept), any data hinting on a likely decision gets intense scrutiny. The second release of GDP estimates (still for Q2) was much higher than the initial estimate at 3.7% (2.3% in first). Not one factor was cited as a major influence; indeed it was across the board. Those looking for downside risk found it in the GDI (Gross Domestic Income) trend, which came in much lower at only 0.6%. Many take the average between the two as a better indicator of economic growth. GDP measures production based spending by households, business and government, while GDI measures income from production in the form of wages, profit and tax. Timing, inventory and other such factors can have a considerable influence over and above the cyclical pattern. Nonetheless, the revised numbers, while backward looking, do not hose down expectations for GDP growth in coming quarters.
Housing and wage data was largely on trend and the durable goods release was also well within range. Overnight, the consumer confidence index has some heightened interest to assess whether the buoyant US consumer is in any way affected by the Chinese economy. Next week, a range of business indicators will be released, with the weekly initial jobless claims the only indication of labour market conditions. This weekend talkfest at Jackson Hole will undoubtedly raise comment as well.
The European economic recovery edges ahead. Loan growth is now positive for both households and corporates. Laggard France looks like it might make a contribution, with the INSEE industry survey in positive territory and even unemployment edged down ever so slightly.Enlarge
Locally, our Q2 GDP release (due mid-next week) will likely incorporate a weak business sector alongside a resilient household sector. Retail sales in the quarter picked up and housing activity was strong. However the focus is as much on the smaller but more important contribution from business investment and spending. In that regard, the release of the capex number received close scrutiny. Current capex outcomes are weaker than expected but the “less worse” intentions was a modest relief, with manufacturing capex indicating a 9% fall in the coming year against 18% in the previous survey. This data series does tend to move around, but the reading on investment will be key as the household sector will be constrained by low income growth.
The RBA will once again deliberate next week. A cut is not expected, but as always it is the language that will count.
For a second week in a row, Australian reporting season was overshadowed by the heightened volatility of global markets. China has again been the primary focus of investors, with concerns revolving around its ability to meet is economic growth objectives in the wake of recent weak data, as well as the sharp drop off in its equity market. While global markets took little notice of the extraordinary rise in Chinese shares from mid-2014 to early June, the large selloff seen since has attracted much more attention. As of this morning, China’s sharemarket actually remained up 37% on a rolling year basis.
What may be lost on the average investor is the fact that, despite the large falls across markets on Monday, equities are set to finish the week higher than last week. The ASX 200 has actually advanced 0.9% for the week. Companies reporting results this week have been better received compared with early August, which has helped our market somewhat. We will provide a more detailed profit season analysis in next week’s Ladder.
BHP Billiton’s (BHP) result reflected the further sharp deterioration in commodity markets over the last 12 months, with underlying earnings falling just over 50%. This looks dramatic on paper, however it was protected to some degree by the company’s efforts at cutting its cost base. By the company’s own measure, US$4.1bn of productivity gains have been delivered two years ahead of its target, with further reductions expected in FY16. The chart below illustrates the cash cost change over the last three financial years at some of BHP’s key assets (WAIO is Pilbara iron ore, Escondida is copper and Black Hawk is US shale).
BHP Billiton: Fall in Unit Costs
With production expected to fall slightly in FY16, attention has rightly turned to the sustainability of BHP’s dividend. To remind readers, the company (as with its peer Rio Tinto) has adopted a progressive dividend policy, despite the large fluctuations in profitability that can result from commodity prices movements. As recently as 12 months ago, the policy appeared to be relatively safe, with the company paying out just under 50% of its earnings
(at that point the prospect of additional capital returns was called for by some shareholders). However, following a 50% decline in earnings, BHP is now paying out all of its earnings in dividends.
As earnings are expected to fall further in FY16 (at this stage analysts expect a 36% decline), it is clear that maintaining this dividend level will be very difficult, barring a sustained recovery in commodity prices. If the current pricing environment persists for some time (improvement is expected across oil, coal and copper) it would be reasonable to assume that the dividend would be rebased downwards.
With the dividend one of the top priorities of BHP, the casualty has been capital expenditure, which will fall from nearly US$22bn in FY13 to a forecast of US$7bn by FY17. This is despite the 20%+ IRRs that BHP frequently cites on growth options across its portfolio. Volume growth will thus be harder to come by under this scenario and the company’s forecast production decline in FY16 (before rising again in FY17) may be a precursor of a longer term trend. While there are significant challenges ahead for BHP in the medium term, we believe that the stock, with its high quality asset base, remains the best way to participate in global commodity demand growth, which continues to be driven by emerging economies.
BHP spinoff South32 (S32) reported its maiden result as a stand alone entity, having listed on the market in mid-May. With the same weak commodity market backdrop as its peers, the company gave some further guidance on its capital expenditure and cost out targets over the next three years. Overall, sustaining capital expenditure is expected to be lower than what the market was anticipating, however the cost out target of $350m (annualised) spread over three years was somewhat underwhelming.
As greater attention should be paid to assets in S32’s new structure, it may mean that this cost guidance turns out to be conservative. While the share price performance of S32 has been disappointing since its ASX listing (driven by the weakness in commodity prices), we have retained a small position in our model portfolios to gain exposure to an extended suite of commodities that is not as dominant in the major miners. The table below lists the relative earnings sensitivities by commodity (from largest to smallest) for the company’s FY16 earnings.
South32: Earnings Sensitivities to 10% Change in Commodity Price (US$M)
Staying with the resources sector, Oil Search (OSH) was able to improve its profitability in the first half compared to last year thanks to a full six month contribution from its interest in the PNG LNG project, which has been producing ahead of its nameplate capacity. Group production rose from 5.4 mboe in the first half of last year to 14.3 mboe in the June half, enabling OSH to lift its dividend from US2c to US6c a share, in line with its new payout ratio guidance. The result was quite impressive on the cost front and, despite being in a relatively comfortable position even in a weaker oil price environment, the company is stepping up its efforts to reduce its operating costs by around US$3 per barrel of oil production.
Compared to its large cap domestic peers, OSH is in the unique position of recent strong production growth, a sound balance sheet and excellent optionality with its expansion opportunities in PNG. These include the likely expansion of the existing two train development of PNG LNG, but also more recently the potential development of Papua LNG (not to be confused with PNG LNG). The latter project became an option for OSH when it bought into the Elk/Antelope gas fields early last year. Both are described by OSH as being in the bottom quartile for costs from a global perspective.
We would expect progress on these developments to be slower given the heightened sense of cash flow preservation in the current environment, however both could materially add to OSH’s production profile. The economics of both would have deteriorated somewhat over the past 12 months (depending on what longer-term oil price assumptions the project partners are now using), however the projects’ forecast costs would also have reduced given the weaker demand for companies in the oil services industry. OSH is our top pick in the energy sector.
LNG Project Break-Even Comparison
One of those oil services companies is WorleyParsons (WOR) which over the last two years has struggled due to the fall in mining capital expenditure around the world. WOR now has to contend with falling spending across its core hydrocarbons exposure, with the oil market rout occurring within the last 12 months. As such, while WOR’s profitability was down 25% for FY15, the weak run rate will provide a challenging task for the company to counter into FY16.
To date, WOR’s revenues have held up quite well given this environment (revenue fell just 2% in FY15), however its margin outcome points to the heightened cost focus of its customer base. EBIT margins have dropped from 8.0% in FY11 to 4.9% in the last year, although the flatter trend in the last three halves is encouraging. This has been supported by the efforts that WOR has made to reduce the size of its workforce, which is now 12% smaller compared to a year ago. With the full extent of the weakness in oil markets yet to be realised in WOR’s results, the risk of further earnings downgrades continues to be high. As such, while we view the company as high-quality, we do not recommend an investment at this point despite the stock trading on a relatively attractive forward multiple of 10.5X.
WorleyParsons: Group Underlying EBIT Margin
Spotless (SPO) delivered one of the better results of reporting season when it beat expectations and provided a positive outlook statement for FY16. The company has had a good level of success with contract wins during FY15 (adding $350m p.a. to revenue), while this momentum has continued into FY16, with $70m in annualised revenue won in the first quarter. The high degree of short term visibility in this revenue stream would be underpinning the confidence that management has in further growth in FY16.
While the new contract wins have been positive for the company, it is the growth in social infrastructure public private partnerships that has the potential to provide a margin uplift. These are also typically long term in nature (SPO’s average tenor is around 27 years across its 14 current contracts) and a number of these will be ramping up across FY16 and FY17. SPO was also recently announced as preferred bidder for the maintenance contract for eight new public schools in WA.
The release of SPO’s full year results gave the opportunity for the private equity group that listed the company, Pacific Equity Partners, to sell down its remaining stake. This was completed this week, removing a stock overhang that may have contributed to recent share price weakness. With a solid medium term earnings profile, a strong balance sheet that should provide the opportunity for additional bolt on acquisitions, a low forward P/E multiple of 13X and a dividend yield of 5.4%, we have SPO as a value stock in our portfolios.
Amcor (AMC) reported another solid result, continuing its recent track record of consistent growth. As the stock reports in $US, the strength of this currency was a drag on reported growth for the year. On a constant currency basis (a better measure of its underlying performance), EPS growth came in at 7.5%. The concern for investors may be the clear slowing of growth in emerging markets in the second half of the financial year, with the growth rate falling from 8% to 4% over this time. A slowdown in the key markets of China, Brazil and Thailand was blamed for this outcome. With emerging markets accounting for a third of the group’s revenue, marginal improvement across North America and Europe (where recent economic trends have been better) could potentially offset this in the medium term.
Overall, Amcor has retained a healthy balance between organic growth, acquisitions, dividends and share buybacks, all of which should again add to the defensive growth characteristics of the group. Despite the buyback that it has recently employed and several (albeit smaller) acquisitions made recently, AMC’s balance sheet remains in good shape, and the stock’s valuation is not overly demanding on a forward P/E of 17X. We have the stock in our model portfolios.
Amcor Shareholder Value Creation
Regis Healthcare (REG) has defied the weakness in equity markets over the past month and so expectations were high as it reported its first full year result since listing last year. With its aged care peers Japara (JHC) and Estia (EHE) both beating their prospectus forecasts over the last two weeks, REG followed suit, with earnings 11% ahead of this figure (although inline with the market’s expectations). On most metrics, REG is performing well. Occupancy increased over the financial year from 93.2% to 94.4% (although just below its prospectus number), staff costs were lower (as a percentage of revenue), and revenue per bed was ahead of its forecast.
With a large pipeline of brownfield and greenfield development projects over the next two years, the capital expenditure requirements will again be supported by the higher cashflows that the company is receiving from new residents paying refundable accommodation deposits (or RADs). The uplift that REG has been receiving from these is twofold; the average incoming RAD has been trending higher (nearly 9% growth in the second half of FY15), and more residents are preferring to pay these as opposed to daily accommodation payments. As illustrated in the chart below, the net receipts from RADs in FY15 were higher than REG’s net capital expenditure. We recently added a small position in REG to our model portfolios and believe that the long term structural growth in its market remains attractive.
Regis Healthcare FY15 Cashflow
Veda (VED) reported a good result, with double digit growth in revenue, EBITDA and net profit, meeting the guidance that the company had given to the market. While the company has made several acquisitions in recent years as it expands its product range, these have been incremental in nature contributing to earnings. VED recorded top line organic growth of 9.5%; consistent with a market that continues to expand at a much faster rate than many other industries.
VED’s share price was somewhat weaker after it forecast that FY16 would grow at a slower rate at a net profit level, although revenue and EBITDA are again expected to record double digit growth. The primary reason for this is the increased investment that VED has made to grow its business (including into new products) and as a result of the introduction of comprehensive credit reporting. Comprehensive credit reporting has for the first time allowed the collection of ‘positive’ data points for a consumer’s credit report (such as repayment history and the opening and closing dates of accounts). Once a sufficient database is built up with this information, it is expected that the volume of credit checks (VED’s core business) will rise in Australia, in a similar way to that seen in other parts of the world where it has been introduced. VED’s stock is not particularly cheap, as it trades on a forward P/E multiple of approximately 20X, however we believe that it deserves this premium rating due to the high quality nature of the business and solid medium term earnings outlook for the company.
Boral’s (BLD) outlook gave some indication that the property construction cycle in Australia is nearing a peak as the company guided towards a flat outcome across key divisions. Favourable domestic conditions and a substantial cost reduction program led to an overall 45% improvement in group profitability. It was, however, the company’s US business which was integral to the FY15 result, with the division finally delivering a marginal profit after several years of losses.
From here, BLD will likely need a tailwind of a pickup in domestic infrastructure spending, which is one of its key market exposures. A further recovery in the US housing market will be supportive for the company, however BLD’s long-term poor track record in this country is not supportive of an investment for this reason.
Boral End Market Revenue Exposure
Flight Centre (FLT) reported profit at the upper end of recently downgraded guidance of $364m pre-tax. It arguably represents a classic case of management providing an honest update on trading conditions and share price overreaction, along with short sellers. A weak Australian leisure sector should not be a surprise given the fall in the AUD, though the group has noted it struggles to provide services competing with low cost holidays such as those to Bali. It appears travellers have adjusted their expectations or destinations for more complex travel requirements, with recent trends indicating a mild recovery in demand. The Australian business, representing some 70% of EBIT, is relatively mature, though there is market share in the lower margin corporate sector up for grabs. Global growth has conversely been strong for FLT, with the businesses a mix of corporate, leisure and student travel brands. Unlike some other industries, travel booking is capable of cross border expansion given the similar nature of requirements.
FLT has a large cash balance of $540m excluding client cash. Conservatively it believes it should hold 3 months of operating costs in cash reserves at all times. Travel has potential large risks – political and environmental instability - that could have a major impact in the short term and this cash balance is a buffer in the event of such an outcome. Based on forecasts, the group will generate excess cash balances in coming years with dividend growth or capital management always on the cards. At 14X forecast P/E, a solid dividend yield of 4.5% and an ungeared balance sheet, we continue to believe FLT is an appropriate industrial company investment.
While essentially an asset holder, Scentre provides a useful insight to retail spending and consumer behaviour. Along with this week’s half year distribution, the group announced the sale of 4 centres, with the funds reinvested into other strong performing or growth assets. This will restrain distributions as new investment takes time to compensate for the higher yielding centres and also indicates that Scentre, amongst other REITs, is somewhat capital constrained given its relatively high leverage. The choice is capital raising or asset recycling. The sales data provided is a good indication of spending patterns, albeit recognising the upmarket nature of the assets. Specialty continues to outperform big stores in key comparable segments such as clothing, footwear and jewellery. The weakness in supermarkets is also notable. Centres in this portfolio further reflect that households are skewing their spending towards entertainment and technology. After an initial growth period, consumers seem to have turned away from food consumption at the centres. A key component of the intended capital spending is to regain ground here focusing on a higher standard than the food court concept. One other notable transition is that the closure of the Myer store at Hurstbridge will see the inclusion of a new JB Hi-Fi, a Cotton On Megastore and a Rebel Sport; a sign of the times.
Scentre Group Comparable Retail Sales Growth
David Jones (DJS) under its new ownership also provided sales and profit data. With details a little sketchy, it would appear that Myer is having a rough ride in the sector. DJS reported sales of 10.7% in the second half (though it would be lower on a comp basis), the 2.1% SCG is reporting for the two would imply negative comps for Myer.
Woolworths’ (WOW) result, though in line with weak expectations (flat NPAT pre significant items, down 12% after significant items), did not give cause for any optimism that trends had improved. The significant items were, in reality, costs associated with normal business ebbs and flows and this fall in profit is an indictment of recent direction. It is clear the group has a long way to go before it has regained consumer confidence in its offer. While having been prepared to give up profits in Big W to get there as rapidly as possible, the determination to hold food retail profit margin means there may be some time before a notable recovery can come through.
The outcome for this group is a salutary lesson that market leadership has to be protected rather than paraded with every increasing profit margin. For WOW, this occurred in both food and general merchandise and points to strategic misjudgement by senior management. The potential for sector wide pressure on competitive pricing in food has not gone away; indeed many believe it will intensify as Aldi and others seek to cement a position in the industry. A large deterioration in Big W and continued losses at Masters will also challenge an incumbent CEO. At present, the direction for the group is in limbo, with the current CEO staying in place in order to optimise his payout on retirement. Upside for shareholders may come from a decision on Masters, though ongoing investment makes the decision all the more expensive. A new CEO may further decide to take a tougher reset to supermarket margins rather than letting this drag on for some time. That would knock profits in the short term but at least give a base from which to recover. We do not recommend investment in WOW at this time.
In line with trend, Harvey Norman’s (HVN) Q4 Australian sales were strong, up 6.9% on a like basis and indicates that recent sales are not far off that growth rate. Outside Australia the company-owned stores fared less well. New Zealand replicates the local performance, but the contribution from Europe and Asia is a net negative in total. The key for shareholders therefore remains the contribution from the franchised Australian operations. The clarity here is low, as Harvey Norman undertakes ‘tactical support’ in times of weakness. This dropped sharply in FY15, but can always reappear.
Signs of increased competition in the small appliance and technology sectors may take the gloss of HVN in the coming year. Nonetheless, the group has the tailwind of the housing theme for the moment, though we believe this is largely factored into the share price.