Making the transition
July was an interesting month for Australian equities with Energy stocks struggling, iron ore driving the resources sector forward and two intriguing takeover bids. We continue to position the portfolio for the transition away from longer-dated cashflows and high multiples.
Environmental, social and governance (ESG) flows remains ever-powerful. The Australian Energy and Utilities sectors are the worst performers through the past year, and it is unsurprising that they contain high emitters. With a few notable exceptions, such as Santos, they also have had management that have had scant regard for the value of the large amounts of capital they have invested through recent years, which has compounded the technical basis for their underperformance. By way of example, this year crude oil has rallied 50% and yet Santos is the best performing stock in the Energy sector, being up 3%. The average stock in the sector is down materially amidst the strong oil price. Equally, ESG flows have compounded the woes for the Utilities sector, which has not only seen earnings pummelled as wholesale electricity prices have fallen, but the ensuing perfect storm has arisen for AGL just as it simultaneously seeks to juggle its decarbonisation driven demerger.
Iron ore reigns
Amidst a broad base of increasing commodity prices, the iron ore price has been king. With cost curve support still suggesting a long run price for iron ore at circa US$60 per tonne, this price has nonetheless been front and centre of the commodity party and spent much of this year above US$200, more than double last year’s already elevated price. This has seen the major miners, BHP, Rio Tinto (RIO) and the major pure play producer Fortescue (FMG) – all produce outstanding cashflows and outperform, albeit the pure play FMG has clearly won the gold medal as the iron ore price has risen. FMG is harvesting the excess returns from a buoyant iron ore price into newer technologies through Fortescue Future Industries, with ambitious plans for green hydrogen and ammonia plants, with commercial scale production of green steel targeted for 2023. In the normal course of events such an ambition would be met with incredulity, however such has been the magnitude of FMG defying the ordinary in achieving extraordinary commercial outcomes through the past decade that it would be folly to write off FMG’s prospects of achieving this goal entirely. As has been the case in iron ore, if nothing else FMG’s ambition acts to intensify the efforts of the major miners to ensure they do not unduly lag the energy transition. RIO, for example, reported a first half profit of US$12.1bn. This discipline and the resulting free cashflow creates its own reward; RIO has parlayed approximately one month’s current profit (US$2.4bn) into the Jadar lithium-borates project in Serbia, one of the world’s largest lithium projects, positioning RIO as one of the largest lithium (electric vehicle) and borates (wind and solar) producers in the world. As a standalone listed entity this production would be currently valued at multiples of RIO’s investment. Whereas in past cycles greenfield developments and M and A undertaken by RIO and BHP have seen extraordinary waste in project spend, the constant (often embarrassing) contrasts to FMG has prompted greater intent to now ensure investment discipline is applied to projects such as Jadar.
Outside of the Energy sector, the commodity price rally has generally seen the resulting earnings momentum drive market value. The ASX listed steel producers, Bluescope and Sims Group, for example, have both benefited from the best steel spread environment they have enjoyed for a decade, and their equity values have risen in simpatico. A year ago they were both at cyclical lows, highlighting how aggressively fiscal policy in response to the pandemic, aligned with supply interruptions have prompted price changes in commodities and in turn equity values for listed steel producers. The key, though, has been production, converting the price changes into cashflows. Which is where Incitec (IPL) has struggled. Through its DAP (a phosphorus fertiliser) plant in North Queensland and its ammonia plant in the US, IPL is heavily leveraged to movements in these commodity prices. Which, prima facie, has been favourable; a DAP and ammonia price index has tripled since its lows of a year ago, significantly outperforming the increase in scrap steel price index through that time, for example. And yet IPL has underperformed the market whilst Sims Group has been a stellar performer, reflecting the unfortunate timing attaching to simultaneous plant outages at IPL’s plants earlier this year. An extended plant outage of this type may occur once a decade; for IPL to suffer two, at the same time, whilst prices are at record highs, was extraordinary and costly for shareholders. The plants have now been fully operational in recent months and consequently the IPL equity price has begun to recover, again highlighting how sensitive the market is to current earnings and revisions.
The yin and yang of takeovers
The Afterpay (APT) takeover by Square needed neither commodity price support nor (very recent!) equity price momentum. At $39bn, this all scrip represents the largest takeover in Australian corporate history. We feel the transaction is a good one for APT shareholders, representing more than fair value, although that is purely academic as we neither hold APT nor have been able to make sense of its market valuation for some time. What needs to be admired is the realisation of value from what was a concept in 2014 and a listing in 2017, reflecting paid up capital some four years later of $1.8bn and revenue of slightly less than $1bn. None of these metrics in themselves portend a market value of $39bn, however the massive scaling in global customer and merchant acquisition since that time is in itself immensely admirable, albeit highly subjective in value given all of the resulting profit arising from the commercial exploitation of this global network is in the future.
In contrast, the $22bn bid for Sydney Airport in in cash, and this is a relatively mature asset with cashflows which (pandemic aside!) are relatively stable. Broadly speaking, we forecast free cashflows (pre interest and tax) of $1bn for the asset which has attracted a $22bn offer for the equity, with a circa $30bn enterprise value. The bidders are hence accepting a stable return of 3% with (small) levels of consistent growth, with some option for further value from 128 hectares of property on the airport perimeter able to be developed. In some ways, Afterpay and Sydney Airport represent the yin and the yang of attractive equity investments through recent years; the promise of growth and the allure of relatively stable yield.
As we have noted previously, global liquidity jumped by US$20 trillion in 2020, 25% of global GDP. To what end? It took a decade for activity to recover prior levels in the 1930s Depression, and two years after the GFC. It took six months to recover from the Covid-19 economic shock; and 2021 has continued apace. As can be readily gleamed from performance differentials through the prior month and earlier, on balance our portfolio remains positioned for a continued transition from longer dated (hoped for) cashflows to shorter dated ones; from (very) high multiples to lower multiples. That is however, a blunt characterisation that smudges many nuances. In many sectors, for example, mean reversion has never been less likely; the energy transition, and increased levels of regulation legitimised by increased levels of government investment and deglobalisation means that historic levels of profitability will probably not recur. Equally, the investor’s dilemma is equally in discerning whether the expected levels of profitability in the highest rated stocks and sectors, will ever be reached. Whilst we have some examples of each in the portfolio – Alumina continues to trade on low multiples, for example, and Hardies on very high – in a market trading at record multiples, our overall portfolio bias towards more defensive earnings streams remains.
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