In this week’s analyst opinion piece we look at the themes coming out of reporting season thus far and the likely implications for the remainder of the companies reporting their results. 
‘Reporting season’ occurs over the months of February and August each year and is when listed companies with a period end date of 30 June are required to disclose to the market their financial performance and position.  We are currently in the August reporting season and the requirement for companies to report results with two months from period end date (30 June) means financial results must be released prior to 31 August. Given the time it takes to finalise these details, companies typically start to report their results in early August.
In this note we split the commentary into three key segments which align to our investment approach of building purposeful portfolios for our customers where the;

  • Large-cap allocation typically seeks to deliver solid yield and some capital growth
  • Mid-cap allocation typically seeks to deliver balance of some yield and solid capital growth
  • Small-cap allocation typically seeking to deliver strong long-term capital growth

Large-cap commentary
The clear theme coming out of the large-cap names in reporting season thus far is give me yield! The main results out this week have been the banks and Telstra (ASX:TLS). These results / trading updates have generally shown low growth and the maintenance of relatively high payout ratios/buy-backs to deliver a solid yield to investors.
Firstly, on the bank results. Unsurprisingly, the rate of earnings growth was benign and largely held back by higher funding costs, relatively low levels of consumer and business confidence, high levels of private sector debt and increases in impairments. We believe this combination of low credit growth, rising impairments and high payout ratios has put a temporary cap on dividends across the sector.
The overall result from TLS was in-line with our expectations with the announcement of the new $3bn capital investment program highlighting that in order for TLS to grow earnings, considerable funds needs to be deployed. It remains unclear whether this new investment program will result in tangible earnings growth or is merely “stay-in-business” capex. The latter would ultimately lead to a lower Return on Equity for the business and is something we are carefully evaluating. Dividends in the near term look to be flat with the Board approving a $1.5bn buy-back of shares. This is akin to paying a special dividend with the additional benefit of reducing the share count in order to limit the downward pressure on Earnings Per Share.
The investor implication of the large-cap results thus far is that earnings growth is likely to be at best limited to GDP growth with current dividend yields supported by reliable near-term cash flows generated from a dominant market position in the domestic economy.
Mid-cap commentary
The first and second order effects of the unwinding of the resources boom can be seen most clearly in the performance of those companies geographically exposed to resource rich areas i.e. Western Australia and Queensland. Whilst the first order effects are widely reported i.e. lower commodity prices, reduced capital expenditure and workforce re-sizing, it’s now the second order effects that are starting to unfold and can be seen through asset prices and appetite for debt. This is illustrated by the results recently released by Credit Corp Group (ASX:CCP) and Genworth Australia (ASX:GMA).
Firstly looking at the results of GMA, the following illustration highlights that:

  • Asset prices are falling, partially in WA while Queensland remain broadly flat; and
  • Unemployment is increasing, particularly in Queensland

The combination of these two factors are resulting in increasing delinquency rates on residential loans, which are shown in the top left section of the tables below.
Macroeconomic Conditions
Figure 1. Macroeconomic conditions.
Source. GMA 1H16 Financial Results presentation
The consequence of this is a loss of appetite by financial institutions to hold higher risk loans on their balance sheet and is playing well into the hands of debt purchasers.
This brings us to the second of our mid-cap companies, Credit Corp who acquire these higher risk loans from originators at a discount to their face value. CCP reported a FY16 NPAT increase of 20% on FY15 assisted by the 62% increase in debt ledger purchasing during the financial year. CCP also provided guidance to the market of FY17 growth in earnings of between 13-18% as the full effects of this purchasing and growth in consumer lending unfold.
The implications of these results on the companies yet to report is that an awareness needs to be maintained on:

  • Companies with an increasing level of receivables, particularly those exposed to WA & QLD and their ability to collect; and
  • Companies with exposure to asset prices and discretionary spending, again in WA & QLD.

Small-cap commentary
The impacts of a grinding cycle encompassing low growth, low interest rates and heightened volatility continue to ripple through the pricing of various asset classes. Few sectors have benefitted as much from this thematic as the property sector. Reflecting back on our messaging at the first half February results, little has changed in the trends highlighted at that time. If anything, they have intensified. We note:

  1. Bond yields globally remain at historically low levels. The Australian 10-year bond yield has compressed to a low of just 1.9%.

Australian 10 Year Government Bond Yield
Figure 2. Australian 10 Year Government Bond Yield.
Source. Bloomberg.

  1. The RBA has cut the cash rate twice since the first half FY16 results period, also to historically low levels.

Australian Cash Rate
Figure 3. Australian Cash Rate.
Source. RBA

  1. Such factors are tangibly and positively impacting asset valuation and investment performance of AREITs. We briefly review a result delivered by one of the first AREITs to publish their FY16 numbers this reporting season below.

Folkestone Education Trust (ASX: FET) delivered another fine result, building further on what has been a remarkable long term story. FET has now delivered an average annual return of 14.5% per annum over the past decade. The trust announced a 20.5% increase in net profit to $107m and a 16% increase in distributable income to $34.2m. The discrepancy between these two figures results from the substantial gains made on property revaluations, which accounted for $72.8m of FET’s reported FY16 profit. We expect this theme with be a significant highlight of AREIT results this reporting season.
This trend is best illustrated by a chart from FET’s full year results presentation, which compares the passing yield of various property subsectors in the AREIT sector since FY2013.
Retail, Office, Industrial and FET Yields, FY13 – FY16
Figure 4. Retail, Office, Industrial and FET Yields, FY13 – FY16.
Source: FET Full Year Results Presentation.
The global thirst for yield continues. As global and domestic buyers continue their hunt for income backed by high quality assets, transactions are being done at increasingly tighter yields. This is leading to a compression of capitalisation rates in listed A-REITs. The capitalisation rate, often called the “cap rate”, is the ratio of net operating income to property asset value. Similar to the pricing of fixed interest securities, as the cap rate compresses, asset values increase.
A word of warning for the uninitiated: while we view this as a slow, grinding cycle that is generally supportive of property, (again similar to pricing of fixed interest securities) cap rates cannot and will not compress forever. We maintain that a focus on quality and value is appropriate not only for operating businesses, but also for property groups. In some instances, we see market prices for select AREITs as becoming stretched.