This week: ASX v Wall Street
FYTD: ASX v Wall Street
It’s that time of the year again. No, we don’t mean tax time.
Over the next few months, the market will look to gain its bearings regarding the outlook for corporate profits.
This Profit Reporting Season is unique, in that occurs at a time when we are standing on the fulcrum of a seesaw.
Behind us lies the COVID-enhanced profits of yesterday. Over the last few years, earnings turned sharply lower as we were confined to our homes. But “panic”, quickly turned to “profits” which were turbocharged by a mammoth amount of fiscal and monetary stimulus.
Ahead lies a future where policy has been slammed into reverse. Governments have tightened their belts, inflation is beginning to bite, and higher interest rates are beginning to flow through to the broader economy. And so, the outlook for corporate profits is likely one of moderation, from the lofty levels we have seen of late.
However, while there is much discussion about the “big picture” of corporate profits (in aggregate), we expect the bigger story to be about a change in leadership, the winners and losers within the stock market.
With the fundamental shifts we have seen in the economy, the winners of yesterday may be the losers of tomorrow. We thus think conditions are ripe for “stock pickers” (a euphemism for company-focused investors) to shine.
When putting companies under the microscope this year, there are likely to be several areas of focus. We explore these in our preview of this year’s Profit Reporting Season.
Looking back at margins…
In our preview of profits for the first half of the financial year (1H-22: it’s at the margin) we observed that investors would be laser-focused on profit margins.
Six months on and this broad focus has not changed.
Leading into reporting season investors are focused on costs, more specifically, how rising costs are managed and their impact on margins.
And so far, we have broadly seen companies able to recoup these costs, with corporate profit margins benefiting. This can be seen in the chart below which plots profit margins (EBIT profit margins) and returns to companies on capital invested (ROE):
While the focus during the half-year was largely on supply chain and input costs, these have begun to ease. This can be seen in the chart from UBS below, which is an aggregate of 20 supply chain indicators.
In place of this is a sharper focus on labour costs. Broadly, corporate profits have benefited from a declining share for wage earners which, should this reverse, will have an impact on corporate profits.
…looking forward at revenue
Profit margins will remain a focus this profit reporting season.
For instance, we will begin to see the impact of a higher cost of debt flowing through the financial and property sectors (discussed below).
However, with interest rates rising and the tailwinds from the last two years dying down, there is likely to be a stronger focus on revenue.
That is, there will be the added consideration of a potential slowdown in demand.
Investors will look to differentiate what has represented a “sugar hit” to growth over the past two years, and what represents a more durable shift.
With this, we may see some companies finding they have accumulated more inventory than they perhaps needed (as we saw with Walmart in the US). The unwind of this is likely to be a factor moving forward.
Furthermore, while it will take some time for recent interest rate rises to flow through, there will also be a strong focus on companies with direct exposure to consumer spending.
So far, households, while pessimistic, have continued to spend. This may change as higher interest rates and inflation impact disposable income.
Statements regarding the outlook for profits will therefore be methodically dissected in determining who the winners and losers in this new economic environment will be.
We look forward to keeping you up to date as Profit Reporting Season begins (in earnest) over the next few weeks.
Australian Equities sub-portfolio
De Grey Mining (positive impact) announced a very promising set of drill results.
De Grey holds a 1,500 square-mile tenement just south of Port Hedland (~60km) collectively known as the “Mallina Gold Project”.
The Tier 1 project is one of few large-scale, low-cost gold finds of the last few decades. It enjoys a privileged location (assisting not only with transport costs but also available infrastructure), with the majority of the identified resource located not far from the surface (<370m) and is open along strike and at depth.
While recent drilling has looked to firm up existing resources, the results from recent step-out drilling (i.e. exploration outside of previously drilled areas) have been promising.
Intercept HEDD128 at Diucon (announced this week) has shown some of the potential to be found across the project at depth.
De Grey is looking to produce approximately 500k ounces of gold per annum and currently has total resources of 10.6 million ounces, which we expect to continue to grow.
We look forward to an update on the economics of the project, incorporating its most recent drill results, which will be provided with the release of its pre-feasibility study this quarter.
United Malt (negative impact) gave what was a disappointing update. The company’s share price ended the week at similar levels to the end of June, reversing a more than 10% rise prior to the announcement.
Elevated barley, supply chain and energy costs have continued to impact the business, a point which was well-understood already. Unfortunately, the company proved unable to reflect these factors in its own forecasting. After providing the market with a positive reassuring update in May, they materially revised full-year expectations just 2 months later. We expect this failure to have ongoing implications within the business and at the board level in the coming months.
The structuring of its contracts and internal forecasting inadequacies have meant it has incurred elevated costs which have not been passed on to customers quickly enough.
Our investment in United Malt has always been predicated on FY24 earnings which should benefit from a post-Covid rebound in demand and are a full year on from the ultimately positive, yet messy short-term, implications of inflation.
With crop-related disruption costs expected to ease as next year’s Canadian crop is harvested, the company will no longer rely on freight heavy imports from abroad.
In addressing pricing issues, the company has begun to restructure its contracts to allow for better pass-through of costs as well as implementing systems and processes to give it better visibility across the business to ensure its pricing is accurate and performed in real-time.
While soft in FY-22, earnings are expected to recover materially next year (circa +40-60%), and further upside to profitability remains, as existing contracts are renewed, speciality malt sales return and through international expansion.
Earnings have taken a hit in the short term; however, we feel that the business’ underlying earnings remain far greater than its share price reflects.
We topped up clients’ holding this week, alongside substantial holder Tanarra Capital and a number of large institutions.
Ioneer (positive impact) announced the signing of its third off-take agreement.
The contract, with Prime Planet Energy & Solutions (a joint venture between Toyota and Panasonic), is for a total of 4,000 tonnes per annum of lithium carbonate for a period of 5 years.
This latest contract means that a total of 90% of production from Rhyolite Ridge is now contracted for its first five years of operations.
These offtake agreements will help underpin the financing required for the project to begin construction in the near term.
Lynas (positive impact) provided further detail about its long-mooted plan for expansion at Mt Weld.
Mt Weld hosts a long-life, high-quality near-surface rare earth deposit, which the market has long speculated can accommodate higher levels of production.
The plan announced by Lynas will involve a A$500m investment at Mt Weld to increase the amount of ore that can be fed into initial processing by more than 70%.
While in the future there will need to be additional capital spent to upgrade processing capacity further downstream (at Kalgoorlie and Malaysia), the plan provides further upside to stronger prices in the near term (2024 onwards).
Where the investment fits into Lynas’ supply chain is visualised in the diagram below:
While “independent” property valuations have remained firm, we saw the market begin discounting the price of the listed property late last year, in line with a rise in long-term interest rates.
As such, much of the property sector trades below its stated net tangible assets (the value of its properties less debt).
We expect REIT distributions to be conservative in this environment, as valuations slowly adjust and lead to a reduction in debt (through asset sales or raising equity).
Property portfolios remain diversified and positioned in what we consider a “conservative” manner given these dynamics.
Centuria Office REIT (negative impact) released its profit result for FY-22.
Its result for FY-22 was largely expected. Property income, in general, is relatively stable (and forecastable, save for 2020), and REITS generally meet the guidance provided by their managers.
However, guidance for DPU (distribution per unit – income) for next year has fallen by approximately 15%.
With interest rates rising, interest payments are now taking up a larger portion of property income, leaving less for distribution to unit holders. Furthermore, with workplace attendance structurally lower post-COVID (working from home), re-leasing has become more challenging in the current environment.
Being the first cab off the rank, COF has foreshadowed some of the challenges office REITS face in the current environment. However, its unit price has already priced in some of these challenges, trading at a distribution yield of 8.4% based on its guidance for next year.
Centuria Industrial REIT (neutral impact) released its profit result for FY-22.
As with the Office REIT, its result for FY-22 was largely in line with guidance.
In contrast, releasing spreads have been strong in industrial property, with the market for industrial property remaining tight (and less impacted by vacancies in the short term).
However, much like the Office REIT, rising interest costs are beginning to eat into distributions. The trust has therefore guided for a reduction in its DPU by 8% in FY-23.
At its current unit price, this represents a distribution yield of 5.4%.