The Medallion Report October 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 appears to be in reasonable shape, with private sector capital expenditure indicating growth is broadening. GDP rose by 0.8 percent in Q2 2017, slightly below the consensus forecast of 0.9 percent. The handbrake on growth caused by the evaporation of mining investment appears to be a thing of the past as the outlook for mining investment was improved from $27.6bn to $28.8bn. Although weak disposable income growth of only 2 percent, the slowest pace since the GFC, remains of concern, in the short-term consumers appear confident enough to run down savings to support growth in spending at levels greater than growth in income.
Consumer spending rose by 1.1 percent exceeding disposable income growth 0.5 percent helped by a fall in the household savings rate from 5.3 percent to 4.6 percent. The Australian government has been a key driver of growth providing 0.6 percent to the 1.8 percent increase in GDP over the past 12 months. This contrasts with the drag on GDP the government has in recent years and signals a shift in policy to support the economy through this period of transition away from a mining focus towards infrastructure spending.
All this follows a promising period for the labour market where the unemployment rate sits at 5.6 percent. The economy added 54,200 jobs in August while the all-important participation rate rose to 65.3 percent, above expectations and the highest levels since 2012. Nevertheless, labour productivity growth declined by 0.2 percent making it difficult for workers to demand higher wages and support sustainable long-term growth.
The question from here is how does this all influence the RBA’s thinking on interest rates. It’s become conventional thought amongst economists that the RBA is finished cutting interest rates in this latest easing cycle. In saying that monetary conditions remain relatively loose, with real interest rates (i.e. cash rate less inflation rate) remaining in negative territory. Generally speaking the RBA has been fairly upbeat on the outlook for the Australian economy however we are of the belief that any imminent rate rise remains unlikely until 2018.
The latest economic data out of China again surprised to the downside, with a weak August following on from an equally lacklustre July. Fixed asset investment, industrial production and retail sales were all weaker than expected. Industrial production increased by 6.0 percent, below the expected 6.6 percent, while retail sales expanded by 10.1 percent compared with the forecast 10.4 percent. Both the reading for Industrial output and retails sales were the weakest of 2017.
Perhaps of greatest concern was the 7.8 percent growth in fixed asset investment, which missed the forecast 8.2 percent rise to produce the slowest growth since 1999. As the Chinese economy modernises and shifts from an investment led economy to a consumption-driven economy a decline in fixed asset investment is to be expected. It’s nevertheless the rate of the decline that is of key interest so the focus in coming months will be on whether the deterioration in the data accelerates further.
Other than the appearance of a slowing growth profile when it comes to China, the other concerns centre on debt. S&P recently downgraded Chinas sovereign debt on rising “economic and financial risks”. For instance, China’s outstanding debt has basically tripled in the past 8 years while the number of companies in China with interest repayments greater than their earnings is growing. The issue however, is more pronounced in the state-owned enterprises, who are attributed approximately 80 percent of the debt burden but only 20 percent of the output. Interestingly the Liability-to-Asset ratio for state-owned enterprises has been increasing steadily over last 15 years, while the same ratio has actually been declining for privately run firms.
This leads us to believe that it’s not the debt load that’s the problem, rather it’s the inefficient allocation of debt. Going forward the focus of the Chinese authorities should be towards allocating capital into the hands of those private run firms who appear to be the more effective allocators of that capital. In recent times we’ve started to see evidence of this reallocation occurring. While corporate debt growth has slowed, households continue to increase their borrowing as a percentage of GDP.
China has announced its intentions to implement anti-pollution measures which look set to have a bearing on Australia’s commodity producers. It has been suggested that China iron ore demand could fall by 7 percent as Northern Cities cut back on steel production as the authorities look to clean up the environment. That comes at a time where the housing market is also showing signs of slowing as the number of Chinese cities with declining prices reached a multi-month high.
The recent weather events Hurricane Irma and Harvey have impacted US economic data of late, albeit the effects haven’t been as significant as expected. As always, the effects of one off events tend to be transitionary with other factors having a greater bearing on the economy. One of those factors is the currency, and a weak US dollar continues to support manufacturing activity which again surprised to the upside.
The question from here is whether the US dollar will continue to depreciate and improving US competitiveness further? History suggests that sentiment can perpetuate the trend further than fundamentals would have you believe, and at present the fundamentals as suggested by the 2yr Overnight Interest Swaps (OIS) market indicate the US should probably be higher.
As indicated earlier in 2018 the Federal Reserve will begin to unwind its balance sheet in October. The mechanics include a cap of US$10bn per month and will increase from there. The newly termed quantitative tightening (QT) program will only reinvest the amount of maturing securities above the specified cap level. In response to the news implied inflation expectations rose.
What did surprise economists, however, was the Federal Reserve’s commentary that appeared to show that they remain on track for a further rate rise in December. In response, the probability of a December rate rise jumped from around 20% to above 60%. It was clear from the statement, however, the Federal Open Market Committee (FOMC) remains concerned about the downward trend in inflation with Yellen stating, “What we need to figure out is whether the factors that have lowered inflation are likely to prove persistent” … “If they do it would require an alteration of monetary policy.” As such if we see a couple of weak inflation reads any chance of a December rate rise will diminish significantly.
Pleasingly the signs are that the labour market remains strong where labour force participation should, in time, boost wage growth. While hiring remains robust, the overall trend points to a slowdown over the past three years. The suggestion is that this is a result of a tightening labour market where the pool of available workers is gradually shrinking, which is to be expected once the unemployment rate falls below the natural rate of unemployment (NAIRU).
The Eurozone economy continues to show pleasing signs with regional powerhouses France and Germany delivering a set of strong numbers. Both France and Germany released composite PMI figures that both meaningfully exceeded market expectations, while French GDP is growing at the fastest rate since 2011, up to 1.8 percent. Increased competition amongst banks may well perpetuate the cycle further by easing credit standards and supporting stimulatory credit growth.
Germany’s business sentiment showed a surprising improvement as current business conditions continue to show signs of improvement. The recent round of German elections, however, may create an element of uncertainty. Despite Angela Merkle winning as expected, the nation’s far-right party won nearly 13.5 percent of the vote which for a country with the history of Germany raises a number of questions that are likely to place ongoing downward pressure on the Euro.
When looking at some of the regional laggards such as Italy, the news is equally as encouraging. Italy’s imports are growing faster than exports, while nonperforming loan balances are declining at a rapid rate. It had been feared that securitisations of the nonperforming loans had failed to materialise, however, those fears have subsided with a jump in securitisations in the September quarter. Elsewhere Portugal and Ireland had their debt ratings upgraded to investment grade, sending the respective bond spreads tumbling and stock markets rising.
Across the eurozone and the unemployment rate in the Euro remained unchanged at 9.1 percent which was in line with expectations. This is the lowest rate since February 2009 and a considerable improvement on the 10 percent rate at this time 12 months ago. Despite this improvement, relative to other large economies the Euro area continues to struggle with excess labour market slack.
Aristocrat Leisure (ALL) over the last 60 years have developed a portfolio of licences to manufacture gaming machines, a broad suite of products, and strong intellectual property. Although ALL has performed extremely well in recent years we don’t feel as though it’s too late to establish a position. The business continues to grow at a rapid rate, with earnings expected to increase between 20-30% for FY17 with a greater portion of earnings coming from recurring revenues.
ALL has a portfolio of very highly regarded electronic gaming machines in an industry with significant barriers to entry. A strong presence in the Asian markets also provides strong long-term growth opportunities.
Management have also taken steps to diversify into the digital space, moving away from a sole reliance on gaming machines for revenue. Profits in the digital space have increased 53.3 percent in the HY17 results and the company may receive an additional boost in the second-half from the acquisition of social gaming company Plarium, for an upfront amount of US$500 million in cash. We see this acquisition as providing Aristocrat with a new platform for growth in addition to its existing organic opportunities.
Since the acquisition, daily active users have increased 11.6% to 1.4 million and its average revenue per active daily user jumped 22.5% to 49 U.S. cents. The acquisition demonstrates the company’s ability to complete accretive deals and diversify into new businesses that which are largely unrelated to its core business.
The share price has retraced notably in recent weeks, most likely down to the rally in the AUD towards 80c. The company generates 2/3rds of its sales in US dollars and the recent appreciation in the AUD represents a headwind for earnings.
Orora (ORA) is a packaging and distribution business with a particular focus on Australasia and North America. An old spin out of Amcor, ORA offers investors a defensive exposure to food packaging and beverage markets where it boasts Coca-Cola and Fosters as major clients. Management continue to pursue a cost out strategy, where savings are extracted from newly built and more efficient packaging facilities, as well as headcount reductions. The cost reduction program has shown signs of success and is ongoing with the Australasian business delivering a 2 percent rise in Revenue and a 6.6 percent increase in EBIT highlighting margin expansion.
The beverages business accounts for 25 percent of revenue and exhibits the most favourable industry position for ORA, who hold 65 percent of the market share. When it comes to fibre business, ORA is the junior player in a duopoly with Visy, yet it still contributes the most to revenue at 40 percent. The remaining 35 percent of revenue is being derived from the packaging distribution business in North America.
ORA has invested heavily in recent years and the fruits of that investment are starting to flow through in the form of strong free cash flow generation and improving return on investment. Albeit a small player in a highly fragmented market, the growth prospects in the US remain attractive, particularly once improving industry margins are accounted for. Margins in the US business continue to improve, up 60 basis points to 5.8 percent for FY2017.
NextDC (NXT) is a data centre provider offering a range of services to corporate, government and IT companies. Data centre businesses tend to enjoy strong operating leverage as once built operating costs remain relatively fixed, while additional revenues are earned at minimal extra cost.
The company recently delivered a stunning 77 percent jump in net profit to $49m helped along by a 33 percent jump in revenue. The business has now clearly made the transition from a loss-making business with a heavy investment focus into a more mature cash generating operation.
In saying that however, the company remains focused on investing for growth. Management are in the process of investing heavily to upgrading capacity and develop market leading 5-star energy efficient data centres, which should help give the business a sustainable competitive advantage. The company has announced significant increases to previously planned capacity at its Brisbane (B2) and Melbourne (M2) centres to 40MW and 12MW respectively. FY18 will be a year of heavy investment with the benefits in the form of lower costs and improved win rates expected to flow through from FY19 onwards once scale is achieved.
The data centre operator has retraced slightly in recent weeks offering investors an opportunity to take a position in a high-quality business with significant sector tailwinds.
Ramsay Healthcare (RHC) is arguably a contrarian play given the negative sentiment in the market at present. RHC has now retraced over 25 percent from its $84.08 high reached in August 2016. In the most recent full-year financial results the company reported a 12.7 percent rise in its core net profit to $542.7m. Revenue growth was a less inspiring at 0.2 percent, albeit inhibited by unfavourable currency movements.
The domestic business continues to progress strongly, although the overseas operations which make up close to 50% of profits have underwhelmed of late. Tariff reductions in France hurt the international result with declining French and UK EBITDA’s likely to drag on companies’ earnings.
The market may be underestimating the capacity for weakness in the international business to be offset by the company’s expansion into the pharmacy space. Ramsay now has 55 pharmacies (more than the expected 35) and is expected to ramp the number up above 80 over the next few years, enabling the business to capitalise on the ageing population via chronic disease management rather than focusing only on acute treatment. The potential synergies to be extracted are likely to be significant and accretive to margins.
There is no doubt that the private hospital industry is transitioning through a couple of structural issues at present. The private health industry is being impacted at present by the inability of insurers to increase premiums without losing participation and forcing patients onto the public health system. This is having flow on effects for the likes of RHC, however the market in our opinion is penalising the company too harshly.
The company has now had its P/E ratio re-rated lower by the market to levels not seen since 2013. For a company still expected to deliver 10 percent EPS growth for FY18, we feel at 25x earnings RHC is reasonable value with strong historical support levels around $60.
Platinum Asset Management (ASX: PTM) is an Australian fund manager specialising in investing in international equities. Managing director and founder Kerr Neilson retains 53% ownership of the businesses that have gone through a challenging period over the last few years. Funds under management for FY 2017 fell 9.6 percent or $3.6 billion to $23.4 billion, the worst ever decline, that resulted in a 7.4 percent reduction in net profit.
Funds management businesses are highly scalable in that as funds under management rise, management fees, admin fees and potential performance fees tend to follow suit provided costs growth remain flat. Naturally, the opposite is true as well and PTM has suffered from that in recent years but as the tide turns the potential upside is notable.
PTM remains unpopular amongst the analysts however we believe the business appears to have reached an inflection point with fund outflows ceasing and momentum starting to build as fund inflows accelerate. The flagship international fund continues to materially outperform its peers which in time we believe will attract further fund inflows. Relative to its peers we feel PTM has superior business momentum and share price upside.
Despite the negative business momentum in recent times, the balance sheet strength and cash flow generation remain attractive attributes, allowing the company to maintain a high dividend payout ratio. As it stands we expect the business to payout a 5 percent fully franked dividend in FY2018, providing support to the share price in a market still desperate for income.
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