The most (and the least) profitable companies on the ASX200

In early May the major Australian banks collectively reported profits for their last six months of A$15.3 billion dollars. This resulted in some media commentary about banks being too profitable, especially as three of the banks reported in the middle of the Royal Commission into the financial services industry, which had highlighted examples of inappropriate financial advice and problems issues with lending standards.

Whilst large corporations generate large profits in dollar terms, what is often ignored in much of the debate on corporate profitability is that these profits have to be shared amongst millions of individual shareholders.

For example, collectively the banks made $15.3 billion, however, divided by 10.8 billion bank shares outstanding this crude measure equates to a mere $1.42 per share. In this piece we are going to look at different measures of corporate profitability for large Australian listed companies, looking beyond the billion dollar headline figure.

Different Measures of Profitability

As a fund manager, the $4.25 billion of cash profit generated by Westpac over the past six months does not mean very much. As an investor, I am most concerned with the underlying earnings per share (EPS), which is what the owner of a single share of the company receives from the profit generated in a particular year. In Westpac’s case, their cash earnings per share compared with the first half of 2017 grew 4.3% to $1.25 – nice growth but not particularly exciting.

We also look at growth in EPS, as often a company’s profits can grow substantially when they make an acquisition. However, if that acquisition is funded by issuing a large number of additional shares, profit per share might not actually grow. Conversely, a company’s profits may be down, but if this is due to the selling of a non-core division it could be a good result for shareholders. For example, earlier this month ANZ Bank reported a 16% decline in cash profits due to the sale of their Asian retail banking businesses. As the proceeds from the sales were used to buy back ANZ Bank shares, their earnings per share actually gained 4%. Additionally, at a company level, we also look at measures such as returns and profit margins, which can be better measures of how efficient a company’s management team is in generating their annual profits. Furthermore, these measures allow the investor to compare different companies in similar industries.

Return on Capital Employed

Return on Capital Employed (ROCE) looks at the profit generated both by the capital that the equity holders have contributed to establish the business, as well as the debt taken on to support the business’ activities.

ROCE is calculated by dividing a company’s profit before interest and taxes by the shareholders’ equity plus debt. The investment by shareholders includes both original share capital from the IPO plus retained earnings.

Retained earnings are the profits kept by the company in excess of dividends and are used to fund capital expenditure either to maintain or to grow the company. Companies with high ROCE typically require little in the way of equity to keep the business running and little need to borrow from their bankers.

The above chart shows the top and bottom companies in the ASX as ranked by ROCE. The top ROCE earners include:

  • a milk company (A2M),
  • three fund managers (Magellan, Perpetual and Pendal),
  • a healthcare company (Cochlear), as well as
  • an internet services companies (REA and Carsales).

The common factor in these businesses is minimal ongoing capital expenditure to run the company.

Bringing up the rear are a range of capital-heavy businesses that require both large amounts of initial capital to start the business and regular capital expenditure to maintain the quality of their assets and finance their ongoing activities. This subset includes a gain handler (Graincorp), logistics (Qube), retailer (Myer), healthcare companies (Healthscope and Primary), and an energy company (Santos). Typically when looking at this measure, miners, steelmakers, wineries and Qantas are prominently featured amongst the lowest returning businesses as they are operating in capital-hungry industries. However, in 2018 these three industries are currently enjoying cyclically strong earnings.

Profit margin

Profit margin is calculated by dividing operating profits by revenues. It measures the percentage of each dollar received by a company that results in profit to shareholders. Here we have used earnings before interest, taxes and depreciation as it allows us to compare companies across different industries with different capital structures, and this margin is for the six months ending December 2017.

Typically low margin businesses operate in highly competitive mature industries. The absolute profit margin is not always what investors should look at when analysing a company’s results, but rather a change in this margin. A rising profit margin may indicate a company enjoying operating leverage as profits are growing at a faster rate than costs. Conversely, a declining profit margin could indicate stress and might point to large future declines in profits.

From the above chart, the highest profit margins are generated by companies that are fund managers enjoying the operating leverage mentioned above (Platinum and Magellan), monopolies (ASX), internet businesses (REA), or energy companies (Woodside and Oilsearch).

The energy companies enjoy a high-profit margin, as once the large offshore LNG trains are built these assets have a low marginal cost of production per barrel of oil. Obviously, this metric does not account for the tens of billions in capital required to build these giant projects. BHP features in this list courtesy of the 60% profit margin that the Big Australian earns from digging up iron ore in the Pilbara when iron ore prices are around US$70 per tonne. Low profit margin companies characteristically receive large revenues but operate in intensely competitive industries such as petrol retailing (Caltex), grocery retailing (Metcash, Woolworths and Wesfarmers), department store (Myer), and construction (Lend Lease).

Companies with low profit margins are obviously forced to concentrate closely on preventing their profit margins from slipping, as a small change in their margins is likely to have a significant impact on the profit available for distribution to shareholders. For example Metcash’s food distribution business runs on a very slim profit margin, such that when the business faced declining margins in 2014 they were forced to cut their dividend, which was not reinstated until 2017. For this reason, we monitor the net interest margins of the banks very closely

Our take

While the banks and the large miners (BHP and RIO) generate large absolute profits resulting in headlines around the billions of dollars they earn, they are generally not among the most profitable large listed Australian companies in terms of profit margins and returns on assets. Over the last six months, Commonwealth Bank’s 48,900 employees produced a $4.7 billion profit, but this represented a return on assets of 1.03% and a profit or net interest margin of only 2.16% on a loan book of $962 billion. When looking at companies to include in the Maxim Atlas Core Australian Equity Portfolio, the indicators of earnings power that we look at is not the headline number, but rather its return on capital or equity and changes in profit margins.

AFR: CSL delivers profit upgrade on better sales

Atlas Funds Management chief investment officer Hugh Dive said that after the latest upgrade CSL was trading on around 35 times forward earnings. Mr Dive, who is a major shareholder, cautioned that a lot of the good news was already priced into the stock.

“There are three things to the upgrade: Seqirus is performing well, higher than expected sales of the two specialty plasma products and the phasing of investment in the heart attack clinical trials – so two of three are considered to be high quality components,” he said.

“Of the $US130-odd million upgrade, the market would like to know what is the contribution of new sales revenue versus timing spend on the clinical trials, a cost which is being shifted into 2019.”

CSL delivers profit upgrade on better sales, flu season

CSL has delivered its second profit upgrade this year on improved sales of its hemophilia drugs and a bad northern hemisphere flu season, propelling its share price to a record high and and market capitalisation above that of two of the four big banks.

 

Banks Reporting Season Scorecard May 2018

The last few months have been tough for shareholders in the major Australian financial services companies, who have seen their share prices drift lower throughout March and April. Evidence of misconduct presented at the Royal Commission on Financial Services has fed market fears that bank profitability will be diminished in the future. However, over the past ten days, the major banks have reported their profit results for the past six months, showing the market how their underlying businesses are performing and how the management teams plan to address the issues raised at the Royal Commission.

In this piece, we are going to look at the common themes emerging from the banks in the May reporting season. We will differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Simplification

The main new theme to emerge from this reporting season was that banks are looking to reduce their footprint on the Australian financial services landscape, by divesting businesses that are deemed to be non-core. This results season was characterised by complexity arising from either announcements of new significant moves, or that were complicated by sales made in 2017.

In May Commonwealth Bank announced plans to spin off their wealth management business Colonial First State, which followed the sale of the life insurance business in 2017. ANZ’s result was complicated by the sale of both their wealth management and life insurance businesses in 2017. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac continued to reduce its stake in BT Investment Management (now renamed as the Pendal Group). These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. Whilst some of these moves to sell these carefully constructed divisions may be attributed to the events of the Royal Commission, some of these sales were consummated well before the titans of Australian finance faced the harsh light of the witness stand.

 

Profit growth

Across the sector profit growth was roughly in-line with the credit growth in the overall Australian economy. Westpac reported the strongest cash earnings growth across the banks courtesy of keeping costs under control, very low bad debts, and the sound performance of their core domestic businesses. NAB brought up the rear in May due to the combination of weaker revenue and elevated costs even when the restructuring charges are excluded.

 

 

Gold Star

Bad debts

One of the biggest drivers of earnings growth over the last few years has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. This resulted primarily from a buoyant East Coast property market and higher commodity prices. Further, at the big end of town there were no major corporate collapses over the past six months which kept corporate bad debts low.

Westpac gets the gold star with a very small impairment charge courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

Gold Star

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 1 cent over 2017. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks) – but not both. In the recent set of results, the banks have held dividends steady to boost their Tier 1 capital ratios to get close to the APRA mandate of a core tier 1 ratio of 10.5%.

Looking ahead, there may be some capacity to increase dividends as the rebuild of bank capital to APRA’s standards is largely complete. ANZ shareholders can expect capital returns in the form of further on-market share buy-backs as the proceeds from the sale of their wealth management and insurance businesses are received. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.9%.

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate increased slightly in 2018, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans onto higher rates. In response to regulator concerns about an overheated residential property market – and in particular the growth in interest-only loans to property investors – the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac currently charges 6.3% on an interest-only loan to an investor, which contrasts to the 4.44% being charged to owner-occupiers paying both principal and interest. This has had the impact of boosting banks’ net interest margins, though these gains will tail off as borrowers switch to principal and interest loans.

One of the key things we looked at closely during this results season was the impact of the May 2017 Major Bank Levy on the various banks’ margins. It was apparent from looking at the numbers that this levy was passed on both to borrowers in the form of higher rates, and to depositors by offering lower rates on term deposits.

 

 

Gold Star – Australian banking oligopoly

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, while also trailing the ASX 200 which has gained 2%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. CBA has been the worst performing bank as it has seen its CEO ushered to the door, faced fines for not complying with anti-money laundering laws, and has faced uncertainty around the potential impact of changes implemented based on recommendations from the Royal Commission.

No stars given

Our Take

How to approach investing in the Australian banks is one of the major questions facing both institutional and retail investors alike. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth, increased regulatory scrutiny, and the sale of some of their insurance and wealth management divisions. However, if investors examine the wider Australian market the banks look relatively cheap, are well capitalised, and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends. Additionally, their share prices are likely to see support over the next 12 months from share buybacks, as the proceeds from the sales of non-core assets come through.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

Monthly Newsletter April 2018

  • In April the Fund gained +3.4%, which was ahead of expectations given our lower risk portfolio positioning.
  • After having a poor start to 2018 due to selling based on macroeconomic factors rather than fundamentals, the Listed Property Index rebounded sharply in April led by retail and industrial trusts.
  • The main highlight in April was the quarterly updates provided by the retail landlords. After a weak December quarter, the owners of Australia’s shopping centres reported retail sales growth of between 2-3% for the March Quarter. Whilst apparel sales were weak, this was offset by growth in food catering, cosmetics and personal services. This suggests to us to some success remixing the stores in Australia’s shopping centres.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.