World champions across the board

The ASX has continued to reach new highs, notwithstanding weak operating performance across the board, with the Telecommunications sector the only sector year to date to see improving earnings trends, and even then it is marginal. In contrast, some sectors have seen material weakness; notably Energy, following oil price travails reflecting a mantra of “Drill, Baby, Drill” and Technology, which whilst suffering from earnings weakness has not seen any weakness in market performance.

In fact, au contraire, Technology led the ASX higher in May. The overwhelming sectoral performance on the ASX through May was IT, increasing by 20%, almost representing the year’s gains in a month. This was led by Wisetech which revealed a US$2.1b acquisition of E2open. E2open had revenues of US$600m in F25, a decline on the prior year; or put another way, its revenues are 90% of Wisetech’s last reported revenues. For 90% of its revenues, Wisetech (ASX: WTC) acquired E2open (NASDAQ: ETWO) for 10% of Wisetech’s market capitalisation. On its most recent results, E2open had no revenue growth and no profitability; given its plethora of acquisitions in recent years, which at more than US$3b is more five times its current revenues, Wisetech’s organic revenue growth and sustainable profitability are also both uncertain. It makes valuing the group highly uncertain, before any corporate governance concerns are considered. It is tempting to apply a software margin to Wisetech’s revenues and impute a level of profitability from this, a methodology which leads to a large value uplift with the E2open acquisition; and indeed, that is what occurred, with the market rerating Wisetech aggressively following the announcement of the acquisition. 

Other Technology names did well during the month following strong reported results, especially Technology One (ASX: TNE), which may trade on higher multiples than we feel warranted (a PE of 100 always has a nice round feel to it), but nonetheless the transparency of the organic operating performance is more visible than that attaching to Wisetech where acquisitions have been such a dominant part of the financial accounts for the past several years.

The performance of the IT sector globally brings to mind Andreesen’s phrase “Software is eating the world”. 

He highlighted that part of the promise of software was that efficiency led to broader competition and innovation: 

“… In 2000, when my partner Ben Horowitz was CEO of the first cloud computing company, Loudcloud, the cost of a customer running a basic Internet application was approximately $150,000 a month. Running that same application today in Amazon’s cloud costs about $1,500 a month…”. 

Fourteen years later, that cost is now approximately the same in nominal dollars, which is unlike most software where the price lever is now being applied with vigour. Indeed, a major bank CEO recounted how the vendor of one of their anti money laundering systems during the past year increased their annual subscription by 100%; and there was nothing the bank could do about it. There is no question that that is pricing power writ large, and no listed ASX Technology stock we are aware of are lifting annual subscription prices by 100%, even though they are now again trading at large premiums to global peers.

Of course, IT stocks (and even CBA (ASX: CBA)) trading at a large premium to global peers is not unique in the ASX context. Only several years ago, CSL (ASX: CSL) traded on multiples well above its direct peers. Goodman Group (ASX: GMG) is another example currently, after a stellar decade and an even stronger past couple of years of market and operational performance after it announced its move into the development of data centres. The US REIT Digital Realty Trust Inc (NASDAQ: DLR) is an example to contrast to GMG. Listed in the US and well regarded by the market, trading at 2.8 times book value, the group has doubled its revenues through the past five years to now be a circa A$9b revenue business. For context, this is almost three times the revenue for Goodman Group, and double the EBITDA that GMG is forecast to make this year; and yet the trading multiple for DLR is 30% less on a price to book basis. As with CBA, this is a large percentage on what is now a large capital value; with GMG now a $70b market capitalisation, a 30% differential is clearly a massive amount of market capitalisation should it revert to a multiple close to DLR’s. As, indeed, is DLR itself trading at a large premium to the book multiple applied to many other REIT’s, especially in an ASX context. Whilst this can be attributed to excess growth, the quantum of excess growth is relatively small compared to the valuation differential, with renewal spreads for DLR currently running at 5.6% on a cashflow basis. Both GMG and DLR are developing data centres for global clients across global locations, albeit DLR has a significantly larger starting base of both installed capacity and planned addition of capacity.

DLR have also highlighted supply constraints, especially concerning energy provision, even though (as with GMG) it is developing assets where it has existing facilities (as highlighted in the below graphic).

The other aspect of DLR that is intriguing when assessing GMG is the pricing it is able to achieve for its Fund which has been established to vend developed data centre assets into. The fund has five stabilized assets vended into it as seed assets, at a “high 5%” cap rate (relative to GMG’s implied cap rate of sub 5%), and with DLR citing 2% expected annual rent increases for assets vended into the fund. That is a higher cap rate and lower rental increases than is currently assumed by the market here with respect to these assets owned by GMG, which highlights the risk to that 30% valuation differential. Whilst this sounds like a dramatic fall in value, all it would do would be to take GMG back to where it was in April (something about Liberation Day?), and to a share price that but for the last year was higher than GMG had ever traded at. Which just highlights what a manic round trip this calendar year has been.

It is not news that CBA has outperformed aggressively, especially through the past eighteen months. What is less remarked upon is how small the operational difference is between it and its peers through this time. CBA is the best bank listed on the ASX, with a splendid retail franchise full of customers who consider it their main financial institution and where they are next preferred if they were to leave their current MFI. This has been an attribute of the bank since it was listed. What has been more pronounced in recent years has been the strength that has emerged in its business bank to join the retail bank as a source of great value. We asked management after the last result whether they felt the retail bank segment or business bank segment was more valuable within CBA, and the answer depended purely upon what the long run loss rate assumption used for the mortgage book was.

It is of course tempting after many years of benign losses to assume that is a perpetuity state, however history suggests that economic systems are fragile, and often unpredictable, and in turn banking systems are leveraged plays upon the host economic system. 

To assume there shall be no consumer losses forever more is one assumption, which is perhaps emboldened by the experience of the state underwriting households through covid. To assume that this can occur, because of the backstop of the state, without any recompense to the state, is another assumption altogether, and one that flies in the face of current experience in Canada (15% tax on bank profits in excess of $1b), Spain (a 4.8% charge on net interest incomes and commissions) , the UK (additional bank corporate tax), Italy (tax on profits from increases in nims arising from deposits), Hungary (banks can reduce windfall taxes if they buy bonds), Sweden (a risk tax to cover the risk to public finances from a financial crisis), Czech Republic (60% windfall tax on excess profits for banks), and other countries. In almost every case, the justification to the tax is tied to state support for the sector; we can accept that losses will be loss than the historical experience due to the state being prepared to absorb some of what otherwise would be consumer stress, but it is unlikely that this will happen into perpetuity without some explicit charge for that benefit.

The other interesting aspect of bank reporting season was the retail bank result at Macquarie (ASX: MQG), which has often been blamed for putting pressure on net interest margins for the whole sector as they have continued to grow share in the mortgage market (from 5% to 6% through the past year). Macquarie confirmed they are happy with the returns they are deriving from that business and have every intention of continuing to grow apace, thereby continuing the pricing pressure that has been seen in the sector. That has manifested itself in retail bank earnings; as can be seen below, whilst CBA’s profit growth was better than its peers in the retail segment through the past half, it is not by much and no major bank is able to valuably grow this segment currently given these pricing pressures. Across several segments, the operational pressures are obvious at ANZ (ASX: ANZ), NAB (ASX: NAB) and Westpac (ASX: WBC). In that context, it was not surprising that Westpac has revealed plans to attempt to reduce its operating cost base by 5%, and we wouldn’t be surprised if the incoming ANZ CEO announces a similar intent. NAB risk being a laggard, as whilst CBA has the highest cost growth in the sector currently, it alone currently has revenue growth to fund the cost growth, albeit interestingly mostly from segments outside of the retail bank.

Market outlook

The relative performance of the portfolio has struggled though the past year as Financials (large underweight) and Goodman Group (not held) have powered the Australian market higher. We now believe there is several ways for the portfolio to outperform. Firstly, especially should cost growth persist and the banks underlying earnings continue to struggle, we see material scope for the rerating of the last year to be unwound. Any increase in bad and doubtful debt expense will exaggerate this trend; and if this is not to occur because of state support, compensation for this support is (rightly) likely to be sought, as is the case in a plethora of other countries. In the absence of a discernable catalyst, sometimes unsustainable prices buckle in the face of investor demands for a cashflow yield; house prices have fallen 25% in NZ and lithium prices by 75% after the peaks reached in recent years, for example. Secondly, as has been seen in recent weeks, the relative underperformance in Materials and Energy has been as marked through the past year as the has been the outperformance in the banks. Little in the way of good news in those sectors could see relative outperformance given each are now trading at lower relative multiples than the rest of the market. And finally, several of our holdings across the broad spectrum of Industrial and related stocks are positioned for better returns; Brambles has done well and yet has only just started reaping the cashflow its market position warrants, Fletcher Building has changed management and the strategy of cashflow deficits is converting to one of realizing a return on its large asset base, and Ramsay is seeing political attention turn to the sustainability of private healthcare and hospital funding and changes in the Board and management which give us hope that capital allocation will significantly improve.

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