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Reporting Season: The unanswered questions

by | Jul 25, 2017 | Market Insight, Reporting Season

Every six months in Australia, reporting season comes around. It’s an important time for investors as it gives us a chance to see in detail how companies are travelling and, in some cases, what their outlook is for the year ahead. As a result, February and August become important times for shaping portfolios and generating investment ideas. Whilst every result will be scrutinised, we believe this reporting season there are a number of major questions outstanding for which we will receive further clarification.
Reporting Season: The unanswered questions
Guy Carson

1) Will Telstra cut its dividend?

Back in February, we wrote that “we expect that Telstra will be forced to cut their dividend sooner rather than later.” That was on the basis that Telstra was paying out more in dividends than it was earning as can be seen below.

Source: Thomson Reuters, company filings
​From the above we can see that historically Telstra has paid out close to, if not all of their earnings in dividends. However, going forward we believe this needs to change. The Telstra of today is a very different company to ten years ago. What was once a national monopoly now faces competition on all fronts. As a result, the company will need to invest in their networks and in other growth initiatives to stay ahead of the pack. Previously, due to their natural advantages the company could pay out earnings and then use to capital markets to facilitate investment. With the increase of competition and the potential decline in margins and market share ahead, we believe this capital allocation strategy needs to be revised. As a result, we expect Telstra to cut their dividend. Whether it happens at this result or they provide guidance for next year, we believe we should get some clarity at this result.

2) Will the end of the residential construction boom factor into the guidance for residential REITs?

The leading indicators for the residential construction industry are pointing down. Building approvals have peaked, commencements have followed and completions typically follow 6-9 months after.

In an economic sense, this has been one of the major drivers of the Australian transition from the mining boom in recent years. With the RBA cutting interest rates from 4.75% to 1.5%, they have sparked the biggest building boom in Australian history. With the downturn upon us the only question that remains is whether we have a hard or soft landing. How the major developers react will be interesting.

The building boom has been kind to some of the major listed players in recent years. Mirvac, for example, has seen residential earnings grow by 51% last year and potentially by another 45% this year.

Source: Company filings
The focus though will quickly turn to next year and the expected amount of settlements as well as the level of presales. If volumes start to decline, earnings will follow.

3) Which companies are shaping up to be the major beneficiaries of an East Coast infrastructure boom?

With the residential construction boom potentially coming to an end, one of the most compelling stories from a top down perspective is the coming infrastructure boom set to take place predominately on the East Coast. The chart below looks at the major construction projects across Australia and their planned timing.

Source: CImic Company filings, Macromonitors

The vast majority of projects are taking place in New South Wales (Bruce Highway, NorthConnex, WestConnex, Western Sydney Roads, Sydney Metro, Sydney Light Rail) and Victoria (West Gate Tunnel, City Link – Tulla Widening, Melbourne Metro Rail, Regional Rail Revival). Both state governments have seen significant cashflows from stamp duty in recent years and are now in the process of spending the proceeds. The focus is very much on roads, which seems a little short-sighted particularly in Sydney where there is a definite need for a legitimate metro/rail system.

There will be some significant winners from this increase in infrastructure work, the question investors have to ask is who they will be and is it already in the price. Obvious beneficiaries such as Cimic have seen their prices run hard but there is one value opportunity that we have initiated a position in recently, which is Veris.

Veris is a Western Australian based surveying company that has expanded into the East Coast via acquisition. The surveying market is highly fragmented and as the first mover with a roll up strategy, Veris has a good opportunity to grow strongly over the coming years.

4) Will WA arrears start to hit the profit line of the banks?

The only one of the big four with a June balance date is Commonwealth Bank. Whilst the other three have quarterly updates around the same time, the focus will be very much on the details of the CBA result. To that end, one area of risk we have identified in recent times is the rising arrears within the Western Australian property book. The rise in arrears started in 2015 (coinciding with the peak in the residential construction market in WA) and has continued steadily in recent periods.

Source: Company filings
If arrears persist, they move to stressed and eventually become impaired. A large increase in impairment expense as well as a stagnating top line saw Bankwest’s cash NPAT fall by 12% in the first half of the financial year.  High volume growth within the Retail Bank saved them as they grow their asset book by 8% in total over the half. The question is will slowing volume start to reveal some cracks.

Source: Company filings

The volume growth from the first half will continue to benefit earnings in this half but we’d expect the rate of operating income growth to slow in coming halves.

Ultimately, these are some of the issues will dictate the direction of the Australian Equity market over the next six months. Of course, there will be other stories that will catch us by surprise and the ongoing movements of commodity prices and the level of the currency will have an impact. Portfolio management is a 365 days a year job and we need to absorb and process information at all times, it’s just in the next month we will see a large amount hit us at once.

The Aussie Dollar: An opportunity or an obituary?

by | Jul 25, 2017 | Market Insight

This week Robert Swift takes a look at the currency debate that has been raging recently. Robert takes a look at what has happened so far and how he expects equities to react accordingly. Is it time to increase or decrease your weighting towards international investments?

Investing internationally can expose you to currency risk. If the AUD$ falls against other currencies then you benefit to the extent that the value of your investment rises when translated back into AUD$. On the other hand if the AUD$ rises then the value of your investment is reduced by the extent of the decrease in the foreign currency. It is important to note that you haven’t lost money if you do not sell the position. It is only a “loss’ or ‘gain’ on the basis of adjusting prices to current market values.

Currencies fluctuate and in the short run can do so for random and illogical reasons. In the long run (5 years +) they tend to follow a more logical path which is determined by relative competitiveness in traded goods. Countries with more debt, more inflation, and less capital investment tend to have currencies which structurally decline in value.

The AUD$ has recently risen by about 5% against the US$ and the global equity portfolio has about 50% of its assets in US$ denominated stocks. This has reduced the value of the portfolio.

We consider below the reason for the increase and, more importantly, if it will it continue. Are we going to see a repeat of the commodity boom from China which drove the AUD$ over parity, and at the time caused all sorts of currency experts to predict that the AUD$ would remain there! As we said – currencies fluctuate in the short run and are notoriously hard to predict.

While equity prices could be said to behave in a predictably irrational fashion, currencies tend to behave in an unpredictability irrational fashion.

So what happened and why do we think this is nothing to worry about? You shouldn’t sell international equities nor be afraid of owning many foreign currencies.
​

  • The RBA’s Deputy Governor successfully (sort of) arrested the Australian dollar’s ascent last Friday, but while it has at least stopped rising for now, its recent surge has not been reversed as it laps at 80 US cents and 5.4 Chinese renminbi (yuan).
  • The US$ was faltering after a strong run as part of the ‘Trump trade’. Political gridlock in Washington (aka chaos) has removed some of the lure of the US$ and the big increase in infrastructure debt issuance at higher interest rates, now looks less likely.
  • The Federal Reserve is once again signalling a slow exit from zero interest rate policy and only gradual increases in interest rates. The Federal Reserve, like all central banks, is keen to keep hinting to the market what they will do and is consequently causing the volatility.
  • As economic news varies between a faltering USA economy and a strengthening USA economy, the US$ rises and falls with expectations of interest rate changes. In the Northern Hemisphere Summer, USA economic activity tends to be softer. Although seasonal adjustments are made in the measurement of these statistics, they are imprecise.
  • The RBA Board meeting minutes released recently indicated the Board viewed the neutral cash rate as around 3½% compared to a current rate of 1.5%. This was (incorrectly) taken as a hint that rates would shortly be on their way there.
  • The iron pre price in US$ has bounced which helps the AUD$.

Why do we think this is a temporary surge and one should remain invested in unhedged international equities?

  • The last thing the RBA wants is a rising AUD$. it continues to acknowledge that …“An appreciating exchange rate would complicate” the transition of the national economy away from its earlier heavy reliance on the construction of big-ticket resource projects.
  • USA inflation, or many components of the index, remains well-contained, and so the RBA’s capacity to switch back to a tightening bias, much less actually raise the cash rate, is limited by the extent to which they want Australian interest rates to be a lot higher than USA interest rates. We show the spread in the chart below. We are at an extreme now and a wider spread is not helpful to a smooth economic transition.

Source: Bankwest
  • Export item prices other than iron ore are still subdued. Note also that Chinese GDP composition will be different in the next 15 years from the last 15 years. In the last 15 years there was a lot of construction and basic infrastructure. As the economy matures there will be more services and less physical construction. To view Chinese GDP as being a predictor of commodity demand may no longer be quite as easy and analysts will have to be cognisant of this changing shift rather than simply measure the rate of Chinese GDP.

Most importantly the AUD$ is not a cheap currency. The OECD calculation of the PPP fair value of the A$, an anchor price around which news flow drives it up and down, is about $0.71. We attach that chart below.

Source: Thomson Reuters
​Consequently the AUD$ at a little above fair value is not likely to rise much more. With the Australian dollar at levels above 80c, one should be investing more into international equities to attain better portfolio diversification and to gain exposure to sectors and themes not present in Australia.

Small Cap Reporting Season Preview – Part 1

by | Jul 20, 2017 | Reporting Season, Stock Insight

As is traditional, with reporting season fast approaching TAMIM have asked our mangers to provide a quick preview of what they expect and hope to see over this always interesting period. This week the Small Cap team review Zenitas Healthcare, Fiducian Group and Pioneer Credit.

Zenitas Healthcare (ZNT.ASX)

​ZNT EBITDA guidance: $6.6m
TAESC estimate: $6.75m
ZNT’s share price weakness of late has been a key contributor to the fund’s recent underperformance. We have written previously about our thesis for investing in ZNT.

This recent interview with Justin Walters, ZNT CEO, provides an up-to-date summary of the ZNT strategy and opportunity.

As noted in this interview, ZNT has, as of late June, re-affirmed its previous EBITDA guidance and we would expect to see ZNT report in August an EBITDA profit in excess of $6.6m.

More importantly, the outlook for FY18 would appear positive, with 14 new clinics set to open early in FY18 which are expected to contribute to FY18 earnings, together with other organic growth initiatives that ZNT are pursuing. ZNT’s management are confident of capturing further market share, in a market that is growing at ~5% annually.

We see the current share price weakness as a reflection of the market’s impatience regarding delays in ZNT announcing an earnings accretive acquisition, rather than a sell down based on any fundamental aspect. That reaffirmation of guidance and positive industry and company outlook suggests that the thesis for investing in ZNT remains very much intact.

We have recently met with ZNT’s CEO and understand that a number of potential acquisitions are being progressed, and we are confident that these will add further scale to ZNT’s GP and homecare footprint* (ZNT already owns the largest network of allied healthcare/physiotherapy clinics in Australia). Irrespective of any acquisitions, the company continues to grow organically.

With a market cap at 30 June 2017 of $42m, cash of $9.7m (31 March 2017), undrawn debt funding for acquisitions of $10m and reaffirmed FY17 EBITDA of $6.6m, we continue to see ZNT as a highly compelling and undervalued investment, with material upside.

An increasing focus on 1) the benefits of community/home care as opposed to high cost hospital care, and 2) the potential for integrative health care to assist in the management of chronic disease will support the ongoing growth of ZNT.

*on 3 July 2017 ZNT announced an investment into an established homecare company with a large presence (800+ staff) across the east coast of Australia.

Fiducian Group (FID.ASX)

FID guidance: “expect double-digit earnings growth”
TAESC NPAT (underlying) estimate: $8.5m (22% EPS growth)
Diversified wealth management group FID does not provide earnings guidance; however, it has outlined a double-digit target for earnings growth. FID has achieved double digit annual EPS growth in 13 out of 17 years since it listed on the ASX.

FID appears to be positioned well for a strong full year result:

  •  As at 30 April 2017, FID’s total funds under administration, advice and management (FUMAA) was $5.6b versus $4.7b at 30 June 2016 – an 18% increase over 10 months, with 2 of the strongest months of the financial year for inflows remaining.
  • As at 31 May 2017, FID’s reported funds under management was $1.8b, up from $1.47b at 30 June 2016 (23% increase for year to date).
  • In the second half of the financial year FID has acquired $52m in funds under advice through the acquisition of 2 financial planning networks.

FID’s operating model benefits from significant operating leverage, so these positive developments in relation to FID’s asset management base are supportive of strong earnings growth. In its half year result, FID noted the reduction of its Cost to Income ratio as a result of the scalability of operations.  FID’s reported operating cash flows as at 31 March 2017 are strongly up on the same period for last year.

For the first half of FY17, FID delivered EPS growth of 22% with underlying NPAT of $4m. Based on a continuation of strong asset flows in the second half, FID is on track to deliver underlying NPAT for FY17 of approximately $8.5m (~22% increase).

Pioneer Credit (PNC.ASX)

PNC NPAT guidance: $10.5m
TAESC estimate: $10.5m
​Financial services company Pioneer Credit re-affirmed its FY17 guidance and provided FY18 guidance in early April.

Since then, we understand that collections have remained steady and average payment terms are steady, underpinned by low unemployment rates across Australia and New Zealand.

Pioneer continues to build out its analytics focus, with a team of 12 now working on more sophisticated analysis, new business initiatives and predictive modelling.

PNC has also been busy recruiting staff for its anticipated growth, and while labor intensive, its success rate in recruiting staff has been improving.  PNC’s staff retention is assisted by a strong culture installed by its impressive management team.

Due to the significant investment in training, it takes 5 months before new staff are profitable. All head count increases in back office, finance, risk, analytics, have been factored into Management’s forecasts.

We understand that Management remain comfortable with its disclosed forecasts. Despite a strong share price performance in recent months, PNC’s FY18 guidance of EPS of ~27 cents puts it on a multiple of under 9x, yielding 6% fully franked based on a 50% payout ratio.  We believe this remains compelling for a business with a very strong management team, which is growing earnings at a double digit rate.

Note: All three stocks mentioned here are currently held in the TAMIM Australian Equity Small Cap IMA portfolio.

Being early is the same as being wrong… or is it?

by | Jul 18, 2017 | Market Insight

This week Robert Swift examines one of the more costly mistakes of the TAMIM Global Equity High Conviction portfolio so far this year. We still believe the investment thesis for Macy’s to hold but this experience underlines the significance of timing on short-term returns in investing.
Macy’s – too early or just plain wrong?
Robert Swift
Contrarian investing is a great approach as long as you don’t forget that other investors are selling the stock because they think they know more than you. Sometimes they do. A stock you think attractive is cheap for a good reason and the cheapness is an illusion. You’re the ‘patsy at the table’ that other investors want to offload their stock on. Consequently, since we don’t want to be wrong too often, we try to identify cheap stocks with a catalyst – “cheapness AND change”.

Anyone can see that a stock is cheap by using publicly available information on P/E, Price to Sales, or Price to Book. This is not really forward looking analysis at all but a simple exercise in sifting stocks based on historical data. What is harder is to identify the reason for the earnings, the price earnings multiples, and the share price to rise. Cheapness alone is not enough for us. There has to be some change to attract other buyers and for the company’s management to convince us and other investors that they can deploy capital into more profitable projects and return the company to even modest growth. It’s the combination of cheapness and change that works well in a value approach.

We categorise the catalysts in 3 dimensions:

  1. Management change,
  2. Strategic change often with balance sheet change, (disposals and/or acquisitions) &
  3. External/Regulatory change.

Most often one or more of these is the catalyst that drives a share back to favour and the share price higher. It is a well-known ‘problem’ to be too early when you buy cheap stocks. It is a ‘problem’ because the investment can take time to come to fruition since other investors have to change their mind and start to buy the stock. Having seen it underperform for so long it is often hard for them to do so rapidly. This time delay is an opportunity cost (there may be much more fun going on in other stocks elsewhere where the crowd is gathered) and it is important to be paid to wait in the form of an above average dividend yield. Timing the entry point perfectly is hard, but even if we invest a little ahead of the catalyst being evident, we don’t mind waiting a while partly because the dividend yield pays us to be patient. Never forget that a significant part of the total return from equity investing is the dividend yield and not just the share price appreciation!

A stock which possessed cheapness and, we thought, catalysts for change was (and still is) Macy’s (M.NYSE). This is a department store which trades under the brand Macy’s and Saks 5th Avenue. It has not been easy for the company but we see both internal and external catalysts.

Unfortunately, we invested both at a higher price and sometime ago at the beginning of 2017. Six months later the price is lower and while we have collected some dividends, we are ‘underwater’.

So what has gone ‘wrong’ and why are we holding on?
This retail industry is certainly a tricky place to invest right now. You’re either forced to pay sky-high valuations for the stocks like Amazon (>1860 earnings) or Ulta Beauty (35x earnings) that are working on momentum alone or to take chances with potential value traps like Macy’s, Target, or Kroger, all of which have near single-digit valuations, but also don’t seem to have many growth prospects in the near term. Some former glamour retail stocks are at the brink – such as Sears, Abercrombie & Fitch,

What do we see in Macy’s?
The retail ecosystem (landlords and retailers) is now, finally, responding to the Amazon and Alibaba category killers. The weaker players such as Sears have been driven to the precipice but survivors will have more market share available, less competition, and the benefits of having managed against a tough backdrop which means a tight cost structure.

Macy’s will survive and should prosper – at these stock prices we are now getting paid 7% in the form of a dividend yield to wait for the changes made by new management to have an effect on profitability, business strategy and the share price. We also anticipate mall owners to respond to the internet by driving more foot traffic through their doors. This morning we saw this story about a Shanghai mall from the local press.

We are generally underweight consumer cyclicals and believe that the consumer is over-leveraged in the UK, the USA and Australia and doesn’t have much spare income at all. We also watched Amazon and Alibaba roll out their business on the internet; saw the demise of Barnes and Noble the USA bookseller which was the first to be hit by Amazon’s internet book sales, and so waited for the retail carnage to continue driving down stock prices everywhere.

Then early this year we decided to enter the retail industry and purchased Macy’s for the model gobal high conviction portfolio.

Why will Macy’s survive and prosper? What on earth were we thinking?!
Asset value – about half of retail space is freehold and worth considerably more than stated in the report and accounts. The credit card business alone is possibly worth several billion $ since it generates about $700m pa. The value of the company in the stock market is currently about $7bn. It is very likely that the net asset value of the real estate is 3x that.

We think the market is effectively ascribing negative value to the retail and credit card operations and has a jaundiced view of the real estate value. It is a classic contrarian value opportunity and we anticipate that even a stabilisation in store sales will see a rapid reappraisal of the company.

Sales and cash generation – sales per quarter are equivalent to almost the market capitalisation of the business. Put another way the company is valued at about 25% of its annual sales. Cost reductions will flow through to the net income line as long as management can stabilise the revenue numbers once the store disposals are completed. We think they can.

Change is evident in Management action:
Cost cutting and refocusing – New management is cutting unprofitable or marginally profitable stores. Real estate disposals generated over $650m last year which is equivalent to 10% of the market capitalisation. A venture with Brookfield (albeit on a small portion of the asset base) has been signed to optimise the real estate portfolio. Meanwhile total sales fell only about 3%. It’s not the sales at any price margin that are important but making profitable sales that matter. We think it obvious that total sales will fall as the company rolls out a closure programme and news flow on this does not concern us.

New management has a positive attitude to shareholders and has continued with share purchases from the considerable free cash flow.

Reinvesting to grow again – The company is driving foot traffic to stores with new formats such as Spas (Blue Mercury) and discount offerings (Backstage) and digitising (belatedly) their retail offering (check out www.macys.com).

Macy’s online sales are growing in double digits so it’s not like Amazon is the only successful online destination! We believe that general retailers have forgotten that impulse buying is important as is the consequent need to bring foot traffic through the door. The food retailers are currently better at this. Tastings and samplings, price discounts on a seasonal basis, and recipe ideas, all help to create excitement. Why for example do Myers in Australia not hold lunchtime “fashion shows” in their stores to showcase this seasons’ looks and to create additional visits? If you travel and want to see how a UK department store is adapting its space to meet a changing market then go to Fortnum and Masons in Piccadilly in London. The 3rd floor has been transformed from menswear (which is offered in overabundance in other local outlets) to a cocktail bar.

A destination for a quiet drink perhaps while some shopping is done? We did a bit of digging and it transpires it is quite profitable AND popular as a starting point for an evening out.
Macy’s is trying to generate more visitors with its Backstage format and value shoppers are able to shop for discounted clothes and help Macy’s improve stock turn. We anticipate more concepts being rolled out.

External change is occurring – All USA malls are adapting to the online impact (finally) so the 50% of leased space that Macy’s have is likely to piggy back that. Macy’s has stores in over 70% of malls categorised as A grade so since these will survive and fight back…Macy’s should do alright. We would be concerned if they were predominantly in B and C grade malls.

The metrics to measure management success are no longer total sales growth or like for like sales growth, but sales per employee and free cash flow to pay dividends and invest in digital platform.

Lacklustre sales growth on a like for like basis is spooking some investors but it shouldn’t be the metric to define success. We continue to judge the transition as being successful if we see the following continue:

  1. Continued asset disposals producing net gains to the profit and loss statement, thereby maintaining the strength of the balance sheet and proving the conservative carrying value of the real estate in the books.
  2. Free cash generation net of continued investment in the digital platform
  3. Sales per employee continuing to rise

The Lendlease Income Opportunity

by | Jul 12, 2017 | Stock Insight

Following on from our previous discussion of income versus capital as a source of portfolio return Scott Maddock and the team at CBG, of the TAMIM Australian Equity Income IMA, look at Lendlease (LLC.ASX).
The Lendlease income opportunity
Scott Maddock

LLC is a leading development, construction and investment management business, operating in 9 countries. We believe the company is positively leveraged to global economic activity. Operationally the company has been on a path of continuous improvement since their last major construction losses in 2004. Delivering a strong operational track record, generating 14% ROE. We expect LLC to have net cash within 18 months (5% gearing currently).

The current dividend does not seem high at first glance; however, LLC has a history of paying excess cash to shareholders – notably following the sale of a major Shopping Centre development for $1.3bn in the UK in 2014. We feel LLC will have the opportunity to deliver more cash to shareholders as current projects mature.

The Australian housing cycle is a fixation for most of us and we assume all our readers have a strong view regarding the near-term path of housing prices. We feel it’s clear that as housing construction activity peaks in Sydney and Melbourne this year, that housing prices will also peak. This process is assisted by controls on bank lending – both internal and those imposed by the bank regulator, APRA.
In this context, many would say LLC is a risky investment – and that’s true to an extent – contracting and construction businesses have inherent risks which we do consider. However, the housing cycle is less of a risk than you would think at first glance;
​

  • LLC’s exposure to Australian apartment earnings peaks this year at only 20% of group earnings.
  • Developments are 80-90% (and higher) pre-sold and most purchasers (especially from overseas) are holding a significant unrealised profit. This suggests there will be a low final payment default rate as buildings are completed.
  • Even during the GFC both LLC and Mirvac Group observed less than a 3% default rate, recently defaults are running at less than 1%.
  • Lend Lease’s apartment construction business includes projects in the UK and USA, further diversifying the sources of likely cash flow.

In summary, our investment thesis is that LLC has invested ahead of the economic cycle, has significant pre-sold revenue for work in progress, with buyers having paid 10% deposits and sitting on capital gains – therefore significant defaults or losses for LLC are unlikely. We expect that as most projects are finalized during the next twelve months (see table) we will see significant cash generated. Since LLC has relatively low levels of debt, cash should be available to increase dividends or potentially allow a capital return.

Source: Lend Lease company filings

Source: Lend Lease company filings
Just as importantly LLC earnings will benefit from growth in construction activity in Australia – particularly in road-building and related infrastructure. The company has also been increasing capital employed offshore. Capital allocated internationally is expected to increase from 23% of total to 30-50% as LLC apply their expertise in Urban Renewal projects around the world.
​
We believe valuation remains attractive vs. history and global peers, on a 12x forward PE vs 17x for similar global listed construction companies. LLC is likely to deliver more cash to shareholders along with a positive share price return.

At 5 July 2017