The truth in the rear view mirror

Disruption. There has been plenty of it in 2018, and there will be plenty more of it in 2019. It is often seen in the context of technology – the rate of computer power increase between the last two iPhone releases was greater than the growth experienced in the prior fifty years. But, increasingly, disruption can be driven by regulatory decisions and the conclusion of the year-old Hayne Royal Commission into Misconduct in Financial Services has been the harbinger of plenty of corporate disruption – with Boards slayed, senior executives dismissed, and regulators chastened and now emboldened. Disruption can also be self-inflicted; as RCR, Lend Lease and Fletcher Building shareholders, including us, have all been reminded to their chagrin through the past month, contractors have a history of internal disruption aka loss making contracts. Whatever the impact to profitability, the impact upon market performance has been far larger; of course, the profitability and market performance impact for RCR was terminal.

Lend Lease announced cost overruns of $350m post tax on NorthConnex and two other engineering construction projects. For a group that has made and is forecast to make between $1b and $1.3b in ebit per annum in recent years, this write down in itself is a circa 5% decrement to economic value. The market reaction to the write down, however, was savage, with almost $3b in market cap taken from the group during the month; a very large part of the remaining engineering construction work in hand of circa $4b, and a 25% fall in market capitalisation.

Fletcher Building was similar, in that a downgrade in ebit expectations of circa 3% (or NZ$25m) has seen market capitalisation fall by 30% during the past quarter, or NZ$2b. With the well flagged Formica sale likely to complete within several months, leaving Fletcher Building debt free, the market capitalisation of NS$4.2b is now presuming a large fall away in F19 ebit of $650m. Several downgrades in the past year relating to construction contracts, resulting in the Chairman, other Board members and then CEO leaving the group, and a strategy of focusing upon the residual dominant New Zealand construction and building materials businesses and to improve the poorly performing Australian businesses, has clearly been met with scepticism. The ultimate irony is the Australian businesses are largely the residue of the 2011 acquisition of Crane Group for NZ$750m, which at the time was promoted as offering “… an enhanced presence and liquidity on both the Australian and New Zealand stock markets …”; no valuation for the assets today would approach what was paid, given the businesses have been break even or loss making for several years, and the market scepticism relates to whether performance can even be improved from this low base. All that can be said is that the current multiple does not impute an expectation that the strategy succeeds; the level of scepticism may ultimately be well placed, however any commercial success that does occur is a free option now for shareholders.

Clydesdale is the same story of a “strategic acquisition” gone wrong, albeit in seeing earnings revisions moved materially downwards within a quarter of completion of the merger with Virgin Money, resulting in the CYB share price almost halving, this just about sets a corporate record in turning “strategic” into “disappointing”. At its IPO two years ago, CYB projected a 10% return on tangible equity by 2020; following the merger, that has been forwarded to 2019. Such a  return – similar to that produced by the lesser performing Australian banks – typically sees a market price similar to tangible book value on the ASX, which for CYB suggests there is now circa 20% upside.

Unfortunately, stock specific factors such as the Virgin Money acquisition and resulting net interest margin demolition in forecasts for the combined group (disclosed just after transaction close), a request for remuneration increases for senior management arising from the “successful acquisition of Virgin Money and the (consequent) vital integration of the two businesses”, and the fact that net tangible assets per share for Clydesdale as a standalone entity before the Virgin transaction was announced had gone down since the IPO, and macro factors such as the impact Brexit may have and the greater competitive intensity that has entered the UK mortgage market in the past year, and a derating of the UK Bank sector, has shattered market confidence in the F19 forecasts and means the stock may continue to trade well below “fair value” until results vindicate the forecasts.

Of course, as shareholders in CIMIC, Monadelphous, MacMahon and other contractors we have experienced in recent years, often the equity leverage to a restoration of fortune after large write offs have been booked, can be immense. The same is true in other sectors – our holding in Nufarm recovered value somewhat in November after a wretched quarter, beset by issues relating to the drought in Australia and emerging litigation concerns relating to Glyphosate globally (given Nufarm has been a large commercial distributor of the product into the Australian market for many years). The announcement effect is not to be underestimated – the market is savage on downgrades, and the share price reaction usually being many times the immediate economic loss arising from the announcement itself. Given the Australian equity market has only produced tepid earnings growth outside of resources for the better part of a decade now, this is perhaps understandable – the statistical likelihood of strong forecast earnings growth being realised, is low, and is likely to remain so. Nonetheless, delineating an earnings level from a direction is an important factor in determining whether a reaction may be an over-reaction, and matching that to a suitable multiple for that earnings level is equally important. The propensity for the multiple to be pro cyclical with earnings is illogical, albeit increasingly prevalent.

The biggest beneficiary in the past several years of the pro cyclicality of multiples with earnings in the Australian market has been the Healthcare sector, and in particular those companies selling products into offshore markets (and this is often dominated by the US). All of CSL, Cochlear, Resmed, and others in the sector have had strong earnings growth and rerating through the past five years, whilst those providing services (such as the private hospital operators) have not enjoyed the same conditions, especially through the past year. This has reflected a strong pricing environment for products in the US market. However, this may be about to change. On 25 October, the Centre for Medicare and Medicaid Services (CMS) in the US issued an Advance Notice of Proposed Rulemaking (ANPRM) requesting public comment on a series of policies aimed at changing the way that Medicare reimburses for Part B drugs, potentially through a proposed model that would more closely align Part B drug prices with an International Pricing Index (IPI) that CMS would develop. It is suggested that US prices for eligible drugs are 80% out of the money; and that spending on these drugs by US agencies in 2016 would have been US$8b lower at IPI prices. A draft is expected to be released within 6 months and the law is intended to be enacted to this end within 18 months. Whilst to date no ASX listed entities are expected to be affected by this change, it is difficult to believe that any entities that have been making excess profits from selling product into the US healthcare sector in recent years could not be concerned looking at this principle; and extrapolation of recent growth in the face of this policy may be ambitious. (For further detail see for example https://www2.deloitte.com/us/en/pages/regulatory/articles/international-pricing-index-model.html. It’s also perhaps unsurprising that increasing regulation is, by far, the largest risk to growth cited by Healthcare CEOs (https://www.pwc.com/gx/en/ceo-agenda/ceosurvey/2018/gx/industries/healthcare.html), far more than is the case for competitive pressures. Regulatory disruption has hit the Australian financial sector hard through the past year; maybe the US Healthcare sector will be impacted in 2019 as IPI is introduced.

Portfolio Outlook

Risks can come from different sources. The most obvious to equity investors is operating leverage – earnings downgrades are normally met with a greater fall in the equity price than the fall in earnings growth expectations (just as, in the longer run, upgrades typically are accompanied by a rerating). Financial leverage hurt equity owners far more than operating leverage through the GFC years, but, ever since, easy monetary and credit conditions have rendered financial leverage impotent as a risk to equity holders. Predictably, more leveraged entities, both publicly and privately owned, have done better in such an environment. The positions that hurt our portfolio performance last month – whether that be Clydesdale, Lend Lease, Fletcher Building, RCR or Alumina – each had downgrades, compounded by a derating, which in some cases was a far bigger driver to share price performance than the downgrade itself. That pain taken, however bitter it may be, the issue now is what opportunities and risks lie ahead. We can only look to be as vigilant as we can in assessing financial and operating leverage, whilst not blinding ourselves to opportunities that may present themselves.