Australian Equity Strategy

Transcription

1 AUSTRALIA Winners & Losers Positive Reinvestment AMC, APA, CAR, CSL, DMP, HSO, IPL, QUB, ORA, RHC, SEK, JHC, REG, SYD, TCL, TWE, WES Negative Reinvestment FLT, GNC, MTS, PRY Lacking Reinvestment AIO, ASX, WOW Capex a declining share of profits 1,,, 6, 4,, Capex to Sales at 21-yr low ASX: Aggregate profit vs. capex Capex to Sales: Industrials F Source: Factset, Macquarie Research April Running on Empty Return of Capital vs. Reinvestment of Capital: Part II Low interest rates have been the primary driver of return of capital over reinvestment of capital in recent years. The trend of growing cash dividends faster than cash earnings has pushed payout ratios back to historic highs (~75). A falling cost of capital will no longer provide aerial cover for unsustainable dividend distribution policy even if stocks are trading on below market multiples (i.e. banks if they disappoint). The need for reinvestment (buying & building) is rising because the opportunity cost of not securing growth is rising. We do not think firms have been constrained by access to capital (either internal or external). The constraint has been uncertainty about economic conditions which has pushed the required return up and driven a reluctance to cut hurdle rates. It is unlikely that this constraint gets meaningfully better in coming quarters particularly with a pending General Election and a focus on fiscal prudence. However, this leaves the market in a bind. Dividend payout policy is unsustainable, earnings are not growing and the key driver of investment is not getting better. We think the market will reward growth enhancing capex (expansionary or acquisition) even if it comes with risk. Rising capital reinvestment does not need a regime change or a reversal of the trend toward running asset-light / outsourcing of capital intensive models. Similarly it does not assume that we see a large change in the direction of offshore vs. onshore investment just because the A$ has weakened (on-shoring is likely to pick up but it is probably a gradual process). The offset to our argument is that strong cash profits provide flexibility for capital management and/or that high payout ratios are a sign of rising confidence in the outlook. Historical precedent supports this view but the earnings growth outlook is different to the upswings that brought the payout ratio back to trend in the past. Similarly, we are not sure how much leverage corporates get from improving asset turn (rising utilization) given where the asset base current sits. Our most favoured stocks to play the capex theme are a mix of both onshore and offshore. Domestically we like TCL and WES. Our preferred offshore capex plays are AMC, CAR, CSL and ORA. -17F Capital Spending Outlook (shaded according to momentum) Capital Goods Comm & Profess. Services Consumer Services Consumer Staples Div. Financials Energy Healthcare Insurance Materials Media REITs Retailing Software Services Telcos Transportation Utilities April Macquarie Securities (Australia) Limited Source: Factset, Macquarie Research, April Please refer to page 1 for important disclosures and analyst certification, or on our website

2 April 2 Fig 1 Macquarie Strategy Recommended Australian Portfolio Share price Portfolio ASX Active Sector Company Ticker 23 Mar Weight () Weight () Weight () Financials Banks Commonwealth Bank of Australia CBA National Australia Bank NAB Westpac Banking Corporation WBC Diversified Financials Eclipx Group Limited ECX Insurance Medibank Private Limited MPL Suncorp Group Limited SUN Real Estate... Lend Lease Group LLC Goodman Group GMG Westfield Corporation WFD Cyclical Industrials Consumer Discretionary Carsales.com Limited CAR Baby Bunting Group Limited BBN Mantra Group Limited MTR ooh Media! Limited OML The Star Entertainment Group SGR Industrials Amcor Limited AMC Incitec Pivot Limited IPL James Hardie Industries JHX Orora Limited ORA Qantas Airways Limited QAN Transurban Group TCL Defensive Industrials Consumer Staples Wesfarmers WES Health Care Cochlear Limited COH CSL Limited CSL Telcos, Infrastructure & Utilities AGL Energy Limited AGL Contact Energy Limited CEN Telstra Corporation TLS Resources Energy Caltex CTX Oil Search OSH Santos Limited STO Miners Rio Tinto RIO BHP Billition BHP Total... Source: Factset, Macquarie Research, April

3 Business investment is not just a key determinant of long-term growth, but also a highly cyclical component of aggregate demand. It is therefore a major contributor to business cycle fluctuations. This has been in evidence over the past decade. The collapse in investment in accounted for a large part of the contraction in aggregate demand that led many advanced economies to experience their worst recession in decades Bank of International Settlements March Low interest rates in combination with weak earnings growth, high uncertainty around investment returns and the desire to run asset-light models have made the debate between returning capital to shareholders vs. reinvesting capital for growth extremely one-sided in recent years. This has been evident in a rising payout ratio, a declining proportion of cash flow going towards capital spending (Fig 1 & 2) and a significant expansion in PE multiples for dividend yielding sectors. Cracks are now appearing in this backdrop. The willingness to re-rate yield has weakened, investors are more focused on dividend sustainability and there is a greater acceptance that profit growth may have also reset to a new normal and not just at an economic level. We first addressed this issue last August (link : Face Off August ). The idea was that if the current rate of returning capital to shareholders was maintained than not enough was being invested in growth to preserve the overall market multiple. Alternatively unless we were entering a cyclical earnings upswing, which is how the payout ratio has fallen in the past two cycles, than the current trend of dividend growth could not be maintained. Either way, our view was that the market was on the verge of hitting a tipping point which required either slower dividend growth, faster capex growth (in order to underpin earnings and future dividends) or that cash balances would need to be slowly drained which was not positive for maintaining valuation multiples irrespective of continued low bond yields. We have now seen the first signs that this is playing out. Concerns around unsustainable dividends and dividend growth have been evident in resources and banks. We would like to have seen these concerns emerge with signs that productivity enhancing capital spending was picking up but rather it has been the reverse (Materials and Energy have been in the process of dramatic forced capex reductions) and at the same time we have not seen any signs that the major contributor to capital spending (return on investment and growth transparency) is beginning to look any better. This implies that the market will continue to show strong bifurcation trends relative to investment trends. It is likely that the split between on-shore and off-shore remains in place despite a weaker currency as firms look outside of the domestic economy for growth opportunities while the Energy and Materials sector (and those directly or indirectly touched) continue to see capital spending reductions over the next few years. We would hope that the lower A$ drives bigger wave of onshoring by the Industrial universe but we do not see confidence or enough clarity around the growth outlook for this to be a driver of any size. Fig 2 Dividends are taking an ever-rising proportion of profits Fig 3...with capex the largest causality as its ratio to profits continues to fall 1, ASX: Aggregate profit vs. dividends 1, ASX: Aggregate profit vs. capex,,,, 6, 6, 4, 4,,, Source: Factset, Macquarie Research, April April 3

4 (Why) Is investment weak? In spite of very easy financing conditions globally, investment has been rather weak in the aftermath of the Great Recession. What explains this apparent disconnect? The evidence suggests that, historically, uncertainty about the future state of the economy and expected profits play a key role in driving investment, and financing conditions less so. As a result investment after the Great Recession appears to have been broadly in line with what could have been expected based on past relationships. A stronger recovery of investment would seem to depend on a reduction in economic uncertainty and expectations of stronger future growth. Fig 4 Investment collapsed in the recession and has not recovered in many countries AU = Australia, BE = Belgium, CA = Canada, CH = Switzerland, DE = Germany, DK = Denmark, FI = Finland, FR = France, GB = United Kingdom, IT = Italy, JP = Japan, KR = Korea, NL = Netherlands, NO = Norway, NZ = New Zealand, SE= Sweden, US= United States 1. For Italy and Switzerland, government real non-residential capital formation is included. 2 Data up to Dec-. Source: BIS, OECD, Macquarie Research March What explains low business investment in the world? Two explanations have been put forward for explaining weak business investment. The first is a mismatch between favourable financial conditions and investment opportunities. This is the view that firms have not had sufficient funding (internal and external) to take advantage of investment opportunities. The second is that that even if firms do have adequate funding, they are uncertain about future economic conditions and question whether the return on investment will justify the cost in a highly uncertain world. The Bank of International Settlements believes the second argument is more plausible. Insufficient internal funds (low cash balances) and constrained external borrowing conditions have generally not been symptomatic of the past few years. Despite some tightening in lending standards, external funding has been readily available and exceptionally cheap. Firms have generally been able to access capital markets and despite modest credit growth this has been a function of weak demand rather than a lack of supply. Instead, weak investment due to elevated uncertainty surrounding the profitability of investment opportunities is the more likely constraint on a stronger global capital spending upswing. Empirical analysis by BIS suggests that the greatest stimulus to investment would come from increased certainty of strong future economic conditions and not further declines in the cost of capital. Fig 5 Returns on physical capital have stayed high, unlike returns on financial assets CA = Canada, DE = Germany, GB = United Kingdom, IT = Italy, JP = Japan, KR = Korea, US= United States Source: BIS, European Commission AMECO, Datastream, Bank of America Merrill Lynch, Macquarie Research March April 4

5 Will investment help support future earnings and dividends? For the most part, corporates have not been penalized for a lack of reinvestment in recent years. This is not surprising. The capital stock is not especially old, capacity utilization rates are around the long-term average (~1), capex has continued to run ahead of depreciation and corporates have been able to generate modest earnings growth allowing them to throw plenty of cash back to shareholders while in some instances also reducing leverage at the same time. This combination is fine if the capital structure is efficient and earnings can sustain a rising payout ratio sustaining stronger dividends. If dividends are growing faster than earnings, as has been the case for some stocks (e.g. the Banks) and earnings growth is slowing, as is the case across the broader market (even ex resources), then we have a problem. In the past, rising earnings have generally been the driver of a declining payout ratio. The payout ratio has tended to peak when earnings have troughed (Jan-4 and Sep-) and troughed when earrings have peaked (Dec-7 and Dec-11). This is expected. However, our concern is that the payout ratio is elevated at the same time earnings are elevated (falling in the case of resources) and the earnings growth out not particularly strong. Fig 6 Corporate profits should not have been a capex constraint Fig 7...and neither have insufficient cash flows or a need to rebuild corporate balance sheets 7 $bn Australia: Company profits (quarterly) $bn 7 $m 35, Cash, Capex & Dividends - Market x Resources 6 5 Total profits 6 5, 25, Cash 4 Profits ex-mining 4,,, Dividends Dec-4 Dec- Dec-6 Dec- Source: Factset, Macquarie Research, April 5, Capex There are range of factors that need to be in place to provide firms with a signal to undertake expansionary capex: There needs to be confidence in current demand conditions and growth prospects; Current profitability needs to be sufficient to fund capacity additions; and Capacity utilisation needs to be sufficiently elevated such that demand cannot be fulfilled by existing assets. We think the second and third conditions are broadly satisfied. The first, (confidence in demand and hence investment returns) is not and against a backdrop where political risks have risen and where fiscal restraint is rising, we do not see why this would change too drastically at least through the next few quarters unless we saw a much steeper cyclical recovery. Recently, a NAB survey published the average hurdle rate (the return businesses require on a project to commit capex) of ~13, and a Deloitte survey found that ~ of corporates still use a rate ~ and higher. Recognising that hurdle rates have not come down in line with declining risk free borrowing rates (as evidence by a historically low cash rate and bond yields), suggests that corporates are still heavily discounting potential cash flows on projects with little reason this will change dramatically in the coming months / quarters. April 5

6 The capex cliff is not just in mining... All sectors, with the exception of LPT s, have seen capex to sales fall below LT averages over the last several years. Unfortunately these capex to sales trends are forecast to fall even further despite relatively strong corporate fundamentals including elevated cash levels, undrawn debt facilities, leverage which is below average and continued low external funding costs. At face value this is not necessarily bad if corporates can improve asset turnover (i.e raise utilization levels) which is expected through 17 but the risk is that top line sales growth remains relatively anaemic as has been the case for the past months particularly as what is good for the economy (rising wages) is typically bad for corporates (falling profits) and what is good for corporates (rising profits) is typically bad for the economy (falling wages) unless we begin to see some offset via productivity. Fig The profit share peaked pre GFC Fig A rising wage = a falling profit share 6 Australia: Income by factor of production ( share of Total factor income) 6 Australia: Income by factor of production ( share of Total factor income) 5 Profit share (rhs) Profit share (rhs) Wage share (lhs) Wage share (lhs) 2 5 Jun- Jun-6 Jun-2 Jun- Jun- Source: Factset, Macquarie Research, April 5 Jun- Jun-6 Jun-2 Jun- Jun- Fig Non mining return on capital has been below average for a decade Fig 11 The average age of the capital stock is close to decade highs 4 Australia: Return on investment (Profits as of Capital stock) Australia: Average age of capital stock Manufacturing Mining Long-run averages 6 Mining 6 Non-mining 3 3 Jun- Jun-5 Jun- Jun-5 Jun- Jun- Source: Factset, Macquarie Research, April Jun-6 Jun-7 Jun- Jun- Jun- Jun- We forecast the Industrial sector capex to sales ratio will fall to a 21-year low in 17. This corresponds with annual sales growth of ~ and capex growth of ~6. over the past two decades. The most recent rebound is attributable to a handful of stocks - predominantly TCL and TLS, which together represent ~1 of total FY capex, and also AZJ, QAN and WOW, which represent another ~ of total capex. Capex to sales is forecast decrease in FY and FY17 to 6.3 and 5.5, respectively. While sales growth of 2. and 7.2 is forecast for FY and FY17, respectively, capex is expected to fall by -.5 and -5.6 over the same period. The sharp drop in spending is attributable to a small basket of stocks AIO, AZJ, CIM, FSF, TLS, WES and WOW excluding this group of stocks, capex growth is only modestly negative (-2.) in FY, and capex as a percentage of sales is 6. (vs. current forecast of 6.3), in line with LT average. April 6

7 Fig Industrials capex forecasts below y low as companies focus on conserving cash Fig 13 LPTs dramatically increased capex in the last 2yrs. Forecast to decline modestly from here 11. Capex to Sales: Industrials Bn A$ Australia: Value of Committed Mining Projects F Jan-1 Jan-3 Jan-5 Jan-7 Jan- Jan-11 Jan-13 Jan- Jan-17 Jan-1 Source: Factset, Macquarie Research, April Not surprisingly, Resources have seen the sharpest fall in capex as current expansion projects reach completion, and with a lack of new projects being sanctioned (see Fig ). Capex is forecast to fall this year. As a percentage of sales capex reached a peak of 26. in FY13 and is forecast to fall to.5 this year (vs. LT average of.6) and to 11. in FY17. At present, the Materials and Energy sectors comprise nearly 5 of total capital spending (ASX) significantly more than what the comparisons would be at a global level (see Fig & ). Those sectors which are not commodity producers but could conceivably be impacted by more aggressive capital spending reductions (Industrials and Utilities) comprise a further 17 of listed capital spending exposure, although the second round impacts become much more stock-specific (i.e. QAN and TCL are big capex spenders within the Industrials space that are unlikely to be impacted materially by a reduction in Mining and Energy related spending but AIO, AZJ, BXB and CIM appear to be more vulnerable). Fig Materials and Energy driving capex... Financials Health Care 4 Consumer Saples Consumer Discretionary 6 Utilities 3 Share of ASX Capex IT.2 Telecom Industrials Energy Materials 3 Source: Factset, BCA, Macquarie Research, April Note: Dark blue shading represents commodity sectors; gray shading represents sectors which are not directly commodity producers but which are likely to be negatively influenced by a fall in commodities prices; and light blue shading represents sectors which should not be affected by lower commodity prices and may even benefit. Fig... similar to global trends Industrials 5 Share of Global Capex Transports Construction 5 3 Utilities 11 Consumer 1 Telecom Energy 23 Source: BCA, Macquarie Research, April Materials IT 7 Health Care 2 Financials 6 April 7

8 Where does capex make sense? We separate capex trends into 3 categories:) Expansionary (growing capex over and above normal maintenance requirements); 2) Offensive (primarily offshore M&A-related acquisitions) and 3) Defensive (older more capital intensive industry or where they are defending positions). We illustrate this via a heat map for the overall change in capex for the period -17F in Figure. 1) Offensive capex: There is a distinction between those who are acquiring growth and those who are building growth. In recent years the trend has been growth via acquisition and this has primarily been offshore driven. This has been relative successful (for example AMC, ANN, BXB, CSL, CPU, DMP) with a strong A$ providing a significant tailwind. This strategy has now become more expensive, and the return on capital within the domestic economy (see Fig ) suggests it is not the only strategy that can pay off. However the list of stocks investing domestically is notably shorter. Those that are investing are generally in areas where there is government backing or a framework to support investment (i.e. TCL, SYD, APA, QUB, HSO. Also JHC & REG to an extent). 2) Expansionary capex: Capital Goods, Consumer Services, Insurance, REITs and Software Services are all growing capital spending over the next few of years. Stand-out stocks include ACX, ALL, CAR, CTD, NXT, SDF, VCX and WFD. 3) Defensive capex: Sectors where there appears to be limited fundamental underpinnings for capex spending (i.e. more defensive than offensive) include Consumer Staples, Materials, Media, Utilities and Telcos. To justify investment spending in these sectors firms would need to be targeting cost reductions, margin expansions, exports or industry consolidations. Firms in these sectors may find they are better placed acquiring existing capital (M&A), rather than expanding industry capacity. Fig -17F Capital Spending Outlook (shaded according to momentum) Capital Goods Comm & Profess. Services Consumer Services Consumer Staples Div. Financials Energy Healthcare Insurance Materials Media REITs Retailing Software Services Telcos Transportation Utilities Source: Factset, Macquarie Research, April April

9 In the following table we highlight those stocks that are successfully reinvesting capital for growth. In an environment where earnings growth is scarce, these stocks will stand out: Fig 17 Reinvesting for growth who s getting it right? AMC APA CAR CSL DMP HSO IPL AMC continues to actively target acquisitions in both developed and emerging markets (in addition to organic investment in product innovation and technology). Most recently, management elevated Flexibles Americas as a growth focus (currently, market share in this region is <5). AMC has developed a track record for disciplined approach to acquisitions (happy to return capital to shareholders in the absence of an adequate return), as well as a good performance on integration and realisation of synergies. As a result AMC continues to deliver incremental margin and ROIC improvement. Operating cash flow is expected to see a step change from FY (+5). While this would ordinarily see a large lift in the dividend, APA sees itself as a growth stock. Thus demand for capital from new opportunities is likely to see the dividend sit at or below the lower end of the soft target of 6-7 payout (of operating cashflow). In the near term annual growth capex of $-4m will be spent on VTS, Goldfields such assets, with ORG asset sales also attractive albeit the latter will be through a competitive process. Other growth opportunities include SWQP (up to $1bn), albeit remain longer term at this stage. On the acquisition front APA mostly recently, acquired a 5 residual stake in Diamantina (the acquisition signal the vertical diversification in remote PPA power), and announced the takeover of EPX, which add a net $7.-$7.5m to cash flow (for a net investment of $1m) for the next 3.5 years. Last month, CAR announced the acquisition of Chileautos, further broadening its exposure in Latin America. Following a period of heavy investment (as well as improving fundamentals) CAR's key international associates (Korea, Brazil) look well placed to contribute to growth in the medium term. New domestic businesses (Stratton, Tyresales, Auto Inspect) are also contributing. Management stated that capex will remain elevated at ~$5m in FY with investment in a new base fractionation & albumin facility in Kankakee, Illinois and a new rcoag plant in Switzerland. CSL also continues to invest substantially in its R&D pipeline, and flagged "major investment" in its commercial capabilities ahead of the anticipated launch of new recombinant coagulation products in 17. Most recently, DMP entered into a JV with UK-listed Domino s to acquire Joey s Pizza in Germany. The acquisition gives the JV immediate scale and provides a base to reach the long term store target of 1, (which our analysts think is conservative). The German acquisition follows on from the acquisition of Pizza Sprint in western France which has stores. Capex will be focused on rebranding newly acquired stores. Management continue to highlight the potential for expansion into more countries as well the acquisitions over the coming months in existing markets (potentially outside the pizza category). This is in addition to an aggressive (and ever expanding) store rollout program with Japan LT store forecasts recently upgraded to 5 vs. 7 previously. Technology is another key focus of investment for DMP, with over 4 technology projects in the pipeline for FY and technology infrastructure to be rolled out across new markets. HSO has a large brownfield development program that will see the number of beds in its portfolio increase by 23 by the end of CY1 (a number of projects will be brought online from 2H). It has also begun construction of the Northern Beaches PPP, a $m project that will receive a 5 contribution from the State government, once opened. FY17 should mark the end of a prolonged period of growth capex that has spanned both Moranbah and WALA. Growth capital deployed across the two projects is likely to approach $2bn by the time WALA is commissioned. The facility is now just 3-6 months away from start-up, which should drive a material step-change in earnings and related cash returns to shareholders from FY17. JHC ORA QUB REG Organic growth will continue to be augmented by acquisitions and JHC s accelerating brownfield development pipeline. JHC will be bringing online 3 new places by FY17 (25 net new places) and an additional 7 (555 net new) by FY1. Collectively this represents a 26 increase of JHC s current places to be added over the next 4 years and we estimate the development will boost EBITDA by ~. JHC also has a high number of acquisition opportunities as the industry continues to consolidate. Since its spin-off from AMC, ORA's focus has been executing on self-help initiatives (most notably at B). More recently the focus has shifted to growth beyond self-help. The growth agenda includes both M&A (eg. IntegraColor) and deploying organic growth capital (eg. glass bottle capacity expansion). ORA is also funding an innovation project, suggesting that product and process innovation is also feature in the next leg of growth. Since the demerger, ORA has deployed $222m in growth capital with targeted returns of over 3-5yrs. Execution remains key, however, we believe this validates management s plan to drive growth beyond B. While not immune to underlying weak market conditions, QUB continues to demonstrate an opportunistic approach to investment, most recently in its JV acquisition of Asciano s container terminal business, Patrick, through which it expects to create meaningful cost synergies. It also entered into a 5/5 JV with TonenGeneral to develop fuel storage facilities in Australia, and prior to that secured the Quattro Grain JV. The Moorebank Intermodal Terminal project remains a substantial long-term investment opportunity for QUB. REG has announced it will complete two developments in FY, adding net new places. It is also about to start construction for an additional 66 net new places, all of which will open before end FY1. Collectively, this equates to a.4 increase vs. end of FY over a three-year period, which may of course increase as further developments are identified. Similar to JHC, REG also continues to pursue acquisitions. April

10 Fig 17 Reinvesting for growth- who s getting it right? (cont.) RHC RHC has a solid pipeline of brownfield opportunities, and continues to target acquisitions in offshore markets (UK, France, Asia). While some remain sceptical about RHC's acquisition of Generale de Sante (French hospital sector challenging due to ongoing price declines) RHC has the ability to extract meaningful head office and procurement synergies, as well as operational efficiencies, driving margin expansion and ROIC improvement. SEK SYD TCL Plans for aggressive reinvestment in the business saw the stock sell off sharply at its FY result, however SEK s management team have a solid track record when it come to deploying capital and executing on strategic priorities. Over the coming months these include: ongoing spend in its aggregator business; a ramp-up in customer acquisition strategies and investment in adjacencies at Zhaopin; increased spend on placement products and Human Capital Management opportunities more broadly; investment in new Learning businesses offshore; and increased investment in emerging market associates. The T3 acquisition completed in Aug- was immediately accretive for SYD, with further step up in CY1 as it captures commercial and valet parking revenue along with the ability to shift the retail strategy at the terminal. The 2nd airport growth option remains a large longer-term opportunity with a decision likely in mid. SYD is working with the government to develop the proposal, so its level of understanding should be superior to its rivals. Moreover, operating the airports as a single system can ensure better returns and lower net costs. The major uncertainty is the means of pre-funding the development before opening in 25. TCL has shown a willingness to invest in new growth projects in recent years, which together with solid organic growth (price increases, volume growth, cost reductions) has seen the company double its size in the past 3 years, and should see it deliver sustainable dividend growth of ~+ over the next few years. Since FY13 TCL has acquired $4.1bn (equity) of toll roads, namely CCT, QML, DRIVE and most recently Airportlink. The company also has a decent pipeline of potential new opportunities including the Western Distributor, the I-5S, I35 & I-66 roads in the US. TWE WES TWE recently acquired the Diageo wine business in the US which will undergo a transformation to integrate into the existing TWE business. The purchase will aid TWE s rapid growth into China which has driven recent strong performance. WES recently purchased UK home improvement retailer, Homebase, which comprises of 271 stores. The recently acquired stores will be converted to Bunnings stores over the next 1-3 years. At a group level, WES continues to recycle capital internally out of Coles and non-retail businesses into high ROC opportunities (Bunnings and Officeworks) and turnarounds (Target and Liquor), with overall capex stable at $2.2bn in FY. The balance sheet and cash flow generation provides optionality to pursue acquisitions while maintaining a + payout ratio and 5+ dividend yield. Source: Macquarie Research, April Equally, there are companies who are reinvesting capital just to stand still (defend market share), or are seeing margins and returns decline on the back of their reinvestment. While we do not necessarily disagree with the strategy for some (i.e. companies doing the best they can to respond to structural challenges), the growth outlook relative to the level of capital reinvestment is less appealing: Fig 1 Reinvesting for not so much growth... FLT FLT has pursued a rapid store growth strategy in recent years. This growth has masked the erosion of margins from existing stores. There are also clear signs that market share losses to Online Travel Agents (OTAs) are becoming more profound. While FLT continues to grow its offshore businesses (US & UK), as online spend and penetration of OTAs increases we believe FLT s high-fixed-cost bricks and mortar network will make it difficult to generate profit on a high operationally geared platform. GNC Last year GNC announced $m investment over 3 years ("Project Regeneration ), involving consolidating its network, upgrading its rail capability and improving logistics. By GNC's own admission this spend represents 'stay in business capex rather than growth capital. Most of the benefits from rail upgrading are to get passed onto growers whilst savings from site consolidation are to be balanced against higher interest costs, loss of tonnage from closed sites and fierce competition. MTS PRY MTS Diamond Store Accelerator (DSA) program (part of its broader 5-year operational turnaround program) is designed to address underperforming stores through refurbishment. While early results appear positive we remain cautious on reading too much into the initial uplift given the small sample size, low base these DSA stores are starting from and significant promotional investment deployed to the DSA stores upon re-opening. MTS continues to face a highly competitive operating environment, with significant downside risks present. While green shoots are appearing, this is insufficient to offset competitive threats. In what we believe serves to highlight the extent of the difficulties facing PRY s medical centre business, the company spent $2m during FY on upfront doctor contracts (.6 higher than in the pcp), comprising $m cash and $m deferred consideration (net amortisation will be ~). However this level of investment is not sufficient to stop EBIT in the segment from falling. Source: Macquarie Research, April April

11 And finally, those companies who are lacking reinvestment of capital to support growth: Fig 1 Who s lacking growth / reinvestment? AIO ASX WOW AIO is facing the same challenging market conditions as AZJ with top line growth limited and earnings being supported by cost savings. Absent the Brookfield bid, AIO would likely follow AZJ's lead in increasing its payout ratio. Earlier this year ASX signalled a shift in strategy from investing in growth to investing in core infrastructure, after an extended period of underinvestment. We view ASX's Technology Transformation Program (TTP) as necessary maintenance capex that will likely result in minimal investment in new initiatives. We expect cost forecasts to exceed initial expectations while financial benefits from the TTP are very limited, impacting free cash flow over the medium term. WOW has stated a priority for capex spend on store renewals rather than new stores. While this is a positive step (given lack of capex spent on supermarket refurbishments through FY13 & FY), it is also clear that they want to maintain their 7 payout ratio and Investment grade credit rating while not receiving any net cash flow from Masters. A major renewal program would likely cost ~$1bn+. We believe it is more likely that WOW will divest non core businesses (Big W, Hotels) to fund investment and store renewals across its supermarket business. Source: Macquarie Research, April April 11

12 Back to the Future EPSg to once again outstrip DPSg Since the GFC, dividend payout ratios have grown substantially particularly amongst banks and top miners - alongside subdued earnings growth and in an environment where corporates have sought to deleverage. The increase is attributable to growth in ordinary dividends (rather than special dividends), suggesting the intention for the rise in dividend payments to be more permanent. In FY, ASX listed companies paid ~$66m in dividends, representing ~75 of companies underlying earnings. Fig Resources slash dividend payments... Fig 21 Banks continue to slow both DPS & EPS g Payout ratio () Resources FY7 Payout ratio (LHS) EPSg (RHS) DPSg (RHS) FY FY FY FY11 FY FY13 FY Actual FY Fcast FY (E) EPS /DPS growth (YoY) FY17 (E) Payout ratio () 7 6 FY7 Payout ratio (LHS) EPSg (RHS) DPSg (LHS) FY FY FY FY11 FY Banks FY13 Actual FY FY FY (E) EPS /DPS growth (, YoY) Fcast FY17 (E) Source: Factset, Macquarie Research, April For the most part, corporates have not been penalized for a lack of reinvestment in recent years and rightly so. The capital stock is not particularly old, capacity utilization rates are only back to the long term average (~1), capex has continued to run ahead of depreciation and corporates have been able to generate reasonable earnings growth allowing them to throw plenty of cash back to shareholders while in many instances reducing leverage at the same time. If dividends are growing faster than earnings, as has been the case for some sectors (e.g. banks and resources) and earnings growth is slowing, as is the case across the broader market (even ex resources), then we would have a problem and either corporates need to slow dividend growth or grow earnings faster (or alternatively run down cash balances). One reporting season later, and we have already started to see the slowing of dividend growth unfold: Miners: In light of a material decline in commodity prices, major miners have slashed their dividends. Pre 1H reporting season, our Resources team was forecasting an elevated payout ratio of 3.6 (vs. 6.6 in FY), which has now been cut back to 66.5 following the announcements that: BHP has abandoned its progressive dividend policy, moving to a minimum 5 earnings payout ratio, which could see dividend payments fall by as much as 7 from previous levels. RIO too abandoned its progressive dividend policy in favour of a payout ratio. The final dividend of US$1.75/sh was in line with MRE expectations and RIO has indicated it expects to return 4-6 of underlying earnings to shareholders through the cycle. To smooth the transition period, RIO has indicated that a minimum dividend of US$1./sh will be paid in CY. WOR declared no interim dividend in 1H (vs. 34 cps in the pcp and vs. MRE forecasts of 17.7cps). Banks: Pullback is also expected to come from Banks, with the sector expected to deliver a second consecutive year of slower DPSg (see Fig 1). Banks are now opting to hold their dividends constant, rather than increasing them, as they face tougher regulatory requirements that oblige banks to hold more capital (the easiest way for banks to increase their capital is to hold onto more of their profits). April

13 Based on Vicktor Shvet s Chasing Dividends February (link) Sustainable Dividends stock list We suggest the Sustainable Dividend Yield list below, designed on the basis of MRE coverage. The list is defined by high dividend yield (F), quality (high ROEs, positive margins, positive FCF, low net debt to equity) and sustainability (history of stable dividends). Some of the stocks that meet this criteria are BRG, CSR, HVN, JBH, MFG, MGR and VRT. The core conditions of our screen identify stocks with the following characteristics: 1. High dividend yields based on FYE MRE forecasts 2. At least three years history of stable or growing dividends per share including next year forecasts (E) 3. Stocks that have high level of ROE (ROE of at least 11) we view this as a key indicator of profitability, with the expectation that such high ROEs will in most cases be able to cover costs of capital 4. Stocks that have and are likely to deliver positive revenue and earnings growth 5. Net debt to equity of less than 5 in FYE 6. Free cash flow positive in FYE as a gauge of cash flow generation capability 7. Positive EBITDA margin expectations as a measure of margin sustainability and an attempt to avoid stocks in which ROE improvements are delivered purely from rising revenues that just happened to be offsetting declining margins. Valuation was not a criterion for selection. Whilst this list does trade at a premium, we believe it is justified by the quality offered. Fig 22 Macquarie Investment Pulse Code GICS L2 Name Recomm. Market Cap ($M) Price Target Current mth fw PER Div. Yield ROE Net Debt/ Equity EBITDA Margin Sales Revenue growth E E E E E ABC Materials Neutral 3, ASX Div. Financials Underperform, Cons. Dur. & BRG App. Outperform BTT Div. Financials Outperform 2, CQR Real Estate Underperform 1, CSR Materials Underperform 1, DXS Real Estate 7, Consumer FLT Services Underperform 4, HVN Retailing Neutral 4, Software & IRE Services Neutral 1, JBH Retailing Outperform 2, MFG Div. Financials Outperform 3, MGR Real Estate Neutral 7, OFX Div. Financials Outperform SGP Real Estate Underperform, SUL Retailing Neutral 1, VRT Healthcare Neutral Source: Factset, Macquarie Research, April April 13

14 Appendix: Age of capital stock by sector This appendix details the average age of industries underlying capital stock. An ageing capital stock would be a signal that upcoming capex may be required, or an industry is slowly declining. The average age of the capital stock has been rising in Professional Services, Financial Services, Tourism, Rental, Hiring & Real Estate Services, Arts & Recreation, Manufacturing and Administrative services. Industries where the average age of the capital stock has been declining include Mining, Utilities, Construction, Transport and Health care. Fig 23 Manufacturing & Mining. Fig 24 Wholesale trade & Utilities. Australia: Average age of capital stock 24 Australia: Average age of capital stock 24 Manufacturing 22 Electricity, Gas & Water Mining 6 Wholesale trade 3 3 Jun-6 Jun-7 Jun- Jun- Jun- Jun- Jun-6 Jun-7 Jun- Jun- Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, September Fig 25 Retail & Construction. Fig 26 Transport & Tourism. 1 Australia: Average age of capital stock 1 35 Australia: Average age of capital stock 35 Retail trade 25 Transport, Postal & Warehousing 25 Construction Accomodation & Food services 6 6 Jun-6 Jun-7 Jun- Jun- Jun- Jun- Jun-6 Jun-7 Jun- Jun- Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April April

15 Fig 27 Telco, Media & Professional Services. Fig 2 Real estate, Rental & Administrative Services. Australia: Average age of capital stock Australia: Average age of capital stock Information, media & telecommunications Rental, hiring & real estate services Professional, Scientific & Technical services 4 Administrative & Support services Jun-6 Jun-7 Jun- Jun- Jun- Jun- Jun-6 Jun-7 Jun- Jun- Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April Fig 2 Housing & Financial Services. Fig Health Care & Arts & Recreation services. 25 Australia: Average age of capital stock 25 Australia: Average age of capital stock Dwellings 1 1 Arts & Recreational services Financial & Insurance services Health care & Social assistance 5 5 Jun-6 Jun-7 Jun- Jun- Jun- Jun- Jun-6 Jun-7 Jun- Jun- Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April April

16 Appendix: Returns on capital by sector This appendix details profits as a of industries underlying capital stock. Above-average returns on the capital stock are a potential signal that an industry should undertake capex to expand. Profits, as a of underlying capital stock, are currently above average across Professional services, Financial Services, Tourism, Construction, Retail, Transport and Administrative services. Non-mining profits, as a of underlying capital stock, are running below average. At the industry level, below average profitability is being experienced in the Mining, Manufacturing, Utilities, Wholesale trade, Telco & Media, Rental, Hiring & Real Estate Services, Arts & Recreation and Other Services sectors. Fig 31 Mining & Non-mining. Fig 32 Manufacturing & Agriculture. 4 Australia: Return on investment (Profits as of Capital stock) 4 Australia: Return on investment (Profits as of Capital stock) 4 Manufacturing Mining Long-run averages Long-run averages Non-mining Agriculture, Forestry & Fishing Jun- Jun-5 Jun- Jun-5 Jun- Jun- Jun- Jun-5 Jun- Jun-5 Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April Fig 33 Transport & Utilities. Fig 34 Retail & Financial Services. 11 Australia: Return on investment (Profits as of Capital stock) 11 7 Australia: Return on investment (Profits as of Capital stock) 7 Electricity, Gas Water & Waste services Long-run averages Financial & Insurance services Long-run averages Transport, postal & warehousing 6 Retail trade 5 5 Jun- Jun-5 Jun- Jun-5 Jun- Jun- Jun- Jun-5 Jun- Jun-5 Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, September April

17 Fig 35 Telco, Media & Wholesale Trade. Fig 36 Tourism & Administrative Services. 4 Australia: Return on investment (Profits as of Capital stock) 4 5 Australia: Return on investment (Profits as of Capital stock) 5 Wholesale trade 4 Administrative & Support services 4 Information, media & telecommunications Long-run averages Long-run averages Accomodation & Food services Jun- Jun-5 Jun- Jun-5 Jun- Jun- Jun- Jun-5 Jun- Jun-5 Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April Fig 37 Housing & Health Care. Fig 3 Real Estate & Recreation services. Australia: Return on investment (Profits as of Capital stock) 1 Australia: Return on investment (Profits as of Capital stock) 1 13 Health care & Social Assistance 13 Rental, hiring & real estate services 11 Long-run averages 11 Arts & recreation services Long-run averages 7 Dwellings Jun- Jun-5 Jun- Jun-5 Jun- Jun- Jun- Jun-5 Jun- Jun-5 Jun- Jun- Source: ABS, Macquarie Research, April Source: ABS, Macquarie Research, April April 17

18 Companies mentioned in this report: Amcor (AMC AU, A$.53, Outperform, TP: A$., John Purtell) APA Group (APA AU, A$.62, Outperform, TP: A$., Ian Myles) Carsales.com (CAR AU, A$11.2, Outperform, TP: A$.5, Andrew Levy) CSL (CSL AU, A$.1, Outperform, TP: A$1., Craig Collie) Domino's Pizza Enterprises (DMP AU, A$56.44, Neutral, TP: A$6.64, Elijah Mayr) Healthscope (HSO AU, A$2.66, Neutral, TP: A$2.6, Craig Collie) Incitec Pivot (IPL AU, A$2.7, Outperform, TP: A$4.25, John Purtell) Japara Healthcare (JHC AU, A$2.1, Neutral, TP: A$3., Craig Collie) Orora (ORA AU, A$2.51, Outperform, TP: A$2., John Purtell) Qube Holdings (QUB AU, A$2., Restricted) Regis Healthcare (REG AU, A$4., Neutral, TP: A$5.5, Craig Collie) Ramsay Health Care (RHC AU, A$61.54, Underperform, TP: A$6., Craig Collie) Seek (SEK AU, A$.47, Outperform, TP: A$17.45, Andrew Levy) Sydney Airport (SYD AU, A$6.5, Neutral, TP: A$6.51, Ian Myles) Transurban Group (TCL AU, A$11.1, Outperform, TP: A$11.5, Ian Myles) Treasury Wine Estates (TWE AU, A$.2, Neutral, TP: A$., Elijah Mayr) Wesfarmers (WES AU, A$4.2, Outperform, TP: A$43., Elijah Mayr) Flight Centre Travel Group (FLT AU, A$41.7, Underperform, TP: A$36.7, Sam Dobson) GrainCorp (GNC AU, A$7.61, Restricted) Metcash (MTS AU, A$1.62, Underperform, TP: A$1.6, Elijah Mayr) Primary Health Care (PRY AU, A$3.66, Neutral, TP: A$2.75, Craig Collie) Asciano (AIO AU, A$.73) ASX (ASX AU, A$41.25, Underperform, TP: A$4., Tim Lawson) Woolworths (WOW AU, A$.2, Underperform, TP: A$., Elijah Mayr) April 1

19 Important disclosures: Recommendation definitions Macquarie - Australia/New Zealand Outperform return >3 in excess of benchmark return Neutral return within 3 of benchmark return Underperform return >3 below benchmark return Benchmark return is determined by long term nominal GDP growth plus month forward market dividend yield Macquarie Asia/Europe Outperform expected return >+ Neutral expected return from - to + Underperform expected return <- Macquarie South Africa Outperform expected return >+ Neutral expected return from - to + Underperform expected return <- Macquarie - Canada Outperform return >5 in excess of benchmark return Neutral return within 5 of benchmark return Underperform return >5 below benchmark return Macquarie - USA Outperform (Buy) return >5 in excess of Russell index return Neutral (Hold) return within 5 of Russell index return Underperform (Sell) return >5 below Russell index return Volatility index definition* This is calculated from the volatility of historical price movements. Very high highest risk Stock should be expected to move up or down 6 in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 4 6 in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 4 in a year. Low medium stock should be expected to move up or down at least 25 in a year. Low stock should be expected to move up or down at least 25 in a year. * Applicable to Asia/Australian/NZ/Canada stocks only Recommendations months Note: Quant recommendations may differ from Fundamental Analyst recommendations Financial definitions All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards). Recommendation proportions For quarter ending 31 December AU/NZ Asia RSA USA CA EUR Outperform (for global coverage by Macquarie, 5.33 of stocks followed are investment banking clients) Neutral (for global coverage by Macquarie, 5.2 of stocks followed are investment banking clients) Underperform (for global coverage by Macquarie, 3.7 of stocks followed are investment banking clients) Company-specific disclosures: Important disclosure information regarding the subject companies covered in this report is available at Analyst certification: We hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. 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