A weakening outlook favouring companies with offshore earnings

This recent result season showed the last year’s earnings to be generally in line with expectations.  Over the past year, revenues have held up, although margins have come under some pressure. But the biggest risk we see, is next year’s earnings guidance.

Underpinning these results are three key themes:

1. Costs:  Specifically labour costs, funding costs and capex costs are impacting earnings. Companies that have had higher labour costs, but cannot pass them through, have generally underperformed.
2. The consumer: As anticipated, we are seeing evidence of deteriorating consumer demand, driven by ongoing cost of living pressures, higher interest costs, the ‘mortgage cliff’ and dwindling savings buffers. This slowdown in demand is occurring at a time when businesses are seeing broad based cost inflation.  
3. China:  With a disproportionate impact on commodity prices (China represents 50% of commodity demand for copper, alumina and coal), China’s slowing impacted the commodity sector.  Weaker commodity prices also contributed to a lower Australian dollar making companies with offshore earnings more attractive.

Let’s delve into the impact of these themes across some key sectors.

Consumer Discretionary with Brendan Mowry, Analyst

As expected, the cumulative impact of inflationary pressure continues to erode consumer demand. This in addition to the incremental headwinds of higher interest rates and mortgage repayments are beginning to diminish cash buffers that had been built up over the pandemic period.

Against a deteriorating sales environment, companies are seeing broad based cost inflation, in particular labour, energy and insurance, which is expected to drive material margin erosion over FY24. Importantly, however, much of this became evident in May and June amidst a slew of downgrades that helped reset investor expectations lower.

What helped separate the winners from the losers?

In many cases, positive surprises were driven by stronger than anticipated gross profit outcomes, which benefitted from lower inbound freight, that has now normalized from the pandemic peaks, and improved supplier terms as broader macro weakness impacted manufacturing in China. These tailwinds assisted in offsetting underlying cost of doing business inflation.

Nick Scali for example, whose model involves importing made-to-order couches manufactured in China were able to benefit from outright deflation in inbound freight, which represents a significant component of costs of goods sold, as well as improved supplier terms, resulting in substantial gross profit margin expansion.

Another company to benefit from similar trends was Lovisa, who import and sell on-trend jewellery and accessories manufactured in China. Lovisa operate a light inventory model with high stock turnover, which meant they are already seeing the benefit of these lower costs. This trend has been a feature of the most recent US reporting season and we expect it to become a greater feature at first half results in 2024.

Did reporting season meet expectations?

In broad terms, reporting season was in line with expectations, although it should be noted that these came down significantly in May and June as a litany of companies announced material downgrades to profit expectations (Universal Group, Best & Less, Adairs, Dusk etc.). Whilst this deterioration is still in play, against a backdrop of weak overall sentiment and high short interest, a ‘better than feared’ outcome was enough to drive significant relief rallies and outperformance.

The market is now looking forward into 2024, where companies will begin cycling a weaker 2023 and some cost pressures will ease, which provides a reasonable backdrop for the sector. However, the consumer remains highly bifurcated and overall demand is deteriorating. The outlook for employment, which is showing some signs of softening into the key holiday trading window, will remain critical in sustaining this newfound optimism.

Healthcare with Justin Teo, Analyst and Portfolio Manager

In the healthcare sector, it was a pretty tough reporting season, with costs higher than people expected and a return to pre-COVID margins taking longer than anticipated. A stock that encountered these pressures was Ramsey Healthcare, the largest operator of private hospitals in the country. 

Covid meant that many people had to delay their non-essential medical procedures and services.    While this has recovered over time, a 60% utilization of services versus a 90% utilization of services has had a huge impact to the bottom line.

On top of this, Australia’s increase in inflation and rising labour costs are difficult expenses for hospital operators to pass through to the end consumer.  Wage inflation is running at around 5%, but for these companies it’s difficult to raise prices more than by a few percent as most of them operate under huge regulatory conditions, whether they be insurance or government regulations.

Many healthcare companies, the likes of pathology providers and imaging providers, have also taken on debt to scale their services.  With rising interest rates, and wage pressure combined, they need to be achieving higher returns than usual to maintain a healthy return on their capital.

Any positive surprises from this sector?

On the positive side, Monash IVF, a specialist fertility company, was more resilient than probably people expected in the face of inflation. So far, we’ve seen demand largely unchanged despite the rising cost of living, and in fact demand is still above pre COVID levels.  That might change in the next twelve months as the overall interest rate pressure flows through, but that remains to be seen.

Another standout result overall was Cochlear, a company that manufactures hearing implant devices.  They’re a lot less labour intensive and buy relatively simple commodity products from overseas to put through an advanced manufacturing process here in Australia to export.

Their inputs have been reasonably easy to source, whereas companies sourcing more complex products have experienced more trouble sourcing their goods.  This problem has impacted companies like ResMed and Fisher and Paykel, with an elevated cost of goods sold and decreasing gross margin.

Commodities with Sam Heithersay, Analyst

The miners in general had a fairly weak reporting season. There were about twice as many misses as there were beats (beating expectations).  A lot of that was driven by three things – margin compression, higher capex spends and an uncertain China macro-outlook.

With regards to margin compression, there has been price top line compression we’ve known about for quite a while- with prices of commodities 20% off their peak, depending on which commodity index you look at.  What probably surprised the market was cost inflation which continues to bite the miners quite hard, particularly with regards to labour costs. Labour can make up about 40% of a miner’s operating costs and we’re likely to see that wage inflation persists in this market.

That also feeds through to capex inflation, the second driver of weakness. We saw a few miners come out with significantly higher capital expenditure than the market was expecting – in the order of 50 to 60 or 70%, and that drove some weakness for companies such as Pilbara and Northern Star.  

We also saw some miners confess to higher capex, but the stock still rallied on the back of their results, which reflects the positioning of the company going into the result. Linus had almost a 50% blowout on one of their projects, but the stock appreciated on the day largely because it was already priced in. So, there were some nuances largely due to positioning prior, but by and large we saw cost inflation and capex inflation drive a lot of the major misses across the miners.

China of course has a disproportionate influence on commodity markets. China accounts for around 18% of the world’s GDP and population but more than half of global commodity demand for things like copper, alumina, coal and accounts for more than 70% of seaboard iron ore demand.

China’s property sector has been particularly weak. The reopening we all expected post COVID has been a sputtering reopening, which has seen a weaker outlook in China and commodity demand and that was being played out through some of the commentary we were receiving from companies.

Some prices have stayed quite resilient in the face of this weakness and it’s worth calling out iron ore, which is back up to $118 – $119 a ton but it’s very clear that the equity markets don’t quite believe this strength. 

Any green shoots for the commodity outlook?

BHP and other miners point to India’s growth, and to copper.  Long-term, China is probably past its peak steel intensity use and so miners, such as BHP, often refer to India’s growth as a green shoot, a bright spot to offset lower demand elsewhere.  They are a major importer of hard coking coal which is likely to grow and have also increased their steel production and their iron ore requirements for that as well.

It’s unlikely to be the kind of tailwind we saw with the mass industrialisation of China in the early 2000s, but it certainly helps to soften the blow of a potentially weaker China macro-outlook short term and a declining steel intensity use towards the end of the decade.  Copper in a very similar way could be a stabilising force. It is also subject to short term macro headwinds, but it has an impressive structural demand tailwind in the form of EVs and the renewable build out.

Source: Fidelity International