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Wood for the Trees | October 2021
15 October 2021
We’ve led with an earnings season graphic this month as we acknowledge yet another stellar reporting season for the vast majority of the S&P500. Up more than 40% year on year, with results beating expectations by a healthy 10%. No wonder equity markets pushed higher in October. After a poor September, with weak returns and mounting worries of Covid infection rates going higher, tight supply chains and rising inflation, October was a refreshing reminder that corporations are resilient and agile, pulling levers within their control to future-fit their businesses according to changing environmental conditions. The proof of the pudding is in the eating, and analysts have had to eat humble pie in October, adjusting their valuation models higher as a result. This month we look at inflation and the strength of US earnings on our offshore radar, while locally, we spend time considering what the data tells us about the health of the South African consumer, surprising to the upside yet again.

We hope that you’ll enjoy the read and will spend a bit of time unpacking the SA budget in December which has just been released at the time of writing the update this month.

International section

By the Numbers

After a dismal September, October produced a strong bounce in global equities, buoyed by robust 3rd quarter earnings growth coming out of the S&P500. Year on year, the 3rd quarter produced earnings growth of more than 40% and, while a strong bounce was anticipated, consensus numbers were 10% on the low side. This “catch up” trade was enough for the market to see through heightening concerns of inflation and subsequent moves in yields. At the end of the month, the US led the pack higher, pushing fresh all-time highs and rising 7% in the process. The rest of the pack was some way behind, with the All Country World Index rising 5%. The downside was underpinned by Japan, but it was a much better month for China as the market became more comfortable with the risk associated with a large property developer defaulting (Evergrande) and the pace at which the government had begun to regulate a variety of industries. Topping the table in the US for October was a company called Nvidia, which has been on a tear since May. For those not familiar with Nvidia, the company produces chips (not fried). On the Nasdaq, Elon Musk made headlines regularly as the world’s richest man, with his wealth catapulting higher, driven by +40% gains for Tesla in the month. Nice to see HSBC near the top of the FTSE100 and in Hong Kong as well – driven by what we imagine are expectations that a steeper yield curve will give them some net interest margin with which to work. We hope this will be the case as this stock has been a disappointing hold for us for a number of years. Gainers in the month were more significant than losers, other than Teamviewer in Europe, which was down roughly 50% in October (they are software providers that facilitate online support and collaboration – in fact it is installed on my pc). It would be unfair to call it a meme stock, but it was a stock that was up 100% in 3 months post the Covid lockdowns, but it has been losing ground ever since. This time, lower guidance unsettled it. Even after the 50% fall in the month, it still trades on a PE of 54.

Inflation – transitory or not – stills needs to be navigated

One phrase that has dominated the market’s attention more than any other over the last couple of months is INFLATION. Current Inflation levels are moving into a territory that has rarely been seen, driven by pent-up demand and supply bottlenecks. With the US Fed using inflation as its yardstick on whether to begin tapering and raising interest rates down the road, everyone is intently focused on whether these elevated inflation levels are “transitory” or more of a structural phenomenon.
Besides the broader macro themes and monetary policy implications that are driven by inflation, going into the third-quarter earnings results we were interested to see how various companies were adjusting to this inflationary environment and, more importantly, how consumers were responding.

Consumer goods companies are particularly sensitive to the effects of inflation; their margins are under scrutiny and their ability to pass on costs to the consumers is limited. Typically, consumer goods are fairly price-elastic, as any increase in price has a negative impact on volumes. Among these are Unilever, Nestlé, and Procter & Gamble, who all felt the weight of sustained inflationary pressures and operating in a volatile supply-chain environment.

Cost inflation and pricing is a highly complex dynamic. With consumer goods companies, there is typically an initial time delay between input-cost inflation and pricing. The timing of price increases in response to inflation varies by market depending on the retail landscape. It is also easier to push through price increases where the company is the market leader. Unilever has mentioned that it is more difficult to increase prices in developed markets compared to emerging markets in fear of losing market share – a sentiment echoed by Nestlé.

Within the consumer goods sector, we saw an interesting trend developing where companies were able to push pricing while at the same time holding volumes. As mentioned previously, this is not the typical relationship. Unilever management noted that they had experienced products that were once very price elastic turn inelastic as consumers accepted the implementation of higher prices without pulling back on volumes. This can potentially be pinned to the fact that this inflation theme is being drilled into consumers across all media channels, making price increases easier to accept.

We have seen both Unilever and Nestlé slowly push pricing more aggressively over the last few periods, with both expressing their intent to increase pricing further over the next 12 months.

The unnerving question remains: how many more price increases can the consumer take before they adjust their spending habits?

Despite these strong pricing trends, the increase in input costs is not being fully recouped, leading to pressure on gross margins. For now, companies can keep operating margins steady by cutting marketing budgets and SG&A costs, but this cannot last forever. Companies with strong pricing power and leading market positions are best placed to navigate this current inflationary environment.

It is not just the cost of raw materials that are pushing costs higher, but also constrained labour supply and transportation costs that are impacting operations, and there imparting further cost pressure into the system; nevertheless, customers are happy to pay more and thus keep margins intact.

FedEx and Amazon, two companies that are critical to the supply of goods across the globe, both reflected on the current labour environment driving inefficiencies in the operation of their networks and significantly impacting costs of getting goods to market. Packages are being redirected to fulfilment centres that have the labour capacity to receive products. In this case, diverted volume is rerouted to less efficient routes, adding incremental linehaul in delivery routes and leading to higher costs.

There may be some light at the end of the tunnel as Maersk, the giant marine freight and logistics company, who has seen profits triple on the back of higher freight rates, mentioned that container supply has begun to outgrow demand in the most recent quarter – the first time in more than a year.

This is a sigh of relief, and it is resonated by the Baltic dry index that has peaked and begun rolling over. Time will tell whether inflation is indeed “transitory”.

As hair-raising as some of these impacts may be, the consumer is still in a healthy position, and the problem of tightness in the labour market and high unemployment seems to be subsiding as payrolls increase. Demand is still healthy as consumers continue to place orders, which means lots of potential for the economy to grow and generate more earnings for companies. There remains a lot of liquidity in the system. Another positive is that we’ve been in a technological revolution that is driving productivity. Rising productivity is one of the reasons that profit margins have continued to move higher.

Earnings continue to be in the drivers seat

With 89% of US companies having already reported 3Q earnings, it is quite clear that analysts have once again underappreciated the earnings power of companies within the S&P 500. 81% of companies have reported numbers above estimates, representing the 4th highest positive surprise rate. The current 3Q earnings growth rate is 39%, with companies beating earnings estimates by 10.3 percentage points.

Despite all the talk of inflation and supply bottlenecks, this impressive bottom-line growth is being driven by revenue growth of 17% and margin expansion, as net margins move up to 12.9% (up 200bps Y/Y).

Company results

Another strong set of results from Alphabet, with revenues increasing 41% Y/Y to $65bln and EPS of $27.99, comfortably beating expectations. Alphabet continues to benefit from broad-based strength in advertiser spend and elevated consumer online activity, as well as a strong contribution from Google Cloud. Google Search and other ad revenues increased 44%, while YouTube ad revenues generated $7.2bln, up 43%. Google Cloud continues to grow above market rates with revenue growth of 45% Y/Y. GOOG remains an incredible cash generative company, generating $20bln in FCF in 3Q, and currently has $252/shr in cash and marketable securities on its balance sheet. GOOG is currently trading at a forward PE of 26x. Given its current growth rate of >40% and long runway, we continue to view the stock as compelling at current levels.

MSFT continues to be a beneficiary of digital transformation with 1Q22 revenues and earnings surpassing expectations at $45.3bln and $2.27/shr, respectively. All segments developed strong performance, driving revenue growth of 22% Y/Y, primarily driven by their Intelligent Cloud business, which saw growth of 31%. Azure, MSFT’s cloud server business, increased 50%. Operating margins expanded by 200bps to 45%, driving operating income and net income growth to 27% and 48%, respectively. Management also guided 2Q22 higher than current street estimates. MSFT currently trades at 23x EV/EBITDA and 34x PE, with growth above its multiples, and tech spending as a percentage of GDP set to double over the next decade. MSFT remains one of the cornerstones in the portfolios.

Apple has created an astonishing amount of value for its shareholders over the past decade, with its share price more than quadrupling. This earnings season was no different, as revenues increased 29% to $83.36bln for the quarter, coming in slightly below expectations primarily on the back of lower iPhone sales which were held back by component supply issues. Earnings per share increased 69% to $1.25.

The service business continues to move from strength to strength as Apple leverages its ecosystem. Apple paid subscriptions increased >30% to 745mln in the quarter. The service business now makes up >20% of revenue, with gross margin almost 2x corporate margins (70% vs 39%). We see a higher sustainable valuation for Apple as justified.

One of the questions about Apple’s service business is its ability to keep charging 30% royalty on App Store purchases given EPIC Games’ recent court case victory against Apple, which allows them to offer “out of Apple App Store” payment. A recent survey from Morgan Stanley revealed that customers would rather not interact with third parties, but prefer the direct agreement with Apple. They value the security and privacy that add-ons like the App Store offer.

This quarter, Shell generated record cash flow and announced an additional shareholder distribution of $7bln related to the Permian sale. Having the highest ever cash flow from operations (CFFO) of $17.5bln for the quarter, they were able to reduce net debt by $8.2bln. This brought down their net debt to EBITDA, and positions Shell to return capital earlier than peers.

PMI released results that were better than expected, but unfortunately, they were not unscathed by the semiconductor shortage as it resulted in tightness in their IQOS device supply. Consequently, they are having to prioritise their existing customers for user retention, followed by device sales that target acquiring more users.

As they transition to reduced-risk products, their heated tobacco units (HTU) continue to grow from strength to strength, as shipment volume was up 27.9% to 69.8 billion units year-to-date. These products account for 13% of the volume, while almost 30% of net revenues come from smoke-free products. PMI remains on track to meet its target of >50% of Revenues coming from Reduced Risk Products by 2025.

The continued growth of IQOS has been bolstered by the launch of IQOS ILUMA in Japan this quarter and was complemented by further sequential market share gains for combustible products.

In February 2021, PMI announced its ambition to generate at least $1bln in annual net revenues from “Beyond Nicotine” products by 2025, leveraging its expertise – in life sciences, inhalation technology, natural ingredients, commercial deployment, and ability to change consumer behaviour – to explore, develop, and grow new adjacent areas to deliver additional growth.

We confirm our confidence in PMI with its record high quarterly EPS and dominant position within the rapidly growing reduce risk market. PMI continues to be attractive compared to its peers and is returning cash to shareholders through increased dividends and share repurchases.

Local section

By the Numbers

SA investors continued to get whipsawed by the resources sector this month. No doubt that one needs a strong stomach to handle the monthly swings at the moment. Down 13% in September and up 9% in October. Not graphed below, but it’s interesting to see the moves in the gold index in October as well, all up between 14 and 20% for the month. Inflation hedge anyone? Our personal darling, the banks index, having a harder time of it this month – dropping 6% and getting the wooden spoon amongst SA sectors in October. Not a devastating drop though, as the index remains up almost 20% YTD even after this large pullback in the month. Property also leaked a bit, but some good results in early November have proved promising. The delisting trend for small caps in SA continues with Long4Life one of the top-performing “financials” (owning beauty parlours and sports stores), jumping 36% for the month on confirmation of having received an unsolicited expression of interest to take it out. Good moves also for Richemont and Anheuser (basically both just very good results in our view) and Royal Bafokeng (a platinum mine) up 48% on the back of a bid from Impala. Unfortunately for Implats, the table has been turned on them in early November, with Northam Platinum not wanting to be left out of the party, sneaking through the back door and acquiring a 1/3 interest in RBP on the sly! Whoever said it was boring in corporate SA? On the downside, we had Aspen giving up some ground on no real fresh news, but this must be seen in the context of a stock that has climbed 90% this year even after this drop. Sasol also pulled back as the rand, oil and global growth data points all seem to be yo-yo-ing around

SA consumer resilience continues

The general perception is that the SA consumer continues to be under strain, as the impacts of the pandemic linger and the civil unrests further disrupting economic activities in the country. We have maintained and demonstrated for some time that the SA consumer is better placed than prevailing sentiment would suggest. Recent data points continue to support our view that the average consumer is better placed than they were pre-pandemic.

  • Average pay continues to grow
    The BankServAfrica Take-home Pay Index (BTPI) for September 2021 reflected a 13.5% increase in normalised average salary, reaching R15,794. This is the highest average since February 2021. If you have a job, your take-home pay is increasing at a rate better than inflation.
The average private pension hit record levels in September, breaking through the R9,500 mark, the highest level ever recorded.
  • Consumer credit reflects significant improvements
    The SA Consumer Credit Index has improved significantly since 4Q20 to reach record levels, signalling a strong improvement in consumer credit driven by falling default rates, improved household savings and low debt service costs. The index measures consumer credit health where 50.0 is the break-even level between improvement and deterioration.
  • Private sector credit extension on a recovery path
    The private sector credit extension data is showing a steadily improving credit growth environment, recoving off the April/ May 2021 lows. Loans and advances increased by 3.32% in September off the 6% y/y pre-pandemic growth pace but moving in the right direction.

    • Household credit has recovered and is currently approaching pre-pandemic y/y growth levels.
    • Commercial credit has been lagging as companies have been paying down debt rather than increasing their borrowing. September commercial credit growth registered its first positive y/y growth since February 2021.
  • Tax receipts strong vs 2019 base
    Tax receipts for the first nine months of 2021 vs 2019 have increased, with employee tax up 5.3%, corporate taxes up 35.4% and VAT up 10.2%. The substantial tax receipts are a good indication of the strength of wages for employees and earnings for corporates, as generally, entities try pay as little tax as legally possible.

SA banks: valuations continue to discount a distressed environment

The financial sector has outperformed YTD, yielding a 17.26% return. Despite this performance, the banks remain at or below their pre-Covid price levels even though they remain profitable, credit risks are subdued, and balance sheets are rock solid.
Valuations across the four big local banks continue to reflect an environment where credit risks are elevated, and the banks themselves are facing balance sheet pressure. Credit loss ratios are tracking normal cyclical ranges and the banks, for the most part, are over-provisioned. The 12-month target prices, calculated by multiplying the exit book value and the target P/B multiple, present significant price upside potential, ranging from 12% to 48%.
Price/Book (P/B) valuation levels are significantly below our targeted P/B multiples. Additionally, current P/B levels are below the 5-year historical P/B multiples ranges, as reflected below.
Our 12-month target prices were calculated assuming sustainable ROE levelsand determined using management’s medium-term targets, which we see are reasonably achievable. Given these significant discounts, we did a sanity check and calculated the ROE levels that the market was currently implying at current stock levels. The results further encouraged our view of upside potential, as the implied ROE levels are below historical averages, while also below last reported levels for ABSA and FirstRand.
We believe that the ROE levels currently priced in are too conservative and do not reflect returns that the banks will deliver over the medium-term or the potential for reserve releases in the near term.
Ultimately, current valuations are attractive, and we continue to bang the drum on SA banks. If loan growth remains subdued (and not yet back at normalised levels), combined with the requirement for high capital adequacy ratios, should advances not pick up as expected, surplus cash will liklely be paid out to shareholders, resulting in increased total shareholder returns over the years.
ANH released their 3Q21 results on 28 October 2021. Results came in ahead of expectations, and management lifted the lower end of FY21 guidance. The stock reacted positively, jumping 14% on the day.

Against a tough quarterly comparative, ANH grew total revenue by 7.9% (17% for 9M21), driven by increased volumes at 3.4% (11.9% for 9M2) and increased pricing (4.3%), allowing ANH to be able to absorb rising cost inflation. Normalised EBITDA grew 3.0% (14.5% in 9M21), with EBITDA margin at 36.5%.

One of the positive takeaways from this quarter’s results was the ability of ANH to increase prices in key markets without a fall-off in volumes. Management increased the lower end of their EBITDA guidance, expecting 10-12% EBITDA growth for FY21 versus prior 8%-12%, as they expect the momentum of increased pricing and volume growth to continue into 4Q21 and 1Q22.

A long-term focus for investors has been ANH’s excessive debt levels. Management is doing a good job from this point of view, with leverage having improved to 4.4x in 2Q21 from 4.8x in FY20. Management continues to prioritise deleveraging to around the 2x level.

ANH continues to trade at an attractive valuation, both from a historical basis and versus its competitors. ANH is trading at a 32% discount to their 10-year average EV/EBITDA levels.

Closing Comments

Thank you for taking the time to read through our update this month. We hope that you’ve been encouraged by some of the information we have shared with you in October. Global earnings have been strong, and the fight against Covid has continued to gain momentum. While inflation remains the canary in the coal mine, interim earnings momentum has been supportive enough to set us up for a good follow-through to the end of the year. Stock selection in 2022 is likely to be critical as we transition to a world of higher inflation and lower liquidity levels.