The great re-rating – defying gravity or yet another new normal?
A strong year for equity performance has seen the ASX200 increase more than 25% year to date. It’s all been driven by re-rating. It was recently put to us that this is a normal course of events as yields compress; why would we expect it to be any different this year and in years to come? The only good answer to that is the fact that it has been different in the past, and often. In 2017 and 2018, apart from the last quarter, bond yields rallied – yet the Australian equity market de-rated. In 2017 the de-rating was almost as large as this year’s re-rating. Same in 2014. And so, while 2019 will go down as the year of the big re-rating on the ASX, with earnings growth a negligible source of growth for the market, and while it is tempting to think this is the natural outcome of tighter yields, history supports neither that conclusion nor the corollary that “it will be the same next year ”.
Tyro and the rewards of profitless growth
The Tyro Payments Limited ipo was a great example of how changing market moods can influence company strategy and valuation as much as cashflows do. Tyro listed with a market capitalisation of $1.7bn, with 51,000 terminals throughout Australia and revenues of $240m forecast for FY20 (a $50m increase on FY19). An ebitda loss was reported in the most recent three years and is again forecast for FY20. For context, Tyro’s terminal numbers are now one-fifth the market leader, CBA, and about 40% of Westpac’s (which has the lowest penetration of the major banks).
The temptation, as ever, is to assume ongoing revenue growth and then operating leverage producing future profits. The irony in this case is that Tyro was profitable when run by Jost Stollman, an enigmatic German entrepreneur who sold his German IT services company, CompuNet, to GE 20 years ago. Stollman became CEO of Tyro and the group became profitable in March 2012, after an investment of $33m (of which Stollman invested a quarter). Tyro was ebitda positive every year from then until 2017, after a $100m equity injection brought a renewed focus on revenue growth, which was running at $20m per annum and has now accelerated to $50m.
In increasing revenue growth, notwithstanding the collateral damage of turning ebitda profits into losses, the uplift on the Tyro investment in FY16 is now more than tenfold. Jost Stollman was one of only two Tyro shareholders to sell equity into the offer. As an exemplar of the ASX performance in 2019, and what has been prized, Tyro takes the gold medal.
Banks chase elusive cost reductions
If re-ratings and de-ratings can come and go from year to year, one thing that will be the same next year is that the banks will again have no profit growth, with regulatory and political forces pressuring their revenues, costs and capital lines. Bad debts can only go up relative to their asset bases, which means that reducing costs is the only lever left for the banks to hold profits at current levels. While trying, reducing costs has been hard for the banks to effect in recent years, as indeed is the case for almost all companies, with very few examples of absolute dollar cost reductions being reflected in corporate costs bases for companies on the ASX200 through the past decade.
Globally, there is also little precedent for cost reductions proving a source of profit release for banks. After a decade of earnings pressure, only two European banks have been able to cut more than 5,000 full-time roles, for example. One of these, Deutsche Bank, has not cut materially its retail operations, and the other, UniCredit, has staff numbers close to double the smaller Australian major banks. In other words, pro rata, world’s best practice among retail banks would see the Australian banks shed a couple of thousand people. This makes Andrew Thorburn’s $1.5bn restructuring proposal at NAB, designed to shed 4,000 jobs (albeit offset to some extent by hires in technology) look unachievable. As one major bank CEO put it to us, “The management execution required to sustainably reduce thousands of roles in an organisation like ours is like running a marathon, while at the moment we are struggling to get beyond a walk”. Brian Hartzer and Andrew Thorburn may have left their roles this year at an opportune time, although in inglorious circumstances. Finally, the circa $1bn fine likely to be levied upon Westpac is yet the latest operating risk charge imposed upon the sector in recent times. Three years ago, we incorporated operating risk charges of circa $9bn for each major bank into our valuations, and the experience to date is that, if anything, these will prove modest.
BHP shows what discipline can do
Andrew Mackenzie departs as CEO of BHP in far different circumstances to when he assumed the role in May 2013, when the adjusted share price was $24. At $38 today, of course it can be said that material value has been added during Mackenzie’s tenure, albeit that commodity prices, especially iron ore, have materially helped that outcome. Aided by a refreshed board, perhaps the most significant aspect of his six and a half year tenure relates to what was not done; after decades of capital misallocation, BHP showed discipline through the past several years on this front, initially through market pressure as commodity prices were pressured and BHP realised their onshore US shale assets when sold to BP for US$10.5bn, being far less than the impairments taken on the shale assets acquired and developed since 2011. In more recent times, however, as commodity prices rebounded, BHP maintained operating and capital cost discipline, with margins restored to their 2011 peaks, although on much lower commodity prices, reflecting productivity gains kept through that time.
BHP still resembles a bureaucracy in search of an ASX ticker, and we maintain a belief that shareholder’s interests would best be served by the creation of South33, South34, South35, etc, reflecting the fact that the group is the historic collection of ownership interests in large mines across few commodities. There is no evidence that the conglomerate structure adds operational efficiencies, whereas there is the example of BHP wasting legacy cashflows for a decade through malinvestment in expensive asset purchases at the wrong times in a cycle. Of course, this is not unique to BHP; M and A cycles across industries are pro cyclical, with the number of transactions always rising in synch with asset prices. Nonetheless, the sheer quantum of wastage arising from BHP’s historic malinvestment means that a structural bar to that recurring in the future remains an attractive option for shareholders.
As we highlighted above, the gains in the Australian share market this year have occurred despite an absence of earnings growth for the market as a whole. Large re-ratings have occurred where earnings growth is hinted at. In few cases are the major beneficiaries of these re-ratings more attractive investments today than they were a year ago, and in many cases our valuations remain as unchanged as the cashflows generated by the company. Low to no interest rates continue to cause large dislocations in the price of Australian equities perceived to offer security of income, on the one hand, and growth on the other, with a squeeze in the ugly centre where a downgrade pimple in a flash is priced as a de-rated mole, no matter the sector. Sustainability of earnings and, more importantly, cashflows, has never been more important, nor securities more harshly dealt with if expected levels of cashflow evaporate. The better opportunities in the current market tend to be idiosyncratic, where cashflows are hit, albeit not by structural factors, and where de-rated multiples become attractive.
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