Weekly Market Review
Written and accurate as at: Aug 31, 2017 Current Stats & Facts
News flow from the busiest period of the reporting season drove the market’s movements last week. The S&P/ASX 300 index was essentially flat (-0.05%), however this masked significant divergence between those who disappointed the market and those who did not.
Looking at the former, telecom company Vocus Communications (VOC) (-23.6%) was the worst performer in the index. It underlying profits for the year were up over 50%, slightly under management’s downgraded guidance from May, although a large write down of assets saw it book a $1.5bn loss. However it was the announcement that a private equity consortium had withdrawn from takeover talks which prompted the share price slump; the stock had attracted some support in anticipation of a buy-out. After a period of rapid growth, VOC now faces issues in digesting the string of rapid acquisitions which drove it, in an environment where the competitive pressures of the NBN roll-out are crimping margins. VOC has the smallest war-chest in the industry and, for the moment, looks set for a testing period. Private hospital operator Healthscope (HSO) (-17.1%) – also among the week’s worst performers – is yet another growth company which has failed to deliver on the expectations implied in its at-times hefty valuation.
Bluescope Steel (BSL) slid -20.1% for the week following a result which hit its FY17 expectations, but delivered a significant downgrade of earnings expectations for H1 FY18. This is surprising given the supportive macroeconomic backdrop, with Asian steel spreads (the margin between the coking coal and iron ore input costs and the price of the end steel products) at historical highs. Management have flagged several issues which they claim are one-offs, such as a spike in cheap steel imports as some anti-dumping measures expire, however there are some inconsistencies here given that Chinese exports remain lower than in previous years. Last week’s correction has priced in the expected hit to earnings, and the stock is still up over 21% year to date.
Insurance Australia Group’s (IAG) (-5.2%) result disapointed investors as many expecting that higher insurance premiums – in both commercial and personal products – can drive an upswing in margins and earnings. However the price increases in commercial lines are not coming through as quickly as some expected, while on the personal side customers are baulking at higher premiums, while higher claims costs are chewing up small margin increases. The sector continues to flag further cost reduction, however this is long-dated and not yet coming through. At the same time, a rotation away from banks to insurers has left the latter on almost 20-year highs in terms of valuation relative to the ASX, leaving scant room to reflect the upside from any operating improvement. IAG’s fall reflects the 8% earnings downgrade – the stock has not yet de-rated.
Issues with its European business have picked up where its US problems left off, continuing to crimp growth opportunities at logistics and distribution company Brambles (BXB) (-4.3%). BXB remains one of the market’s favourite defensives, although there is a sense that investors are starting to believe that the underlying growth may not eventuate to justify its valuation rating.
Woolworths (WOW) (-3.5%) is another of the market’s favoured defensives. It delivered a good result in terms of sales momentum, with sales in the final quarter up +6.4% versus the previous corresponding period and an improvement in gross margin. However this did not translate to an improvement in operating leverage and earnings as staff-related costs have increased. The outlook for price discounting remains crucial for the supermarket sector. Price cuts driven by intense competition have seen margins fall from 8% several years ago to 4% today. Indications are emerging that the level of discounting may be decreasing – driven in part by higher power and input prices for the supermarkets and their suppliers – allowing some grocery price inflation for the first time in four years. This, in turn, could see supermarket margins edge back towards 5%.
Scentre Group (SCG) (-3.7%), which owns the Australian-based Westfield malls, delivered a reasonable result however there was little to suggest that the trend towards falling retail rents is waning. The group is also absorbing higher costs as it repurposes malls away from the traditional smaller speciality fashion shops to focus more on food and international “mini-majors” such as Zara, H&M, and UNIQLO, which typically require a larger store footprint. This process can cause closures and disruptions in malls, but ultimately is part of the reaction to the growth in on-line retail.
On the positive side, LNG producer Santos (STO) (+11.3%) did well as the market started to gain confidence that its improvements in cash flow, cost reduction, and de-gearing may be sustainable. Crucially, the company is demonstrating the ability to reduce drilling costs at its coal-seam gas (CSG) sites; given that CSG requires ongoing drilling, the cost to do so forms a major part of the project’s value, and STO has reduced its cost here by 30% over the past year. This, in turn, will allow better cash flow and a further reduction in debt. Concerns over the implication of government intervention into the domestic LNG market also seem to waning, on the view that the price STO should receive if forced to sell into the domestic market should be at least what they can receive from its offshore contracts. Oil Search (OSH) (+8.6%) also did well, snapping back from the bottom of its recent trading range as some investors gained confidence on the addition of further LNG trains to its project in Papua New Guinea. Optimism here must be tempered by the fact that this isn’t the first bout of enthusiasm the market has had regarding this expansion.
Elsewhere in resources, Fortescue Metals (FMG) (+9.1%) continues to reduce costs, while its hefty dividend demonstrates the strength of its balance sheet, low levels of debt, and discipline in returning capital to shareholders. The market is also gaining comfort that the discount for its poorer-grade iron ore is compressing from its recent highs. FMG’s turnaround in recent years has been remarkable and operationally it is without peer in the Pilbara; that said, it pays to be mindful that its outlook is ultimately hostage to the iron ore price. BHP (BHP) (+5.1%) also fared well, beating the market’s expectations of free cash flow and debt reduction and emphasising the point that capital discipline can continue to underpin decent shareholder return. The intention to divest North American assets was well received, although there is significant uncertainty about how long this will take and the ultimate price that they will receive, given the diverse mix in quality of assets. Ultimately, at this point resources remain one of the few parts of the market where free cash flow is improving, as they continue to retain discipline in terms of spending. As an example, BHP is currently claiming they can operate with annual capex of around $8bn versus around double that just a few years ago.
Qantas’s (QAN) (+5.6%) strong run into the result implied high market expectations, which it largely met. Capacity growth continues to lag demand, supporting higher yields, while it announced a further $500m of capital return to shareholders via dividends and buybacks. The stock has now repurchased 20% of its shares since July 2015 which has provided ongoing enhancement of shareholder value which has underpinned much of QAN’s strong gains over that period. The outlook for demand remains crucial to the stock’s performance from here. The headwind to domestic demand from declining mining construction seems to be waning, while business and leisure travel appear to be remaining resilient, helped by events such as the upcoming Ashes. Nevertheless, this remains a key area to watch. There may also be more upside from the international segment with signals of an improvement in yields following a period of capacity addition from QAN’s competitors. Elsewhere in transport, Sydney Airport (SYD) (+6.2%) was the only bond-sensitive to do well, with stronger revenue from its retail segment at Kingsford Smith driving a better-than-expected dividend.
Medibank Private (MPL) (+4.0%) rounds out the best performers from last week. MPL has been spending on customer service and advertising to arrest declining market share. Indications of an improving trend in market share, ie. a lower rate of decline, and suggestions from management that they can reduce cost and relieve the pressure on margins encouraged the market.