A booming domestic economy and surging consumer confidence have seen well-managed businesses reap rewards. Yet they aren’t the only drivers of sharemarket performance. Higher market multiples have seen companies in highly-favoured sectors like IT lift to extraordinary valuations, especially those perceived to have revenue growth potential. We continue to prefer real cashflows to nebulous projections, and sound management to the pursuit of growth at any cost.
The domestic economy is booming. Relative to the best case expectations of the RBA six months ago, unemployment is 3% better. Consumer and business confidence is at ten year highs. At 15% of gdp, Australia’s fiscal stimulus last year was as high as any country, apart from New Zealand. And the RBA commodity price index (dominated by iron ore) is in AUD terms almost as high as it was in 2008, the “stronger for longer” epoch. Interest rates at 0.1% can’t go lower and the RBA has proposed keeping that rate for at least another couple of years, whilst adding another $100b of QE to the mix. In short, after the terrifying prospect of social and economic devastation from COVID‑19 less than twelve months ago, the policy measures that have been put in place have seen the domestic economy remain strong, with consumer related areas and housing extremely strong.
That isn’t just an economic abstract; it has come through in earnings numbers. Especially when coupled with good management, the leverage enjoyed from these conditions has been immense.
Premier performance as consumers bounce back
Premier Investments is a case in point; led by the redoubtable pair of Solomon Lew and Mark McInnes, Premier has performed extremely well through the past decade, with year on year improvements in profitability. First half ebit has improved $5m to $10m per annum every year until 12 months ago, seeing a base level of profitability when Mr McInnes joined the group of $50m more than double to $120m last year. A 100%+ or $70m increase in a decade; great work.
This year, the first half to June saw profits increase by $100m to $220m. More than a decade of hard won growth in a year; albeit a weird year, rocket fuelled by fiscal policy, monetary policy, rental and wage holidays and strong consumer confidence, more than offsetting lockdowns and viral concerns.
The Premier example isn’t unique; better management in the consumer sector have seen hitherto unimaginable increases in profitability through the past twelve months. In this context, the gradual abolition of a prospect of bad debts emerging for the banks is hardly a surprise. In each case, though, the issue for investors is what comes next; clearly there must be an unwind of the current exceptional conditions, but “par” is far from settled.
The gravitational pull of revenue growth
If earnings have fuelled the consumer sector performance, market multiples have clearly driven many others, of which IT is the poster child. The IT sector in Australia has been the star over 1, 3 and 5 years. Valuations are now beyond full, in the main, for those companies in the sector making little or no cashflow, which is almost all of them that have done well.
The sector has two stocks which make strong cashflows but have low revenue growth – Computershare and Link - and as a combination of attributes about as popular as Craig Kelly at an epidemiologist convention they have not enjoyed market favour. It’s all about the g – growth is the word, and revenue growth especially is the magnetic force for market attraction. In a low growth world, that’s understandable, but the risk attached to the presumption that early stage revenue growth will translate to longer term free cashflow, let alone cashflow growth, is not to be underestimated.
Building on Hardie’s heritage
It’s always hard for a leader to assume the role following a successful predecessor. Sir Alex Ferguson managed Manchester United for 27 years, and there have been four managers in the ensuing 8 years. Two years ago, Louis Gries retired after being the James Hardie CEO for 13 years, replaced by Jack Truong. Gries had been in a senior role at Hardies for more than two decades and had been CEO for more than a decade. In that time, profitability and returns increased exponentially, as did the market value of the group.
Against the odds, Hardies hasn’t just held high performance levels in the US during the past two years, they have lifted the bar materially. Profitability and returns are at all-time highs with housing starts still 39% below the all-time high levels of a decade ago. The European business Fermacell, acquired by Hardies under Dr Truong’s watch three years ago, hasn’t performed well and is a latent source of potential for the group. Other building material companies in the portfolio – Fletcher Building and Boral – have prospered as activity levels in Australia have boomed during the past year, however, their low secular revenue growth means they remain investment corks in the ocean, bobbing with the ebb and flow of cycles and management’s focus upon operational efficiency.
Cleaning up in the waste sector
As Cleanaway shareholders, we can only hope we have a James Hardie and not a Manchester United type succession as Vik Bansal leaves after six highly successful years. And not just on the total shareholder return scoreboard (which is easy to calculate and in the top quintile of ASX industrial stocks in his time as CEO). People is one of the five strategic planks for Cleanaway and the success of the business through the past several years has seen the workforce increase by 50% to 6,000 people; whilst workplace injuries have declined at 15% cagr through that period, and employee engagement has increased (with participation rates in the survey increasing materially).
We first invested in Cleanaway soon after Mr Bansal commenced as CEO, with his background in heavy industry (such as steel) influencing his productivity focus. But for margins to have increased towards the levels of the best global operators such as Waste Management and Republic in the US through the past several years has required revenue growth as well, whilst improving returns.
The history of Cleanaway had seen billions of value destroyed in poor M and A activity and operational sloppiness in the decade prior to 2015. That history, coupled with the prospect of industry dislocation locally as the two major competitors – Suez and Veolia – undergo forced realization of their major assets in Australia as they mull their own merger plans in Europe, means that the incoming Cleanaway CEO has a good opportunity, but expectations are not low and easy to meet.
The waste sector saw further activity through the month with the announcement of an indicative bid for Bingo industries. We have rarely seen a company that has evoked such emotional reactions from market participants than Bingo. It may be, that as with Cleanaway, this reflects an intolerance of cultural diversity. The skepticism that has been directed at Bingo since it listed four years ago at $1.80 per share has been immense.
Since then, Bingo has raised $500m (which saw the controlling family group invest a further $100m into the business, slightly more than many others listing companies on the ASX in recent years), and maintain and improve high margins and returns. A recent short report highlighted the prospect of non arms length contracts being undertaken (presumably at inflated prices to the cost of minority shareholders), whilst also suggesting that Bingo’s margins and returns are unsustainably high (despite, presumably, the depression to returns caused by the excessive payments to some suppliers). It also criticised Bingo’s revenue recognition policies whilst neglecting to mention that cashflow conversion through the past year has been exceptional relative to other ASX industrial companies.
We have been large shareholders in Bingo since listing, and remain unabashed admirers of the group’s ability to grow revenues and gain share whilst having a focus on using technology and innovation to be the lowest cost (and hence highest returning) producer in the market. Whilst the gain from the listing price to the bid price is exceptional for all shareholders, given the increasing environmental focus upon recycling rates and waste to energy opportunities in the market, it is hard to believe that the best is not yet to come for Bingo and its shareholders.
The option value on waste to energy is something that has intrigued us. Many of the calls we have done with renewable energy producers in the Australian market in recent times has led to a view that network replacement is far more imminent, costly and disruptive than many may believe.
Many market participants believe that 3 or more coal fired power plants will be closed within the next several years (some suggesting within 3 years). Estimates of the capital cost to augment the network to maintain stable supply in this event vary widely but are all well in excess of $30bn.
At a required rate of return of 5% for that investment (and no doubt project proponents will claim higher rates; and that the returns are not back end loaded) that requires a return of circa $2b. Industry profits are not currently much more than that, especially at a retail level. Although as in the past, in the year of closure returns for remaining base load power generators are expected to spike and hence the industry profitability level will be very volatile. Consequently, either (much) higher prices and/or dislocation of existing profits is inevitable. Little wonder AGL and Origin have both announced multi billion dollar writedowns in recent times.
It is also worth noting that, globally, the energy transition is not deterring investment; a similar sized plot of offshore wind seabed in the US has seen prices rise from less than US$1m in 2015 to US$135m currently, and leases for two 1.5GW plots in the Irish Sea had been won by companies willing to pay option fees in excess of £200m a year, against expectations of between £15-45m. Take that Gamestop.
Our portfolio position
At all time high multiples on earnings which have been buffeted by large, ephemeral and often conflicting forces, it is impossible to say the Australian equity market in toto offers good value currently on any basis other than relative to bond yields. Nascent signs of inflation, especially across soft commodities, has seen bond yields inch higher in recent months.
Further, the bifurcation between the winners and losers within the market remains as large as ever; growth stocks have never been more highly prized, nor value stocks more despised. As with Premier Investments, Hardies, Cleanaway, Bingo, AGL and Origin, management decisions in capital allocation, pricing and productivity will continue to have just as much influence in determining returns as those transient macro conditions, and the growth or value label attached to any particular company at any particular time, and that in turn is driving our portfolio positions and changes wherever possible.