Summary: Flight Centre’s share price woes this week point to both the difficulty of sustaining a business in the technological age in Australia and the pressure it puts on PE ratios, especially in the low interest environment. Meanwhile, problems on the horizon for our apartment sector have seen shorters turn their attention to the banks.
Key take-out: The decline of manufacturing in Australia and unemployment figures suggest that politicians should understand cost of living pressures and very important to voters.
Key beneficiaries: General investors. Category: Australian economy.
Technology and the race for profits
The trashing of Flight Centre stock on the back of a relatively small profit reversal tells us a lot about the state of the Australian market. This week I am also going to describe how what is happening in the Australian market helps explain what is happening in the US and Australian political scenes. And there are more developments in the Australian apartment/housing market.
I can remember at least five years ago saying that Flight Centre (FLT) was amongst the companies likely to be adversely affected by the internet revolution. Chief executive Graham Turner proved me wrong and ran a brilliant operation to ride through the initial internet impacts. But now it is catching up. The internet revolution is substantially reducing the costs of transacting services in so many areas, including travel and accommodation and Flight Centre, albeit a brilliant marketing operation, is a high cost business. To generate its profits it requires an income margin of about 13.5 per cent compared to Webjet, which attempts to provide a similar service online, and looks to a margin of around 10 per cent. Turner has been able to brilliantly use his buying power to capture substantial airline and hotel discounts that provide the margins required to justify his high cost, bricks and mortar store distribution network – but it is getting tougher. Airlines fares are coming down and although international traffic is responding positively to the lower fares, the extra volume does not appear to be flowing through into Flight Centre. Much of extra traffic is going to low cost carriers. Flight Centre kept away from low cost carriers (LCCs) because of the lower margins. It only relatively recently entered the LCC space. The company has a strong balance sheet and will continue to prosper but like a great many Australian shares, Flight Centre was priced on the basis that nothing would go wrong.
Looking at the Australian market, the average price to earnings ratio in Australia is between 16 and 17 times earnings and that level of PE ratio is very justifiable because bond interest rates are low and, if the Reserve Bank indications are to be believed, interest rates will go lower. If that happens PE ratios could go even higher. But down in company land a great many enterprises are not finding it easy to lift profits and most of those that do manage the task via slashing their costs rather than solid business growth. If anything disturbs the lower interest rate environment and /or there is a hiccup to profits (as shown in Flight Centre) shares will be hit hard. Indeed the share market is basically assuming that Australian corporations will run like Black Caviar – so they then become as a source of yield that is higher than that available from bonds.
The international shorters in the market picked Flight Centre as a company that would run into trouble because of its heavy reliance on bricks and mortar retailing and high base costs. They were right.
Blood to be spilled in our property sector?
The shorters are making a similar plunge on Australian banks, believing there is no way Australia can maintain the high level of bank share prices given the bank problems that will arise from the apartment glut, plus the low inflation environment and the fact that salaries are not rising. But the bank shorters will only be right if there is a major collapse in the Australian dwelling market. The banks and the bank regulator APRA are playing a dangerous game because they are refusing to support the buyers of the current round of apartments which means there might be blood all over the floor in Melbourne and to a lesser extent Sydney and Brisbane. That blood, in terms of unsold apartments, may damage to our banking system and yield the shorters a profit. I have promised to keep you updated on the apartment market and in the last two or three weeks the gap between off-the plan apartment prices and “used” apartments in Melbourne widened. More “used” apartments are coming into the market and prices are falling. Where the shorters may be caught is if the Hong Kong middle class sees Australia as an avenue to secure real estate in preparation for a possible change in residence, given the increased pressure being put on Hong Kong by the mainland.
In essence, to get us through the current big rise in apartment production we need more migration and Hong Kong migrants would be among the best available.
Politicians must understand this:
During the week I viewed a discussion between two Columbia Business School professors, Joseph Stiglitz and Bruce Greenwald, who explained that the base reason for the great depression was the dramatic decline in the fortunes of agriculture. Higher productivity boosted production and lower prices bankrupted many farmers at a time when the farming community employed about a third of the total work force in countries like the US. The agriculture crisis spread to urban areas. While US President Roosevelt helped the situation it wasn’t until the Second World War that people were employed in either the manufacturing industry via arms production and in the forces themselves. The great prosperity that followed the war arose from the rise in manufacturing in developed countries.
The current decline stems in part from the fact that manufacturing is suffering similar blows to those that affected agriculture in the 1930s. Productivity and output has jumped and prices have declined. In the US much manufacturing went offshore and people have been retrenched. The US (and Australia) has a way of calculating unemployment that masks the size of the problem.
According to Greenwald and Stiglitz, unemployment in the US is much higher than the official figures show and the same applies to Australia. While it’s true that service industries are replacing a lot of the manufacturing jobs, service industries generate a different income pattern. Large sums of money are made by executives and shareholders at the top of service industries, but down the line employees earn at a far lower rate than manufacturing employees so the population is not doing anywhere near as well as a couple of decades ago.
This enables people like Donald Trump and Bernie Sanders to campaign brilliantly because they understand the buttons to press. Here is Australia Bill Shorten talks about issues that reflect those that are suffering in the wake of lower service industry wages – the costs of education, health and so on. Malcolm Turnbull is talking about economic management, entrepreneurship and innovation. These are very worthy subjects to place emphasis on but they have nowhere near the impact of medicine and living costs in today’s environment. I am not in the business of forecasting election results but just as Australian companies need to understand the change in the market place, so do politicians. Meanwhile given the speed with which the economy has moved from manufacturing to services, Australian companies wishing to prosper in that environment will need to act fast to make sure their costs compare well with rivals – unless they have a unique product. Flight Centre is an alert to all chief executives.