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WEEKEND LADDER

A summary of the week’s results

31.07.2015

Week Ending 31.07.2015

Eco Blog

The US Commerce Department estimate of Q2 GDP growth was 2.3%, a decent acceleration in pace from Q1, but below the 2.7% economic analysts had expected. The strongest growth was in consumer goods, particularly auto sales and household goods. Investment spending was weak as anticipated due to the energy sector, but was also well below par in IT equipment while the outlay on software stepped up. This soft tone in investment is likely to weigh on the equity market into the second half of the year. On the positive side, the personal consumption price index advanced 1.8% excluding food and energy, suggesting tightening capacity and some product pricing power.

What garnered more attention, however, was the revision of GDP back to 2012. Average GDP growth over the past three years is now given as 2.0%, compared to 2.2% previously. While at face value a small change, it highlights the ‘new normal’ rate of economic expansion in this cycle. The downward revision was largely in consumer services, particularly financial and professional services, indicating how hard it is to measure the economic benefit from such activities. The Bureau of Economic Analysis was, however, unable to cast a light on the persistently low GDP growth in the first quarter of recent years.

Overnight the US employment cost index (ECI) will be released, considered the key metric used by the Fed to assess the labour market.

In Europe there are a few bright spots. Preliminary data indicated that the Spanish economy grew by 1% in Q2, lining it up for over 3% this year and likely to be one of the better outcomes in developed economies. German data has been soft in recent months, with the EU Commission Index showing that the industrial sector, Germany’s engine room, lagging consumer and services.

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The housing sector is the bright spot of many economies. Yet UK data shows that mortgage growth has been surprisingly subdued, while consumers have taken on more debt in credit lines, partially associated with the persistent improvement in auto sales and other assets at low interest rates.

Lending to Household and Private sector non financial corporations (%y/y)

Source: Barclays Research
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Private non-financial corporate (PNFC) lending is remarkably slow compared to history as companies have turned to the bond market for financing but, once again, constraint is the name of the day when comparing to the 2000’s.

PNFC funding breakdown

Source: Barclays Research
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In a light data week, Australian credit grew by 0.4% in June, or an annualised rate of 5.9%. Investor housing once again topped the ranking, up 10.7% year on year, above APRA’s target. The persistence of investor lending has been a thorn in the side of the regulator and RBA for most of this year. They would be looking for early indications that recent steps by the banks to increase the interest rate on these loans has a meaningful impact on restraining demand.

Meanwhile China has also been quiet, at least on the economic front. With many countries trying to engender inflation, it is more likely China is aiming for a stable reading, allowing it to use monetary policy without risk of price volatility. We have often noted idiosyncratic issues with data and China’s CPI weights are likely to require consistent adjustment as the spending patterns mature. At present, food, tobacco and beverages account for over 35% of the CPI weight and pork alone 3%. After excess production drove down prices, the pig stocks and sow herds are at 5 year lows and prices can be expected to spike up some time this year.

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China will not be the only country with a likely rise in inflation due to seasonal or one-off patterns. Getting inflation in and out of the genie bottle has been an ongoing headache for central banks. Japan may consider it successful to print a 0.5% annualised CPI this week, indicating how hard it is to for that country to accept price rises. Locally, the lack of pass through from the fall in the A$ has been notable and unlikely to last, pointing to a probable rise in the CPI later this year

Corporate Comments

Early off the mark in reporting season was Navitas (NVT) with EBITDA in line with forecasts (A$163m), but the flat guidance for FY16 was below consensus expectations. Given that it is not being swamped by others, it gave time to use this company to reflect on the opportunities and risks in the Australian equity market in industrial mid caps. Beyond the longevity of stalwarts in the ASX200, stocks such as Navitas attract attention as they may become the next big performer. The company has the structural appeal as a service provider in a growth sector - tertiary education. Navitas programmes mostly relate to bridging the gap between school and university courses. For some years this has been a highly symbiotic relationship between the company and universities.

Two unrelated issues have however unwound the upside. Regulation is an ever present issue for most companies, and Navitas got caught up in restrictions on student visas. While this has been temporary, it is a constant reminder that the risk of changes in regulation is often unpredictable.

The second was fundamental with Macquarie University electing to take the services in house. It raised the issue that universities may not need to outsource this bridging education and in the world of limited funding sources, would look here for additional revenue. These University Programmes comprise some 70% of NVT EBITDA before corporate costs and are the key to the corporation. The others divisions are the related English proficiency programme and SAE which offer media technology courses.

To adapt its model, NVT is now looking at joint ventures where the university can share in the upside. It has also moved into global markets, particularly the US and UK which are growing strongly and mostly offsetting the loss of the Macquarie contract. However, as enrolments per educational institute tend to level of quickly, the company has to add further contracts to grow profits over time.

Face time, student specific courses have inherent value, yet the explosion of online options and education cost pressures may mean NVT has to further transform its offer. Currently it is achieving an ROE of over 40%, similar to other asset-light disrupters and new models. It has low debt to equity of approximately 15%. However we believe the visibility on the medium to longer term outlook is low and only appropriate within a managed fund which can keep a close watching brief on the business and its customers.

McMillan Shakespeare (MMS) has similar characteristics to Navitas in that it is a service provider with regulatory overlay. The business is relatively well known for its salary packaging services, where potential changes to allowable deductions persistently loom. After taking a hit in 2014, the group stabilised that division but has since expanded into corporate and retail auto leasing sectors. This week it acquired United Financial Services to complement the Presidian business it bought earlier this year.

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While not asset-light due to the vehicle fleet with assets under finance pre United at $353m, it describes this division as a ‘virtual car dealership model’ where it buys and finances the asset, recycles it into the retail sector and underwrites warranty product, provides insurance broking services and indirectly auto maintenance.

A small cap market favourite until the setback in 2014, it has rallied off its lows and if it can prove up this expanded model is likely to regain favour as a service company intent on changing an industry. With a 30% ROE and on a P/E of circa 13.5X FY16 it has valuation support but is not without relatively large risks which are challenging to assess. If it can prove up the worth of these recent acquisitions a rerating is more likely.

Dual listed Henderson (HGG), which was spun out of AMP in 2003 delivered an above expectation half year net profit of GBP102m (+29%). This did include a one off gain, but the core business is doing well enough to have attracted investor attention.

Financial asset managers such as Henderson depend on: 1) market movements 2) sector funds flow 3) the performance of their funds 4) the fee structure and 5) expense ratios.

The chart below shows the flows in the different asset segments and HGG’s asset under management in each. The various funds buffer the group as views across markets change.

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The case can be made that the group has been a direct beneficiary of monetary easing in Europe as investors moved out of cash products into investment assets. With particularly strong relative performance against its peers in Europe, these funds saw a large inflow.

The group is also expanding its capabilities having recently acquired the local Perennial fixed income and growth equities funds. Pan Asia assets under management will now represent 11% of the group and there is clearly scope to accommodate further managers.

The stock is assessed to be fairly valued at a FY15 (calendar year) P/E of 15X and unfranked dividend yield of 4%. Aside from the pure equity groups of Platinum and Magellan, the other asset management companies are similar valuations. We have recently favoured AMP as it provides a lower volatility exposure to the sector, however we will reassess their outlook in this reporting season.

Resmed (RMD) reported Q4 results above expectations largely due to strong sales in the US. Within a relatively narrow product set the ebbs and flows of competition product launches, possible recalls, regulatory and funding arrangements can result in a relatively volatile pattern of quarterly profit outcomes. The stock trades on a 22x multiple and while not expensive in the healthcare sector, this unpredictable earnings cycle is arguably should see it at a small discount in the sector.

With CSL edging within 1$ of the $100/share price mark, the high valuations  investors are prepared to pay for earnings from companies that have truly made it onto the global stage does not look set to diminish quite yet.

Fixed Income Update

As widely anticipated, Westpac announced a new tier 1 hybrid deal this week. This is a capital note listed debt security with an issue size of $750mm (with the option to upsize), call of 5.5 years, conversion to equity at 6.5 years, and a price guidance of BBSW +400-420.

On the back of this announcement the listed hybrid market saw some spread widening (fall in price) as the market looked to absorb the additional supply of the new issue. Secondary hybrid securities are now back trading at the lows we saw following the Greek crisis at the end of June. With investors switching out of secondary hybrids in order to buy the new Westpac deal, we can expect further weakness in the coming days. A good comparison for this new deal is the existing NABPB which has a similar credit profile and call date. The chart below shows the fall in price of this security following the announcement of the Westpac deal on Monday.

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Earlier this week, concerns around China resulted in a flow of capital into US Treasuries as a safe haven option. In addition there has been buying of Aussie government bonds across the curve (rumoured to be Japanese investors), pushing yields lower.  10 year Government bond yields have fallen from just above 3% 12 days ago to 2.80% today.

On the shorter end of the rates curve, the Aussie interest rate futures market is now fully pricing in a 25bp rate cut by the RBA by April next year. This is up from only a 50% probability 4 weeks ago.

As expected, the US Federal Reserve left rates on hold this week. There was little change in their announcement, however they were slightly more upbeat on the economy and jobs markets. Market reaction was quite benign, with the US Treasury yields rallying only a couple of points on light volumes. Market participants remain divided on the timing of the rate hike, albeit most remain split between September and December.

 

 

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