Have corporate strategies for the current financial environment worked?’
FY2013 results flat as expected.
Brad Potter, Portfolio Manager and Senior Analyst, Tyndall AM provides his key take-outs from the August company reporting season.
Weak consumer demand, a slowdown in China and a high Australian dollar are just a few issues challenging Australian businesses. To maintain or improve their profit margins companies have needed to cut costs, reduce capital expenditure and improving efficiencies. Is it working?
Benign reporting season – no great surprises
Overall, the company reporting season was benign with earnings coming in close to market expectations. Around 56% of companies beat expectations. Earnings overall in FY2013 were flat, but up 7% when excluding resource companies, which have fallen substantially because of the decline in commodity prices over the year.
FY2014 earnings forecasts have been lowered as expected in the current environment. Prior to reporting season the expectation was 8% to 10% earnings per share (EPS) growth in FY2014. Those expectations have now been reduced by about 1% or 2% (this is likely to be revised as analysts fine tune their numbers).
Many of the rallies during reporting season were based on ‘no further bad news’ or that the news wasn’t as bad as priced in going into the result – rather than good results. Stocks such as Qantas, Arrium, Origin Energy and UGL were typical of these stocks which had acceptable to probably slightly down results, but were not as bad as what the market was expecting.
Top line growth continues to be weak
The key takeaways from reporting season were very similar to last reporting season. Top line revenue growth continues to be poor. This was expected. Companies suggested things were not getting any worse, which is a positive.
When there is no top line growth companies cut costs. Cost outs were again a major thematic this reporting season across the market. Companies as diverse as BHP, Rio Tinto, AMP, Boral, Coca-Cola Amatil, Fairfax, Toll, Downer and all the banks have cost out and efficiency drives in place in a bid to keep margins flat or improving.
In the case of resources companies, such as Rio and BHP, their large cost-out programs are only just beginning. They’ve slashed their exploration programs, which has saved them between $500 million to $1 billion per annum. Miners have seen substantial cost inflation over the last decade during this mining boom and they need to pare that back substantially because commodity prices have arguably peaked. They need to cut costs as there are a number of mines in a range of commodities that are now looking unprofitable. This is likely to be an ongoing theme, which provides a poor backdrop for the mining services industry.
Dividends still the flavour of the month
Dividends surprised on the upside again, like they did last reporting season. Payout ratios continued to rise, which reflects a combination of investor appetite for yield in a low interest rate environment, strong company balance sheets, a lack of investment opportunities and/or risk appetite to invest their money. In this environment, the easiest thing for companies to do is pay back excess capital as dividends, especially when they’re being rewarded for it. Therefore dividends again outstripped EPS growth quite substantially this reporting period.
Company outlook statements were guarded
Company outlook statements were quite guarded or non-existent. That’s understandable given the problematic economic environment, exacerbated by the uncertainty of the September Federal election.
Post the Federal election consumer and business confidence, currently at very low levels, should rebound. Companies are not investing at the moment because of this low confidence. This was clearly illustrated by the low levels of capital expenditure (outside of mining projects that are already in construction) that we saw during the reporting season.
Profit downgrades were quite modest and many CEOs suggested that business conditions haven’t deteriorated further. This reflected a combination of interest rate cuts finally starting to have an impact and the recent decline in the Australian dollar. Although, that hasn’t had a full impact yet given that the Australian dollar only tumbled in May.
All the banks stated that provisioning levels, while very low, they couldn’t see any issues currently. That was quite positive, given that investors worry about that on an ongoing basis.
Housing was a strong theme during reporting season. Lend Lease commented that their residential property sales in July were two times higher than March levels and they also had increasing apartment commitments. Stockland made similar comments about residential land sales, with the run rate in the second half of the financial year the best since 2010. The positive signs have continued with long queues for residential land sales on weekends. The first release of the Barangaroo apartments in Sydney was sold out in three hours and they were all $1 million plus apartments.
James Hardie commented that they’re seeing rising building activity in Australia and New Zealand, which was interesting given we saw more comments from other building materials companies. The company was very positive on the US environment with profit margins over the 20% level, and they’re suggesting that housing is continuing to pick up in the US.
Iluka also made the point that they sold more zircon in the first half of 2013 than they did in the entire 2012, so they are starting to see green shoots in the zircon market. I expect, given the recent positive news out of Europe (one of the biggest consumers of zircon), that may continue. They also commented that the titanium dioxide market, which tends to be primarily used in painting, is turning.
Seven West Media suggested that advertising spending appears to have stabilised. This is a grey area at the moment due to the election period because there is extra advertising spending by the political parties. A lot of companies peel back their spending during the election period and start after the election. They are now suggesting they’re seeing good interest for commitments post the election, so that’s quite positive.
Companies that provided negative comments included Toll, which suggested activity levels had yet to show any signs of improvement. Fletcher Building also pointed out ongoing weakness in Australia, but commented that New Zealand was going full steam ahead. At Wesfarmers, Target was quite disappointing, with no signs of improvement, which the market disliked. Echo commented that the weak consumer environment was driving soft conditions on the main gaming floor. Tabcorp made similar comments about the weak consumer environment.
Boral disclosed that activity in Australia remains broadly flat in FY2014, so similar to Toll. BlueScope had a solid result but their outlook statement suggested that the first half of this year would be flat on the last half, but over the year would be up, thus indicating the second half would be strong. The market was initially disappointed with that, and the stock was punished severely on the day and subsequent days. It has however subsequently recovered. This was a classic example of where market expectations for the stock were very high and when the company didn’t meet those expectations, the stock was sold off heavily.
Mining boom is over
The reporting season didn’t provide any further clarity on the mining boom. My views pre the reporting season haven’t changed. The mining boom is effectively over in the sense that we’re close to the peak of capex. Commodity prices have also peaked so if that’s the definition of a mining boom then it is finished. I don’t expect commodity prices to fall in a hole though. I expect them to remain at reasonably elevated levels for the next few years at least, given demand from China is still reasonably strong and so I expect mining companies to do quite well in certain commodities. Rio & BHP for example are making great margins in iron ore. On the flip side of that, coal companies are really struggling because coal prices have fallen substantially. A number of coal mines have shut down because margins are just not good enough, and there are a number of them really struggling given the low margins.
Gold is another commodity whereby a number of mines have become marginal, even at current prices, just because cost inflation has been so great. Reserve decreases are the likely next shoe to fall.
Highlights for the Tyndall share portfolios?
In our flagship fund, the Tyndall Australian Share Wholesale Portfolio, Twenty-First Century Fox, our largest overweight, was a highlight. They had an in line but quite messy result given the recent split from their publishing assets. Two days later however they had a strategy day where, for the first time, they laid out quite detailed information on their strategy and all their new revenue streams. The market upgraded substantially on that view. The market, particularly in the USA, has been reluctant to price in these new earnings streams. The share buyback continues at a meaningful pace and there’s an expectation that once this buyback finishes they’ll start another one. The stock was up about 5% over the month.
Downer, which is our only exposure to mining services (albeit it’s not entirely mining services as it represents only about 30% of the business), had a solid result, slightly ahead of guidance, which is very credible given the negative sentiment in the sector due to the peaking in mining capex. The company’s mining segment was down but that was offset by other divisions. It’s been hurt over the last six months because of the ongoing downgrades from other mining services companies, despite the fact that Downer has continually maintained their guidance, which they delivered. The dividend was ahead of expectations and their cash flow was very strong. The cost-out program has doubled to $500 million given that they achieved $250 million two years ahead of forecast. The stock rallied substantially to be up nearly 15% during the month.
Qantas had a strange result in the sense that it was one of those stocks that rallied on the fact the news wasn’t as bad as what the market was factoring in. Transformational initiatives delivered $428 million to EBIT during the year. They started up the small buyback, it’s continuing and the stock rallied 11% over the month.
Sims Metal’s result was also close to what the market was expecting. All divisions had good results, other than the European division which has been problematic over the last year or so due to governance issues. Operating cash flow was strong. No guidance was given, but Sims is leveraged to the US economy and in particular the housing market and scrapping of automobiles as people trade up cars and white goods as the economy improves. So the stock actually responded very favourably; again I think it was a relief rally with the expectations that it was going to be ugly. The stock was up about 11% for the month as well.
Portfolio positioning
Banks have run hard over the past 12 months or so. We’re underweight banks because we believe they’re expensive despite the attraction for yield. We have selective exposures in domestic cyclicals, tilted towards housing and residential as we think that’s a reasonable area given the interest rate cuts and hopefully we’re seeing some green shoots at the moment so that’s quite positive. We also have reasonable exposure to the USA, both from a growing US economy perspective and also a falling Australian dollar.
Conclusion
It was a by and large a non-eventful reporting season, due mainly to many companies confessing or reducing earnings guidance prior. Companies are adapting to the structural changes occurring in the Australian economy as evidenced by the various cost cutting and efficiency programs in place. These initiatives are having a positive impact on company bottom lines, but we now need to see a recovery in top line growth. Lower cash rates, a weaker Australian dollar and resolution of the Federal election, together with signs of stabilisation in the Chinese economy should assist this.
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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Wholesale Portfolio ARSN 090 089 562 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.
