Reporting season: Caveat emptor
We’re now in the middle of AGM season. Companies are making outlook statements based on the first quarter of trading. So what can investors expect to see? As someone who has relocated from the UK, several issues strike me about the Australian equities market.
As evidenced by the full year reporting season in August, driving revenue growth and gaining market share are challenges for companies in all developed markets. Low to mid-single digit revenue growth ranks as a good achievement – shareholders hoping for more in FY15 may be disappointed as many outlook statements feel pretty cautious, with several factors being cited: long term lows for commodity prices, a reduced level of growth in the Chinese economy, economic weakness and political uncertainty in the Eurozone, a rising level of unemployment in Australia, and subdued consumer confidence, to name just a few.
Achieving sustainable earnings growth is also difficult – across all sectors. For many companies, earnings growth at the full year was underpinned by cost efficiencies and improved operational efficiency. In terms of the FY14 reporting season this was positive, but it does raise red flags for the future in terms of how much further the companies can go along the track of cutting costs? In years ahead, the economy, and shareholders need companies to drive growth by innovation and organic investment. Is that happening enough?
The capital position of Australian companies is impressive. On average, cash flow is robust, balance sheets are strong, and in addition to organic investment to drive growth investors are supportive of companies making acquisitions that are in line with the stated strategy, and that are realistically priced. For the right deals, they are also willing to provide further equity. Although the market is supportive of M&A activity, it strikes me that there has not actually been a great deal of activity in 2014 to date – on a par with the level of deals in 2012 and 2013 at around A$40bn.
In the absence of attractive investment opportunities, either organic or by acquisition, there is an expectation among Australian investors that capital will be returned to them via special dividends and share buybacks. There were several examples of this in the full year reporting season, which were met with positive price reactions.
Other notable points about the Australian market? Firstly, and obviously, the economy is much more anchored in oil and gas/commodities/mining than other international markets. This makes it much more vulnerable to commodity price fluctuations. It is also more directly linked to the success of Asian economies, notably China. Both these points are not within the control of individual companies but they have to be ready to adapt to events caused by this macro-economic backdrop.
Additionally, the Australian market seems much more of a dividend driven market, with the average yield being around 5 percent, well above the average of 4 percent for the UK market. This is perhaps a reflection of retail investors being more prominent in Australia than they are in the UK. While the UK is approaching an historic threshold of a 50 percent payout ratio on average, the figure is currently much higher in Australia, at around 70 percent. At the full year stage, Australian corporates grew the dividend by an average of 7 percent. My query would be whether boards will feel comfortable pushing the payout ratio above 70 percent, if earnings growth dips below that of dividends over the next few years? It is worth bearing in mind that investors read a great deal into dividend declarations – they are a clear indicator of the board’s confidence in future earnings growth potential. In short, shareholders like to see the dividend grown in good times, maintained in bad times, and cut only at times of real crisis.
The IPO market in Australia seems buoyant at present, with institutional investors having cash reserves to deploy, and private equity owners offering companies with good growth prospects and strong competitive positions. Obviously pricing is key, but it strikes me that plenty of recent IPOs are trading well above their issue price, which must be a good sign.
Finally, my observation is that only a few Australian companies communicate their capital allocation framework to investors. Without requiring prescriptive details, shareholders like to understand the board’s thinking on allocating capital between organic investment for growth, acquisitions, the ordinary dividend, and returning surplus capital to shareholders. These aspirations tend to be set against the desire to maintain a stated credit rating, and/or a range of gearing on the balance sheet, in terms of the net debt / Ebitda ratio.
These are just my observations. As always, investors should undertake their own careful analysis during AGM and reporting season. Caveat emptor!