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WEEKEND LADDER

A summary of the week’s results

31.10.2014

Week Ending 31.10.2014

Eco Blog

Europe started the week with the release of the ECB 2014 Comprehensive Assessment of banks across the region. Of the 130 banks under analysis, 24 were deemed to have a capital shortfall, reducing to only 6 when taking into account restructuring plans already underway or complete post the analysis. The outcome does give some comfort that a banking crisis is unlikely to see the counterparty or capital risk experienced in the past. Now lending growth has to pick up, yet economic momentum and a desire for leverage by corporations is missing.  Data on lending in the ECB showed household loans up 0.6% in September, while corporate loans fell 1.8% year on year.

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Nonetheless, investors can take some comfort dividend payments from the European banks are generally able to be sustained or will commence in the coming few years and lending may pick up a little, having been restrained by the unknown outcome from the assessment. Early indicators from the ECB of lending conditions in October pointed to the potential for higher demand for credit in the coming months.

Through the week an optimist could make the case European growth has therefore arguably bottomed. The German labour market was reasonably strong, Spanish GDP sustained its growth trajectory and lower energy costs should provide a useful increment to manufacturing profits.

The call for a higher level of coordination in Europe has, however, once again come to the fore. Many hold the view that a banking union and central issuance of bonds and therefore combined responsibility and oversight, is required to prevent the potential disintegration of the Euro. With disparate political pressures and unique cultural and structural issues, it is hard to envisage closer cooperation at this time. Change is more likely in a period of stability and strength, yet then does never appear as essential.

In the US the FOMC stuck tightly to its script. QE, after nearly six years, has come to an end and the current Fed funds rate would remain ‘for a considerable time’.  As before, the labour market and inflation data will see investment market participants seek to second guess the timing of the first rate hike with most anticipating third quarter 2015. Elsewhere, US releases suggest more of the same on economic momentum – durable goods orders were weak, consumer confidence was strong, housing modestly weak and the initial GDP (possibly the most revised series) indicating solid growth of 3.5%.

Commodity analysts appear to have been caught out by the fall in the oil price and progressively followed the price with downgraded forecasts. The cause of the weakness is put as due to the rise in production from Libya, in particular, without offsetting restraint from others in the Middle East. The growth in supply out of the US was widely expected and should not have surprised, though the relatively weak demand from China and Europe were unanticipated. The lack of reaction to geopolitical tension has also been a surprise.

Saudi Arabia appears to be willing to suffer the lower prices this time, given it has all too often been the only OPEC member that has made an effort to restrain supply.  Its motivation is to put pressure on others in OPEC to share the load in true cartel fashion, and to take the gloss off expanded production from the higher cost US sources. A forthcoming OPEC meeting in late November is key and the Saudi’s in recent days appear to be willing to show their hand with a modest decline in production, while looking for others to do the same. In the meantime, the stronger US dollar is acting as a partial compensation for oil exporters.

The global demand/supply for oil, based on the International Energy Agency data, is shown below:

Source: IEA
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Year to date OPEC has exceeded the required output to cover demand by approximately 0.6mb/d, given the rise in output from the Americas of 1.7mb/d.

The basis for a sticky price of around $100/barrel ( for the moment putting aside the circa US$6-10 differential between WTI and Brent) had been based on the persistence of disrupted supply from the Middle East, the decline of some traditional fields such as the North Sea and the much higher cost of production from new sources. There are few prepared to make adventurous forecasts at this time.  Soft prices are expected to persist until there is a catalyst, such as a cut in supply or a pickup in demand.

Crude oil and petrol price forecasts

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Corporate comments

Investors gave a tick of approval to CSL’s acquisition of the flu division of Novartis for US$275m adding to its own subscale business. The company expects to generate more than US$1bn in flu vaccines by 2019. While this is a somewhat volatile product category, it has demographic appeal and potentially sees the group expand into other vaccines.

In the first year, the acquisition is expected to reduce the cash earnings of the group due to integration costs and the completion of a number of product trials, though it may account for a balance sheet gain as the book value is higher than the purchase price. For once, the market appears to be prepared to take a longer term view given the track record of the group, with expectations of a decent contribution to earnings post FY18.

In FY15, CSL sales revenue from its existing operations is expected to be $5.8bn, with the overwhelming majority from its plasma products. This extension to other products beefs up the company, one of the few Australian companies most international investment managers note as a global leader. Never cheap on a P/E basis, the support comes from a DCF valuation, indicative of the stable cash generating operations and projected long term growth. 

Coca Cola Amatil sold 29.4% of its Indonesian operations to its parent in the US, allowing it to spend the proceeds of US$500m on capex and product promotion. Investors took on board the co-operation with the parent, and the capacity to reinvest into supporting its domestic operations with the share price picking up from its underperforming trend. While this may be a new beginning, the net profit is still expected to fall sharply this year (year end December) and the path towards higher profit is likely to be slow. CCL’s EBIT margin peaked at 18% in 2011 and most believe it will struggle to exceed 13% in coming years. At a forward P/E of 16x, the potential upside in the share price is likely to be a slow grind.

Wesfarmers sales for the first quarter were sound. Food sales are holding up well with the group claiming real comparable growth in the order of 5% for some time. Implicitly it is gaining share, though it is less clear which food retailers are losing share at this time.

Bunnings is steamrolling along in the sector with no apparent impact from the Woolworths Masters format. Kmart registered small positive sales, while Target is losing revenue as it seeks to wean itself off discounting. The discount department store format in Australia is arguably over-mature, that is, too many stores given that their product ranges have come under pressure from speciality formats also offering low prices.

Signs of heightened competitive pressures from discount food formats and any impact from scrutiny by the ACCC have not yet dented the key Coles business. The oligopoly structure of grocery retail in Australia would certainly protect incumbents, though we would be uncomfortable to see margins higher, given they are already top of the world on a pre-rental basis.  We hold a small position in WES in our models on the basis their businesses have some upside from cost leverage and with the option of an in specie or asset breakup of the business.  We would be less enamoured by a significant acquisition outside of its existing operations.

In the meantime the lower cost of energy has been welcomed as a boost to household incomes, but in turn is also resulting in suppressed inflation. Australia will see a muted impact given the move in the A$ and lower competitive intensity. Direct fuel costs make up just 3.4% of our CPI, though there are ancillary impacts from indirect transport costs.  Tax also changes the equation.

The chart below indicates that the consumer is most likely to see bowser prices flat rather than falling.

Wesfarmers retail stores quarterly sales

Source: Wesfarmers
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Macquarie Group reported its first half result, with net profit up 35% and ahead of recent guidance. At face value the business looks complicated with multiple operating units. To make it simple, it is worth considering it as representing two streams of income.

Firstly, annuity businesses, which are subject to the ebbs and flows of financial market activity, but do not typically have one off factors. These comprise of 1) the fund management arm, 2) the lending and financing undertaken in the corporate and asset division and 3) the banking and wealth management services. The second is the capital market divisions which include the securities, investment banking and FICC (fixed income, commodity and currency), where the determinants of profit can be idiosyncratic.

The diagram below is a useful indicator of the size and variability of profit in the divisions.

Source: Macquarie Group
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We have recently added MQG to our models in anticipation of better than expected profit and to participate in the global upturn in capital activity. MQG’s geographic spread with approximately 35% of operating income from Australia, 30% from North America, 25% from Europe and 10% from Asia, is also an appealing spread. The stock is trading on 14.5x forward P/E and a yield of 5%, 40% franked.

Both ANZ and NAB released their final results. We have covered many aspects of the banks in recent weeks and will therefore limit these comments to the headline features and outlook. ANZ reported in line with expectations at NPAT $7.1bn. Final dividend of 95c represented a 73% payout ratio. The capital position of the group was strong, in part due to low growth in assets as demand for credit remains weak. Other key drivers such as bad debts and margins were stable.

The Asian operations have yet to achieve the ambitious goals of the present management team. There is a natural inclination to support these efforts in Asia both as a logical extension of global capital flows and for diversification outside the restrained Australian banking sector. We are not betting the house on this outcome, but feel it is worth staying for the ride.

NAB has been making headlines on its efforts to fix the problematic parts of the business rather than its core banking assets.  There is little to fault in the overarching strategy to exit underperforming divisions and renew growth in the core; execution is another matter. There are two legacy issues handicapping NAB – the UK banking operations and the wealth management group. Realising the both without a book value loss will be massive assignment and likely to absorb a lot of management energy.  In the meantime, the domestic banking business is soft albeit holding onto excellent return on capital ratios of around 18%.

Investors are often tempted to add NAB to portfolios as it has the highest yield (6.1%) out of the major banks and the lowest P/E. It is however a poster child example of why these headline metrics should be treated with care. NAB has underperformed the other banks for the better part of 20 years and while its potential to scale back to its core is a tempting outcome, the timing and capital consequences are unclear.

The key for the banks now is the release of the Financial Stability Review. Bank management have been strident in their view their capital ratios are just fine, housing is not a problem and they should be left to look after the provision of credit to grow the economy. The RBA and APRA have begged to differ to de-risk the banking sector from any potential government handout. Tea leaves suggest the review will find a middle ground between the two positions.

AMP announced an A$240m investment to take a 20% stake in China Life Pension Company (CLPC).  This company is the largest pension group in China operating in a sector similar to our defined contribution super industry. Details are light, with CLPC currently making a loss, but expected to break even in two years. The thesis of participating in a sector with unquestionable growth opportunity has clear appeal and investors pushed the stock up on the news.

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In a raft of AGMs a few caused a flurry of activity in the stock market.

-      Domino’s Pizza Enterprises (DMP) has been a stellar performer over the past year, with a total return of 82%. Guidance of 25% profit growth for FY15, up from 20% saw an initial jump in the share price before the heady 43X forward P/E brought investors back to earth. What it does illustrate is that a product category which would not at face value generate any excitement in financial markets, can achieve extraordinary investment returns due to innovative and disciplined management.

-       JB Hi Fi (JBH) belied the bears with a small increase in sales, a substantial turnaround from the negative trend of 2014. Sustaining this momentum into the key Christmas period could result in profit upgrades and, given the extent of short interest in the stock, the squeeze saw JBH end the week up 5%.

-      Flight Centre was sold off with the news the first quarter profit was flat due to slow growth in Australia and some cost pressures, offsetting improving trends in the global operations. Concerns that the travel sector will become harder in Australia with the fall in the currency, fewer low prices for local fares and now Ebola have preyed on the stock for some time. While these are unlikely to be resolved in the near term, the valuation at a FY15P/E of 15.5x, yield of 4.2%, fully franked and low debt should reward patient investors. Our thesis is that travel will grow in terms of consumption spending and that Flight Centre will continue to evolve its model, as shown below, to accommodate the changing pattern of travellers.

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-      IAG insurance stated it was on track to achieve its net insurance margin of 13.5%-15.5%, given claims and gross written premiums to date. Insurance is a naturally cyclical industry, prone to unexpected events and competition. IAG noted that global participants could misprice risk, given their relatively low level of understanding of local conditions. It is reasonable to assume that both events and pricing will, at times, result in insurance margins falling unexpectedly and sharply. This should be taken into account in the valuation, weight in portfolios and holding time frame, but at present the industry does appear to be in a sweet spot.

-      Mirvac and Stockland gave an upbeat assessment of the housing market. Both have geographically appealing exposure to the Sydney market and a sound pipeline of projects. We have tempered our view, possibly prematurely, of these stocks as the combination of investor rather than occupier demand, concerns from financial regulators and lack of decent real rental yields suggest the sector could easily come off the boil.  MRV and SGP offer unfranked yields of 5.4% and 5.8% respectively, with single digit growth potential. In our view this does not sufficiently compensate for equity risk.

-      On the eve of the Spring Racing Carnival we will end with comments on gaming companies. Echo Entertainment raced ahead with a solid performance from its The Star casino in Sydney. Both mass market and VIP did well off the refurbished asset and concerns of overinvestment have dissipated. While subject to ebbs and flows, gaming revenue tends to grow in low single digits and the relative success depends on marketing initiatives and capital programs. The key for Echo will be the Brisbane contract, due to be awarded early next year and in the longer run, the impact of Barangaroo.  Echo has not suffered the complications of the Macau market and outperformed Crown in the past year.  We are reluctant to chase it now given these impending decisions and the risk inherent in the VIP market, which is notoriously volatile.  Crown is a riskier proposition but with better longer term growth potential.

-      Tatts made a good start to the year with lotteries revenue up 12%, driven by favourable outcomes and larger pools. Wagering with 1% growth lost share, though management plan to relaunch this division in 2015. These businesses generate high cash flow from relatively low risk revenues. Regulation, tax and occasional tendering can at times disrupt momentum. It is the valuation which is harder to swallow, with TTS trading at 18.5x FY15 and a yield of 4.8%, neither of which represent great value in our view.

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