The hits and misses from each ASX sector
This reporting season saw a relatively balanced outcome of results, with EPS beats slightly ahead of misses. However, free cash flow results were generally below expectations on elevated capex due to cost pressures, and heightened working capital as businesses stocked up on inventory in response to supply chain bottlenecks. While the All Ordinaries rose marginally in Feb (up 0.8%), volatility was high in the backdrop of rising rates, elevated cost pressures and the Russia/Ukraine conflict.
There are 4 key themes that were evident across this reporting season, and that carry into future investment thesis:
- Omicron outbreak: The Omicron outbreak proved to be highly disruptive by exacerbating labour shortages and supply chain bottlenecks as workers were forced to self-isolate. While the outlook is improving as businesses are learning to adapt and borders have reopened, we can’t rule out the risk of new variants causing further disruption. Furthermore, the economic ramifications of COVID continue to be felt in forms such as elevated inflation and changes in consumer behaviour, which may prove to be persistent on a medium-term view.
- Cost pressures: Cost-push inflationary pressures accelerated from last reporting season. Supply chain bottlenecks, high freight costs, a tight labour market, elevated commodity prices and significant levels of Omicron community transmission all contributed to a challenging cost environment. Cost pressures have so far proven to be more pervasive and persistent than the market anticipated 6 months ago. Our view is that this is likely to continue, which should weigh on corporate margins.
- Elevated commodity prices: The materials sector across the board reported very strong cash flow results and dividends on the back of strong commodity prices, despite elevated costs and capex. Demand is a key area to watch in an environment of rising prices, though supply continues to be constrained for a number of key commodities and should be supportive of higher commodity prices on a longer-term view.
- Impact of rising rates: With the strong likelihood of a higher cash rate by the end of 2022 and a major rally in swap rates since the beginning of last quarter, investors’ attention has turned to who the winners and losers are in a higher rate environment. Banks stand out as key beneficiaries as we see the potential for their fortunes to improve as lending rates rise and low cost deposits see the benefit of higher rates. “Bond proxies” and long-duration assets like tech stand out as the losers from a rise in the risk free rate, though we continue to like a select few of the highest quality ASX-listed tech names as secular growth stories with many years of outsized returns ahead of them.
We are becoming more cautious on the outlook. In the backdrop of slowing global growth, tightening monetary policy and the risk of sustained cost-push inflation, we see the potential risk of heightened volatility persisting over the medium-term. The economic fallout of the war in Ukraine may accelerate these trends as Russia and Ukraine account for a substantial portion of global supply for commodities such as oil & gas, platinum, palladium, and wheat among others. As the year progresses we remain focussed on the key fundamental drivers of business confidence, consumer sentiment, inflation and unemployment to gauge the extent to which the economy can absorb macro-economic headwinds.
In an environment of heightened risk and volatility, it’s important to invest in quality companies with pricing power who can continue to grow their earnings and cash flows independent of underlying macroeconomic disruptions.
In names where we have conviction on a longer-term view we can look through near-term volatility and stay focussed on the fundamentals. With this in mind, we tend to construct portfolios with a mix of:
- Long term compounders. Those with structural tailwinds that enable compounding returns over our investment horizon, regardless of what path the economy takes.
- Defensive companies offering very predictable earnings and strong cash generators, albeit lower growth.
- Businesses that are more cyclical in nature, but with very strong fundamentals that may be unfairly punished by the market due to short-term volatility.
Below is a more detailed sector-by-sector round-up, with a focus on our holdings across the different strategies.
Ongoing competitive intensity in mortgages, divergence in market share between the winners (NAB and CBA) and the losers (ANZ and WBC), and impairment charge write-backs were the dominant themes this reporting season. NAB was the strongest performer with net interest margins falling by only 2bps, thanks to improved lending rates and solid growth in business lending. Westpac saw the largest contraction with a 10 basis point fall in underlying NIM but was partially rescued by strong trading income. The credit environment appeared to be relatively benign despite Omicron’s impact. Westpac took a more conservative approach to provisioning relative to its peers by taking a $118m impairment charge for the quarter.
Banks have seen their margins eroded by a falling cash rate for the past ~5 years, though in an environment of rising rates we see the potential for the pendulum to finally swing the other way as lending rates rise and banks see the benefit of a rising cash rate on low rate deposits.
The ASX delivered yet another resilient result, buoyed by increased capital market activity late in 2021. While expense growth was guided up due to inflationary pressures, the CHESS replacement project remains on track for delivery in April 2023 and the outlook is also fairly positive with ongoing equity market volatility aiding trading volumes and the rising likelihood of RBA increasing cash rates this year also assisting with the recovery in interest income and interest rate future volumes. However, the surprise news of the CEO’s impending retirement weighed on the stock, adding to what was perhaps some overdue catch up on valuation sensitivity to rising discount rates. Similar themes were observed in the NZX result with high levels of market activity and good growth in the SmartShares and Wealth Technology divisions. However, cost investment and a volatile start to 2022 had management err on the side of conservatism, with softer forward guidance although strong operating leverage is still expected in 2023. The NZX also executed the highly strategic acquisition of a partial stake in dairy trading platform (GDT), which should boost the NZX’s dairy derivative volumes over the medium term.
It appears that headwinds of the prior year ranging from uncertainty over business interruption claims, higher peril expenses and legacy increases in long tail provisions driven by claims inflation is finally subsiding somewhat. Strong premium rates have firmly taken centre stage, allowing insurers to earn-through pricing increases which are gradually restoring beaten up margins.
IAG reported a strong result, with premium rate increases delivering more than 6% GWP growth, further aided by margin improvement in the underperforming intermediated business and encouragingly, organic volume growth returning in the direct division after a long period of absence.
A refreshed executive team and a strong capital position were also welcomed, as was the upgrade to GWP guidance and the increasingly likelihood of progressive capital releases from the conservative business interruption provisions. The insurance brokers reported similarly strong premium rate growth, although operating leverage was curtailed by a period of expense catch up, after costs were tightly controlled through COVID. The outlook for the insurance brokers remains buoyant, with what is likely an elongated domestic hardening cycle complemented by ongoing digitisation initiatives and acquisitive growth. Our preference in the insurance broking sector remains AUB Group.
NWL and HUB continued to enjoy strong rates of net inflow growth and each now command ~5% of the platform market. While strong topline growth was observed at the most recent result, revenue margins were impacted by client mix and the flow through of RBA rate cuts that were fully absorbed. Overhead investment across operations, sales and distribution and increasingly, IT personnel were also a major theme, resulting in NWL disappointing the market with limited operating leverage in the period. HUB experienced a warmer market reaction given it was able to better protect revenue margins and continued to demonstrate positive jaws despite the ongoing cost investment.
Both platform operators continue to enhance their non-platform offerings with HUB completing the acquisition of CL1 and NWL expected to launch their non-custodial offering later in 2022 (after abandoning their proposed takeover of PPS).
While the sector is leveraged to equity market volatility both from its underlying FUA base, but also through the market’s wanning appetite for growth businesses, we continue to have high conviction in the secular growth trends that are accelerating, and note that these speciality platform providers are highly earnings and cash flow generative, which is a key differentiating factor to many other high growth businesses.
Industrial stocks had a mixed reporting season with domestically focused cyclical businesses generally reporting solid top line growth led by both strong price increases as well as a return to volume growth, albeit cost pressures curbed the upside, with the market selectively rewarding those who were able to pass through inflationary pressures and maintain margins. Auckland International Airport reported soft results as the arrival of Omicron delayed plans for the reopening of the NZ international border and crimped what was otherwise a strong recovery in the domestic travel market. We expect unrestricted international travel to gradually restart later this year, and with that a rebound in Auckland Airport’s earnings. We expect a healthier travel environment to play neatly into their upcoming pricing renegotiation with airlines, the expected duty free operator consolidation, and a restart in capital growth projects.
Outside of travel, activity levels in the mining services sector continue to be elevated, our holding in Perth based mining service contractor MND reported better than expected top line growth led by a strong recovery in their bread and butter maintenance and shutdown work, much of which have been backlogged due to COVID restrictions. More importantly, while the labour constraints are persisting, MND reported an improving EBITDA margin which signals the cycling off of prior work that have been contracted at lower prices and now more adequately reflects the current cost environment.
Finally, patent firm IPH Limited delivered a strong set of interim results driven by robust growth across its Asian IP network and most encouragingly, EBITDA margin expansion that was achieved across all operating regions despite the operating challenges that were experienced. We continue to view the IP sector as offering attractive quality characteristics and see IPH as having both the organic levers to grow its leading regional franchises, as well as an under geared balance sheet that will support its proven acquisition strategy.
With the sector having underperformed the market year to date owing to inflation concerns having led to a sharp rise in bond yields, investors as a whole were particularly keen to get a better understanding on both balance sheet leverage, as well as the level of interest rate hedging as we headed into reporting season. Retail REITs in general offered mixed results, with better than expected occupancy resilience offset by the Code of Conduct that remained in place for the two largest states NSW and VIC resulting in higher rental relief, as well as softer cash collections and therefore interim distribution for investors. We witnessed this through our holding Mirvac; although this was offset thanks to their residential division as strong volume of settlements continue to support group earnings, whilst their vertically integrated model meant that they were able to offset elevated construction cost pressures through forward purchasing and volume discounts. We saw that scale does matter during bouts of rising cost pressures and intermittent disruptions, as the same cannot be said for our smaller size developer Cedar Woods, whereby the Omicron wave resulted in workers having to isolate or take sick leave resulting in weaker settlement and revenues, whilst margin on certain projects were also impacted by rising costs.
Fund managers continue to smash expectations, with both our holdings Goodman Group and Charter Hall Group materially upgrading their full year guidance as equity flows into the real estate sector remains unabated, whilst Goodman in particular continued to enjoy the structural tailwind of last mile logistics as customer demand for their products remain strong, whilst record low vacancies supported rental growth.
This was the same observation that we got from our other holding Centuria Industrial REIT, where they are strategically acquiring land in infill locations with the aim of consolidating these lands in order to enable development of multi-storey warehouses that are becoming in demand. Finally we do not currently hold any direct office exposures (except for Mirvac as a diversified REIT and asset developer), however observations are that elevated incentives means net effective rental growth in the short to medium term will remain subdued, whilst corporate interest for new age buildings that incorporate the latest technologies, offer flexible layouts and help companies facilitate the level of collaboration and culture in this hybrid working environment has been just as strong as prior to the pandemic, leading us to continually favour companies that has an active development pipeline of high quality office assets.
With AusNet having been acquired by the Brookfield led consortium, our only holding that reported in this dwindling sector was Mercury NZ. The renewable generator reported a soft result as pre-guided, owing to sustained dry conditions inducing below average hydro generation, whilst the short outage of their Kawerau geothermal plant back in June-July 2021 continued to impact this result. Looking past these short term disruptions, the company made solid progress on their windfarm build, with all 33 turbines from Turitea North now running whilst Turitea South remains on track for mid 2023 completion despite slight cost increases. The company’s internal cost out program remains on track despite COVID interruptions whilst management also gave some early insights into future potential growth projects that has arisen as part of their Tilt NZ acquisition. We remain confident that continued steady dividend growth for this company remain on the cards, and that this sector continues to offer defensive resilient cash flows which have become more important and attractive to investors as they seek shelter from these volatile market conditions.
Most of the healthcare names held within our portfolios posted results ahead of expectations, with share prices reflecting this on the day. Amongst our large cap names, we saw a clear recovery from Covid disruptions, and a favourable outlook for a sustained recovery given demand remains resilient for many of these non-discretionary products and drugs.
Specifically, CSL announced a recovery in plasma collections, which will enable the company to return to positive operating leverage within its core business, Behring.
Their vaccine division, Seqirus, also posted a stellar result, driven by higher strong demand for influenza vaccines, predominately in the northern hemisphere.
Cochlear was impacted by lower surgical capacity, but this was more than offset by strong upgrades to existing recipients. Both companies are expecting higher costs in the second half, as market conditions normalise. Supply chain restraints prevented Resmed from taking full advantage of their key competitor's devices product recall, however we continue to view this event as likely protracted whilst any incremental share gains made will benefit the company longer term.
At the smaller end of town, ProMedicus delivered an exceptional result that saw margins expand and a number of large project implementations contribute to earnings. Unfortunately, the strong share price reaction on the day was given back by the market on further risk-off days given the long-dated nature of its cash-flows. Nanosonics was the only company that reported a somewhat disappointing result, off the back of a major change in its distribution arrangement with GE Healthcare in North America, whereby Nanosonics will now be going direct with their high level disinfection device and consumables.
All our health care companies are global leaders in their respective industries, with strong competitive moats, enabling their high returns and margins to be maintained.
Bumper dividends were the highlight of the financial results for the large miners courtesy of elevated commodity prices generating very healthy cashflows. ESG risk management and decarbonisation remains at the forefront with the OZ Minerals notably releasing an aggressive climate transition strategy – BHP, RIO and Fortescue all executing into their decarbonisation strategies.
Industry costs are rising, both opex and capex, and the outlook points to further increases with productivity gains unable to fully offset these pressures. Inflation is evident and compounded by COVID and labour constraints due to boarder closures.
Whilst the latter will dissipate, the feedback from BHP is that supply chain bottlenecks will persist for 1-2yrs. With production growth and new project challenges for a variety of reasons including the aforementioned supply chain and labour issues, but also capital discipline, ESG headwinds and geopolitical risks and assets already operating at their upper levels, this underpins higher for longer commodity prices. The macro with risks to demand a key area we are watching, though the credit impulse from China suggests that region could be more resilient, and supply risks could certainly outweigh demand downside on a longer dated horizon.
There has been no large scale M&A, RIO noting that it would be pro-cyclical to do a large deal at this time of the cycle though smaller acquisitions appear to remain on the agendas. For BHP a lot of focus has been on capital allocation post-unification of share structure which is expected to make them more agile, however at this stage they have widened the net debt range and remain committed to disciplined investment.
For the gold miners, results were generally soft due to the impact of Omicron community transmission in the mines, shortages of site workers due to WA’s hard border, and poor weather obstructing access to open pit mines. Rising costs and a weaker gold price in 2H21 relative to 2H20 resulted in earnings and operating cash flows below that of the prior year, though these were still relatively strong in a historical context as the gold price remains elevated on a longer-term view.
After being unloved for most of 2021, gold rallied in February on the back of a Russian invasion of Ukraine, which has the potential to flow through to elevated prices for key Russian and Ukrainian commodities exports, exacerbating already elevated rates of cost-push inflation and presenting possible downside risk to global GDP.
Regardless of how the gold price develops, we prefer to invest in gold miners who can consistently generate cash through the cycle. In the large caps, Northern Star and Evolution Mining continue to offer attractive free cash flow yields, are trading at historically low valuation multiples and have optionality to continue growing production. In the small caps, Gold Road Resources has low all in sustaining costs and an enviable production growth outlook relative to peers, with potential upside to come from ongoing exploration work being undertaken at the Southern Yamarna Terrane in WA.
Cash generation was key feature for the oil and gas stocks given commodity prices with Woodside’s dividend the standout for the sector and Santos reviewing their capital management framework to enable higher returns to shareholders in the future. Woodside, Santos and Beach Energy are all heading into higher capex periods though with oil and gas prices at multi year highs, cashflow generation will remain healthy and buffer the balance sheet.
Woodside has the highest exposure to spot prices and so a key beneficiary of the aggressive commodity price rally due to Russia’s invasion of the Ukraine as well very tight market fundamentals.
The sector is transitioning with scale and diversification important, both Woodside and Santos executing deals to accomplish this, in the face of ESG pressures and delivering an ambitious and credible decarbonisation and low carbon strategy is critical with the domestic sector still having a long way to go but making early progress.
A key driver of technology share prices year to date has been the market rotation away from growth stocks as higher interest rates have been re-priced into equity market valuations. A number of our tech holdings report on a different year end schedule, but of those that have reported a key trend is higher investment levels. The war on talent is most evident in the tech sector where attracting talent is challenging, costs are rising yet this investment is critical to deliver into long dated, high growth strategies underpinned by first mover advantage, market leading technology as they build out their competitive moats. For Megaport, FY22 is an inflection year as they scale via the sales model , enter new geographies and grow new products. Altium’s investment is weighing on margins however the semi-conductor industry issues are generating higher revenue for their Octopart business.
In the fourth quarter of 2021, Omicron forced food and liquor retailers to grapple with significant levels of community transmission in distribution centres, staff shortages in stores, supply bottlenecks, inflationary pressures and elevated COVID-related costs eroding margins.
Woolworths was the first to flag elevated COVID costs in December and high levels of staff absenteeism, which caused all food and liquor retailers to fall to varying extents as the market extrapolated Woolworths’ pain to its peers. However, Coles and Endeavour Group proved to be comparatively more resilient, with Endeavour in particular producing a stellar result thanks to elevated at-home liquor consumption, reduced promotional intensity, increased penetration of EDV-owned Pinnacle Drinks, and customers opting to consume higher priced liquor. Food retailers typically perform well during periods of heightened inflation and volatility, and should be well placed to weather many of the macro-economic risks the rest of 2022 may present.
Reporting season created material volatility in share prices, despite many results being pre-released. Retailers broadly reported that consumers lifted spending in January and February, but noted that inflationary pressures were emerging across most categories. While costs are easing with respect to COVID, there continues to be a significant increase in supply chain and digital investment. Autos reported strong earnings as demand remained robust, though cash conversion was unusually low as manufacturers stocked up on inventory to alleviate the risk of supply chain bottlenecks impeding production. ARB had a solid result as operating leverage from strong revenue growth fed through to margin expansion, and Bapcor saw a like-for-like improvement in sales across all divisions from 1Q22 to 2Q22 as COVID restrictions began to ease.
Telco results were largely in line with expectations with both incumbent carriers experiencing strength in mobile services revenues as demand for data continued. Telstra reiterated its full year earnings guidance, while Spark New Zealand had a small upgrade. Both telcos are on track for a growing dividend trajectory in future years, and have opportunities to further monetize their infrastructure assets. Domain Holdings’ results benefited from a surge in property listings following the end of COVID lockdowns.
The outlook remains solid, even as interest rates are expected to rise, as there remains ample pent up demand from prior years, and as property owners reassess their needs as working arrangements become more flexible following the pandemic restrictions.
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Michelle joined abrdn in 2004. Previously, Michelle worked for Watson Wyatt as a Quant Analyst. Michelle holds a BA in Applied Finance and Commerce (Marketing) from Macquarie University, Sydney and is a CFA® charterholder.