Read the previous week’s Investment matters.
Photo © from khunkorn Via Canva.com
Background
ASX reporting season
Most companies with an accounting year-end date in June select August as the month to report their full-year results. We’ll provide updates in Investment Matters over the next few weeks. Here’s a snapshot of results reported in the week just past for stocks held within clients’ Australian shares sub-portfolios.
Many companies reported this week, and we will return to those not discussed in September. Amongst the more prominent portfolio positions not covered today, we note our overall view and market impact below.
| COMPANY | FIRST SAMUEL VIEW | MARKET REACTION |
|---|---|---|
| Insurance Australia Group (IAG) | Neutral | -1.2% |
| ARN Media (A1N) | Negative | -9.9% |
| Stockland (SGP) | Positive | +3.5% |
| Burson Auto Group (BAP) | Neutral/Positive | +1.2% |
| Healius (HLS) | Positive | +14.0% |
| HMC Capital (HMC) | Neutral/Positive | |
| IMDEX (IMD) | Neutral | -2.8% |
| Ventia (VNT) | Neutral/Positive | -2.2% |
The Market
BlueScope (BSL)
First Samuel View: Neutral
Market reaction since result: -0.5%
The BlueScope results clearly distinguished between short-term operating conditions and medium-term value creation. Like the Seek result discussed last week, we have been pleased to build a position in this company at a reasonable price when short-term conditions are challenging while the company invests in long-term improvements.
The company’s preeminent asset, North Star, located in Ohio, USA, is undergoing a debottlenecking capex program and further investment in a new midstream facility. This investment will underpin growth, including the successful Colourbond product roll-out and its leading proprietary AM1 metal coating technology.
Weaker global steel prices
Domestic demand in China has waned, but local steel producers largely maintained their production levels, sending excess stock into the global market. This has had a depressing impact on the price of steel.
Operating integrated steel mills and manufacturing
Steel producers have high fixed costs in running their plants and, as such, must maintain adequate production, almost regardless of the price. This creates highly cyclical earnings in their mills; for instance, in times of high demand for steel products, there will often also be high prices, leading to very high margins/ known as “spreads”. Plants will be producing at the highest possible levels, generating huge returns. This was the case in 2022.
Softer demand and downward pressure on steel prices (and hence spreads) make the environment more challenging for a steel producer like BlueScope. The company must find a balance between maintaining production, filling supply chains, and managing margins.
The vast majority of the company’s earnings are derived from US operations, the majority of which, in turn, comes from North Star. The chart below shows demand in North America. BCPNA refers to the Building and Coated Products division, which, whilst significantly lower in volume, generates a higher proportion of earnings ($221m in 2H24, vs. $293m generated at North Star).
The chart demonstrates the balancing of activity. While BCPNA had lower despatches and North Star faced lower margins, BlueScope’s North Star smelting plant delivered higher volume despite weaker general conditions.
North American steel despatches (thousands of tonnes)
Source: Company reports
The much smaller Asian and Australian businesses also saw lower steel dispatches.
Domestic Australian demand softening.
Asian market steel despatches
Source: Company reports
The Asian business which includes contributions from Chinese operations were affected by weaker Asian steal spreads shown in the chart below.
Source : Company reports
The near-term outlook is challenging
BlueScope’s own outlook statements told of tough times ahead in the near term.
Source : Company reports
Reflecting the cyclical low for steel prices, management continues to restructure in order to improve the business including
- Approving a debottlenecking project to increase North American supply in its North Star asset
- Spend capex on its domestic blast furnace manufacturing capability
- Reviewing property holdings across Australia and New Zealand for potential sale
Medium to longer-term looks better
In the medium term, we believe that increased protectionism by countries and a partial unwind of globalisation may position BlueScope as a beneficiary of US demand for steel. This should diminish the impact of low-cost Asian steel producers.
Longer term, we believe that the business’s strong market position in Australia and New Zealand, continued demand for premium steel products like Colorbond, and the best-in-class nature of its US North Star asset will see it earn a better-than-cost-of-capital return across the cycle.
What they said – “No time to give up”
“Outperform. Market conditions are weak, but BSL is controlling what it can well. The balance sheet remains pristine. While Asian market conditions could drag longer (despite recent production cuts in China), we are more conducive on a US recovery supporting our thesis” Macquarie
Judo Bank (JDO)
First Samuel View: Positive
Market reaction since result: +10.8%
Key operational trends are all positive
As a small player with 2% market share, there is plenty of runway for growth. A need for scale demands that Judo Bank must keep growing if it is to meet its required return hurdles. Currently, the loan book is expanding at a multiple of 3x system growth, driven by an expansion in banker numbers, widening of its broker distribution capability and the general benefit from continued ability to execute well for both customers and Judo’s distribution partners.
Net Interest Margins (NIM) have bottomed, having now dealt with the entire refinancing of the very cheap Term Funding Facility (TFF) provided to banks by the Federal Government (which was designed to keep the provision of credit flowing during the covid period).
While there will be some residual impact from an averaging perspective from the drop out of the TFF, management was keen to reinforce the bottom of the cycle on NIM and that it will return to a level above 3% (major banks are below 2%) by the end of FY25. New lending spreads remain consistently above 4%, providing a solid base from which to expand returns.
Source : Company reports
Most importantly, as a fast growing, non-major bank (often a recipe for credit problems), credit quality signs have improved, with management reporting that 30-day arrears levels have declined and past 90-day loan arrears having taken a step down (improved) since March. At the same time, management has been able to increase the provisioning coverage of its loan book, providing more resilience to future earnings
We think that Judo is well placed to take advantage of the major bank’s industrialisation (dumbing down) of credit processes at a time when the economy is making a continued structural shift from being consumer-led towards business investment as its growth engine.
There remains a substantial opportunity for Judo to profitably grow business customer share for several years and progressively improve its returns on shareholder capital.
At a valuation of 1.1x Net Tangible Asset backing (versus CBA at 3+ times), we’re happy to continue to back in Judo management to execute on its strategy and to see further upside in the share price as they do.
What they said –
“Although there are still significant challenges ahead for Judo as it approaches its ‘metrics at scale’, we believe the worst has now likely past. The TFF has been repaid and NIM is now recovering. The SME loan book pipeline is at record levels and strong lending spreads. Economies of scale are being delivered. Asset quality is stabilising. If Judo can continue on this path, we estimate EPS could triple by FY27E. Not bad for a stock trading on 1.1x book (Majors are on 2.3x) and 8x PPOP (cheaper than any Major or Regional bank). Maintain Overweight rating and increase our PT to $1.80.” Barrenjoey
Reliance Worldwide (RWC)
First Samuel View: Positive
Market reaction since result: +10.6%
There was a lot to like about Reliance Worldwide’s Tuesday result. Based on the 10% rise in the share price, you may assume that the company’s earnings far exceeded expectations or that the company had announced significant changes to its operating model.
But neither of these was the case. Instead, the company, which is famous for a cautious, bordering on pessimistic outlook, had few concerns despite the market being braced for margins to come under further pressure.
The company is increasingly demonstrating that it has genuinely defensive earnings, which are not as volatile as the economic cycle in which it operates. Great, well-run businesses build more resilient or defensive earnings profiles.
Defensive earnings are possible when the products sold are needed across a range of economic cycles, or the business’s cost structure is adaptable enough to respond to short-term changes in demand.
As discussed earlier, such businesses are often priced on higher earnings multiples than more cyclical companies such as BlueScope. When a business such as Reliance Worldwide trades at a higher earnings multiple, it also assists with generating future value through M&A opportunities.
Investors seek this virtuous cycle of higher multiples, allowing more accretive acquisitions, and it is an important factor leading to the company being amongst our largest portfolio holdings.
Other positive features of the result included.
- Confidence in the medium-term margin outlook post the movement of crucial manufacturing capacity from Australia to the US
- Successful integration and earnings upside from the recent Holman Industries acquisition
- Cost control and ongoing improvement remain features; the business noted some carry-forward benefits in FY25 and expected to realise a further US$10-15m in savings.
With strong execution, the focus can move to the strategic direction of the business and anticipated economic conditions. Both appear strong.
Cyclical low points in the US and EMEA?
Whilst weakness in Australian housing construction is expected to remain this year, both First Samuel and Reliance expect conditions in the major US and EMEA markets to have reached cyclical lows.
Any movements towards higher demand is likely to be supportive of both revenue and margins. Based on the likelihood of such a rebound in demand, we view the current share price as having a good deal of upside.
Source: Company reports. UK Office of National Statistics, US Department of Housing and Urban Development
What they said – “Operationally solid; D&A drag in FY25”
“The key takeaways from RWC’s FY24 result are: 1) Things are getting better, not worse: While the 2HFY24 result was broadly in line, 1HFY25 guidance for flat YoY sales (+/- LSD) likely undersold commentary that conditions have stabilised/bottomed in EMEA and likely tracking +ve in the US.” UBS
Cleanaway (CWY)
First Samuel View: Positive
Market reaction since result: +1.8%
We like the ‘privileged assets’ that exist within its waste portfolio (including more significant landfill sites closer to the distribution of the population, meaning more efficient waste processing) and also see Cleanaway as a beneficiary of both ongoing population growth as well as the shift towards renewable energy in this country. In the event of poor execution by management, we also believe that these waste infrastructure and land assets would have strategic value and be sought after by operators like Seven Group Holdings (SVW) or private equity firms.
Result in short
We were also pleased with the quality of the Cleanaway result. While significant work remains to be done to improve returns, top-line revenue growth continues at a good clip and operational efficiency improvements are being made to ensure strong resultant strong cashflow and (cash conversion). Problem areas such the Queensland operations (now profitable) and labour-force instability (1,000 vacancies are now ~200) have taken a notable turn for the better.
Strong uplift in earnings growth to come – EBIT > $450m in FY26
The company has clearly set out the path to significant growth in earnings (EBIT = Earnings Before Interest and Tax) and returns over the next 2-3 years. Executive incentives are focussed on an earnings target of $500m (Mission 500), revealing significant ambition.
Achievement of this growth will be dependent upon a combination of growth initiatives, improved returns from low return/underperforming businesses and most significantly from a significant uplift in efficiency and business optimisation.
Building blocks to earnings growth
Source: Company reports
Significant growth options in the portfolio
Source: Company reports
The company has several exciting growth initiatives in the works, which will help to underpin top-line growth for the Group. The more complex waste handling and processing, the higher returns that should accrue to Cleanaway. These include
- CDS – the company developing a national Container Deposit Service similar to the one that has been in operation in South Australia for many years. Consumers will receive a 10c incentive for drink containers handed in for recycling. Victoria got in on the game in November 2023.
- NSW FOGO – There is an increasing shift towards itemised collection and processing of household Food Organics and Garden Organics waste. This is most notably focussed on the Groups Eastern Creek Organics (ECO) site
- Western Sydney MRF – In Victoria (e.g. Laverton and Coolaroo) as well as in Sydney, the business operates a Material Recovery Facility that sorts out co-mingled waste from commercial and household customers and better separates and then recycles the materials once sorted
- Santos – was a significant contract win in FY23 as part of an arrangement to progressively manage Santos Industrial and Waste Services requirements as part of the Group’s increasing push into the Oil and Gas sector (also recently signed by Exxon Mobil in Australia)
Given a defensive earnings profile on the core business, with ongoing efficiency improvements to make, these growth initiatives add a little spice to the investment appeal of the business.
What they said – “Another step towards Mission 500”
“Management reiterated that the key drivers of the upper end of efficiency target EBIT benefits ($100m) are branch optimisation and fleet transformation. While we would prefer to see the Mission $500m EBIT target replace a >$450m ambition, we see positives in management’s commentary that upside to the $500m is a matter of timing rather than any question around delivery of the EBIT improvement..” UBS
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.