Last week saw the end of reporting season for 180 of the S&P/ASX200 companies and around 2,000 of the companies listed on the ASX. Over the past month, these companies revealed their profit results for the six months ending December 2017 and provided guidance as to how they expect their businesses to perform in the upcoming year.

Whilst listed companies are required under the ASX’s continuous disclosure requirements to update the market when they become aware of new information that would impact their share price, reporting season always brings positive and negative surprises. In this week’s piece we are going to run through the key themes that have emerged over the last four weeks.

 

 

 

 

 

 

 

Few unpleasant surprises
The February 2018 reporting season was a pretty solid for Australian listed companies, which reported aggregated earnings growth of +9.5% and – more importantly – a sunnier than expected outlook for 2018. After being down -3.5% at one stage earlier in February, the ASX200 finished +0.4% on improving   Australian corporate profits. This result was a significant outlier when most developed countries’ markets finished down between -3% and -5%. Across the ASX100, 33% of companies delivered results ahead of market expectations, with only 15% failing to meet expectations.

Having listened to close to eighty management presentations over the past four weeks, the general tone was observed to be more positive towards the future than it has been in recent years. This attitude was at odds with the doom and gloom coming from the share market.  Positive views of the future can be seen in the 2% improvement in aggregate guidance for companies for profit growth of +5.8% over the next 12 months.

Give me my money back!
Capital management was a feature of the recent reporting season, which was understandably popular with investors. New buy-backs were announced by Rio Tinto, Lend Lease, Mirvac and Dexus. QBE Insurance reiterated their commitment to their buy-back. However, looking deeper into QBE’s balance sheet leads one to question the company’s capacity to conduct this buy-back. See Does QBE have the capital for their buy-back?   Counter to this trend, APA Group and Woodside had shareholders reaching into their pockets, timing large capital raisings with the release of their results to fund growth projects.

At a dividend level Woolworths, Alumina, BlueScope Steel, ASX and Perpetual rewarded their investors with dividends ahead of expectations. Across the ASX, dividend growth for 2018 is now expected to be a relatively modest +2.7%, though this number is skewed by the -29% cut in market heavyweight Telstra’s dividend.

Across the ASX the dividend pay-out ratio remains high at close to 80%. Increasing dividends and buying back stock boosts share prices in the short term and may allow some management teams to achieve share price hurdles related to their bonuses. However, in the longer-term companies do need to retain cash to reinvest in their operations in order to grow.  Contrasting with the ASX’s high payout ratio is the lower 51% dividend payout ratio of the US’s S&P 500.

Rock diggers good, but is this as good as it gets?
The miners reported solid profit growth in February, but this was expected as they continued to benefit from elevated commodity prices courtesy of the tail end of a Chinese stimulus plan from late 2016. Rio Tinto, BHP and Alumina reported strong profit growth, whereas Fortescue reported falling earnings and cut its dividend. Over the last year buyers have had a strong preference for higher quality iron ore due to Chinese moves to limit damage to the environment, which has pushed Chinese steel producers to use higher quality iron ore. Consequently, Fortescue’s lower quality iron ore has attracted discounts of up to 40% compared to BHP and Rio Tinto’s higher quality product.

On the conference calls to investors, management teams from the mining companies promised to maintain capital discipline, pay down debt and not waste the windfall of temporarily higher commodity prices, which was positively received by shareholders. What concerned us was the evidence of rising costs apparent in the results of BHP, South32 and Rio Tinto.  We are concerned that over the next year the mining companies could face costs moving higher (particularly labour) at a time when commodity prices are weakening as Chinese stimulus measures fade. Our concerns around rising labour costs were exacerbated by the news in March that the Fair Work Commission approved the merger of the Construction, Forestry, Mining and Energy Union (CMFEU) and the Maritime Union of Australia (MUA) to create a 144,000-member super union.

Banks and their pound of flesh

Whilst the banks performed well during the reporting season, largely because they are viewed to be a beneficiary of rising interest rates and continued low levels of bad debts in the Australian economy. Commonwealth Bank reported cash profits of $4.87 billion in a result that was not easy to analyse due to estimates of a potential anti-money laundering fine and costs surrounding the Royal Commission. What seemed to be ignored by the market was that Commonwealth Bank expanded their net interest margin over the last six months, with repricing of their home loan book more than offsetting the much-decried bank levy. In their quarterly updates NAB, Westpac and ANZ all reported low bad debt charges and generally favourable business conditions. We see that the banks are well placed to have a good 2018 as the repricing of their loan books will drive revenue growth and low bad debt charges.

Best and worst results
Across the results presented last month, the best was delivered by CSL, Qantas, Flight Centre, A2Milk, IAG, Origin Energy and ResMed. The common theme among these companies was management’s ability to keep costs under control, while growing revenue at a rate well ahead GDP growth. Aside from the stratospheric growth rates achieved by milk producer a2 Milk in penetrating the Chinese infant formula market, the highlight for Atlas was CSL. It is very unusual for a company of CSL’s size ($70 billion market cap) to grow profits to the extent that it was able to do over the past six months, with profits up 31%. CSL achieved this due to increased sales in higher margin specialty biotherapeutics and their influenza vaccine business swinging from a loss to a healthy profit. CSL was criticised when a large part of the loss-making flu vaccine business was bought from Novartis in 2014 for US$275 million, however this business made US$185 million over the last half.

On the negative side of the ledger Vocus, Harvey Norman, Domino’s Pizza, South32 and Suncorp all reported disappointing results compared with other companies. The common themes across this group included either high price-to-earnings rated companies not delivering on high expectations, and companies that reported lower profit margins as management struggled to contain cost growth.

Our take

In contrast to other reporting seasons, this one was a relatively benevolent one for quality-style investors; who generally eschew high priced growth stocks and companies with issues such as Vocus. After falling market aggregate earnings in recent reporting seasons, this reporting season provided evidence that company profits are rising again and that profit margins are rebuilding. Whilst we expect the financials sector and stocks with offshore earnings to have a solid 2018, commodity prices (which we expect to weaken) should dampen ASX earnings for the remainder of the year.

 

 

• In February the listed property sector was sold off -3.3%, following global markets that finished down between -3% and -5%.
• The Atlas Fund returned -2.7%, in a month where there were the share prices of most trusts fell regardless of their asset quality or even management upgrading guidance!
• Against the doom and gloom on the share market, the February reporting season revealed that the actual economy is performing quite well.  Over the last six months, the trusts held by the Fund delivered an average weighted increase in profits of +5.1% and and increased their distribution by +3.1%.
• Whilst Atlas can’t influence the day to day share prices, what we can control is having the portfolio populated by trusts with secure distributions supported by recurring earnings and are growing ahead of inflation. Over time companies that are able to consistently grow the returns to shareholders will be rewarded by rising share prices, whereas those with unstable earnings inevitably languish.

 

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

The first two months of 2018 have been a wild ride for Australian shares, with big falls and then big recoveries. However, from looking at the headlines in the financial press most investors would be surprised to find out that the ASX 200 index actually finished February exactly where it started the year.

Last week we looked at the causes behind the volatility in February – Volatility and Melting Markets – and in this week’s piece we are going to look at how we approach market dislocations.

Surviving previous crashes

In my funds management career, I have had the “fortunate” experience of having observed both the GFC in 2007-08 and the Tech wreck in North America in 2001 from the front lines, helping to manage large institutional equity funds when the prices of all stocks regardless of their quality were falling heavily.  During both of these crashes, I worked with firms that ran conservative value-style funds, based on fundamental analysis of companies.

During these periods the portfolios were populated with companies paying dividends from stable recurring earnings such as TransCanada Pipelines and Amcor. These portfolios had no exposure to companies that were reliant on the previous frothy market conditions continuing such as Pets.com, Nortel, Babcock & Brown, or Allco Finance. What I learned from these experiences is that a portfolio constructed in a conservative manner populated by companies paying stable and growing dividends with low gearing will bounce back from the blackest nights of doom and gloom.

Know when to hold them

In a perfect world, investors with perfect knowledge would head into a major market meltdown having sold all equities would have a 100% cash weight. However practically that would never happen due to both taxation consequences and the risk that the call may be very premature or even wrong. Many investors may remember RBS’s advice in January 2016 to sell everything as oil was going to $15 a barrel and equities markets were going to fall by 20%. Consequently investors and fund managers only tend to have hard looks at their portfolios when the bull market stops and stock prices are falling.

In our opinion the worst thing that investors can do is look at the sea of red on your computer screen for hours at a time, or read the some of the breathless market commentary in the financial press or coming out of the trading desks at the investment banks. The former is designed to sell newspapers and the latter is produced in an attempt to influence you to incur brokerage, when doing nothing may be the best option.

When a major market dislocation occurs, the best thing for investors to do is step back and think what this particular dislocation will do to the earnings and dividends from the companies held in their portfolio.  If the answer is not much and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. For example, it was hard to see how the falls in the US market in February were going to impact rental income from SCA Property’s portfolio of neighbour shopping centres, or Amcor’s sales of PET soft drink bottles and flexible food packaging.

Know when to fold them/ know when to walk away
Conversely, companies in an investor’s portfolio that rely on benign debt and equity markets to finance their growth or are still proving up their business model should be looked at with the most critical of eyes. These companies are typically characterised as “concept stocks”. Often they are companies with exciting technologies in new markets that may have significant future value, but are often have minimal current earnings and assets that could help them weather the inevitable storms. Recent examples of high growth concept stocks that have run into trouble include GetSwift and BigUN.

Amongst the larger stocks on the ASX, investors should look critically at companies with both high PE ratios, high gearing or those that have recently made significant acquisitions. During major corrections, companies with these characteristics tend both to get sold off the most, and might also face dilutive equity raisings due to pressure from their bankers.

All weather stocks

Whilst listed property trusts as a sector are viewed with suspicion by many investors at the moment we continue to like SCA Property. This trust is exposed to domestic food, liquor and services consumption via long-term leases to Woolworths. During major market meltdowns such as the GFC, consumers tend to cut back spending on discretionary items such as clothes and going out to restaurants in favour of cooking and drinking (larger than normal) glasses of shiraz at home, all of which are supportive for SCA Property’s earnings.

Woolworths’ landlord continues to benefit from the supermarket giant’s battle to regain market share from Coles, as a portion of the rent is tied to turnover. The trust is conservatively run by an experienced and honest management team and importantly has low gearing and minimal near-term debt maturing. In February management upgraded profit guidance for 2018, yet the trust is trading on a yield of 6.3%.

Current Positioning

In the current environment Atlas see that investors should be looking through their portfolios for the stocks that could “torpedo” portfolio performance. In early 2018 rather than scouring the market for the next Blackmores or A2M Milk, we are spending time thinking about what could go wrong with the various companies in our existing portfolios.  As a quality style manager, we are spending time looking closely at the quality of company earnings and the percentage of earnings that are derived from recurring earnings that will hold up over time, rather than profits coming from revaluations, accounting changes, asset sales or performance fees.

In terms of sector positioning Atlas are very cautious on the mining sector, especially at the sexier end of lithium and graphite. The frenzied activity, promise and hype in this sector looks like a movie that I have seen before.  Whilst the consensus view is that commodities will stay strong in 2018, a large part of the price moves we saw in 2017 was the result of Chinese stimulus plans enacted in 2016 which has begun to fade. Declining Chinese dependence on fixed-asset investment to drive growth will put downward pressure the prices of commodities such as coking coal, iron ore and copper.

 

• January was a weak month as the listed property sector was sold off -3.3%, due to rising bond yields weighing down on income stocks globally.
• The Atlas Fund returned -2.7% in a month where there were few places for investors to hide,  as all trusts were sold down with little regard to the quality of their property assets,  nor their earnings outlook.
• The Fund remains positioned towards Trusts that offer recurring earnings streams from rental income rather than development profits. As the Fund’s distributions are supported by long-term lease agreements with blue-chip industrial companies, and not swinging emotions of the market, we see that the Fund will be well placed to weather current market volatility.Go to  Monthly Newsletters for a more detailed discussion of the listed property market in January and the fund’s strategy going into 2018.

This morning European property company Unibail-Rodamco announced that it had entered into an agreement to acquire Westfield (WFD) to create a global developer and operator of flagship shopping centres in the US, UK, the Netherland and France. This deal values WFD at A$33 billion, or at a price earning multiple of over 22 times future earnings, what appears to be a full price.

Westfield is the largest holding in the Atlas High Income Property Fund, so we were understandably quite pleased with this development. In this note we are going to look at what will likely be the largest takeover in Australian corporate history.

Today’s deal marks the end of an era for Westfield, which was originally listed on the ASX the middle of the 1960-61 recession when unemployment spiked to a post-war high of 3.1%. The above image is from 1959 and is of Westfield’s first shopping centre in Blacktown.

Westfield Development Corp’s initial public offering offered 300,000 shares at five shillings! In recent years, the various corporate changes at Westfield have appeared to be movements of the chess pieces on the Westfield board leading towards this day. Moves such as the separation of the Australian assets (Scentre: SCG) from WFD’s global assets, seemed to be designed to increase the attractiveness of Westfield to a foreign suitor such as Unibail-Rodamco, and allow the Lowy family to exit the company first listed close to sixty years ago. For a deeper dive into the corporate gymnastics that Westfield has engaged in over the years look at our piece Westfield: the Thimble and the Pea.

The Deal
Under the agreement WFD holders will receive a combination of cash (US$2.67) and 0.01844 Unibail-Rodamco shares for every WFD unit owned. This equates to A$10.01 or a 18% premium to the price at the close of trading prior to the deal being announced. It is anticipated that the combined entity will have a primary listing in Paris and Amsterdam, with a secondary listing on the ASX.

Investors in the new combined entity will own a property trust with 104 shopping centres across Europe and the US valued at A$95 billion.

A higher bid?
In our opinion this deal is likely to go ahead with a minimal chance of competing bids, as the Franco-Dutch Unibail-Rodamco revealed that they already own 4.9% of WFD and that the Lowy family which own 9.5% of WFD are supporting the deal. Digging into the detail in the documents, there is also a US$150 million break fee that must be paid to the other party if either Unibail-Rodamco or Westfield were to decide to walk away from this deal.  The details on when this deal is likely to be completed is yet to be fully announced, though the parties expect that this will be consummated around June 2018 if shareholders vote in favour.

Our Take

Looking ahead, this takeover is likely to provide a positive boost in the near term to the Australian Listed Property market, as it raises the prospect of further takeovers. In the medium term, investors that decide to cash in their Westfield holdings are likely to look to deploy some of the proceeds in other Australian Listed Property Trusts which will boost share prices in the next six months.

The Atlas High Income Trust are likely to take the money that the Europeans are offering and reinvest elsewhere, as typically these situations represent a transfer of wealth from the aquiror’s shareholders (Unibail-Rodamco) to those of the takeover target (Westfield). This occurs due to the premium required to consumate the deal ineviatably is higher than the synergies actually achieved.