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Patrick Poke

What will the world look like in five years’ time? A difficult question to answer, but one that long-term equity investors must ask themselves every day. In 2014, Amazon remained outside the world’s top 10 companies, Telstra’s share price peaked at over $6.60 per share, and Afterpay was nothing more than an idea in Nick Molnar’s mind. A company that compounds at 30% per annum, after five years, will have grown to nearly four times its original size; a difficult, but not impossible endeavour.

To get a better understanding of the long-term prospects for Australian blue-chips, we recently reached out to a group of fund managers and asked them to put their long-term thinking-hats on. The question was in two parts: first, which small-medium sized company could be in the ASX20 in five years’ time; and second, which current blue-chip could drop out of the ASX50 over the same period? 

Despite the varied contributors to this article, their responses were surprisingly similar, with one company being mentioned twice as a future blue-chip, and another mentioned twice as a potential drop-out.

Responses come from Daniel Moore, Investors Mutual; Ben McGarry, Totus, Capital; Tobias Yao, Wilson Asset Management; and Ben Chan, Walsh and Co.

A recurring earnings stream that’s resilient in all markets

Daniel Moore, Investors Mutual

We think Tabcorp (TAH) has an exciting future. We really like the lottery side of the business, which is approximately half the earnings, but in terms of value we think it's more than half of the value of the company. The lotteries business is effectively a monopoly with licences in every state in Australia (excluding WA) which go for decades. For example, in NSW, the licence lasts out to 2050.

On top of that, it's got a very strong recurring earning stream which is resilient in all markets. Even in recessions we think the lotteries will continue to grow – people like to buy hope in tough times. We see very strong long-term growth potential from customers shifting from buying tickets from newsagents to online sales. Currently, online sales are 20% of sales, but we think that can grow substantially over time. I see no reason why that can't be 50% of their sales in the longer term.

Source: Tabcorp strategy day & 1H19 presentation; November 2018 & February 2019

When a customer converts from a newsagent to online there are two benefits. First, Tabcorp doesn't have to pay commissions to the newsagent. Secondly, they know a lot more about their customer, so they can market directly to them. Evidence has shown that when a customer converts from being a retail customer to an online customer, their spend increases about 50% on average. That's because Tabcorp can actively market individually to customers based on their spending habits and encourage people to spend when jackpots reach their personalised level. So, maybe you are someone who only buys jackpots when the jackpot's over $50 million, they can make sure they always send you a message alert when the jackpot hits $50 million so you never miss it. This was never possible through the newsagency model.

On the wagering side of the business, we are optimistic of an improved competitive environment. Wagering has been a very competitive market for a while due to many online competitors operating out of Northern Territory and not paying the same taxes paid by Tabcorp. Now the state governments have put in a Point of Consumption Tax (POCT). This has meant that their competitors are now paying significant amounts of tax, which means some online competitors are no longer profitable.

We think this will lead to a much more rational competitive environment. We expect marketing from their competitors to reduce over time and we also expect betting yields to improve for all companies. Because of the new taxes, based on our assumptions, we only expect one of their competitors will be making any material amount of profit which is Sportsbet. All the other players, such as Ladbrokes and BetEasy, will be making either no profit or very little profit.

Source: IML estimates & PaddyPower Annual report; as at 20 March 2019

Commodity prices to head downwards

South32 (S32) was spun out of BHP in May 2015. Unlike Tabcorp is it cyclical. South32’s profits are exposed to commodities including Aluminium/Alumina (35%) and Manganese Ore (30%). At this point in the cycle South32’s share price has had a very strong run in line with rises in these commodity prices. We believe that in five years’ time, commodity prices are unlikely to be as high as they are today. Alumina prices have strengthened due to supply disruptions caused by the Chinese environmental focus and the partial suspension of an Alumina refinery in Brazil. Manganese Ore has been in demand as it is used to strengthen steel in blast furnaces, however we believe steel demand in China has peaked and supply will increasingly come from electric arc furnaces which use scrap steel, rather than Iron Ore, Met Coal and Manganese.

We regard South32’s mining assets as second tier, being relatively high cost. Therefore, if commodity prices do fall in the next five years, that would have a disproportionate impact on their profit.

On the positive side, they are looking to simplify their business by selling some assets which they view as non-core, including South African Energy Coal and Manganese. Divestment proceeds would likely to be returned to shareholders through special dividends or share buy-backs, reducing the size of the company. We consider this a positive for shareholders, however it is another factor which may see it drop out of the top 20.

Revenue growth combined with margin expansion

Ben McGarry, Totus Capital

Xero (XRO) is the company we think is most likely to be a blue chip in five years. Xero has built a very high-quality recurring revenue stream selling subscriptions of its industry leading cloud accounting software to SMEs. We think they have a long runway of revenue growth and improving margins as a result of two factors:

  1. There is still a large opportunity to grow subscribers in offshore markets, where cloud accounting software is relatively underpenetrated.
  2. Huge R&D investment and switching costs provide an economic moat which we think management will exploit to increase prices on the existing customer base.

Looking at the top 20 Australian stocks most are large diversified businesses with strong market positions and multiple revenue sources. If we had a to take a stab at picking one with potential to fall out of the top 50 stocks it would be one of the resources companies given the non-renewable nature of their asset base and the boost commodities have had over the last 15 years from the urbanisation of china. 

Looking at the four resources stocks in the top 20; BHP (BHP), Rio Tinto (RIO), Woodside Petroleum (WPL) and South32 (S32) we would have to choose S32 as the stock most likely to meet that criteria given that from current market caps it would take a truly catastrophic bear market in commodities for BHP, RIO or WPL to fall outside the top 50 within five years. (We do not currently have a position in S32)

Aiming to replicate their local success

Tobias Yao, Wilson Asset Management 

Xero (XRO) has created a very impressive ecosystem that continues to resonate with their clients around the world. The recurring nature of their business model gives them the ability to focus on long term priorities which continues to pay off as evidenced through the strong subscriber growth momentum. While the core accounting software is still the foundation of the business and a key growth driver, over time we expect them to extend their existing platform through offering additional services and solutions to SMBs, driving other growth channels. If Xero can replicate their ANZ success in the UK and US and grow their revenue at a CAGR of 30% over the next five years, they will be a strong candidate for a truly blue-chip company.

Like all the other ASX20 companies, Scentre Group (SCG) is a high-quality business that has one of the strongest brand names in Australia with Westfield. However, structurally, we believe online retail will continue to win market share from brick and mortar retail and foot traffic in shopping malls will continue to decline. Landlords such as SCG will be negatively impacted as retailers focus more on their online offering, leading to less favourable lease deals over time.

True-blue (chip)

Ben Chan, Evans & Partners

My eye is on Qube (QUB) – an Australian logistics and infrastructure company that is currently in the process of further strengthening what is already a strong vertically integrated domestic logistics operation. The two most attractive assets in the portfolio are the fully automated ports (Patricks) acquired during the Asciano breakup, as well as the Moorebank Intermodal Terminal currently under construction in Sydney. 

Optimising freight movements to avoid empty hauls is the main game in logistics and the Moorebank facility enables this, with key containers railed to the terminal where customer warehouses are located. These containers are then filled for export back to the port or interstate transport. Moorebank will be serviced by more than just the Patricks ports in Sydney; however, it does add a further point of integration where efficiencies can be achieved in that market. In my view, the bidding war that ensued for the Patricks terminals some years ago provides validation of how well regarded and sought after the fully automated technology is. Capacity utilisation in Australian ports is currently not strong enough for Qube to fully extract the benefits embedded here, but we expect that economic growth could help this happen over the above five-year horizon. 

Qube is a relatively young company, having been established only 9 years ago, but we expect that as its volumes and earnings grow and as more people become exposed to its services outside of investment markets, it could become a true-blue chip in the Australian market.

Conversely, there are several companies within the ASX20 for which we have medium-term concerns about potentially falling out of the top 50, such as the banks and Telstra. However, given their size and the fall required to drop out of the ASX50 in this five-year timeframe, we see this as unlikely. On my radar, though, is Coles (COL)– one of the smaller companies in the ASX20. 

Australian supermarkets earn relatively high returns already compared to their global peers, but as competition has intensified, we see that this industry is still susceptible to further shock from new entrants. On a longer-term basis, the whole industry is at risk of disruption from the increasing online presence currently revolutionising the distribution model – something that could result in additional margin contraction for the established players with a heavy physical footprint.     

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Comments

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Eric Nguyen

Nice Pat!

John Abbink

All the above so called Guru's are very sorry they missed out on After Pay! It's called sour grapes. Also , calling commodity prices to be much lower in 5 years time is a big call, a bit like all of them calling Iron ore to be finished a while ago....

Nicole Cameron

Thanks, Helpful Insight, you sound very down to earth 🍀

ELEANOR MARTIN

Thank you for that helpful insight.