This week we would like to offer our thoughts on certain megathemes that are impacting investment markets. Firstly, credit where it is due, this is a topic inspired by an oped in the AFR by James Thomson who summarises what he sees the recent bid by Cannon-Brookes for AGL represents. He categorizes the bid as representing three broad megathemes: 1) Energy Transition; 2) Private Capital; and 3) The Billionaire Activist. While we broadly agree with this categorisation, we would like to give our take on them and add in a final component that we feel is missing: the politicisation of everything.
Context: On Saturday Mike Cannon-Brookes, co-founder/co-CEO of Atlassian and Australia’s third richest person, launched an $8bn bid with Canadian company Brookfield (who will pop up again later) to buy AGL (AGL.ASX). The plan would be to shut all remaining coal plants by 2030 and spend $20bn replacing them with renewable energy and batteries. AGL’s board has rejected the offer, representing a 4.7% premium to their Friday closing price, saying that the consortium would have to pay a significantly higher premium to gain control. This is to say nothing of the feasibility of the 2030 timeline; AGL’s board and Scott Morrison, amongst others, saying that it is wildly unrealistic while the other side is adamant that it is perfectly reasonable with the resources and right experience (Brookfield’s in particular) behind it.
Many of you may be aware of our thoughts in this sphere given some of our previous pieces, especially in relation to oil and nuclear energy. Mr Thomson posits that the pace is accelerating rapidly, a pace at which policy makers are increasingly caught by surprise. We, however, have a different angle which is that this may just be more intentional than previously thought. AGL had previously announced the closing down of her coal fired stations and, despite the rhetoric from the government around the implications for power prices and the noise made, we are cynical enough to think that this might be just that, rhetoric. After all, it was a Liberal government (under Turnbull at the time) that signed (granted, non-binding) the Paris Accords, committing to a target reduction in emissions of 26-28% on 2005 levels by 2030. This showcased at least a broad willingness to consider targeting net zero emissions. At the end of the day, the transition is happening. The issue is currently one of the timeline.
We find it hard to believe that there is such little financial literacy amongst policy makers to understand that this places immense risks on any new financing for traditional fossil fuels projects. It raises the question of stranded assets, front and centre. After all, what rational banker would underwrite large capex projects with decades-long payoffs if the risk is that there may not be a market at the end of that time horizon? This is why the yields on debt for coal or oil producers remains egregious. Newcastle Coal Infrastructure Group’s (NCIG) shorter-dated 2031, for example, comes through at a coupon of 12.50% p.a.; low interest rates anyone?
In fact, if it were not for the easy money policy from the Fed over the decade plus since the GFC, much of the shale boom that made the US the largest producer on the planet would not have been possible. Assuming that is about to change, the implications are tremendous for high cost producers and US production broadly. What we feel has been lagging is at best a lack of forward thinking and at worst a blatant disregard for the transition period. Economies dont transition overnight. Our base case is peak oil and upward energy costs either way, which makes the economics of renewables easier to swallow.
2) Private Capital
We have seen an increasing amount of capital flow towards the private side of the equation. And little wonder. With yields negative (and likely to stay there in real terms), institutions are forced to find bond proxies. This is why we see tremendous appetite for utilities and infrastructure from private players. For the more cynical, illiquidity is precisely what makes them so attractive. Much easier to massage the numbers and even out volatility using private markets than it is in public. We refer here to asset revaluations and, in a world of heightened volatility in equity markets, we will see this trend grow. Especially so given an aging demographic and surplus savings in the form of superannuation and pension schemes.
Sydney Airport and AusNet – a takeover offer from a consortium (including Sunsuper and three Canadian pension funds) led by the aforementioned Canadian outfit Brookfield being approved a few weeks ago – are the first of what should be many to come over the next few years. Looking globally, pension funds will have nominal targets of 7% on average in order to keep up with liabilities. With financial repression (i.e. official rates staying below CPI) very likely on the cards (closer than many may think), we see an even greater incentive for institutional players to show a preference for private markets.
Infrastructure and utilities might be worth a look.
3) The Billionaire Activist
Not since the Gilded Age have we seen income and wealth inequality reach present levels. It is precisely this confluence of factors that enables and emboldens a new class of billionaires to be increasingly active in their investments. Mr. Thomson points to Twiggy Forrest and Mike Cannon-Brookes as his examples, but think for a moment about the political front. The amount of time and money spent Stateside on fund raising for election cycles – via PACs (Political Action Committees) or otherwise – or the sheer ratio of Wall Street lobbyists to Congressmen and women; those within these financial services firms contributing US $2bn to campaigns/lobbying in the 2016 Presidential cycle, US $2.9bn for 2020 (that’s about $4m a day!). The Koch brothers of Koch Industries fame are another prime example, activism in public markets is only one aspect of this.
What we feel is oft forgotten is that, despite the pushback from the more traditional central banker, QE has potentially given this trend further impetus. Valuations of tech giants and eyewatering multiples has ended up creating and exacerbating income income inequality not seen across most of the Western world since the late 1800s. It has arguably never been more visible. The Covid-19 era fiscal and monetary policies, for example, has allowed Australian billionaires to almost double their wealth.
Why does this matter to the investor?
This new class of billionaires will continue to have a disproportionate impact (more so than historically) upon both the policy environment and the investment landscape. This newer generation of billionaires clearly has no issue using their wealth outside the political sphere to advocate and/or force change. The more cynical view is that it is less to do with climate activism and more to do with the fact that there might now be outsized returns available in the green energy industry over the short to medium term. That is to say, the green transition is happening, the global renewable energy market was already valued at $881.7bn in 2020 (Source: Allied Market Research), and we are near an inflection point in terms of both technology and large scale adoption. Is this particular bid centred on Cannon-Brookes getting in early on a lucrative investment or climate activism?
Our guess at the reality? Two birds with one stone for Mike (he does have form on the climate change issue, to be fair).
4) The Politicisation of Everything
The recent price action around the ongoing Russian debacle is rather telling. Unfortunately, we have grown up in a world where markets are supposed to be forward looking instruments and efficient. Despite the tremendous amounts of work done by father of the efficient-market hypothesis Eugene Fama, markets are made up of people. People aren’t always rational. Take the US’ stance on Russia preparing for an invasion of Ukraine despite very little evidence provided by the Biden administration. The volatility that we saw in the market digesting this is, we would argue, in no small part that of some traders (even on institutional desks) disbelieving an administration that does not align with their views while the other side does.
The debate on climate change and the energy transition is one we feel should be a purely economic question. But somehow it has ostensibly become a political debate between left and right, something we see as a megatheme the world over. The level of polarisation Stateside is at levels not seen since the Civil War. The debates across most of the developed world are similar, no doubt helped along by strongmen like Tsar Putin and Emperor Xi in their quest to dismantle a West they blame front and centre for their nations’ historic declines. Putin for the chaos after the fall of the wall (which arguably paved the way for his rise) and Xi restablishing Chinese “national pride” after the last 200-odd years of insults from the Opium Wars through to WWII and beyond.
But why does this matter to the investor? Simple, too often now we are seeing policy decisions made along broad partisan lines as opposed to being genuinely considered on the nuances/ economics of the matter. As the mainstream political spectrum has (seemingly) become wider and wider, compromise has become harder and harder. The Green Transition a perfect example; the further left you go on the spectrum, the more consideration given to immediacy and less consideration given to the economic impact (both the cost to consumers, how it will be achieved, and broader) while the further right you go it reverses. It is a variable that has become increasingly difficult to account for.
Over the next few weeks we will be providing commentary on half yearly results for some of our key holdings. During February companies report their half yearly results for the period ending December 31st while also providing an outlook for the full year results. Companies will typically host a conference call with investors and you’ll hear just about every analyst asking management to “provide more colour” to the results in the Q&A section to get as much commentary as possible on why the numbers came out the way they did and what to expect for the next set of results. This week we will discuss the results of MNY and SWM.
Seven West Media (SWM.ASX)
Author: Ron Shamgar
Seven West Media Limited is a national multi-platform media business based in Australia. SWM’s media comprises of Seven Television, The West Australian newspaper and associated WA regional newspapers and radio stations. Media companies like SWM have been overlooked by the market even though they are undergoing significant business transformations and generating lots of cash flow.
PRT Acquisition
Late last year SWM completed the acquisition of Prime Media Group, formerly Prime Television Limited, for a cash consideration of $121.9m (they also failed to acquire them in 2019). To fund the deal SWM refinanced their debt facilities, halving their interest costs and extending their maturities. PRT did $170m in sales in FY21 and over $30m in EBITDA. The rationale behind the sale is as follows:
Providing advertisers with a single platform that will deliver superior audience reach across metropolitan and regional markets
Unlocking the premium and integrated revenue potential of the combined metropolitan and regional audience base across broadcast and digital platforms
Enhancing the audience proposition through re-investment in content and expanding the digital delivery of SWM’s offering in regional markets
Generating estimated cost synergies of $5m to $10m on an annualised basis. The costs savings are expected to be fully realised within 12-18 months from completion of the acquisition. Revenue upside is also expected but has not been quantified
Source: SWM company filings
Results Commentary
We thought SWM reported a strong result with revenue up +27% and NPAT up +48%. Management also upgraded their FY22 EBITDA guidance to $315m-$325m, marking the second time they have upgraded guidance in the past few months. The key driver behind these results was the growth in digital revenue which was up +176% and made up 35% of the group’s revenue. This is projected to make up 40% in FY22. They commented on the integration of their PRT acquisition which has already realised $5m in cost synergies. It is important to note that PRT currently has no digital revenue and, seeing how SWM grew their digital EBITDA from $62m in FY21 to $130m in FY22F, there is potentially a lot of upside there. SWM had tough starts to the calendar year in CY20 and CY21, losing just about all their ratings weeks. However, in CY22 they have won the first four out seven weeks and are taking revenue share away from channels Nine and Ten. SWM currently has a 41.4% revenue share of a $3.8bn market and expect to maintain at least 40%. Seven are currently airing the Winter Olympics, boosting their digital numbers, while they also had the Ashes at the back end of last year.
Outlook
Whilst SWM reported a strong result we were a bit disappointed that there weren’t any capital management initiatives. They are on a leverage ratio of 0.9, well within their target range of 1-1.5x which means they are planning on returning capital and/or have room to look at more M&A. The board is assessing how they will be returning capital over the next six months and should announce a dividend or buyback in FY22. We think that the reinstatement of dividends is a major catalyst and currently what is holding the share price back. SWM currently has $295m of net debt and, taking their midpoint guidance, they are currently trading at approximately 5x FY22F EBITDA ($320m minus ~$40m of capex). Assuming they do $200m of NPAT for FY22 and they were to payout 30%, that would be a 4 cent dividend. A 5.6% yield at the current share price. Upcoming tailwinds include the return of their number one show, The Voice, as well as the upcoming Federal election. While it is a small piece of the business, Seven West’s Ventures portfolio is up +56% to $87m. This portfolio is part of their ‘media for equity’ strategy where they provide advertising for companies in exchange for equity. Recently they did a deal with Raiz Invest (RZI.ASX) which saw SWM gain a 6.6% stake in the company.
Money3 (MNY.ASX)
Money3 Corporation Limited is involved in the delivery of secured automotive loans as well as secured and unsecured personal loans. The secured automotive loans relate to the purchase of a vehicle with the vehicle as security for the loan. MNY currently has a loan book of $600m, having grown considerably over the past few years. They operate through three segments:
Money3, its Australian auto finance business,
Automotive Financial Services, prime consumer and commercial loans
GoCar Finance, NZ auto loans business
Source: MNY company filings
Results Commentary
MNY also provided a strong update for H122 with revenue up +34.5% and the loan book up +45.7% to $690.8m. MNY are on track to reach an $800m loan book for FY22 and are currently originating around $40m of new loans every month. Their EBITDA margins have been higher as result of artificially low bad debts due to a lot of MNY’s clients benefiting from the superannuation drawdown. The team still expects to maintain margins above 50%. MNY also saw the credit quality of their loans rise in the half.Looking at their other businesses, GoCar and AFS, their NZ-based business GoCar has struggled over the past six months as a result of lockdowns, meaning dealerships were closed. Management noted that in September they were operating at 20% of their usual volume. It will take time to rebuild their pipelines but simply reopening is a huge tailwind. Their AFS business has seen strong originations with its loan book up around +80% since MNY acquired them last year. In terms of further M&A transactions, MNY are looking to broaden their addressable market. It would have to be either product expansion (i.e. personal finance) or another loan book that gives them access to more dealers and a larger overall presence.Rising rates is a huge concern for financing companies like MNY as their cost of funding will rise accordingly. However, MNY believe that their cost of funding will continue to decline even in a rising rate environment. A significant portion of MNY’s loan book has been funded through equity; MNY were late to the party in terms of establishing debt facilities which means their funding costs are higher than their competitors. With the credit quality of MNY’s loans rising and with the increasing scale of their facilities, MNY expects their funding costs to decrease even as interest rates rise.
Outlook
MNY are forecasting an NPAT of at least $50m for FY22 which currently places them on a PE of around 14x. MNY are well on track to reach their goal of achieving a $1bn loan book by FY23, this should translate to at least $60m of NPAT, putting them on a forward PE of 11x earnings. All while paying out juicy dividends. The semiconductor shortage remains a tailwind for the industry with second hand car prices at all time highs, increasing the value of MNY’s loans and reducing bad debts. We also expect to see their NZ business gain momentum coming out of lockdowns.
Disclaimer: SWM & MNY are both currently held in TAMIM portfolios
This week we again look to the headlines and look at an issue that has been front and centre for the markets, that of the Ukraine situation (perhaps a reprieve from the endless monetary policy commentary). Firstly, we begin with a rather macabre fact about the markets. Wars (we aren’t suggesting that this will be an all out conflict, at least in the traditional sense) aren’t necessarily bad for returns, think back to the First Gulf War. Looking through history, some of the best returns for equities investors in the first half of the last century were in fact the US’ entry into WWII (1942 – 1945) before entering into a period of what has been termed the postwar blues (1945-50). When was it they saw the next leg up? While it may be a touch oversimplified, entry into the Korean War. For the precious metals fans amongst you, gold hit all time highs over the course of the first year of the Soviet invasion of Afghanistan (1980).
So now with that rather calming start, lets look at Ukraine and where this situation might head. Ending, as always, with the implications for the investor.
A walk down history lane
Again, we begin with the usual disclaimer for the historians amongst you that we are taking a rather broad strokes approach to explaining what can at best be summed up as a complex situation. This is a topic one could write books on, we’ll attempt to sum it up in a few paragraphs.
The second largest nation in Europe (as we know of it today) is one that , some may be surprised to learn, actually preceded the power that now seeks to dominate it in many ways The Kievan Rus’ was a loose federation of tribes (categorised as East Slavic, Baltic and Finnic peoples) that arguably came into existence by the sheer force of the Varangian, being a name given by Eastern Romans to Vikings (primarily Swedes), prince/chieftain Rurik (reigning 862-879). Thus founding the Rurik dynasty which ruled the Kievan Rus’ and its successor states until the 17th century; over the centuries consolidating power and creating some semblance of a Rus’ identity. As with all things, dynasties in particular, this particular federation eventually disintegrated; dissolving into independent principalities each ruled by a separate branch of the Rurik dynasty by the mid 12th century. Of particular importance to remember here is that the Principality of Muscovy became the dominant player in the region. So much so that when Ivan IV (commonly known as Ivan the Terrible) came into his inheritance at the wise old age of three, his appointed regents decided to crown him Tsar of all Rus’ (his grandfather Ivan III, Grand Prince of Moscow, being the first to style himself as “tsar” of all Russia, albeit not officially) .
Unfortunately for the Rurik dynasty, Ivan’s formidable anger also saw him kill his eldest male heir in a fit of rage, he also saw the miscarriage of a daughter-in-law while the one son that did inherit his seat (Feodor) wasn’t able to leave a male heir upon passing in 1598. Leading to the eventual extinction of the house of Rurik (at least in the male line). This again led to disintegration of what was previously the somewhat united Rus’ until the ascension of 16 year old Michael I (Mikhail) of the house of Romanov to the Tsardom in 1613. A decision made entirely by the nobility at the time despite the initial protests of young Michael’s mother; the title carried with it a rather fatal reputation at this point. This particular house, with its quite legitimate concerns around stability (and self-preservation), instituted a trend towards the centralisation of power in the hands of Moscow. Bringing to heel many of the outer principalities, including what we know to be Poland (more recent Tsars also being Grand Dukes of Poland), modern Ukraine, the Caucasus and central Asia.
The above is a vast simplification given that it is primarily Russia-focused. Failing to focus on the uniquely Ukranian principality of Kyiev which reached its zenith in the reign of Vladimir the Great (985-1015) when its place on the top of the food chain ensured that the Rus’ adopted christianity, in particular the Byzantine version of Eastern Orthodoxy. Following the latter’s disintegration, later rulers could legitimately claim leadership of the church. It also ignores its dramatic fall from grace under Polish influence (when that particular polity was still independent of Moscow), the Mongol hordes and the Ottoman Empire (the Rus’ submitting to Mongol rule for 300-odd years). The context we are trying to establish is that the concept of Rus’ is evolving, the ethnicities/cultures quite diverse and the way in which Moscow dealt with the situation was to centralise power.
How did Moscow go about this? Let’s take Catherine the Great as an example, her attempt to ensure stability involved inviting Germans into the lands that are now modern Ukraine in the hopes of changing the demographics of the population. Ring familiar to recent events? That is, the granting of Russian passports to Ukranians (Russians, by the way, are the largest ethnic minority in Ukraine). Add to that the process of what is now referred to as Russification, a process by which culture would be standardised and a common language adopted.
So how did the Bolsheviks handle this trend? For one, it was more of the same, perhaps worse. Once coming into power, their quest for getting rid of feudal traditions and rapid industrialisation led to even greater centralisation in the hands of Moscow. It was Stalin (a Georgian himself) who is perhaps most infamous in the Ukraine story. Manufacturing a famine in the region that wiped out close to five million people in order to force them toward collective farming and quell any vestiges or notions of independence. Suffice it to say, they continued Russification but this time on an industrial scale.
So, the point of the above brief history? Moscow has seen these peripheral territories as her own for the best part of 500 years and any instability (at least insofar as it is not aligned with her interests) is automatically deemed to be her issue.
Kiev
So, back to the modern context?
Let’s begin with the agreements, handshake or otherwise, that Western governments (NATO included), especially the US, made with Moscow. Eastern Europe was supposed to be out of bounds, Regan went so far as to assure Gorbachev that no military installations would be made there. Fast forward to the Yeltsin era, we all know the debacle and chaos that was 90s Russia. It is within this context that a little known but rather efficient ex-KGB agent named Putin (serving in a number of roles in the upper echelons of the St Petersberg administration) really began his ascent. Appointed by Yeltsin as Director of the FSB in 1998, Putin was Prime Minister by the end of August 1999 with Yeltsin also making it clear that he had found his successor. When Yeltsin unexpectedly resigned on 31 December 1999, Putin became Acting President of the Russian Federation. Arguably escalating the Second Chechen War over the course of his time as Prime Minister/Acting President, Putin’s popularity rose (war does tend to do wonders for approval ratings). That conflict also shows Moscow’s views on stomaching diversity (it is, after all, a confederation in name at least). Officially inaugurated as President on 7 May 2000, Putin installed another strongman, Kadyrov, as “head of administration of the Chechen Republic” in June and ensured the capital’s supremacy. High oil prices during the first half of the 20th century saw a resurgent economy and surging approval ratings.
Fast forward to post-GFC, sanctions had taken their toll and low oil prices saw the economy in doldrums. So, the rhetoric again changed. This time it was Georgia as a substitute for Chechnya, nominally supporting independence for South Ossettia and Abkhazia. The story again, much like the Second Chechen War, centred on stability and ensuring safety (at this point, there may be a pattern emerging). This is all despite ethnic cleansing of Georgians from her previous territories…
Which brings us to poor old Ukraine. A nation that fought for her independence and, during the initial days of the collapse of the Soviet Union, was given assurances by both sides that there will be little interference. Believing this to be the case they promptly disarmed (the nation having one of the biggest nuclear arsenals at the time) and even more promptly fell apart (politically with interference). Being pulled on one side by the prospect of greater integration with the EU, which aggressively took on ten new additional members previously under Moscow’s reigns in short order, and on the other by Russian fears of encroachment.
On the latter front, Moscow decided that the best potential strategy was to rig the elections that saw Viktor Yanukovych come to power. Following public outcry, it also decided to use one of its more infamous problem solving techniques; radiation poisoning of the opposition candidate Yushchenko. This however led to the Orange Revolution and, despite back and forth between establishment parties over the next decade, it was the public that paid the greatest price. Yanukovych eventually came to power again in 2010. Some stability followed but following his dislodgement in 2014 in favour of the Pro-EU Poroshenko, Moscow’s response this time (instead of poisoning) was an outright annexation/secession (whichever way you wish to look at it) of Crimea. Again, an oversimplification but the broad strokes are there.
The latest foray by Moscow can perhaps be construed as another penalty on Ukraine for the election of a pro-EU government led by outsider, actor/comedian Volodymyr Zalenskyy, in 2019. Whose most recent claim to fame at that point, by the way, was playing the role of the President of Ukraine in a TV show. One can appreciate the level of the public’s disenchantment with the establishment for this to have occurred (with this disenchantment perhaps we see parallels with US politics recently). Again, in sticking with tradition, the message from Moscow is rather clear; if you want stability, the only way you get it is via Moscow.
Not to mention, as with all Tsars of the past (there is little doubt in our minds that the Rus’ never truly let go of the concept, whether they wish to call them Tsar, Comrade or President), justification and legitimacy has always been on the premise of looking towards Moscow for direction. Effectively in his third decade in power, Tsar Vladimir Vladimirovich of the House of Putin does need to justify his rule after all.
Where does this go then?
Perhaps the one of the best analogies to the world of geopolitics is that it is closest to the game of chess. At the end of the day the outcome is predicated on the king, it is not a question of who takes the most pieces in the game. Great powers/leaders are exactly that. It is not quite immediately obvious how precarious their situation is until the very end (and they can usually move very little). But the pieces around them are exactly that; some are pawns, some rooks and others queens. Their survival predicated on their ultimate necessity to the king, sacrificing a piece is so often the play. Don’t believe us? Look at the Cold War. How many proxy wars? How much collateral damage? And yet the two “kings”, the US and Soviet Union, never came into direct conflict. Only to fall like a house of cards. More recently, the untouchable Gaddafi (who died in a gutter). And if certain intelligence services are to be believed, the supposed rigging of an entire election in that bastion of democracy that is the United States of America (take your pick, depending on which side of the political spectrum you sit on, 2016 or 2020).
Back to the issue at hand, neither “king” can afford to lose face and must withdraw amicably, perhaps at the cost of a pawn (i.e. Ukraine). Basically, Moscow cannot lose face nor its influence in its so called backyard. Europe cannot put its energy supply at risk and the US cannot afford a war over Ukraine (to be blunt, it just might not be valuable enough). There will be a solution at the expense of Ukraine for the kings to draw back and not surrender at the feet of the other. Biden ironically made the first move by implying that Russia was amassing troops at the border for an invasion which Moscow explicitly stated was not the case (they were of course in our view waiting for the right weather and an opportune excuse). If they invade, it makes them look like they reneged on their word to the international community. However, if they withdraw Putin loses face to the gallery (i.e. electorate) with the added advantage the US administration can claim to have de-escalated the situation. Our base case? Some nonsense about perceived (real or otherwise) oppression of ethnic Russians being sorted out and lip service given. It will be back to business as usual with Russia gaining concessions and biding its time, waiting to rig the next election. There will also be an understanding that Ukraine will not have the opportunity to join the EU or NATO any time soon (if ever). At least not as long as Tsar Putin is in power (given that he has spent part of his reign ensuring he can basically remain in power indefinitely, this could be a while).
As Biden unfortunately put it, Russia would “be held accountable if it invades [but] it depends on what it does…it its a minor incursion….etc”. Basically indicating that it could get away with something, within reason of course. In many ways this dovetails perfectly with the other side of the equation; the Russian stance here reeks of Putin testing where the line is (in saying that, his Chinese counterpart will be watching this unfold with great interest). He may stick his toe over the line but we doubt very much that he would cross it properly and risk full scale war with the US/NATO (though the odd cyber attack clearly isn’t off the cards).
Outcome driven, pure and simple, no one actually wins. The major players will advertise that they did while Ukraine certainly loses. Its the unfortunate reality of the world we live in.
Implications for markets?
The uncertainty will certainly put continued upward pressure on the price of Brent and LNG. Although a perceived resolution should see some reprieve, given our contention around peak oil, this will be short-lived (a buying opportunity perhaps?). The most important implication for us however will be the impact on monetary policy, especially CPI data (upon which central banks must at least be seen to do something about). We could either see this turn the Fed more hawkish or offer a much needed excuse for why inflation is not transitory thus allowing them much more flexibility. If the latter, then this may be good for the marginal investor. If the former, we could have a problem.Nevertheless, we stick to our contention that there is very little breathing room left for the Fed. Why do we say this? If we go to historic norms about the nominal yield being at least 50bps above inflation, then the rate should already be at around 4%. Good luck with that. Effectively quadrupling the interest burden on state and local governments within the space of a year? One wonders how long central banks may stay independent in that instance (i.e. without pushback from the political establishment).
If there is an accident and there is a conflict (more likely to be via a proxy). It will almost certainly allow for more dovish stances from central banks with some much needed reprieve for the equities investor (not to mention precious metals).
Concluding remark
The above may seem a rather cynical and blasé approach to take and we do firmly acknowledge the blatant unfairness and disregard for even common decency that the situation entails in relation to the Ukrainian citizenry. Being a pawn in a larger game of geopolitical chess is no fun for the pawns. If you do truly want to avoid more wars in Eastern Europe, pray that oil prices stay high enough and sanctions are dialed back enough that the modern Tsar wont need another war to push up his approval ratings domestically.
2022 hasn’t started like most people were hoping with January being the worst start to a year on record, the S&P500 being down -11%, at one point. The ten largest stocks on the index were down -20% at one point and the average Nasdaq stock was down -50%. In Australia, the tech index hit an intra month low of -25% while the Small Ords was down -13% at one stage. This week we have seen a bounce back in equity markets but one could argue that we are in bear market territory based on some of those figures, yet there’s no global recession in sight.
Author: Ron Shamgar
In our view, this is primarily caused by inflation concerns which will lead to higher interest rates this year and next. We are of the view that inflation will ease in twelve months as Covid-related supply bottlenecks and labour shortages ease up. In saying this, some companies are actually significant beneficiaries from an inflationary environment and higher interest rates, today we highlight three:
EML Payments (EML.ASX)
EML Payments Limited (formerly EMerchants) are a provider of payment solutions; offering payment technology for payouts, gifts, incentives and rewards, and supplier payments. EML issues mobile, virtual and physical card solutions to a number of corporate brands around the world and manages more than 3,500 programs across 26 countries in North America, Europe and Australia.
Outlook
EML has seen a depressed share price since announcing its issues with the Central Bank of Ireland (CBI) in May of last year, even though these issues have since been resolved. It makes no sense that EML is still trading at half the market cap they were since resolving their CBI correspondence. EML is now trading at a lower multiple to its peers despite their FY22 guidance being reaffirmed, which should see a 30% increase in EBITDA. Their pipeline is huge at $10.5bn while their recent acquisition of Sentenial and their contract with Banco Sabadell gives them a huge presence in Europe. Heading out of lockdown and into Christmas they would have also seen an increase in their gifts and incentives segment. EML is sitting on an EV of around $1.05bn, we believe EML will do at least $80m of EBITDA in FY23 which will put them at a forward EV/EBITDA of around 13x.
Source: EML company filings
EML will be a big beneficiary from rising rates. As a global E-money issuer, they currently hold a growing balance of customer card funds worth $2bn. EML gets to invest those funds but, with rates at zero, they aren’t making any return at the moment. Going forward, investors should think that for every 1% rise in rates across the US/UK/Euro, EML should earn $20m of incremental profit. If rates rise 2-3% over the next couple of years, EML will earn an incremental $40-60m of profit (2-3x their current profitability). We don’t believe investors have fully grasped this and it is why EML is our top pick for 2022.
PeopleIn (PPE.ASX)
PeopleIn, formerly People Infrastructure, is a provider of workforce solutions mainly in health and IT. Services provided by the group include recruiting, on-boarding, contracting, rostering, timesheet management, payroll, and workplace health and safety management. The four main sectors PPE is targeting include healthcare, community services, industrial services and information technology. PPE has a track record of successfully acquiring and growing businesses through leveraging its core capabilities in the sourcing, skilling, deployment and management of workforces
Outlook
PPE has a strong pipeline of acquisitions and is well funded to pursue them with $50-70m of available funding through debt and free cash; given their strong funding, the strategy is non-dilutive to shareholders. Their past acquisitions have been earnings accretive and have expanded the industries PPE operates in. Their most recent acquisitions, Techforce Personnel and Vision Surveys, increased earnings per share by 19% and the combined deal was done on a valuation of approximately 3.7x pro forma EBITDA. Their acquisition strategy opens up new regions for PPE to capitalise on and creates a much bigger addressable market for the group, as seen by their move into the healthcare recruitment space.
Source: PPE company filings
PPE provided a robust update recently, confirming FY22 earnings to be within analyst expectations (PE multiple of 12x). Their business is a massive beneficiary of wage inflation driving higher margins as they earn a commission. In addition, low levels of unemployment in Australia and a high turnover of employees, are all factors seeing higher demand for PPE services. With the borders reopening PPE should benefit from the resumption of international labour. Next catalyst for the stock is acquisitions which they have been very disciplined on. Our valuation is $5.00.
Note: At the time of writing, PPE announced the acquisition of Perigon Group, a leading accounting recruitment business, which will be key in executing PeopleIn’s growth plan with high anticipated growth expected in finance and accounting recruitment services over the next five years. Annualised expected EBITDA contribution of ~$4.3m and earnings per share accretion of approximately +8% in FY23. Upfront consideration of $16m (on a cash and debt free basis) representing a multiple of 3.7x pro forma expected FY23 EBITDA
OFX Group (OFX.ASX)
OFX is a provider of Forex services to consumers and corporates globally. As revenue is transaction based, OFX is a beneficiary of elevated inflation. Last week OFX provided a strong Q3 update with revenues up 21% to $39m. Management has upgraded FY22 guidance from 10% growth to 17-22% revenue growth. We think that’s conservative based purely on the Q3 run rate.
Firma Acquisition
At the back end of last year, OFX announced the acquisition of Canadian foreign exchange business Firma for AUD $98m, representing 9x Firma’s LTM EBITDA. The deal will mostly be funded through a new $100m debt facility OFX has secured, meaning the deal is not dillutive for shareholders. The acquisition is part of OFX’s strategy to increase their presence in North America and it will allow them to further leverage their sponsorship of the NHL. Firma will add over 9,600 clients, increasing OFX’s North America revenue by 121%.
Source: OFX company filings
Firma will add $50m of revenue and approximately $11m of EBITDA to the group. The deal makes a lot of sense; it will be immediately EBITDA accretive and give OFX increased exposure to corporate clients who are more stable than the consumer market.
Outlook
As mentioned, OFX is a beneficiary of elevated inflation. We have already touched on their strong Q3 update (revenues up 21% to $39m) and upgraded FY22 guidance (to 17-22% revenue growth) which we think is conservative based on the Q3 run rate. The above acquisition should see EBITDA grow to $55m in FY23, placing OFX on a 10x EV/EBITDA valuation. This, in our view, is cheap compared to global peers and we think OFX is worth $3.00. OFX have been buying back shares and will be releasing their full year results mid-May.
Growing up it was ingrained that two topics are rather taboo to discuss at the dinner table; the first being politics and the second money. So, with the hope that you’re not having dinner as you read, this week we discuss the former while touching on the latter. Perhaps a subject that you may not be expecting to read about in an investment newsletter.
In particular, the subject we wish to explore is whether our esteemed or not so esteemed PM (depending on which side of the political spectrum you sit on) has been backfooted in formulating a national strategy with regards to Covid policy and in particular in relation to the McGowan government of WA and their stringent adherence to a 0-Covid policy (a policy that rhymes with that of Beijing one might add). So, we would like to address that topic and whether it is even the right question to ask of a Commonwealth Prime Minister? This may not seem like a topic of particular interest to the investor but bear with us and toward the end you may just understand why it does.
For the lawyers or historians amongst you, this may seem rather basic. Before proceeding further however, let’s begin with the conclusion. It is a definitive no. Why? In order to understand that one needs to understand how institutional building occurred in this country.
A walk down history lane
Have you ever asked the question why we need different licenses when we cross state borders? After all, we live in the same country. This is the question that started a journey to understanding how Australia has been built. The nation and polity as we know it today is a young one, one that came into being in 1901 when six self-governing colonies decided to join together to form a Commonwealth (on a side note, Fiji and New Zealand were also initially part of these discussions before going their separate ways). A process that took close to five decades given the original idea (justified by efficiency) was drawn up by the 3rd Earl Grey (his father, the 2nd Earl Grey, being of Earl Grey tea fame according to some legends) in 1847.
The idea of federation received much opposition (justifiably so) during the initial stages given that many of the smaller colonies feared that a national polity would be dominated by the more populous states and their rights suppressed; each colony having evolved its own unique sense of identity and organically developed their own institutions at this point. It is within this context that Australia, unlike the UK with a unitary polity, developed its federal structure. A structure which, after much negotiation, was supposed to ensure checks and balances, whereby a Federal government would be curtailed to issues of national interest. The constitution specifically enumerates 39 areas in which the Federal Parliament may make laws, the most important of which is trade and commerce, taxation, immigration and external affairs. Those areas which are not specifically set out still reside with state legislatures by default. There was such suspicion about government overreach that when states decide to voluntarily delegate certain powers to the federal level out of necessity, sunset clauses (whereby they expire after a certain date) can be applied. Many may be familiar with the debate on funding for public hospitals which was a rather contentious topic what seems like a lifetime ago, in 2007. In particular, should the Federal or state legislatures bear responsibility for it. States are still responsible for health.
So, why then has the Commonwealth become so powerful? Simply put, control of the purse strings. Remember that it is the Commonwealth that has the first right to levy taxation. The most familiar of taxes, income tax, was first imposed by the Commonwealth during WW1 as a temporary wartime measure and, up until 1942, was imposed both by State and Commonwealth governments. Following WWII, the Commonwealth took over the raising of all income tax to the detriment of the states. In essence, while the states remained responsible for providing the majority of services, the revenue primarily remained with the Commonwealth. Ensuring an unequal partnership.
Aside from this, landmark decisions by the High Court have supported this power imbalance. The case in question here is the Tasmanian Dam Case (Commonwealth v The State of Tasmania, 1983), where the Hawke government prevented the Tasmanian government from constructing its hydroelectric dam on the Gordon river by using nebulously defined provisions under its enumerated powers (i.e. external affairs) and claiming the dam went against Australia’s obligations under the UNESCO world heritage program. It was a direct examination of the division of powers between the Australian federal government and the individual state governments. Part of a broader trend that sequentially ate away at state powers.
So, with that history, let’s come back to the present. Asking whether our PM is showing a lack of backbone in dealing with state policies that seemingly go against the Commonwealth government’s stance?
Our system and constitution, much like the US or many modern democracies, was designed with the intention of checks and balances. As it currently stands, this is a state issue and it is arguably not a call for Scott Morrison to be making. It is a choice for the people of WA, who have seen fit to re-elect the McGowan government with a resounding majority. Moreover, even the implication that a Commonwealth PM attempts to circumvent institutional frameworks and take a hardline against what has been explicitly stated as a state issue is, in our view, a dangerous precedent to set. That is not to say that the Federal government could perhaps have done more in taking a leadership position on the issue or been more or less forthcoming with support, we are not here to pontificate on that, but the issue is ultimately a state one as the Constitution of Australia is currently understood.
Our democracy may seem flawed at times, it may be that times have changed and people no longer think in terms of state identities, but the question of checks and balances should be one that is always front of mind. We’re not making a judgement but let’s put forth the hypothetical that what was supposedly said by Cabinet members in recent text messages is true and we do have a so-called “psycho” or “liar” running the country. The very framework that seems so blatantly inefficient at times is also one that protects us. This isn’t an issue unique to Australia, we don’t need to go into the issues around the US political system and how their checks, balances and inefficiencies in dividing state and federal power are probably in need of review. None of these systems of government are perfect.
So, why should we care about this as investors?
In our view, we see the rhetoric and the positively vitriolic debate, as well as a blatant mistrust of institutions, as a potentially dangerous move for the investor. And one which the investor must always be cognizant of. Larger global institutions like the UN, EU and WTO may be flawed, our Federal structure may be flawed but one must remember why they were created in the first place. The first two institutions, over-simplifying things a touch, so that we don’t kill off each other at an egregious pace. How often were all out wars fought in Europe pre-EU and how often after? The drop off is remarkable. The WTO may also seem flawed but, again, how many trade wars and nations undertaking beggar-thy-neighbour mercantilist policies did we have preceding its creation and how many after.
For every failure of the rules based democratic institutional framework, there are countless other success stories. For every China that didn’t follow the path, there is a South Korea, a Taiwan, a Japan etc. The spectrum is broad.
So coming back to the local context, next time you get frustrated perhaps ask your Premier or your local representative? Too much has been lost and countless sacrifices made for our democracy, whatever its flaws may be.
As for the protests and the countless ethical and social questions, this particular author would be more concerned if there were no protests at all. Whatever your view may be on the validity of the opinions of the participants. If one truly believes that there is government overreach (whether in reality or not) and does not do anything about it, that is arguably more dangerous for democracy than anything else in a given democracy. It would be fantastic if we could vote on every issue and live in a true “democracy” (not a guarantee that anything would be or have been different) but this simply isn’t feasible or efficient. It was even less feasible when many of these systems/democracies were formulated (think about how technology and communication has advanced). Hence functions like three, four, five year election cycles. Modern democracies are a compromise of efficiency and democracy and the checks and balances that surround this.
So no, whatever Mr Morrisons faults may be, an unwillingness to bully states as a Commonwealth PM in a Federal structure is not one of them. If you expected him to do so because you don’t necessarily agree with what your state governments are doing, then ask the question (at the risk of making a slippery slope argument), if the Commonwealth steps in on this issue, where will it stop? Were income taxes not meant to be a temporary measure? We all know how that went. If you think they were, do reach out, it would save us a lot of helpless despair and tears during tax season.
Coming back to investment markets, we feel that this is one of the biggest risks you should be aware of. The gradual decline of institutional trust and the frameworks that helped us all as investors see phenomenal returns were made possible precisely because of this context. Have you ever wondered why, despite a 0.1% cash rate or laughable interest rates across most of the developed world, investors still pay a premia to park their funds there? It is a trust in the institutions. Consider even a mining company with operations in say Guinea with the same economic metrics as one in Australia, the differential in valuations are astounding.
It may seem that we are drifting away from the original question of the Morrison government and its stance, but we see this as a broader tendency (and a global one at that) which questions the very foundations of our so called neo-liberal world order. Every little instance, such as a Twitter feed, matters. This, in our view, is one of the greatest long term risks for the investor. One that much be watched carefully.
We may feel frustrated, we may rant, the alternative for the investor is the differential in valuation between an Alibaba and an Amazon. It is precisely the reason why Gazprom, despite arguably better metrics, does not have the same value as an Exxon Mobil. The protection of the rules based global order is the single and most important aspect of the global economy.
Still can’t accept this notion? Consider Ukraine at the moment. What most people consider when looking at this story is the fact that a significant amount of the EU’s gas and energy supply comes from Russia and thus any imbalance will have a significant impact on global growth. But look further, there is another story, it is a contest between a rules based, liberal democratic outcome and one expounded by Russia, of ruthless pragmatism. For the investor, consider also something that most people don’t look at. Something as simple as sunflower oil, for example. Ukraine accounts for around US $4bn in that particular export to India, stop that and you will have a significant impact upon CPI data with flow on impacts on monetary policy. Flow on effects on monetary policy means asset valuations and growth. Say India’s growth slows as a result, what is the effect for you as an Australian investor? Ask the question what is the eventual impact for commodities such as iron ore?
This is not to say that the current institutions aren’t flawed, all compromises require give and take, or that we don’t need to examine and evolve our institutions over time. But perhaps the greatest advantage of institutions is that they curtail action (it may seem inefficient and frustrating but thank god/s for that).
