As we hit the halfway point of reporting season, we have seen a resilient domestic and global economy support FY23 earnings.
So far, there have been more beats than misses for FY23 at a ratio of 2:1.
However, this positivity has not extended to upgrades for FY24. There appears to be a growing sentiment that FY23 might be peak earnings for some stocks and sectors, such as retail and the banks.
In terms of upgrades, we have seen 38% of companies (that have reported) with upgraded FY24 consensus earnings in August. Reporting season has not stopped the trend of downgrades on the ASX 200, with the gap between the number of companies upgraded and downgraded widening.
We still believe that FY24 profit risks are to the downside.
Consumers Holding On: Navigating a Tougher Year Ahead
The major retailers that have reported to date have delivered better than feared results in the face of sharp increases to interest rates, the fixed rate ‘mortgage cliff’, and widespread cost of living pressures across the domestic economy.
Sales across JB Hi-FI (JBH), Super Retail (SUL), Nick Scali (NCK), GUD (GUD), and Bapcor (BAP) all showed a resilient consumer at home and abroad for FY23. FY23 sales were growing across these companies.
How is the consumer doing this?
Savings and mortgage buffers - Australian consumers have showcased resilience thanks in part to a savings buffer, built up during COVID, that has allowed them to weather higher rates and cost of living pressures.
Mortgage rates not completely felt yet - Households are currently experiencing a somewhat muted impact from recent rate hikes, largely due to the timing of their transition from fixed-rate to variable-rate mortgages. Notably, a considerable portion of households have made this shift within the last quarter. As a result, the full brunt of rate increases has yet to be felt by these households.
Taking Stock on Inventories
The inventory levels reported by retailers and distributors have generally pointed to a positive trend, with inventory days ratios trending downwards over the year for companies. This is particularly constructive in the context of less aggressive promotional activity/discounting required to clear stock given the softening macro backdrop. Broadly speaking, elevated inventory levels are a concern for retailers given:
- It can be a forward indicator of softening consumer demand.
- It can necessitate discounting to clear stock, weighing on gross margins.
- Inventory costs money to hold and excessive working capital levels weigh on free cash flows.
- Write-downs may be required for unsold, obsolete goods.
Therefore, it is a positive sign that inventory levels generally remain in check, indicating retailers and distributors have been relatively resilient to date in spite of rising costs of living and a softening macro backdrop. This does not mean we are out of the woods yet and we still believe a rise in promotional activity may be required over the next 12 months as the consumer comes under further pressure.
Cost of Doing Business Climbing
Both SUL and JBH are currently grappling with increases in their cost of doing business (CODB), with factors such as labour, rent, and energy costs contributing to this rise. This upward trajectory observed during 2H23 is anticipated to extend into 1H24, leading to a higher proportion of CODB relative to sales for both companies.
As these trends unfold, retailers will need to implement effective cost-management strategies to navigate the evolving market conditions successfully; however, this certainly adds another risk to the retail sector.
Kicking the Can Down the Road
For most retailers, this is peak earnings. JBH, SUL, and NCK all signalled that like-for-like sales or sales orders had fallen in July relative to last year. Consensus is expecting FY24 earnings to fall for JBH, SUL, and NCK.
While the consumer has remained resilient, it is important to recognise this can change very quickly, and the operating leverage of these businesses works both ways.
Forecasts indicate interest rates will likely remain restrictive until at least August 2024. The fixed-rate ‘mortgage cliff’ is only halfway through, with a peak in the fixed-rate expiry in 1H24, this impact is expected to hit households with a lag. This transition could usher in a period of increased financial pressure, testing the mettle of Australian consumers. Therefore, we expect consumption to continue to slow over the next 12 months.
Downside Risks Moderating
The earnings outlook for retailers is bleak, however, this is now reflected in consensus. While there still remains some debate on the magnitude of how bleak earnings will be, we see less downside risk to retailers' forward earnings in FY24 than we did 6 months ago.
These retail stocks look cheap on a PE basis. However, we struggle to buy stocks where earnings are going backwards, and still believe that in an environment of negative economic news flow, the retail sector will struggle to outperform on a 6-12 month view. Stock selection in the sector will be key to outperformance.
Telstra (TLS) – Turnaround ongoing but delay to key catalyst
The TLS result was solid. FY23 EPS beat expectations, while the FY24 guidance was consistent with consensus.
Telstra (TLS) has strategically implemented price increases within a more rational mobile market, leading to a steady rise in average revenue per user (ARPU) since 1H21. 2H23 ARPU growth slowed slightly relative to the previous half (2.4% vs 3.7%). However, we expect ARPU to continue growing over the next 12 months. This was a driving factor behind the company's robust guidance regarding price adjustments.
Concurrently, TLS has demonstrated an impressive ability to retain its existing customer base and take further market share, resulting in sustained subscriber growth, even in a rising price environment. This growth trajectory remains a core focus for the company as it moves into FY24, further reinforcing the strength of its service and its position within the mobile market.
Furthermore, the company remains committed to its medium-term objectives, which encompass achieving a 'high teens' compound annual growth rate (CAGR) for EPS up to FY25. Despite the challenges posed by an inflationary environment, the company aims to accomplish a substantial portion of its ambitious $500 million cost reduction target by the close of FY25.
Infraco shelved
The choice by management to postpone the monetisation of InfraCo Fixed assets was disappointing. We expected a partial sale or spin-off to boost shareholder value and fund capital management. Although an InfraCo sale was not the sole reason to hold the stock, it was a significant near-term opportunity for a revaluation uplift.
We think the stock still looks reasonably well priced at 7.6x for ~7% FY24 EBITDA growth, and continue to see earnings upside from ARPU over the next 12-24 months. However, we are disappointed at the loss of a near-term catalyst.
Goodman Group (GMG) – Good result that gets better
Overall a strong result, driven by significant contributions from development and investments. FY24 earnings growth guidance was slightly below consensus (9% vs 11%). However, GMG tends to underpromise and overdeliver, so we see upside risk to guidance over the next 12 months.
GMG remains one of our preferred real estate exposures with low gearing and a track record of achieving above-market EPS growth. Investors should be exposed to in-demand sectors, such as GMG's logistical warehouses, with high occupancy and tight supply that should continue to drive organic rental growth.
Data centre diversification
The company aims to achieve this by developing an impressive 3-4 gigawatts of data centre facilities across its existing portfolio. To put this into perspective, this could be ~10% of the total GW’s used globally in 2030. This is expected to hold an approximate end value of $30 billion.
Around 30% of Goodman Group's ongoing development projects, valued at a total of $13 billion, are dedicated to the development of data centre facilities. This proactive approach positions the company at the forefront of this dynamic sector.
We like this strategy due to:
- Diversification of assets to another in-demand sector of data centres.
- Comparable typology - We can draw parallels between current distribution centres and data centres from a construction and development aspect.
- Customer synergies - Amazon is a key tenant of GMG’s distribution centres. Amazon Web Services (AWS) would be a key tenant for GMG’s data centres. GMG is not starting from scratch in building key relationships with one of the largest hyperscalers globally.
GMG still looks reasonable at a fwd PE of 21x with 9% annual earnings growth over the next 3 years (with upside risk to earnings due to data centres).
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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