Weekly Market Review
Written and accurate as at: Aug 24, 2017 Current Stats & Facts
The Australian equity market was up last week (S&P/ASX 300 +1.0%) with defensives generally having a better time of it than cyclicals (S&P/ASX 200 AREITs +2.3% vs S&P/ASX 300 Metals & Mining 0.0%). However it was the ongoing results season which primarily drove returns within the market.
Looking first at the underperformers, Domino’s Pizza (DMP) (-12.4%) largely met the market’s expectation for FY17, but flagged that the outlook for FY18 was for 20% growth in net profits after tax (NPAT) versus the 30-40% they have historically delivered. The key issue here is slowing same store sales growth in Australia, which fell from 20% to around 7% in H2 FY17. Many Australian businesses would be overjoyed with 7% annual growth in sales, however DMP’s valuation rating has been based on far higher rates of growth. The long-term case for DMP is grounded in its ability to replicate its success in Australia with its franchises in Europe. While operations in Belgium and the Netherlands look good, France and Germany have experienced teething issues and the market is now questioning whether growth here will be as straightforward as many thought.
QBE Insurance (QBE) (-8.3%) hit the mid-range of its earnings guidance with the caveat that this had been downgraded in June due to a blow-out in claims costs in its emerging markets business. It downgraded its FY18 outlook yet again in its results, due to a deteriorating ability to release reserves from its European business, as claims costs increase there as well. The market has retained faith in QBE to a degree in recent years, despite a string of negative surprises.
Telstra’s (TLS) (-6.0%) decision to cut its dividend dominated headlines late in the week with the stock down sharply as investors digested the implications for one of the retail market’s perennial favourites. The stock had run up +5.5% month-to-date leading into the result, which may have exaggerated the snap back, however the crucial question is what the dividend cut says about the outlook for the company. TLS’s P/E valuation versus the S&P/ASX 300 based on earnings for the next 12 months is now below a standard deviation under its 10 year average. The positive case for TLS is that this valuation prices in all the negative pressure in its NBN and mobile phone divisions, while the stock continues to offer a decent yield, the potential for further buybacks, and the possibility of unlocked value via the securitisation of the NBN payment stream.
The risk to this case is twofold. The first is a further leg down in earnings from either its NBN or mobile business. At the moment the valuation implies that TLS will never turn a profit in NBN. The market’s fear around mobile phones has centred on TPG Telecom’s (TPM) arrival as an aggressive fourth player. However at the moment TPG is haemorrhaging cash in their fixed line business, which we think crimps their ability to be too aggressive on mobile pricing. The upshot is that we think the risk to earnings in these two key divisions is not as bad as many in the market fear.
The second risk to the positive case is that TLS squanders capital. At the moment the company is making $10-$11 billion in earnings before interest and depreciation (EBIT) per annum, but is spending close to $5bn. The key question is whether they will be making questionable purchases in order to fill the hole in earnings, or whether they invest wisely, de-gear and perhaps fund further buy-backs as greater clarity emerges.
Elsewhere, annuity provider Challenger (CGF) (5.6%) signalled that margins were coming under pressure. They have had to invest up the risk curve in order to maintain profit on their investment book and now seem to have reached a limit. This implies the need to grow volumes in order to maintain earnings – funded by its dilutive capital placement with Japanese insurer MS&AD. CGF’s margins have remained strong for longer than we expected, however there are signs of increasing pressure. Seek’s (SEK) (-5.1%) result suggested that, like DMP, they are struggling to maintain their growth trajectory and are having to spend more. Computershare’s (CPU) (-2.7%) outlook disappointed the market, with its strong run year-to-date suggesting more optimistic expectations. AGL Energy (AGL) (-2.9%) delivered a strong set of results, however its underperformance reflects the sense that electricity prices may have peaked.
Cochlear (COH) (+12.4%) was the week’s best performer. The stock did not beat expectations by any significant margin, however delivered enough to retain investor support. Bendigo & Adelaide Bank’s (BEN) (+9.5%) surge reflected the better trends in margin growth across the banking sector – particularly on deposit margins, which is better for the regional banks than for the majors, given the former’s skew towards deposit financing. This incremental improvement in margin trends has been confirmed by results and updates from other banks, which helped ANZ (ANZ) (+2.6%) and National Australia Bank (NAB) (+2.3%) outperform last week, while alleged governance issues continued to weigh on the price of Commonwealth Bank (CBA) (-1.8%).
Like AGL, Origin Energy (ORG) (+8.4%) benefited from unsustainably high electricity prices, however the market is looking for promised cost reductions in its LNG business for the next leg of earnings growth.
Tatts (TTS) (+8.0%) snapped back following weakness leading into its results, while Treasury Wine Estate (TWE) (+7.5%) downgraded its outlook for FY18, but managed to convince the market to look through this to a strong FY19, on the back of a good harvest. Brick-maker Adelaide Brighton (ABC) (+7.2%) did well on a firm Australian construction market into H2.
We see online property group REA (REA) (+6.1%) as being in something of a sweet spot relative to other growth stocks such as SEK in terms of its ability to grow earnings. REA continues to develop a pipeline of new initiatives and products that allow them to retain good pricing, maintaining its trajectory of double digit earnings growth.
Bunnings continued to underpin growth for Wesfarmers (WES) (+3.4%), however this is supported by a long period of benign weather, so we are wary of extrapolating too much there, while Coles continues to face significant competitive pressure. JB Hi-Fi (JBH) (+1.0%) reported strong sales growth compared to the previous year, with that momentum continuing into FY18 with sales up 5.5% for July, versus the same month in CY16. These strong trends defy the bears on the retail market, although the major concern remains the ultimate effect of Amazon.
The guidance from CSL (CSL) (+1.9%) was slightly weaker than consensus expectations, although this is partly due to currency movements. The underlying business remains strong and they continue to grow earnings at double digits, while their flu vaccine business looks to be nearing breakeven within the next two years.
Many companies are having to spend more capital to grow – or even to stand still. We have seen this with AMP, TLS, CSL, SEK, and AGL among others and ultimately this chews into free cash flow and reduces the opportunity for capital return to shareholders.
It has been interesting to see a greater focus by companies on emphasising their role as good corporate citizens, contributing to the community. This is likely as a response to the political backlash against elements of corporate Australia displayed in government intervention in the LNG sector and the surprise imposition of the bank levy. Again, this is leading to some investment from companies, contributing to larger capex bills.