This month the team spends a bit of time looking at the outlook for global advertising (a big driver in some tech earnings) and moves in global interest rate expectations. On the local side, we cycle back to topics we have covered in previous updates, looking once again at SA listed property (one of our biggest listed property companies now offering yields close to 14%). We also comment on SA bank credit exposure.
Enjoy the read.
By the Numbers
What a difference two months make
As we approached the Fed meeting on September 21st, forward rates suggested that another 75bps hike was a near-certainty, with a slight chance of a full 100bps hike being on the cards.
The September meeting also saw the Fed members update their forward expectations for various important economic figures and their views on where rates will be over the next three years.
Firstly, the Fed members suggest that they can successfully navigate this inflation cycle without triggering a recession.
Secondly, the Fed expects the unemployment rate to go from 3.5% in July to 4.4% in 2023. History suggests that a movement in the unemployment rate of this magnitude almost always triggers a recession.
Don’t advertise harder; advertise smarter
During these unprecedented economic conditions, we are paying attention to what companies and industry experts say about the ad ecosystem. Notably, as many companies face margin pressures due to cost inflation, the easiest string to pull is to cut marketing budgets and reduce ad spend to protect margins. For some companies, this cut in ad spend is also due to product availability. Supply constraints have limited product availability, reducing the need to advertise or stimulate demand.
Additionally, demand has been so strong that it took minimal effort to make sales. The sole driver of sales has been nothing more than having products available for customers. Auto manufacturers substantiate this, as vehicle inventory has been very lean due to the shortage of semiconductor chips required for car production. “We’re selling every vehicle we can make right now,” noted the CEO of General Motors in their most recent earnings call. “They’ve been waiting, and all indications are they remain ready to buy.”
As supply chain constraints begin to iron out and availability returns, we hear that these companies are planning to increase ad spend in the second half of the year.
Nestlé was one of these companies that made a tactical move to cut ad spend due to supply chain disruptions, saying that you “should not promote what you can’t sell”. The Hershey Company’s CEO said, “it didn’t make sense to make those investments given some of those constraints. But we very much look forward to re-upping the investments as we look at the second half [of the year]”.
Unilever seconded this: “And as far as the second half is concerned, we’ll continue to invest more in brand and marketing investment.” This ad spend is going digital, as noted by the comment: “…investment in digital, whether that be in our supply chain, our marketing, or in our relationship with customers and platforms.”
So again, we see the recurring theme where marketing budgets were cut and companies are now planning to increase their ad spend and marketing investment.
There are other trends that are coming to the surface when looking past the irregularities mentioned above. There are opportunities for companies to transform their ad spend and placements. As companies reflect upon the best strategies to optimise their ad budget, it has become increasingly important to use AI, data, and analytics to find the most effective measures and return on investment (ROI). This has led to the revolution of ad spend that is disproportionately favoured towards digital advertising. Digital continues to be a key driver of global ad market growth and remains on an upward trajectory.
Companies also see the benefits of different ad partnerships to help advertisers reach customers in innovative ways. Walmart is building on the recent expansion of its ad partner program by adding ‘innovation partners’, which will help advertisers reach customers in new ways across the shopping journey. Tapestry, which sells designer bags and shoes, is also following the social commerce trend to reach customers. In their most recent earnings call, management said they continue to invest in their marketing program as they test innovative ways to engage with customers and expand their use of influencers on social platforms.
Another topic of discussion is the ad-supported tier that streaming services like Disney, HBO, and Netflix offer. Subscription Video on Demand (SVOD) and the convergence of the internet and television has enabled access to new ad space and increased the addressable media possibilities. Over 50% of content viewed is via SVOD, while only 10% of marketing budgets currently target this format. This is where AI and algorithms step in to measure and analyse cross-platform metrics and findings. Microsoft has recently partnered with Netflix on its prospected ad-supported streaming service, making the massive streaming audience available to marketers and brands, while endorsing Microsoft’s full-stack ad platform in this profitable ad market.
Another one of our holdings involved in the ad market, Apple, has recently announced that it would expand its ad business and increase its advertising inventory due to strong demand. This move comes at a time when Apple is investing to increase its revenue from services and strengthen its recurring revenue.
In the near term, catalysts exist that will boost ad spend and benefit our Ad-Tech holdings. Towards the end of the year, the 2022 FIFA World Cup in Qatar is forecast to have a $2bn ad spend. With the US midterm elections on November 8th, political spending will boost ad revenue in September, October, and November and is estimated to hit a record of $9.7bn. Keeping in mind that this spend goes over and above the annual festive advertising around Black Friday and the seasonal holidays.
If companies are to flourish in this ad space, platforms should allow for easy and flexible ad management options and a variety of ad placements while responding quickly to ever-changing consumer and market demands. This allows the customer to be more tactical and efficient, thereby protecting profitability for shareholders.
Customers are looking to buy value as the environment gets more constrained, and this ad spend will be drawn to an increasingly performance-driven ad ecosystem. There is a fundamental shift in advertising. As we enter into a new ad era, we look to hold companies that show competitive strength in all aspects of digital advertising across all sides of the value chain. For these reasons, we believe Google, Microsoft, Apple, Alibaba, and ITV stand to benefit from these advertising trends.
By the Numbers
SA listed property: time to start paying more attention
Discounts to underlying NAVs remain excessive
The price to underlying NAV is a strong sentiment indicator as it shows how the market is pricing property names versus their underlying asset valuations. A premium suggests that the underlying assets are growing faster than the cost of equity, while a discount suggests that asset prices will weaken. On average, across the listed property sector, the market is pricing in a discount of around 40%. The integrity of the underlying NAV is a critical component, as an incorrect estimation could skew this metric. However, results show that property sales are taking place at or close to NAV. Therefore, the accuracy of the NAV is sound, and the discount being priced in by the market can be attributed to pessimism towards the sector.
The continued focus by management teams to bolster balance sheets, increase dividend payouts, and get a handle on rental reversions while reducing vacancy rates as much as possible is a general theme across the sector. LTV ratios continue to fall, with most around the 40% level.
Retail: getting there, but it might take a bit more time
The biggest exposure across the SA property universe is to the retail sector. Covid created a perfect storm, and tenants forced the hand of landlords to provide Covid relief in addition to opening years of rental negotiations favouring the tenant. Given the risk of vacancy over reduced rentals, power shifted away from landlords and into the hands of retailers. The past year has seen a marked improvement in the retail sector. Covid discounts have largely washed out of results, and trading densities have increased – an important factor for future rental negotiations. The SA consumer continues to show incredible strength despite the challenges of high unemployment, inflation, and rising interest rates. Results from the major retailers and banks have been strong and clearly show that the underlying SA consumer continues to show resilience.
Almost all retailers are pushing ahead with expansion programs and hunting down space to meet those demands. Fairvest, in its pre-close results call for FY22, spoke of the strong demand from anchor tenants, noting that Shoprite, Boxer and Pick n Pay are aggressively looking for space. Truworths, TFG, Shoprite, Pick n Pay Stores and Woolworths have all provided store expansion plans in recent results.
Industrial: moving in the right direction
The industrial space has remained resilient over the past few years, and the rhetoric amongst the management teams is that the environment is starting to normalise, with valuations moving in the right direction. Vacancies are at low levels and continue to improve, with demand for space remaining despite the challenges that loadshedding has created in the manufacturing sector. SA Corporate reported negligible vacancies on their industrial book, while Growthpoint has indicated their expectation for rental reversions to turn positive in the next few months – a positive for the sector.
Office: looking up, but pressure remains
Tenants are starting to return to the office: smaller tenants are re-entering the market, while big corporates continue rightsizing. The demand for smaller space is increasing, existing tenants are taking up additional space, and tenants are committing to slightly longer leases than before. While there are shoots of recovery, the sector, in general, remains under pressure, with the Sandton area, in particular, an issue due to oversupply.
Vacancy rates have fallen in some areas, but renewal rates remain negative, although to a lesser extent than in the past. Landlords continue to sell non-essential buildings where appropriate. When pressured by investors on their plans for further sales in the office space, many have stated their intention to hold onto properties which, in their opinion, hold far more value than what is currently being offered in the market. The potential to repurpose office assets is constantly evaluated but only becomes economically feasible after a reduction in rent per m2 following a shift from office to other use. Growthpoint highlighted how the high cost of new developments is not feasible, which has provided some support, but the overall recovery in office is primarily tied to the economic growth in South Africa. Most management teams shared these sentiments.
Management confident enough to provide guidance
Historically, SA listed property has been in a position to provide clear guidance on distribution expectations. The uncertain macroenvironment of 2020 and the years which followed saw guidance removed from financial results, with the sector choosing to hold its cards close to its chest. The latest results season showed a change for the better, and we began to see guidance on FY23 distribution expectations. The decision to place this information in the hands of investors shows the confidence of management teams going into 2023, as the repercussions of coming short of these expectations can be severe.
Looking at distributions in detail, we have seen strong dividend declarations across the board. Net property income showed solid performance, with payout ratios climbing from the required 75%. The result saw strong distribution growth across the sector.
The underlying performance of the listed property sector continues to show much improvement from the dark days of 2020: balance sheets are stronger, vacancies continue to decline, reversions are beginning to see the light, and dividend payouts are solid. Retailers are demanding more space, and with it, a change in the tide from tenant to landlord is imminent. Market commentators, analysts and investment houses are starting to acknowledge the deep value that property presents, yet the market remains overly pessimistic in the face of macroeconomic challenges. As such, listed property is yet to feel significant demand from the greater market, and remains severely undervalued in our opinion. We are buyers of listed property at current levels.
SA banks: credit quality concerns are overblown
Recent bank results show strong performance, reflecting a resilient operating environment. Credit demand remains robust, while management teams focus on disciplined credit origination with tight credit criteria. Revenues and profits continue to grow at double-digit rates.
Furthermore, banks are beneficiaries of the rising interest rate cycle. The endowment effect on their existing loan books should continue to drive strong net interest income growth. Every 100-basis point increase in interest rates will positively impact net interest income ranging from 0.5% to 6.06%. Given that interest rate increases for 2022 will likely amount to 300 basis points, banks will benefit from a double-digit tailwind in net interest income in 2023 when the full impact of the rate increases materialises.
This is not a scenario we believe will happen as provision levels remain elevated, with the provision coverage ratio materially above pre-pandemic levels. It is therefore unlikely that banks would have to raise additional provisions, with excess provisions acting as a buffer should any unexpected decline in credit quality materialise.
Robust earnings supported an improved return on equity (ROE), while increased capital levels also supported healthy dividend payouts. In most cases, ROE levels are now above the cost of equity (COE).
Valuations continue to reflect significant upside potential, with our 12-month target prices suggesting an upside range of 20% to 45%.