Weekend Ladder

A summary of the week’s results

Week ending: Friday 11th July, 2014

Giselle Roux Chief Investment Officer David Bruty CFA Investment Analyst

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Eco blog Tentative signs are emerging that the Australian economy is very slowly moving on from its autumn weather and budget related hiatus. ANZ job ads survey for June was up 4.3% after the fall of the previous month, yet employment in June registered a modest 15.9k increase and the unemployment rate ticked up to 6% partly due to a slight rise in the participation rate. The NAB business survey recorded a solid rise, possibly reflecting their relatively unscathed outcome from the federal budget. Companies reported better sales and profitability, however that employment conditions would remain soft. Amongst industry sectors, services is the standout, particularly recreational and personal services, with residential construction also unsurprisingly noting better times. Wholesale trade, manufacturing and transport are recording weak conditions, symptomatic of the structural shift in the economy. Since 2000, the average annual employment growth in services has been 2.5% per annum, while the goods sector (which includes mining) has recorded growth of 1.5% p.a. The current reading, according to NAB, implies a sluggish recovery in activity. Staring down these business conditions is consumer disinterest with little signs of improvement. The Westpac Consumer Sentiment Index registered a disappointingly small recovery from the post budget gloom. This divergence between business and households is highly unusual. Three outcomes are possible: 1) the household sector turns sharply confident as they become attuned to their rise in wealth and resilient labour market, 2) businesses discover that domestic demand is not going to get much better and turn bearish 3) this is the new normal – households are likely to remain more cautious and spend differently while corporate confidence narrows increasingly to the service sector.

Business versus Consumer confidence

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As much as there is little hard evidence to date, there are many who believe a round of global inflation is inevitable as economies gain ground. We have previously noted that without a rise in labour costs, it is hard to achieve high inflation apart from cyclical bouts driven largely by commodity prices. Money printing alone is unlikely to be the culprit. Japan is evidence of that. Nonetheless any uptick in labour costs and the CPI in the US, widely predicted to be the case over the coming year, is likely to see commentary on investments deemed to be a bulwark in the event of higher inflation. Typically these are real assets and commodities. We will touch on the three commodities generally most associated with inflation – gold, energy and agricultural products. The others are more affected by industrial production, cost of production and demand/supply dynamics. This year to date the movement in commodity prices can be seen from the chart below:

2014 Year to Date Commodity price movements - % change

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Gold is often the iconic inflation hedge, but as many point out, that depends on monetary policy and currency trends. In the aftermath of the financial downturn and the commencement of QE, gold found favour. However last year more investment gold was realised than had been bought in the previous three years combined as can be seen from EFT holdings.

Gold ETF flows

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In the current environment supporters of a higher gold price suggest the Fed is less concerned on inflation relative to growth and is therefore likely to persist with low interest rates. However, if the Fed indicates its intent to raise rates, or the US economy disappoints, gold bulls are likely to be disappointed. The floor for the gold price is however sustained by rising production costs, falling grades at most mines and decent demand from Asian retail buyers. This is a separate aspect to the inflation theme. Energy prices have popped due to geopolitical tension in Ukraine and now Iraq. Yet the extent of price movement is low to date and the futures market is putting only a 15% chance of Brent oil at above US125/bbl.

Brent Dec ’14 option market probabilities

Oil demand has been sluggish in the first half of this year, partly due to slower growth in China. Once demand picks up again into the northern winter, any supply disruption in the Middle East would be problematic. Higher energy prices tend to have a relatively quick, and arguably unreasonably large, impact on consumer spending due to the visibility of price rises and the inability to avoid most of the cost. Food and agricultural prices have a bigger impact on household hip pockets. Yet it is rare to have more than 12 months of elevated food prices due to the typical seasonal production cycle. While food prices in Australia have been volatile, the longer term trend is largely in line with the overall CPI. The China CPI released this week had no impact on markets with a benign read of 2.3%p.a Food inflation in China runs at a higher level, having ranged between 2.3%-4.1% over the past 18 months. Outside the official data, the Alibaba shopping price index (all goods) has been negative or flat for more than two years. In part this underpins the behaviour of Chinese consumers, long expected to be the next driving force for the economy. With rising housing costs, moderate food prices but generally low goods inflation, the incentive to spend in anticipation of higher prices is not there.

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Our view is that specific inflation protection in a portfolio is not required at this time. Instead there are a number of companies in hard assets and commodities which could hold up in the event of higher inflation but have merit even in the current environment. Investors can have exposure to higher energy prices without taking undue risk just by holding stocks with growth in production. Our recommended local stocks (Oilsearch, Santos, Origin and to some extent BHP) are very much skewed to that outcome. In a similar vein, companies such as Transurban and Sydney Airport are asset based companies. For the moment we are largely steering clear of gold stocks, not only due to the uncertain price support but the lack of high quality companies in which to invest. As we noted, it is wage costs that are most likely to nudge the CPI along. In the US there are increasing signs of a tight labour market across enough sectors to push up wages even though unemployment is still relatively high. In the UK, where GDP growth is expected to be highest in the OECD this year, a recruitment industry survey (REC/KPMG Report on Jobs) finds starting salaries rising at the highest rate (5%) since the late 1990’s. Higher wages should support higher consumer spending and economic growth which could then justify higher equity prices. However, there may well be a gap, where companies find their input costs increasing before they rediscover any pricing power.

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Company Comments

A market favourite in recent years, Navitas (NVT), announced that their contract with Macquarie University would come to end in 2015. The stock price fell more than 30% before stabilising into the end of the week. NVT built its business offering bridging courses for those who required additional education to enter their university degree. A significant number of the enrolments are foreign students who may need an intense English programme or where their school courses may not have fully covered the subject matter of their intended tertiary course. The large influx of foreign students attracted to Australia’s good global reputation and English language education delivered increasing student numbers into Navitas courses, muddied only in 2013 when there was a temporary clampdown on visas. NVT pays the universities a royalty and generally uses their facilities and staff for the courses. This symbiotic relationship has worked well to date. However, now its largest client, Macquarie, has chosen to deliver these services in house. The sharp reaction was partly associated with the unexpected nature of the outcome but also the risk other universities decide to follow Macquarie’s lead. Universities would be keen to keep the 25% EBITDA margin NVT accrues for themselves but have to weigh that against the cost and risk of running programmes important to attract foreign students. The Universities Programme currently provides 2/3 of group EBITDA. SAE is a newer division that offers training courses in multimedia. Its profit path is not yet established as recent acquisitions are taking time to integrate. A further business arm focuses specifically on English and integration courses for Australian migrants. NVT has been increasing its global reach with over 30% of revenue now from outside Australia, though the profitability is substantially lower than at this time. The opportunity to invest in education providers is narrow. We have G8 Education in our model portfolios, itself making news this week with the acquisition of further childcare centres. NVT is likely to have lost its high premium P/E as investors price in the uncertainty of its other contracts and the lower margin of the other divisions. Another growing feature of tertiary education is the MOOC’s (Massive Open Online Courses) which could also impact on NVT’s business model. NVT has screened as a potential stock for our models but we have viewed the valuation as excessive. With this new risk, the challenge to appropriately assess growth and therefore valuation is even harder. Transurban (TCL) reported its June quarter and full year traffic and revenue data. Overall revenue was up 13% for the year, a mix of transactional growth and managing the toll revenue. As can be seen from the table below, the Average Daily Transactions/Trips (ADT) show a much more subdued outcome compared to revenue, a function of the regular imbedded toll increases and as TCL tweaks elements such as charges for motorbikes or trucking.

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Source: Transurban Note: 495 express was for a partial year in 2013

The company has closed its acquisition of Queensland Motorways and has a large programme of intended enhancements to its existing infrastructure. While this provides long term relatively secure growth, it is expected to limit distribution growth due to the capital spending. TCL is well established as Australia’s largest listed infrastructure company and we continue to recommend a holding for long term investors. At present the stock is fully valued; the distribution yield is a modest 5% for FY15 and the group is leveraged to interest rates, not only through its debt, but also in its valuation which is tied into the bond yield. With so many fundamentally attractive companies trading at the high end of assessed valuation, the investment community has turned an eye to stocks which have lagged to discover neglected opportunities. QBE is one, and in due course the stock has been gently outperforming. We were previously singed in selecting QBE for our model portfolio and have a cautious approach this time. To possibly oversimplify the thesis behind the stock, it has substantial leverage to rising US bond yields as well as a weaker A$. Further, it has over the past year undergone a major change in management across many senior roles who, we anticipate, could shake off some of the strategies which caused grief in recent years. On the other hand, its reserve position to cover unexpected claims is judged as low and it is operating in a more competitive insurance sector than it did when growth was strong. We have learnt how complex insurance can be and QBE has many moving parts. Specialists may be able to make judgement on the many divisions, and it is one we would rather leave to fund managers who have access to such sources to make this investment decision. The retail sector has not escaped the headlines for some weeks. Rumblings continue on potential M&A deals and management changes add to the intrigue. Small cap, The Reject Shop (TRS), has new management, while its unlisted parallel, DSG Holdings is in receivership. Globally these deep discount chains such as Poundland in the UK and Dollar General in the US, are doing very well. It would not be surprising to see another party look at options here. Similarly Pacific Brands (PBG), already under pressure from a mooted takeover, has split from its CEO due to differing views on the product portfolio. Brand companies can rate highly, as they deliver robust cash flow from intangible value, yet PBG has been unable to achieve any consistency from its broad portfolio. At a different level there is persistent speculation that someone will make a play for Myer (MYR), given the probability David Jones will have different ownership. These stocks have tended to perform relatively well in the sector, yet we consider them to be poor options for a medium term portfolio. While Super Retail (SUL) has been somewhat disappointing, the challenges it faces are, in our view, much more surmountable than those of the companies noted above. For investors seeking a second option, JB Hi-Fi has also performed well in very tricky circumstances.

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Sector Focus In light of the market reaction to Navitas we have considered stocks where one of the factors supporting the valuation is a high ROE, such as was the case for NVT. High ROE’s are an important criteria as the data marries a component of the balance sheet with the profit and loss. Stocks with high ROE’s generally provide high free cash flow and therefore can undertake capital management or make growth acquisitions without resorting to major equity raisings. It is not failsafe, nor do low ROE companies necessarily underperform and we are always mindful of the rationale behind the data rather than just the return figure in isolation. On average the ASX200 is currently showing a ROE of 16.4% for the coming year. The highest ROE sectors are Healthcare, IT and Telco, none of which is a major surprise, though high telco ROE are somewhat an Australian phenomena as they are relatively capital intensive. Low ROE sectors currently includes Energy, due to the upfront capital spending currently underway. At below 10% ROE, property trusts and utilities naturally hold high levels of fixed assets and are generally low growth. The table below gives a selection of higher than average ROE stocks. The top half are financial companies with low asset base requirements. At face value they should therefore be higher growth, but that is not always the case as a number are dependent on the fortunes of investment markets and valuation will therefore wax and wane in unison.

Company ROE current year (%)

ASX ASX 16.0

Computershare CPU 25.9

Iress IRE 54.3

Oxforex OFX 58.5

Platinum Asset Management PTM 53.5

Magellan Financial Group MFG 47.6

Perpetual PPT 24.8

Henderson HGG 17.8

Flexigroup FXL 22.2

REA group REA 42.2

Seek SEK 18.9

Carsales.com CRZ 35.8

Domino's Pizza Enterprises DMP 22.7

G8 Education GEM 16.5

Navitas NVT 34.3

McMillan Shakespear MMS 25.3

ALS ALQ 17.6

Monadelphous MND 41.9

Source: Bloomberg

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The second group are mostly service companies. The likes of Seek, carsales.com and realestate.com are asset light and the ROE can be dependent on whether they have made acquisitions and therefore carry high intangibles in the balance sheet, such is the case for SEK. The remainder are a somewhat eclectic group, ranging from Domino’s Pizza where the corporate structure does not have to carry the asset base, to two which may surprise – ALS and Monadelphous. With their exposure to the mining sector these two groups have done exceptionally well to hold up their ROE to date, though it remains to be seen if that can be sustained. ALS has diversified from its mining focus and even though the outlook is muted, the high ROE partially explains the 18X PE multiple the stock is trading on. Amongst these companies we have included Iress, Flexigroup, Seek, Carsales and G8 Education in our models.

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Disclaimer This document is based on information from reliable sources, no representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented. Any conclusions, recommendations and advice contained here in are reasonably held at the time of completion but are subject to change without notice. EPL does not accept any responsibility to inform you of any matter that subsequently comes to its notice, which may affect any of the information contained in this document and assumes no obligation to update and reissue this document following publication. EPL, its directors, employees and agents disclaim all liability for any errors in, or omission from, this document or for any resulting loss or damage suffered by the recipient or any other person as a consequence of relying upon this document. EPL may receive commissions, underwriting and management fees from transactions involving securities referred to in this document. EPL, its directors, employees and agents may from time to time hold interests in the securities referred to in this document. This document is a private client communication and is not intended for public circulation or for the use of any third party.

Contact Escala Partners Ltd. Level 19 / 90 Collins Street Melbourne Victoria 3000 Telephone: 03 8651 2600 information@escalapartners.com.au www.escalapartners.com.au