Keep A Close Eye On Market Dynamics

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By Rudi Filapek-Vandyck, Editor FNArena

It is one of my long-standing observations that investors are too focused on what management teams at listed companies plan, do and say. Instead, they'd be much better off paying attention to changes in specific market dynamics.

The recent past has shown many excellent examples of this: Reckon ((RKN)), Blackmores ((BKL)), Cabcharge ((CAB)) and Monadelphous ((MND)) had for a long time been robust and reliable performers for their shareholders, until market dynamics changed.

Many of recent disaster stories can equally be linked back to changes in operational conditions: more competition for Wotif ((WTF)), a double squeeze, international and domestic, for Qantas ((QAN)) and accumulating pressures on Metcash ((MTS)).

Changing market dynamics do not always represent a negative. UBS analysts last week pointed out that retailers selling household durable goods have seen their market shrink to leave 33% fewer competing stores in Australia over the three years past. No wonder management teams at Harvey Norman ((HVN)), JB Hi-Fi ((JBH)) and Dick Smith ((DSH)) seem to have righted the ship, but how much of this is solely due to their talent, experience and effort?

The recent past provides many more, easy to pinpoint examples. Imagine anticipating the turn for gold stocks pre-2010. The downturn for traditional media companies? Or even the general change in context for mining companies?

Note most of these changes are not one-on-one linked to the economic cycle.

When viewed from this angle, the share market all of a sudden looks a whole lot less attractive with more and more segments of the Australian economy facing threats and challenges that weren't there in the past. Yet all of the above examples show it pays to pay attention, because sooner or later cracks and weaknesses will reveal themselves, and the effects can be nothing short of devastating for shareholders who rely too much on the past, and listen too much to management and the board.

Below are a few of the changing market forces that deserve investor attention, in my view. None of these may seem to matter in the short term, but the recent example showcased by Metcash (for a long time a solid, reliable dividend payer) has once again revealed that when the dam breaks, there's serious damage to be endured.

Power retailers in Australia

A few weeks ago I pointed out how business models, and market capitalisations, of traditional power retailers and owners of power grid infrastructure, a la AGL Energy ((AGK)) and Origin Energy ((ORG)) here in Australia, have been brought into question in offshore markets such as Germany and California. According to some forecasters, the decade ahead will be nothing short of devastating for these operators and their business models.

That's a longer term view and given Australia often experiences these overseas changes at considerable delay, it may take a long while still before we see similar questions being asked regarding the future for AGL and Origin by sophisticated investors and the media. But there are negative changes taking place in the short term too.

Power retailers have been trying to outsmart each other in recent years by sending sales representatives (often foreign students on nothing but a sales fee) door to door to offer households ever larger discounts on their quarterly gas and electricity bills. The result has been a noticeable hike in customer churn and lower margins. Both AGL and Origin have disappointed in recent years, as analysts constantly had to reduce their estimates, but it was all meant to be temporary and eventually sanity was supposed to prevail and conditions become normal again. Unless, of course, this is the new normal.

In a recent update on persistent trends in the Victorian market, analysts at Credit Suisse question whether the industry is not simply going through a transformation in competitiveness which includes all kinds of telephone services and websites that allow for households to compare rates and to switch to cheaper alternatives. If CS is correct, then what AGL and Origin have offered investors in years past is not temporary, it is the new normal.

Note AGL's share price has pretty much failed to make any sustainable advance since 2009, though shareholders received robust dividends throughout the period, while Origin shares have enjoyed a come-back since late 2012 but the share price is still lower than where it was in 2009. Shorter term both stand to benefit from the Abbott government's changes to carbon tax, Renewable Energy Targets (RET) and subsidies for solar panels, but will it be enough to offset future challenges in what may well have become the new normal for the sector?

Wagering

International competitors Paddy Power, William Hill and bet365 have set their sights on Australian punters and they seem serious about making further inroads into the Australian wagering market. It appears James Packer is also interested with Crown Resorts ((CWN)) reportedly mulling over its own plans through full ownership of Betfair.

Most analysts seem pretty sanguine about all this and continue to view domestic players in the wagering industry, Tabcorp ((TAH)) and Tatts (TTS)), as relatively robust players in a transitioning market, but analysts at CIMB are talking "structural channel shift" in addition to "significant loss of market share" for the local players and this explains why they have become much more cautious. Investors are clearly preferring Tabcorp over Tatts, with the latter share price in a downtrend since the start of the year.

It can take a while before such changes in competition make their mark, but from a certain point onwards things can move very fast. Just ask shareholders in Wotif ((WTF)).

Health Insurance

The Abbott government will privatise Medibank later this year and this is likely going to mark the start of significant transformation for the circa 34 remaining health insurers in Australia. Just about everyone expects Medibank and main competitor Bupa (together good for 60% market share) to start gobbling up the rest of the sector. Oh sorry, that should be "to start consolidating".

There's one listed health insurer on the ASX, and NIB Holdings ((NHF)) has proved to be a very solid and reliable performer for shareholders. Total return has been some 370% since listing in 2007 and so far this year the shares have again outperformed the broader market. No doubt this is partially because just about everyone considers it a target for either of the two giants in the sector. But what if Medibank and Bupa don't feel like playing to that script and instead go for cheaper, unlisted alternatives?

Is it possible the NIB of today might turn into the Metcash of the health insurance sector tomorrow? I certainly would not exclude the possibility. If anything, I certainly wouldn't take any take-over premium for granted.

Iron ore

We can talk about this until the cows come home but it isn't going to change one little bit of the fact that iron ore prices are now in a downtrend. Does this mean spot in China will drop to US$80/tonne later this year, or maybe next year? Nobody really knows, but with ever more supply coming into the market there will come a point when demand sits below supply, and stays there, whatever the resilience of Chinese producers. And iron ore companies, just like every other company, will find it difficult to grow when the price for their product is in a downtrend.

Both BHP Billiton ((BHP)) and Rio Tinto ((RIO)) have short and medium term offsets via increasing output, and there are lots of costs that can be cut, and their margins are still nothing but phenomenal, but for most of the smaller players this downtrend is effectively the end of an era. Soon growth will be a distant memory and those who pay dividends will be forced to cut and to scrap. It's only a matter of time.

Coal

I believe the world is getting ready to abandon coal. Sure, the world and developing economies in particular, is still going to rely on cheap coal for its power requirements a long while into the future, but it'll be a mental re-set, just like we all did with newspapers and magazines in years past. We very well know print media are going to be around for a while still, but mentally we are looking forward to the day when the last printing machine is taken apart and sold to a merchant for its steel parts.

A few years ago I returned from Vancouver with the observation that a new kind of opposition was emerging. Today this movement has grown to the point whereby large international investors are questioning whether they still want exposure to coal in their portfolio. This is the slow process that is evolving overseas and management at BHP and Rio would be very well aware of it, which probably explains recent statements in support of their enormous coal operations.

Wall Street is awaiting a break-through in solar power technology within the next 3-5 years. I think once this break-through has occurred, coal stands to be villified and crucified and we all start looking towards the day when the last coal powered power station is dismantled and replaced by a beautiful set of polar panels.

The impact on listed coal producers can be significant, ranging from higher funding costs (if they can get it at all), to increased obstruction from regulators, to sizeable discounts applied to their assets. This is not something that is going to impact in the short to medium-term, but give it five, seven or ten years and we could be looking at dirty coal as being really, really dirty indeed.

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AUD, The Party-Pooper

Last week I warned the Australian share market was likely going to be hit by downgrades in the weeks ahead, as analysts incorporate lower prices for coal, iron ore and copper in their models and because a heavy skew towards H2 in local guidances has increased the risk for corporate profit warnings in May-June. Strategists at Citi have by now drawn the same conclusion for global equities and profit projections.

I did not mention the Australian dollar last week, but it should be clear by now the Aussie dollar can potentially cause some real havoc in the Australian share market. Forget about US95c, some experts are asking the question whether AUD/USD can return to parity this year. Investors better not lose out of sight of the fact smaller producers of iron ore in Australia have, in the absence of a sustained upswing for the price of the bulk commodity, turned into a currency derivative. Those popular overviews published by the likes of UBS showing cost levels for all producers in Australia will have to be revised in case of AUD/USD at 95c, let alone parity.

REA Group Seen Targeting $100

Most investors and commentators still find it difficult to get their heads around what appear to be super-inflated Price-Earnings (PE) ratios for proven performers such as Domino's Pizza ((DMP)), Ramsay Healthcare ((RHC)) and REA Group ((REA)), but analysts are starting to catch on to the apparent contradiction that what appears expensive today is actually one of the better investment opportunities around, at least some of them are.

On Monday, analysts at BA-Merrill Lynch enthusiastically reported further research into product uptake in Sydney had suggested risks remain to the upside for REA Group, both in terms of sales and margins. NSW has traditionally been dominated by competitor Fairfax Media's ((FXJ)) Domain, but BA-ML believes the time seems right for Sydney to succumb to the attractions of the online market leader. In addition, suggest the analysts, print still accounts for 50% of all display, leaving plenty of room for further migration towards online, where REA Group is King.

Bottom line: even BA-ML's growth projections may well prove to be conservative in the years ahead. Currently, BA-ML's EPS growth projections are 45.1% (FY14), 32.9% (FY15) and 24.8% (FY16). Stock Analysis on the FNArena website shows market consensus is positioned a little lower for each year. On BA-ML's numbers, REA Group's PE sits at 40, but it drops to 30 on FY15 numbers. Is this really too expensive for a company that is projected to achieve 30% EPS CAGR over the next five years? How about we leave the answer to this question to the analysts: "[we] continue to see this stock pushing towards $100/share in the next 2 years".

But, of course, REA Group shares are too expensive, aren't they?

Santos, The Dividend Stock

Last year, I traveled through the country giving presentations such as (tongue-in-cheek) "Where Else Are You Going To Put Your Money?". One of the central themes in my predictions was that rising East Coast gas prices and ginormous LNG projects approaching completion were going to re-shape Australia's oil and gas sector to the point that stocks such as Woodside Petroleum ((WPL)), Oil Search ((OSH)) and Santos ((STO)) will turn into cash flow/dividend plays, just like their big, international uncles in Europe (BP, RD/Shell, etc) have been for decades. I still stand by that prediction.

Regarding individual projections, my boldest prediction was that Santos' share price will reach $20 in the years ahead. However, a recent report by JP Morgan strongly suggest that $20 projection might be too conservative. On JP Morgan analysts' calculations, Santos should be able to offer 10% dividend yield post FY16, grossed up this becomes no less than 14%. Assuming JP Morgan's calculations prove correct and assuming the market is going to re-value Santos to the same yield as Woodside today, which is between 6-7%, suggests a share price of $20 should be right in the middle of that range.

Maybe I wasn't bold enough?

(This story was written on Monday, 31 March 2014. It was published in the form of an email to paying subscribers on that day).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

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