This week we continue (and conclude) our series on the mobility thematic with the final two pillars in our framework, that is connectivity and shared mobility. Both of these pillars are intrinsically interrelated and are perhaps where we have seen the greatest focus from a consumer perspective. I will try to tie it up by looking at two companies that are personal favourites from an investment perspective.
Author: Sid Ruttala
When we speak of connectivity, we are primarily referring to the data-driven and enhanced experience that consumers are given. At a simplistic level, this can involve the basic requirements of tracking vehicle usage and monitoring technical status right through to the virtual chauffeur that is able to predict driver or occupant fatigue. Think for a moment of the applications not only from a transport perspective but the ability to advertise, say a coffee stop, to a passenger. Or the implications of having this enriched data for the likes of insurance companies or transport operators. In the case of insurance companies, for example, drivers could be offered incentives based upon where drivers were driving and how they do so, with secondary data around things like fatigue giving them specific and actionable risk metrics. Similarly, an insurer’s in-car risk platform might get additional revenues from advertising coffee stops to fatigued drivers or meal stops to those on long trips.
What we are seeing evolve is an ecosystem that is predicated upon not only consumers having a better travel “experience” but also increased opportunities and threats for the broader business environment. The data and access thereof creates immense opportunities even for incumbents in industries such as consumer discretionary alongside contextualised advertising, especially with personalised infotainment content. For example, massive chains like McDonald’s or Starbucks could use driver/vehicle data to optimise locations and easily geotarget advertising accordingly. We also see the development of SaaS providers that target the extraction/mining of data within this segment. As previously mentioned, Connexion Telematics (CXZ.ASX) is one company that comes to mind if one were to be encumbered by solely investing in the small pond that is the ASX.
The second aspect of shared mobility is probably the most obvious in terms of economic impact given the rise of Uber and Lyft. However, what isn’t immediately obvious within this is that it has broader implications for transport in general. Think, for example, of the rise of e-hailing and what this means for public transport and congestion. For one thing, there is great evidence to suggest that e-hailing has in fact lead to the increase of congestion since, as one McKinsey study showcased, fully a half of all ride-sharing trips would not have taken place in the absence of e-hailing (i.e. effectively meaning that there were a greater number of vehicles on the road than would otherwise have been the case). Another question that is immediately bought to mind within this context is automobile sales. One could easily argue that there might be a marked incentive upon policymakers and the population alike to put downward pressure upon private ownership of the automobile in preference for shared mobility especially in densely populated regions like Asia. Take Beijing for example (fun fact: China has already surpassed the US as the largest automotive market in the world), where locals spend approximately 1.3 hours in commute per day on average. As a case in point, across major metropolitan areas in China, including Shanghai, Guangzhou and Beijing, a number plate effectively costs more than the car itself.
Similarly, take note of nations like Singapore which actively discourages private car ownership with a 20% excise duty that effectively makes the nation one of the most expensive in the world to even buy a low-end Toyota. As such, it is logical to assume that we will see the greatest emphasis placed upon shared mobility and connectivity (especially in terms of data requirements) come from developed Asia before anywhere else.
Now, two companies worth a look.
Corning (GLW.NYSE)
It might seem a tad bizarre that after speaking about mobility and connectivity, the industries of the 21st century, I would recommend looking at Corning. This company is decidedly seen as a dinosaur, rightly so if one were to look at its age of 169 years. Their shot at fame within the automotive space came in helping the automotive manufacturers reduce their emissions as part of the requirements under the Clean Air Act of the 1970s. Most people are aware of the company as primarily a glass manufacturer and to a certain extent they would be right.
The more interesting story however is that Corning worked with Steve Jobs around the creation of the ultra-thin iPhone glass, now known as the Gorilla Glass. If you have a smart-phone you would probably be looking at or through a Corning manufactured product. It has proven not only to be adaptable but resilient in a dynamic space. As of last year, core sales for the company annualised $11.7bn USD or $1.76 USD per share. For me and within the broader connectivity and mobility thematic, think for a moment and ask yourself the question what are the components that go into connected automobiles. Yes, glass and windshields are required but more importantly, glass that is compatible with digital displays, that has the ability to respond to touch, connect with the web etc. My take is, look at it this way, if you’d asked me twenty years ago who would’ve won the mobile phone market, I wouldn’t be able to tell you but I could’ve jumped on the thematic by placing my bets on and investing in the controllables (i.e. the things that go into the manufacture of that mobile or smartphone). With Corning, it is not the Tesla of this thematic but it is a company that has a proven history and market share in a niche that it will likely continue to dominate.
It currently works as the original equipment manufacturer (OEM) for most of the major auto manufacturers across the planet, add in a diversified business that works across optical solutions as well with collaborations with Intel, Verizon and CenturyLink for the manufacture of its extreme density cable. This is one company that will benefit from the broader mobility theme. If you didn’t catch it earlier, optical solutions that go into enabling the 5G infrastructure is something I also consider part of this thematic since it is required for the connected car.
NXP Semiconductors N.V. (NXPI.NASDAQ)
Many of you are probably aware of NXP Semiconductors, but let us embark on a brief walk down history lane. The company itself is a spinoff from Phillips (PHIA.AMS) from which it was de-merged in 2006. Since then it has been a rather busy bee, announcing a merger with Freescale (which itself was a spinoff from Motorola eventually bought by Lenovo). It initially fell across my radar properly when Qualcomm (QCOM.NASDAQ) tried to make a bid in 2016 and, although it was given approval by US regulators, China refused to come up with a ruling.
That series of events in itself is interesting given it showed 1) increased consolidation within the broader semi-conductor space and 2) the political incentives that are also at play. We would posit that Chinese regulators were unwilling to give the green light for one simple reason and this is the same reason the discerning investor should look further into the company. The company now makes up close to 12% of the global automotive semiconductor market, a segment that is not only expected to grow at 7.5% CAGR for the next decade but one that is crucial for the building out of the connected car and shared mobility in general.
Importantly, the company acts as an OEM and key supplier of close to 95% of all automakers globally with considerable headway made in the Chinese market where it is in JV with Datang Telecom (600198.SHA). For the reasons mentioned throughout this series, including the upward pressure on data collection, we see semi-conductor usage and the market more broadly not only growing in volume but margins. Just think about the very simple maths of it all. If the new generation of connected and autonomous vehicles all have in the ballpark of 5x the requirement for semiconductors and there will be major incentives to transition to these vehicles, then it doesn’t take a genius to see the upside. NXP offers a unique opportunity to gain exposure to not only a market leader but also a potential takeover target if not from Qualcomm then a Chinese alternative. Or even a sale of NXP’s Chinese operations to a Chinese firm, since we’re quite sure the US and EU regulators would put up a decent fight, with the western operations being allowed to be taken out by Qualcomm.
This week we visit the first of the categories within mobility, that is the most obvious, the electrification of transport and automobiles. There are several key catalysts for this process including the continued adoption of regulatory frameworks by governments across the planet towards sustainable development and tackling climate change.
(Please forgive the title, it was too tempting to quote Eddy Grant’s iconic chorus. Ignoring that the song is about the 1981 Brixton riots, it is particularly fitting given that the song’s title refers to Electric Avenue in the south London district of Brixton, which was the first market street to be lit by electricity.)
Author: Sid Ruttala
Wherever you stand on the subject, and I shall avoid going into the science of climate change and the efficacy of the research behind it, these policy changes are happening. What we have been presented with is the certainty that there is general consensus towards creating sustainable goals and a key aspect of this is certainly the electrification of transport. However, when we talk of electrification we are not just referring to the electrification of automobiles but also large scale transportation including rail.
Let me set the scene, according to the International Energy Agency (IEA) and assuming a business-as-usual scenario, the demand for the passenger vehicle fleet will need to double to 1.7bn by 2035 and triple by 2050 in order to sustain even a modest amount of global growth. This increase comes at precisely the time when governments across the planet set out towards ambitious goals to diversify their energy base and reduce emissions. Regarding this, the EU has placed a reduction in emissions of close to 40%, China and carbon neutrality by 2060 and the US targeting reductions of 26-28% by 2025. This places immense pressure on both the automotive sector and the R&D race. This scenario makes electrification not only a “want” but a “need”, vital for the survival of auto manufacturers. This is because even if the average efficiency of the combustion engine were to be doubled it would not only be unable to meet the increased demand but also, from a regulatory perspective, meet emissions reduction targets (a double whammy).
To put this into a little more context, the world’s current stock of cars, trucks, buses, two-wheelers, trains, ships and aeroplanes account for about 20% of all primary energy consumed, almost 93% of which is dependent upon fossil fuels. Given that this is the case, there is a marked incentive for nations with a high level of population growth to diversify their energy supply, especially across Southeast Asia and much of APAC. This is perhaps the primary reason why the CCP decided to set up ambitious targets. It is not simply a question of emissions but also energy independence and national security. China and much of Asia is not only dependent upon fossil fuels but broader macroeconomic policy remains at the whims of energy prices. Take India as an example, its demand for energy is set to outpace domestic supply which, according to DFAT, will probably contribute less than 30% of that nations energy mix by 2035. It’s marked incentive is to diversify away from fossil fuels, including thermal coal which it remains on track to be self-sufficient in the medium term. From a policy perspective, this makes it imperative for Delhi to commercialise electric vehicles as quickly as possible.
What does this require?
One of the most misconstrued notions about the electric vehicle (EV) market is that it can be self-defeating in the sense that the source of the electricity generated might remain as fossil fuel. This requires a little more nuance. One interesting study I came across was a case study using British Columbia, where a renewable energy penetration target of 93% is set. Through the course of the study including scenarios making the utility controlled charging of vehicles to supply and demand. It showcased that electrifying the entire road vehicle fleet would require increased generation of up to 60% (relative to without electrification), though levelling the total cost of electricity at an increase of 9%. There are several angles to this study including the use of low-cost generation options such as wind and solar, as well as showcasing that the energy target would reduce carbon abatement costs by up to 30%. Further use of utility controlled charging actually reduces total system capacity up to 7%.
What is required if one were to extend the premise of that study to a global scale however is the necessity of a massive outlay in global infrastructure, not only in terms of charging stations but also increased R&D into battery efficiency. Without these outlays, large penetration of new technologies could have a detrimental impact upon grid operations and issues pertaining to excess generation, lack of flexibilities with the other headache being increased localised peak demands. This brings us to the first requirement, the building up of viable charging infrastructure and broader grid infrastructure that enables this while also maintaining current requirements for managing peak times. Take a look at the below graph which showcases the exponential growth in power generation requirements to over 280bn kilowatt-hours by 2030. The below scenario and assumptions bring us to the second requirement, that is innovation. In particular, the battery efficiency assumptions which are capped at 20 kilowatt-hours per 100km. From an investors perspective, there are two angles to look at here. The first is to find companies that are at the forefront in terms building out infrastructure capacity including incumbents, such as Royal Dutch Shell which recently beat expectations on dividend payout but is also looking to pursue its growing electricity business or traditional utilities businesses with a renewable energy mix. The second angle is to find companies that are actively seeking to increase battery efficiency, this might not necessarily be even the auto manufacturers, such as Tesla (TSLA.NASDAQ), but also companies like LG Chem (051910.KRX), Hefei Guoxuan High-tech Power Energy Co., Ltd (a subsidiary of Guoxuan High-tech, 002074.SHE), Contemporary Amperex Technology (300750.SHE), Samsung SDI (006400.KRX), Microvast (a pre-IPO company headquartered in Texas) to name a few that come to mind.
Source: McKinsey & Co.
Now that we have the infrastructure and battery efficiency covered, it is time to move on to the inputs. Most people think of materials including lithium or copper. What is perhaps more pertinent to look at are niches including red-flags and companies actively seeking to target these. For example, traditional battery technology (i.e. lithium-ion batteries) are cobalt-based. This system consists of a cobalt oxide positive electrode (cathode) and graphite carbon (anode). This in itself creates a constraint of sorts, since 60% of the global supply of Cobalt comes from the Congo, more specifically the Democratic Republic of Congo (DRC), which has been historically unstable and the extractive industries are themselves prone to gross abuses including the use of child labour. Investors could then seek to identify companies like Novonix (NVX.ASX), which is actively seeking to produce and commercialise cathodes that are purely lithium-based without the use of cobalt.
On a global level, it would pay for investors to look towards companies who can dominate a particular niche within the manufacturing ecosystem, including semi-conductor and GreenPower subsets. GreenPower, for those of you unaware, is “a subset of renewable energy and represents those renewable energy resources and technologies that provide the highest environmental benefit. The U.S. voluntary market defines green power as electricity produced from solar, wind, geothermal, biogas, eligible biomass, and low-impact small hydroelectric sources” (Source: EPA).
For the more adventurous (and those willing to stomach the volatility), the more traditional primary materials offer some exposure to the electrification trend, including lithium and graphite. I believe that current lithium prices should have considerable upside since most demand-based scenarios are predicated upon an undue focus on light-duty vehicles, with the assumption that the technologies underpinning the EV market will not be able to target the heavier duty large haulage market. One study I came across, by Han et al., showcased that mass electrification of the heavy-duty segment on top of the light-duty would substantially increase lithium demand and impose an immense strain on global lithium supply. A result that is attributed to the large single-vehicle battery capacity required by heavy-duty vehicles and the required increased replacement requirements. Under the above scenario, the net demand (including recycled) goes to about 38.9m metric tonnes, with current proven reserves stacking up at 62m. However, even here investors must remain cognizant of the interconnectedness of this to battery efficiency and broader technological advances taking place (i.e. higher the battery efficiency, the lower the replacement and hence lower demand for lithium).
Source: Han et al.
The majority of transport electrification studies, examining the demand and sustainability of critical metals, have focused on light-duty vehicles. Heavy-duty vehicles have often been excluded from the research scope due to their smaller vehicle stock and slower pace of electrification. This study fills this research gap by evaluating the lithium resource impacts from the electrification of the heavy-duty segment at the global level.
There are many ways to play the electrification of transport aside from the simple headline-hogging automakers. One should take a look at the relevant supply chains and adjacent categories, there are hundreds of possibilities here. There is also geographic segmentation to consider and one must take a look at some of the Asian markets for this or risk missing out. Don’t forget to look at the niche players out there that can target specific red flags too. This is still just the beginning but one thing is for sure, this thematic is going to produce some real returns for the savvy investor over the next decade.
Sources: Han, H., Geng, Y., Tate, J. E., Liu, F., Chen, K., Sun, X., . . . Zhao, F. (2019). Impact of transport electrification on critical metal sustainability with a focus on the heavy-duty segment. Nature Communications, 10, 1-7.
Last month we launched a unique TAMIM special purpose vehicle (SPV). This Fund has invested in what we saw as a special opportunity to invest in a company that had reached a seminal moment in its history. A milestone that would be the catalyst for crystallising significant shareholder value. Our thesis was bang on (if a little early) and we now expect further upside. Read on to find out why.
Authors: Ron Shamgar
This TAMIM SPV was established to invest in just one company, amaysim Australia Ltd (AYS.ASX). No, the ‘a’ is not supposed to be capitalised in amaysim’s case. AYS is Australia’s largest mobile virtual network operator (MVNO) and is also the fourth largest mobile subscriber base in the country with 1.2m customers, but importantly 850k contracted subscribers.
AYS, as a MVNO, utilizes the Optus mobile network. A MVNO is essentially a marketing company that helps mobile carriers fill up capacity on their networks in order to get a return on their large infrastructure investment. AYS owns its customers and its brand. AYS has a network service agreement (NSA) with Optus which expires in June 2022. At that point AYS can take their customers to another network if they chose to.
What is a MVNO?
Broadly speaking (the definition varies a bit from one market to the next) in this context, a Mobile Virtual Network Operator or MVNO is an organisation that provides a mobile service to its customers but does not have an actual network of its own. That is, they don’t own or manage all or part of the underlying physical network and infrastructure. They typically ‘piggy back’ on an larger mobile provider’s network while retaining the actual subscribers via a network service agreement (NSA).
MVNOs are very common and every competitive mobile market around the world has them. For a MVNO, in order to make a financial return you need significant scale. From time to time a MVNO becomes extremely successful and even a dominant player in its industry. AYS is such a case. This leads to profitability and strong cash generation.
In FY20 AYS’ Mobile division generated $191m revenues and $10m in EBITDA. As MVNOs become large and a meaningful part of any given carrier’s subscriber base, their NSAs become very strategic assets and valuable to their network partner or other carriers in the market. AYS’ contracted subscriber base is now 8% of Optus’ 10.5m subscribers and their only growth channel.
Source: AYS company filings
In a sense, Optus simply can’t afford to lose the AYS contract in 2022. It is this unique situation that we saw as an opportunity and a catalyst for AYS to potentially be taken over. Although Optus is the natural owner of AYS, it is not too difficult to switch mobile subscribers onto another network and so AYS is a very attractive MVNO for the other players, including Telstra (18m subscribers) and Vodafone (now TPG with 5.4m subscribers).
Source: TPG company filings
As we researched the entire global MVNO industry, we noticed that most players that have hit scale get acquired at this point of their evolution. The reason being that the carrier cost of a MVNO is the revenues and margins to a carrier. In FY20, AYS generated Optus $100m in revenues and this year we estimate that AYS will generate $140m in carrier revenues which, by our analysis, is 70-80% increments EBITDA margin to Optus or $100m EBITDA (Singtel is Optus’ parent company).
Singtel, TPG and the like currently trade on 10x EV/EBITDA multiples, hence AYS is arguably worth $1bn in market cap to either of these incumbents. We believe that AYS is the last remaining opportunity in Australia for a carrier to simply grab 850,000 contracted mobile subscribers in one hit and thus add significant profitability right away.
This can happen through a couple of avenues. The first is simply an improved NSA agreement, which AYS has tendered out, or an acquisition of AYS or AYS’ Mobile business. The initial thesis presented to our investors estimated that an acquisition attempt would take place within six months of the SPV’s launch. It ended up taking less than four weeks…
The current situation has Optus offering to buy the AYS Mobile business. The sale is for $250m and is not, we believe, on favourable terms to investors. An outright scheme for AYS would be more attractive. The current offer will see AYS distribute approximately 84 cents (including franking) after costs and taxes to investors. On our entry prices, that is an approximate 25% return over an estimated nine month time frame – not bad but not good enough.
We believe this is an opportunistic offer by Optus and sets the scene for other players such as Telstra, TPG, or even the likes of supermarket chains and AGL to make competing bids or even just match the offer as a scheme. In any scenario, Optus can’t afford to lose AYS’s subscribers and Telstra and Vodafone/TPG can’t afford to pass on the opportunity to grow their subscribers by 5% and 15% respectively. Optus will have to match or counter bid. Either way, we see AYS’ worth well north of $1.00 per share and, with the AYS EGM slated for January 2021, we anticipate a bidding war emerging in the next couple of months.
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%.
