October was a weak month, with global markets continuing to fall for the third month in a row, driven by expectations of more rate rises to combat the stickier-than-expected inflation. There was nowhere to hide in global markets, with the S&P 500 down -2.2%, the NASDAQ down -2.8%, and the ASX200 down -4%.
The Atlas High Income Property Fund pulled back by -5.6% despite several companies in the Fund reporting robust quarterly earnings. Indeed, the two toll roads held in the Fund reported quarterly profits on record average traffic and inbuilt inflation-linked toll escalators.
Concerns of higher inflation and rising geopolitical tensions have dominated the last three months quarter, with many trusts having share prices below what they were during the middle of lockdowns in mid-2020 when they faced an uncertain future and were having trouble collecting rents. Conversely, in October 2023, many generated profits higher than pre-CV19 levels and enjoyed close to full occupancy. Early November has seen a sharp recovery, with October’s losses recovered in the first few days of trading.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2024.
In October each year, listed Australian companies with a June financial year end host their annual general meetings (AGMs). Fund managers rarely attend these events as they are designed to allow retail investors to pose questions to company management and vote on directors and the company’s remuneration report. Institutional investors do not vote in person but rather by instruction to the custodians holding their fund’s shares. They would have met with company management in August when they released their financial results.
In this week’s piece, we will look at the quarterly trading updates given by a range of Australian companies to try and piece together what is going on in the Australian economy. While the broad-based fall in share prices since mid-September suggests that companies are struggling, the quarterly updates showed robust trading conditions for many Australian companies.
Normally, we don’t pay much attention to AGM’s and the trading updates given by management are usually very similar to the conditions the company was facing in August.
However, this October has seen greater interest in company updates at the AGMs due to the sharply changing economic conditions. Over the last 18 months, the average mortgage rate has increased from 2.14% to 6%, along with cheap fixed-rate mortgages converting into higher variable rates dubbed the “fixed rate cliff” by the media. This should have seen cratering retail sales in 2023 and significant falls in house prices, neither of which have occurred. Additionally, increases in inflation of the same period have posed challenges for many companies.
Consequently, Atlas has been looking closely at management presentations over the past two weeks at company AGMs. While some companies are exhibiting signs of weakness, the October updates showed that many Australian companies are navigating the changing environment quite well.
Retail Mixed
The non-discretionary grocers had a good start to their years, with Woolworths and Coles posting sales growth of over 5% for the first quarter. The grocers both mentioned that food inflation is moderating in late 2023 to between 2-3%, with the prices for some items such as fruit, vegetable and packaged meat now falling. Higher interest rates have seen shoppers trading down to cheaper home brand items, which deliver a higher profit margin, with Woolworths citing an 8% increase in home brand sales. Liquor retailer Endeavour saw modest sales growth at BWS and Dan Murphy’s of 1.8% and, like the grocers, experienced value-conscious customers trading down to mainstream beer and lower priced rosé and pre-mixed drinks.
JB Hi-Fi’s first quarter was much better than expected, with Australian sales falling -1.4%, cycling off a very strong first quarter last year. Conversely, electrical goods rival Harvey Norman saw Australian sales falling by -14% but announced a surprise $440 million on market buy-back as a salve for investors. Atlas’ calculations indicate that the company will be borrowing to buy back their shares, an aggressive move from an already highly geared company in a market with rising interest rates and weakening retail sales. JB Hi-Fi appears to be benefiting from their lower cost business model, which has seen them take market share off Harvey Norman.
Wesfarmers produced a fantastic first-quarter result, demonstrating that consumers are still willing to spend money and trade down to lower-cost products across their offerings. We see that Bunnings and Kmart, the lowest-cost operators across the hardware and discount department store markets, will continue to benefit and take market share over the short-medium term.
Miners facing cost inflation
The iron ore producers had in-line first quarters and are continuing to benefit from higher iron ore prices but will face headwinds over the coming months and years. BHP, Rio Tinto, and Fortescue are all facing inflationary problems, with higher oil prices set to be higher for longer and ongoing labour costs, which will increase production costs. We remain cautious towards the iron ore producers due to concerns about the sustainability of iron ore prices above US$100/t in the face of a slump in Chinese residential construction and a government plan to cap steel production at 1 billion tons per annum.
Energy powering ahead
Woodside Energy had a solid quarter, with production up +8% to 48 million barrels of oil. The company also announced that they had started producing at a new field in the Gulf of Mexico, which was six months ahead of expectations which saw full-year guidance being upgraded. Woodside has little exposure to a weakening Australian consumer, selling energy into a global market primarily via long-term off-take agreements to utilities in Japan, China and Korea. Stronger energy prices in the latter part of 2023 and a weaker Australian dollar are setting Woodside up for a strong finish to the year. Similarly, oil refiner and petrol retailer Ampol released a stellar quarterly update in October, showing that profits were up +65% on the previous quarter. The company continues to benefit from higher fuel sales, strong margins from refining crude and, surprisingly, an increase in convenience retail sales. We had expected a big fall in convenience retail sales for Ampol due to higher petrol prices, but motorists are still buying Gatorades, Mars bars and Guzman y Gomez burritos after filling up!
Toll Roads Stronger than Ever
After the Ampol quarterly that showed Australian fuel sales were up +11%, it was not a great surprise to see the toll road operators report strong traffic numbers in October. Transurban reported record quarterly average daily traffic across their network with 2.5 million trips per day, with traffic up +3% on the prior period. Similarly, Atlas Arteria saw traffic up +2.3% in the past quarter, mainly in their French assets, with revenue up a healthy 6.1%. Due to the impact of quarterly escalators on their inflation-linked tolls and long-term fixed-rate debt, higher traffic will see expanding profit margins.
Healthcare robust, but weight loss Fears Dominate
The past quarter has been tough for investors in healthcare stocks, with the dominant theme being concerns that GLP-1 weight-loss drugs will impact demand for a range of therapies treating sleep apnea, cardiovascular diseases and kidney damage. Indeed, these weight loss drugs have even impacted the share prices of pathology testing companies under the assumption that a potentially slimmer society will result in fewer oncology, fertility, gastrointestinal and respiratory tests.
Resmed has seen its share price hit the hardest, losing a third of its market capitalisation due to the view that slimmer patients will see diminished demand for sleep apnea devices. While this may occur in the future, Resmed’s quarterly update showed revenue of +16% and profits up +9%. Similarly, CSL’s share price has been under pressure due to the unproven potential of the GLP-1 weight-loss drugs on the company’s kidney disease treatments, despite dialysis comprising a small part of company earnings. At their annual capital markets day in October, CSL revealed that the company was trading strongly and confirmed guidance for profit growth in 2024 between 13-17%.
Out Take
Global equity markets have fallen by close to 10% over the last three months, and at the close of October 2023, many companies on the ASX200 are trading near or even below the lows of March 2020 despite having better business operations and higher profits in 2023. Toll road operators Transurban and Atlas Arteria are trading at a 25% discount to their pre-COVID share price despite higher traffic volumes and toll prices. Similarly, healthcare companies Sonic Healthcare and CSL both have share prices below January 2020 despite having higher earnings per share and servicing more customers worldwide. While some companies will struggle in an environment where money is no longer free or falter due to higher geopolitical tensions, for many companies, these factors will have limited to no impact on corporate profits and distributions to their shareholders.
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine” – Warren Buffett.
September was a weak month, with global bond yields rising to Global Financial Crisis levels driven by macroeconomic concerns around higher interest rates and oil prices. This saw global stock markets uniformly fall between -3% and -5%. There were also few places to hide in Australia Listed Property, which fell -9% on concerns for rising interest rates reducing profitability for property and infrastructure assets.
The Atlas High Income Property Fund pulled back by -6.2%, a fall based on global macroeconomic fears rather than any specific issues with the companies held in the Fund. In aggregate, the companies held in the Fund have an average occupancy rate of 99%, with lower gearing, lower interest costs and a longer tenor of debt than the wider Australia Listed Property index. Despite this, the companies held by the fund trade at an average discount to net assets of -19%, with this net asset value backed up by actual transactions in the direct property market.
The Fund declared a quarterly distribution of $0.027 per unit for the September Quarter. The distribution was paid to investors earlier this week.
Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2024.
Editor’s Note: This article provides general, educational information on investor resilience and dealing with occasional sharemarket losses. Every investor is different, so seek advice from a licensed financial adviser or do further research of your own before acting on themes in this article.]
Last month, Commonwealth Bank reported a record annual after-tax profit for the 2023 Financial Year of $10.1 billion. CBA’s profit result was viewed as controversial by some Corporate earnings’ obscene’ as CBA posts record profit, say Greens. However, this specious analysis ignores the fact that the “large” headline profit number must be divided by the 1.67 billion CBA shares on issue.
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 must be shared amongst millions of individual shareholders. 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, which frequently does not tell investors how efficiently management is running the business or how well they are using the capital given to them. This piece originally was published in Livewire.
Different Measures of Profitability
As a fund manager, the $10.1 billion of cash profit generated by Commonwealth Bank over the past twelve months does not mean very much. Investors should be 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 CBA’s case, their cash earnings per share in the 2023 financial year compared with last year grew 5.9% to $6.06 – nice growth but not particularly exciting.
We also look at growth in EPS, as often, a company’s profits can grow substantially when it makes an acquisition. However, if that acquisition is funded by issuing a large number of additional shares, profit per share might not actually grow. This has been the case with fund manager Perpetual, which has increased net profit over the past five years from A$116 million to A$163 million in 2023. However, earnings per share have declined from $2.46 to $1.97, as the increase in profit was derived from acquisitions funded by dilutive equity issuances.
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. In 2019, Suncorp sold its smash repairs and life insurance businesses, with the proceeds recycled into a share buy-back and a special dividend. Suncorp has increased annual earnings per share by +15% despite selling two businesses since 2019.
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 at generating its annual profits. Furthermore, these measures allow the investor to compare companies in similar industries. For example, the profit margins of Coles and Woolworths or NAB and Westpac are compared on results day to evaluate how the different management teams are navigating the prevailing economic conditions.
Return on Capital Employed
Return on Capital Employed (ROCE) looks at the profit generated by the equity holders’ capital to establish the business and the debt that is 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 the company keeps in excess of dividends paid and are used to fund capital expenditure to maintain or grow the company. Companies with high ROCE typically require little in the way of equity to keep the business running, little need to borrow from their bankers and are generally seen as good investments.
The above chart shows the top and bottom companies in the ASX as ranked by ROCE. The top ROCE earners include a lithium company (PLS), three coal companies (Whitehaven, Coronado and New Hope), a healthcare company (Promedicus), as well as cloud-based software provider (Technology One). Qantas appears high on this list for FY2023 as the net equity position of the airline is a mere $5 million due to accumulated losses, share buy-backs, and net debt of $2.9 billion. We would not expect Qantas to feature as highly in future years as the company spends between $12 and $15 billion to update its fleet after years of underinvestment in aircraft.
The common factor in these businesses is high commodity prices, low or no debt and minimal ongoing capital expenditure to run the company. The three coal companies are in an interesting position. Typically, high commodity prices result in takeovers and significant capital expenditure to expand existing mines, both of which result in higher levels of debt and equity issuance that expand a company’s capital base. Due to difficulties in getting approvals to expand mines and concerns about banks in the future refusing to lend to coal companies, management teams had paid down debt. This places the companies in a net cash position. Additionally, the companies have conducted on-market buy-backs to shrink their capital base. This results in high return on capital positions for the three coal miners.
Bringing up the rear is 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. For the purposes of this analysis, Atlas has only included companies that generated a profit in FY2023. This subset includes food companies (Bega and United Malt Group), a construction company (Lend Lease), a telco (TPG) and an embattled casino company (Star Entertainment).
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 2023, these three industries are currently enjoying cyclically strong earnings. Return on capital employed is a measure not used to evaluate banks due to the sheer size of total assets on the bank balance sheet used to generate profits – in CBA’s case, 2023, $1.25 trillion.
Profit margin
Profit margin is calculated by dividing net profits by revenues. It measures the percentage of each dollar a company receives that results in profit that can be paid to shareholders. 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 faster than costs. Conversely, a declining profit margin could indicate stress and might point to large future declines in profits.
From the above chart that looks at the profit margins for ASX for the six months ending June 2023, the highest profit margins are generated by companies that are miners with operating mines enjoying high lithium and coal prices (PLS, IGO, Whitehaven and Lynas), royalty trust (Deterra), medical software (Pro Medicus) and energy company (Woodside).
Mining and energy companies enjoy high profit margins, as once the large offshore LNG trains or mines are built and operating smoothly, these assets have a low marginal cost of production per barrel of oil or tonne of ore. This metric does not account for the tens of billions in capital required to build these giant projects. The highest margin company on the ASX 200 is Deterra Royalty Trust, which is somewhat of an anomaly in that it does not actually operate an iron ore mine in the Pilbara but rather collects a quarterly royalty payment of 1.23% of the value of iron ore sold by BHP mined in its royalty area.
Low-profit margin companies characteristically receive large revenues but operate in intensely competitive industries such as grocery retailing (Metcash), fast food (Dominos Food, Collins Food) labour intensive healthcare and engineering (Ramsay Health, Worley), and petrol retailing (Viva Energy). Toll road operator Transurban made the list in 2023, making a minuscule profit despite toll roads being very profitable and high-margin businesses. Typically, the company’s $1 billion non-cash depreciation and the small $100 million annual maintenance capex charge allow Transurban to avoid making a statutory profit yet deliver healthy free cash flows to pay distributions to shareholders.
Generally, 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 impact the profit available for distribution to shareholders significantly.
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 53,754 employees produced a $10.5 billion profit, representing a return on assets of 0.8% and a profit or net interest margin of only 2.07% on a loan book of $926 billion. When looking at companies to include in the Atlas Core Australian Equity Portfolio, the earnings power indicators are not the headline number but instead its return on capital, dividend and earnings per share growth as well as changes in profit margins.
