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WEEKEND LADDER

A summary of the week’s results

29.08.2014

Week Ending 29.08.2014

Eco Blog

US data had a positive tone for the week, especially consumer confidence, where the Conference Board Index hit a post-recession high. In particular, the view on labour market, as measured by those that think jobs are plentiful, is improving rapidly and comfort with their present financial circumstances is reassuring. Given the size of the household sector, it is not surprising that economists are keen to see a higher level of activity from consumers. Yet household debt levels are relatively high (though debt servicing relatively affordable) and the corporate sector is arguably more likely and important in driving spending and investment.

The data on this count looks promising too. US capacity utilisation is rising and the closely followed Philadelphia Survey capex expectations has been rising sharply

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US durable goods orders were up strongly in July at 22.6%. Clearly a lumpy series, it nevertheless rounds out a decent and welcome outlook for GDP growth in the US for the second half of the year.

Locally news was patchy. The pace of housing activity looks likely to plateau at around current levels. The Housing Industry Association reported new detached home sales down 4.7% and apartments down 10.9% for July. There have been numerous views expressed that the apartment market is overdone, especially in Melbourne, resulting in falling rental yields and vacancies. Detached housing is more likely to perform better, though restricted by land cost and location.

Under scrutiny from the financial system enquiry, the recent interim report is further likely to temper the level of contribution from housing to the economic cycle. Each bank may be able to justify its capital position and conservative lending book, but the authorities clearly are concerned on the linkages in the financial banking system where the risk in each bank is similar and therefore the overall risk to the economy is substantial. 

We have commented on the relatively high level of household debt in Australia on a number of occasions. Debt servicing has eased due to historically low interest rates, but debt to income is high. The chart below is a variation on the series we frequently see published by the RBA and the ABS, presumably due to their concern on personal debt, specifically housing.

Housing Debt and Other Debt as a % of Total Household Debt

Source: ABS
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Real (deflated by CPI) Household Debt Per Person

Source: ABS
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The initial headline reading of capital expenditure and investment intentions could have drawn a bearish conclusion.  The actual data for the June quarter was weak enough to imply a further slowing over the coming year. Yet, there was good news. Mining, unsurprisingly, will see a big fall in investment, bigger than current estimates. Manufacturing, plant and equipment spending is likely to at best flat-line. The star was ‘other selected industries’ where investment intentions indicate positive momentum rising by 12% compared to a year ago. The question is what is ‘other’? The ABS report states that this embraces utilities, logistics, information and media amongst others, but excludes health, education and agriculture which appear to miss out on any such survey. The complexities in sampling economic momentum is once again evident; retail sales which essentially excludes retail services and online falls under the same issue.

The potential importance of ‘other’ should not be understated. Commonwealth Bank economists, commenting on this release, noted that it was experiencing an uplift in credit demand from non-financial firms. If these trends come through in the aggregated credit data, the eventual shift away from mining to other sectors may indeed transpire. Then the challenge is to identify investment which match this changing pattern, regrettably thin on the ground in quality and size.

Europe has recently lost some of the glow that emerged last year. Germany is battling to accelerate its growth, arguably understandable given the proximity and impact from the crisis in the Ukraine. Conversely, activity in Spain continues to improve, albeit from a low ebb. It is Italy and particularly France that drag down the aggregate numbers for the Eurozone.

While it is the lack of reform in the latter countries rather than other headwinds, the view is that the ECB will be easing further into the remainder of the year. Investment markets are largely positioned for that, explaining the very low bond yields across all of Europe. 

Eurozone Growth Rates and PMIs

Source: ANZ
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Company Comments

Woolworths (WOW) was one of the last large cap companies to report. We will keep our comments short as we have covered the retail sector at some length in recent times. EBIT growth for FY14 was up 5.3% on a comparable basis, in line with EPS, while dividends for the year rose by a more modest 3%. Woolworths faces rising competition, increased regulatory oversight and store maturity for its Australian supermarket business.  New Zealand has been an underwhelming story for WOW since acquisition some years back and even now barely makes a 10% return on funds employed. Big W’s earnings fell sharply as the discount department store sector shows the strain of excess floor space and resulting competition. As previously reported, the Masters business requires a restart. In our view WOW, while a solid group and with a relatively safe delivery of profit, runs the risk of being downgraded by the market in valuation as the conviction that more of the same does not deserve a market premium.

Harvey Norman’s result received a good response from investors. Revenue growth was relatively weak, up only 3% in Australia on a like for like basis, and down 2.2% in New Zealand. The trend, however, picked up in the 4th quarter, and with housing sales robust in recent times, higher sales growth in FY15 would appear very likely.  In recent years, HVN has been reducing its store count, an unusual step in the Australian market, with franchise stores now at 198 (versus 213 at end FY12) and owned stores at 82 down from 96 at the peak in 2011.

EBIT took a meaningful step up, mostly due to reduced support for its Australian franchisees and a favourable translation effect from its business in NZ. The dividend was increased from 9c to 14c for the full year, still a rather mean 2.6% yield; very low compared to other retailers. Cash flow was very strong due to the lower franchise support and what would appear to be tight working capital control. HVN’s accounts are hard to interpret due to the mix of franchise and owned business and the unique operating structure.

One of the features of HVN compared to other retailers is its property book - some $2bn in investments consisting of around 120 properties. We are not swayed by the value per se, as it is highly unlikely to ever be realised and most of the value sits with the security of the tenant, HVN itself. But it does give the group flexibility others would find useful, particularly to close or reconfigure stores at will. We stress that HVN does not own all its properties and outside NSW many are in outer suburban and regional areas. On the margin, there is a consistent pattern of property investment outside the retail core – currently in mining camp joint ventures for example.

The investment case for HVN is more difficult to assess compared to other retailers largely due to management’s willingness to subsidise the franchisees through tough periods.  The predictability is therefore lower than can be assessed from other retail ratios. In our view, a cyclical leaning towards housing activity is warranted in a portfolio. In our models we have an indirect exposure through WES (Bunnings) and in Mirvac. While HVN looks likely to gain some support in the coming months if the outlook continues to improve, we do note that the competitive environment is also rising. Bunnings, Masters, JB Hi-Fi, Dick Smith are all looking to increase their share of household goods and electronics. In our view, HVN is a trading opportunity rather than for longer term holders.

Rather than a dry run though data, we will make some general comment s on the REIT sector year end reports. Both Goodman Group and Charter Hall Group were well received. These companies are leveraged to transactional property income rather than valued as rent collectors. Given the interest rate environment, cap rate compression and buyer demand, it is no surprise these groups are doing well recycling their asset base. The question we find hard to answer is how to value them, as they present as a mix of rental income, capital realisation, performance fees and capitalised interest. Debt refinancing has played a meaningful role in earnings growth in recent times. The blander ratios of unfranked yields in the order of 5-6%, and underlying growth of 5-7%, strike one as less appealing. Of the retail REITs which reported recently, net operating income is rising very slowing, generally at between 1-3% and again the bulk of the upside has come from valuation through compression of the cap rate. Until recently, the sector has performed well, but now is trading at above its net asset value and distribution yields leave little leeway for any risks. A higher dependence on asset recycling has introduced potential volatility not associated with the sector.

Unlike some others in investment management, we do not view REITs as a separate asset class; they are equities, with management decisions, operational risks and discretionary distributions. Higher reliance on capital profit only underscores our view. This does not imply we don’t like the sector, but that it has to line up against other equities in order of merit. With the next move in interest rates up rather than down, we do not believe it is timely to add to REIT’s.

WorleyParsons (WOR) scraped into its profit guidance range of $260-$300m, with a full year underlying profit of $263m. The figure represented an 18% decline on FY13, despite just a 3% fall in revenue. Lower profit margins have been an ongoing problem for WorleyParsons over the last few years as the chart below illustrates. Had FY10’s margins been sustained, the group’s EBIT would have been approximately $180m higher in FY14.

WorleyParsons: EBIT Margin

Source: WorleyParsons
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While WOR’s full year margin continued its recent year-on-year trend, management was keen to highlight the improvement in the second half. Part of this was due to the non-recurrence of some problem contracts in its Canadian construction and fabrication business, and part was also a result of the restructuring and cost-out initiatives which were announced the market in early April.

With its profit decline over the last few years, WOR has lost its P/E premium to the market and its international sector peers. The outlook for the company still looks clouded, with restrained capital spending in the global oil and gas sector, outside of a few pockets of growth, such as the US shale industry - unfortunately this is not an area of strength for WOR. WOR had a good track record in the past in growing its EPS via acquisitions and has been assisted by much more robust market conditions. Given the much larger current size of the company, its operating environment and the low interest rate environment, it would likely create higher shareholder value in the medium term through a share buyback rather than pursuing further acquisition opportunities.

Flight Centre’s (FLT) outlook was perhaps mildly disappointing, with the company guiding towards 5-8% growth in underlying profit before tax, however it should be noted that the company has a history of under-promising and over-delivering. This may be achieved via a comparatively weak first half, with growth accelerating into the second half as it cycles easier comps. The recent downturn in consumer spending in Australia appears to have a lingering effect on the company’s results in the short term, however the longer-term thematic of increasing levels of air travel driven by cheap airfares provides significant positive support for FLT’s investment case.

While Australia is the core of the company’s business, FLT is increasingly sourcing its revenue from overseas markets, as the chart below illustrates. Pleasingly, all countries reported a positive result from a TTV (total transaction value) perspective. FLT is also making progress in its plans to allow its customers to transition between the various booking mediums, including in-store, online and by telephone – once this is fully rolled out, this will give it a distinct advantage over its competition.

Flight Centre: FY14 Result by Country

Source: Flight Centre
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We have FLT in our model portfolios as an attractively priced mid-cap stock with solid long term opportunities. With multiple growth drivers (including international and corporate markets), a solid balance sheet (the company is net cash) and high ROE, we are prepared to look through any near-term weakness in the company’s trading environment.

Qantas (QAN) arguably generates more headlines in the media from its results than its 0.2% weighting in the ASX 200 warrants. A $2.8bn loss is quite material for most companies, even more so when one considers that this is almost the equivalent of the entire group’s market capitalisation. The statutory figure was largely due to an impairment on the carrying value of its aircraft fleet (a non-cash item), many of which were purchased at a time when the $A was much lower. Investors instead looked to QAN’s underlying result, which showed a lower-than-expected loss before tax of $646m.

Despite its best efforts to restructure and lower its cost base, a multitude of factors outside of QAN’s control led to the deterioration in the group’s profitability in the last 12 months. Rising fuel costs, lower yields and load factors as a result of a competitive marketplace, and general inflation costs all impacted the result. In the short term at least, conditions look to be improving for QAN, particularly in the domestic market, which has experienced a period of over-capacity as each of the airlines chased market share. QAN is forecasting a return to underlying profit in 1H15, however this prediction perhaps has more ‘ceteris paribus’ assumptions than any other ASX 200 company, referencing the competitive environment, global economic conditions, market capacity growth, fuel prices, FX rates and material adverse events. The low overall profitability of the global airline industry, and QAN’s position within it, make it difficult to consider the stock as a long term holding.

Orora (ORA) and Recall (REC) both reported their first full year results after being spun out of the much larger entities of Amcor (AMC) and Brambles (BXB). With perhaps weaker organic growth opportunities compared to their former parent companies, the perception that they may have been neglected, to a degree, as part of the larger corporate structure, sees the investment case rest on improving the operating performance from increased management focus.

ORA beat expectations with its result, with the stock continuing its good run since first listing last December. ORA’s medium term earnings growth is forecast to be almost entirely due to its cost reduction program, and the company delivered at the top end of its guidance on this measure. With limited top-line growth compared to some of its industrial peers, it would appear that it would need to again continue this trend to justify its current valuation.

REC aim is to be more acquisition-led growth, however it was its commentary regarding margin contraction into FY15 that spooked investors. A requirement to increase investment in marketing, sales and digital product development will all combine to cap any margin improvement that REC was hoping to make in the current financial year, with the benefits from this to be realised from FY16 onwards. Technology remains the key structural risk for REC’s longer-term ambitions, with its expertise lying in the physical storage of paper records. While this process should play out over an extended period of time, it is difficult to see how effective REC can compete against the likes of Google, Microsoft and IBM. In the meantime, the difficult outlook for REC and its competitors could well result in further consolidation in the industry in order for companies to expand their top line, which is not without its risks. The chart below shows REC’s key measure of carton growth over the last three years, showing net organic growth to be in the low-single digits:

Recall: Carton Growth

Source: Recall
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Boral’s (BLD) result beat expectations, with management performing on its cost-out measures, resulting in a significant rise in earnings and dividends, as well allowing the company to strengthen its balance sheet. BLD, however, is still generating poor returns from its various businesses, with its overall return on funds employed of 7.2% well short of its 15% target, the point at which it would be generating value by exceeding its cost of capital.

In FY14, BLD’s four divisions reported varying ROFEs between -5.8% and 12.7%, with its US division again loss-making despite the pickup seen in the US housing market. BLD has some nice tailwinds in its key markets over the next few years, and should continue to improve its profitability as further benefits flow from its cost reduction program. However, the incremental year-on-year gains here are lower compared to FY14 and we believe that there are better quality companies in the sector. It doesn’t screen as good value on a forward FY15P/E of 19X.

Lend Lease’s (LLC) full year profit (and dividends) were boosted by the previously announced sale of its interest in the Bluewater Shopping Centre in the UK. Transaction profits such as these are a regular feature of LLC’s earnings and so are not treated as one-off in nature. As a result, the magnitude of the Bluewater sale clearly won’t be repeated in coming years, and investors should not thus be surprised to see expectations of a lower NPAT for LLC for FY15.

With its various projects, LLC has a high degree of revenue visibility for the next three years, as the chart below illustrates:

Lend Lease: Project Pipeline

Source: Lend Lease
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Subject to the successful completion of these various projects, LLC would appear to be well-placed to record reasonable underlying growth in the medium term. The cyclicality of its end markets should mean that LLC trades at a discount to the market, however its geographic diversification tempers this to a certain degree, and we are comfortable with the stock’s current position in our model portfolios.

Ramsay Health Care (RHC) again produced a solid result, with EPS growth in excess of 20% for FY14. Investors were encouraged by an outlook forecasting a further 14 to 16% growth in FY15. RHC operates in an attractive sector with high, predictable growth rates ahead of many other parts of the market, and this thematic shows no sign of abating. Its success, however, is also due to excellent execution, with a mix of improving the performance of its existing hospitals base, low-risk brownfield expansion of these facilities, and complemented with recent acquisitions. RHC currently sits in a group of high-growth companies in which the market has placed a highly elevated premium on its earnings, with it sitting on a FY15 P/E of 27X, and so we are happy to sit on the sidelines for the time being.

 

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