Preferring catwalk corduroy over the sexy things
It has long been difficult to place rationale around valuations in certain areas of the market. While the supermodels get all the spotlights, it’s the cardigan wearing brigade that seem more like a solid investment, allowing scope for many different futures — both good and not so good — without blowing everyone up.
Emotions continue to run high in equity markets. Adding much in the way of sensible commentary around share price moves is difficult, as we struggle to rationalise the majority. In searching for a song that most aptly describes current market behaviour, I’d probably have to go back to the 70s to Hot Chocolate’s, You Sexy Thing. Much of the equity market remains grounded in the harsh reality of making profits, which are capitalised at (largely) sensible multiples to arrive at a business value. The rules are very different for the ‘sexy things’. Exposure to the intoxicating prospects of the ageing population, booming Chinese consumer or better yet, ‘a globally scalable technology platform’, is allowing a number of businesses to well and truly break free of traditional valuation shackles.
The vast majority of business valuation in these instances is dependent on profits into the distant future and requires a path of growth which has only been realised by a tiny proportion of companies globally.
However, when emotions run high and short-term gains are extraordinary, discipline is hard to retain. Far easier to edge up the long-term growth rates in your DCF value such that it is still a little higher than the share price. Deduced Crazy Forecast would be a more apt version of the acronym than Discounted Cash Flow.
The supermodels of the ‘sexy thing’ segment are those where a ‘global’ business can be combined with an intoxicating theme. Wisetech Global (+40.1%) Altium (+37.4%), Appen (+41.2%), Afterpay (+27.9%) and Xero (+19.3%) led the charge up the catwalk, collectively reaching $23bn in market valuation for a grand total of $1bn in revenue. None are anywhere near $100m in operating profit.
At the more established end are the global healthcare businesses: CSL (+15.6%), Cochlear (+6.1%), Fisher & Paykel Healthcare (+10.6%) and Resmed (+10.2%). Market capitalisation for this highly appealing cohort is approaching $150bn (total debt is relatively immaterial) for some $16bn of revenue and a little over $4bn in operating profit. For comparison, the 12 months to June 2018 saw Rio Tinto (-8.4%) deliver more than three times the collective revenue and more than four times the collective operating profit. In return, market capitalisation is about $50bn lower (it also has very little debt). It is clearly strutting down the catwalk in a brown cardigan and corduroy trousers.
In case you hadn’t guessed, we believe the pricing of these stocks to be wildly optimistic. Pricing a business is a combination of art and science; however, according to a very high and generally random multiple to the entire earnings base of a company with a high growth rate is both lazy and misleading. One way to think about valuing growth (or decline) is to determine a reasonable valuation for the business as though it was stable and mature and then determine the additional increment (or decrement) for the expectation of an improving or deteriorating future.
Let’s take a business like CSL. As a high quality business with an expectation of long duration (albeit always subject to the risks of being supplanted by new and more effective therapies), if we were to assume the current product portfolio was fairly mature and product pricing fair, we might reasonably accept a return of say 8% on our money (before we worry about financing), equating to 12.5x the operating profit (this is a little higher than long run average market multiples). Having just reported operating profit of about $3bn, we would be prepared to pay $37.5bn. Based on the current business valuation (around $107.5bn), we can derive the amount we are paying for future growth to be around $70bn. The astute mathematicians might observe that we are paying for nearly two more businesses of the same size to be created in the future, despite already dominating the category in nearly all developed markets.
In reality, the growth that investors get excited over often stems disproportionately from increasing prices on existing products, as selling vastly more of the existing products at the same prices tend to be both challenging and very long dated. Price increases, on the other hand, provide instant gratification and emerge largely as extra profits for shareholders (just ask REA Group). It is a more than reasonable expectation that CSL will be able to raise prices in the short- to medium-term as demand is strong and supply tight; however, in our view, an attractive short-term price environment goes little way to justifying the $70bn gap between current market pricing and a sensible multiple on the $3bn of profit arising from decades of hard work, astute decisions and strong management. Powerful emotions can add market capitalisation quickly; adding sustainable profit that doesn’t stem from price gouging is hard.
As an aside, in explaining our preference for Rio Tinto over CSL, we look at our margin of safety in two ways; assuming the same 12.5x multiple of operating profits, where CSL has an additional $70bn imputed, the Rio Tinto valuation allows for operating profits to halve from current levels or for another $100bn or so of market capitalisation to be added. We don’t have to worry much about whether we are overpaying for future growth at present.
Among the usual assortment of winners and losers from results season, most of which reflect aggressive reactions to short earnings direction, one of the more interesting developments was the announced merger intention between TPG and Vodafone Hutchison Australia.
Given TPG gained 52.7% for the month, it is fair to say investors have reacted positively. The merged business is valued at some $20bn, including $4bn of debt, a little under half Telstra’s value, although a little more than half if we remove the value of payments receivable by Telstra from NBN which do not apply to TPG. Prima facie, it appears to us that TPG has received the far better side of the deal, while the valuation of the merged business appears extremely optimistic. At 6 million subscribers, $3bn of service revenue, and a multi-billion dollar asset base, Vodafone is a more significant enterprise than TPG with $2.5bn of corporate and broadband revenue and 2 million broadband subscribers. It is difficult to rationalise why TPG would have chosen to spend $1.25bn purchasing 700MHz spectrum at a price far above that paid by Vodafone and merge part way though construction of a network which significantly overlaps that of Vodafone. Among the potential conclusions, either operating conditions were transpiring to be tougher than anticipated and the outlook for a fourth mobile entrant darkening (particularly given the #3 wasn’t making money), or the spectrum purchase was a high stakes gamble to bring Vodafone to the negotiating table (which worked).
Despite assertions that the merged business remains beautifully positioned to win customers from Telstra and Optus, it is difficult not to observe that both companies have been pursuing this objective aggressively over recent years and have been largely unsuccessful, garnering neither significant market share nor significant additional revenue. TPG are also battling headwinds from transitioning previously lucrative subscribers to far less lucrative NBN subscribers. They have, however, been very successful at keeping costs low. Interestingly, many observers have taken solace in the ability to take this cost base lower again through ‘synergies’, that beloved term of M&A advisers globally. Given management control is passing from the lean and mean operator to the global business, one could be forgiven for harbouring some cynicism on this front.
When telecommunications is approached from a high fixed cost network ownership perspective, rather than the resale basis on which TPG was founded, dynamics change completely. Evidence suggests high levels of profitability tend to be elusive for sub-scale operators. It is also why analysts tend to focus on EV/EBITDA multiples. A third operator will normally shoulder levels of capital investment not markedly lower than larger peers, meaning similar depreciation charges on lower EBITDA. As a result, actual cashflow or EBIT is a far less appealing measure than EBITDA. It is also why Vodafone in Australia has significant debts and large tax losses. Shareholders don’t earn EBITDA. We expect winning large numbers of incremental subscribers through cutting prices further will remain a tough road, and Telstra and Optus will continue to protect market share zealously. While Telstra has plenty of revenue and a cost problem, the alternative of very low costs and a revenue problem is not necessarily superior.
In the assortment of aggressive share price moves during August, the preponderance of tech and healthcare names at the positive end was largely mirrored by the assortment of materials and energy businesses at the other. Origin Energy (-18.6%), Iluka Resources (-18.1%), Sims Metal (-26.8%) and Newcrest (-9.7%) were among the weakest.
Trade tensions, increasingly sharp currency moves and limited scope for interest rates to buffer against future shocks create a volatile global backdrop. Domestically, the inevitable slowdown in residential construction and a far more measured outlook for credit growth as banks adjust to an environment in which borrowers actually need to be able to afford repayments from wages rather than relying solely on speculative house price gains, creates obvious challenges. Just as companies which excessively increase prices to customers create an adjustment problem for the future (as sustainability is borne of satisfied customers receiving reasonable value for money), economies are no different. On the positive front, the need for significant infrastructure replenishment together with ongoing technology improvements, offer substantial opportunity to offset the adjustment of these excesses from years past. We continue to caution against measuring economic progress against the yardstick of financial asset prices. The latter remain elevated whilst the former will continue unabated. For the record, economic growth also has nothing to do with population growth. We remain amazed at the number of senior executives believing population growth is crucial to economic (and corporate) success. The misinformation wrought by that emotive word ‘growth’, is widespread.
Sustainability remains key to our assessment of the value of any business, as we continue to believe durable earnings are far more valuable than those with appealing short-term trajectory. We are currently being steamrolled by an investment landscape in which ‘growth’, whether stemming from increasing prices, voracious merger and acquisition activity or just a persuasive story on huge unmet demand and geographic rollout potential, is more highly prized than almost any time in history. As Hot Chocolate put it all those years ago, “I believe in miracles, since you came along, you sexy thing”. We tend to prefer an assessment of numbers and facts rather than relying on miracles.
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