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The Market
Interest rate cuts begin in the US – foreshadowing movements in Australia?
The biggest economic news of the week was not in Australia. In the spirit of the hype associated with interest rate decisions of the GFC and those surrounding Covid 19, commentary by Federal Reserve Chair Jay Powell was once again vital to market sentiment and the future direction of economics around the globe.
Although foreshadowed by others and market reaction earlier in the week, the decision to reduce rates for the first time since Covid-19 will have a significant impact on Australia in due course. Its significance lies in the cut being a turning point in monetary policy and in the sense that policy is being recalibrated to the conditions created by the higher interest rates global economies have been labouring under for the past 12-18 months.
The way we see it
Interest rates reapproached zero due to an unprecedented health emergency, following more than a decade of near “free money”. Following a colossal liquidity injection into the real economy through Covid-19, inflation re-emerged.
Based on the Federal Reserve’s aggressive inflation-targeting mandate, the onset of inflation required the Fed to raise interest rates aggressively from 2022. It was unclear how high rates needed to be raised, and for how long they needed to remain high.
In searching for the level and duration of restrictive interest rates, the Fed recalibrated the system this week by moving rates down 0.50% points and noted they may be allowed to fall further. The balance of risks between inflation and unemployment is now more balanced, allowing the Fed to reduce the pressure on the economy.
Five years since the previous rate-cutting cycle – FOMC Federal Funds rate since 1996
Listening to Chairman Powell’s presentation, I was impressed by the nuance of competing objectives that he is seeking to navigate, and which is ultimately encapsulated in a single interest rate number.
He sought to explain that the US labour market is still near full employment, but that pressure on households was increasing, and future job growth would likely not be as strong. Powell said the policy direction was moving toward a more neutral level, and the FOMC (Federal Open Market Committee) will go faster or slower depending on how the data and risks unfold.
The US FOMC laid out a good roadmap for the way Australia’s RBA is likely to tackle the same issue of excessively high interest rates.
Impacts on Australian markets – short-term and long-term
Markets will respond to expectations regarding the RBA’s movements and the actual path of rate cuts. There is little doubt that interest rates are too high in Australia for the level of household debt and the expected path of current non-government investment.
In such an environment, we and the market expect delays in the RBA following the Federal Reserve’s decision. Still, in time, the direction and magnitude of reductions will ultimately be similar, especially in an environment in which the world (ex-China) avoids a recession.
The delay in rate cutting from the RBA will be due to a mix of:
- Slower progress in inflation reduction due to excessive migration-led demand growth
- Complications related to our extreme levels of household debt and our desperate intergenerational inequality
- Strong reported labour market conditions, including this week’s report of solid employment growth and healthy levels of labour force participation. Our employment market remains more robust than in the US.
We expect a range of impacts such as:
- Curve steepening
The difference between the long-end (say, 10-year bond yield) and the short-end (cash rate or 2-year bond yield) is called the steepness of the yield curve, and the difference is called a term premium. Lower short-term rates, mixed with a general level of future confidence, and some uncertainty regarding future inflation can steepen the yield curve, creating a positive term premium.
In our opinion, an economy provides a solid basis for sustainable growth when there is a positive term premium and accommodative real short-term interest rates.
Higher long-term rates help intergenerational wealth transfer and improves the outlook for sustainable business investment and likely productivity growth (see The Circular Relationship Between Productivity Growth and Real Interest Rates, Bergeaud,Cette,Lecat 2019).
These conditions can also reduce excessive speculation and move investment (with the correct tax regime) away from non-productive investment.
- House prices having an oversized impact on short-term rates in the US and Australia
Especially in Australia, but also increasingly in the US, central banks’ capacity to reduce interest rates is limited by citizens’ reactions to the signal. If the RBA could be assured that lower rates would only assist existing mortgage holders spending capacity, and not generate a further surge in house prices, rates could arguably fall faster.
However, the addiction of two generations of Australians to housing investment and price growth makes that problematic.
Unfortunately, this factor consistently constricts the outcomes for businesses and non-leveraged households who are trying to build real non-housing wealth through investment and productivity.
We are wary of the likelihood of this time being different and Australians not responding to lower rates by increasing their interest in housing. We are positioning our portfolio accordingly. We believe that rate cuts will have a positive impact on housing, at least in the short term. We retain positions in building products and companies that benefit from the flow of housing investment and financing (including Macquarie Group and Judo Bank).
3. Rotation
We believe rate cuts will help drive rotation in the equity market. This will include investors showing less interest in buying the more expensive structural growers which have dominated global market performance and shifting into areas which are more cyclical. Stocks sensitive to US rate and global industrials should perform well. These stocks include Bluescope Steel , Beach Energy, Seven Group and the Commodity producers. Our preferred Commodity producers include Sandfire Metals, .
Our portfolios will benefit from higher than index exposure to stocks outside the ASX100, especially higher levels outside the Top 20 stocks by market capitalisation. Anticipating the cyclical rotation we have also increased our direct index exposure to the smaller part of the market. The XSO (total market capitalisation of $326bn) has underperformed the broader market by a large amount
4. Direct impact of lower rates.
We also own businesses which will dramatically benefit from lower levels of interest rates and improvements in the cash flow in the economy. Names such as
- EarlyPay, benefits from a lower cost of funding to fund its invoices, and its clients would prefer to pay lower rates for borrowings. This would tend to increase the demand for invoice finance, reduce the risks of lending and increase the volatility of invoice turnover, which increases EarlyPay’s non-interest income (transaction fees).
- Seek Limited. For a number of years, Seek has been amongst the “cheapest” of the ASX-listed technology companies. Part of the reason for its relatively low price is concerns for the Australian labour market whilst rates remain so high. The closer we are to creating an economy that can operate at lower rates for households, at the same time as strong government spending we will see a more robust environment for hiring (more job ads) and more movements between jobs (more job ads).
5. Continued elevated role for government.
Given the complexity of the RBA response, it is likely that government spending and investment will remain the principle driver of the economy until rates are much lower or business investment returns to much higher levels. As such, we see no change to our view that high government spending will continue to support Medicare-related medical services and labour support services for a company like Ventia.
Summary
Turning points in monetary policy are important for markets and the real economy.
This week, the US Federal Reserve provided a lead and a road map for adjusting Australian interest rates.
Lower short-term rates and the anticipation of short-term rates continuing to fall are likely positive for smaller companies. The market’s predilection for the largest companies in the ASX, almost regardless of price, was a short-term feature that was fermented by short-term interest rates remaining too high.
Our portfolios are positioned for smaller company outperformance.
In the long run, the change in monetary policy could signal a more productive level of investment and growth, which is critical for the broader Australian economy as it moves past the Covid-19-induced inflation scare.1
Interesting new research on Newmont Mining (NEM)
Based on the few mentions analyst recommendations and price targets have received in Investment Matters over the years, it should be clear we rarely get moved by such calls.
But now and then, a stock call and a price target receives our attention. This happened this week with a report from the highly respect Levi Spry at UBS. He noted that regarding Newmont Mining that the firm had…
“…increase our PT (price target) from A$75 per share to A$100 per share, reiterating our Buy rating.”
$100 a share for a company that recently traded for less than $50 is an exciting call and supportive of our valuation in the $80 range. The reasoning behind the call made us wonder if we were being too conservative.
Clients will recall that Newmont Mining (formerly Newcrest Mining) is the cornerstone investment in our Gold basket. Following the merger of Newcrest Mining with the other global major Newmont Mining, we now hold an asset with the mine life and quality characteristics we appreciate.
UBS noted that “post-divestments, NEM is set to have one of the best portfolios in the industry consisting of predominantly large long-life assets in low-risk jurisdictions & attractive brownfield growth projects.”
We agree with this point. But in addition, UBS believes that the combination of asset sales and optimisation, will lead to “higher production and improved costs to drive improving FCF [free cash flow] from 2H24…. This will quickly return Newmont to an exceptionally strong balance sheet position.”
Based on the few mentions analyst recommendations and price targets have received in Investment Matters over the years, it should be clear we rarely get moved by such calls.
But now and then, a stock call and a price target receives our attention. This happened this week with a report from the highly respect Levi Spry at UBS. He noted that regarding Newmont Mining that the firm had…
“…increase our PT (price target) from A$75 per share to A$100 per share, reiterating our Buy rating.”
$100 a share for a company that recently traded for less than $50 is an exciting call and supportive of our valuation in the $80 range. The reasoning behind the call made us wonder if we were being too conservative.
Clients will recall that Newmont Mining (formerly Newcrest Mining) is the cornerstone investment in our Gold basket. Following the merger of Newcrest Mining with the other global major Newmont Mining, we now hold an asset with the mine life and quality characteristics we appreciate.
UBS noted that “post-divestments, NEM is set to have one of the best portfolios in the industry consisting of predominantly large long-life assets in low-risk jurisdictions & attractive brownfield growth projects.”
We agree with this point. But in addition, UBS believes that the combination of asset sales and optimisation, will lead to “higher production and improved costs to drive improving FCF [free cash flow] from 2H24…. This will quickly return Newmont to an exceptionally strong balance sheet position.”
A chart of their anticipated cash flows shows more than $1bn per quarter being generated through FY26.
Source: UBS
We had anticipated slightly less value creation (both direct and through market-based share price reaction) from divestments. We also had not baked in assumptions of as significant falls in all-in-sustaining costs (AISC) as UBS is now assuming.
In terms of investment implications, clearly, Newmont is already a large position in clients’ portfolios. However, UBS has provided a set of benchmarked expectations for cashflows and AISC outlook that will give us more confidence in the valuation upside of the great assets it already owns.
As each quarterly report is presented, we will look to these results as proof that our valuation requires upgrading.
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 Emeco Holdings (EHL) and Catalyst Metals (CYL).
Emeco Holdings Limited (EHL)
First Samuel View: Neutral (potentially Positive)
Market reaction since result: -10.4% (since August 22nd, including dividends)
Movements since June 30th : +8% (including dividends)
Emeco Holdings Limited provides surface and underground mining equipment rental, complementary equipment, and mining services in Australia. In colloquial terms Emeco owns, operates, leases and repairs a huge amount of yellow kit for miners.
Our longstanding position in Emeco Holdings delivered an 11% return in FY24. The company rebounded from a difficult FY22/3 period in which bad debts and problems with its Underground segment destroyed profits and the market’s confidence.
While trading in the 70c range, Emeco represents a good value exposure to increasing mining services activity. At this level, the stock is priced at a PE ratio (price to earnings) of circa 6x, which is excessively cheap. Stocks trading at these levels are usually shunned for cyclical, structural, and execution reasons.
The drivers of negative sentiment are abating. We are seeing some improvement in activity cyclically and structurally. The demand for refitting and reconditioned leased equipment remains robust. Despite this, the mining services sector has not seen much market interest. We suspect that the inability of companies such as Emeco to generate genuine free cash flow (after investment spending) limits its upside.
FY25 represents the best opportunity in several years to flip this script and generate a large amount of free cash. Market analysts, including those from Macquarie Group and Canaccord Genuity, forecast free cash flow after investment in FY25 in a range of $80-100m. We agree with the forecast and suggest that such levels represent the minimum acceptable level of returns.
Considering Emeco’s market capitalisation is approximately $400m, generating these levels of cash flow would represent a fabulous free cash yield and necessitate the stock trading at significantly higher levels.
In the medium term, gross cash flow after tax should remain higher than $70m per year. We must see these cash flow levels to justify the reported asset value. Our estimates suggest an NTA (net tangible asset) backing of between $1.15 and $1.25, or between $600m and $650m.
The time for excuses regarding shortfalls has ended. Unfortunately, uncertainty as to the delivery of forecast cash flows limits the size of our position in Emeco.
More details on the company and the FY24 result
The FY24 results were in line with guidance and market expectations. EBITDA was $280.5m and reported (non-normalised) earnings per share was circa 10 cents. However, our version of genuine cash flow was weak at less than $40m.
As a reminder, the company generates the majority of its revenue and earnings from its Rental business (see chart below). The Force Workshops segment is a great business, and despite generating only 6% of earnings, we believe that it represents more than 25% of the stock’s current value.
Emeco Holdings, revenue and earnings by segment
Source: FY24 results, First Samuel
Turning to segment-by-segment commentary, it becomes clear why FY25 represents a clear opportunity for execution success.
Rental segment
The Surface Rental business performed well in FY24. Revenue grew by 10%, and EBITDA rose 11% compared to the previous year. EBIT (profits after allowing for the depreciation in the equipment used) margins increased ~60bps for the year. Growing EBIT margins, especially if the company turns these earnings into genuine cash flow, is the true measure of operating performance for a mining services company.
Higher demand in the Rental segment was driven by growing demand in the gold mining sector and some strength in bulk materials. Emeco’s investment in 18 798D and 5 789C second-hand trucks was the reason genuine cash flow was low. It will be critical to see this investment turn into earnings growth in FY25.
Underground segment
The underground business was a source of value destruction in recent years, and a poor acquisition in hindsight. Following the sale of the underground contract mining projects to Macmahon in Dec-23, revenue fell and profits were subdued, although higher margins were delivered.
With the Underground segment now repositioned to a pure rental offering supported by a new relationship with MacMahon (MAH), which can now expect revenue growth in Underground.
Force Workshops
Activity levels remained strong, with revenue growth of 6% to $166.2m, supported by 128 machine rebuilds. Force undertakes both internal work for Emeco and external work for other companies.
41% of total Force segment revenue for FY24 came from internal work, much associated with its growth capex program. With fewer growth projects FY25 should be able to free up capacity, generating more external revenue and better cash flows.
What they said
No firm guidance, but plenty of positive indicators: No specific earnings guidance was provided; however, management noted on its call that revenue should broadly be flat in FY25 while earnings should shape upwards. – Canaccord Genuity Capital Markets
Catalyts Metals (CYL)
First Samuel View: Positive
Market reaction since operating update: +52% (24th July)
Over the past two years, most clients have benefited from including a relatively small position in Catalyst Metals.
Catalyst Metals share price over past 3 years
Source: asx.com.au
Clients may recall from earlier Investment Matters articles that we have built a basket of Gold exposures, including our investments in Aurelia Metals and Newmont Mining. We own Catalyst Metals for its regional and operational upside.
First Samuel initially purchased the stock through its participation in a capital raise in March 2023 that funded a corporate transaction to build out the current asset base. Following some turbulence associated with the approval and completion of the transaction, the stock traded poorly through calendar 2023.
The first signs of improvement occurred in calendar 2024. The company has recently provided the market with various financial and operational updates that have helped the market understand the value of the options we had researched. This included its Quarterly Activities report on the 24th of July and a series of conference and market presentations.
The market now understands this business can mine a considerable volume of gold at a reasonable cost with a plant that is operating with a better cadence than previously achieved.
Catalyst acquired Plutonic on 1 July 2023; it has now operated it for 12 months. Under Catalyst’s ownership, Plutonic produced 85koz compared to 60koz of production in FY23 under previous owners.
Production at Plutonic Mine – past 3 years
Source: Company reports
Our proprietary research highlighted the production opportunities that were available at this mine.
Combined with the fabulous increase in the gold price shown below, the combination has created a short-to-medium outlook that will be allow further value to uplocked.
Spectacular growth in USD Gold Price over past 2 years
Source: goldprice.org
The FY24 delivery and its anticipated cash flow in FY25 will enable the company to invest in the additional opportunities we identified in the 20223 transaction. We see future value in the company developing the Trident and Plutonic East sites. Each would have generated value in isolation but when combined with the Plutonic production capacity the total value
What they said
Catalyst’s Managing Director & CEO, James Champion de Crespigny, commented:
“It has been a big year for Catalyst. Producing well over 100koz of gold, repaying A$28m of debt and still growing our cash balance.
Now, with Plutonic stabilising, we are able to focus on developing Trident and Plutonic East which will see our production grow to over 150koz.
Catalyst is entering the next financial year in a balanced position with a long pipeline of near-term, low capital, organic growth options.”
The following graphic shows the range of options the company has.
Catalyst Metals – a gold miner with plenty of “catalysts”
Source: Company reports, Sept 2024
First Samuel view
Given the growth in the share price, we will continue to manage the size of clients’ positions based on their individual risk profiles. In general, it is a small position, reflecting its underlying risk, and its role in the Gold basket.
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.