Today, a tale of two ASX turnaround stories: one off to a good start, the other not going well at all. Two of the market’s worst long-term underperformers, Santos and Myer, are respectively returning to favour and falling further out of favour after divergent market updates last month. Backing turnarounds of larger ASX companies is mostly a reliable investment strategy but only when the fundamental economics of the business change sufficiently for the better. This is happening at Santos but not at Myer – let’s explore.
When oil prices fell heavily in 2014 as the cost curve for US shale oil production shifted lower and production ramped, Santos was caught with too much debt and not yet enough LNG production to provide sufficient interest cover. The earlier debt buildup funded the expansion of the company’s gas extraction and LNG export facilities, the acquisition of LNG interests and development of the Cooper Basin but assumed higher oil and gas prices for longer. After peaking near $18 before the GFC the stock today languishes around $3.30 – where it was in early 1982. It’s nearly incredible 35 years of activity and investment have added no value at all.
But for the brave and patient investor Santos is now worth further research. There is a long way to go before Santos can internally fund organic growth but the June quarter activity statement confirmed progress towards the intermediate goal of debt and cost reduction to ensure viability in the likely future era of low oil prices. The quarter was strong across the board with sales and revenue above expectations, upgraded production and sales guidance, lower costs of production, more drilling for GLNG and in the Cooper Basin, and all with no increase to capital expenditure or depreciation. Net debt fell to US$2.9 billion, down from US$3.6 billion on 31 December.
Santos also hedged its 2018 sales against another fall in oil prices. It will receive US$47 per barrel until oil falls below US$40, when it will receive a US$7 premium for the hedged barrels. This is smart planning for the future, when the cost curve for US shale will shift lower still and global demand for oil will slow as internal combustion engines are phased out, but the clever feature of this ‘collar’ is the upside for the hedged barrels is limited to US$59. We do not see oil returning to this level, so Santos is unlikely to lose upside from the hedge.
The relief rally from the June low of $2.87 is justified because the efficiencies targeted at the 2016 investor day are being delivered. Santos is derisking and the stock can rerate further on more progress like we saw in the June quarter. There is value in the stock below $3.00.
Myer Holdings, in contrast, has not sufficiently derisked to hold its value in the current hostile retail environment and the stock is languishing at all-time lows after last month’s earnings downgrade. The cut to 2017 guidance is not severe – down to $66-70 million from the earlier prediction of a result greater than the $69.3 million achieved in 2016 – but it does reveal the New Myer strategy is not as transformational as the company and some investors hoped.
While cost reductions continue, revenues were weak in the second half despite initiatives to improve in-store experience. Management described the first few weeks of July as “incredibly weak”, which highlights the tough retail market and the poor underlying appeal of Myer’s offer. The deputy CEO left without much explanation to the market. The $45 million of writedowns to the carrying value of designer women’s apparel label Sass & Bide and the stake in the owner of the Topshop Topman brands are particularly discouraging because they reveal the board did not understand the value of these brands at the time of acquisition. The writedowns add to the impression the “wanted brands” central to New Myer are not wanted after all, at least not now.
Myer’s downgrade also reveals the fundamental problems with the old Myer model remain. The retail environment is challenging but Myer has not derisked like Santos has to survive its own adverse market. Myer still depends heavily on margins in premium women’s apparel and on the traditional midyear department store stocktake sale, which went badly this year.
Myer is exposed as more a straight play on retail conditions than a turnaround certain to deliver for shareholders. The 2020 New Myer financial targets, which include annual 3 per cent annual sales growth, are not achievable without the good luck of supportive conditions in apparel retail, and the bearish case is sales are flat until then. For the moment we would rather not provide a valuation. To own Myer an investor must expect a meaningful retail upturn – a prospect which is quite possible if the labour market continues to tighten. The stock will have its day again – one day.