The momentum in earnings growth has peaked. Here are the companies we’re watching

This reporting season we saw a more balanced outcome of results, with those surprising to the upside; in-line; and missing expectations, broadly evenly split. So while at the top level it may seem that the market carried on relatively unaffected (ASX200 gained 1.5% over August), the level of volatility and the heightened reaction for misses suggests a different story under the surface.

What were the major themes that emerged from the reporting season?

There were four key themes that were evident across this reporting season, and that carry into future investment thesis:

1) Lockdowns and re-opening:

Round two for the largest state NSW (in economic terms), and Round six for Victoria, had little impact on the reported 2H21 period (January-June 2021), but will certainly create a headwind into 1Q and most likely 2Q of FY22. With that came conservatism in outlook statements, with many companies choosing to avoid them given the heightened trading uncertainty. However with vaccine rollouts gathering momentum, reopening sentiment has turned positive. Critical milestones loom for October and November and will influence decisions around domestic/ international borders and in turn broader reopening sentiment for CY22 which will influence business capital allocation.

2) Cost pressures:

While more acute in certain parts of the market, it was felt across the board and centred around Labour shortages (mining and transport), Materials (construction) and Components (technology/chips and auto). Freight was another area we saw a material increase in costs and even our banks weren’t spared, all with cost reduction targets or disciplines in place. It remains to be seen if these cost pressures are temporary, or more persistent. Our view is the latter, at least for the upcoming 12 months, which will likely weigh on corporate margins.

3) Capital allocation:

While the banks kicked off the capital management rhetoric pre reporting season, we have seen a number of other large market stewards follow suit, including Telstra and Wesfarmers. From a dividend perspective the Miners certainly came to the party, with Rio Tinto and BHP Billiton paying out a healthy dividend yield of 14% and 10% respectively, with free cash-flow yields in excess of this given the huge windfall from elevated iron ore prices.

4) Mergers and acquisition:

Intensity of M&A activity has continued to rise across all sectors and across all market caps. At the large-cap end we had square’s takeover of Afterpay (all script) and a consortium bid for Sydney Airport. But also included announcements at the smaller end of town, including Autodesk’s bid for Altium (subsequently knocked back), and there is speculation IGO is looking at Western Areas in the nickel space. Our expectation is we are likely to see this level of activity continue as asset values remain well supported in a low interest rate environment.

What does this mean for forward looking expectations?

The market has upgraded FY22 earnings growth by approx. 2% and is now factoring in 20% EPS growth. This is dependent on Industrials (+51%), Materials (+20%), Energy (+69%) and Financials ex Property (+17%) sectors as the key growth drivers. However, with lockdowns continuing to impact a number of our companies, lower iron ore prices and headwinds for Banks emerging (in terms of margin pressures) we see downside risk to the 20% growth expectations, unless there is a very strong recovery into the second half (January-June 2022)¹.

What is our view on the outlook for the Australian Market?

We remain cautiously optimistic on the outlook.

As we see the domestic economy re-open we will turn our focus to the fundamental drivers of business confidence, consumer sentiment and unemployment to determine whether the earnings up-cycle can continue from here and whether the recovery can be sustained. While we think the momentum in earnings growth has peaked, we still expect a positive growth skew over the coming periods, albeit at a more normalised rate.

However, we acknowledge we are in the early stages of the recovery and there are different pathways the global recovery can take from here, let alone the domestic one.

How are we approaching the recovery from a positioning perspective?

We understand that there will be certain industries and companies that will perform better as we move through the next phase of the business cycle, and as such we tend to construct portfolios with a mix of:

1. Long term compounders. Those with structural tailwinds that enable compounding returns over our investment horizon, regardless of what recovery path is taken.
2. Businesses that are leveraged to the economic recovery. Those more cyclical in nature, but with very strong fundamentals.
3. Defensive companies offering very predictable earnings and strong cash generators, albeit lower growth.

We tilt into these 3 broad categories, depending on forward looking views, with the aim of looking beyond current market volatility and displacement and remain focused on high-quality companies.

Sector-by-sector round-up, with a focus on our holdings across the different strategies:

Financials:

Commentary on the sector:

Broadly in-line, with cost inflation coming through and capital management and margin pressure a continued theme amongst the banks.

Commentary on key stocks held:

Banks: CBA (ASX:CBA) was the only bank to release their full year results, with the others delivering either first quarter (MQG) or third quarter (NAB, ANZ, WBC) updates, with no financials. However, there are some clear catalysts (positives and negatives) that we should expect from this sector over the coming 6-12 months, which was reinforced at the results: capital management (as a result of holding excess capital), margin pressures (mainly from competition), and focus on costs. What is perhaps more surprising is that credit quality has remained high even throughout the most recent lockdowns with banks seeing very little take-up of loan deferrals (compared to 2020) and as such remain well provisioned. The housing market remains resilient and the general outlook remains supportive. Given the strength in the housing market, macro-prudential policy is back on the agenda, but what is keeping the regulator from imposing this is the lack of investor loans to date. 

Longer term, as funding costs increase and competitive pressures remain, margins will continue to come under pressure, until we start to see interest rates lifted, which is not our expectations for the next 2 years.

Exchanges: the ASX continues to prove its mettle, delivering a resilient performance despite material declines in interest rate future volumes as a result of the RBA’s yield curve control and quantitative easing measures that have been put in place as a response to the ongoing pandemic. There was relief that the findings of the independent review into the ASX outage were relatively benign, and we would expect the ongoing ASIC review to offer concurring comments. The market also rewarded ASX’s result as the company signalled peak expense growth was coming to a head, and while capital project spend remains elevated, the CHESS replacement project is on track for launch in April 2023 and project risk is quickly receding as it moves into the testing phase. Across the ditch, the NZX also produced a robust result with high traded volumes being largely maintained despite strong growth in the comparative period. Importantly, traction within the two key growth businesses of Smart Shares and Wealth Technologies remain positive, with management confident in achieving both the year end targets, as well as longer term strategic ambitions.

Insurance: it has largely been another 12 months best forgotten, with higher peril expenses and increased long tail provisioning due to claims inflation more than offsetting what has otherwise been a strong premium rate environment. However, looking forward, the premium rate cycle momentum is expected to persist for longer and the competitive environment remains rational, allowing insurers to earn-through pricing increases and restore margins. Furthermore, outsized provisions that were booked by insurers like IAG (ASX:IAG) for COVID business interruption claims continue to look conservative given the modest actual claims experience observed to date, as well as the conservative levels of risk margin that have been incorporated into these estimates. 

There is a fair likelihood, depending on the outcome of remaining test cases working its way through the legal system, that insurers like IAG may benefit from provision releases and capital surpluses in 2022. 

The insurance brokers, including our investment in AUB, delivered strong results that demonstrated not only industry tailwinds by way of rising insurance premiums, but also organic self-help initiatives such as IT upgrades and supplier renegotiations assisting to drive exceptional topline performance, which pleasingly also translated into significant operating leverage. The growth outlook for the insurance brokers remains buoyant and AUB continues to be our preferred exposure.

Wealth platforms: amidst a strong backdrop of organic FUA growth, this reporting period saw major wealth platforms record faster than expected margin deterioration as a result of back-to-front book repricing, the RBA cash rate cut in November 2020 that was fully absorbed, as well as higher reinvestment in IT and product development. There have also been increased focus on augmenting non-platform offerings that have seen operators like HUB acquire a number of businesses over the past 12 months. Another consistent theme was labour cost inflation particularly for experienced IT professionals who remain in high demand, adding further to elevated levels of product development spend that we expect will continue, as the industry broadens its ecosystem. While sustainable platform margins have been rebased downwards, we continue to have high conviction in the secular growth trends that appear to be accelerating, and expect this will continue to benefit the speciality platform providers including our holdings in both HUB and NWL.

Materials

Commentary on the sector:

Cash generation the standout as they delivered record earnings, with strong balance sheets returning bumper dividends to shareholders driven by elevated commodity prices

Commentary on key stocks held:

Going forward we still expect the miners to be able to deliver healthy capital returns to shareholders though we have likely reached a peak as commodity prices moderate and cost pressures rise whether that be labour, freight or input costs. The miners are progressing with their strategy to pivot and grow their businesses. BHP (ASX:BHP) announced a transformational strategy update as they seek to unwind the DLC, de-merge their petroleum assets and approve the Jansen potash project. These align with their over-arching strategy to simplify the business, improving agility and retain capital allocation discipline focusing on future facing commodities which is expected to generate long term value for shareholders. Fortescue (ASX:FMG) announced further headline detail on their Future Facing Industry strategy which sensibly diversifies and decarbonises the business, though how that translates into project risk and return for shareholders is yet to be presented to investors. 

The large miners share prices were all weak in the period mainly driven by a weaker iron ore price on the back of Chinese policy announcements. 

Elsewhere Oz Minerals (ASX:OZL) approved a project expansion as they progress their strategy to add low cost copper volumes into a commodity that has structural tailwinds from decarbonisation. In the Building Materials sector, James Hardie (ASXJHX) is executing well into a strong US market, supplemented by their strategic decision to grow market share with a leading product portfolio, mix shift and margin expansion. We expect these to persist and act as a buffer to the risk of future US market volume normalisation.

Gold: The primary driver of gold miners during August was a major selloff in gold at the beginning of the month as a US employment beat drove fears of early tapering. Gold recovered back above US$1,800 by the end of the month when the US Fed Chair’s speech at the Jackson Hole Symposium was interpreted by investors as dovish (or less hawkish than anticipated). Results were in line for the gold miners as they had already released their 4Q results with accompanying outlooks. A tight labour market driven by a shortage of site workers has driven wage inflation and pushed up costs for most operators in the space. Despite volatility in the gold price, large cap names such as Northern Star (ASX:NST) and Evolution (ASX:EVN) are still generating solid free cash flow through the cycle and have optionality to grow production.

Healthcare:

Commentary on the sector:

Mixed results, depending on end market exposures, and outlook statements.

Commentary on key stocks held:

This sector had one the widest variance of share price returns this reporting season. There were clear Covid winners (eg Fisher and Paykel, Resmed, Pro Medicus) and losers (CSL, Cochlear, Nanosonics), with the latter group being affected by access to hospitals and procedures. However, as we begin to look through the impacts of Covid, there is one thing that sets this sector up for consistent future growth: the awareness of the underinvestment in public health systems and the necessity to continue innovating in this space. CSL, the market steward, provided an update on the challenges they face from a plasma collection perspective, with the market choosing to look through the downgrades implied from its guidance and ongoing margin pressures. 

Cochlear, on the other hand provided a robust 11-20% NPAT growth guidance range, but this was not enough to please market expectations of higher growth. They remain focused and investing in building awareness to drive penetration in the very large Adult market for cochlear implants. 

At the smaller end of town, Pro Medicus (ASX:PME) continued it’s very strong rally with the announcement of commercialisation of their AI algorithm and their growing market opportunity as hospital groups consider the Cloud. Nanosonics (ASX:NAN) announced the much awaited launch of their second platform product, Coris, which addresses a very large, unmet problem of high level disinfection in endoscopy equipment. We remain constructive on this sector going forward given the consistent growth opportunity, high returns and competitive moats our holdings have developed, ensuring that these returns are sustained.

Consumer Discretionary:

Commentary on the sector:

Strong FY21 which benefitted from stimulus and pent up demand, but outlook tempered by impact of current lockdowns

Commentary on key stocks held:

Consumer Discretionary stocks enjoyed strong operating leverage and earnings growth in FY21 driven by substantial fiscal stimulus measures and pent up demand following the lockdowns of 2020. The outlook is tempered by Delta lockdown restrictions requiring physical store closures for our holdings including Wesfarmers (ASX:WES) (Kmart, Bunnings, Target), ARB Corporation (ASX:ARB) and Bapcor (ASX:BAP). All companies reported a step change in online sales penetration, which is expected to be a persistent feature, even once lockdowns pass. This has particularly benefited our holding in online furniture & homewares retailer, Temple & Webster (ASX:TPW), which reported early FY22 sales growth of 49%. All of our holdings reported supply chain fragility and substantial escalations in freight costs. This is being managed by holding additional inventory and passing on cost escalation to consumers in the form of price rises. Most of our holdings were optimistic of a re-opening prior to Christmas as vaccination rates rapidly increase.

Real Estate:

Commentary on the sector:

Surprised to the upside given sharper than expected bounce in economic activity and willingness to provide forward looking guidance and dividend distribution certainty. Stand-outs were the property fund managers (Goodman Group and Charter Hall Group)

Commentary on key stocks held:

The focus this reporting season, particularly those invested in passive rent collecting REITs were two fold - namely YTD performance which broadly surprised the market given the sharp bounce back in economic activity, and secondly the ability and willingness to provide forward guidance and dividend distribution certainty to investors given the ongoing lockdowns. Despite the disproportionate impact on the CBD office sector, our holding Mirvac was able to give guidance thanks to portfolio quality, whilst their ability to deploy capital as part of its diversified portfolio into Residential supported earnings momentum. Our other passive income holdings also delivered in line results including the likes of Charter Hall Long WALE REIT and Centuria Industrial REIT, as high occupancy and long lease structures delivered on the defensiveness that we were after, whilst the latter benefited strongly from the structural tailwinds of e-commerce, supporting an outlook of solid rental growth and further asset appreciation. 

The standouts for this season continues to be the fund managers namely Goodman Group (ASX:GMG) and Charter Hall Group (ASXCHC), as equity flows into the real asset sector remains unabated in the face of low interest rates. 

Both large cap names were able to find their own ways to deploy capital and grow funds-under-management, Goodman through their rapidly expanding internal developments pipeline, whilst Charter Hall leveraged their transactional network to secure a vast array of off-market sale opportunities. Overall whilst solid transactional evidence seen across this sector meant investors were less focused on debating COVID induced structural drivers and more on near term income certainty, our portfolio remains skewed towards asset classes that benefits from those long term structural tailwinds which includes the likes of property fund managers, industrial and residential whilst remaining selective in the remaining sub-sectors.

Industrials

Commentary on the sector:

Broadly in-line with domestically focused cyclical businesses reporting decent growth rates, only to be offset by cost and supply chain pressures and weighed down by dim outlook statements given the resurgence of COVID and lockdowns

Commentary on key stocks held:

Industrial stocks had a largely uneventful reporting season with domestically focused cyclical businesses reporting decent growth rates, only to be offset by cost and supply chain pressures in addition to being weighed down by dim outlook statements given the resurgence of COVID and much dreaded state-wide lockdowns. Both Sydney Airport (ASX:SYD) and Auckland International Airport (ASX:AIA) reported soft results as international travel continues to elude us, although it was encouraging to see a sharp rebound in domestic travel activity on both sides of the Tasman, albeit this momentum was unfortunately interrupted by the raging Delta variant. While passenger volumes remain anaemic, the accelerating pace of vaccine roll outs offers some light at the end of the tunnel, complemented by the federal government’s 4 phase reopening plan, which provides a clear pathway to restarting unrestricted international travel over the next 12 months. 

Our holding in SYD benefited from an ongoing takeover attempt which does not surprise us given the highly strategic nature of the airport’s assets, opportunistic timing, and our conviction that the long term productivity of the asset base has not materially degraded. 

Outside of travel, while activity in the mining services sector has seen a strong uptick, our holding in Perth based mining service contractor MND reported lower than expected margins despite delivery a beat at the topline. While iron ore activity in the Pilbara is running red hot, contractors like MND have been impacted by rapidly escalating labour rates, higher workforce churn and lower productivity due to COVID restrictions. We expect margin recovery as the current batch of projects complete, and new work is repriced to match current market conditions. Finally, while offshore earners such as patent firm IPH were impacted by the strength of the Australian Dollar in FY21 (which has seen receded), it pleasingly delivered a commendable operating result and managed to grow like-for-like earnings and lift margins meaningfully. We continue to view the IP sector as offering attractive quality characteristics and view IPH and having both the organic levers to grow its leading Asian franchise, as well as strong support to pursue its proven acquisition strategy.

Consumer Staples

Commentary on the sector:

Broadly IN-LINE, with the major supermarkets positing strong operating environment, which we expect will normalise post Covid-induced behaviour (in- home consumption).

Commentary on key stocks held:

Consumer staples FY21 results were broadly in line with consensus estimates, though Woolworths performed well as its FY22 trading update (first 8 weeks) indicated an acceleration from 4Q despite cycling strong results in the prior period. Retail food and liquor consumption remains elevated with ongoing closures of restaurants and bars. Online penetration for food and liquor retailers has continued to grow and is an opportunity to expand market share, albeit at the expense of margins, given these sales channels currently lack the scale efficiencies of in-store. Higher cost and capex forecasts for the sector also partially offset the strong 7-8 weeks of FY22 trading. Investors continue to find the sector’s defensive properties attractive at this stage of the cycle. Valuations are beginning to look stretched for the large food retailers (WOW/COL) with earnings multiples sitting around all-time highs.

Information Technology

Commentary on the sector:

The sector performed strongly in August as the structural tailwinds under-pinning this sector remain intact and post COVID have seen an acceleration.

Commentary on Key stocks held:

The period kicked off with US company Square bidding for Afterpay (ASX:APT) in a scrip deal which saw the share price soar 30%. There is a lot of merit in combining the two businesses, delivering material revenue and cost synergies. Megaport (ASX:MP1) reached a major milestone delivering an EBITDA break-even run-rate in the month of June as they reach scale with operating leverage coming through, following a period of heavy investment. We expect this to accelerate as they scale up their operations in a less capital intensive manner and further open their total addressable market. Audinate (ASX:AD8) is experiencing strong demand, a combination of cyclical recovery from COVID as well structural drivers with a shift to digital as the clear market leader in digital audio networking technologies. Leading indicators point to sustained high levels of demand growth in their core, and opportunities for growth as they penetrate the video market. However, supply is a key risk due to the global semiconductor shortage. NextDC (ASX:NXT) is also experiencing strong demand as digitalisation and the shift to the cloud accelerates post COVID. Alitum (ASX:ALU) was a key detractor as the result missed at the EBITDA line and whilst the outlook remains for healthy demand as they continue to take market share in the printed circuit board (PCB) market with their market leading cloud product, costs are higher than previously expected. The share price was punished as the medium term flight path detail was removed and the long term aspiration pushed out a year.

Communication Services

Commentary on the sector:

Largely IN-LINE with expectations

Commentary on Key stocks held:

Telstra (ASX:TLS) reached an inflection point with underlying earnings returning to growth in the second half, even after taking into account the substantial headwind of the NBN. This was driven by the successful execution of the T22 cost reduction and simplification strategy, and an improvement in mobile division performance. Telstra also announced a $1.35bn share buyback and there is increasing confidence that it will be able to self-fund its existing 16cps dividend going forward. Domain Holdings’ (ASX:DHG) strategy of simplification, optimization, and investing behind their market place strategy paid off, delivering strong improvements in revenue yields as the housing market recovered post COVID lockdowns. While the short term outlook is clouded by delta lockdowns, we are confident that once restrictions are lifted, there will be a strong rebound in listings volumes and operating leverage.

Energy

Commentary on the sector:

Broadly IN-LINE, while the focus for this sector has been on M&A and production outlooks

Commentary on key stocks held:

Results were broadly in line however the focus for this sector has been on M&A and production outlooks. Woodside (ASX:WPL) announced a transformational deal to merge with BHP’s Petroleum business in a scrip merger. The deal, if approved, will provide global scale, shoring up the balance sheet and growth profile, as well as adding higher returning projects to the portfolio. Woodside also announced Meg O’Neill as CEO, an internal candidate that comes with strong international experience. Santos (ASX:STO) is pursuing an acquisition of Oil Search (ASX:OSH), increasing its overall exposure to PNG. While both companies have committed to long term Net Zero goals with near term carbon reduction targets, we would like to see more progress delivering into credible decarbonisation strategies. Beach Energy (ASX:BPT) disappointed the market with their FY22 production guidance outlook, although we continue to believe there is upside to valuations as they execute on the longer term growth profile.

Utilities

Commentary on key stocks held:

Our only holding that reported during the reporting season was Mercury NZ (ASX:MCY). The renewable gentailer reported a weak result as pre-guided, owing to dry weather inducing below average hydro generation, which was further compounded by a short outage in one of their geothermal plants. Looking past these short term disruptions however, the company made solid progress on their upcoming windfarm build, with Turitea North expected to contribute to earnings from 2Q22. Pleasingly, MCY also reaffirmed that their internal cost out program remains on track. 

The favorable regulatory landscape for electrification in NZ coupled with the company’s recent acquisition of Tilt Renewables NZ likely sets them up well for long term growth, as perhaps evidenced by management’s decision to reward investors with a rise in dividend, the company’s 13th consecutive year of dividend growth. 

Our other holding, Ausnet (ASX:AUS), reported back in May and somewhat disappointed investors, as dividend growth profile appears muted given management’s preference to retain capital in a bid to fund the growth capex within its unregulated asset base over the medium term. We continue to believe Ausnet will be a net beneficiary as the nation’s energy transition ensues, with the regulated asset framework supporting its core business and allowing it to deliver a steady defensive income profile that we have come to expect.

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