weekend takeaways - escala€¦ · page 8 weekend takeaways 31/01/2014 treasury wines (twe) hit...

Weekend Takeaways

31/01/2014

Weekend Takeaways 31/01/2014

Eco blog

‘Are we at a turning point?’ This was the headline on the NAB business survey for December, with a big jump in business conditions. After recording a negative reading (implying deteriorating conditions) for nearly 2 ½ years, a +4 reading provided a possible glimmer of evidence that businesses have come to terms with the economy. According to the participants in the survey, trading conditions and profitability has undergone a sharp improvement. Employment and forward orders remained soft, but less so than before. The only data point to have retracted is inventory, though possibly due to better trading. To date, few listed corporations have given any indication of improvement and therefore the profit reporting season, starting in earnest next week, will be closely analysed for such a change in trend. Of the few companies that did comment, a feature was a squeeze in margin from weak pricing power. The chart below shows the problem. Labour cost growth has eased, but is above retail and product price trends.

It raises a dilemma: no one wants higher prices, yet higher prices are required to get margins up and meet or beat earnings forecasts. The alternative is to reduce costs, and that would inevitably mean cutting back the wages bill, therefore reducing household buying power and ability to raise prices. Households could borrow more (or reduce savings) to increase consumption, but perhaps sensibly have to date decided not to. Investment portfolios, in our view, should continue to emphasise companies which show a good degree of control over their own destiny


or have a unique proposition, rather than being dependent on rising prices or demand for mature products and services. As we noted in our first Investment Themes 2014 report, inflation is a topic we are likely to revisit during the course of this year. Locally, the surveys of consumer confidence and expectations have for some time expressed concern on rising prices, especially in ‘cost of living’, that is utilities, education and housing. Many therefore feel disconnected to the ABS CPI measure, which has been quite moderate for some time. The CPI measures the weighed cost increases based on spending from the household expenditure survey. The weights are shown in the chart below: Source: ABS

The tendency is to be conscious of prices rises of non-discretionary products one buys frequently with few substitutes. We have extracted a few to highlight selected price rises over the past three years.

Source ABS

Selected components 3 year average % change Housing 4.2% Property rates and charges 6.2% Electricity 11.1%

Medical and hospital Services 6.4% Secondary school 6.6%

Fuel 4.4%

Domestic holiday and travel -3.9% Audio visual and computing equipment -13.5%


Housing costs include rent or imputed rent, house purchase costs, maintenance and rates. The average of this single largest component of the CPI has been above the average. Many will feel the cost rises have been higher as rates are more obvious than maintenance for example.

Utilities in total represent only 3.6% of the CPI, but again most households are very conscious of the price of these services. Electricity is the standout, having risen by 11% p.a for three years.

Health and education are generally non-discretionary, with CPI rises double the underlying rate of inflation.

On the other hand, holidays are cheaper and the price of gadgets has fallen sharply for some time. As these are rarely repeat purchases of the same product, few would be conscious of the rate of deflation.

In summary, if a household consumed services rather than goods, it is likely to have experienced cost increases of 5-6% p.a over the past 3 years - roughly double the stated CPI. Inflation is often said to be the worst enemy of savings and investments. Portfolio returns should exceed inflation, but may struggle to hold real value if income is not reinvested. Further, it is all too clear cash should be minimised or only held for the short term in the event of expected market instability. Globally, taper caused barely a ripple with the Fed once again pulling back on its rate of purchases. Given the dislocation caused by the comments from Bernanke in May 2013, it appears that the Fed will be forthright in its ‘guidance’ to prevent surprises. The FOMC statement therefore was clear: the economic recovery remains well underway and that growth had ‘picked up’ sufficiently for the Committee to ‘likely reduce the pace of asset purchases in further measured steps’. Similarly there is clarity that the cash rate will remain where it is, even if unemployment edged below 6.5% if inflation also remained low. The economic week ended on a reasonable tone. US Q4 GDP was 3.2%, with business investment trending well while consumption demand was a little softer than expected. A negative contribution from fiscal spending reflects the cuts of 2013 and into 2014 these will no longer be a drag. Trade (net energy) made a notable addition to GDP while the weakest link was inventory, though usually a volatile item. The stars are aligning to a circa 3% GDP growth for the US this year, though any weaker data such as a pull-back in housing (such as in this week’s release, though possibly weather affected) will make delivery of such a growth rate harder. In Europe, credit growth was negative, which will supress the extent of any improvement. The combination of high dependence on bank debt rather than corporate credit issuance, the need to build capital in the banking system and tight balance sheet management will inevitably restrain supply and demand for leverage.


Increasingly, the divide in Europe is becoming starkly obvious. German households are quite buoyant, indicating a desire to spend. The reality, however, is that they are not spending on goods - once again, an indication households are shifting both their priorities towards saving and when spending, choosing less traditional services and other avenues rather than stores.

Europe also produced a further bit of better news. Spanish GDP was back to positive growth in Q4, though negative for the 2013 year as a whole, but a clear sign that the worst is behind them. German unemployment was down to 6.8%, based on their national definition, while the ILO definition has it at 5.1%. The differences in measuring unemployment is worth noting; the two above have alternative definitions of underemployed and ‘persons seeking work but not currently available. In the US, the unemployment rate would be 2% higher if those in jail or otherwise in incarcerated are included in the statistics. The week saw a continuation of volatility in emerging market currencies we noted last edition. Turkey took a big step and sharply raised interest rates in an attempt to support the currency. A short lived rise in the lira was not sustained and it is likely problems lie ahead for these countries with high current account deficits.


The chart shows the trouble spots and their external funding requirements:

Source: Barclays

Closing down the monetary easing window and resulting impact on perceived liquidity is seen to be the major problem for these countries. That said, current accounts are inevitably a problem for countries with a low credit rating, as well as inflation, budget deficits and occasional political instability. Taper alone is not the cause of their problems.


Australian Companies JB Hi-Fi (JBH) pre-released a summary of its half year profit to head off speculation it may have suffered a similarly difficult trading as Super Retail (SUL) and The Reject Shop (TRS). Sales growth for the half year was 6.8% with 2.8% comparable store growth. Gross margins have edged up, cost of doing business rose in line with sales and therefore net profit for the half year is up 10%. In tricky retail conditions and faced with a rapidly changing industry segment, JBH has done well to achieve this outcome and remains one of the better retailers in Australia. In effect, however, JBH has to run to stand still with price deflation (as noted in the section above) in most of their products. Holding gross margin may also become harder with the pass through effects of the currency yet to be fully felt. The stock price initially rallied sharply and then gave up more than that in subsequent days. The valuation is now in line with the sector at 16x forward year’s earnings and given a somewhat uncertain future, including potential competition from recently listed Dick Smith, it is in our view fully priced for its expected growth of 6-8%. Boral (BLD) also released a profit update, guiding towards first half earnings of $90m, above what many in the market had expected. The company pointed towards a number of factors, including favourable weather and earnings from its major projects. The company also said, however, that earnings would be skewed towards the first half; this led to relatively immaterial changes to FY14 forecasts by analysts. Boral’s management have been making encouraging comments about improving its return on invested capital (EBIT to funds employed), which has fallen from a high of 18.2% ten years ago to 4.7% last financial year (see below). With a loss-making US business and on a FY14 P/E multiple of 23X, however, we believe that the market is already pricing in significant improvement (and maybe a sharp recovery in the domestic housing market) before this potential is realised. Source: Boral


Treasury Wines (TWE) hit investors with another downgrade to its profit and was aggressively sold off. In 2013 the company announced a write-down of its US inventory which culminated in the resignation of the CEO. This week’s announcement went a step further, with poor sales in the US, Australia and China dragging down earnings. The question is: what is wrong? Certainly the company has never found solid ground in its US operations, and most have suggested it sell these assets. In China, the government had made it clear that ‘excess’ entertainment and gifts from state enterprises would not be tolerated. Most global luxury goods companies have felt this headwind and therefore it is not entirely surprising TWE was also affected. However the poor sales in Australia are of its own making. TWE has been holding back inventory and trying to reduce discounting to shift the balance of profit away from the retailer. However others in the market are unlikely to have followed the same tack, causing a major loss of share. Suppliers to the two dominant retailers in Australia show an unhappy trail of falling sales and margins as Woolworths and Wesfarmers exert their market power. That said, suppliers have been slow at cutting costs and launching new products where prices are more defensible. On the other hand, global companies have been keen to buy Australian based production. Our view is therefore that TWE has a good asset base of brands and value in its inventory. Its operational execution in recent years has been poor and it has allowed the US business to become imbalanced. For patient and higher risk investors, a new CEO could have a big impact. And then there is the option of a buyout. Oil Search’s (OSH) fourth quarter production report and FY14 outlook was better than expectations on both fronts. The company’s production in the December quarter was flat quarter-on-quarter, however this was sufficient to lift full year production to 6.7 mmboe (6% higher than 2012), above its guidance range of 6.2 – 6.7 mmboe. Fourth quarter sales volumes were even better thanks to a draw down in inventory levels. Increasing confidence in the delivery of the PNG LNG project saw OSH upgrade its FY14 guidance, from 10 – 13 mmboe to 12 – 15 mmboe. The increase effectively amounts to approximately an additional month of production from PNG LNG - with OSH’s existing oil operations expected to produce at a similar level to 2013, the potential doubling in OSH’s production this year will be attributed to PNG LNG. Production should nearly double again in 2015 with a full year’s contribution from the project as it ramps up to full capacity. While the production upgrade was positive, Oil Search also provided guidance to operating costs for FY14. As the company highlighted, these are expected to be higher in the initial ramp-up phase of PNG LNG and are then expected to decline significantly once operating at full capacity.


OSH has previously talked of first LNG sales from the project commencing in the second half of 2014, without being more specific – the revised guidance indicates that this could be relatively early on in the September quarter. The positive update from the company increases our confidence in the project hitting its delivery targets (both budget and timing), and the focus will soon turn to potential expansion opportunities. For us, OSH is a preferred holding in the energy sector. The past two weeks have also seen production reports from a number of the second tier iron ore miners – Fortescue Metals (FMG), Atlas Iron (AGO) and Mount Gibson Iron (MGX), with production figures largely in line or slightly better than expectations. FMG has enjoyed a strong share price rally in the last six months on the back of a sustained high iron ore price (despite some weakness in the last few weeks), which has led to receding fears around the state of its highly-leveraged balance sheet. The company made good progress in the quarter as it ramps up to a targeted 155 mtpa run rate by the end of March, however disappointed investors with its revised shipments guidance, which are now expected to be at the lower end of its previous indications due to the impact of wet weather this month. AGO and MGX meanwhile reported a strong sales result (ahead of production figures), and thus benefited from the strength in the iron ore price. As we have previously highlighted, the iron ore price is expected to trend lower over the next few years, with a slowing demand growth profile being swamped by larger increases in supply, particularly from the big three producers (RIO, BHP and Vale) as well as FMG. For FMG, despite an expected increase in production levels over this time, this is unlikely to offset the impact of lower pricing, as shown in the following consensus forecasts for the company’s profitability over the next four years:

Source: Bloomberg, Escala Partners

With higher operating costs and a lower-grade iron ore produced (thus leading to lower sales prices), these second tier miners have lower margins compared with the likes of BHP Billiton (BHP) and Rio Tinto (RIO), and are thus more exposed to falling prices. We are more comfortable gaining access to this market through the diversified miners. January - ASX200 In what has been a fairly bumpy start to the year, the domestic market has been impacted by several events, both domestic (weak employment data, profit downgrades) and international (concerns over China’s growth, Fed tapering, emerging market currency issues). The chart


below shows the performance of ASX 200 sectors (on an accumulation basis), to the close of trade on 30 January:

Source: IRESS, Escala Partners

While only two sectors have shown a positive return for the month; the most notable moves have been at the other end of the scale. Consumer discretionary stocks fell the most, with retailers sold off following a number of downgrades. Twenty-First Century Fox (FOX) also fell after the company announced plans to delist from the ASX. The materials index held up surprisingly well despite the decline in the iron ore price over the month, although Newcrest (NCM) had a rally following a more positive production report and some recovery in the gold price. Health Care was the best performing sector, led by continued strong performance of CSL and Ramsay Health Care (RHC), which are large components of this index. Next week, reporting season kicks off, with the following companies due to announce their results: Downer EDI (DOW), REA Group (REA), Echo Entertainment (EGP), FlexiGroup (FXL), News Corporation (NWS), Tabcorp (TAH) and FOX.


Stock Focus: Telstra (TLS)

Telstra is the dominant telecommunications company in Australia. The company provides fixed line services to homes and businesses, including phone and broadband internet. Telstra also has a market leading position in mobile phone services across Australia. The company has a 50% interest in Foxtel. Fixed line services has been the cornerstone of Telstra's earnings since the company floated on the ASX. The company owns the key infrastructure of its traditional copper network, which has enabled it to historically earn significant sales and strong margins (42% EBITDA margin in FY13). The business, however, has been in decline for some time now, with a trend for households to drop their fixed line telephone service in favour of going mobile-only. This operating landscape has changed with the introduction of the National Broadband Network (NBN), which has essentially paved the way for the structural separation of Telstra's fixed line network. As a result, Telstra will become a retail provider only, and lose the infrastructure margin that it enjoyed on its fixed line services as customers transition to the NBN. While this outcome might be seen as a negative for the company, the news is not all bad - as part of the agreement with the Australian Government, Telstra will receive payments of approximately $11bn in post-tax net present value, providing the company with good cashflows as consumers migrate to the new network, enabling it to reinvest into the other parts of its business. The slow progress of the NBN rollout similarly is not a bad outcome for Telstra - while it may mean that these government payments will progress more slowly, this will be offset by a longer earnings profile from its copper network. Mobile has made good gains for Telstra in recent years and has been the key source of earnings growth for the company to offset the decline in fixed line. In the four years to FY13, the company grew its EBITDA by 40%, driven by subscriber growth. Key in improving this profitability has been in maintaining its margins, despite relatively higher levels of competition. Telstra's advantage in this area is its superior mobile network, which attracts consumers and enables it to price its services at a premium to its competitors. Going forward, in the absence of further market share gains, the key will be how the company (and the broader industry) tackles the problem of monetising the fast-paced growth in mobile data, which has risen with the uptake in smartphones. Telstra does have a number of risks that it may face in coming years. Not least of these is further regulatory risk, including the potential for the new federal government to renegotiate the NBN payment deal. This is also, however, a potential source of upside, particularly if it was involved in the NBN build. In addition to this, its fixed line services could come under some pressure given it will then will be on an equal footing with


other retailers, however its existing customer base and strong brand should hold it in good stead. Technological change is perhaps the biggest risk for the company, which could force it to adapt to a fast-changing environment, whereas smaller players may be more nimble. Outlook Telstra's strong market positions see it well placed to handle the transition to the NBN environment. The recent sale of Sensis, although at a low price, removes an unwanted distraction for management. Following its recent share price run, the company is now looking more fully valued, however key in underpinning its share price will the high dividend yield that it pays. Following recent asset sales, the company's balance sheet is in a better shape, raising the prospect of capital management initiatives, however these appear to be largely discounted by the market. We recommend Telstra as a core holding for Australian equity portfolios, though note that capital growth is likely to be subdued.

Source for all tables/charts: Bloomberg, Escala Partners


Important Disclaimer The content of this document has been prepared without consideration of specific client

investment objectives, financial situation or needs. Thus, before any investment decision is made based on this document, an Escala Partners Limited (“EPL”) investment adviser should be consulted. 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.

Escala Partners

Escala Partners Ltd. Level 19 / 90 Collins Street

Melbourne Victoria 3000 Contact

Telephone: 03 8651 2600 Email [email protected] Web www.escalapartners.com.au

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