Watch risk, not just growth

Tuesday, March 14th, 2017

Growth is easy to observe but risk is less apparent. As we look forward from reporting season, investors are valuing stocks based on the growth rates recently reported and guided, but valuations should also reflect whether stocks are becoming riskier. Wesfarmers and CSL are telling case studies because the former is slowing and becoming riskier while the latter is accelerating and becoming less risky.

Wesfarmers’ headline interim numbers seemed reasonable enough. Sales grew four per cent, operating earnings were 15 per cent higher and after-tax earnings rose 13 per cent. But the results from Coles, which contributed over a third of operating earnings, concerned us. Like-for-like sales growth decelerated to 1.3 per cent for the half and one per cent for the second quarter, down from 4.3 per cent in the previous half, and operating margins narrowed. Coles earnings fell eight per cent. These results were worse than we and the market expected. In particular Coles was unable to pass on increases in the cost of meat because Woolworths cut its own prices. Earlier price inflation in produce levelled out, restraining overall grocery margins.


Figure1. Coles category selling price inflation, 2Q16-2Q17
Source: Wesfarmers

For so long Coles enjoyed buoyant margins and sales growth because Woolworths, distracted by the Masters misadventure, was uncompetitive. But this period of ‘Peak Coles’ is over now Woolworths is resurgent. Coles is being forced to cut prices to stay competitive as Woolworths finds efficiencies to help offset its own price cuts. Meanwhile Aldi’s rollout in South Australia and Western Australia continues, so Coles is presumably losing share there.

Coles now faces a difficult strategic question: does it stick to its former strategy of supporting longer term sustainable earnings or does it fight on price and market share? Both will be costly and the outcome is unknown.

Bunnings’ like-for-like sales slowed and losses in the UK will expand in the second half and into 2018. We are yet to be convinced selling DIY products in the UK will work given trade services there are cheaper than in Australia so households generally prefer to engage tradespeople rather than do projects themselves. At best a material payoff from the UK is three years away.

Wesfarmers as an investment proposition is complicated by the intended divestments of the Curragh coalmines and Officeworks, as both exits would derisk the group. Mining is a volatile, unpredictable game and coal prices are already off their recent peaks, while Officeworks stands to be substantially disrupted by Amazon so Wesfarmers is being prudent by attempting to sell it in an initial public offer. Wesfarmers missed an opportunity to sell the coal business at the peak of the last commodities boom so we support the current attempt and hope it leads to a full exit at or above written down book value.

Wesfarmers is entering a new era. There is a new CEO, exits from coal and Officeworks are possible, offshore expansion is underway and headwinds are emerging for businesses contributing two thirds of EBIT: Bunnings and Coles. While we don’t expect the strategy to change materially under new management, earnings risk is higher. In StocksInValue we value Wesfarmers at $41 but the share price is strong at nearly $44 due to optimism the coalmines and Officeworks will be sold. The market in its current enthusiasm for the divestments could be missing the deteriorating picture at Coles, which should eventually justify a discount in the stock.

CSL, in contrast, upgraded its guidance in January and interim net earnings surged 36 per cent. This week CSL is hosting analysts on a tour of its European facilities and the insights are no doubt adding to the rally as the stock at $125 continues on its journey towards our new $143 2018 valuation. In our model portfolio we are set with a large seven per cent weighting.

In contrast to Wesfarmers, CSL’s growth is visible, accelerating and less risky than before. This is one of the few ASX 50 stocks, perhaps the only one, capable of compounding earnings at double-digit per annum. Product sales at the key CSL Behring division grew 18 per cent. Competitors underinvested in US plasma collection capacity, so CSL’s capacity expansion became a competitive advantage. It took share from competitors by meeting more of the ever-growing demand for immune therapy products known as immunoglobulins.

The derisking came from guidance that Seqirus, the lossmaking vaccine business acquired from Novartis, is on track to break even in FY18. Investors will now start to engage with Seqirus not as a risk and a headwind but a new source of upside.

Idelvion, a new hemophilia therapy recently approved for sale in large markets, had a strong start and we are also bullish on Afstyla, another new hemophilia treatment. Both are longer-lasting than the competition and require less dosing.

The growth outlook for CSL is as attractive as at any time since the launch of the immune treatment Hizentra in 2010 and this is reflected in our bullish valuation, which admittedly also depends on the ongoing share buyback. We see several sources of potent margin expansion: sales growth and higher margins for Idelvion and Afstyla; increasing the penetration of Kcentra, a treatment for perioperative bleeding, in US hospitals; patient conversion to CSL’s Berinert and Haegarda treatments for hereditary angioedema, and ongoing growth in demand for existing immune treatments Privigen and Hizentra.

So to conclude, it’s essential to consider not only the growth a company reports and guides but also whether the core business units are becoming riskier or less volatile. It should be clear why our model portfolio owns CSL but not Wesfarmers.

Originally published in The Australian newspaper on Tuesday 14 March 2017.

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