The Medallion Report November 2017
Medallion has access to a vast range of research material helping our investment committee to collate ideas and form robust investment theses. Via this report our clients will be given direct insight into the thoughts and minds of our investment team.
Each monthly report will provide general advice and information on what we feel are some of the best opportunities in the Australian equities market, as well as containing a succinct macroeconomic overview. Each business has been carefully analysed and selected by our highly experienced team in order to help clients make confident and informed investment decisions.
In addition to this report, the advisers at Medallion are here to assist you with the timing and overall management of your portfolio. We hope that you find the report inciteful and welcome any questions or queries you may have.
The Australian economy continues to produce encouraging signs. The Labour market again delivered a result that was better than expected adding 19,800 new jobs, constituting 6,100 full-time jobs and 13,700 part-time roles. The unemployment rate now sits at 5.5 percent, the lowest level since early 2013, with 85 percent of jobs created in the last year being full time. After a weak year for jobs growth in 2016, 2017 has proven to be impressive with leading indicators such as job ads and business surveys pointing to ongoing strength.
With firms finding it harder to recruit required staff and the emergence of industrial disputes, most notably the National Union of Workers dispute on behalf of Woolworths Depots, perhaps the ingredients required to spark wage growth are starting to come together. At Medallion we aren’t convinced, headwinds are starting to emerge in key industries such as housing, while an abundance of spare capacity in the labour market is likely to persist for some time yet.
The inflationary pressures in the economy remain weak coming in at 0.6 percent for the quarter, below the forecast 0.8 percent. On an annualised basis inflation sits at 1.8 percent, below the forecast 2 percent to remain outside the RBAs target band of 2-3 percent. Perhaps more important are the core inflation figures which looks to strip out volatile items. The trimmed mean ran at 0.4 percent over the September quarter and 1.8 percent year on year.
Consumer spending has been exceeding disposable income growth helped by a fall in the household savings rate. However, if housing prices continue to soften, the risk is households begin to feel less confident and again start to accumulate savings, a scenario that would likely drag on consumption growth and broader economic growth. It’s difficult to see inflationary pressures forming in that environment, meaning that it’s conceivable the RBA could remain on hold until beyond 2018.
The outlook for the Australian economy in Medallion’s view remains precarious. Despite closing in on the Netherlands record run of economic growth there are few headwinds. Immigration has been a key driver of growth but is now placing a heavy burden on infrastructure and the riches of the mining booms have passed without the benefits finding its way into the pockets of the average Australian. Whilst households carry a tremendous debt load, wages have barely grown in the face of declining gains in productivity. Australia continues to run large current account deficits as a result of its reliance on volatile and unpredictable commodity prices. Essentially Australia adds very little value to its exports, meaning the value of imports will continue to be greater than the amount we receive for our exports. To give it some perspective, it takes 10 tonnes of Iron ore exports to buy just one iPhone, a situation which should drive government to deliver productivity boosting infrastructure, education and training in order to create an attractive destination for global businesses.
After a soft couple of months, the Chinese economy showed renewed signs of life. GDP growth slowed slightly to grow at 6.8 percent in the third quarter down from 6.9 percent in the second quarter. The slowdown was expected however, as the government ramped up efforts to rein in the level of debt and temper a surging housing market. There are other signs that government measures are starting to bight as the number of Chinese cities with declining prices reached a multi-month high, while new construction starts rose by 6.8 for the year to date, falling from 7.6 percent in the previous month.
After a lacklustre July and August, Industrial production and retail sales showed signs of life whilst the level of fixed asset investment stabilised, albeit at the lowest level since 1999. Industrial production grew at 6.6 percent up from 6.0 percent in the previous month as retail sales rose 10.3 percent in September from a year earlier, faster than the previous months 10.1 percent and exceeding analysts’ expectations of 10.2 percent.
Fixed asset investment continued to decline from 7.8 percent to 7.5 percent in September as the Chinese economy modernises and shifts from an investment lead economy to a consumption driven economy. A decline in fixed investment is expected, nevertheless the rate of the decline is of key interest.
China continues to focus on growing its services industry, particularly high value-added services such as technology and financial services, that way reducing the traditional reliance on heavy industry and fixed asset investment. In the interim, the government cannot completely disregard fixed asset investment for risk of creating a protracted slowdown as the economy waits on the services industry to reach critical mass and become self-sustaining.
Private business activity in China’s service sector grew at its slowest pace in 21 months in September, illustrated by the Caixin services purchasing manager index (PMI) declining to 50.6, the lowest reading since December 2015. China’s infrastructure spending as a percentage of total investment has been ramping up indicating that government fiscal stimulus has been increasing to smooth the transition.
China’s producer price inflation (PPI) unexpectedly accelerated to a six-month high in September as a government crackdown on air pollution triggered a jump in commodity prices. The PPI rose 6.9 percent in September, up from 6.3 percent in August signalling continued resilience in China’s economy. Investors would recall that at the start 2015 markets where spooked by a slowing Chinese economy which led to rapid capital outflows. The stabilisation and now recovery of the Net Capital Flows has further highlighted the resilience and renewed confidence in the Chinese economy.
United States Economy
The US economy suffered its first month of job declines since September 2010 after hurricanes Irma and Harvey hit the USA. Non-Farm payrolls fell 33,000 and well below the market expectations of an 82,000 gain. The market nevertheless wasn’t too perturbed instead choosing to focus on the upward revision to August’s numbers and the fall in the unemployment rate from 4.4 percent to 4.2 percent, the lowest levels since 2001. Furthermore, the underemployment rate fell to 8.3 percent from 8.6 percent, however some market watchers caution that these figures may all in fact be skewed by the storms.
Interestingly, hourly earnings jumped 0.5 percent in September to 2.9 percent for the year, the strongest pace since 2009 and comes off the back of an upward revision in August. The producer price index (PPI) also came in above expectations at 2.2 percent, leading many to believe that inflation was about to rear its head. As it turned out that wasn’t the case. Core inflation, excluding food and energy, rose 0.5 percent in September, below the estimated 0.6 percent. The inflation data saw the probability of a December interest rate rise by the Federal Reserve decline slightly, however the probability still remains above 80 percent.
Most economists believe it’s only a matter of time before rising wage pressure flows through to inflation, particularly once slack in the labour market is exhausted. This is a view shared by Fed Chairperson Janet Yellen who recently indicated that she believes the persistent weak inflation reads are transitionary, stating that “My best guess is that these soft readings will not persist, and with the ongoing strengthening of labour markets, I expect inflation to move higher next year.” Despite persistently weak inflation, the economy continues to deliver promising results elsewhere. The business activity report was better than expected for both manufacturing and services sectors. Manufacturing PMI came in at 54.5 above the expected rise of 53.4 although some would contend that a disconnect has again emerged between the soft and hard data. The reality is that once employment rate stops falling, it will be increasingly more difficult to boost the speed of the economic expansion unless we see productivity improvements. That however is unlikely in the face of a stagnant prime-age population and tougher immigration laws.
On the back of an improving economy, Mario Draghi announced the start of the QE tapering, nevertheless markets remained unperturbed as the move was anticipated and the measures on the more dovish side of the ledger. The ECB will start by buying fewer bonds per month, but will extend its bond purchases to next September and possibly beyond, with Draghi signalling there won’t be a sudden end to the purchases. The probability of a rate hike by the end of 2018 is now below 30 percent after reaching a level of close to 90 percent, while inflation expectations, as indicated by the 5 year/5 year forward swaps, has risen to 1.67 percent.
Economic sentiment in the Eurozone has been softer than expected in recent months weighted down by weaker sentiment coming out of Germany. This is despite investor confidence in the Eurozone reaching the highest level in a decade and industrial production continuing to improve in the likes of Italy and Germany. Broadly speaking, economic data from the Eurozone remains solid. Whilst the momentum in the Eurozone services sector has slowed, manufacturing activity has continued to deliver the best result since 2011. For the first time in a long time, the performance of the Eurozone economy isn’t just being carried by Germany, with the likes of France, Italy and Spain doing their fair share of the heavy lifting.
Despite the strong performance of the European economy, the lacklustre inflation rate merits caution. Inflation currently sits at 1.5 percent well below the ECB’s target range, with a core inflation rate of just 1.1 percent albeit trending higher. The trend in inflation is positive however it’ll be interesting to monitor how the stronger Euro starts to impact import prices and inflation. Somewhat offsetting that is the unemployment rate at 9.1 percent, which currently sits well below the 2012 high of 12.1 percent. Many economists believe that as the employment rate continues to fall, inflationary pressures should begin to emerge.
IDP Education (IEL:) is Australia’s largest student agent company. IEL is a world leader in international student placement services with 93 offices helping students from 30 countries to study in Australia, Canada, New Zealand, USA and the UK. IDP Education is 50% owned by 38 Australian universities. For more than 45 years, IDP Education (originally known as International Development Program) has played a major role in international education. During this time, IDP has placed more than 400,000 students into quality institutions in Australia, the United Kingdom, the United States of America, Canada and New Zealand.
International education was estimated by the ABS to contribute $19.7 billion the Australian economy in 2014-15. Emerging middle classes, renowned educational institutions and a low AUD are all tailwinds that are set to continue for some time yet. IEL’s strong brand, scale and history dealing with universities gives the company a strong competitive advantage placing it in an enviable position to capitalise on these favourable structural tailwinds in international student numbers as well as their increasing geographic mobility.
IDP Education is also co-owner of IELTS (International English Language Testing System). IELTS is jointly owned along with British Council, and Cambridge English Language Assessment. Since its launch in 1989, IELTS has become the world’s most popular high-stakes English language proficiency test, used to determine anything from migrant intakes, university admissions to scholarship programs.
IELTS market share has shown signs of stabilisation in Australia while student placement volumes were up 9.9 percent in the most recent round of reporting. The surge in popularity for Canada as a destination for international students appears to be continuing. Recent data from ‘Hotcourses’, the UK’s number 1 course search website, shows that Canada is the number 1 study destinations for Indian students. This is supported by ‘GoogleTrends’ which show Canada has firmed as a favourite for international students in recent times. For IEL, this has had positive implications for both IELTS volumes and student placements to Canada. When it comes to attaining a study visa, the Canadian government currently only accepts either IDP Educations, IELTS, or a local provider, Paragon Testing.
Steadfast Group (SDF) is Australia and New Zealand’s largest general insurance broker network, consisting of over 360 brokerages with over 1300 offices in Australia, New Zealand and Singapore. The sheer size, scale and systems of the company is such that it draw’s new brokers into their network. The two largest insurance groups in Australia are Steadfast and Austbrokers whom make up 36 percent of market share. This allows their networks to negotiate better insurance terms as well as centralise IT and administrative services.
SDF have equity ownership in 62 of its 348 networks, allowing synergies in the form of combined back office functions which facilitate the reduction of operating costs. The stewardship of the business is an additional key strength with a highly experienced board of directors, each with over 30 years’ experience within the industry, ensuring strict financial and cultural selection criteria are considered before any new acquisition is undertaken.
Insurance brokers generate revenues from two sources, fee for service and commissions. Fee for service occurs when an insurance broker filters through numerous policies to identify the policy most applicable to the client’s needs. For instance, some commercial operations are more exposed to bushfire damage and others water damage, the differences are often far more complex than that, but we’ll keep it simple for all intents and purposes.
The second source of revenue is commissions, and it’s this revenue source that offers the real upside for this business albeit the most susceptible to competitive pressures. Increasing commissions leads to greater revenue and expanding margins given costs tend to be fixed. In recent times competition in the space has been high and commission rates low. Nevertheless, there are signs starting to emerge that the tide is beginning to turn, and insurance rates are starting to rise. When you consider that SDF has been able to operate and perform well in a more challenging environment, it should become even easier for the business to generate growth now that the cycle appears to have changed for the better.
Speedcast International (SDA) is an emerging business that provides satellite-based communication networks and services in the satellite service provider industry. The business is one of the worlds most trusted providers of end to end Communications and IT Solutions to businesses operating in remote locations. For instance, the business services the likes of the Maritime, Enterprise, Telco, Mining and Government sectors, with a particularly close relationship with the energy space where it currently provides its services to 9 of the top 10 global drilling contractors.
In simple terms, SDA purchases satellite capacity from satellite operators and then resells the satellite usage and telecommunication services to over 100 different customers worldwide. A market leader, SDA leverages a large global network in the mobile satellite industry, with 39 strategically located teleports spanning the globe to deliver its services.
Increasing reliance on big data and a requirement to be connected to the internet at all times are set to drive increased data demands for some time to come. Satellites are an effective way of providing data to remote and isolated locations where traditional forms of communication are either not economically viable or simply not possible. As such, SDA services a large portion of the shipping and cruise liner industries for instance.
The company has won a number of key contracts in recent times, highlighting the businesses strong industry position and their ability to provide networks, communications and support in remote locations, both on and offshore. The company has recently won a major contract to provide managed services for a large Oil and Gas operator in Equatorial Guinea, as well as contracts as diverse as with the Australian Government to provide “mission-critical” remote communication services to the Australian Antarctic Research Stations.
As well as winning new contracts which generate growth organically, SDA has demonstrated an acquisitive streak. Management in June purchased Ultisat for US$65 million, allowing them to gain exposure to the US Government and Military. This looms as a profitable area which would otherwise have been an extremely difficult market to crack, given the security clearances, relationships and client specific expertise required to gain traction.
Fundamentally we are comfortable with this business and the trends in the key financial metrics. Debt is elevated but the company has demonstrated an ability to generate strong cashflow which over time can be used to reduced leverage. The company operates with attractive economies of scale as highlighted by growing earnings transferring into expanding margins.
BAPCOR (BAP) is an automotive aftermarket parts provider and is arguably one of the brightest prospects in the consumer discretionary space. The business recently delivered an impressive annual report, which highlighted strong margin growth, same store sales and cash generation, once again confirming the businesses resilience and competitive advantage. The business has a defensive earnings profile while management have shown themselves to be apt at allocating shareholder capital towards quality acquisitions that have gone on to deliver synergies.
The business operates two key divisions, automotive parts (Trade) and operations (retail). The automotive parts section delivers 80 percent of the company’s income and provides various replacement parts and car accessories to customers all over Australia. The core focus of this segment is the distribution of auto parts to independent and chain mechanic workshops throughout Australia and New Zealand. They distribute over 500,000 unique parts from over 1,000 suppliers through an extensive distribution network. The trade division has 165 service stores across Australia delivering 11 percent and 4.6 percent, revenue growth and same store sales respectively.
The retail segment distributes to an Australia-wide network of over 120 Autobarn, 85 Autopro, 40 Sprint, 85 Car Parts and 80 Opposite Lock stores. Although the retail sector has been performing strongly, the market has in Medallion’s opinion been unfairly penalising the share price given the perceived threat of Amazon entering the market. The reality is however the vast majority of revenue and earnings are generated from other unrelated areas of the business. Additionally, there is a significant opportunity with the New Zealand operations which looks set to drive ongoing revenue and margin growth for the business.
BAPCOR recently delivered a set of very strong results, revenue grew by 47.8%, EBITDA by 52.4% and EPS by 36.4%. Although debt levels remain relatively high after a series of acquisitions, impressive free cash flow generation ensures it can comfortably service debt. For a business with an impressive earnings profile and strong competitive advantage, the valuation multiple appears attractive at only 17 times 2018 earnings. The business recently confirmed that it had reached an agreement to sell some of its non-core assets including the NZ footwear business. This is expected to deliver NZ$92m in cash which can be used to address some of the debt overhang and improve the balance sheet position.
After facing challenges post the Brexit vote, Janus Henderson (JHG) appears to have reached an inflection point. The most recent result delivered Funds under management, fund flows, and investment returns all better than the market expectations. Looking forward, and the company is set to announce its third quarter results on November 9, and it’s our belief that better operating trends and stronger markets are yet to be reflected in market estimates.
The newly combined entity will be a far more diversified global enterprise, providing the opportunity for growth through an imposing transatlantic distribution platform. The recent merger between Janus group and Henderson global investors not only brings together two asset management businesses with excellent reputations and track records, but should also offer the new entity an opportunity to cut costs. There have been $57 million cuts so far in areas such as HR, compliance, risk, reporting and marketing. Costs of back Office functions such as settlements, reconciliations, and corporate actions, as well as IT and consulting expenses, once incurred by 2 companies, can now also be reduced substantially.
Broadly speaking funds management businesses tend to benefit from being low capital-intensive operations. Therefore, once scale is achieved, then it becomes possible to generate sizable profit margins and cashflows particularly when global equity markets are performing well. Relative to its peers JHG trades on far less challenging multiples. On a P/E ratio of 14, JHG compares favourably when compared to the likes of Magellan Financials Groups (MFG) P/E of 21.5, Platinum Asset managements (PTM) P/E of 23.5, and BT Investments (BTT) P/E of 19.50.
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