Weekly market update - 21st of February 2022

Several themes are emerging from Australia’s reporting season:

• The Australian economy is in good shape with a strong outlook
• Companies that have been challenged for some time by Covid disruptions are responding well and positively surprising the market
• Labour availability and inventory management have been a challenge for some companies
• US-based businesses are seeking to put through material price rises

Globally, the valuation de-rating of growth companies and concern over Ukraine weighed on equity markets last week. The S&P 500 fell 1.5% and the NASDAQ was down 1.7%.

A generally good menu of corporate results helped support the local market, which ended up 0.2%.

Year to date, the S&P/ASX 300 is -2.9% versus -8.6% for the S&P 500 and -13.3% for the NASDAQ.

Macro-economic news

Inflation

There was little newsflow last week. Our view remains that financial conditions — including asset markets — need to tighten further for any real chance of inflation cooling.

Headline inflation data may moderate in coming months due to the base effect. But US economic momentum looks to be strengthening.

For example, company survey data from researcher Evercore ISI indicates the US economy continues to pick up following the most recent Covid wave.

This is supported by Bank of America credit card data and air travel sales. Housing is staying resilient despite mortgage rates moving higher. This may reflect pent-up demand and supply constraints.

Meanwhile monetary policy remains loose. This is not consistent with the need to bring inflation down, which is becoming a political imperative given the mid-term elections in November.

Fed Chair Powell is still yet to be officially confirmed for another term. The process has been delayed by wrangling in the Senate over the appointment of Sarah Bloom Raskin to a key regulatory role at the Fed.  If this situation drags on it raises an outlying risk that Powell may not be confirmed if he is failing to quell inflation. This is arguably putting more than the usual political pressure on the Fed.

Ukraine

There are two very different perspectives on the Russia-Ukraine stand-off.

The first is that Putin is almost certain to invade in the next couple of weeks and is trying to engineer a pretence to do so via claims of an unwarranted act from Ukraine.

The other is that the US is overstating the risk to put pressure on Putin and reframe Biden’s image.

The outcome remains to be seen.

History suggests any sell-off in risk assets in response to military action will be relatively short lived.

If a solution is found, it could see the oil price back down to about $80 very quickly — particularly if the market starts to price in the possibility of a new deal with Iran.

This would give Biden some relief on the inflation issue, with high fuel prices becoming an acute political problem.

Australia

The domestic economic looks primed for a period of strength thanks to a combination of:

• Pent-up demand supported by excess savings
• Border re-opening as cases numbers fall
• Labour market and wage strength
• Renewal of immigration
• Policy — rates remain low and we are likely to see a stimulatory pre-election budget

Employment-to-population ratios continue to climb. There is little evidence of the “great resignation” seen in the US.

The job market also looks strong, based on Seek’s job ads data, which continues to climb to 10-year highs.

Immigration is also recovering quite quickly, helped by a near-term boost from returning students.

This all bodes well for aggregate corporate earnings, which can help protect the domestic equity market from the valuation de-rating seen elsewhere.

Markets

The rotation away from growth continues.

Speculative tech names declined again after a recent small bounce. Meanwhile, mining stocks continue to climb.

It was interesting to note some positive noise on gold last week. The gold price is up 5.8% for the month and has broken out a recent technical range, helped by geopolitical concerns.

This needs to be watched. Gold miners have been material underperformers for almost two years and when they do run, they tend to do so sharply.

There is a lot of debate on the link between real rates and gold. There has been a strong negative correlation in recent years (as real rates rise, gold underperforms). This has helped entrench bearish sentiment recently.

Iron ore fell 11.8% as Beijing clamped down on speculative activity by traders. But underlying demand and economic strength appear to be constructive, supporting a price in the low US$100 range.

Reporting season results

Good results

CSL (CSL, 6.9%) had been weak going into the result on concerns over the rate of improvement in collections and margin pressure in FY23 as a result of low volumes and higher donor fees. The result allayed both these concerns. Collections have almost returned to pre-Covid levels and remain on a positive trend. Management guided to 2H FY22 as the low point in gross margins and only marginally down on 1H FY22, leading to some small consensus upgrades. The market remains undecided on the recent Vifor acquisition. The stock has come back to 32x FY23 price/earnings, with significant latent earnings potential as margins and volumes recover as well as underlying growth. 

Tabcorp’s (TAH, 1.7%) result beat expectations on the back of strong revenue growth and digital-driven margin expansion in its Lotteries division. This more than offset a weaker result from its wagering business, which suffered heavily from Covid-driven shutdowns of its retail network in the half. The company remains on track for a demerger of the two businesses by June. Management offered a positive outlook with Lotteries implementing changes to its OzLotto product and Wagering to benefit from the reopening of its retail outlets.

Treasury Wine Estate’s (TWE, 11.8%) interim result was in line with consensus. The stock surged as fears of the potential impact of Omicron on wine demand and rising costs of shipping were calmed. Management flagged continued growth in the Penfolds brand as penetration increased globally to offset lost volumes in China. In Asia (ex-China), revenue from Penfolds was up more than 100% for the half. TWE’s luxury wine portfolio in the US is also enjoying strong growth driving margins higher. The recovery of “on-premise” demand as the US re-opens is also expected to provide a tailwind.

Orora (ORA, 9.2%) beat expectations handsomely on the back of a surge in earnings at its US packaging distribution business. The company is a beneficiary from the inflationary environment in the US. Strong demand allows it to raise prices more than the rise in its own input costs. It is also benefiting from fixed costs pulled out during the Covid downturn and its “value over volume” strategy of either repricing or shifting away from less profitable customers. ORA pointed to a continued runway of growth, with >50% of accounts still to be repriced and end demand remaining strong.

Seek (SEK, -3.3%) delivered an exceptional result (EBITDA +83%) on the back of a strong cycle combined with product development and investment in technology. It beat already lofty expectations and upgraded guidance by about 10 per cent. The stock’s fall partly reflected concerns about sustainability of cycle, but was probably driven more by the ongoing de-rate in growth. The strong jobs cycle is likely to drive continued good earnings growth. A headline FY23 price/earnings of about 38x doesn’t look overly compelling. But continued pricing power, new services and potential growth in Asia indicate value is emerging.

Goodman Group (GMG, +1.8%) had another great result. It beat consensus by 10% for the half and raised full-year guidance from “at least 15%” to 20%-plus. The stock is on 27x FY23 price/earnings. Like SEK, Macquarie Group (MQG) and REA Group (REA) it suffers from being one of a number of well-owned quality growth names in a de-rate environment, so the stock did not reflect a good result.

Vicinity Centres (VCX, +12.1%) rose in stark contrast to GMG, as an under-owned stock with low expectations. VCX is seeing rental waivers receding and leasing spreads improve from -12.7% to -6.4%. Overall visibility is improving in retail malls for first time in a while.

Adelaide and Bendigo Bank (BEN, +9.3%) was another bank where margin trends were not as bad as feared. Management were more conservative than Commonwealth Bank (CBA) in their view on leverage to rising rates, flagging the unknown effect of competitive pressures. The market liked a more disciplined tone on cost control.

Reasonable results

Telstra’s (TLS, -2.7%) overall result was decent and in line with expectations. Its mobile business was strong, delivering about $400m in EBITDA growth in the six months on the back of about 8% growth in service revenue. All divisions in mobile delivered positive revenue growth for the first time in years. Average revenue per user continues to improve, supported by broader trends as the mobile phone sector returns to profitability. Management reiterated their FY22 and FY23 EBITDA targets and flagged a further $500m cost-out in FY23 while still investing for growth. This creates a path for further operating leverage to positive revenue growth profile. It remains a good quality defensive on a reasonable valuation.

BHP (BHP, -1.8%) delivered a good result, in line with expectations, on the back of higher commodity prices. Cash flow improved and shareholders got a higher dividend, with the company on track for a yield in excess of 10% in FY22. Cost inflation is emerging as an issue, notably in their coal division. As a result high commodity prices and cost discipline remain critical for the sector.

Santos’s (STO, -5.7%) result was largely in-line with expectations. CY22 production guidance disappointed some in the market, with some confusion from the run-down of Darwin LNG as well as complexity from its production sharing contract structure, but nothing material. Management announced $2bn to $3bn of asset sales in progress. The stocks has had a good run year to date, but sold down last week. This was partly on a view that the oil price had run too far, but there was also some rotation to the less well-owned Woodside Petroleum (WPL).

South32 (S32, +3.4%) had a solid result. It delivered $894m of free cash flow for the half, off a market cap of about $21bn. This highlights the benefit of strong commodity prices. Management announced another $200m buy back, reflecting the strong balance sheet.

Star Entertainment’s (SGR, -1.4%) 1H22 result was hit heavily by casino closures during the half. The company pointed to short-term cost pressures from labour shortages but is also seeing a robust recovery in revenue as Omicron restrictions are unwound. The share price was weaker on the day following news that the Victorian government was planning to legislate mandatory pre-commitment to poker machine loss limits at Crown Melbourne, with concern the NSW and/or Queensland governments may follow suit.

Domain (DHG, -9.7%) delivered a strong result, in line with expectations. Variable costs were higher and management flagged a tick up in cost guidance as it reinvests for medium-term growth. Overall, the company is executing well on its strategy, but the market is not in the mood for complicated stories. The stock’s fall was partly on concerns over the outlook for the sector, but mainly driven by the de-rating in growth stocks.

Transurban (TCL, -0.1%) missed EBITDA expectations on higher corporate costs, but the market was reassured by company commentary on a strong recovery in traffic at its Australian assets as Omicron restrictions were unwound. The company also highlighted the high level of hedging of its interest rate exposure, which will insulate it from rising interest rates in the short term.

Boral’s (BLD, -2.1%) result was slightly better than expectations as the negative impact from Covid during the period was less than originally flagged. The outlook is looking positive with major projects being awarded and multi-residential construction activity looking set to recover after a major decline in recent years. The company’s transformation project is delivering good reductions in costs and there are signs of life in the pricing environment.

Cleanaway’s (CWY, 0.3%) interim earnings beat expectations. The outlook was lifted on the back of very strong double-digit revenue growth, driven by the Solids business. The company has been winning market share in municipal waste contracts and is seeing a strong volume recovery in its Health Services business. The company will deliver similar earnings in 2H22 with higher short-term labour costs due to Omicron-linked absenteeism.

Disappointing results

Wesfarmers (WES, -4.5%) met expectations after pre-announcing numbers in January. The stock fell on disappointing cash flow and negative updates on Officeworks and Kmart, with earnings falling 55% in the latter in a tough trading period. Bunnings earnings appear to have peaked after spiking last year, as revenue flattens. The retail businesses, largely driven by Kmart, have excesses inventory which creates material risk into 2H. This comes at a time when costs are rapidly increasing.

QBE (QBE, -8.5%) looked to moderate market expectations despite a good set of numbers, potentially as part of a strategy by the new CEO to deliver a more consistent growth pathway. The company highlighted higher perils claims; costs; concerns over inflation; more reserving; and delays in benefits from higher rates. All this saw the market downgrade CY22 earnings by 5%. Despite this we think underlying performance is solid and the path to improved returns in on track. It is also among the most leveraged to higher rates, despite the company’s effort to downplay it. It remains on a sub-12x FY23 price/earnings with an improving rate cycle in front of it.

Fortescue’s (FMG, -13.1%) net profit after tax (NPAT) fell 32% as a discount for lower-grade ore remained wide even as the iron ore priced dropped during the period. The company is operating well with good cost discipline. Its challenge is that it is embarking on a reasonable capex program, combined with the Fortescue Future Industries investment, where there really is no line of sight on what could be spent.

Origin (ORG, -7.5%) surprised the market with higher costs in its Energy Markets division, which saw it miss expectations but retain FY guidance. It brought forward the closure of the Eraring coal-fired station from 2032 to 2025. This saw some downgrade to out-year expectations, with consensus assuming Eraring would remain profitable.

Incitec Pivot’s (IPL, –5.9%) key US ammonia plant was brought down by a hydrogen release. This will probably take two weeks to fix, but will take about 3% off F22 earnings given the current high pricing.

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