Introduction:
Before we begin this Bennelong Funds Management podcast, we would like to acknowledge the traditional custodians of the land on which we are recording and pay our respects to elders past, present, and emerging. We celebrate the stories, culture and traditions of Aboriginal and Torres Strait Islander communities who work and live on this land, and we commit to an ongoing journey of reconciliation and respect.
Jonas Daly:
Hello and welcome to our podcast for June 2023. My name is Jonas Daly, Head of Distribution at Bennelong Funds Management, and today I'm joined by the BAEP investment team, including founder Mark East, the Chief Investment Officer, and Neale Goldston-Morris, Senior Investment Analyst, also covering economics and market strategy, and Brad Clibborn, Portfolio Manager and Senior Analyst. Welcome, gentlemen.
Today's podcast will focus on the relative performance of our portfolios, all of which have recovered well and are currently ahead of their respective benchmarks for this calendar year. We'll also cover the current portfolio positioning, including some recent earnings guidance from a few of the companies that we hold, but also an outlook and both the opportunities and the risks that lie ahead for Australian equities. So we might just start off with you, Neale, on the macro side.
Neale Goldston-Morris (1:11):
Thank you Jonas, and welcome everybody. We thought we might start with just an overview of the big building blocks for the globe at the moment, because the overall picture is a lot better than certainly what you'll read in the media at the moment. So let me start with the main blocks and the US. It's true that the US economy is slowing, but it's also highly resilient. The consumer is still spending, he's still got lots of savings, employment is still strong. Yes, rates have gone up and they're starting to slow the economy, but it's a very ordered slowdown, a very ordered one indeed. And wages that were strong have slowed a bit. Supply channels are normalising. Inflation is coming down quite quickly. Now remember, it peaked at 7, 8% on the headline line. It's half that now. It'll come back further in coming months. Yes, the Fed has some further work to do, because core inflation is still in the 4 to 5 range, so still work to be done there, but the bulk of it has been done. And most importantly, corporate earnings in the US are still intact because it has a flexible market-orientated wage environment, which is seeing it adjust very effectively. So our portfolio is very overweight a lot of US exposures, James Hardie, Aristocrat, ResMed, CSL, et cetera, the list is long, because the fundamentals there, in our view, remain sound.
The other building block offshore is China. And yes, China has had a slow recovery, but the good news there is that service is doing very well and manufacturing, while it's lagging, is improving off its lows. More importantly still, China has more flexibility now than any major economy to provide further stimulus. Inflation there is effectively zero. The federal government is not over-geared, so we can cut rates and provide fiscal stimulus at the same time and it's starting to do so. So it cut rates yesterday, on Wednesday, in China. Good news: the further stimulus will be provided in a fiscal sense, but also deregulation of the housing market, further stimulus in auto, et cetera. So there's every reason to believe that China can meet, or the Beijing's forecast of 5% growth for their year-end March '24 target of 5%. So not fantastic, but it's going in the right direction, and our portfolio has a significant resources exposure through BHP and the lithiums, Mineral Resources and Pilbara Minerals. In particular, Beijing will be stimulating the auto sector and the EV component of the autos.
So that brings me then to the third block, which is Australia, and superficially Australia looks very similar to the US. The economy has slowed, rates have gone up, corporate profitability is slowing a bit, but there is a big difference. The US has a highly flexible market-orientated wages system. We do not. Ours is a legislated, Canberra designated, if you like, system, which is insisting on full indexation. That's causing a real problem for a lot of the domestic companies as far as cost control, or trying to just manage the costs. And Canberra, the federal government doesn't seem to care really about inflation.
So the poor old Reserve Bank of Australia has its work cut out to get things under control and keep them under control. And that's why our portfolio has a very large bias against the large, employee-heavy, old companies in our market. Obviously the banks, where we've had that underways, the old, mature retailers like Woolworths, Wesfarmers, Harvey Norman, and lots of other counters as well, because that lack of cost control – or let's call it boost to costs – will continue to come through, and the list is long. I've mentioned the regulated wages system, the federal government is looking to regulate it even more. Immigration is at a record level, when we've already got a 200,000 dwelling shortage in this country, let alone what the newcomers will need from accommodation. That's pushing up rents as everybody knows, and it will continue to do so. And our energy policy is, let's just say, in a mess. There's a huge build still to be done for transmission lines in particular, that's going to take many years, not just a few years, that's for sure. So there's lots of underlying problems which cause us to have that big bias towards overseas exposures that are available within the ASX.
So in total, when we look across the board, the overall building blocks in a global sense, with the big economies, are sound. Yes, there'll be some bumps along the way and it won't be easy, but they're going in the right direction. Australia is going to lag as far as performance is concerned, unfortunately. Hopefully the RBA can get on top of things and hence our bias in our portfolios offshore.
Jonas Daly:
Right, thanks Neale. And just moving over to you, Brad, just in regards to some of the attribution of the portfolios and in particular a couple of stocks. More recently, IDP came out with some news as well. We know that we have a meaningful position there as well, so if you could make a few comments that'd be great.
Brad Clibborn (7:05):
Thanks Jonas. Yeah, I'll touch on IDP. It's one where the share price has been impacted this quarter. It's following an earlier than expected regulatory change in Canada that impacts their English language testing business.
A little bit of background in IDP Education, they provide services to students primarily in developing markets, wanting to study abroad. International education is a sector that's been growing strongly and continues to grow steadily over time. And IDP operates two primary businesses in this student education sector, which account for about 50% of group profit each. The first is student placements, this is a business that helps place students from developing markets to study in Western countries, universities in Australia, Canada and the UK primarily. IDP is the market leader in that space, but still only has a single-digit percentage market share globally in placements. This business continues to perform strongly, and is expected to be the primary driver of earnings growth for IDP over the next five years. So there's no change to that.
The second business is the English language testing business. IDP is a partner in the IELTS English Language Test, and contributes both to its development and also operates as a distributor of that test. IELTS is an English proficiency test that's taken by both students and workers wanting to obtain a visa to an English-speaking country. It's the number one test globally for English proficiency, and the barriers to entry are quite high in terms of governments having to approve those tests for visa applications. The Australian and UK government have already allowed multiple English language tests to be accepted over the last five or six years, Canada was the last remaining quasi-monopoly for IELTS. In May, the Canadian government announced it would accept three competitors of IELTS for their student direct stream visas. This was always expected. The surprise was that those competing tests would be accepted from August 2023, this is a couple of years earlier than the market was expecting.
The interesting dynamic in terms of this competition opening up in Canada is the two examples that we've already had, both Australia and the UK, have resulted in quite different market share outcomes for IELTS. In Australia, IELTS lost around 40% market share, whereas the UK only around 10% market share as those markets opened up to competition. The big difference between the two being the score required by students on the competitor tests being relatively easier in Australia versus the UK. The important thing here is the Canadian test equivalencies have been set more in line with the UK than Australia. So consensus earnings have taken quite a conservative view around the likely market share loss for this English language testing, assuming they will lose 30% or more in FY24.
We think IDP has a strong response to this. They have a new product launching under IELTS called the One Skill Retake. This has already been accepted in Australia and is being reviewed by the UK and Canadian governments, and we think this offers quite an attractive value proposition to consumers looking to take those English language tests and will be a key plank in their response around this new competitor in Canada. So despite this, we think IDP continues to have a very strong earnings growth outlook. Consensus is forecasting over 20% earnings growth over the next three years, and that's been driven by the ongoing technology investment that they've been making into their student placement business that will continue to support market share gains and that strong earnings growth. So we continue to like IDP.
Jonas Daly:
Okay great, thanks Brad. And just, Easty, we might just move over to you. Mark East on the travel stocks. It's obviously been a popular sector, especially for a lot of the baby boomer generation, and it's had some good results of late, and obviously through COVID was a bit of a challenge and probably same for IDP obviously when the students couldn't travel, but just some comments there on the stocks you hold in travel.
Mark East (11:15):
Yeah, sure. Yeah, the travel stocks we own, Flight Centre and Corporate Travel, performed reasonably well over the last few months.
On Flight Centre they announced a small upgrade to earnings when they presented at the Macquarie conference in early May, and provided commentary which suggested the company's performing reasonably well across both its leisure and corporate businesses. In relation to leisure travel, the company commented that the recovery was accelerating and they said that demand had been extremely strong with TTV up 280% for the first nine months of the year versus COVID-impacted PCP. In relation to corporate travel, the company has won a number of new clients over the last few years. At the May update, the company announced it was on track to win new accounts over financial year ‘23 with a projected annual spend of around $2 billion. The company also noted at that May update that they saw record levels of transactions and TTV in March. So these wins importantly are flowing through to TTV and revenue. The company's corporate business is now one of the top global travel management companies in the world. Company as a group's targeting profit before tax margin for FY25 of 2%, and the update in May confirmed that this is still the target. Achievement of this target would lead to some good earnings upgrades for Flight Centre in future years.
In relation to Corporate Travel Management, in April they announced they'd been awarded a significant contract by the UK government, contract worth around $3 billion will run for two years with the ability for a one-year extension. Contract relates to the provision of border security and immigration services to the UK home office. The company more broadly continues to win new clients at a good rate, so this combined with recovery and corporate travel spend should see the company generating some good earnings growth over the next few years.
Jonas Daly:
Right, thanks Mark, and obviously got both ends of travel covered with leisure and corporate travel as well, so two good stocks to get some exposure there. Brad, just Aristocrat, interesting one, obviously poker machines locally have come under the spotlight, but Aristocrat again, the earnings are offshore so it had a good result recently if you could cover that one off.
Brad Clibborn (13:38):
Yeah, for sure. That's a good point Jonas, 80% of the gaming earnings for Aristocrat do come out of the US so it is very much a US-based story, and Aristocrat had a couple of updates over May, both their half year 2023 results and also announcing the acquisition of NeoGames. The first half '23 results were stronger than expected trends in its US land-based gaming business. They saw earnings up 12% year-on-year and that landed at about 6% ahead of where consensus was for that business. Aristocrat's continued to diligently reinvest 11 to 12% of its revenue into design and development of new games every year, and that investment continued through COVID despite the temporary loss of revenues during that time. And this is why we've continued to see Aristocrat come out of COVID very strongly, and continuing to see them grow ahead of the market in that land-based gaming business.
Important to note, consumer spending in US casinos continues to hold up at a pretty healthy level as well through 2023. The mobile gaming business within Aristocrat did miss expectations due to elevated costs and some relatively flat revenue trends, but management have guided that they're addressing those costs in the second half of the financial year, which should see a turnaround in the earnings of that business. That business accounts for about 25% of group earnings overall.
The other big news was Aristocrat announced the $1.8 billion acquisition of NeoGames. NeoGames is a software company that provides systems and content to online casino operators, online lottery operators, and online sports betting companies. It doesn't operate any direct-to-consumer brands, it's simply a systems and content supplier into those consumer-facing brands. The US has been slowly legalising online sports betting and online casino over the past five years, and there are now 26 states allowing mobile sports betting and around six states in the US offering online casino. Aristocrat's been working on its entry into that market for a couple of years now, and as the number one provider of slot content into land-based casinos in the US, we think they have a very strong position to take a lot of market share in the online casino world as well.
The online casino market we think also provides them a very attractive long growth runway as new states continue to progressively legalise online gaming. NeoGames gives Aristocrat that technology platform that they need to start distributing their slot games online, and also the platforms that they can sell to their brick-and-mortar casino customers to help them launch their online casino operations. So we see this is the third leg of the stool for Aristocrat to support growth over the medium and longer term.
Jonas Daly:
Great, a great opening up story as well along with some of the travel stocks you mentioned earlier. And just in regards to James Hardie, now I know this is one of your favourites and yourself and Mark and the team have spent a huge amount of time on this one, well over 50 meetings with builders and suppliers and the like. And obviously, it got caught up at the end of last year with the whole interest rate headwinds and association with property, which is obviously fair call for a lot of people to be worried. But what made you really hold your ground with James Hardie and just an update there on your current views?
Brad Clibborn (17:07):
Yeah, James Hardie reported its fourth quarter results in May and it was a strong result coming in ahead of consensus expectations for their fourth quarter. They also provided guidance for the first quarter of their FY24, which is the June quarter. In the midpoint of that guidance was 12% ahead of consensus expectations and if they deliver that, we'll see Hardie holding earnings about flat year-on-year against what’s some still difficult comps for the earlier part of 2022 before the housing market slowed. So we think that's quite an impressive result. The driver of that stronger-than-expected earnings guidance has largely been driven by margin. The market has been skeptical on Hardie's ability to manage margin through a housing down cycle. However, Hardie is proving the quality of both their business model and the management team's response through this time. They took action on costs late in 2022, and at this result they announced a further range of procurement and other cost-saving initiatives that over the next three years will support about another $160 million of cumulative incremental cost savings. So management are working hard to preserve the margins of the business. The other theme coming out of the result was the thing we're always looking for, was continued evidence that Hardie is still taking market share in the US. They've adapted their go-to-market strategies over the last nine months, ensuring they continue to take market share in the softer housing market, and we're seeing that pay dividends.
From a broader US housing market perspective, we've continued to see positive signs in terms of a recovery or green shoots in the US housing market through 2023. The public builders in the US have generally reported new sales orders ahead of consensus expectations over recent months. New home starts in the US have also generally surprised to the upside. And while the repair and remodel has been a little slower in 2023, it's still performing ahead of consensus expectations. So both James Hardie and their major competitor, Louisiana Pacific, have both confirmed those better-than-expected demand trends to start 2023. So we see the fundamentals for the US housing market remaining positive over the medium to longer term, and that is where Hardie earns 80% of its earnings. So we've continued to see a good runway of market share and favourable market trends building from here, so that remains a core portfolio holding for us.
Jonas Daly:
Thanks Brad. Great summary and great summary, Mark, as well. Thank you for that. Now what I'm hearing here today, obviously, is there's further headwinds of the Australian economy as Neale pointed out, so that does lean across to offshore earners. A big focus on earnings is where we're at, staying to the process and the philosophy which BAEP have done. They're not changing their spots. And I'd just like to thank you all for the call today and everyone's support. Thank you.
Conclusion:
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