The Long and The Short: What reporting season can tell us about life in Australia

Kardinia Capital

2 September 2021

Just as the Australian Census promises to provide a comprehensive snapshot of the country and how we are changing, so too the recently-complete Australian profit reporting season can tell us what life has been like for Australians over the past 12 months.

Growth of online sales
With so many Australians stuck behind their computer screen during the day, it is no surprise that they have been spending online with a vengeance, fast-tracking the structural move from bricks and mortar to online shopping. The CEO of Australian online book seller Booktopia stated "the pandemic was a massive bump for people buying online ... online retail in FY21 was 13% of all retail. In three years by FY24 online retail will be 24% of all retail, almost double"[1].

Source: Booktopia FY21 Results Presentation

Australian online home furnishing retailer Temple and Webster (TPW) is another such example, where FY21 revenue is up 85% on prior calendar period. We also got a glimpse of current trading, with July month to date revenue growth accelerated to +39%. We expect TPW to report a tremendous uplift in gross profit, enabling significant reinvestment in FY22.

Savings rate still elevated
The savings rate among Australians has fallen, but remains at elevated levels (at ~12% of disposable income). Reporting season saw a record in dividends declared, with over $40bn of dividends to be paid: almost double that paid in the same period last year. Most of these dividends will be paid in September and October. Consumers' banks balances will swell as a result of these record dividends as well as buybacks and the proceeds from a record year of M&A deals. Retail will remain a beneficiary, as will the share market (given a significant amount of this cash will undoubtedly be recycled back into Australian equities). FY21 has seen some of the biggest deals in Australian history with Square's takeover bid for Afterpay, BHP Petroleum's proposed merger with Woodside Petroleum, MIRA/Aware Super's acquisition of Vocus, Seven Group's partial takeover of Boral and the bid for Sydney Airport by a consortium of super funds.

Internet data usage swelling
Many Australians no longer find themselves catching the train to work in the city. Instead, government-imposed COVID restrictions mean they are housebound, working from home and juggling the demands of home learning for schoolchildren. For this, they need a fast and reliable internet connection - and as a result, demand for high speed broadband has gone through the roof. Uniti Group's share price increased by 133% for the year, with "work-lifestyle changes making fibre networks an essential commodity"[2]. Aussie Broadband (ABB) has seen revenue growth of more than 80% from its residential and business customers.

Solid demand for cars
While at home, people are getting onto jobs that usually take a back seat, such as renovating the house or upgrading the family car. Based on VFacts, the Australian new vehicle market grew +38% over Jan-May 2021. Strong demand, reduced discounting and a normalisation of parts and servicing demand has contributed to explosive car dealers' results.

We have seen very strong profit results and growing forward order books from dealers like Eagers Automotive (APE) and Autosports (ASG) - both companies' share prices have appreciated over the previous 12 months, at 145% and 118% respectively. APE's "order bank growth is expected to continue as new vehicle demand remains strong and vehicle supply remains constrained"[3].

Source: Morgans, ABS

Renovation explosion
Further to the above, Australians are building and renovating their homes with vigour, driven in large part by support from the Federal Government's Homebuilder program. James Hardie's Asian Pacific region's sales growth increased 55% in the three months to the end of June. As an aside, the US restore and restoration market also grew at around 15% in the previous quarter.

Source: J.P. Morgan, ABS

Weak travel results
This spending around the home has come at the obvious expense of travel, with significant losses reported by the listed travel companies (Qantas $1.8b loss, Flight Centre $507m loss, Corporate Travel $33m loss). It's refreshing to hear from a CEO who states it as it is, and Rex was perhaps the most direct of the airlines with its outlook statement, saying "the second half will still be struck by further waves of infection given the experience of other highly vaccinated countries. As such the outlook for the FY is pessimistic."[5]

"It's not for lack of trying. Australians are ready to travel. Qantas Chief Customer Officer, Stephanie Tully, commented: "So we [have] obviously been researching our customers throughout the pandemic on their desire to travel and doing that monthly and in the last couple of months, particularly for international, we've seen the highest demand levels we've ever seen. When you compare that to pre-pandemic levels of people that are likely to travel in the next 12 months, we're seeing triple the amount of people looking to travel internationally in the next 12 months."

Aircraft are being pulled out of storage, including the A380s, and reconfigurations are currently underway with the intention to return to the skies when the magical 70% and then 80% vaccination rates are achieved. Bolstering management's confidence was the strength of the domestic business in the June quarter of FY21 - by the end of June, management basically saw the domestic business booking curves back to pre-COVID levels.

Concerning inventory levels
Arguably the number one theme of reporting season has been online retailers ending up with too much inventory.

Everyone seems to want to 'invest' in inventory as a strategic play. A stretched global manufacturing and supply chain is creating challenges - including longer lead times, higher freight costs and shipping delays - leading to companies growing inventory levels. Supercheap Retail (SUL) management said: "If it's [inventory is] not in the shed or on the shelf today, for Christmas this year I think the chance of it being [in stock] come that peak time is incredibly remote."[7]

However, we do not want inventory growth outstripping sales growth, and this is something we'll watching closely in future periods. Retailers (BRG, SUL, KGN) continue to show higher levels of inventory and it's concerning us. Only JBH and BBN have managed to keep inventory days down so far. Whether customers will be the major beneficiaries of heightened promotion activity (for inventory vulnerable to obsolescence such as technology) remains unknown; only time will tell.

What does all this mean for the future?
With COVID vaccinations accelerating across the country, we believe Australians can look forward to a happier 2022; with blunt lockdowns less likely, and more targeted measures introduced when COVID hospitalisations or deaths spike. At the time of writing, ~60% of Australians over the age of 16 have received one dose of vaccine while ~35% have received two doses. Globally, more than 5 billion doses have been given.

Source: Australian Government 

Department of Health

We predict the 70% threshold for vaccinations will be reached by the end of October, which will be around the same time as AGM season. Our view is CEOs will start to get more optimistic around this event. This is likely going to continue the rotation towards coronavirus-impacted sectors. 

The Kardinia portfolio is positioned for re-opening, with stocks that benefit from this comprising ~30% of the long book and lockdown stocks only ~10%. We believe some themes, such as the shift to online, are enduring, and we continue to hold exposure to the technology sector. Of course, new COVID variants and government nervousness around a likely rising death rate (as witnessed overseas) present risks to our view, but the Kardinia fund's ability to shift its net exposure to markets in a range of -25% to +75% allows us to quickly respond to any change in outlook.

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Covid-19 has created an unprecedented global change in how we pay for things. There's been a profound and permanent change in behaviour in Australia and many parts of the world.

Payment apps are easy to use, they offer improved security and the work from home offers balance introduced since Covid means more time to browse from home via laptops and phones, says John Lobb

Insync's Portfolio Manager, John Lobb tells us more on The Rise of the Contactless Economy Megatrend.

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Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

10k Words - September 2021

Equitable Investors

8 September 2021

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Equitable Investors Dragonfly Fund

To invest or not to invest in China?

Robert Swift, Delft Partners

September 2021

Investing in China remains a moral question, but to not invest now because of more government intervention and capricious legislation is illogical, since that would be to ignore the fact that these trends are clearly evident in other countries. More government, capricious and unexpected legislation to the apparent detriment of companies and shareholders, is now omnipresent as a global systemic risk to equity returns. Consequently, prepare for lower rates of profit growth and 'fatter' tails in your investment outcomes, even if you decide to never invest in China again.

There are similarities between Xi Jinping's increasing intervention in the Chinese corporate sector and those by Western governments

1. Policy with social objectives (with a lack of awareness that the years of free money created the wealth inequality in the first place)

2. More taxation and worryingly more centrally directed capital allocation and subsidies (Tesla anyone?)

3. Penalising 'rentier capital' aka private savings 

4. Population coercion to behave by scare tactics/messaging, and surveillance; China uses facial recognition software and 'social scores' (but you may care to read this: Amnesty - New York Police Facial Recognition Revealed)

At least China has finally done something about moral hazard which would still seem to be prevalent in 'the West'. China Evergrande is 95% certain to default on over $80bn of bonds and we'll have to see how that pain gets allocated between locals and foreigners before making more judgements, but bankruptcy is part of capitalism, or it used to be. In this respect China is ahead of the US perhaps and certainly the Europeans in letting a failed enterprise actually fail.

For those of you who think that China's decision making comes without due warning and therefore makes it too risky in which to invest, the second part of the US 'Infrastructure' bill, equal to a 3.5tln $ spend, will take 17 days (!) to debate. Obamacare took 9 months even with a significant Democrat majority, (which is not the case now) and FDR's programmes were spread over his first 2 terms - 8 years. The UK government recently announced hikes on national insurance and dividend tax increases in essentially a unilateral decision by the prime minister. The unelected European Central Bank has essentially decided both monetary and fiscal policy for Europe and the result has been less than stellar growth. The Euro remains a political construct not a valid economic one but it's an ideology akin to 'Mao thought' and so on we go regardless.

In short, governments everywhere are consulting less and intervening more quickly.

Government exist to provide essential services but to also redress other imbalances dangerous to national cohesion - or they should. Currently imbalances are very evident in wealth inequality and the share of profits in the economy relative to wages. Using the US data (the best around) we can see from the chart below that corporate profits have been on a rising trend relative to wages. Since the consumers of the companies' products need money with which to buy them, this % allocation tends to oscillate around an average. If wages rise too quickly then companies become less profitable, can't invest and won't hire which the reduces wage growth. Vice versa. Sometimes a nudge is needed - the General Strikes in the 1920s, the Reagan, Thatcher, Laffer curve revolution of the late 1970s and the Schroeder reforms in Germany in the 1990s serve as examples.

Source: BEA, BLS

This swing back to wages is needed and will come with the attendant ever bigger government. Don't blame government - blame companies that have indulged in such anti-social behaviour as zero contract hours, and paying no taxes while enjoying the legal protection, trained workforce, and infrastructure that other people's taxes have provided. Could this have been prevented in the last few years had companies perhaps not bought back stock to the tune of c$900bn p.a., significantly benefitting corporate executive share option schemes, and instead raised wages, increased re-investment and improved job security? This imbalance got a big tailwind from ZIRP aka "monetary policy for rich people", and so we would actually view this shift as much need rebalance because without the rebalance...economic distress causes revolutions and if you want examples checkout Wikipedia -The_Great_Wave

Two final thoughts.

Trickle-down economics is dead and as investors you should prepare for more government, National Industrial Polices, thus more inflation and taxation and lower returns from equities. Our advice is to focus on smaller companies since they are seldom directly in the firing line of legislation, find companies that do 'useful things' such as building a country's capital stock, look very closely at Japan which we think is both cheap and showing change for the good, and increase the volatility of returns if you do such things as portfolio optimisations.
The moral issue of investing in China requires consistency. If you don't like the idea of benefitting from profits made in China's repressive regime, shouldn't that dislike include profits made in China regardless of the geographical listing and domicile of the company?  

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One way or another China is always in the news. The current nervousness by some fund managers surrounding China is a reflection of the risks involved, while others see resulting lower prices as an opportunity.

In this video Chris Gosselin explores both sides of the argument with Rob Swift from Delft Partners, Jack Dwyer from Conduit Capital, and Alex Pollak from Loftus Peak.

Damen Purcell, COO of Australian Fund Monitors, speaks with Jonathan Wu, Executive Director at Premium China Funds Management.  

The Premium Asia Income Fund began in August 2011 and has achieved an annualised return since then of 9.63% with an annualised volatility of 5.52%. The Fund's up-capture and down-capture ratios (since inception), 132% and -60% respectively, highlight its capacity to significantly outperform over the long-term regardless of market direction.  

Funds operated by this manager: Premium Asia Income Fund, Premium Asia Fund, Premium China Fund

Best and Less Group Case Study:

How Do Private Equity Managers Make Money?

Vantage Asset Management

03 September, 2021

In the third of our case studies on how Private Equity managers make money and the importance of exits (Part 1, Part 2) we will examine a recent transaction that highlights opportunities that exist to transform assets that do not form part of a larger organisation's core strategy.

Turnaround opportunities often represent the higher risk/return opportunities in the Private Equity universe, however a distressed business can present a great buying opportunity to a Private Equity manager where they have a unique insight into what the problems plaguing a business are and have a clear thesis on how those problems can be rectified.

In a 2016 study by McKinsey "How private-equity owners lean into turnarounds", a comparison of the performance of 659 Private Equity backed and publicly owned businesses recovering from a distressed situation showed that the Private Equity backed firms recovered significantly faster than public counterparts.  Their study showed that Private Equity backed firms on average recovered their EBITDA margin within 18 months of a negative quarter, much faster than public firms.  McKinsey attributed this to Private Equity owners holding management teams accountable for driving a turnaround and the speed at which Private Equity backed firms decide upon and in turn, implement turnaround strategies.

But not all turnaround opportunities come in the form of distressed businesses.  Sometimes opportunity comes in the form of an "unloved" or non-core asset within a larger business that is undertaking a strategic change in direction.

CASE STUDY: BEST AND LESS GROUP

The Best & Less business was founded by Berel Ginges and opened its first store in Parramatta in 1965. Best & Less predominately sold basic products (socks, underpants, tea towels, t-shirts, etc.) and was known for its frugal in-store appearance, with minimal fixtures, and an advertising slogan of "You don't pay for any fancy overheads". Like most successful Australian retailers at that time, Best & Less opened new stores and transitioned into a national retailer.

In 2012 Best & Less' ("BLG") new owner Pepkor put in place a new management team to reposition BLG and improve financial performance. As part of a renewed focus on product, BLG's strategy evolved, with the aim to be "famous for the baby and kids' categories" as well as for underwear. New design, buying and planning capability was added into these functional areas and purchasing directly from manufacturers increased.

Further transformation of the business progressed from 2016 when the current CEO Rodney Orrock joined the business however after the acquisition of Pepkor by Steinhoff International, Best & Less was integrated into Steinhoff International's Australian furniture division which included the Freedom Group. During this period, BLG operated within a group that had a different focus in respect to strategic, operational and financial outcomes as well as capital allocation. Important elements of the BLG transformation program were put on hold, trading and inventory decisions were affected and sales and profits were adversely impacted, especially in FY19.

Steinhoff International, through its Australian subsidiary Greenlit Brands, divested BLG to Allegro Funds in December 2019 after a strategic review of its holdings.  Allegro Funds then put in place an experienced Chair to oversee the delivery of three significant outcomes:

1. Separate Best & Less Group from Greenlit Brands and take control of its own strategy
2. Accelerate the disrupted transformation program
3. Set a more ambitious growth strategy

During the period following Allegro Funds' acquisition, BLG successfully established itself as a standalone business, accelerated its business transformation and traded through COVID-19, during which BLG experienced continued sales growth. This occurred by bringing focus on the following key areas:

• understanding the customer;
• attracting traffic to each channel;
• growing the baby and kids' categories;
• ensuring that online sales were profitable;
• increasing the Friends Club database while concurrently upgrading the customer relationship management (CRM) capability;
• improving productivity;
• optimising the store portfolio; and
• improving the performance of Postie by introducing the key elements of the Best & Less brand to the Postie offer.

Under Allegro's turnaround program BLG has repositioned from a discount retailer to a value apparel specialty retailer with a 245-physical store network in Australia and New Zealand and an online platform across its two brands:

• Best & Less (in Australia); and
• Postie (in New Zealand).

With approximately 50% of product sales being in the baby and kids' categories, BLG aims to be the "Number One" choice for mothers buying baby and kids' value apparel in Australia and New Zealand.  Revenues have increased from $608.7m in FY19 to $663.2m in FY21, which includes a remarkable doubling of online sales in the last two years.  More impressively,  EBITDA was reported at $71.6m for FY21 up from $24.5m in FY19 and an increase of 165.2% for the year.  This validates the effectiveness of the changes that Allegro and the management team put in place.

During July 2021, Allegro completed the successful exit of BLG via an IPO. Best & Less Group (ASX: BST) listed on 26 July 2021 at a share price of $2.16, giving it a market capitalisation of $271m. Pleasingly BST has continued to perform since listing up 63c from its listing price at the end of August off the back of recent results well in excess of prospectus forecasts.  Once fully completed the exit will deliver Allegro fund investors, including VPEG3, with top tier performing returns across a 1.7-year investment period. 

If you would like to share in the growth and ultimate returns derived from similar small to mid-market company investments, Vantage Private Equity Growth Fund 4 ("VPEG4") remains open until 30 September 2021.

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