Sid Ruttala fleshes out a number of the points that Robert Swift has been talking about in his weekly Ausbiz appearances. Heading into the pointy end of the US presidential election, there is always heightened uncertainty in investment markets and (as much as we might want to given 2020 so far) this is not the time to bury one’s head in the sand and hope for the best.
Author: Sid Ruttala
This week we revert back to the macroeconomy, taking stock of what the markets may look like in the final stretch of this year and heading into 2021. The fundamental question on everyone’s mind is what things look like going forward given the continued instability in the geopolitical space and upcoming US elections on November 3. This uncertainty always has an impact on investment markets. Longer-term, we may have finally crossed the debt rubicon – where we may never actually pay back the incredible amount of both household and fiscal debt. If this is the case, what does this mean for financial markets and asset classes going forward? Quite a chunky, and one might say ambitious, project to sum up in a few paragraphs, but let me try in any case.
Some Context
Firstly, let me begin by saying I gave up on watching the first presidential debate after spending all of ten minutes fending off a migraine. Suffice it to say, the markets didn’t react all that well either. As though the uncertainty surrounding the current policy environment wasn’t enough, the rhetoric was positively vitriolic. But, never fear, investors can take reprieve in the fact that election cycles have short-term implications (volatility) but never in the long-run. At worst, as is shown below, we may have to worry about a democratic sweep (even here history is on the investor’s side). For the long-term investors, think back to the Bush election that was decided by the court as well. I say “as well” because this one is in all likelihood going there too, hence Trump’s urgency with a supreme court nomination. We certainly didn’t flinch then and this time is not likely to be any different. Same with every doomsday scenario that we faced in recent history, Watergate, First Gulf War, 9/11, Iraq War, the list goes on and on. So what do we care about?
What Does Matter?
So now that I’ve told you that it’s the liquidity and monetary policy that matters more for financial markets than questions of underlying GDP growth (if that were the case then we should all be growing at 1.5% p.a. as opposed to the double digits that we have become used to), let us look at the biggest risk of them all: The probability of a reversal in monetary policy. One that is only possible should we see surprises in headline inflation. If so, when and how is this likely to happen?
Let us begin with some basic figures around debt. As can be seen in the figure below, current gross debt to GDP in percentage terms stands at close to 400% of GDP. As of this year, US Federal Government debt stands at close to 107% of GDP, a sum vast enough that the natural impulse from any central bank is to keep a lid on rates to keep up serviceability. In Australia, this figure stands at a more “manageable” 45% of GDP, but household debt is second highest amongst OECD countries which presents an altogether different but perhaps more severe headache. Why is this a problem?
It’s not a problem immediately since it does naturally keep a lid on yields. However, the cost comes in other forms, typically income inequality and asset price inflation. Since subsequent increases to liquidity end up flowing towards asset price inflation and yield suppression.
For investors, the bigger problem is that even slight increases to CPI inflation can have amplified flow-on effects for asset prices. As I have mentioned in previous articles, the discount rate for valuations is typically the risk-free rate of return, which is the cash rate, and even a slight change from a true 0 to a nominal positive can have vast implications, especially across the high growth segment that is trading at historically high PE’s. With regards to Australia, have a look at the below graph of asset prices plotted against the (inverted) cash rate.
Coincidence? Methinks not.
So Where to Next?
What has been immediately evident when pouring over past comments from central banks across not only Australia but Jackson Hole in the US and the ECB is that there is a slow realisation that rates are unlikely to be normalised in the short-run. The only way out of this pickle is to actively have headline inflation shoot above the cash rate, with the outcome, of course, being that you inflate away the real value of the debt over time (positive). Effectively a write-off but not called as such. The fall guys, if Japan and Europe are anything to go by, are the financials who 1) have to hold a certain proportion of their balance sheets in government bonds; and 2) are forced, via the cash rate and ES transactions, to take the pain should inflation come back into the picture and real rates stay put.As such, the biggest risk is not necessarily political but an impetus for change in central bank policy. This is not the markets as we know them and it is for this reason that the yield curve no longer predicts the future as was typically the case (i.e. predicting the likelihood of monetary tightening and recessionary scenarios) and the 10-year barely budges despite increased volatility or sell-offs (another way of saying, if necessary, they will control the slope). In any case, we still can’t grapple with the notion of taking 10-year duration treasuries for a paltry 0.63% yield. It doesn’t make sense when you consider that this becomes significantly negative in real terms after taking into consideration the Fed’s target inflation of 2%. That is unless you have conviction that yields will go further into nominally negative territory, which we won’t rule out yet even if Powell has. We all know how long Lowe lasted in his vehement ruling out of QE closer to home.
How to Allocate?
This is where the political policy side does come back into the equation, albeit indirectly. Fiscal policy can change the inflation expectations and headline CPI quite drastically. This happened to be the reason why most direct stimulus measures advocated by the Chancellor of the Exchequer in the UK, Rishi Sunak, and the $600 USD a week jobless benefit advocated by the Democrats are good short-term measures. Since they feed through directly into spending as opposed to tax cuts or cash rates, which feed through to asset price inflation. Direct demand targeting measures that come through these types of spending programs, even infrastructure-related, have a two-fold impact: 1) they squeeze out the corporate sector as a percentage of GDP (i.e. assuming finite capital) and 2) increase consumption.
The allocation in this instance should depend on whether the higher inflation warrants a change in monetary policy, in which case the allocation would then be towards lower growth but higher correlated and higher-yielding materials and commodities (e.g. copper) sectors as well as, TIPS (Treasury Inflation Protected-Securities) and infrastructure. If inflation is low enough to not warrant any overarching changes to monetary policy (which is more likely) then the idea is to sequentially revert back to value and gold. By the way, this is where I disagree with Robert, I continue to believe that gold is not the best hedge against inflation but is one against uncertainty.
Finally, remember that even if we have a different administration in the US, good luck reversing the corporate tax cuts in the Senate. Probability-wise, we will have more fiscal stimulus and this time around there will not be much opposition to spending as was the case in the past. Trying to oppose big-ticket spending programs with rhetoric about prudence, as was the case under the Obama administration, won’t fly when your own party threw caution to the wind and blew it out (Federal government debt) by $8.3tn USD in the space of four years and tax cuts in the middle of uninterrupted economic expansion.
Whoever wins and however much uncertainty there is, the two rules to assess these markets by, just like Buffett’s two rules of investing, are 1) liquidity; and 2) remember rule one.
All things considered, Brambles put out some stellar numbers. CHEP America delivered sales growth of 10%, Latin America (LatAm) at 15%, with the major impact of Covid being felt in the Eurozone area where the Kegstar and Container businesses, as was evident, reported a 7% decline in revenue in constant currency terms (12% if you take currency out of the equation). As a result, overall guidance remained on the conservative side going into 2021 with flat to 4% y-o-y growth in sales and flat to 5% of EBIT growth.Management has broadly been rather disciplined in managing its costs, though the lockdowns did materially create some cost inflation. The business remains well capitalised with Net Debt/EBIT at 1.1x and a cash flow conversion for the FY2020 coming in at 106%. Across the board, the outperformer has been the resilient consumer stables segment which saw a surge in demand for pallet volumes though this was somewhat offset by higher costs (i.e. higher transport costs as a result of Covid related disruptions).
What was pleasing to see was the fact that close to 50% of the growth across North America came from increases in the price of related products, growing unit profitability. The current payout ratio stands at 53% (including share buy-backs).
We expect the company to stay consistent in the payout ratio and assuming no further lockdowns that the business progressively returns to pre-covid levels of growth in Europe.
Red Flags & Risks: Management has some consistency and is of a good enough pedigree when it comes to the business. The big risks come from external shocks especially with regards to the Eurozone business. The indicators to watch will be new car registrations and European automotive data, which seems to indicate some recovery within the broader segment. UK is probably a laggard due to uncertainty around lockdowns and Brexit.
The cost side of the business, when it comes to increased supply chain complexity and lockdowns, is a metric that the company will have to manage effectively going forward. Currency has also been a headache in terms of overall profitability and, again, I am more bullish on the AUD relative to the Euro and USD, which presents a hurdle for the company going forward.
My Expectations: Personally, I remain optimistic about Brambles assuming that governments across Europe and North America don’t insist upon further lockdowns. Numbers-wise, we have seen consistent growth across automotive sales and registrations as well as demand catching up in Europe (the main laggard). I remain positive on management and its focus on carbon neutrality as well as the ESG frameworks that should see the company trade at a decent valuation premium. BXB is also a good defensive to add to any portfolio (i.e. consumer staples), I would be surprised if the company doesn’t beat guidance through 2021.
Dividend Yield: A dividend yield of 2.4%, assuming a share price of $10.72 AUD.
We expect this to stay consistent through much of next year with further growth likely to be in second-half of 2020 on a nominal basis.
Amcor Plc (AMC.ASX)
Decent numbers from Amcor, sales growth came in at -1.6% in constant currency terms and EBIT growth was 6.7%. More importantly, management has seemingly integrated last year’s Bemis acquisition well with significant reductions in overhead and procurement costs feeding through into the bottom line ($80m USD). AMC reported adjusted EPS of 64.2c (an increase of 13%) and free cash flow of $1.2bn USD (an increase of 26%).
Drilling down further, the flexibles segment came in slightly lower (-0.9%) though volumes were largely flat indicating that this was a result of unfavourable raw material costs and product mix. Rigids continued to remain flat despite demand from broad-based pharmaceuticals (higher volumes but lower return due to currency and pricing mix issues).
Perhaps more surprising was the minimal impact of Covid-19 on the companies’ operations with plants continuing to operate at full capacity. Though this was somewhat offset by lower than expected demand across emerging markets in the Food & Beverage segments. While the business remains well capitalised, there is a concern (maybe a tad old-fashioned on my part) with debt coming in at close to $6.13bn USD and continuing to increase year-on-year. Guidance-wise, management has indicated continued EPS growth of 5-10% in constant currency terms.
Red Flags & Risks: AMC is probably an unusually complex company for the everyday investor to assess, with operations across 39 countries and 180 plants. This makes it hard to determine what the impact of any single factor is on the overall numbers. Currency remains the biggest issue as are costs on a relative currency basis.
The geopolitical and inflationary risks across emerging markets are likely to create continued headaches for management, especially across LatAm following the acquisition of Bemis. China also continues to act as a buffer of sorts.
My Expectations: A complex business that will continue to behave as a defensive rather than a growth play. I do not see any catalysts for a rerating of the underlying price but there is a fairly established price-range so if you wished to trade it between the $14-16 AUD mark, good luck. A strong AUD should see a disproportionately negative impact for the Australian based investor. That said, we should continue to see sustainable EPS growth in the high single digits for the foreseeable future and the lack of a material impact from Covid indicates that the business is somewhat operationally Covid-proof in terms of cash flows.
Dividend Yield: Assuming a share price of $15.16 AUD, then the current yield stands at about 4.42%.
On a nominal basis, my expectations are that this will go up at a high single-digit rate over the coming decade or so.
Insurance Australia Group Ltd (IAG.ASX)
What a year for IAG… and not in a good way. We have a new CEO, Nick Hawkins, after the retirement of the previous one. It cannot be said that the chair looked for the replacement exhaustively seeing as Mr Hawkins has been a fixture of the company for more than a decade, acting as the CFO for much of that tenure. Mr Hawkins took up the reins and immediately set to work by backing the lockdowns as a policy along the east coast of Australia. Of course, the fact that auto claims might be avoided would have nothing to do with it. One must accept though, he has to get all the help he can.
Numbers-wise, the group has been buffeted by one headwind after the other. The FY20 reported margin fell by 10.1% with $53m AUD attributable to widening off credit spreads and an overrun of the net natural peril claims (Covid-19, bushfires etc. etc.) as well as deterioration of long-tail classes. To explain this concept briefly, these are liabilities of the business, claims incurred but not reported since they take a longer period to settle. Overall profit fell about 40% to around $435m AUD. Of concern in this overall NPAT number is the fat that if we strip out the sale of IAG’s stake in SBI (State Bank of India), which added approx. $326m AUD, then we have a grand total of $108m of profit. Compare this to the previous year which stood at $1.076bn AUD, a decline of close to 90%. Diluted EPS was down by 68.8% to 12.2c p/s. CET1 was down slightly to 1.23, though this is one thing not to be overly concerned with (finally!) since it is well above regulatory requirements.
The one upside for this year has been the slight increase in gross written premium (GWP) across both Australia and NZ, up 0.3% and 2.4% respectively.
Red Flags & Risks: From a risk perspective, CET1 stands well above requirements though there has been downward pressure. The biggest risks remain continued uncertainty in credit markets and long-tail liabilities as a result of both Covid and the related business continuity insurance segments. The sale of the SBI stake at precisely the bottom of the market was rather disappointing from a shareholder perspective but might have been required from a prudence standpoint. That is not even mentioning the optics/marketing side, seeing as the headline would have been profit decline of 90% without it.
Insurance margins continue to be concerning as does the general outlook for the insurance sector overall, a segment which was arguably blindsided by the market volatility. Credit spreads, though stable at this stage, are likely to see continued volatility going into Q4 and early next year. The business has withdrawn all guidance for 2021.
My Expectations: Former-CEO Peter Hammer, in my opinion, could not have chosen a worse time for retirement. That said, the business has been prudent in its balance sheet management and withdrawing guidance. Not a buy for me though as we will likely see stable GWP but declining profitability and insurance margins.
Dividend Yield: The current yield stands at 2.2% assuming a share price $4.54 AUD.
For me, there is total uncertainty and no expectations as to what the next financial year might look like. From a risk-return perspective for the yield based investor, the company remains prudently capitalised enough that a better option may be to buy the notes (IAGPD) which offer the BBSW+4.7%.
This week we look at one of the most overlooked but stellar results of the 2020 reporting season. This company has grown earnings at a compound rate of 44% p.a. for the last four years and requires little capital to grow. The business is benefitting from structural tailwinds and, we believe, is on track to potentially hit the $100M net profit milestone in 2021 yet is only being valued at $550M or a PE of 6x by the market.
Authors: Ron Shamgar
Resimac (RMC.ASX) is one of the largest non-bank mortgage originators in the country. Over the last four years, RMC has grown AUM from $8.9bn to $14.9bn, a CAGR of 14%. Over that same period NPAT has grown from $13m to $56m, or 44% CAGR, demonstrating the strong operating leverage in their business model. This was driven by strong net interest margin (NIM) improvement to 190 bps, compared to 153 bps last year, and a significant improvement in their cost to income ratio, now 37.9% compared to 56.6% in FY19. Return on equity (RoE) increased from 17.3% to 25.5%, given the capital light nature of the business. The final dividend was raised from 1 cent to 1.8 cents while the net cash balance rose to $23m.
Source: RMC company filings
More importantly, RMC is benefitting from favourable cost of funding while its banking peers are seeing deposit margin pressure. RMC is growing at 7x system growth by offering quick turnaround time for brokers and an excellent service proposition and positioning itself as more of a digital non-bank with a strong direct to consumer digital brand in homeloans.com.au.
Source: RMC company filings
RMC has the most extensive funding of any Australian non-bank both through their international RMBS issuance program and their seven warehouse facilities. This is a key competitive advantage while other lenders have struggled. This was demonstrated by RMC’s AUM growth over the Covid period, where their rate of growth was maintained despite a significant dip in the market. Other non-banks were forced to reduce volume over funding and capitalisation concerns.
Also important is the fact that RMC’s profit is driven not just by NIM but also strong volume growth and a tightly managed cost structure. Their AUM base is 22% higher as a starting point so, in the absence of any further growth in the loan book, RMC could still grow profit in FY21. Dissecting the NIM movement further, NIM increased from 153 bps to 190 bps in FY20, noting that NIM was 183 bps in the 1H FY20 and 197 bps in 2H. The increase was driven by a reduction in the spread between the BBSW and the Cash Rate and RMC only passing on three of the four rate cuts in FY20 (noting that 1 bps is worth $1.3M of PBT).
Source: RMC company filings
If conditions remain as they are today, we believe RMC could deliver a NIM result in excess of 204 bps. If this is the case, RMC could see NPAT in the range of $74m to $105m or a PE multiple of 5-7.5x based on a range of scenarios. Another way to look at the FY20 result is that in spite of the $16m special Covid provision, RMC were still able to grow 2H NPAT to $28.8m. This absorbed 100% of the incremental provision which gives a potential $90m profit start for FY21 plus additional growth.
We are forecasting potential for $100m net profit in FY21, which should then see the stock valued at around $3.00, more than double its current price.
Disclaimer: RMC is currently held in TAMIM portfolios.
Sid Ruttala once again delves into the top end of the market, working his way down the larger companies on the ASX. This week we look at Goodman Group (GMG), Newcrest Mining (NCM) and Woodside Petroleum (WPL).
Goodman has put out some interesting results, the most surprising of which was the WIP (Work-in-Progress) increasing to $6.5bn, a sign of future earnings growth. Although the headline does require a little more nuance given that much of this was a result of low completions over Q4 ($100m AUD vs. the $1.3bn expected in the previous 9-month period). Covid-19, as expected, did impact the business in that it has, for one thing, decreased the payout ratio, a positive sign of good balance sheet management. The downside being slower completion of the WIP through much of this year and the first half next year. Earnings are thus likely to stay muted until Q4 of next year especially curtailed if we see further lockdowns across the jurisdictions the firm operates in.
Earnings-wise, operating profit came in at $1.06bn, an increase of 12.5%. EPS was 57.5c, an increase of close to 11.5% and above guidance of 9%. They also reported an increase in AUM, increasing to $51.6bn AUD. Of this approximately $2.9bn AUD came from revaluation (mark-to-market) gains across the Group and Partnerships.
An overall solid result delivered from management who have shown both balance-sheet and strategic discipline. Management’s commentary and guidance remained bullish throughout the reporting, pointing to strong occupier and investor demand as well as a focus on logistics assets (though commercial has been the big red-flag). Looking at the business overall, we remain of the view that Goodman has maintained the right focus across the industrial and multi-tenant warehousing assets that will see both secular growth as well as increased profitability from the digitalisation trends that were catalysed post-Covid, a trend rewarded by its share price returning 34% CYTD, a clear outperformer in the ASX20.
“Scarcity of land is driving increased intensity of use including multi-storey logistics, data centres, and other commercial uses, providing potential value add opportunities – Continued transition to fewer, higher value and longer lead times of development projects.”
- GMG Full Year Results Presentation
Red Flags & Risks: GMG operates in the right segments of the property market going forward, which should not only sustain them from an underlying valuation standpoint but will likely see continued growth. That said, much will be contingent upon the impact of Covid on WIP. Going into next year we are likely to see delays further impact the balance sheet and put downward pressure on the payout ratio as management seeks to maintain working capital, a big risk for the dividend and yield-starved investor.
Gearing also remains a big issue to us. Although management has indicated that it will seek to cap gearing to below 10%, I think it highly unlikely that this expectation will be met or management will seek to use partnership leverage in an effort to supplement an increased development throughput (somewhat hiding this aspect from the parent company’s balance sheet). That said, with rates as low as they are and unlikely to head higher across Australia, North America or the UK, this might not necessarily be a bad thing.
My Expectations: Personally, I remain optimistic about Goodman. The company has the ingredients to make up a stellar anchor for any portfolio. Management’s focus on the Logistics business as well as land scarcity being a major issue across every jurisdiction it operates in, including the UK and China, they are playing within the right sectors and at the right time to benefit from the move toward digital and the advent of e-commerce. Their promotion of Carbon Neutrality and playing to ESG frameworks should allow the securities to trade at a consistent premium to their peers. Overall, a solid business and well-capitalised.
Dividend Yield: A dividend yield of 1.6%, assuming a share price of 18 AUD.
We expect this to stay consistent through much of next year with further growth likely to be in 2022 on a nominal basis. This may be unattractive for many, but I would say look at it like a bond proxy (i.e. a substitute for investment-grade bonds with nominal upside even without inflation) and things get interesting, especially with a WALE of 15 years. It remains a buy for me.
Newcrest Mining (NCM.ASX)
Solid results from Newcrest, nothing to write home about though. Production stood at 2.2 Moz (million ounces) of gold and 138 Kt (thousand tonnes) of copper at an AISC (All-In Sustaining Costs) of $862/oz, showing that Newcrest remains a relatively low-cost producer. Given the continued upside in the price of gold, underlying profit increased to $750m, an increase of 34% on the previous year, with FCF (Free Cash Flow) of $647m.
The Lihir project was a disappointment with production only coming in at 776 Koz and is beset with issues around clay content, ore mix and the grade. Breaking down the AISC, Lihir (Newcrest’s largest project by resource) stands at approximately $1,204/oz. The Telfer and Red Chris projects come in at $1281/oz and $1703/oz respectively. The outlier is the Cadia project, at $160/oz, which enables the company to drag down the cost base massively.
Numbers-wise, EBITDA at $1.3bn USD is in line with my expectations and net debt stands at $624m. The firm maintained a 30% payout ratio.
Red Flags & Risks: Newcrest remains an outlier from other gold majors from a risk perspective. I say this because their main projects retain a reserve life of 21 years, astounding in that this is significantly higher (by about 50%) than their nearest competitors, Barrick and Newmont. However, the biggest risk remains the cost of production once Cadia the outlier is stripped out, with the average set to then rise above $1200/oz. Management has been prudent in keeping debt limited and rolling over existing debt onto a new rate given the interest rate environment.
From a valuation perspective and for a gold play, the company remains at a reasonable valuation. In saying that, there will likely be continued issues with production, especially at Lihir. The company will have to keep growth in mind along with jurisdictional risks, especially across Ecuador and the PNG.
My Expectations: I remain optimistic about the price of gold given the global monetary and fiscal policy environment. That said, we are likely to continue to see volatility as much of the selling in the short-run will be the result of covering losses across other asset classes. Assuming that we sustain prices at current levels, much of Newcrest’s future will be contingent upon curtailing costs that seem to have gotten ahead of the company.
The growth catalysts are likely to come from Wafi-Golpu, Hevieron and Red Chris which could double the output over the coming decade if executed correctly. I remain of the opinion that much better plays for gold exposure exist, so not yet a buy for me.
Dividend Yield: Assuming a share price of $13.50 AUD, then the current yield stands at about 1.1%.
On a nominal basis, my expectations are that this will go up at a double digit rate over the coming decade or so, despite the cost of production and assuming the payout ratio stays put at 30%.
Woodside Petroleum (WPL.ASX)
For those of you unaware, this author is a particularly long-term bull when it comes to oil. This isn’t necessarily in the hopes of V-shaped recovery but rather a consideration of the supply-side of the equation, with the contention that much of the high-cost production across the Permian is unlikely to recover back to pre-Covid levels. This, taken in conjunction with the fact that low-cost producers in the case of Saudi Arabia and Russia, have break-even budgets (i.e. budgetary break break-even as opposed to cost of production) above $80 USD p/barrel (please refer to my previous articles for a breakdown of this thesis).
WPL has been interesting to watch, especially given the upside of many of the junior gas players following Morrison’s rhetoric around a gas led recovery. Even based upon this thematic one would’ve expected one of this nation’s largest producers of LNG to have benefitted, but investors seem to think otherwise. Numbers-wise the company continues to meet expectations with production and expenditure guidance largely unchanged. 2020 came in at approximately 100MMBOE (million barrels of oil equivalent) and total expenditure was flat at $2.4bn. With investment expenditure down, this shows that most of this was a result of FX and Covid-related oil mess (i.e. a positive, indicating that the actual cost of production is in line with expectations).
The company remains well-capitalised with $7.5bn in liquidity, making it likely to target M&A activity going forward and being a prime beneficiary as the global supply chain continues to consolidate. Recent key catalysts have included the outright bid for Sangomar (Senegal) in competition with Lukoil, a bid that I would personally applaud given the fact that it was, for one thing, at a palatable price (something that was perhaps enabled by US sanctions on Russia, who said politics wasn’t good for business?).
Red Flags & Risks: The company remains well-capitalised and is a cash cow with current free cash flow yield coming in at approximately 11.6% at 2021 guidance. The big risk will be the short-term volatility in the price of oil, though the company remains well hedged with over 13m barrels through to December 2020 (so any upward swing in the price before then is a disadvantage, though there were call options purchased for 7.9m barrels), potentially expensive but prudent.
My Expectations: I have conviction that management will remain disciplined and that they will continue to scout for deals, providing good catalysts into the future. The underlying security will be volatile, given the procyclicality of oil, but remains a consistent provider of income. The discussions with regards to Pluto and Scarborough are ongoing and provide short-term catalysts (Exxon out). Personally, I would look to accumulate from weak hands at anything below $20 per share. Long-term price target, assuming an oil price of $50 USD/barrel, is $36.
Dividend Yield: The yield is a solid 7.2% assuming a share price of 18 AUD.
On a nominal basis, this is likely to stay consistent for the next 12-24 months and there is potential for significant upside thereafter.
Sid Ruttala continues his exploration of the top end of the market, this time moving just past the surface of the ASX and going outside the Top Ten. This week we look at Macquarie Group (MQG), Telstra Corporation (TLS) and Rio Tinto (RIO).
Author: Sid Ruttala
This week we continuing publishing my notes on individual companies. At the beginning of this particular series, we were going to limit ourselves to the Top Ten but due to significant interest from readers, we’ve decided to continue down the list by market capitalization. Next on the list for this week are: Macquarie Group (MQG), Telstra Corporation (TLS) and Rio Tinto (RIO).
MQG is one security that held up relatively well through the Covid selloff, the twelve-month number coming in at -8.3%, a stellar achievement given the performance of financials on the ASX broadly. Numbers-wise, overall operating income was down -3% for FY2020, to $12.3bn AUD, with profit coming in at $2.7bn AUD, an 8% decline on the previous year. The more important metric in my opinion was the EPS. At $7.91 AUD per share, it represents a 10% decline from the previous year.
Breaking it down by division, MAM (Asset Management) and CGM (Commodities & Global Markets) were the performers in terms of income. The Asset Management division printed higher than expected (my expectations at least) management and performance fees, while commodities and global markets have held up relatively well with particularly higher business in the commodities lending business (thank you, iron ore). As expected MacCap has seen lower DCM (Debt Capital Markets) revenue partially offset by M&A activities and, for the foreseeable future, this will be the silver-lining if management continues to get themselves onto deals which we can certainly expect (given their track record).
Looking to the future, recent HY21 guidance suggests that NPAT will be down 35% YoY. Management has taken a conservative and prudent approach by increasing provisioning for Covid-19. Also problematic is the higher Australian Dollar, given that 69% of MQG’s income is now global. Numbers-wise, a 5% swing in the spot rate will result in a 3.5% swing in the NPAT (either way). For the number-crunchers among you, happy to share the TWI (Trade Weighted Index) calculations.
Red Flags & Risks: The biggest risk comes from Covid. One saviour for Macquarie Capital has been M&A activity and unless we see a marked improvement in the overall economy we will continue to see stress (including increased provisioning) across BFS (Banking and Financial Services). There is downward pressure on EPS and management will need to be diligent in increasing AUM for MAM in order to circumvent these headwinds. On the upside, however, the continued decline in AUM for AMP has meant that it has been receiving flows (including to its Macquarie Wrap platform). The key will be reaching enough scale in terms of inflows to offset the margins on the annuities like business (i.e. infrastructure and green assets).
My Expectations: A fair substitute for the Big Four. Messy short-term outlook with headwinds across the investment divisions and likely increases to provisioning going forward. We will see increased M&A activity but it will probably not be big enough to offset the declines across DCM. The Asset Management division is likely to be the knight in shining armour given the illiquidity and stickiness of the underlying assets, including renewables and infrastructure. That said, the business has a proven track-record of close to 51 years of profitability, one can probably trust that track record. A long-term hold.
Dividend Yield: The current dividend yield stands at an exceptional 3.6%, assuming a price of $118.69 AUD.
Though on a nominal basis we don’t expect this to stay put through the next FY due to increased provisioning and short-term declines in NPAT. Over the long run, we expect the company to maintain a consistent payout ratio (above 50%).
Telstra Corporation (TLS.ASX)
Telstra is one Australian company that never ceases to disappoint. Every time it starts to look cheap, it surprises investors by getting even cheaper (eventually it becomes a habit). With that in mind, I can’t say I was overly surprised by a rather disappointing FY20 result. NPAT was down 12.6% to $1.8bn AUD with the biggest declines by segment across Fixed (-11%) and, more concerningly, Mobile (-4.4%). Greater than expected decline, in my opinion, in ARPU (Average Revenue per User) even factoring in less roaming charges (i.e. no international travel). What was more disheartening was the DATA and IP segment declining close to 13% due to increased competition. This is while we live in a Covid world where consumers don’t do much other than use the internet; everything was online for at least a few months there.
On the positive side, the one bright spot is the value (longer-term) of its infrastructure with close $1bn p.a. in recurring payments from NBN. InfraCo has a lot of untapped potential and should create a buffer for the company.
Much will be contingent on management. One trend we have seen is that TLS has taken the lead in raising prices higher, especially 5G, and others will likely follow suit. Until now the play has been to increase usership at all costs, but a rationalisation might be in order. Especially targeting premium customers and increasing margins per customer. Its main competitors, Optus and TPG, are also likely to follow suit with TPG also indicating that its discounts are not going to become a permanent fixture. The accelerated digitisation as a result of Covid could become a tailwind for the largest telco in the country (though they do have a track record of not taking advantage of such things…).
Red Flags & Risks: Simply put, competition is the biggest risk for the company. Until now, telecommunications has been a race to the bottom (granted, beneficial for the consumer). What we are likely to see is a consolidation and rationalisation, with market shares becoming stable. TLS will have to focus less on the acquisition of customers and more on the monetisation of its existing infrastructure and user base.
What has been frustrating to watch has been the lack of willingness to look at alternative revenues and diversifying the business. It took the company until last year to even think about rationalising its product line. Looking at their global counterparts in the States, AT&T acquired Time Warner, Verizon made multiple acquisitions across cloud security and more recently drone tech company Skyward, and Singtel (Optus) is buying up broadcast rights to sports left, right and center. It will be key for TLS to move into the 21st century and shake off its public sector roots. Vision 2022, which includes a move to digital and IoT, at this stage remains all flash and no fire. They’ve talked the talk, time to walk the walk.
My Expectations: While at current valuations it does look cheap, especially when one considers the true value of its infrastructure assets, there is too much up in the air and it relies on flawless execution by management. Even with regards to InfraCo, there has been no clear outline of how it will be monetised.
The company needs to modernise, ARPU will get higher but this is probably contingent on international travel being opened up again. One thing I did like was the Capex brought forward despite Covid,
Personally, I am a fan of Andy Penn but he is fighting an uphill battle. If you hadn’t picked up on it by now, to put it bluntly, still not a buy for me.
Dividend Yield: The current dividend yield stands at an exceptional 5.7% assuming a price of $2.82 AUD.
On a nominal basis we expect this to stay put, though the yield might keep going higher if past performance is anything to go by.
Rio Tinto (RIO.ASX)
Before getting onto the recent events that culminated in the ousting of CEO Jean-Sebastian Jacque and several other top executives, let’s go through the numbers. The company has certainly put out some stellar results buoyed by iron ore prices, NPAT was at $4.8bn USD while EPS was at $2.94 USD per share which represents a slight decline of -3%, a positive given the environment. What is immediately evident was that the impact on the firm from Covid was minimal, only showing up in terms of slightly lower cash conversion.
Division and commodities wise, iron ore was, as expected, the outperformer. What was rather surprising to me was the aluminium and bauxite numbers, driven primarily by prudent cost management and margins despite the prices tumbling. Corporate cost cuts were also evident across Escondida. Projects-wise and in terms of growth catalysts, fieldwork across the assets in Guinea is to commence this year, despite my expectations of it being pushed into next year (another positive). The Oyu Tolgoi copper/gold project has been facing some hurdles in terms of a slower than expected ramp-up (this one is a negative).
It was exciting to see the maiden resource for the Winu project coming in at 500m tonnes at a grade of 0.45% CuEq (copper equivalent), Australia’s newest tier-1 project. Though still in its infancy this could be the next catalyst for Rio, especially given the likely upward trajectory in Copper spot prices.
Red Flags & Risks: The biggest risks currently are related to the uncertainty around management going forward. Whatever the market may say about the previous CEO, he has been interesting for shareholders from a pure numbers perspective, putting steady dividends into our pockets. That being said, the rather blasé attitude to corporate and social responsibility has done some irreparable damage to the company’s brand. Blowing up a 46,000-year-old site of immense cultural importance and then trying to assume plausible deniability in a parliamentary inquiry will do that. You would hope they have learned their lesson.
Scalps have been taken. These include the CEO, the Head of Iron Ore division and the group executive for corporate relations, all by mutual consent of course. Though the consent did cost a tidy $80m AUD. The new CEO, whoever that might be, faces a decent challenge. This includes but is not limited to dealing with the Mongolian government in putting the Oyu Tolgoi copper mine in order and ramping up production, hitting the ground running with the Guinea assets (i.e. Simandou Iron Ore project) and placating a wide group of rather aggrieved stakeholders due to the aforementioned PR disaster.
Risks also include project execution and keeping Capex in line, to meet the expectations of now rather spoilt shareholders (this will include the Oyu Tolgoi, Amrun and Koodaideri projects).
Currency wise, Rio’s revenues are inversely correlated to the AUD and a higher AUD will create a rather messy P&L.
My Expectations: I tend to be contrarian when it comes to the price of iron ore, though many have said it is toppy, and my expectation is that, while volatile, there are catalysts that will apply upward pressure in the medium to long-term, including higher infrastructure spending around the planet. Copper will remain an interesting buffer for the company and Winu creates the potential for stellar upside.
That said, there is a lot of uncertainty concerning the leadership of the company and what this means for the existing strategy, including the cost-cutting measures. Simply put, environmental and ethical concerns aside, a great business. I would hold if I already owned but wouldn’t be adding to the position with great conviction.
Dividend Yield: The current dividend yield stands at an exceptional 5.9% (approx.) assuming a price of $103.740 AUD.
On a nominal basis we expect this to stay put with potential upside on the underlying security if management gets its act together and doesn’t decide to ignite a museum or look for ore under the Pyramids.
