Profit Reporting Season: Week 2
Reflation was the word on investors’ lips this week as bond yields continued to rise. The market continued to contemplate the impact of rising commodity prices, a lift in producer prices and the longer-term effects of unprecedented fiscal and monetary support.
This was reflected in the rise in the 10-year bond rate in the US, which broadly represents expectations around future real growth and inflation. However, expectations for inflation are perhaps best reflected by the 10-year breakeven inflation rate.
The 10-year breakeven inflation rate represents the yield difference between a 10-year bond and a 10-year bond that pays a yield that is adjusted for inflation. This rate can broadly be a proxy for long term inflation expectations.
As can be seen in the chart below, the breakeven rate has steadily been rising but has recently reached the highest levels we have seen since 2014:
In the Australian market, this translated to the outperformance of sectors that have seen demand as a result of rebounding activity, such as Materials (commodities) and Consumer Discretionary. Meanwhile sectors whose valuations are underpinned by low rates, such as Utilities and REITs, or defensive such as Consumer Staples, underperformed
Whether inflation does appear remains to be seen. However, we have constructed portfolios with this possibility in mind, for example, we have with no exposure to “lower for longer” utilities and cash flow generative companies that have pricing power in an inflationary environment.
Sector movements of course, also reflected the results of companies that reported this week, as reporting season continued to roll on.
Six companies within client portfolios reported this week.
Webjet (Positive impact)
Webjet’s result for the first half reflected a business that has adapted well to an industry that has faced its share of challenges over the past year.
As the broader travel industry begins its recovery, Webjet has shifted its focus to what it can control – predominantly its operating expenses.
This has seen the company’s cash burn reduce significantly, with a continued reduction of expenses targeted.
The company largely operates two distinct businesses, WebBeds, which functions as a “bank” for beds – selling hotel rooms between businesses (hotels and between travel agents) and WebJet – an online travel agent.
Pleasingly, even the stunted recovery we have seen in domestic travel has seen the WebJet break even on an operating basis for the half – a reflection of the variable cost base of the business and the benefits of pent-up demand and a broader shift to online travel agencies away from brick and mortar.
The WebBeds business continues to be challenged, however its losses have fallen by a third despite a 30% drop in revenue (as restrictions were re-instated in Europe over the December 2020 quarter). This is a testament to the strong cost discipline the company has implemented over the period, which it sees as translating to a 20% improvement in efficiency once operations are again at scale.
The company also took the opportunity to remind the market that it is predominantly exposed to domestic and regional leisure travel. This provides an ideal exposure to the travel industry – domestic leisure travel is anticipated to be the first segment to rebound, and less likely to be impacted by structural changes brough about by COVID.
Furthermore, the company retains ample cash to see it through to an eventual recovery. We see WebJet as well placed to benefit in the recovery of the sector and take advantage of any opportunities that may arise from any weakness in the sector.
Origin Energy (Neutral impact)
We came into Origin’s result with low expectations.
As pre-announced, profitability in the company’s Energy Markets division (electricity and gas retailing) was significantly weaker, owing to a mild summer, lower wholesale electricity pricing (reflecting both a change in demand and increase in renewable energy supply), market pricing dynamics and the rolling off of a number of gas supply contracts.
The company is working diligently to reduce its costs to serve its customers to offset this weakness, with targeted costs reductions of over $125-175m – to be delivered with the help of the Kraken platform it is implementing as part of its partnership with Octopus Energy.
It is also looking to reposition its generation assets to adapt to these new pricing dynamics, by reducing capital expenditure and generation.
Longer term, the company is looking to reposition these assets, including the addition of batteries to existing generation, sourcing energy from virtual power plants and a range of other measures. We see that it has a reasonable balance sheet and cash generating assets to do so, retaining a key role during the broader energy transition.
The highlight of the result was APLNG (in which Origin has a 37.5% stake) which continues to be a strong cash producing asset. It delivered a $256 m in cash, despite weaker pricing, due to the lag until the higher oil price begins to flow through. It continues to work to reduce capital and operating costs to give maximum leverage as the oil and LNG price recovers.
The company also announced an interim dividend of 12.5 cents in line with its payout policy of 30-50% of free cash flow, which if annualised would represent a dividend yield of 5% at current prices.
It also continues to generate a significant amount of cash despite weaker operating performance, generating $655 million of free cash flow in the half – 8% of its current share price.
United Malt (Neutral impact)
United Malt provided an update to its profit guidance at its Annual General Meeting.
The company expects to make an operating profit of $47-50 million in the first half of 2021.
The reduction in on-premise consumption, particularly in the US, Canada and the UK due to COVID related restrictions has continued to impact the company – with respect to product mix (lower sales of higher margin malts) and demand.
This figure includes a number of one-off costs relating to foreign exchange impacts, a facility closure and business transformation costs.
Our position in United Malt is one that is designed to benefit from the eventual COVID recovery in eating out and restaurant dining. On premise alcohol sales globally remain impacted by closures, lockdowns and other restrictions. We will retain the patience required to benefit from this recovery.
ANZ Banking Group (Positive impact)
In line with CBA last week, ANZ released a positive result that bodes well for the banks.
Much like CBA, ANZ has seen a significant reduction in deferrals, with only 15% home loans remaining deferred and 12% of business loans remaining deferred in Australia.
The improvement in the outlook saw the bank release $172 million it had provisioned for bad and doubtful debts – approximately 10% of the total that it provisions in FY-20, which reflects its assessment of a reduction in the risk of these loans.
Net interest margins (the bank form of gross margins i.e., lending rates less borrowing rates) were also higher than expected, driven by lower funding costs (cheaper deposit funding and wholesale costs) and a better loan mix, with growth in retail and commercial lending.
Stable costs and higher profitability also saw the banks common equity tier 1 ratio (the amount of equity it is required to keep absorbing losses) increase to 11.7% from 11.3% which is also a positive with respect to future dividends and growth.