The All Ordinaries Index has now trended sideways for a month and is up some 845 points or 18% since its February low of 4,762. At the index line the investing environment could be described as calm or even buoyant. Those who call a 20% rally a bull market are just two percentage points away from their threshold.
The true story of the August 2016 reporting season, however, is quite different. Beneath the calm surface some sharp repricings for risk are occurring and so far this reporting season, right or wrong earlier calls about risk are making all the difference to investor returns. The movements are important for value investors to understand because risk is one of the three main inputs to an intrinsic valuation, the others being profitability and capital management.
It’s easy to forget or misunderstand risk. Growth in the form of higher sales, earnings, dividends and share prices is tangible and visible but risk is intangible, not directly visible and harder to understand and measure. Despite this the most successful value investors have a keen understanding of risk in a company and make the right calls on risk before the rest of the market does. At StocksInValue our universe stock valuations not only reflect where risk is now but where it is heading. This knowledge is valuable because the market can very quickly price in shifts in risk and catch out the uninformed investor. It’s important to act in advance.
Risk in a business relates to the volatility and predictability of earnings (earnings risk) and the security of shareholders’ funds, especially from lenders (financial risk). The two concepts are related and sensitive to the level and variability of return on equity, how wisely boards and management reinvest earnings for growth, indebtedness, whether a business uses acquisitions to strengthen competitive advantage or build a larger but less profitable empire, and how easy or hard it is for management to predict the future and provide accordingly.
In this week’s investing report we review four companies repriced by the market this reporting season because earnings and/or financial risk changed.
Ardent Leisure derisks and focuses on the US for growth
The market warmly welcomed the sale of the Health Clubs division for $260m to private equity and the FY16 result. Revenue, profit and capital management initiatives all surpassed expectations and all divisions grew revenue and earnings. Group revenue, earnings and cashflows grew at double-digit.
We applaud the sale of the Health Clubs division, which substantially derisks the stock by reducing debt. The sale price was higher than book value and significantly higher than stockbroker estimates of value. The Marinas division is also for sale and proceeds of ~$110m are likely, so AAD is set to de-gear further in coming months.
This allows management to redirect capital to the higher growth, higher margin businesses that remain, especially the US Main Event Entertainment business. Management for the first time guided to a potential target of 200 centres, which was surprisingly high. There are currently only 27 centres, which demonstrates the upside for shareholders. A further 11 new centres are planned for FY17, with centre roll-out growth to continue at 30-40% pa until 2020.
Figure 1. AAD’s Main Event Portfolio
Source: FY2016 Results Presentation, Slide 22
There could be 100 centres by the end of the decade. With this footprint, Main Event alone could generate $250-300m of EBITDA per annum.
Market consensus now expects core earnings of $100m+ by 2019. While this will require a smooth rollout of Main Event, if achieved AAD would compound earnings by 18% pa over the next three years. By selling non-core assets, reducing debt and gradually concentrating its earnings in Main Event AAD is both reducing earnings volatility and increasing earnings growth potential. This is why the stock rallied.
ANZ derisks its loan book and is rerated in the market
ANZ shares have been to seven-month highs because the volatile institutional loan book, which caused surprise spikes in bad debts expense in the interim result, is being run down but revenue from institutional loans is falling without causing operating deleverage. Operating cost savings are supporting earnings here. ANZ is not necessarily set for faster earnings growth but the market is correctly pricing in less variable and more predictable future earnings.
Soft demand for credit in the Australian economy is boosting ANZ’s capital strength by reducing the amount of regulatory capital needed to back new loans. Tier 1 capital surprised on the upside in the recent June quarter trading update and we no longer think ANZ will need a rights issue in FY17 to raise more capital sooner. This also justifies the recent rally.
There is further derisking to come. ANZ’s four Asian banking joint venture stakes (AmBank in Malaysia, Peran Bank in Indonesia, SRCB and Bank of Tianjin in China) are all for sale. While the exits could take time, the end result will be a stronger capital position because the partnerships are currently capital deductions for regulatory purposes.
The 1H16 dividend was rebased lower to more sustainable levels and the shares rallied in response to price in the stronger capital position and lesser chance of a rights issue. Underlying Tier 1 equity capital at the end of the June quarter surprised on the upside by rising 44 basis points or 0.44% to 9.7 per cent of loans. The regulator APRA’s minimum is 8.0% and ANZ’s internationally comparable Tier 1 ratio is well within the top quartile of banks globally, consistent with APRA’s requirement Australia’s banks be “unquestionably strong”. ANZ did not discount or underwrite the interim dividend, which indicates the board’s comfort with the capital position. There are no immediate capital pressures here.
Figure 2. ANZ’s lower dividend payout derisks the business
Less certainty about Telstra’s dividend pushes the shares lower
Telstra shares fell after the FY16 result because there is more uncertainty around future earnings and dividends than the market thought. TLS is suddenly and unexpectedly having to invest a higher proportion of sales in capital expenditure to fix the mobile network outages which damaged the brand this year, and to remain competitive in the rapidly changing world of telco and data technology. The final dividend was flat, not half a cent higher as the market expected, a sign of the pressure on the dividend from flat earnings and higher capex intensity. It dawned on the market Telstra is in a defensive position and having to run harder to stay still.
After the FY16 result we downgraded NROE from 40% to 38% and increased RR from 10.50% to 10.75%. This was the first time we rated TLS as riskier since December 2012 and the adjustment is a message there is now more uncertainty around future profitability and therefore dividends.
TLS is on a journey from a legacy telco to a “technology company” (its own self-description) when communications technology is changing rapidly. The company has the advantages of size, brand recognition and billions of dollars of free cashflow but we are not sure enough TLS can maintain its profit margins and ROE when the costs of competing with TLS are falling and the ways to take share from the company are growing. TLS might aspire to be a tech company but this is not Facebook or Apple, two first-movers which changed the technology world with revolutionary customer offers. TLS has a $2-3bn pa EBITDA gap to fill as the NBN replaces the legacy copper network, and retail margins will not be those of the pre-NBN world.
The $3bn of new capex on fixing the mobile network outages and otherwise upgrading the network surprised us because our understanding was capex was supposed to diminish after earlier projects. We view the $3bn as defensive and necessary to reassure mobile customers something is being done about the outages, which detracted from customer confidence in the brand. Guidance for the capex to sales ratio was increased to 18%, which means TLS is becoming more capital-intensive, partly for defensive reasons and where the profitability of the capex is harder to predict. We do not think mobile margins post the $3bn will be the same as before.
The $1.8bn profit on the sale of Autohome was impressive but TLS also wrote off $246m against its investment in streaming video provider Ooyala. It is going to be hard for TLS to reinvent itself through venture capital investing.
These concerns follow TLS’s earlier withdrawal from a year-long negotiation to buy into the Philippines mobile market. We don’t like how TLS is being forced into risky, timeconsuming offshore acquisitions to replace growth which is evaporating in Australia.
Subscribers should interpret our $5.79 30/06/17 valuation as the midpoint of a widening band of possible valuations for various bullish and bearish scenarios. Now the is ex-dividend we see no catalysts for a rerating towards our valuation and think the most likely outcome near-term is a drift back to $5 while the market tries to forecast the 1H17 result due in February.
Figure 3. Telstra’s rising capital intensity, some of which is defensive
Fortescue back from the brink as it deleverages
For miners and mining services contractors, one of the key themes of reporting season is the focus on cashflows with companies over the last year:
- Halting expansionary capex and pushing out maintenance capex
- Finding improved efficiencies via lower staff numbers and higher production grades.
The outstanding example is Fortescue Metals Group (FMG), whose demise many commentators predicted as iron ore prices trended lower from their 2011 peak. This year’s steady share price rally from January lows of $1.44 to $4.88 at the time of publication reflects the iron ore price rally but also the lower required returns used in valuations of the stock. FMG used the higher iron ore price, lower capex and operating cost reductions to boost free cashflow, which it then used to pay down debt levels still high after the resources boom. FY16 free cashflow was $2.7bn, a 93% increase on FY15, and debt declined by $2bn. Gearing is down from 49% to 38%. We reduced the required return in our FMG valuation, which valuation rose from $2.92 to $3.54.
Elsewhere, Whitehaven Coal achieved the same outcome. Derisking through debt reduction will be a consistent theme at other miners for the rest of the reporting season.
Figure 4. FMG’s lower gearing is reflected in its higher share price
Source: Fortescue Metals Group