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WEEKEND LADDER

A summary of the week’s results

03.10.2014

Week Ending 03.10.2014

Eco Blog

A modest level of building approvals for August, skewed heavily towards multi-unit developments did little to detract from the growing expectation the RBA and APRA would intervene in the investment property market. Housing remains set to make a decent contribution to GDP growth into 2015 as these approvals find their way into starts. The proviso is that apartment approvals can often be deferred and also make a much smaller contribution to activity compared to private homes.

The RBA is arguably hoping its now strident views on investment housing may cause banks to restrain their lending into this segment rather than direct intervention. Rather than necessarily undertake direct measures such as restricting the loan to value ratio, the central bank may instead require banks to apply a barrier by assuming rates rise by, say 300bp, and examine loan serviceability based on potential vacancies.

Retail sales for August were soft, with the structurally challenged department stores recording another fall in sales. Even household goods retail was relatively weak, implying the flow on effect from housing sales is not strong. The clear implication from recent data is that the consumer is unwilling to dig into savings or leverage up to support spending.

The opposite is occurring in China, where a raft of easing measures have been introduced to encourage home purchases, a sign the government is concerned that the oversupply and consequent fall in the value of homes may feed back into consumption spending.

The chart shows the dramatic change in the house prices in the 70 largest cities in China in recent years.

China: Monthly Housing Price Change

Source: CIEC, ANZ
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In Europe, Draghi disappointed the investment market by hedging his commitment to a sizeable expansion of the ECB balance sheet. Given recent criticism that much of global easing has done little more than support financial assets, it may be sensible for the ECB to avoid ‘printing’ money purely to appease those interested in these financial assets. Instead, Draghi made it clear that avoiding deflation was the main purpose of the policy. The fall in the euro may well be of some assistance and it is therefore possible the ECB will drag its heels on any further accommodation in the coming months. Nonetheless, the economic signals from Europe are uncomfortable and apart from isolated pockets, growth may falter further, putting pressure on the ECB to do more.

Currency movements have shown the most meaningful change in pattern in the past few weeks. The US$ has strengthened against all major cross rates and the potential for 2015 to see a regional divergence in interest rates and growth sets up for this pattern to be maintained. A weaker Euro and Yen sit comfortably with most forecasts and would be welcomed by the monetary authorities.

Conversely, the prospect of capital flight out of emerging markets is disruptive to those economies and reminds investors of the sharp moves in EM currencies in 2013.

This time it may not be as intense as the current account deficits are less problematic than before.

Current Account Balances Across Asian Economies

Source: Barclays
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Ever so slowly the Chinese renminbi is finding its way into foreign reserves with both the RBA and UK BOE stating that they are holding RMB. Incrementally, emerging currencies, bonds, credit and equity are likely to become mainstream as a natural response to the relatively better prospects for those economies, but also as some of the imbalances of the past have dissipated. 

Company Comments

Treasury Wine Estates (TWE) surprised the market this week when it decided to cease takeover talks with two private equity groups that were bidding for the company. TWE had received a proposal outlining an offer of $5.20 cash per share, which represented a 28% premium to where the company’s share price traded prior to notifying the market of the first proposal back in May. The timing of this was fairly opportunistic in that it came just a few months into the tenure of its CEO appointment, Michael Clarke.

While it was still judged as early days, investors had generally been encouraged by the strategic plan put in place by the new management team, which included cutting overhead expenses, reinvesting back into the business through increased marketing and focusing on growing market share in its premium wines. Interestingly, it appears that several large shareholders (who hold around half of the company’s equity) backed TWE in terminating the takeover discussions, believing that the offer price was inadequate. While in a way this deflects the responsibility of the decision from the board back to its shareholders, it does reveal the confidence of these shareholders in the management team executing on this strategy, as well as their longer-term investment views. TWE indicated that its financial year-to-date performance had been tracking “ahead of plan”, however the pressure on the company to continue to perform without any hiccups will be high in light of this week’s events, with the takeover premium disappearing from its share price.

Lend Lease (LLC) moved a step closer to a significant contract win when it was announced as part of a consortium to deliver the East West Link project in Melbourne. The project is expected to reach financial close by the end of the month, and will deliver long-dated revenues to LLC, with construction expected to take five years (starting later this year), followed by a 25 year operating and maintenance contract for the asset. The Public Private Partnership deal means that the Victorian Government will retain the tolling and traffic risk for the road.

LLC has produced solid share price returns over this calendar year. Notwithstanding this, it has a reasonable medium term earnings profile (excluding the one-off nature of a large asset sale that contributed to its profit in FY14) and its valuation remains attractive compared to the broader market. This contract win builds on other successes that it has had in the infrastructure space, adding to its large residential pipeline of work. The company will update the market further on the progress of these and its strategy at an investor day next week.

News Corporation (NWS) this week combined with REA Group (REA) (owner of realestate.com.au) to acquire Move, a US-based online real estate portal. In terms of audience reach, Move is the third largest player in the industry, behind market leader Zillow and second-placed Trulia (which themselves recently have come to a merger agreement, with the outcome hinging on competition issues). In an industry that has typically trended over time towards just one or two dominant brands, NWS will have its work cut out for it not to lose further ground to the market leaders. An increased investment in marketing will most likely be required in the medium term. What should also be noted is the structure of the online real estate market in the US, which leads to high marketing spend and lower margins. Listing data is available to all market participants (compared to Australia where REA builds its own), and thus marketing is higher to promote brand awareness.

The transaction is an expensive way to gain access to higher growth industries (the transaction price is at a 37% premium to Move’s previously traded share price), away from the ‘old-media’ newspaper assets which dominate NWS’s portfolio. The cross-shareholder interest also creates a messy situation, with NWS already controlling REA through its 62% shareholding and REA now holding a 20% stake in Move. We note that the transaction is also in a relatively mature market, compared to the international investments undertaken by Seek (SEK) and carlsales.com (CRZ) in developing economies, which have a much higher opportunity for growth over the longer term.

The Federal Government this week dismissed the recommendations that had been put to it in a review of the National Broadband Network, which included opening it up to competition and selling off parts of the network. The proposals were rejected on the grounds that the cost would be too much of an impost on taxpayers, as competition would emerge in the most profitable urban regions of the country (eroding the profitability of the NBN), and leaving the expensive rural connections to the NBN.

The decision to stick with the status quo reinforces our view that the smaller telcos should be able to more effectively compete in an NBN environment, taking market share away from the dominant incumbent in Telstra (TLS). With its financial muscle and the payments it is receiving from the government for switching off its legacy copper network, TLS would have been best placed to build a network that could have materially affected the NBN business case. TPG Telecom (TPM) is exposing a loophole in legislation, which is allowing it to connect up to 500,000 apartments to its own high speed network, however it is likely that it will have to offer wholesale access to other telcos. This week also saw M2 Telecommunications (MTU) partner with Fetch TV, an IPTV provider that is looking to take market share away from Foxtel. Fetch is also aligned with Optus and iiNet (IIN), which we have recently added to our model portfolios.

Sector Focus: Australian LNG Projects

With the backdrop of fairly benign earnings growth across the Australian equity market over the next 12 to 18 months, the energy sector stands out as one that is expected to deliver substantial profit growth in this time. While the oil price is most often the key driver of earnings growth in the sector in any given year, in the medium term a step change in earnings is expected to be delivered from the various LNG projects that have either commenced, or are closing in on, first production.

The table below illustrates the earnings growth of the market, the energy sector, and selected stocks within the energy sector that are exposed to this earnings growth through LNG. On a three year basis, the stocks with this thematic are expected to show compound annual growth of between 25% and 31%, compared to the market’s growth of just below 9%.

Earnings Growth: ASX 200 and Energy Stocks

Source: Bloomberg, Escala Partners
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The table below details the key Australian (and PNG) projects that are expected to reach their first production milestone in the next few years. The planning and various approvals of each project occurred several years ago when the companies took advantage of a window of opportunity to fill a supply gap that was emerging in global LNG markets. The lead time on each project is material, generally four to five years, hence the risk of project blowouts and delays has hung over the various companies involved over this time period. News on project delivery has generally been quite positive, particularly over the last 12 months, and hence the risks of any significant delays would appear to be receding by the day. The various LNG projects are centred on three separate locations – in PNG, in north-west Western Australia and Gladstone in Queensland.

The three projects at the top of the table are those in which ASX-listed companies have an interest. PNG LNG was the first of the current wave of projects to reach first production, with the project shipping its first LNG cargo in May, ahead its revised schedule of the second half of 2014. Oil Search and Santos both have an interest in PNG LNG, with the project much more significant to Oil Search given its stake and more concentrated portfolio of assets. GLNG and APLNG are the other two which will be critical to the prospects of Santos and Origin Energy. Officially, GLNG production target is 2015 (the project partners have not been more specific than this), however expectations are for this to occur around mid-next year. APLNG has a target of mid-2015, which would also suggest that it is less than 12 months away from first production. Last month the GLNG project was reported as being 85% complete, while Origin has stated that APLNG is 75% complete.

Australian and PNG LNG Projects

Source: Company reports, Escala Partners
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Following the successful delivery of these projects, two other factors will become important in the actual level of earnings – the oil price and the $A. The LNG supply contracts that each has in place have prices that are linked to the oil price (which is priced in $US). What has been notable in recent months has been the decline in the oil price, which has been driven by several factors, including slow global demand growth, increased levels of supply (particularly from the US shale industry) and no supply disruptions from Iraq and Russia, despite conflict (or the threat thereof) in these regions.

Longer term forecasts centre around US$90-100/barrel, a similar level to current prices, through demand growth from emerging economies, existing oil field depletion and the relatively high breakeven costs of new supply. Offsetting this impact has been the weakness in the $A in this time, largely neutralising the negative effect on the valuations of these companies.

In our model portfolios, we currently hold an overweight position in these LNG-exposed stocks. The cross over from the highly capital-intensive phase of construction to production is much more material from a cash flow perspective, which will provide opportunities for further growth and increased shareholder returns. Over time, the possibility for brownfield development of these projects may emerge, which typically has more favourable economics compared with the initial phase, however we note that the global LNG market appears to be better supplied at this point in time. PNG LNG is the best placed and most likely of the projects to succeed in this area for several reasons – timing, quality and size of its resource.

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