|Summary: Australia’s economy remains fragile, despite low interest rates, being underpinned by factors such as weak consumer sentiment and retail sales, a slowdown in resources development, low capital investment, slowing employment growth and high levels of household debt. These factors set the background for the next corporate reporting season, but most surprises should be already out of the bag.|
|Key take-out: Investors will be hoping for higher dividends from the likes of BHP Billiton, Rio Tinto, Commonwealth Bank, Woolworths and others.|
|Key beneficiaries: General investors. Category: Income.|
This week I wish to set the scene for the forthcoming reporting season as it applies for the companies in my portfolios.
Overall, I am expecting a fairly benign reporting period that covers the six months that ended June 30. This is because we already know that the main economic indicators tracked by the Australian Bureau of Statistics, Reserve Bank of Australia, and leading bank economists suggest that things are pretty tough for business. For instance, retail sales are barely tracking higher, consumer sentiment is fragile, and private credit is showing very mild growth.
The Australian economy, like the overseas experience of major developed economies, is not responding dramatically to lower interest rate settings. However, unlike overseas, Australia has maintained steady employment growth. Thus, our slowing economic growth must be caused by some similar issues mixed with some uniquely Australian factors. To my mind these unique issues are:
1. The dramatic actual and expected slowing in the resource development cycle. This is causing Australia's overall capital investment cycle to slow, and is impacting on the outlook for employment;
2. Slowing employment growth and the high level of household debt has resulted in younger households with mortgages to prefer to retire debt rather than use lower interest rates to recommence debt-funded consumption. Australia’s mortgage debt equates to about 140% of household income, which is very high on a world comparative scale. However, those percentages understate the fact that Australian households with debt actually have higher debt loads than the averages suggest; and
3. Lower interest rates are affecting the cash flow income of retirees. As more people reach retirement (the ageing demographic) more people are having to adjust their consumption aspirations. Collectively retirees account for a significant portion of the unencumbered part of the residential property market, but it is an asset that does not generate income. The wealth of retirees is rising but their income is falling.
That is the broad background of what to look for in the profit reports of the companies in my portfolio?
BHP Billiton Limited (ASX:BHP final result) and Rio Tinto Limited (ASX:RIO interim result)
Both of the major mining houses have changed their senior management in the last six months and so the direct consequences of these appointments will not really be seen. We do know the production numbers of both companies, but the unknowns are the actual average selling prices, currency effects and operating costs over the last six months. A key metric to watch will be the reported cash flow from operations, noting the level of capital investment devoted to mine development. Outlook statements will be important as will the dividend payments and payout ratios. Both companies held back dividend growth when earnings were lifting due to Chinese growth and record commodity prices. Both companies have recently lifted dividends despite lower profits, and payout ratios have lifted. Will this continue with the June results?
Commonwealth Bank (ASX:CBA)
We know from regular quarterly updates that all banks are struggling to grow their assets for the reasons stated in my opening comments. Of the banks, CBA does present as the most Australian-centric of all, but it does offer a quality range of financial services divisions outside pure banking. Notable is its funds management and retail advisory business, which developed from the acquisition of Colonial First State. On the banking side CBA has had an advantage in accessing retail deposits, but this continues to be nibbled away by competitors and particularly those banks operating online. The key watch for CBA will be the stated return on equity (ROE) (best amongst its Australian peers), its cost-to-income ratio (should improve slightly), its interest margins (holding), profits from non-bank activities (always a revelation), bad debts with loan arrears trends and its capital ratio (improving). The slow asset growth with solid profit growth should lead to improving capital ratios and open the opportunity for a higher or special dividend.
Woolworths Limited (ASX:WOW)
Once again a lot is already known about the upcoming WOW result. Sales have been pre-released and even the likely losses from the roll-out of the Masters joint venture. So the market will be watching for other key trends. In particular, margins will be scrutinised and compared to those of Coles in the supermarket area. Also under the microscope will be WOW’s balance sheet and debt movements following the sale and release of property assets. Dividends are likely to lift by about 5% over the previous year and I expect WOW should be a result with no material surprises.
The Reject Shop Limited (ASX:TRS)
The market is expecting a solid profit improvement from TRS, with an accelerating store roll-out and strong balance sheet following the recent capital raising. The stabilisation of the business following the Brisbane floods should be confirmed and dividends should grow nicely despite increased capital investment. The outlook statement will be closely scrutinised for an indication of new store acquisition performance, the Western Australia roll-out, the potential effects of a weakening Australian dollar, and improvements in the logistics of the group. The second-half result should show solid growth over last year, but remember that TRS makes much more profit in its December half.
McMillan Shakespeare Limited (ASX:MMS)
The company in its ASX release of last week disclosed a record profit for 2012-13. It also stated that the new FBT arrangements, announced as an immediate change by the Federal Government, were already affecting its business with uncertain consequences.
I reiterate my view that the decision of the Government represented poor policy that has been disgustingly implemented. I do not dispute that the Government has the governing right to change the tax law if its sees a problem. However, it should be careful to target those who it seeks to target. It should not cause unintentional consequences and attack innocent employees or businesses. The policy adjustment would appear to assume that no employee is entitled to a car allowance, or if they are then they should fill out streams of paper. Log books were replaced years ago because they affect productivity. So the new policy is a leap back into the past! As for the final dividend for MMS – who knows?
SMS Management And Technology (ASX:SMX)
Once again this company has already flagged its reported profits to the market. It has disclosed that reported profits will decline due to the weakness across a range of industries. The critical issues, apart from confirmation that cash flow approximates reported profit, are the performance of the recent acquisition, the roll-out of new contracts and the outlook for growth in Hong Kong. The dividend should be held somewhat steady given the strength in the balance sheet.
Minerals Resources (ASX:MIN)
This company could well surprise the market given the iron ore price over the last six months. Many commentators forecast a lower iron ore price but the actual $A price is above that recorded in December 2012. This will convert into solid earnings and cash flow for MIN from its iron ore operations. The other side of the business is its crushing operations. Based on production reports disclosed by its clients there could be positive surprises here. Dividends could lift if the capital investment required to fund new contracts is sufficient.
I suspect the company will report a lift in full-year earnings based on a solid half-year result and a pretty poor result last year. There appears no doubt that the residential housing market is improving, and no more so than in WA. The property development joint ventures will be solid but not as good as the interim result. The key statements of interest will be the steady dividend lift, a comment on price rises to compensate for the Carbon Tax, and an outline by the company of its investment in alternative energy sources. Also, the performance of its major investment in Washington H. Soul Pattinson will be critical. The result will not be declared until early September due to the July 31 balance date.
Most eyes will again be on the dividend but this looks very secure at 14 cents fully franked (final). More interesting will be the working capital movements as TLS invested heavily in mobile retail devices prior to Christmas. These should have now sold through and operating cash flow should be good in the June half. Of note will be any statement regarding NBN payments as there was none received in the December half. Surely some payments flowed in the June half? Overall the market is expecting a 5% lift in underlying EBIT. This should translate into a similar growth in net profit and thus a stronger ROE performance.
John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.
Clime Income Portfolio Statistics
Return since June 30, 2013: 3.01%
Returns since Inception (April 24, 2012): 29.41%
Average Yield: 7.46%
Start Value: $150,754.88
Current Value: $155,286.33
Dividends accrued since June 30, 2013: $154.51
Clime Income Portfolio - Prices as at close on 30th July 2013
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