Banks Reporting Season Scorecard 2018

On Monday this week, Westpac ruled off the 2018 financial year-end profit results for the Australian banks. In the words of Queen Elizabeth, 2018 could only be described as an annus horribilis for Australian banks and their investors. In addition to the CEO of one major bank losing his job, the revelations of the Royal Commission on Financial Services resulted in remediation provisions and a spike in legal fees (which should see new sports cars and beach houses at Palm Beach being left by Santa for sections of the legal community this Christmas). Numerous fines have also been levied on financial institutions, and credit growth has slowed. These factors have combined to create an environment of fear that has weighed on bank share prices.

In this piece, we are going to look at the common themes emerging from the banks in the October 2018 reporting season. We will differentiate between the major trading banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

 

Scaling back the empire

The main theme from 2018 was the banks breaking down the allfinanz model that they have carefully built up over the past 30 years. Allfinanz or bancassurance refers to the business model where one financial organization combines banking, insurance and financial services (such as financial planning) to provide a financial supermarket for their customers. This model is based on the somewhat false assumption that the bank’s employees can efficiently cross-sell different financial products to their existing customers at a lower cost than if this was done by separate financial institutions. Operating in this way obviously creates some of the conflicts of interest that have been on display at the Royal Commission over the past eight months.

Over the past year, we have seen Commonwealth Bank sell their life insurance business to AIA as well as their asset management business a week ago to Mitsubishi UFJ for a very solid price. Similarly, over the past year ANZ have exited both their wealth management and life insurance businesses. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac has 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. They might also have been motivated by concerns as to what recommendations the Royal Commission is likely to make in 2019.  If adverse rulings are made on vertical integration in the Royal Commission’s Final Report, most of the banks have already made moves to simplify their businesses, so shareholders won’t be exposed to significant “fire sales” of assets by motivated sellers.

Profit growth

Across the sector, profit growth was quite subdued in 2018 as the banks grappled with slowing credit growth, the application of tighter lending standards, customer remediation, and additional legal costs stemming from the Royal Commission. The above Banks Scorecard looks at the growth in cash earnings inclusive of these costs. Whilst many companies encourage investors to look through these charges, ultimately they are real costs that impact the profits available to shareholders. In aggregate the four banks have set aside $1.3 billion to cover customer remediation.

Westpac reported the strongest cash earnings as a result of keeping costs under control, very low bad debts, and a lower level of customer remediation charges. NAB brought up the rear due to both $755 million in restructuring costs and $435 million in customer remediation charges.

 

 

Gold Star

Bad debts

A big feature of the 2018 results for the banks 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. Additionally, declining bad debt charges year on year create the impression of profit growth even in a situation where a bank writes the same amount of loans at the same margin. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. The principal factors causing this fall have been the low unemployment rate and a near absence of major corporate collapses over the past 12 months.

Westpac and Commonwealth Bank both get the gold stars with very small impairment charges courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

 

Gold Stars

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of two cents over 2017. It would be imprudent for the banks to raise dividends in an environment where loan growth is slowing, provisions are rising, and the management teams of the banks are regularly appearing either in front of the Royal Commission or before our political masters in Canberra.

In 2018 dividends were maintained across the banks, which was a surprise in the case of NAB, as we expected a dividend cut. In 2018 NAB paid $1.98 in dividends on diluted cash earnings per share of only $2.02; a very high payout ratio and not a sustainable situation given that the bank’s capital ratio is below the APRA target of 10.5%.

Looking ahead, dividends growth is likely to be subdued in 2019 as the banks digest the outcome from the Royal Commission. ANZ and CBA shareholders can expect capital returns in the form of share buy-backs to offset the dilution from asset sales. In 2018 ANZ have bought back $1.9 billion of their own stock, with an additional $1.1 billion to be bought back over the next six months. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 9.4%, quite an attractive alternative to term deposits.

 

                       

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate declined in 2018, reflecting higher wholesale funding costs and borrowers switching from interest only (which attracts a higher rate) to principal and interest mortgages. This switching was done in response to regulator concerns about an overheated residential property market and in particular the growth in interest-only loans to property investors. Looking ahead in 2019 margins should recover courtesy of a rate rise of around 0.15% announced in mid-September. In September all the banks put through a similar rate rise with the exception of NAB, and it will be interesting to see whether NAB increases its market share as a result of this or follows suit at a later date.

 

 

 

Gold Star

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, also trailing the ASX 200 which eked out a small gain of 0.24%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. Westpac has been the worst performing bank, mainly due to concerns raised earlier in the year about the bank’s lending standards in their $400 billion mortgage book, though we are yet to see any evidence in the form of rising bad debts to back up these claims.

No stars given

Our View

Whilst it is hard to be a bank investor at the moment and some fund managers are advocating avoiding them all together, our view is that at current prices investors are being paid an attractive dividend yield to own solid businesses that have a long history of finding ways to grow earnings and navigate political minefields. Looking at 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, the share prices of ANZ and the Commonwealth Bank will see the benefit from share buybacks, as the proceeds from the sales of non-core assets are received.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

IPO Watch: Coronado Global Resources

We are generally pretty sceptical about new IPOs (initial public offerings). Occasionally, however, a great IPO comes along, either for a long-term investment or one with a high probability of making a short-term gain on its opening day, so it is always worthwhile to run the ruler over companies about to list on the ASX.

In this week’s piece we are going to look at the seven key questions we ask when assessing an IPO and apply them to Coronado Global Resources (ASX: CRN). Coronado’s prospectus was one of the largest that I have ever seen – close to 700 pages – perhaps reflecting what is likely to be the biggest IPO in 2018 with an expected market capitalisation of between $3-4 billion.

When analyzing IPOs few have been more eloquent on this subject that Benjamin Graham, the father of Value Investing.

Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer”  (The Intelligent Investor 1949 edition, p.80)

History

Coronado was founded in 2011 by private equity group EMG and since then they have spent US$1.2 billion acquiring 4 producing coal mines located in Queensland, and in Virginia and West Virginia in the US. This places Coronado as the 5th largest metallurgical coal producer globally with annual coal production of around 20 million tonnes (of which 75% is metallurgical coal and 25% thermal coal). In terms of profit, in 2017 60% came from the Curragh coal mine in Queensland and 34% from the Buchanan mine in Virginia.

Can the business be readily understood?

Yes, as a miner Coronado essentially digs coal out of the ground and sells the coal predominately to steel mills in Northern Asia and the US. The thermal coal produced by Coronado is sold to the Stanwell power station in Queensland under a long-term contract.

Whilst coal is a dirty word globally – mainly in conjunction with power generation – 75% of Coronado production is metallurgical or coking coal, which is used in the smelting of iron ore to make steel. This is high-quality coal (commanding a higher price) that low is in ash, sulphur and phosphorous and will burn at a very high temperature (1,300C in a blast furnace). Metallurgical coal is necessary for the production of steel, both as a source of carbon and as a means of heating the iron ore to around 1,300C. By contrast, thermal coal can’t be used in steel production, due to both its high ash content and because it cannot be coked (a process to concentrate the carbon and reduce impurities by heating or cooking the met coal in an airless environment). Globally metallurgical coal is much scarcer that thermal coal and currently trades at twice the price of thermal coal per tonne.

How does the company make money?

Coronado digs the coal out of the ground at a cash cost of ~US$80/t (after royalties) and then sells it to steel mills in the US and Asia. Current prices per tonne of met coal are a little over US$200/t which makes this a profitable exercise.  However, in Australia, Coronado’s product is priced at a discount between 6-16% to the benchmark price due to higher imperfections. Additionally, Coronado is subject to two separate royalty payments from production out of its two biggest mines which will cap profits in the near future. This results in Coronado having weaker profit margins than competitors such as BHP Coal and Whitehaven.

The biggest factors determining the price for metallurgical coal have been spikes in Chinese demand fueled by the construction of new Chinese mills (2006-2010) and pollution controls in China (2016-2018). During these periods Coronado’s coal mines have been very profitable, however, the below chart showing the metallurgical coal price over the past 10 years demonstrates that prices have been quite volatile. Over the past few years, metallurgical coal has risen from US$80/t in early 2016 to around US$200/t, leading to perceptions that the price is vulnerable to a fall if demand for steel weakens. Arguably current high prices above US$200/t for metallurgical coal encouraged Wesfarmers to sell the Curragh mine to Coronado earlier this year for A$700M (or at a multiple of only 1.5 times current annual profit).

Why is the vendor selling?

The motivation behind the IPO is one of the first things to look at. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business, or when the vendors are using the proceeds to expand their business. Coronado is a little bit different from most IPOs – which typically see the vendors seeking to exit as much of their investment as possible – in that post the IPO 80% of the company will be retained by the vendors. This is an unusually high proportion to hold onto, as prospective investor usually likes to see the private equity owners retain a stake in the business on listing between 20-30%.

Whilst the owners floating a company may want to sell out completely, an effect of the 2009 Myer IPO – which saw the department store’s private equity owners sell their entire holding – is that new investors are unlikely to accept a full exit without a substantially lower price (in terms of profit multiples). However, seeing private equity owners retaining an ownership stake after the float is no guarantee that the IPO will be a sure-fire winner; the vendors of Dick Smith retained a 20% stake on the listing which was sold down 9 months later. Within three years of the float, Dick Smith went into administration.

The issue with an 80% stake being held by EMG is that the market will perceive this to be an overhang that may depress the CRN share price following listing. This 80% stake is subject to voluntary escrow. Coronado’s owners expect to raise around A$774 million. Of this around $600M will be used to repay debt and pay the costs of the IPO with the sellers banking around $110 million.

Is the business profitable?

Yes: rising coal prices in 2017 saw Coronado’s net profit after tax move from -US$9 million loss to US$282 million profit in 2017 with a similar amount expected in 2018, before a big jump to US$400 million in 2019. However, this is very dependent on the coal price; for instance, a 10% change in the coal price would move 2019 EBITDA by either plus or minus US$200 million. The coal price is highly volatile, despite current very high prices, driven by expansion in the Chinese steel-making industry and demands for high-quality Australian coal over lower quality domestic Chinese coal to reduce pollution. During 2011-2016 the coal price fell dramatically, which saw Coronado’s US mines move to break-even at the EBITDA line (Earnings before interest tax depreciation and amortisation) and the glitzy Curragh mine’s EBITDA decline to US$61 million (2018 EBITDA $360 Million).

Financial stability?

Coronado is expected to have net debt of only around 0.5x EBITDA in 2019, which will equate to an interesting cover of around 14x – two very strong debt metrics. This reflects a $500M reduction in debt as part of the IPO. However, we see that this is a business that cannot handle too much debt, due to the volatility in pricing of its product, of which Coronado is a price taker.

How attractive is the price?

A decision to invest in Coronado should be based on your outlook for met coal prices. If current prices are maintained Coronado will trade on an EV/EBITDA multiple of around 4x, and based on the company’s stated pay-out ratio of 100% free cash flow this results in a dividend yield between 10-12%!  Whilst this looks sensational, there are questions about its sustainability. Comparable coal stock Whitehaven Coal is currently trading on 5x EV/EBITDA multiple and a 6% yield with no debt. Globally coal companies are trading on an EV/EBITDA multiple of 4.5x, a very cheap multiple that indicates that the market does not believe that current high prices for coal will be sustained.

Our take

Using a conservative coal price of around US$150/t, our modelling indicates that Coronado’s free cash flow will drop from around $400M today to around $180M, which would place Coronado on a yield of 5%, i.e. solid but unspectacular.

Whilst we are comforted by vendor EMG retaining an 80% holding, we are concerned about buying into a recently put together company trading at peak earnings, especially when the previous owners of major assets that make up Coronado’s portfolio were happy to sell at lower prices.

We will be passing up Coronado due to this concern and our inability to predict the metallurgical coal price in the near future.  Additionally, with the last line of Ben Graham’s quote from above on IPO’s in mind, given the movement in the coal price over the past few years, it is hard not to take the view that October 2018 may represent a very favourable time for Coronado’s owners to be selling shares to Australian investors.

Politics and Rising Energy Prices

Over the past few months, rising energy prices have dominated newspaper headlines, treating readers to the sight of politicians wringing their hands, promising to get to the bottom of this issue and find out who is responsible. Large power generators, energy retailers and transmission companies are accused of being behind the rising cost of lighting, heating and cooling our nation’s homes.

Whilst the profits that companies such as AGL Energy, Spark Infrastructure and to a lesser extent Origin Energy have increased over the past decade, we see that a significant proportion of the increase can be attributed to energy decisions made by various governments. As an economist, these price increases were predictable based on changes in the supply and demand curves of energy in Australia. There is scant evidence that they are the result of a long-term insidious plan by energy companies to capture a greater share of the nation ’s pay packets.  In this week’s piece, we are going to look at energy prices impacting Australia’s consumers and industrial users alike.

 

 

Energy prices this century

The above chart shows household gas and electricity prices in Australia and compares them to inflation. Using June 2000 as the baseline year, the CPI [Consumer price index which measures the prices paid by consumers for a basket of goods and services including energy] has risen by 61%. Over this same period, electricity has risen by +226% and natural gas by +207%.  As you will note from the above chart, energy price rises roughly matched inflation up until 2008, however energy prices have accelerated in relation to CPI particularly since 2012. It is worth noting that electricity prices are influenced by natural gas prices in that gas is used in gas-fired power peaker plants that can be fired up in response to peak periods of electricity demand.

 Gas Prices Up – a new source of demand

Due to the size of the Australian continent and the absence of pipelines linking the major fields off the coast of WA with Eastern Australia, gas prices are greatly influenced by geography. As you can observe from the below table, due to the lack of physical infrastructure WA’s gas from the giant offshore LNG fields is sold to consumers in Seoul and Tokyo rather than Sydney and Melbourne.

Until the construction of the construction of three liquefied natural gas (LNG where natural gas is cooled to -161 C to allow transportation) in the last five years, producers of natural gas on the East Coast of Australia could only sell their gas into the East Coast domestic market. This resulted in gas being priced below world prices for East Coast consumers. For example, in 2008 the wholesale price of 1 gigajoule of natural gas was $15 in WA versus $5 in NSW. The opening of these three export LNG plants in Gladstone in Queensland by Origin Energy, Santos and BG in 2015 and 2015 allowed the export of natural gas from  Eastern Australia to Northern Asian customers that were willing to pay over $10 per gigajoule.

Additionally, unlike in WA which mandates that 15% of gas produced in the state is reserved for domestic consumers, no such gas reservation scheme was enacted on the East Coast of Australia. AGL’s plan to construct an LNG import terminal by 2020 to serve the Victorian gas market will further link the prices that Australian consumers pay for natural gas to the world market, with gas expected to be imported from the USA and Qatar.

Consequently, with a new source of demand for natural gas being introduced and East Coast gas markets opened up to world prices, domestic prices naturally gravitated towards the higher export price. The construction of these three LNG export terminals has not only had negative consequences for consumers but due to the elevated construction costs of around $71 billion have also been a burden for shareholders with returns below expectations.

Gas Prices Up – new sources of supply halted

At the same time that demand for natural gas was increasing, a range of decisions were made by governments in NSW and Victoria to restrict new supply. Arguing about the benefits and harms of coal seam gas is beyond the scope of this piece, but economics dictates that if demand is going up and supply is unchanged, prices will naturally rise. In 2012 Victoria imposed a moratorium on coal seam gas exploration and in 2015 the NSW government banned new gas exploration. This saw AGL announce that it would not proceed with their projects in NSW and that they would be relinquishing their exploration licences. This action contributed to the energy company recording an impairment charge of $640 million in 2016.  We note that in April 2018 the Northern Territory reversed its ban on gas exploration outside towns and conservation areas in a move designed to put downward pressure on power bills.

Generation Costs Up – changing the mix and reducing supply

In the electricity market prices have been driven higher by the Federal Government’s Renewable Energy Target. This will require electricity retailers to acquire a fixed proportion of their electricity from renewable sources and is likely to result in  33,000 GWh of Australia’s electricity coming from renewable sources by 2020. Politicians seem surprised that regulations have added to electricity costs, following the closure of coal-fired base-load power stations in favour of more expensive renewables. For example, in 2017 Energie closed the Hazelwood power station that had previously supplied up to a quarter of Victoria’s electricity and AGL have announced that they will be closing the 1,680-megawatt Liddell coal-fired plant in 2022. Whilst we recognise that burning coal to generate electricity releases carbon into the atmosphere contributing to global warming, it is also a very cheap and consistent method of generating electricity. Additionally, coal-fired power plants are well-placed to provide a base-load of consistent generation, as these plans can generate electricity continuously, without requiring the wind to blow or the sun to shine.

Until the battery storage technology catches up to allow generators to store significant amounts of electricity, relying on solar and wind power generation requires natural gas-fired generation to step in to maintain consistent supply. As discussed above, this source of electricity generation is more expensive today that it was 10 years ago. Switching power generation to renewables – whilst socially desirable – comes at a cost, and this is reflected in higher energy bills. Further, in any market when supply is removed and demand remains relatively constant, prices tend to rise. This effect has proven profitable for incumbents who have generators, such as AGL Energy.

Our Take

Rising energy costs have impacted consumers and industrial users alike, but they have not arisen in a policy vacuum nor as part of a conspiracy. We see that they are the logical outcome of decisions that have changed the supply and demand for energy and that various companies have predicably acted to generate profit from these shifts. In the Atlas equity portfolio, we own positions in AGL Energy and Spark Infrastructure, both of which have benefited from changes in the energy markets in Australia over the past ten years. Neither of these companies is involved in the LNG export terminals that at this stage look to be a poor investment for shareholders.

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. For fund managers, this is somewhat like Christmas, in that opening company results are like gift-wrapped presents: tearing the wrapping off starts to prove or disprove your reasons for owning a company.

In this piece, we will run through the key themes that have emerged over the August reporting season, the winners and the losers amongst Australia’s listed companies, and how our companies have performed.

 

 

Volatile price action on the day of the results

On the day of the result over the last month, we observed more over-reactions to profit results (both positive and negative) than usual.  We see that this occurs as the market price on the day of a company’s result is generally set by the short-term holders (i.e. hedge funds) and very short-term holders (i.e. machines) of equities, rather than the more measured long-term investors. Often the short-term investors trade with reference to whether a company misses or exceeds their expected earnings, rather than the drivers behind a company’s profits. For example, global packaging company Amcor fell -3.5% on the day of their result, which was weaker than expected due to higher resin prices. Whilst the market priced Amcor as if these headwinds were permanent, the nature of Amcor’s contracts with their customers means that rising raw material costs are passed on, albeit with a lag of several months. Conversely, construction company CIMIC (which we also own in the portfolio) had a good result that was above expectations, but probably not deserving of the +17% gain on the day of the result.When thinking about the noise that we face as investors, a great quote from Ben Graham, one of the titans of investing, comes to mind: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Short-term prices are dominated by sentiment and short-term holders, but in the long term, share price growth is delivered by those companies that can constantly grow dividends flowing into their shareholder’s bank accounts.

Comparison to 2017 and a look ahead

The August 2018 results season was in aggregate better than expected for Australian listed companies, which reported on average earnings growth of 8% for the 2018 financial year. However, there was a large degree of variation amongst the different companies, with earnings growth in the miners (courtesy of higher commodity prices and a falling AUD) offsetting stagnant earnings growth in the financials. Having listened to close to eighty management presentations over the past four weeks, the general tone feels more cautious than it was in February or August last year. Companies with global exposure were concerned about inflation and the impact of a trade war between the US and China, whereas companies that are exposed to the domestic economy spoke about increasing political uncertainty and the potential for radical policy changes that may result from a change in government in mid-2019.

Market favourites did well 

One of the key themes coming out of this reporting season was that, unlike in the February 2018 reporting season, high price to earnings (PE) stocks that are well-regarded by the market mostly lived up or exceeded high expectations and their shareholders were rewarded. Polarising pizza company Domino’s Pizza (+9%) and JB Hi-Fi (+12%) both saw the short interest in their companies increase in the lead up to reporting their results, which ended up being better than expected. Similarly, a2Milk (+20%), Xero (+19%), ResMed (+10%) and CSL (+16%) all were expected to deliver very strong profit growth and did not disappoint.  The exception to this group was Flight Centre (-14%) which was sold off despite growing profits by +17%.

Give me my money back

Capital management was again a prevalent factor in the recent reporting season and was understandably of interest to investors. A number of companies increased their dividends above expectations, including AGL Energy, Qantas, Magellan and Fortescue. Additionally, we saw a few companies announce special dividends; Suncorp, Woolworths and IAG which was well received by investors with the exception of IAG due to concerns about the outlook for 2019.Rio Tinto, BlueScope Steel, Janus Henderson, Qantas and Crown all announced buy-backs, which should support their share prices over the coming months. Bucking this trend of returning capital to shareholders, Transurban announced a $4.8 billion capital raising to help fund their share of Sydney’s WestConnex motorway, and Harvey Norman raised $164 million to reduce debt on their balance sheet.
Whilst buy-backs boost share prices in the short term, in the longer-term companies do need to retain cash to reinvest in their operations in order to grow earnings in the future without adding to debt.

Cost inflation

Rising costs was a common thread through this reporting season, with most companies mentioning rising costs in their results commentary. Higher labour costs were cited by resource companies Rio Tinto and Alumina, which took some of the shine off otherwise solid results as investors extrapolated the impact of rising costs and falling commodity prices over the near term. Unsurprisingly packaging companies Amcor, Pact and Orora all felt the impact of higher resin prices, though these additional costs are expected to be recovered via pass-through contracts to their customers in 2019. Qantas saw an additional $690 million in costs from rising jet fuel prices, so travellers can expect the company to recover this via higher fares over the next year.Rising energy prices delivered AGL Energy a record annual profit of over $1 billion which allowed the company to increase its dividend by 29%. Whilst this was positive for AGL shareholders, large electricity users such as the office and shopping centre owners GPT and SCA Property faced higher energy bills.

Best and worst results

Over the month the best results were delivered by A2Milk (+20%), Magellan (+17%) and CSL (+16%) 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 2019. QBE Insurance’s (+11%) shareholders were rewarded when the insurance company produced a result absent of negative surprises the market has come to expect from this stock.On the negative side of the ledger Origin Energy (-19%), Iluka (-18%), Ansell (-12%) and Challenger (-12%) all reported disappointing results compared with other companies. The common themes amongst this group were the profit results coming in below expectations combined with bearish management commentary for the coming year, mainly due to higher costs.

How we fared

Overall, we were reasonably pleased with the results from this reporting season for the Atlas Concentrated Australian Equity Portfolio.  As the Atlas High Income Property Fund focuses on owning conservative Trusts that are rent-collectors, reporting season offers few surprises especially as most of the Trusts we own pre-announced the distributions several months ago in June. Positions in Amcor, Pact and Flight Centre were offset by strong results from CSL, Wesfarmers, JB Hi-Fi and QBE Insurance.

As a long-term investor that is interested in delivering income in the portfolio to investors, something we look closely at is the dividends paid out by the companies that we own and whether or not they are growing. Following the great quote from Ben Graham mentioned above, we look to “weigh” the dividends that our investors will receive, as we view that talk and guidance from management is often cheap, but physically paying out higher dividends is a far better indicator that a business is performing well. Using a weighted average, the dividends that our investors will receive will be +11% greater than for the previous period in 2017.  Using this measure, we are pretty happy with how the recent reporting season went.

The little Aussie Battler under pressure

In the press, large movements in the Australian dollar are often erroneously presented in the press as a vote of confidence in Australia as a nation or the management (or mismanagement) of our elected leaders. A falling Australian dollar is often viewed as a negative event, raising the cost of online purchases, imported cars and overseas travel.

Over the last year, we have seen the AUD fall 8% vs the USD, continuing the volatility in the AUD that we have seen over the past decade since the AUD peaked at 1.10 vs USD in 2011. Over 2018 we had seen the AUD slide downwards from a peak of 0.81 in January to 0.725 as uncertainties over the leadership of the country have increased. Political instability is likely to continue to weigh on the AUD in the short to medium term, as over the next year Australia faces a National election and a likely change in government to a party that has few business or investor-friendly policies.

In this week’s piece we are going to look at currencies, the AUD and in particular the winners and losers from currency movements.

 

Fixed Rates

For much of the last 200 years currencies have been fixed either against another stronger currency or commodity such as gold. For example, following the second war the Bretton Woods agreement pegged currencies against the USD, which was fixed to gold at the rate of US$35 per ounce.

When a country has a fixed currency and faces adverse economic conditions, their treasury inevitably uses the nation’s stock of foreign currency reserves to prop up a faltering exchange rate. The outflow of foreign currency reserves occurs as investors seek to exit and sell the county’s currency which is viewed as overpriced based on the changing economic circumstances or market sentiment.  A great example of this occurred in Russia in 2008, which saw Russia chew through US$200 billion in carefully hoarded foreign currency reserves in a futile attempt to defend the value of the rouble before eventually devaluing the exchange rate.

Additionally, fixed rates can attract the attention of speculators that may look to profit from a forced reset in the exchange rate, where the rate is perceived to be fixed at a rate higher than the currency’s fundamentals. For example, in 1992 the GBP was set at a rate of 2.7 DM to the GBP as part of the European Rate Mechanism, fundamentally this over-valued the GBP as it the UK’s inflation rate was three times that of Germany’s. Speculators famously led by George Soros shorted the GBP, after spending large amounts of foreign currency reserves defending the GBP and raising interest rates from 10 to 12%, the GBP was ultimately devalued, netting Soros’ fund a profit of GBP1 billion.

Floating Rates

In the 1970s as a result of inflation induced by spending in on the Vietnam war, the US abandoned fixing the USD to gold and allowed the USD to float freely in line with market demand. The free float of the USD eventually forced other major currencies to follow suit, with the AUD switching to a floating rate in 1983.

By allowing its currency to float freely, a country loses the ability to control its exchange rate, but it gains control of its monetary system. Before 2000 (when the Greek Drachma was fixed to the €), the current Greek debt situation would have arguably been much less painful to the Greek economy. The current Greek debt crisis would have seen the Drachma being sold down heavily, thus making summer holidays on the Aegean and Greek olive oil much cheaper than similar products offered by Italy or France.

History of the AUD

In 1983 when the Hawke government came into power, one of their first decisions was devalued the AUD by 10% and float the Australian dollar, assuming that this action would cause the AUD to fall and improve our international competitiveness and stimulate the export sector. Before 1983, the value of the AUD was set each day by the Reserve Bank of Australia (RBA) and the Federal Government and either directly pegged to the foreign currencies such as the GBP or USD or pegged to a trade-weighted basket of currencies.

Corporations had to apply to the RBA to buy foreign currencies to buy imported goods or make investments offshore, with the RBA selling the company USD or GBP in exchange for their AUD at the official fixed rate.

Two floors of the RBA Building in Martin Place were occupied by Exchange Control staff whose job was to make it hard and discouraged for Australian businesses and investors wanting to invest offshore. While this sounds archaic, this level bureaucratic obstruction may have prevented BHP US shale gas debacle or Wesfarmers UK hardware expedition, both of which resulted in significant transfers of wealth from Australian shareholders to companies domiciled in the US and the UK.

 

 

 

Since floating in 1983 the AUD/USD has averaged 76c. However, the AUD was in a downward trajectory from 1983 to 2002. This was broadly due to Australia’s higher relative inflation rate. The strength in the AUD over the past ten years has been a result of China’s industrialisation and its unprecedented associated explosion in demand for Australian minerals since China’s integration into the global economy after joining the World Trade Organisation in 2001. More recently the interest rate differential between Australia and the US and Europe has boosted the AUD; though rate cuts since 2011 and higher US rates have closed this gap. In the medium term, we would expect the AUD to move towards fair value based on purchasing power parity, which we estimate, is approximately US$0.66.

WINNERS

The companies that are likely to benefit from a weaker AUD fall into four categories;

  1. Import substitution:  Companies that produce something in Australia and compete with the now more expensive imports such as steel (BlueScope), fertiliser (Incitec Pivot) or tourism (Crown).
  2. Exporters: Companies that have production costs such as wages in Australian dollars but sell a commodity globally like iron ore that is priced in USD (Rio Tinto) or Grange Hermitage wine (Treasury Group). Here a falling AUD translates into higher revenue for the same quantity of goods sold.
  3. Companies with inflation linked-pricing: When a falling AUD results in inflation, companies like Transurban should see an expanding profit margin. Here their road tolls will increase with inflation, while a proportion of these companies’ costs remain fixed, thus resulting in higher profits.
  4. Offshore Operations: The falling AUD also benefits companies with substantial offshore operations such as CSL, Atlas Arteria and Unibal-Rodamco-Westfield, as their USD or Euro denominated earnings are worth more when translated back into AUD for Australian investors.

Losers

The companies that are likely to hurt from a weaker AUD fall into three categories;

  1. Resellers: The companies that are typically hurt by a falling AUD are those that buy goods offshore for resale to Australian consumers such as retailers Myer and JB Hi-Fi.  Here Australian consumers wages are not impacted by a fall in the currency, but a new iPhone or LED TV’s cost has gone up.
  2. Users of foreign content in their production process: Similarly, a falling AUD presents a challenge for companies like Qantas and Seven West Media that earn revenue in AUD from domestic consumers, but have significant USD-denominated costs such as aviation gas or television series produced in the USA.
  3. Unhedged borrowers of offshore debt:  Further, companies that have significant un-hedged USD borrowings such as Boral will see their interest costs increase, especially if the company does not have USD earnings to service their debt. This situation occurred in 2010 and required Boral to raise $490 million to keep the company within their debt covenants.

Our Take

We expect the AUD to continue to trend down towards 66c in-line with purchasing power parity, diminishing interest rate differentials between Australian and other Western economies and expected further falls in commodity prices. Accordingly, we have structured the portfolio to benefit from a falling AUD. One additional benefit in having a strong bias towards companies with earnings offshore is that the variability of domestic political decisions and the uncertainty brought on the turnover in leadership will have less of an impact on profits and dividends.