Wednesday, September 18th, 2019
BHP and Rio Tinto
Despite BHP’s disappointing FY19 result the stock is now trading higher than after the result. This is because the US-China trade conflict has not escalated further, investors hold hopes for the next round of talks between the two countries in October, the US equity market has rotated from ‘momentum’ to ‘value’ and US long bond yields have risen significantly in recent days – a move usually linked to hopes for reflation and higher commodity prices. The gold-copper ratio had also already priced in the world recession widely feared in August so BHP shares, via the company’s exposure to copper, also would have factored in some of this fearful outlook, leaving mostly upside.
Figure 1. Gold-copper ratio was at levels consistent with a world recession
Source: Macquarie Equities
We also reiterate the positive iron ore thesis in our review of Rio Tinto’s 1H19 result in our 15 August report. RIO shares have rallied with BHP in recent days. Adding to our thesis is a new round of Chinese infrastructure construction stimulus, which should support steel mills’ demand for iron ore during the steel production slowdown in China’s winter and ahead of the Communist Party’s 70th anniversary celebrations in October, when leaders desire blue skies over Beijing.
However all these effects are moderate and we have to manage the risk the trade conflict escalates again, which would trigger another selloff in commodities and miners. Further central bank monetary easing can also do little to accelerate world growth and we are not seeing the coordination of fiscal and structural policies to do this either. Compared with BHP’s and RIO’s respective index weights of 6.09% and 1.90% we have portfolio weights of 4.30% (moderately underweight) and 2.32% (moderately overweight).
The moderate underweight in BHP also reflects the company’s constrained growth outlook and recent tendency to disappoint on costs. FY19 earnings fell short of consensus expectations due to higher costs in petroleum and iron ore, while FY20 costs guidance for Escondida, Queensland Coal and WA iron ore was also higher than the market expected. BHP originally expected to deliver $1bn of productivity gains in FY19 but weather disruptions, changes in mine plans and higher strip ratios reduced productivity by $1bn. BHP still expects to deliver cost reductions and productivity gains in the medium term. This, portfolio optimisation, constrained capex, low gearing and stable commodity prices are reasons for exposure to the stock while it is undervalued.
Figure 2. BHP’s attractions to investors
Figure 3. BHP plans to increase ROCE at every asset
Figure 4. Current earnings pressures vs. long-term opportunities for BHP
Last month MQG raised $1bn of new equity in an institutional placement to fund capital investment by Macquarie Asset Management and Macquarie Capital in renewables, technology and infrastructure while maintaining appropriate regulatory capital. The bookbuild was priced at $120.00.
This will also be the subscription price for the share purchase plan for retail investors. The SPP closes on 20 September and the model portfolio will subscribe. MQG reiterated its initial FY20 guidance for the group’s result to be slightly down on FY19 but also said 1H20 should be up ~10% on 1H19 though lower than 2H19, which benefited from higher contributions from market-facing businesses. The composition of this guidance amounts to a soft upgrade given the strength of the 1H, so we now have more confidence MQG will meet or beat its FY guidance. We expect the reasons will be the recent build-out of the Commodities & Global Markets platform, lower interest rates inflating infrastructure valuations, A$ depreciation and performance fees as various funds realise assets.
The pipeline of investment opportunities increases our confidence in the structural growth available to MQG in renewables, technology and infrastructure. Macquarie Capital is set to deploy $0.9bn of net regulatory capital this 1H, which could be 30% of its current book. This is larger than the capital Macquarie Capital deployed in all of FY18 and FY19. Growth options are also substantial in Macquarie Infrastructure & Real Assets, which raised $21bn in the last 15 months and is set to accelerate its renewable funds rollout.
The equity raising is dilutive-near term, with the benefits of the resulting investments to flow over FY22-25. This should mean MQG can sustain gains on sale at current levels over time. The stock is out of review with a downgraded adopted NROE but a steady RI, leaving its valuation at $139.
Figure 5. MQG investment proposition
Treasury Wine Estates
FY19 net sales growth of 12% (constant currency) was a record for the company and the result was strong elsewhere. EBITS surged 25% and group EBITS margins widened 160bp to 23.4%. NPAT and EPS were respectively 16% and 18% higher. TWE delivered in all regions, led by volume growth and higher prices in luxury and masstige. Group revenue per case rose ~$9 on pcp while the cost of goods sold per case rose ~$6. Mix and cost reduction in Australia were excellent. FY cash conversion pleased at 75.8%, ahead of the 60-70% guidance range. Globally, shipments were in line with depletions and forward days inventory cover were in line with pcp. The company is clearly executing well.
Asia EBITS margin of 39.2% exceeded guidance of 35%+ due to positive mix shift from increased availability in Luxury, as well as positive operating leverage. TWE has substantial opportunity in the region from expanding distribution in China’s cities by 50% over the next three years, increasing supply from acquired French vineyards, investing in its salesforce and continuing to transition to a warehouse model, which should help reduce working capital and improve cash conversion. In Asia TWE should be able to sustain or expand margins.
We also expect margin expansion in the US from improved cost control, a decline in aggressive competitor discounting and access to an 18% distributor margin from taking distribution in-house.
TWE reiterated its FY20 guidance for growth in reported EBITS of 15-20%, with FY20 cash conversion expected to be in line with FY19. FY21 earnings risk is to the upside with the anticipated release of high-quality and high-volume 2018 and 2019 vintages in Australia and California. We released TWE from review with an upgraded RI and a lower RR, and remain confident in our position at current prices given our $19 valuation. Our position’s small size reflects the stock’s above-average volatility, China’s current economic slowdown and some caution after another large share sale by the CEO recently.
Figure 6. Trend improvements in performance metrics