Something’s gotta give

Friday, March 8th, 2019

Australian company earnings update – eps growth of 3% for FY 19

The Australian company reporting season is almost complete. Reported company results have broadly been in line with expectations that had been lowered in the “confession season” last year.

Guidance has generally been slightly negative. Sixty per cent of changes to forecast earnings have been down, which is the largest downgrade cycle for 5 years. Aggregate market EPS growth figures for FY2019 have been cut by 0.7% and now stand at +3%, with the increase driven by upgrades in the resources sector. Dividends have been a little disappointing. While there have been some exceptions (e.g. Wesfarmers, Woodside Petroleum and Flight Centre), few companies have rushed to pay special dividends ahead of possible franking credit changes.

Key themes of the reporting season: mostly solid dividends, lots of commentary around cost pressures. We’ve had positive earnings surprises from Seek, Bravura, Webjet, Magellan, Jumbo, Woodside and Credit Corp. We have seen in-line results from the big banks (CBA and Westpac), CSL and Amcor. And negatives from AMP, Unibail-Rodamco-Westfield, Citadel and Bingo.

Being a very open economy, what happens in the rest of the world is of vital importance to the domestic economy – and that relates to credit conditions and interest rates, currency movements and commodity prices. But perhaps the paramount issue of broad concern in Australia during this year will be whether the housing downturn deepens and causes a recession (it would be the first in 28 years).

The factors requiring ongoing scrutiny include homebuyer sentiment (reflected in auction clearance rates), bank lending rates (new loan approvals), business and consumer confidence (both are relatively weak and likely to weaken further in the run-up to the Federal election), dwelling and construction activity, and, importantly, the labour market.

Australian unemployment rate over the long-term


Source: TradingEconomics.com, Australian Bureau of Statistics

Today the unemployment rate is 5.0% and closely watched by the RBA. It reached just 4.0% prior to the GFC in February 2008 and has averaged 6.85% from 1978 until 2019. Whether the unemployment rate has found its base and starts rising from here will be highly significant for the short-term market outlook.

 

Earnings expectations for FY2019 are dropping


Source: Evans and Partners

We highlight below a few companies that are widely held in Clime portfolios and which produced market-beating performances: BHP and RIO, Webjet, Afterpay, Magellan, Jumbo and Audinate.

 

Bulk Commodity Stocks – BHP and RIO

After sliding during the December quarter market selloff, BHP shares bottomed on 26 November and RIO shares on 10 December. The subsequent rally reflects:

  • The freeze of US tariffs on China and subsequent US-China trade talks, which if successful stand to limit further damage to China’s economy.
  • Expectations of Chinese stimulus met by monetary stimulus (interest rate cuts and reductions in banks’ required cash reserves), fiscal stimulus (tax cuts, support for consumption of cars and household goods, new railway infrastructure) and approval for local authorities to borrow to spend on local projects.
  • Expectations of further share buybacks by RIO after their interests in Indonesia’s Grasberg mine was sold for US$3.5bn and its Dunkerque aluminium smelter for US$500m.
  • EPS accrual from BHP’s US$5.2bn off-market buyback, and the attraction of the A$1.41 fully franked special dividend paid on 30 January.
  • The spike in global iron ore markets following the deadly dam breach in Brazil last month at one of Vale SA’s mines, which has spurred concerns about a shortage. Since the initial incident in Brazil in late January, Vale has announced supply cuts of as much as 70 million tons.


Source: Mysteel, Mining.com

Since the Vale disaster, benchmark spot prices have spiked to the highest since 2017, then lost some ground. Spot iron ore is currently sitting at US$82/t and consensus for 2020 is about US$60/t – so a mark-to-market would see one year forward consensus earnings for RIO increase by about 60% and BHP by 50%.

Both stocks have significantly outperformed the ASX 200 over the last twelve months and most recently it has clearly been the strong iron ore prices that have driven the share prices higher. Further, in an encouraging sign, both major miners in their financial commentaries made declarations to spend shareholders’ funds only on “value-accretive projects”.

Over the last month, BHP has risen from $33 to $37.60, and RIO from $80 to $95.40.

 

Webjet

Webjet (ASX code: WEB) is Australia’s leading online travel agent and the second largest player globally in hotel room procurement, with hotel room inventory provided to bricks and mortar and online travel agents. The WebBeds business acts as an intermediary between hotels and global travel agents, with a growing pool of over 28,500 directly contracted hotels. Both businesses are growing strongly and, importantly, are expected to continue to do so for the medium to long term.

Market concerns about the consumer environment in Australia and in the UK/Europe prior to the result contributed to significant recent mispricing of this stock.

WEB’s growth continues to be about penetration and margin expansion, supporting growth despite the economic backdrop. WEB’s 1H19 net profit increased by 61% to $38.3m, (which included an additional two months of JacTravel and one month of Destinations of the World). Organic growth was resilient in Webjet.com.au and very strong in WebBeds. Webjet.com.au achieved revenue growth of 12% and EBITDA growth of 11%, supported by bookings growth at three times the industry and faster growth in ancillary products. WebBeds produced a particularly strong result, with 22% organic transaction value growth in Europe despite the industry growing only 2%.

Management is targeting bookings growth in the segment at more than 3 times the industry growth rate for the medium term and is achieving this. They have been able to successfully defend against the entry of large international players, such as Expedia, because of the established brand and ease of use of the webjet.com.au booking engine. Despite the strong growth over many years, webjet.com.au only accounts for approximately 5% of domestic flight bookings and 3% of international flight bookings in Australia. The business looks well placed for a strong FY20 year.

Over the last month, Webjet has risen from $12 to $16.

 

Afterpay

Afterpay (ASX code: APT) provides an innovative consumer finance solution, which enables customers to spread the cost of retail purchases without taking on longer-term debt and associated interest payments. This has resonated with millennials in Australia and the US, most of whom do not use credit cards.

APT recently provided a business update, which demonstrated the strong momentum both in Australia and the US. At a group level, Afterpay processed $2.2bn of underlying sales in the six months to December 2018, up 140% on the prior corresponding period. This included growth of approximately 100% in Australia and New Zealand.

There are now over 21,500 retailers in Australia and New Zealand offering the payment service, meaning the “land grab” is largely complete. From here, the main driver of growth will be increasing penetration of each retailer’s trade (including in-store purchases which is now 16% of sales). APT has 1,400 retailers transacting in the US, with a further 800 in the pipeline. In the first full half year of operations in the US, the business has already transacted $260m of underlying sales (which took the Australian business over two years to achieve). APT is at an early stage in the US and is preparing to launch in the UK, with these two markets representing online sales of 14x and 7x the size of the Australian market respectively.

While there is a degree of “regulatory risk” with Afterpay, this has materially reduced with the publication of the Senate Committee report. The Senate supported ASIC’s suggestion of product intervention powers and did not go as far as recommending inclusion of buy-now-pay-later in the National Credit Code.

Valuing APT requires taking a view on the long-term penetration in its respective geographies of operation. Near term multiples of earnings or revenues are not informative, given the early stage of the business. We conservatively assume the business can replicate half of what they have already achieved in Australia in the much larger markets of the US and the UK. The ability of the business to secure major online retailers such as Urban Outfitters and the very strong feedback from those retailers to date gives us confidence in these expectations.

Over the last month, APT has risen from $13.50 to $18.

 

Magellan

Magellan Financial Group (ASX code: MFG) is a Sydney based asset manager, specialising in global equities and offering infrastructure and Australian equities. The business has been highly successful in winning FUM in both the domestic retail space and from global institutions, backed by a consistent long-term performance track record. MFG has FUM of $70 billion, a market cap of $4.6 billion, and a prospective dividend yield of 6.1% (partially franked). It is viewed as “high quality” – scoring well across factors such as profitability, financial strength, excellent margins, low leverage, strong cash flow and growth prospects.

MFG’s recent strong investment performance will support a continuation of improved inflows performance and drive a PE multiple rerating of the stock. MFG de-rated at the start of 2018 on global equity market volatility and a decline in inflows. Retail inflows fell to negative in mid-2018 and the stock price fell in consequence. Both relative investment performance and inflows have since improved, with inflows tracking at 5% of FUM annualised.

MFG offers an attractive dividend yield, reflecting its high free cash flow generation and the low capital intensity of the business. The new policy is to pay out 90-95% of funds management net profit.

Over the last month, Magellan rose from $28 to $33.75.

 

Jumbo

Jumbo Interactive (ASX code: JIN) is one of only two online lottery ticket retailers (the other is Tabcorp). As the sole online pureplay, JIN is the key beneficiary of sales migrating away from bricks and mortar. Sales of official lottery tickets total $4bn and are growing at GDP. However, the proportion of online sales has increased four-fold since 2010 to 21.5%. JIN has a difficult-to-replicate customer database of over 2 million verified accounts and largely fixed cost base.

A change to Powerball odds in April 2018 resulted in a step change in the frequency of large lottery jackpots and a corresponding step change in ticket sales. FY19 has already seen two record Powerball jackpots of $100m. At the same time, the migration of ticket sale to the online channel is accelerating, reaching 21.5% as at 31 December, up from 17.7% in June. This trend is likely to continue.

These factors have led to two significant increases to earnings guidance as well as broker upgrades.

At its 15 February update, JIN disclosed “Total Transaction Value” up 66%, new customers up 92%, revenue up 58%, net profit after tax up 140%, operating cash flow up 96%, cash of $67m and no debt. With only $20m required for working capital, special dividends are likely.

Over the last month, Jumbo has risen from $7.70 to $10.

 

Audinate

Audinate (ASX code: AD8) develops and markets digital audio networking technology used in professional AV environments. Its flagship “Dante” product suite comprises hardware (chips, modules, and software) and software that is embedded within audio products of its Original Equipment Manufacturer (OEM) customers. Dante enables distribution of audio signals over computer networks – “audio over IP” – which yields significant advantages over analogue “point-to-point” technologies.

We expect Dante to become the “de-facto standard” for audio networking, benefiting from a network effect of increasing OEM and end-user adoption. Recently released Video over IP and Dante Domain Manager software expands the addressable market from $400m to $1bn. The current market value of AD8 implies that it captures only a fraction of the opportunity (<10%), which we think is too conservative. Growth rates of 50% suggest AD8 is on track to better these forecasts.

In their 1H19 report, AD8 noted sales up 60%, gross profit up 57%, EBITDA up strongly, cash of $12.2m and no debt. We expect sales momentum to continue.

Over the last month, AD8 rose from $3.85 to $4.85.

 

A Day and a Week in the Life of the Australian Dollar!

Over the course of Thursday 21 Feb, the Australian dollar spiked on news of good employment data, then collapsed when Westpac’s chief economist forecast two rate cuts. Then it fell even further late in the day on the back of a Reuters story. A week later, it is … back where it started.


Source: FT

Markets can be difficult to read. The chart above shows movements in the AUD / USD rate over the course of a 24-hour period. On Thursday morning last week, the ABS released the monthly employment data. The figures were good: employed persons increased 24,900 to 12,747,700; full-time employed increased 16,800 and part-time 8,100. These were better numbers than forecast. The unemployment rate remained steady at 5.1% for the second month, supported by strong participation in the labour force at 65.7%.

In its latest policy meeting minutes, the RBA said it expects the unemployment rate to “edge a little lower” to around 4.75% in the coming year but acknowledged that wage growth had been slower to pick up than during previous expansions.

The seasonally adjusted employment to population ratio (which is a measure of how employed the population aged 15 years and over is) increased by 0.1 pts to 62.4% in January 2019 and increased by 0.3 pts from the same time last year. This is a ten-year high number, clearly good news – provided it doesn’t represent the high point.

EMPLOYMENT TO POPULATION RATIO, PERSONS, January 2009 to January 2019


Source: ABS

Pretty good news, showing the economy is still growing at a reasonable rate. Traders in the currency markets buy up the AUD, pushing it from 0.7165 USD to 0.72 on the new information.

But the good news was short-lived: when Westpac’s Bill Evans forecast two more rate cuts in coming months, the AUD reversed and fell below where it had started the day.


“Westpac now expects the Reserve Bank to cut the cash rate by 25bps in both August and November this year. We have revised down our GDP growth forecasts for 2019 and 2020 from 2.6% to 2.2%. With the slower growth profile, we now expect to see the unemployment rate lift to 5.5% by late 2019. That makes a strong case for official rate cuts to cushion the downturn and, in turn, meet the RBA’s medium-term objectives…

“Momentum in 2018 slowed dramatically through the year. The annualised growth rate in the first half was 4% whereas in the second half we estimate that the pace slowed to 1.5%. Moving from a 1.5% pace to a 3% pace in 2019 seems to be a very large stretch. Westpac’s growth forecast in 2019 and 2020 has been a much weaker 2.6% in each year but even that number now appears too high…

“Our new forecast for GDP growth in 2019 and 2020 is 2.2%. In particular, we have been expecting only a modest impact on consumer spending from the likely negative wealth effect associated with falling house prices in Sydney and Melbourne.

“… (H)ouse prices in Sydney and Melbourne will continue to fall through 2019. Our estimates of the need to restore affordability and the impact of tighter lending standards on prices point to falls of around 5%-10% in Sydney and Melbourne over the course of 2019 complemented by softness in other markets. Absent any policy response from the RBA we expect that further falls will be necessary in 2020 before stability in these markets will be achieved.”

 – Westpac Bulletin, 21 Feb 2019

So first we get good news, then we get the forecast for bad news to come. Down goes the AUD. If interest rates are coming down in Australia, international investors will park their capital elsewhere. Certainly not in Europe, where available rates are even lower. Maybe in the US, where the official cash rate is now 2.5%. In other words, international investors can get 2.5% in the US versus only 1.5% in Australia, and that is before the RBA potentially cuts rates even lower (whereas the Federal Reserve in the US has been on a raising rates path until Fed Chair Powell’s statement in late January).

Interestingly, while the AUD fell on the Westpac forecast of two rate cuts, the stock market rallied hard. After been down 13 points at midday, the S&P/ASX200 ended the day up 43 points at 6,139. Presumably, the share market bounced on the expectation that rates would be coming down, but the logic of the forecast was that rates would only be coming down because the economy was seriously slowing.

Westpac has revised down their GDP growth rates in 2019 and 2020 from 2.6% in both years to 2.2% respectively. Consumer spending; residential housing construction and equipment investment are all key to the outlook for jobs growth. They expect the unemployment rate to lift to 5.5% in the second half of 2019 and further by end of 2020.

The forces around a slowing economy, falling house prices, and weak consumer spending are already apparent. Growth remains stuck well below trend and is constraining inflation with little likelihood of achieving the RBA’s current forecast of 2.25% inflation in 2020.

If the two-rate cut scenario plays out, and it remains a big “if” (the Clime house view is that rates will probably remain unchanged), we would anticipate further retracement of the AUD. Partially offsetting the weaker profile for the AUD will be more “patience” on the part of the US Federal Reserve with the federal funds rate. Perhaps the AUD falls below 0.70 USD in anticipation of the RBA cutting rates, but all will depend upon how the economy performs over coming months, and there are lots of moving parts – inflation data, employment figures, wages growth, house prices, retail sales, business confidence and investment, commodity prices, terms of trade, fiscal policy … the list goes on.

But the day was not yet over. After the stock market closed, a report appeared on Reuters news citing an unnamed official at the Chinese port of Dalian as saying it had banned Australian coal imports and planned to cap total coal imports in 2019 at 12m tonnes. As we well know, the Australian economy is heavily and increasingly exposed to China, which is the major importer of our commodities, especially iron ore and coal. This news, highlighting our vulnerability to both Chinese economic growth trends and policy decisions imposed by China’s government, produced the third dramatic move in the AUD chart, as seen below:


Source: FT

So very late in the day, the AUD dropped as much as 0.9% to 0.71 USD following the publication of the Reuters report. So first up on employment news, then back down on the Westpac forecast of rate cuts, then down again on the China story. Makes one scratch one’s head. As we noted above – markets sometimes behave very strangely.

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