Reporting season for the big industrials

Thursday, October 12th, 2017

The reporting season just completed was fairly uneventful – and so it should have been. The requirement for listed ASX companies to keep the market and therefore investors informed has worked – at least over the last few months. The declared results from our largest companies were well within market expectations.

In summary, the whole “market” earnings per share lifted by approximately 12% and this represented the best earnings growth in over 5 years. However, the earnings growth was heavily slanted to resource companies that recovered from their poor results in the previous few years. Stronger bulk commodity prices against expectations and disciplined cost management saw strong underlying earnings recoveries in BHP, RIO and Fortescue.

Meanwhile the large industrial sector produced marginal earnings growth as many battled through some company specific issues. In this report, we review a broad cross section of them to understand both what has/is happening and to determine their current outlook. In each case the market capitalization is flagged as a marker for investment logic as earnings are reviewed.

AMP LIMITED (ASX: AMP) – market capitalisation $14 billion

Following its June half release, AMP shares have traded at levels of March 2003 – some 14 years earlier!  This is an abysmal outcome for shareholders given 14 years of population growth, GDP growth, low and falling interest rates, rising house prices and household wealth, compulsory superannuation and ownership of one of Australia’s most-recognised heritage brands. Capital intensity, competition, legislative and regulatory change, AMP’s complex internal economics, the difficulty of driving change in such a large company with legacy businesses, poor management, and the GFC and its aftermath are all responsible.

Unfortunately the 30 June report produced more of the same. The underlying result was ordinary, with divisional results boosted by one-off items including investment performance fees and better than expected life insurance claims. Looking forward, some of the key operating metrics are likely to deteriorate in the second half. Superannuation inflows will probably decrease after the strength in the June half, ahead of reductions to contribution limits from 30 June. Performance fees will be seasonally lower and life policy lapse rates will be seasonally higher.

AMP’s share price also suffered from the decision to pause the $500 million buyback after completion of just $200 million. The reason given was AMP’s need to invest for growth, which is reasonable, so why was the $500 million buyback ever announced?

Arguably AMP should be more transparent in explaining how much capital it has available to return to shareholders. AMP has surplus capital above regulatory minimums, but the uninformed market expectations about how much of this could be returned to shareholders have been disappointed.

Following the result, AMP made a landmark decision to reinsure some two thirds of new life insurance policies from 1 November. This de-risking releases $500 million of capital and is worth the extra reinsurance premiums because it reduces exposure to the volatility in income protection claims which has dogged the sector for over 10 years. Over this period, income protection claims due mainly to disability (such as mental illness and back pain complaints) have surged way above actuarial expectations because policyholders have turned to their policies for cash flow support in the patchy economy. Premiums are catching up now, but the sector remains capital-intensive, price-competitive and vulnerable to regulatory/legislative change.

AMP share price over the last 5 years … gone nowhere


Figure 1. AMP Share price, 2012 – 2017
Source: Bloomberg

Looking forward, there are two words of caution for investors considering AMP. First, AMP will need stable investment markets to eventually perform. Second, investors should ensure their expectations for further buybacks are realistic. AMP’s aspirations to double volumes through AMP Bank and grow China earnings to $50 million are capital-intensive. The buyback program will probably not be increased in February and could be cut, while the capital released by reinsuring the life book is more likely to be reinvested than returned to shareholders.

Shareholder value can be created only by growing earnings faster than shareholder equity, thus lifting returns on equity. While that is hard to achieve, the current market consensus expectation is for 2017 earnings of $930 million to grow by 10% in 2018 while capital is maintained at about $7.3 billion.  If that is achieved, then we can value AMP at $5.30 to $5.50. The stock is interesting below $5.00 and cheap at $4.50. However, based on historic performance, AMP has to be cheap for investors to purchase it and its returns will be dominated by dividends. Our stocksinvalue.com.au dashboard covers these views.


Figure 2. AMP forecast valuation
Source. StocksInValue

 

QANTAS (ASX: QAN) – Market capitalisation $10.5 billion

The FY 17 Qantas report was both well anticipated and well received by the market. The company was solid at most of its key operating metrics, with only freight and Jetstar reporting lower earnings. Importantly, the key Qantas branded domestic and international businesses produced steady growth with reasonable momentum noted in the June quarter. The domestic profit growth was impressive, given the continued weakness in resources routes.

Looking forward, the international business continues to build capacity into Asia with China (Beijing) a continuing focus. Qantas seems to be well positioned with inbound tourism growth, which has been heavily slanted to Chinese and US visitors.

A continuing feature was the growth in membership and profit attributable to the Qantas Loyalty program. During FY17, Qantas added about 400k new loyalty members representing growth of 3.7% and ended the year with about 11.8 million members.

Before looking more closely at the outlook, the following table tracks the recent 5 year financial progress for Qantas. Readers will note:

  • Fairly solid recovery in profits;
  • Excellent generation of cash (pre capital expenditure);
  • The slight reduction in debt without drawing upon shareholders; and
  • Release of capital to shareholders via dividends ($262 million) and buybacks ($1.76 billion).


Figure 3. Qantas financial summary, FY2013 – 2017
Source. StocksInValue

In the recent result, Qantas announced a further $500 million of cash returns. A 7 cents per share unfranked  dividend was declared ($127 million) and a $373 million buyback.  At June, Qantas still carried a near $1 billion of tax losses as a reminder of how bad things were in the past.

Readers should note that while operating cashflow is both impressive and substantial, this is eaten into by ongoing capital commitments. In its guidance, Qantas forecasts at least $3 billion of expenditure over the coming two years. This expenditure will be focused upon plane refurbishments and fleet optimisation programs. This expenditure will slightly exceed projected depreciation. Consequently net debt will be maintained at about current levels with its cost well covered by cash flows.

Looking forward, market consensus pre-tax  earnings are fairly flat, sitting at about  $1.5 billion per annum for the next few years.

While Qantas is well positioned to benefit from the tremendous growth in both inbound and outbound traffic, the continuing commitment to maintain and upgrade its fleet is an everpresent issue that restricts cash earnings growth. Further, the past few years have certainly benefited from a sustained decline in the cost of oil.  While supply imbalances suggest continuing downward pressure on oil, it appears that the current US$50 per barrel price will hold due to OPEC production controls. There are probably no more easy gains from this source with further operational cost improvements highly dependent on expensive technology enhancements.

Qantas has soared over the last 5 years … if you were clever/lucky enough to pick it


Figure 4. Qantas Share price, 2012 – 2017
Source: Bloomberg

 

WOOLWORTHS (ASX: WOW) – Market capitalisation $34 billion

Following a few years of severe operation problems, Woolworths reported an underlying NPAT for FY 17 of $1.42 billion, which was well within market expectations. Therefore much significance was placed on the supporting commentary, from which we gleaned the following:

  • There was solid sales growth momentum in the fourth quarter. Same store sales growth in the June quarter of 6.4%. This compares with 3.6% for the full 2017 financial year, so the acceleration through the year is clear;
  • Operating cash flow was extremely strong with an impressive improvement in working capital management. Strong cash generation led to a reduction in net debt to $2.1 billion. The closure and liquidation of assets related to Home Improvement (the Masters disaster) also helped the balance sheet improve; and
  • While NZ, liquor and hotels performed better, Big W continued to bleed with a decline in both sales and customer satisfaction levels.


Figure 5. Woolworths financial summary, FY2013 – 2017
Source. StocksInValue

Overall, the result and the cash flow (even if supported by asset liquidations) led to the board paying an impressive final fully franked dividend of 50 cents. The dividend was some small compensation for the value destruction of the Masters foray and the lack of focus on customer needs.

Value destruction for Woolworths shareholders over 5 years … perhaps now turning


Figure 6. Woolworths Share price, 2012 – 2017
Source: Bloomberg

So what is the outlook for Woolworths?

Woolworths is becoming as well-managed as at any time since the glory days of the 1990s and there should be a solid management premium in the share price; but at $26 the 2018 earnings multiple is 20 times market expectations of NPAT of $1.6 billion for FY 18.

Shoppers have returned to Woolworths, reflected in accelerating growth in comparable transactions and stronger internal measures of customer confidence in the brand. Items per basket have also resumed growth.

Attracting customers back to the supermarkets has however come at the very high cost of over a billion dollars in price cuts to restore shoppers’ trust that Woolworths will be price-competitive with Coles and Aldi. Unfortunately, there is more profit margin compression to come as electricity costs surge and Woolworths comes up against internal limits to how far it can boost margins by reducing shrinkage (lost, spoiled, incorrect and stolen stock). Same-store sales will slow through fiscal 2018 due to the high base created by the successful relaunch of the loyalty program in September 2016.

Big W’s serious problems and financial losses have worsened to become a burden and distraction for management. Management admits the problems with Big W are fundamental and go to core processes. Big W cannot simply close unprofitable stores, as this would require not only paying out the leases but in some cases also compensating landlords for lost foot traffic to nearby specialty stores.

There are other headwinds, for example higher depreciation expenses in food as capital expenditure tilts towards assets with shorter lives. The challenge and opportunity for management is to offset more losses from Big W with earnings growth in food & liquor. This is achievable but everything will have to go right for the group, and our contention is this “best case scenario” is already in the share price – a reality which does not sit comfortably with management’s reluctance to provide earnings guidance for 2018. A wide range of earnings outcomes next year is thus possible.

Commonwealth Bank (ASX: CBA) – Market capitalisation $145 billion

Readers will no doubt recall that the CBA’s FY17 result announcement was completely nullified by the Austrac revelations.  The reported NPAT of $9.9 billion was solid and the reported ratios were the best across the banking sector. However, the Austrac revelations quickly tested the share price which had pushed CBA’s capitalization to over $160 billion – the largest in the Australian market.

Looking forward, the issue for CBA is becoming complex. The defending of legal actions, the dealing with regulatory enquiries, the exiting of non-core assets and finding a new Managing Director, are issues that will certainly stall CBA’s momentum. More importantly, they will test the premium market rating of the bank.

Since the result, the CBA has announced some significant initiatives. Let’s briefly review them.

The exit from life insurance underwriting in Australia and New Zealand is one of the better strategic decisions the bank could have made. Life insurance underwriting in this country has been a serial disappointment. Actuaries have not been able to forecast claims accurately because they did not understand the links between the patchy economic conditions of the last 14 years and mental health claims (see commentary for AMP above).

The profitability pressures on underwriters create incentives to avoid paying claims, which was alleged at CommInsure and is widely perceived in the community. Although the Future of Financial Advice reforms allowed life insurers to continue paying salespeople by commission (this practice was phased out for managed investments), Australians remain underinsured for personal risks and this is not resolving. One reason is the products and their providers lack credibility in the community. Therefore, CBA’s reasons for selling its life books to AIA are valid. Only underwriters with global scale, diversification and risk management systems will earn adequate returns in the future. CBA is better off as a distributor, hence the 20-year marketing deal with AIA.

The sale for $3.8 billion is incrementally positive for value. Although CBA will lose businesses that contributed $236 million of after-tax earnings last year (2.4% of total earnings of $9.2 billion), the 70 basis points of capital released will vault CBA to a pro-forma common equity tier one capital ratio of 10.9%, higher than the 10.5% APRA requires by January 2020.

Thus, depending on the size of any Austrac fine and further capital charges applied by APRA for not reporting oversize cash deposits and allowing money laundering, CBA could by late-2018, after the sale completes, have surplus capital. However, a special dividend is unlikely given CBA does not have surplus franking credits other than a precautionary buffer.

CBA also announced a strategic review of Colonial First State Global Asset Management with several options to be considered including listing on the ASX. Based on fiscal 2017 earnings of $229 million, proceeds of $3.5 to $4.5 billion are possible assuming a 15-20 times earnings multiple. An exit at these multiples will in the first instance detract from value given CBA trades on 13-14 times earnings, but as with the exit from life insurance it depends on what CBA does with the sale proceeds and surplus capital created.

Distressingly, seventeen years after CBA acquired Colonial, the group is finally admitting it cannot generate sufficient value by cross-selling life insurance and funds management to its vast retail customer base – the original justification for the controversial acquisition. This is quite a strategic disappointment, if not a total failure.

CBA shareholders enjoyed great returns for period 2013 to 2015, peaking in March 2015 at $95 but thereafter … not so much


Figure 7. CBA Share price, 2012 – 2017
Source: Bloomberg

Clime Asset Management owns shares in AMP, WOW and CBA for and on behalf of various mandates for which it acts as investment manager.

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