Costs, capital (management), corporate (activity) and cautiousness

Articles 3/09/2021
Following an incredibly strong earnings season in February, our local sharemarket continued to be buoyed through the rest of the first six months of 2021 as we enjoyed an environment largely absent of social restrictions.  By the end of July, Macquarie's analysts noted that consensus forecasts for Australian equities had been upgraded for 11 consecutive months and meanwhile, US companies had just delivered impressive results.  Australian equity investors had every reason to be excited for the looming August reporting season.

However, an outbreak of the delta COVID strain in NSW and the resulting lockdowns across much of the east coast, combined with a moderation in forward-looking indicators for the local economy saw a tempering to some of this optimism.  With no JobKeeper program to support and a housing market that's already given as much as it can, what would be corporate Australia's take on the outlook?  

Key themes we identified from the reporting companies in August were:

  1. Cost pressures were confirmed, with only the strongest business models able to deliver price rises to offset

    Companies across a variety of industries, ranging from building products to food and beverage packagers reported notable increases in various cost lines such as freight and raw materials.  Thankfully, the majority of inflationary pressures relate to temporary supply constraints (driven either by regulation or COVID-related lockdowns) and so are expected to be one-off in nature as restrictions ease.

    This dynamic is best illustrated by the price of timber in the US (below).  What US$1,000 purchased in January last year was but a fraction by June this year.  Thankfully, prices have quickly normalised as much-needed supply returns.


    Businesses such as Amcor, Brambles and James Hardie, who each command strong competitive positions in their respective markets, were able to pass on these cost pressures to customers, protecting margins and thus profits.

  2. Investors should see healthy dividends drop into their portfolios over the coming month.  

    With profits well and truly recovering from their COVID-induced lows in 2020, nearly half of all reporting companies increased their dividends with less than 10% reducing shareholder distributions.

    Each of the big 4 banks delivered a result or trading update last month, demonstrating a notable improvement in profitability.  This was primarily driven by the reversal of hefty provisions for bad loans taken during last year in anticipation of what was supposed to be a lockdown-driven horror show for banking.  As it eventuated, the scorched earth scenario never arrived and has now left the banks with a great problem: excess capital that can be returned to shareholders.  While some banks have commenced on-market buybacks, the Commonwealth Bank will instead provide its shareholders with the opportunity to participate in an off-market buyback.  Regardless of the method, shareholders will benefit.

    We also remain on the lookout for an announcement from Qube regarding capital management as soon as it receives the sale proceeds from its warehouses at the highly valuable Moorebank intermodal freight facility.

  3. Corporate activity is clearly rising

    Buoyed by record low interest rates and, increased confidence in the economic effects of a successful vaccination rollout (notwithstanding the east coast's latest lockdowns), companies and institutional investors are looking for acquisition opportunities ahead of an expected re-opening of interstate and eventually, international borders.

    Sydney Airport continues dialogue with a consortium of primarily industry super funds, who are keen to opportunistically acquire a premium and irreplaceable piece of national infrastructure.  Wesfarmers lobbed an unexpected (and yet to be accepted) offer for pharmacy owner Australian Pharmaceutical Industries as it attempts to build a foothold in the domestic healthcare marketplace.

    While consolidation within the Energy industry has been occurring for the better part of the last year (evidenced by the announced Santos / Oil Search merger), the deal on everyone's mind last month was the proposed merger of BHP's Petroleum business and Woodside.  For BHP, it delivers a swift exit from its exposure to the fossil fuel industry as it looks to bulk-up on "future-facing commodities" like battery metals (such as copper and nickel) and potash (a high-grade fertiliser).  Woodside receives a portfolio of low-cost, highly-cash generative assets that will assist it to fund its next growth projects such as the Scarborough LNG project.  However, we continue to assess the stock's longer-term position in portfolios as the global transition towards cleaner forms of energy is now well underway…

  4. Corporate Australia continues to lead politicians in setting firm environmental and sustainability commitments 

    While the Federal Government remains uncommitted to a net zero emissions policy, a rapidly growing number of companies are setting ambitious but realistic targets.  Macquarie estimated that over 50% of the companies within the S&P/ASX 100 have now committed to a net zero policy compared to only 20% just a year ago!

    Furthermore, companies are taking further steps with regard to sustainability.  Global consumer goods packager Amcor remains well on track to achieve its target of having all its products either fully recyclable or reusable by 2025 and are now pursuing compostable solutions.  Notably, Amcor has set these targets well in advance of its own customers. These issues are also driving corporate activity, as illustrated by BHP's exit from the Petroleum business and Woolworths' recent demerger of its liquor and hotels business.

    Investors, particularly institutions like industry super funds, retain a strong focus on these issues and we expect them to remain so for many years to come.  We expect shareholder activism to continue and will be evident as AGM season looms in the coming months.

  5. Domestically-focussed businesses hold a very cautious outlook

    With the re-emergence of lockdowns across the east coast since June, earnings in the second half of 2021 will likely prove very different to that of the first six months.  The result: few companies had confidence (nor the clarity required) to provide earnings guidance for the months ahead.  Even COVID beneficiaries like Wesfarmers (think Bunnings and Officeworks), provided an extremely conservative outlook for the year ahead.

    Given these restrictions have now been in place for some time, we are expecting downgrades to analysts' earnings growth forecasts in the coming months.  However to date, investors seem to be ignoring this issue.  We suspect that once AGMs get underway (where trading updates are commonly provided) and assuming lockdowns continue to prevail, investors may be in for a reality check.

With our local market having experienced a solid run in recent months, we feel much of the strength shown in last month's results are now being comfortably reflected in share prices.  Furthermore, we remain watchful of the potential for volatility in the coming months as the market digests a softer outlook for corporate earnings at the same time as the United States' Federal Reserve looks to start winding back part of its stimulus before year's end.

As a consequence, we have been taking profits in names that have performed exceptionally well so far this year.  We continue to position portfolios modestly underweight their Growth targets and retain an incremental preference for offshore equity opportunities on the basis of more attractive valuations than their Australian counterparts.
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