Read the previous week’s Investment matters.
Photo © NuTz from Via Canva.com
The Market
Long term trends in global trade
One of the core thematics that the First Samuel looks to incorporate in client’s Australian shares sub-portfolios is the changing nature of global supply chains.
In an interesting article by Macquarie Equities last month, we noted a simple chart showing global trade evolution over the past 60 years.
Source: Macquarie
As we move past the disruptions of covid, we can see that in 1H24, that global merchandised trade has stagnated. The pattern of eroding trade flows, as a % of GDP, that has been the dominant theme since the GFC has returned.
Macquarie notes, “whereas for two decades to 2011, merchandise trade grew at 1.6x GDP; the intensity has since meaningfully dropped to below 0.8x.”
The reason for the fall is multi-factorial and must be included in the fundamental analysis of economic policy.
For 20 years, the economic textbook dominated. Countries were inclined to pursue only industrial policies that supported industries with strong “comparative advantage” (the ability to produce a particular good or service at a lower opportunity cost than its trading partners).
But real life is more complicated than textbooks, and China’s industrial policies follow different rules from those of the rest of the world. Luckily, Australia benefited from its capacity to mine scarce materials for Chinese-dominated global markets but was disadvantaged in most other spheres.
Since the GFC, the global reaction, including from the US since 2016, has included tariff and non-tariff measures to halt the expansion of trade. The natural limits of Chinese growth, combined with some areas of their economy failing to generate globally relevant products, have stalled the rise.
So, will global trade intensity continue to decline? We believe so for four reasons.
- Industrial intervention
Industrial interventions continued to rise, especially in China, US and Europe. But increasingly, even in countries such as Australia that has previously devoted itself to “pure” economics we see the emergence of industrial policies and directed investment.
- Technology
Technology simplifies supply chains and shifts economics away from many industrial products. How the global response to the dumping of Chinese EVs over the next decade will be a fascinating component of the global trade outcome.
- ‘Friendshoring’
As countries such as Australia continue to respond to a combination of aging and excess financialisaton of their economy (household debt, government spending and deep use of insurance), the requirement to deepen local supply chains and undertake friend-shoring grows. Friend shoring refers to recreating supply chains to include more trade and production benefits to allied countries. Instead of opting for the lowest cost, firms increasingly select partners in a group of geographically closer countries that align politically, economically, and socially.
- Service exports
It is possible that the evolution of service exports may display lower trade intensity. We understand that as economies grow in wealth, the inclination to visit Italy and the Leaning Tower of Pisa grows. At some point, however, consumers look for other local, more personalised or perhaps more unique services. Perhaps Pisa loses some lustre simply due to number of people visiting?
So, who wins?
In a world of declining trade, faced with higher levels of protectionism, the countries that will be advantaged will be those:
- with large young populations; or
- small countries with the most friends, especially friends without aging problems
The solution for others will be to increase localisation and protectionism until the next global growth driver emerges.
Where is Australia placed in such an environment?
At first glance, it could appear that we would again favour the circumstances of 1996-2008. After all, our terms-of-trade-induced income growth and declining global interest rates were sensational for house prices, real incomes, and the retirement prospects of an entire generation of Baby Boomers.
From now on, our advantages will be more nuanced.
In part, we are likely to retain the advantages of high volumes of mining output, regardless of the price we receive for iron ore and other products. We also benefit from a range of catch-up infrastructure development and education infrastructure. Wisely, Australia has also used the past 30 years to increase our investment level in global businesses through the Future Fund and our superannuation regime.
But the textbook disappears at this point, and hence the following becomes core economic policy:
- alignment with India
- developing our own industrial policies
- taking advantage of US protectionism in the Inflation Reduction Act
- deepening our industrial connections with neighbours
- investing in the geographically sensitive regions of Papua New Guinea and the Pacific
Building a less interest rate-sensitive household sector, especially one that generates wealth in non-housing assets, and managing intergenerational wealth will also be critical.
Q: How is this reflected in our clients’ Australian shares sub-portfolios?
A: Very widely.
We own companies with deep local supply chains, either those assisted by a duopoly structure such as Woolworths or specifically local due to the nature of service such as Cleanaway (waste collection). We own Seven Group, which not only owns Boral for the ongoing building task but also companies such as Coates, which gets the advantage of cheap goods from China as inventory but works in a domestic market that is strengthened by friend shoring. We own Macquarie Group, which seeks to benefit from both local markets and the infrastructure investment needs of most of our allies.
We own domestic production in biosecurity-protected and food-related industries such as Bega Cheese and Inghams. In mining, we concentrate on future materials (copper and lithium) and businesses that benefit from volume growth, including Imdex and Emeco.
We own industrial properties in our property sub-portfolios, which benefit from local supply chain development.
Finally, in the medium term, as this transition away from the pure advantages of high prices from traded goods evolves, the role of government is likely to remain elevated. High government spending supports Medicare-related medical services and labour support services for a company like Ventia.
Reporting season reviews
As noted in recent week we will continue to cover off on some results from the recently concluded profit reporting season. This week we have covered Bega Cheese, Johns Lyng and Nanosonics.
Bega Cheese (BGA)
First Samuel View: Positive
Market reaction since result: +26% (including dividend)
Most clients have benefited from the inclusion of a relatively small position in Bega Cheese over the past year. Its performance, including the rise since the result, has been pleasing: up about 60%, although in hindsight the position size was too small.
We anticipated a turnaround in performance for the Bega business at the end of last calendar year. With the stock price falling by more than 50% since early 2021, the market expressed significant reservations about the company’s margin outlook and concerns about the medium-term profitability of its bulk milk segment.
Weak cash flow generation also created concerns for its balance sheet.
Our thesis was that margins would recover quickly with ongoing inflation in branded goods (including Dare milk, Yoplait yogurt and Vegemite). We were also patient enough to wait for the likely outcome of the bulk milk segment facing more sustainable industry pricing conditions.
The following chart of company revenues since 2021 demonstrates the importance of the Branded Segment. The growth in 2022 is predominantly due to the impact of the Lion acquisition.
Source: Company reports.
The FY24 result franked all our expectations and delivered improved cash generation on top.
- There was continued improvement in the Branded Segments’ profit margins
- FY24 Branded EBITDA margin was 6.6% with 2H 0.30% above 1H24
- This is the highest Branded margin delivered since the Lion portfolio acquisition 4yrs ago
Source: Company reports.
- There have been signs of improvement in the Bulk milk business. We and the market anticipate a recovery in this segment through FY25/6. Considerable capital is employed in this business, which has the potential to generate high earnings.
- The more robust balance sheet, following good cash flow performance, will, in our view, stimulate future merger and acquisition (M&A) capacity. In general, Bega has been reasonably successful in acquiring new businesses.
With the share price now elevated and much of the recovery priced in, we have also turned to the future growth drivers. Bega Cheese, as noted in the previous section of Investment Matters, is a relative beneficiary of the changes in global trade.
But businesses that rely on branded product margins need to be much more innovative and nimbler than a simple manufacturer or commodity goods providers.
To this point, we appreciate the following diagram from the company presentations, which noted four areas for future positioning. It also provides a snapshot of the company’s advantages in the branded foods market.
Positioning Bega Cheese for future growth
Source: Company reports
Increasing “Value” at this point of the economic cycle is essential, and pack sizing and a wide range of quality in its product lines can assist much of this value creation.
With a high market share in a range of categories, Bega is well placed to make variations in its product suite with the cooperation of the supermarkets. Smaller suppliers can often lack this capacity for change in the face of supermarkets.
The diversity of households (“Demographic Evolution”) is an exciting area of future upside that Bega may yet fully exploit. Australian farm standards and manufacturing protocols can only assist in enhancing Bega’s capacity to generate growth from its Sustainability theme.
What they said
“Bega shares are continuing to re-rate nicely, largely underpinned by the continued profitability improvement in the higher-multiple Branded business. We remain attracted to this division and its portfolio of resilient consumer staple products that have strong No.1 and 2 market positions.” Barrenjoey
Johns Lyng (JLG)
Market reaction since result: -34% (adjusted for dividend)
At first glance, Johns Lyng delivered another year of almost double-digit revenue growth in its core maintenance and construction business and it was simply a decline in more volatile, but higher margin catastrophe reconstruction and repair business (‘CAT,’ which was already understood to have been quieter) which saw revenue and earnings fail to meet its usual path of very solid growth.
What went wrong, in order to cause the share price retracement?
But a modest ‘miss’ on estimates in FY24 was compounded by an outlook estimate on earnings that was up to several percent shy of consensus expectations. This was a significant factor in the stock continuing to sell off on result day and exacerbate share price losses already sustained in the run in. JLG has been the worst performing stock in our clients’ sub-portfolios to start the FY25 financial year, falling almost 40% in that time.
We would also note that earnings guidance for anticipated CAT revenues is limited to current allocated work in hand and no estimate for a ‘normal’ cycle of events which might drive revenues higher.
Notable CAT weather events with ongoing construction requirements
Source : Company reports
First Samuel thoughts:
Like Steadfast, a program of acquisitions by JLG helps underpin growth in the business. These are progressively expected to add scale efficiency as well allow JLG to win a greater share of insurance panel work given the breadth of their resourcing.
Its US market expansion is seemingly progressing slowly, but offers demonstrable future growth opportunities given the market size.
In the past year, JLG landed on its first national insurance provider panel, when it was awarded that status by Allstate.
JLG USA – a growing national presence
Source: Company reports
What they said – “Flooded, without insurance”
“We think earnings expectations have been sufficiently rebased and the stock offers value following the recent share price move. Our valuation of 11x EV/EBITDA is a standard deviation below its historical trading range, reflecting CAT uncertainty and lower growth.” Macquarie
Nanosonics (NAN)
First Samuel View: Positive
Market reaction since result: +31%
The market reaction to the Nanosonics’ result was incredibly stunning, considering the company had pre-released most of its FY24 results.
Readers may recall we are attracted to four key features of the Nanosonics business:
- Fabulous underlying demand profile as the global health industry understands the critical role of infection prevention at the point of care across a range of health modalities that require the use of expensive probes and reusable devices
- Expanding capital sales model that leverages capital sales by selling consumables products at high margins – the so-called razor and razor blade model.
- The promised value creation possible in the expansion of its product set from the global leading Trophon product to also include CORIS, a cleaning device solution for endoscopy probes, and finally
- Although Nanosonics is based in Australia, and although it also has a dominant position in the Australian market (>80% share), the company is fundamentally a global healthcare solutions provider.
The company’s result presentation includes two diagrams designed to show the breadth of use cases for Nanosonics Trophon devices. The breadth of specialty services that use the devices is shown below.
A snapshot of the range of services that the Trophon can be used to disinfect is provided below.
In the FY24 results, Nanosonics revenue increased 2% to US$170m. This was weaker than expected prior to the start of the year, although there were some improvements in the second half, which was pleasing. The weaker Capital revenue in FY24 was likely the main reason that the stocks had sold off so heavily in FY24. Clients may recall that it was among the most negative portfolio return contributors in the last financial year.
Consumables/servicing revenue increased 9% to $121.8m. The gross margin achieved was also at the top end of the 76%- 78% full-year range.
The strong growth of consumable and service revenue indirectly demonstrates the importance of growing the installed base each year. Whilst capital sales in any given year increase profits, the key is to continue to grow the installed base, for this is the set of Trophon devices responsible for future consumables and service revenue. The steady growth in the global installed base is shown in the figure below.
Source: Company reports
Going forward, the FDA approval for CORIS remains the most important catalyst over the next 6-12 months.
The reasons are two-fold:
- Nanosonics is spending a great deal of money and resources on the final stages of development for CORIS. In fact, without the current spending on CORIS, the stock would be worth all and slightly more of its current price, just based on its current underlying earnings.
- The size of the opportunity that CORIS represents. The CORIS product works in current testing, provides a very large market opportunity, and, if the business can correctly leverage its existing client base, it will have highly profitable and scalable path to market.
Given its fantastically strong balance sheet ($130m, 60 cents per share), it is well funded to launch CORIS post-FDA approvals and pursue M&A opportunities within infection control.
What they said
“The set-up for NAN shares remains attractive in that the FY25 guidance looks for nothing special on the Trophon front, leading into the CORIS approval catalyst in 3Q25e. With major market CORIS approvals ahead and our fundamental research view on that asset unshaken, Nanosonics remains a key call in Medtech.” Wilsons
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.