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What we have learned from reporting season

During the months of February and August every year, the majority of Australian listed companies reveal their profit results and most provide guidance as to how they expect their businesses to perform in the upcoming year. Whilst we regularly meet with companies between reporting periods to gauge how their businesses are performing, during reporting season companies open up their books to allow investors a detailed look at the company’s financials. As company management have been on “black out” (prevented from speaking with investors) since mid-June, share prices in the six weeks leading up to the result are often influenced by rumours and theories, rather than actual financials.

Yesterday marked the final day of the August 2017 reporting season. Those listed companies that have not reported their results are probably suspended from trading today, inevitably blaming accountant incompetence or coming up with creative excuses for the ASX as to why they were unable to submit their accounts. In this piece, we are going to run through the key themes that have emerged over the last four weeks and how our companies have performed.

 

 

 

 

 

 

 

Growth

August 2017 was a pretty solid reporting season with Australian listed companies (ex resources) reporting earnings growth of +6%. This expands to +17% profit growth when you include the miners that have benefited from high commodity prices courtesy of a 2016 Chinese stimulus plan.  Whilst 6% might not sound very impressive, it is a big jump on the paltry +0.2% recorded in August 2016. Having listened to close to eighty management presentations over the past four weeks, the general tone feels more positive towards the future than it has been in recent years. This sentiment can be seen in the aggregate guidance for industrial companies for profit growth of +5% over the next 12 months.

No room for disappointment for high priced market favourites

One of the key themes coming out of this reporting season has been the harsh treatment meted out to high price to earnings (PE) stocks that deliver less than market expectations. Pizza/tech company Dominos Pizza (-18%) was priced on a PE of 60x but fell heavily after delivering only 28% earnings growth. Similarly, the market was unhappy with hospital operator Healthscope (-15%) which was trading on a PE of 22x and was sold off after reporting a 6% decline in profit due softer revenue growth from the company’s private hospitals  and project delays.

Whilst not a high PE stock, Telstra (-8%) is a core part of the portfolio for many retail investors who sold down their holdings after the company announced that they would cut their 2018 dividend to 22 cents per share from 31 cents per share.

Giving money back to shareholders

Capital management was again a prevalent factor in the recent reporting season and was understandably of interest to investors, more so in 2017 than it has been in recent years. We considered this topic in our recent pieces Give me my money back and bad and fake buy backs . In our view, the factors contributing to the 17 large companies that announced buy-backs in August are the perceived lack of investment opportunities, the level of balance sheet repair (paying off debt) that has occurred over the past few years, and the capacity for a buy-back to direct investor attention away from issues a company might face, thereby supporting the share price.

Treasury Wine (+19%), S32 (0%), Qantas (+7%), Rio Tinto (+5%) announced new share buy-back plans that have had a positive influence on their share prices. Alternatively, for BlueScope (-18%), and Dominos (-18%) investors looked past the carrot offered by the buy-back.

Whilst buy-backs boost share prices in the short term, in the longer-term companies do need retain cash to reinvest in their operations in order to grow earnings in the future without adding to debt.

Paying off the mortgage

In an environment of stronger than expected cash flows, companies either have the option to return money to shareholders in the form of higher dividends, or pay down debt. Whilst balance sheet repair has been a feature over the past two years, this reporting season showed several companies making big moves to pay down their debt. BHP (+6%) resisted the urge to follow Rio Tinto’s lead in announcing a buy-back funded by the sharply increased profits from high commodity prices. Instead management reduced the company’s debt burden from US$26.1 billion to US$16.3 billion.  This action did however come at a cost, with BHP paying several hundred million in fees for the early redemption of bonds.  Similarly, high Australian electricity and gas prices and asset sales allowed Origin Energy to reduce net debt by A$1 billion to A$8.1 billion.

Best and worst results

 

Over the month the best results were delivered by Treasury Wine, Alumina, Orora, IOOF and Medibank. The key theme amongst this diverse group of companies all in different industries was a strong profit result and expanding profit margins combined with a positive outlook for 2018.

On the negative side of the ledger Vocus, Dominos, BlueScope, Healthscope and QBE Insurance all reported disappointing results compared with other companies. The common themes amongst this group was either high price-to-earnings rated companies not delivering on high expectations, or companies that had downgraded expectations and then delivered results that were worse than the lowered expectations.

How have we gone

Whilst stock prices were volatile late in the month due to concerns over the launch of North Korean missiles, for the companies owned by the Atlas High Income Property Fund, August revealed a generally benign set of financial results. Using a weighted average, portfolio companies delivered earnings growth of +6% and grew distributions by an average +3.7% over the previous year. Additionally, 4 of the 12 trusts in the portfolio announced buy-backs.

 

Bad and Fake Buy-backs

Earlier this month casino operator Crown Resorts announced a buy-back of up to 4.2% of its outstanding shares, which builds on the $500 million of stock the company had already bought back over the past 12 months. Despite this prima facie positive announcement Crown has fallen 9% in August as the market looked past the buy-back and focused on concerns about returns from the $1.5 billion Sydney Casino.

In last week’s piece give me my money back, we looked at buy-backs that have a positive influence on a company’s share price. However, as you can see with the Crown example, buy-backs are not always positive. This week in the second part of our deeper dive into buy-backs, we are going to look at bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Bad Buy-backs

Theoretically, a company should raise capital when the market is over-valuing their company, and buy back their shares when the market is undervaluing their company. One of the greatest examples in history of a company using their over-valued stock to make an acquisition was dial-up internet company AOL’s US$164 billion purchase of Time Warner in 2000. By issuing shares, AOL shareholders ended up owning the majority of the new media entity, despite Time Warner having significantly more assets and revenue, and ultimately a viable business. In 2009, Time Warner spun off AOL for $3 billion, 2% of the entity’s value in 2000.

Buybacks should only be pursued when management is very confident the shares are undervalued, as companies are no different than regular investors. If a company is buying up shares for $20 each when they are only worth $10, the company is clearly making a poor investment decision

Lack of options

Sometimes buy-backs may be taken as a signal of a lack of attractive growth opportunities in which the company can invest. Particularly in the case of cyclical companies such as miners and airlines, bad buy-backs are conducted after a period of buoyant activity. They are typically done at the top of the cycle, when the costs to develop news assets or buy competitors are at their highest. Whilst this is clearly preferable to a large acquisition such as Rio Tinto’s purchase of Alcan, this approach to capital management often this leaves the company operating in a cyclical industry vulnerable during the inevitable downturns. We view that in some situations it may be best for companies to hoard cash at the top of the stock-market cycle and use it in the next trough to buy back shares at a discount or buy the assets of distressed competitors.

This week BHP resisted the urge to follow Rio Tinto’s lead in announcing a buy-back funded by the sharply increased profits from high commodity prices, ultimately funded by a 2016 Chinese stimulus plan. By paying off debt, BHP may have more options when commodity prices come off.

Offset dilution from executive stock options

Another situation where buybacks are not positive is where they are done to offset the dilution from executive stock options being exercised. This is more common in the US where stock options often form a bigger component of remuneration, but here there is no earnings per share accretion as the number of shares on issue don’t change. This is a poor outcome for shareholders, as the new shares issued to executives via stock options are exercised at a discount to the prevailing share price and those bought via buy-backs are bought on market at the current price! In 2015, IT networking company Cisco Systems bought back 155 million shares, but after the effects of employee stock compensation it only reduced the total shares outstanding by 38 million. Here the buy-back is not capital management, but executive remuneration.

Short term sugar hit to the share price

Many listed companies award senior management bonuses based on the share price of the company they manage. This provides management with an incentive to recommend actions that may deliver a short-term boost to the company’s share price, such as a large buy-back delivering earnings accretion over a long-term investment opportunity. Companies deliver long term growth in their business by investing in future growth.

Buy high sell low

When a company either issues new shares to the market via a placement or buys back their own shares, they are effectively acting as a fund manager in valuing their own shares, making a judgement as to whether their shares are cheap or expensive. However, company management teams have access to a far greater array of information on their company’s finances and future prospects than an external investor could ever hope to have.

Qantas has a long history of capital management, buying back $506M worth of stock in 2008 (average price $5.56), $100M in 2013 (average price $1.45), $500M in 2016 (average price $3.50), and $366M in 2017 (average price $3.32). However in between was a large equity issue of $525 million shares QAN issued at $1.85 in 2009, and in 2014 Qantas’ debt was rated as junk, as the CEO lobbied the federal government for a bail-out of the then embattled national carrier.

 

 

Similarly, steelmaker BlueScope is currently buying back stock over 80% above the level at which it issued over $2 billion in equity not so long ago. Certainly, this has pushed up the share price along with some solid profit growth. However, one may think that retaining capital rather than buying-back shares could prove to be a more prudent cause of action for the steel company. Two years ago, BlueScope were seeking assistance from the government with their struggling Port Kembla steelworks in New South Wales and the company announced a $1 billion loss in 2012!

Fake Buy Backs

In some situations, the company announces the buy-back and enjoys a short-term bounce in the share price without actually buying much in the way of stock. In the listed property trust space, the buy-back often acts to support the price at NTA. For example, in 2014 SCA Property Group announced its intention to undertake an on-market buy-back of up to 5% of its units, as the price jumped above NTA ultimately no units were bought and the buy-back faded into the ether.

Unlike property trusts that have a reference point of net tangible assets per share, it is harder for industrial companies to justify announcing a buy-back and then sitting on their hands. Building materials company CSR last bought back a share in its $150M buy-back in late September. Platinum Asset Management are yet to open their wallet for their $300M share buy-back, also announced last September. Insurer QBE announced a $1 billion buy-back in February, but bought their first share back on 21 August.

Our take

Whilst we are generally in favour of companies returning excess capital to investors rather than retaining it, we concede that not all buy-backs are in the best long-term interest of shareholders. Companies that are returning all their earnings to shareholders may not be investing in research and development or new growth projects. These strategies are necessary to generate returns over the longer term that are ahead of inflation.

 

 

 

Give me my money back!

Two weeks ago, shopping centre owner Vicinity announced it would buy back up to 5% of its stock on market after it delivered its full-year results on August 15. This delivered investors an immediate 5% bounce in the trust’s share price, as the market anticipated over $500 million of Vicinity’s stock being repurchased over the next 12 months.

In this week’s piece, we are going to look at share buy-backs and why they generally have a positive influence on a company’s share price. However, buy-backs are not always positive. Next week in the second part of our deeper dive into buy-backs, we will analyse the bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Buy-backs are almost universally popular with investors as they not only reduce the number of shares outstanding by which to divide a company’s profit, but they return certain capital to investors today, rather than waiting for an uncertain return tomorrow. This is important, in light of the numerous occasions where company management teams have frittered away excess cash on questionable acquisitions or hastily conceived expansion plans designed to buy growth or move into new markets.

Types of buy-backs

There are essentially two ways that a company can repurchase or buy-back its shares. They can do it on-market using a stock broker, or off-market by inviting shareholders to tender their shares for repurchase. Off-market buy backs are generally done by companies such as BHP that have large balances of franking credits, as the buy-back can be structured in a tax-effective manner for domestic investors by returning a combination of cash and tax credits. Companies such as CSL that earn the bulk of their profits offshore are more likely to buy back their shares directly from investors on the ASX as they don’t have excess franking credits.
Occasionally companies will limit the buy-back to a particular investor, though this is usually very poorly received by the wider investor base. The last company that tried to do this was Woodside in 2014 when it offered the equivalent of $48 per share to buy back$2.7 billion in shares from Shell. This failed to get shareholder approval and with the share price currently around $29, it was clearly the right move for shareholders to block this move. Currently Rio Tinto is conducting an on-market buy-back that is limited to the company’s London listed shares. This selective buy-back is being done to close the price discount at which Rio’s shares trade on the London exchange compared with the price in Australia.

Why investors like buy-backs
Signal that future prospects are good

Buy-backs signal to the markets that a company’s management has strong confidence in the future financial prospects of the company, as the company is returning what it sees as excess capital to shareholders. A weak company in a weak financial position, with nervous lenders raising concerns about the repayment of debts due is extremely unlikely to be returning capital to shareholders. As raising new capital is both time consuming and expensive (fees going to investment bankers in sharp suits), if a management team has some concerns about the outlook, they will retain excess capital on their balance sheet.

Change in capital structure

By returning cash to shareholders, the buy-back alters the capital structure of a company, by increasing the proportion of debt on its balance sheet used to fund its activities. Similarly, it increases the financial leverage or net gearing by reducing the cash component in the denominator of the below calculation.
Net Gearing = (Total Debt – Cash) / Book Value of Equity
If the company is “under-geared”, repurchasing of shares increases leverage. In the case of shopping centre owner Vicinity, due to the $1.5 billion in asset sales sold over the past 18 months, the trust’s gearing decreased to 24.7%. Buying back stock below net tangible assets (NTA) is not only earnings accretive, but it organically increases financial leverage and thus the equity owner’s share of rising profits.

Reduces the chance of poor acquisitions

A buy-back also provides investors with comfort that excess cash is not just being retained for empire building, possibly to be squandered on bad investments which tend to be made by companies in cyclical industries at their peak. A great example of this was Rio Tinto’s purchase of Canada’s Alcan in 2007, which not only drained the company of the excess capital built up by the mining boom, but resulted in an ignominious and highly dilutive rights issue in 2009.

Scares off short sellers

Buy-backs tend to cause share prices to trade upwards, as the companies’ buying puts upwards pressure on shares. When buying back shares, companies are required to file a new notice after each day when they buy shares. This notice is posted on the ASX for investors to see and details the number of shares bought and the price paid.

This may cause short sellers to close their short positions in a company conducting a buy-back (also causing upward price pressure), as they know that there will be a new buyer consistently purchasing shares in a company in which they have a short interest. Further, a company is likely to step up that program and increase buying on any share price weakness.

When I was working at a US investment bank writing research on building materials company James Hardie, I was able to observe the wave of buying from short sellers of James Hardie on the morning that the company announced a share buy-back. This pushed the share price higher than the announcement actually warranted.

Our Take

Returning excess capital to investors as distributions rather than retaining it reduces the capacity for management teams (acting as investors’ agents) to expend capital in ways that might not be in the best interests of investors. Where excess capital is returned to investors in the form of distributions and buy-backs, this excess capital sits in investors’ bank accounts rather than the company’s. If management want additional equity for an acquisition they are then required to make an investment case to their investors. We are expecting the announcements of a few buy-backs over the next few weeks, especially in the Listed Property space from trusts that are able to buy back their own shares that are trading below net tangible assets per share.

Monthly Performance July 2017

  • July was again a very volatile month in the Listed Property sector and after falling heavily mid-month, the index rallied to finish down -0.1%. Normally July is a quiet month as property trust management cannot speak to the market in the lead-up to revealing their results in August.

 

  • The Fund slightly underperformed the index, declining by -0.3%, with the primary cause of being the position in Westfield which generates profits in USD and GBP. Westfield’s share price was impacted by the strength in the AUD/USD which surged +4% over the month to finish at US$0.80.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in July and the fund’s strategy