Investment Matters

As good as it gets?

This week we consider costs, in particular, cost pressures that are being faced by companies – and the implications.

Fairly consistently over the recently completed reporting season (and the one before) companies have cited rising costs as a concern.  We are conscious of the implications of this.

Which costs?

The clearest example is perhaps the cost of debt.  This is evidenced by the Bank Bill Swap Rate (BBSW) – the benchmark rate for corporate lending.  As can been seen in the following graph, this rate has stepped up in the last six months.  This comes as global interest rates have been increasing.  With the US Federal Reserve expected to put through further interest rate increases, we expect the BBSW, and thus cost of debt for companies, to increase over the short to medium term.  (It should be noted that each company has its own debt quantity, maturity profile and hedging, and thus the magnitude and timing of impact will be individual to each company.)

 Source: IRESS, First Samuel

There are other factors which are putting companies under bottom line pressure.  These include the oil price, especially notable for airlines and miners (higher diesel costs).  Electricity prices are having a significant impact on manufacturers, and a lesser extent more broadly.  The lower AUD exchange rate is impacting the cost base of any company sourcing inputs from overseas (for example, retailers).

Perhaps the only cost category where we currently aren’t seeing meaningful pressure is labour.

Most pronounced

The impact of cost pressures will be most pronounced for those who also have benign revenue growth, or revenue decline – in effect they can’t hide the extent of the pressures they are facing.

We are seeing this at the moment with the big 4 banks.  For example, for FY-18 CBA had a 3.1% increase in operating expenses (this excludes all the fines etc), and operating revenue grew at a soggy (compared to the boom years) 3.4%.  With funding pressures increasing, and a benign credit (revenue) environment, it was creating a scenario whereby cost growth might exceed revenue growth (i.e. profit declines yoy).  As a result we have seen 3 of the big 4 put up their standard residential mortgage rates.  The funding cost pressures are expected to continue.

Peak margins

The implications of what we are seeing is that FY-18 may mark peak margins for this business cycle.  And given revenue growth is, generally, looking moderate, it may also mark the earnings peak for this business cycle.

Expectations

We think analysts are currently a little too optimistic about the future, because they are failing to adequately allow for cost inflation.  We would not be surprised to see downgrades in expectations leading to, or subsequent to, earnings releases over the coming year.

What your companies said / experienced

The companies you invest in are not immune to cost pressures.  Some snippets from the recently completed reporting season:

  • Aveo's weighted average AUD borrowing cost in FY-18 was 3.8%, vs 3.4% in FY-17
  • South32’s operating costs (cost per unit of production) is increasing at many of its operations.  Much of this is driven by factors specific to the mines themselves.  Power prices have also been cited as a pressure at multiple operations. 
  • Pact - higher raw material input costs (lag in recovery) and a significant increase in Australian energy costs were cited as impacts on FY-18 earnings.  The latter was cited as continued pressure for FY-19.
  • Suncorp noted that it expects funding cost pressures will continue.
  • In H1 FY-18 BHP’s productivity fell, with an improved performance in H2 FY-18.  They seem confident of good performance in this regard in coming periods.  But as a minimum, there seem to be many companies, including BHP, having to work really hard to keep cost pressures contained.

Implications for companies in your equity portfolio

For your investments (or any potential investment) understanding the balance sheet, including sensitivity to increased interest rates, is an important first step – and a point to monitor over time.

Then it is being aware of the specific cost pressures for each investment, and building that into the expectations we have for the company over the 3-year investment horizon.  We attempt to not to be overly optimistic about the future (but without the benefit of a crystal ball!).