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WEEKEND LADDER

A summary of the week’s results

28.11.2014

Week Ending 28.11.2014

Eco Blog

The debate on the likely growth in 2015 for the Australian economy is heating up. While the consensus is still around 3% GDP growth, a touch better than the expected outcome for this year, there are a few taking a more bearish tack and suggesting growth closer to 2% could eventuate.

In summary, the 3% is based on a modest uplift in domestic demand, through a combination of household spending momentum and resilience in housing activity while acknowledging the drag from low investment spending and tougher terms of trade. Those edging to lower growth are of the opinion that domestic spending will remain weak and that the housing contribution has already peaked, as well as a more bearish view on the terms of trade.

Households are showing great reluctance to commit to higher spending, given their expressed uncertainty (as evident in surveys) on the longer term outlook for the economy. As employment conditions are expected to remain soft, an uplift in contribution from the household sector must come from higher debt, or reduced savings. While commodity prices may have bottomed, most forecasts do not fully take into account the current low levels and if these persist, higher GDP growth forecasts will inevitably have to be wound back.

At this time of the year it would be uncharitable to not offer an optimistic note. A mild recovery in commodity pricing is far from improbable as there are now many marginal producers that could reduce output into 2015. The promise of higher infrastructure spending could also become reality and recent capex data shows a decent pickup in non-mining spending, though the total trend is still down. Finally, the fall in the A$ may have a bigger impact on both services and select product markets.

Translation of export earnings is the ultimate free lunch from a lower currency. Regrettably, it appears the agricultural sector will miss out, as an El Nino event is now firmly in forecast. The extract below is from the current week’s NAB rural outlook with rainfall likely to be well below averages in coming months. 

Forecast to January 2015

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The US initial Q3 GDP print of 3.9% supports the consensus that US growth has been upbeat in the summer period. Indications, however, are shifting towards a softer tone for Q4 of circa 2.5% as durable goods orders (ex defense and airplanes) fell 1.3% in October, suggesting the pace of manufacturing growth was abating and that weak oil prices were reducing demand for associated capital goods. Personal income and spending was also soft, up a very modest 1.4% and 1.6% year on year respectively.  The lower oil price has yet to do what is broadly expected, that is, lift spending in the absence of any contribution from wage growth across the US. This wage dynamic is arguably the key metric for 2015, as emergence of a broadly-based sustainable rise is likely to be the trigger for the change in tone from the Fed.

The currency movements since mid year essentially reflect the tone of the respective central banks. Indexed against the A$, the highlight has unsurprisingly been its fall against the US$. Conversely,  the A$ is holding its own with respect to the Euro and UK Pound as we too struggle with our economic outlook, even though it is clearly better than that of Europe. After an initial period of stability, the Yen has capitulated to its destiny, falling sharply against most major currencies. 

Source: IRESS, Escala Partners
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Given the slightly less bullish US data, there is a case to be made that currency markets will now stabilise into 2015 to assess the next possible steps in monetary policy. The focus is likely to fall on the Eurozone and actions from the ECB to stoke life back into the region. However, a US-style QE is unlikely to work. Holders of bonds will be reluctant to sell them to the European Central Bank, with cash receipts from the sale deposited at the bank earning a negative return. Further, given that banks are required to hold highly rated paper to achieve their capital ratios, there is an added disincentive to realise bond holdings. The ECB may extend itself to credit or other debt securities, though this is unlikely to gain favour with the likes of Germany. 

The resistance in Germany to ECB moves was, if anything, reinforced this week with solid growth in employment. Germany measures its unemployment rate differently to International Labour Organisation standards and therefore its own reporting of a 6.6% unemployment rate is a globally comparable 4.9%. Not only is the growth in employment concentrated in long term full time jobs, but wage growth is also holding up at around 2% per annum. While Germany also has unfavourable demographics, immigration from elsewhere in Europe has added 340,000 to the labour market since 2010, again reinforcing the strength in the underlying trends.

The ECB may therefore find itself incapable of doing much to drive Eurozone growth and a more imaginative solution may have to emerge.

OPEC provided no support to the tumbling oil price and many view the outcome as a watershed event shaped by the change in supply. Assuming OPEC sticks to its circa 30mb/d output, attention will be on the US companies and their capacity to cope with this new paradigm. The substantial shift in power from commodity suppliers to commodity consumers may well be a major feature of the next few years. 

Company Comments

Harvey Norman (HVN) is undertaking a 1 for 22 deeply discounted (~30% to last price) rights issue raising $121m. The group will then distribute a 14c/share special dividend, doubling the yield for this year.

HVN has historically been reluctant to lift its payout, or pay out special dividends, notwithstanding a franking balance of about $670m. This payout will account for some $64m of that. EPS will be diluted by about 5%, but for low tax investors the net effect of the franked dividend offsets the cost of additional investment into shares. The size and discounted issuance appear to be struck to allow Gerry Harvey to sub underwrite the issue and participate such that his shareholding level is maintained.  The investment community is divided on the merits of this move. If the outlook for the group was strong, a higher debt level to cover the special dividend should be tolerable, rather than resorting to a very dilutive issue where the benefits are heavily skewed to domestic investors on low tax rates. Conversely, some view the release of the franking pool as a welcome addition to returns. 

The HVN share price has performed reasonably well this year, as it was able to reduce support for franchisees due to improved sales and profit margins off the back of the level of housing activity.  However, the unpredictability of the balance between franchisees and shareholder returns adds a dimension to HVN likely to imply a longer term share price discount to fair value. Additionally, we believe many products will continue to be challenged by competitive pressure and easy online price comparisons. 

Dick Smith (DSH) also gave a trading update with comparable store sales up 1.7% financial year to date as well as the estimate for this half year. Marginally better than that of its nearest competitor, JB Hi-Fi (JBH), investors nonetheless treated the outcome with some caution and the stock traded sideways. 

Dick Smith: Total and Comparable Sales Growth

Source: Dick Smith
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Low comparable sales indicate how critical cost containment is now. Maintaining staff ratios in a category where service is generally expected, placed the emphasis on other costs such as rental, which in turn is feeding into low growth for the retail REITs. Investing in discretionary goods retailing has been a tough sector for some time and we generally continue to recommend steering clear of the stocks in the sector.

At its AGM Woolworths’ (WOW) management felt the pressure of a weak share price and were at pains to reinforce their expectations of 4-7% profit growth for the year. With the key Christmas trading period ahead, the group may hold off any major changes to its product pricing in order to support margins for the first half. Whether these will inevitably buckle under the impact from discounters and the ‘space race’ of new store openings which cannibalise sales, will only become clearer over a longer time frame. The vulnerability of the highest pre-rental food margins in the developed world in what has been a reasonable comfortable duopoly may be a good test to see if operating in ‘island Australia’ truly will allow domestically oriented business to set their own destiny, or whether global trends inevitably infiltrate.

Aristocrat Leisure (ALL) released its full year result, with a 10% increase in profit for the year, largely a function of more favourable currency movements. The result, however, was commendable considering the weak gaming conditions, particularly in the key North American market. This market experienced a contraction over the year of greater than 10%, with casinos deferring capex plans on the back of low turnover. The group recorded an impairment on its Japanese business as a result of regulatory changes in the country, highlighting one of the ongoing risks of investing in the sector.

What has helped ALL in the current environment has been an uptick in its market share as it has reaped the benefits from an increase in investment in its design and development team. Maintaining this momentum will be important as little assistance is expected from the market, making the investment case for the stock more difficult. The company does appear, however, to have a solid pipeline of releases in the medium term, providing further scope for share gains. Extracting synergies from its recent acquisition of VGT is a further potential driver of performance over the next year.

Investors could not conclude whether ALS’s (ALQ) half year profit was a good outcome, with the company’s share price jumping on the result before retreating in the following days. The result came in ahead of its previous (downgraded) guidance given in September, however earnings were still down 33% on last year, with an even bigger hit to its dividend. A decline in organic revenue across its mining and energy testing businesses has been compounded by sharply lower margins, with the relative stability of its life sciences (targeting the environmental, food and pharmaceutical markets) failing to provide an adequate buffer. As we have previously noted, the company’s acquisitive growth in the energy sector has been inopportune in its timing, following the decline in oil prices in recent months. For the stock, risk of further earnings disappointment does not appear to be fully reflected in a forward P/E of 14X.

Seek (SEK) gave a trading update at its AGM, which broadly reaffirmed its previous guidance of “solid growth” in revenue and EBITDA for the year. The company gave more specific details around the performance of its three divisions, and most pleasing was its comments on its core domestic employment classifieds business. SEK noted that trading conditions had been positive, with revenues ahead of the guidance that it had formed back in August at its full year result. SEK’s “New Job Ads Index” (illustrated below) shows this gradual improvement over the last year. This outcome is significant, because it has been this division that has underperformed over the last few financial years with the backdrop of a benign employment market. A cyclical turnaround could provide a nice tailwind for the company, although we note that the current valuation of the stock may well be already factoring such an outcome.

Seek: New Job Ads Index

Source: Seek
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OzForex (OFX), which listed on the ASX a little over 12 months ago, reported a half year result that was ahead of expectations and its own prospectus forecasts. For those who are unaware, OFX is a provider of online international payment services and is seen as a disruptor to the dominant entrenched positions held by banks, which typically offer considerably less attractive rates than OFX and poorer customer service. Client, transaction and income growth all showed solid double-digit increases, and its US business delivered its maiden profit. OFX has sound long-term structural drivers, with increasing international payments and the shift to online transactions. This sees the stock screen as an attractive growth company, albeit illustrated by its forward P/E of 24X.

Market Focus: Free Cash Flow of BHP and RIO

After several years of over-investment in expanding production (which is coming at the detriment of prices, particularly in iron ore), the big diversified miners, BHP and RIO, had been expected to reward shareholders in coming periods with increased capital returns, either by the payment of special dividends and/or share buybacks. This expectation was borne out of a change in strategy,whereby they would focus on reducing costs that had been inflated in the commodity boom, wind back capital expenditure plans and look to gain efficiencies from sweating their assets further.

One of the complicating factors with the dividend policy of both companies is that they look to pay progressive dividends, i.e. they attempt to act more like an industrial company by growing their dividend year on year. The argument is that this policy can be supported, given the diversity in their commodity exposures, which reduce the volatility in their earnings, resulting in a more predictable income stream that is linked to growth in production volumes (which are more within their control). In practice, however, the correlation of commodity price movements is greater than they may have you believe.

Making the case more difficult for progressive dividends is that both companies have become increasingly concentrated, with a focus on a small number of commodities. The dominance of iron ore on RIO’s portfolio is well known, and BHP will further reduce its diversity following the expected spin off of non-core assets next year.

The other limiting factors to increasing returns to shareholders has been the desire by both companies to strengthen their balance sheets. A more conservative approach has been taken by both in light of a less supportive commodity price environment and a greater level of uncertainty over the path of global economic growth.

Emphasising both company’s reliance on iron ore, in light of the spectacular drop in the iron ore price this year, expectations over the timing and size of capital returns have been wound back. So where do these companies sit with regards to the sustainability of these progressive dividends?

To simplify our analysis, we will assume that the free cash flow available to pay dividends is defined as net profit after tax + depreciation and amortisation – capital expenditure. We will use consensus figures for profitability and company guidance for capex. We will then compare this to the dividend payments made by each company in the last financial year (i.e. assume that dividends are flat year on year).

The summary for BHP is provided below. On current projections it is likely that BHP’s current dividend payments will approximately equal all of its available free cash flow for this financial year. For FY16, it would appear to be in a more comfortable position to meet these dividends, however the risk would be on the downside to these current forecasts. We note that consensus forecasts for FY16 profitability have been revised down by approximately $2bn over the last three months – equal to the current free cash flow buffer assumed by the market. Such a scenario would also see BHP’s payout ratio lifting above 50% over these two years, up from 47% in FY14.

BHP: Free Cash Flow Forecasts (US$bn)

Source: Bloomberg, Escala Partners
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RIO’s summary is detailed in the table below. Its position looks to be less precarious than that of BHP, although as we noted above, its leverage to iron ore could be problematic. Consensus forecasts show flat profit year on year in 2015 (its financial year is December year-end), which would be a solid result given the expectation of a full 12 months of lower iron ore pricing. The other point to note is that its payout ratio is coming off a lower base than that of BHP, and this is the key difference between the two companies. Longer-term investors may recall that RIO slashed its dividend during the GFC as it dealt with its over-leveraged balance sheet resulting from its acquisition of Alcan. It has maintained a progressive dividend policy since then, which it has been able to do because of this rebasing of dividend payments.

RIO: Free Cash Flow Forecasts (US$bn)

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Faced with declining commodity prices, BHP and RIO have pulled considerable levers in order to improve their cash flow in recent years. While further savings are expected in coming years from a number of sources, including volume efficiencies from increased production and further cost savings, the prospect of additional capital returns over and above ordinary dividend payments is low at this point in time. 

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