Week Ending 30.10.2015
More babies from a 2 child policy is unlikely to have any impact on China in the next few years, but represents the shift in attitude that is widely expected. Plenary sessions otherwise tend towards grand statements, with innovation, easing price restrictions and improving the social safety net likely to be well received. China’s working age population has turned, but there is substantial scope to raise the productivity of the existing workforce. Comment on the cost and inconvenience of children (restrictions on migration to cities, housing size, childcare and access etc) is likely to limit the impact of this policy measure for some time. Along with many other countries, self- selecting small families is now the norm.
For financial markets, further easing of monetary and banking constraints will likely be the near term focus. The decision to include the renmimbi (RMB) in the IMF’s Special Drawing Rights (SDR) programme due this month will also signal the potential for China to widen its bond and credit markets to foreign interest. Otherwise, the inclusion of the RMB will have a modest impact, requiring only a small holding in the currency by the major central banks.
The door to December was left clearly open at the Federal Open Market Committee’s (FOMC) October statement. The change in wording to “whether it will be appropriate to raise the target range at its next meeting” has been widely interpreted as a hawkish statement. Once again, we remain watching employment and inflation data into the year end. The next FOMC meeting is on 16 December.
Other US economic trends remain somewhat less supportive. Consumer confidence eased in October, with the job market judged as somewhat less attractive than earlier in the year. Mortgage applications have levelled out, suggesting the housing market cycle was maturing. The current 15 year effective mortgage interest rate is sitting at 3.33%, a touch below that of a year ago. Durable goods orders continued their soft pattern to end the third quarter 3% below the previous year.
In Europe, the promising signs of money growth and credit expansion fell back in September. With disinflationary trends looming, the incentive to invest appears to have waned.
Arguably, most economies are at the crossroads. Monetary policy has been the main tool to date, when the problems are not monetary in nature, as interest rates are surely already low enough. In turn, exchange rates have worn the brunt of the impact. A dovish ECB and BOJ risks the US$ being pushed to the level that is unproductive for everyone.Enlarge
Locally, a weak inflation print caught the eye, annualising at 1.5%. On the up were prices of tobacco (+10.7% year-on-year), fruit, international travel, property charges, furnishing and childcare. Offsetting these were falls in vegetable prices, fuel, telco, domestic travel and apparel. A surprise was the decline in utility prices, reflecting the regulator’s decision to lower network electricity charges.
Notably, the translation impact from the lower A$ has not resulted in a rise in tradeable and goods products. Somewhere, someone is taking a margin squeeze. Assuming the hedging that would have caused a lag in the rise in import price is currently maturing, import prices will have to rise in coming months to compensate.
Source: Commonwealth Bank
International trade prices hints at this prospective rise in imported goods prices. In turn, our terms of trade will deteriorate and hurt the income side of the economy. As we noted previously, this should result in another bout of downward pressure on the A$.Enlarge
Lifting the gloomy tone is the benefit from lower interest rates and A$ that have flowed into NSW and, to a lesser extent, the Victorian economies. The housing sector, components of retail spending and professional services sectors have been clear beneficiaries. This should be followed by further tourism growth and what appears to be a long-awaited infrastructure spending uplift in NSW.
Fixed Income Update
Central bank policy decisions remain the focus of bond and credit markets. The US bond market had been range bound earlier in the week in anticipation of the FOMC rate decision. Despite the ‘no change’ result, the hawkish statement that followed pushed yields higher across the treasury curve, with moves more exaggerated at the front end. At time of writing, 2 year treasuries were up +8bp to 0.7%, 10 years up 6bp to 2.10% and 30 years up 2bp to 2.88%. The futures market is now pricing in a 46% probability that the Fed will hike in December, up from 37% prior to this week’s statement.
Domestically, the chance of a rate cut by the RBA on Cup day is priced as more likely than before. The fallout from the weak CPI number this week, the delay in the Fed lift off and the move by the four majors to raise interest rates on their mortgage books, pushed yields lower. The chart below depicts the 2 day shift in the Australian yield curve following the inflation figures this week. The market is now pricing in a 67% chance that the RBA will cut rates next week.
Yield Curve Move Post Inflation Data
Source: Bloomberg, Escala Partners
Prices in the domestic listed hybrid market have posted positive gains this week, with spreads continuing to tighten since this market hit its wides a month ago. This has been despite supply side pressure with AMP launching a new tier 1 deal this week. Following a successful book build AMP issued a $230 million 6 year (to the call, 8 year conversion) tier 1 mandatory convertible at BBSW +5.10%. Demand was said to be high, with an order book in excess of $600m. In addition, the performance of this market appears unaffected (so far) by any switches out of hybrids to fund the new Westpac capital raising.
The table below shows the performance of a few select hybrids in the mid to long part of the curve over the last four weeks.Enlarge
Source: Iress, Escala Partners
In spite of increased volatility in hybrids, this market remains very much open for business at the right price. A good testament to this was the recent offshore issuance by BHP of an $8b multi-currency (EUR, USD and GBP) tier 1 bond which was the second largest deal ever done after the Electricite de France issue in 2013. This deal has so far performed well in the secondary market and after two weeks the 60 non-call 5 is already trading above par (c.$103.50).
National Australia Bank (NAB) was the first of the major banks to report results this week, with an annual earnings figure slightly below expectations. Underlying earnings growth of 2.4% resulted in a 2.8% fall in earnings per share following the bank’s capital raising earlier this year. The dividend was flat for a third successive quarter, although the total dividend to be paid will be higher given this higher share count.
While each of the major banks have been affected by the industry-wide issues (such as benign credit growth and increased capital requirements) the restructure of NAB’s business is also a significant driver for the stock in the medium term. Broadly speaking, NAB has acted to reduce its exposure to a number of underperforming divisions among its portfolio of assets. Most notable among these is its UK bank, which is on track to be demerged in the early part of 2016. This week, NAB also announced that it would enter into a new partnership with Japanese firm Nippon Life, which would see it sell 80% of its life insurance business to the company for $2.4bn. The sale would result in a further 50bp improvement in NAB’s tier 1 capital ratio, an important outcome given the poor capital generation of the group’s underlying operations.
A key benefit of NAB’s divestments was that the attention of investors would turn to the higher-returning domestic banking operations. Unfortunately for NAB, the performance of its business bank (which is considered as one of its relative strengths) has become somewhat disappointing in this transitory period. The bank has been undertaking significant investment in this business, enabling it to achieve solid volume growth for the period. This, however, has come at the expense of margins (as shown in the chart below), with NAB falling into line with more competitive pricing across the market. Having closed the P/E gap to the average of the other major banks, NAB will likely need a better performance from its Australian bank in order to regain investor favour.
NAB Business Lending Net Interest MarginEnlarge
ANZ’s result was also mixed, with a slight miss to expectations. Earnings were up on a year-on-year basis, although similar to the other major banks, were pulled back on a per share basis by the capital raised this year.
The positives for ANZ were largely related to its Australian and New Zealand businesses. The Australian retail division recorded 10% profit growth (before provisions), the commercial segment grew earnings by 2%, while New Zealand growth was 7%. Compared to the other banks, ANZ has better managed the fall in net interest margins this year, with a flat result in the second half.
The marks against ANZ were weak earnings in its global markets trading operations (often a volatile component of its earnings) and an uptick in bad debts (which was foreshadowed at its third quarter trading update in August). This latter factor is yet to materialise in the results of the other majors. While part of this has been explained by some sector-specific exposures in Asia, it does highlight the low bad debts rate across the industry at present and the potential for this to drag on earnings in the medium term.
ANZ is the higher risk/reward option in the banking sector at present, with its higher exposure to Asian markets the key point of difference to the other majors. While we have been underweight the sector given the current and future headwinds to the industry, ANZ is been one of our preferred holdings given its relatively cheap valuation and the longer-term opportunities available in Asia.
FlexiGroup (FXL) this week announced the acquisition of Fisher and Paykel Finance, a leading New Zealand consumer finance business. The transaction is a significant one for FXL and the acquired business will represent close to a third of FXL’s combined operations. The deal will be funded by a 1 for 4.46 pro-rate entitlement offer, with the new shares priced at $2.20.
FlexiGroup: ProForma ReceivablesEnlarge
While the price paid for Fisher and Paykel Finance appears to be high (2.9x book value), it plays into FXL’s strengths of achieving value-enhancing growth via acquisition. As a result, FXL is expecting that it will be “high single digit” accretive to earnings per share, despite the full price.
We have been supporters of the FXL story and have recommended diversifying away from the major banks into these smaller, more agile and niche players in the financial sector. However, we have been more cautious in the shorter term given the recent changes at the board and management level and a slowing organic growth profile. Taking a longer-term view, the stock still screens as good value with the next catalyst the appointment of a new CEO.
Macquarie (MQG) has been one of the best performing financial stocks in the domestic market over the last year and the company backed it up with a solid result today. Net profit grew by 58%, again exceeding its most recent guidance (issued three weeks ago) of 55% growth. While a high international presence (71% of income was from offshore in the first half) assisted the group’s growth given the weaker $A, MQG estimates that around a quarter of its profit growth was from currency movements, pointing towards solid underlying trends.
Strong fund performance, increased market volatility and higher transactional activity all led to improved trading conditions for MQG in the half. The higher profitability now has the group generating a much-improved return on equity; pleasingly this is higher among the core annuity-style businesses:
Macquarie Group: Return on Equity
Source: Macquarie Group
All divisions of MQG reported higher profits in the half, however it should be noted that approximately half of the overall profit growth could be attributed to higher performance fees from the infrastructure funds it manages, which more than doubled compared to the previous half. We had previously highlighted this as a medium term driver of profit growth, although the sustainability of this outcome is clearly questionable. We have MQG in our model portfolios and believe that the current market conditions remain supportive for the company’s performance.
Telstra’s (TLS) investor day confirmed the changing dynamics across the telco industry. TLS was able to reaffirm its full year guidance of low-single digit EBITDA growth, however noted increased competitive behaviour in the broadband and mobiles market. Prices had been moving downward in broadband, while in mobiles, operators had been trending towards increased data allowances in their plans (in some plans, data allowances had tripled over the last year).
The theme of increasing data as a result of a higher number of connected devices and faster download speeds may not necessarily be a positive for telcos as this increased activity is competed away by the industry. If consumers increasingly choose their telco on the basis of price, this should play into the hands of the smaller operators given Telstra’s premium pricing point. We have been underweight Telstra in our model portfolios, preferring to gain exposure to the sector through companies that are gaining market share at Telstra’s expense, such as TPG Telecom (TPM).
Late in the week, Qube Holdings (QUB) entered the race to acquire part of Asciano’s (AIO) assets when it combined with Global Infrastructure Partners and Canada Pension Plan Investment Board to acquire 19.99% of the company. The consortium plans to vote against the current offer on the table from Brookfield Infrastructure (with the scheme meeting taking place on 10 November), which requires 75% of votes cast to be in favour in order to proceed.
If the consortium were to be successful in acquiring AIO, Qube would take control of AIO’s ports business, while its co-investors would take ownership of the Pacific National rail business. With additional parties now pursuing AIO, the likelihood of a deal being completed has increased, although competition concerns may yet hinder the chances of either progressing. The ACCC has already noted its concerns over the Brookfield proposal, while similar issues may be raised over the position of Qube.
The operating leverage in the retail sector could not have been more succinctly exposed this week. Woolworths’ (WOW) first quarter sales figures faded into insignificance given the scale of the earnings downgrade. For the record, food and liquor comparable store sales declined by 1%, indicating that early attempts to reinvigorate the business had found little traction. Big W’s same store sales fell 8.1%; its 12th quarter of declining revenue per store. Home improvement (Masters and Home Timber) sales were up 20%, largely from new stores.
Management indicated that they expected the first half profit to fall by around 30%. The combination of reducing prices, relaunching its loyalty scheme, additional labour and the low inflation in food prices (which is below the rise in the cost of business), has a dramatic impact on margins. Woolworths is not the first group to come under this pressure. Much has been written in investment circles on the rout experienced by the major supermarket chains in the UK, particularly Tesco. The finger is commonly pointed at Aldi and there is no question this group is also gaining credit for its offer in Australia. Yet, Coles to date has been largely unscathed and while it has had its eye on prices for some time, the value differentiation to Woolworths has not been large.
This points to a deeper malaise at WOW than just price. Staff morale, shelf stocking, fresh quality and selection are all factors which WOW let slip to achieve an ever increasing profit margin, rising to near 8%. Management had been given too much credit for their claim that success was coming from lowering their cost of doing business. EBIT margins at WOW may now eventually settle at around 5%; on a pre-rental basis this would still make them one of the highest in the world.
The outlook for the group is clouded and it is by no means certain that this is the end of the downgrade cycle. Exiting the Masters business may give a short term fillip to sentiment, but also will deprive the group of growth in this product category. In the long run, it is possible to see WOW as a company that can grow at the rate of food inflation plus population and that would imply a lower P/E multiple than it has been rated at for much of the past decade. European food retailers, for example, trade on a forward P/E of 14X, while WOW is still at about 17X by most estimates. A cut in the dividend is also a real possibility given its balance sheet is below the S&P indicators to hold its credit rating. Debt/EBITDA is at 2.6X versus the 2.7X threshold and fixed cover is at 2.6X versus the 2.7X threshold.
The WOW outcome carries a broader lesson for investors. Cost cutting alone cannot carry the can to achieve profit growth. In recent reporting seasons, many companies are appeasing investors with programmes to reduce expenses and there is a notable absence of those that are talking about what benefits they are taking to their customers or how they achieve growth. The second is that investors do rely on the board of directors to hold management to account. In this case, this has not occurred, and indeed allowing the departing CEO to linger in order to receive retirement benefits only reinforces that board accountability can be lacking when it is most needed.
In contrast to Harvey Norman (HVN) and JB Hi-Fi (JBH), Dick Smith (DSH) had to downgrade (-30%) its profit guidance for FY16 following pressure on gross margins, particularly due to its online channel. In its relatively short period as a listed company, the group has swung from pushing sales, then emphasising gross margin, then store rollouts and formats as strategic initiatives. In reality, it has found itself with excess inventory, subject to product cycles and lack of a clear customer offer beyond price.
We have been cautious on all these retailers through the housing-driven cycle. In our view, JB Hi-Fi is the one that could justify a portfolio position, yet, as noted in our comments on inflation, the risk of higher product prices due to the fall in the A$ looms as a headwind. Harvey Norman is producing good sales momentum at present, but shareholders are vulnerable to the unexpected swings in their participation in profit growth versus the benefit flowing to the franchisees.
Retail stocks have been a tough environment for investors in the past few years. Wesfarmers (WES) has been the clear large cap stock to hold, though now dragged into uncertain grounds by Woolworths. Super Retail (SUL) has been the other stock of choice and after a bumpy start, we believe is in line to produce a respectable profit pattern. In our view, investors should continue to cast the net more widely than just retailing to participate in household spending.