On Our Wavelength- Episode 5: The most interesting reporting season since the GFC
In this edition of On our Wavelength, Raaz Bhuyan and Kirsty Mckay-Fisher discuss the August earnings season, the importance of a quality management team when evaluating businesses and the impact of economic factors such as rising interest rates on investment strategies.
Episode Transcript:
Sinead Rafferty: Welcome to another edition of the On Our Wavelength Podcast. I’m your host, Sinead Rafferty. Today, I am joined by portfolio manager, Raaz Bhuyan and deputy portfolio manager, Kirsty Mackay-Fisher. We’re going to discuss the August earnings season and, in particular, the importance of a quality management team when evaluating businesses. Welcome, Raaz and Kirsty.
Kirsty Mackay-F…: Hi.
Raaz Bhuyan: Hi.
Sinead Rafferty: Raaz, firstly, can you set the scene for us, given the economic backdrop, what parts of the market were you most concerned about leading into earnings season? And were those concerns realized?
Raaz Bhuyan: I guess the main thing that I’d say is, given continuous disclosure rules, we were not really worried about the results, per se. We were a lot more concerned about the consumer. Obviously, there’s a lot going on in terms of costs going up, people paying higher rents, fixed rate mortgages rolling off. So we were generally quite concerned about the consumer.
Sinead Rafferty: And what about any big surprises, either good or bad?
Raaz Bhuyan: Yeah, there was a lot going on through this market. And, to be honest, there were quite a few surprises. The first one was, obviously, just the operating environment’s been a lot tougher. And it appears that operating costs, across the board, were quite a lot higher. So companies, we obviously know which increases have happened and are going to happen this year. Generally speaking, the consumer was probably the surprise on the positive side that it was much more resilient. But, generally, the operating environments had stayed tough, and we think that the next 12 months will be more of the same.
Sinead Rafferty: And were there any themes that emerged?
Raaz Bhuyan: I think the big thing that we saw was this big differentiation between good quality companies that we tend to invest in, outperforming in the same sectors. Good examples of that would be Woolies and Coles. Coles, obviously, have called out this big issue that they’ve had with shrink, which is theft. In contrast, we didn’t see that with Woolies at all. Wesfarmers were very, very good results. Similarly, car sales versus Goodman, Dexus, there’s a lot of these companies that are operating in similar sectors. But certain companies were basically running their own race and, effectively, managing their businesses much better than the other side. And that, I think, will persist, given the operating environment is likely to get tougher.
Sinead Rafferty: And, Kirsty, can you share how you incorporate an assessment of management quality in the different companies that you look at?
Kirsty Mackay-F…: Yeah, so our process looks at management track record as an indicator of future success. And we’re also conscious that change in management can almost always bring about a shift in the strategy, which can be a risk. So Qantas might be an example here. It’s a stock we held in the portfolio from about the middle of COVID. The airline industry is typically a pretty tough industry, with a lot of things outside of management control. That’s why our exposure to the travel sector has traditionally been through Sydney Airport. But with Sydney Airport being privatized, and midway through COVID, we wanted an alternative exposure, so we looked to Qantas. So we owned Qantas an expectation of a significant recovery in earnings post-COVID, basically, on the back of a large pent-up demand coming out of lockdowns. We also held Qantas on the view that Virgin, following its privatization, would act as a more rational domestic competitor.
So the position worked quite well for us. We sold out early this calendar year, primarily as the stock was trading quite close to our through-the-cycle valuation. But, also, as we were becoming more cautious on the consumer. At this stage, it was also clear to us that we were pretty close to a management transition. As I mentioned earlier, with management change, there’s always a risk. So with that in mind, we made the decision that we preferred to sell down with the tailwinds still in place, even if that meant leaving a little bit still on the table. And we exited a few weeks before the change was announced formally.
Sinead Rafferty: Okay. So was there any changes to the portfolio more broadly as a result of the announcements throughout earnings season?
Raaz Bhuyan: The main one was Goodman Group. I talked about Goodman doing quite well. Obviously, it’s a company that has been sitting on our bench. We haven’t owned it before. And, obviously, the issues with the property sector has meant that the stock has actually come back a long way. And so post the result, we’ve actually introduced a position in Goodman. They’ve talked about their expansion into data centre’s, given that they’ve got these industrial sites which can actually become good locations for data centres. And so that, basically, extends the duration of the earnings profile for this business. So that’s one we’ve added.
On the other side, I guess we’ve seen the issue around the strikes in WA on the oil and gas side, on the LNG side. That’s basically led to a huge spike in the LNG price, and has meant that stocks like Woodside and Santos have done quite well. Santos has been closer to valuation, to be honest, for us. And so, we’ve taken a bit of Santos, as the stock has gone through $8. But outside of that, there’s been no wholesale change in the portfolio.
Sinead Rafferty: And what about the higher interest rate environment, Kirsty? Are you seeing that there’s some winners and losers? And how are you playing that particular factor in your stocks?
Kirsty Mackay-F…: Yeah, I think what we saw through reporting season was actually quite varied. The rising rate environment makes it quite hard to hide a poorly managed balance sheet. In addition to that, rising interest costs, not every company has the capacity to pass through those higher costs to its consumers. So, does that company have pricing power?
And I’ve got a couple of examples. On one side, we’ve got Ramsay Healthcare. Now, Ramsay is quite heavily levered. It’s net debt to EBITDA at the funding level group, it is at 3.2 times. Now, that’s above management’s upper bound of their threshold, which is three times. Ramsay’s debt book is also quite short, which means it’s quite exposed to the rising rate thematic. So net interest costs for the group were quite a shock at the result. They rose 34% in FY23 and have been guided to rise a further 24% in FY24. So, in total, that’s a 64% movement in debt costs in just two years.
So ideally for Ramsay, in order to have funding and CapEx flexibility, the leverage in the business needs to be lower. Earnings growth will help this metric. But Ramsay’s recovery out of COVID has been difficult. The business has faced less predictable volumes. And has also had to face rising labor costs, in terms of the nursing staff. And has little capacity, or at best, a lag, in their ability to pass on those costs to insurers. So in addition to that, for Ramsay, debt reduction, they don’t have a lot of cash left over. Because while NPAT is fairly reflective of the cash flows in the business, with a dividend payout ratio of around 70%, there’s little leftover to grind that debt down. So it probably means they need to look to an asset sale in order to resolve the leverage issue. And, to that end, management are looking to sell Ramsay-Sime Darby. So we expect that this may be the answer with time.
Now, on the other side of the spectrum, we’ve got Transurban. This is a stock we do hold in our portfolio. Now, Transurban’s fairly highly leveraged. On a proportionate basis, they’ve got about $23 billion in debt. Its leverage is higher than most industrials, at almost nine times net debt to EBITDA. But this gearing is fairly typical for what we call a highly cash generative infrastructure business. These businesses have strong competitive moats and quite resilient demand.
So the company also manages its debt book quite well. It’s largely fixed, at 96% at the FY23 result. And they’ve got quite long duration in that debt book as well, with an average maturity of about seven years. So this gives the business quite some time before the higher rate environment flows through to a materially higher debt cost. And if you think about the current environment, Transurban’s able to capture that higher inflation we’ve seen in its revenue line. But debt costs, as we’ve just mentioned, through hedging and tenor, may not raise at the same pace. So this is a good outcome for earnings and distributions from the business and it’s the key reason why we continue to hold the stock in the portfolio.
Sinead Rafferty: So is it really, rather than avoiding companies that have high levels of debt, about choosing carefully which ones you want to be investing in at this point?
Kirsty Mackay-F…: I think it’s important to find companies that have the pricing power to capture that increased cost in their top line.
Sinead Rafferty: Perfect. And, Raaz, just finally, what is the outlook looking forward from here for the Aussie market in your view?
Raaz Bhuyan: Yeah, Kirsty has actually touched on some really good points around leverage and debt. I think what we saw over the course of reporting season was the fact that interest costs generally have gone up. And people hadn’t modeled that well. And that’s a headwind for earnings per share. Similarly, what we are seeing is a lot more companies spending more capital, capital spend has gone up. And that’s not because they’re spending on new things, it’s existing stuff that is costing a lot more.
And this actually reminds me of the time when we had the big mining boom in the Pilbara, where BHP Rio and Fortescue were building these huge asset bases. But they were essentially spending $2 on the dollar. And that has a few implications. First and foremost, as Kirsty pointed out, the net profit after tax and EPS get impacted in the short-term because your interest costs have gone up. The other thing that happens is your free cashflow goes down because you’re spending more capital. So I think dividend sustainability will be in question over the course of the next little bit. Because if you go back in time again, going back to the specific Pilbara boom, BHP ended up with more than $30 billion of debt because they were spending money as the commodity price fell. Which is to Kirsty’s point about having pricing power, like Transurban, to be able to put through those cost increases.
So that’s a big issue going forward, I think. And it really worries us when we see companies spending big dollars right now. And I think that’s actually spread across the board. You’re seeing a situation here, for instance, in the Eastern Seaboard, where something that would’ve cost you a dollar before COVID, is now costing you a dollar fifty, $2. But you’re not going to get that extra return for the extra capital that you spend. So it is actually quite worrisome. So the way we’ve presented ourselves is typically try to avoid companies that are high CapEx. And focusing on those businesses that have got moats and have global businesses where they’re growing to… We talk about companies marching to the beat of their own drum, and that’s really what we are looking for. Fortunately, I think that’s the time to go forward, given that the environment is a lot more complex, it’s going to actually favour those companies. And we’ve seen that in spades over the reporting season, as we just saw offline.
Sinead Rafferty: Thank you both for your time, that was really insightful. And thank you all for listening.
Raaz Bhuyan: Thanks, Sinead, and thanks, Kirsty.
Kirsty Mackay-F…: Thank you.