Jonas Daly:
Hello and welcome to our podcast for March 2024. My name is Jonas Daly, Head of Distribution at Bennelong Funds Management. And today I'm joined by the BAEP Investment team, Neale Goldston-Morris, senior investment analyst in economics and market strategy, Brad Clibborn, portfolio manager and senior analyst, and Doug Macphillamy, portfolio manager of the Emerging Companies Fund.
I'd also like to make a special introduction to the recent joiner of the Bennelong Australian Equity team, which is Ron Sargeant. Ron has recently joined the team as a portfolio specialist and has more than 20 years of experience in finance, having worked in a variety of positions in Australia and Asia, funds management, equity research and investment banking.
In his role as portfolio specialist, Ron's primary role will be client facing. He'll be meeting with advisors, institutions and other stakeholders. He'll also be part of the BAEP investment team and in this role will also cover some stocks, but also report directly through to the CIO marketers. And is part of BAEP's commitment to its clients on increasing access to information. Ron, welcome. How's it going so far?
Ron Sargeant:
Thanks, Jonas. It's great to be on board. It was a really good way to start, doing reporting season with the team and meeting all of our companies and then obviously going out and seeing clients.
Jonas Daly:
Excellent. Well, welcome aboard and we look forward to working with you and the various advisors and clients over the course of the year. Neale, we'll just pass over to yourself on the global macro side. Always plenty of moving parts there. Let's kick off there as an update and then we'll dig into the portfolios with Brad.
Neale Goldston-Morris:
Thank you, Jonas. And welcome, everybody. Let's start with some broad-based good news. Both the US and Australian economies show clear signs of accelerating. Consumer confidence is rebounding. Labor market remains tight, people are confident about their jobs, they have money to spend and you're starting to see that in auto sales, consumer spending, et cetera.
In the US but also here. US GDP growth is the order of three and accelerating. We are coming up a lower base of one but accelerating. Most importantly, businesses have pricing power. That means over the next six months we should continue to see a broad base trend of earnings upgrades, EPS upgrades if you like, to many stocks. There'll be some not participating very well because they've not managed well, but that's always the case.
The price of that of course is that inflation is likely to remain very sticky. Those that are hoping for rate cuts, you might have to be patient until later this year or maybe next year. We shall see. But that's the partial offset if you like. But for the moment, the economy is actually operating very well.
In the reporting season, the overall industrials generated earnings pretty much in line with expectations. The result was about three or 4% EPS growth across that spectrum, particularly US-based did stronger. The one sector that didn't perform well was the resources. Large earnings downgrades. Not just because of some commodities that have fallen like lithium and the like, but some very poor operating results on large cost increases, production shortfalls and some very ill-timed acquisitions.
In our portfolios we have very low weightings to resources. Zero in the ex-20 and just a position in BHP alone in the other core portfolios. That's skew there. But in a nutshell from us, the economies are evolving much as we expected. In other words growth would exceed expectations, pricing power would exceed expectations, so overall operating results will be better than generally expected.
Jonas Daly:
Thanks, Neale. That was a great update from a macro point of view. But just turning to Brad more on the bottom up point of view, how did reporting season go on? Any observations from that one?
Brad Clibborn:
Yes, as Neale mentioned, it was a fairly solid reporting season. There was generally more beats than misses in profit results and margins were particularly stronger than consensus had forecast. As Neale mentioned, materials and energy were the weaker sectors, but a call-out was definitely the consumer discretionary sector where pretty low expectations were generally saw results ahead of that, particularly on margins and reasonable outlook statements, again against fairly low expectations.
But the reality is from a portfolio point of view is we build that portfolio bottom up with companies that can march to the beat of their own drum to some extent. We look for those companies that have a discipline of consistent reinvestment back into their business by way of R&D and brand building. Means they have a strong competitive advantage making them global leaders in their niche.
They have new products to release, they have new markets to enter, which means they can take market share over time. And that enables them to grow their earnings ahead of the broader market over the longer term without having to rely on the broader market cycle.
That's true whether it's a James Hardie and fiber cement siding, Breville and espresso coffee machines, or IDP in the education sector. The truth there is those broader themes don't always carry through the portfolio and we're really focused around the individual earnings of our companies and the drivers for them and as Neale mentioned, the strength in the economy is a mild tailwind, but it's really about the investment in their products that'll drive them over the longer term.
Jonas Daly:
Thanks, Brad. That's some big picture themes there that you've covered off, but anything in particular that stood out from a stock point of view this reporting season?
Brad Clibborn:
Yeah, Goodman was definitely one that delivered a really strong first half of FY24 profit result. Their earnings were up 29% and about 15% ahead of consensus expectations as well. The development profits were very strong, up 34%. And the outlook was solid with positive news flow on their four gigawatt data center pipeline, which has definitely been a big focus for the market over the last 12 months.
We expect the significant number of starts in the data center space over the next 12 months. And we should see data centers reach around 50% of their work in progress in calendar year 2025. And the other thing they updated in regards to the data centers is the demand is such that they see that pipeline playing out more over the next five to seven years rather than the next seven to 10 years just given customers really want to move faster and get that capacity on the ground.
That data center opportunity's accelerating. And meanwhile we'd probably say Goodman was more positive in terms of the industrial side of the business as well, looking out to 2025 and 2026 as the fundamentals remain quite strong in their core markets. It's another high quality business of ours that we see at compounding earnings at over 10% with strong industry tailwinds.
Jonas Daly:
Sounds good. And another stock that has done well for you is James Hardie. You've had a good run and got into that at the end of 2022 whilst others were a bit nervous there. That's done well. Is it looking a little bit toppy now or what are your thoughts there?
Brad Clibborn:
It's definitely had a big move in share price over the last 12 months, but I think it's important to put that in context. If we look 12 months ago, consensus expectations were for Hardie to deliver about 520 million of net profit in the financial year 2024 period, which actually ends at the end of March this month. Based on current guidance and consensus where we sit today, that is expected to be about $714 million of profit. That's a 36% upgrade to consensus earnings in the space of 12 months. It's a pretty big change in where earnings have actually landed versus what the expectation was a year ago.
And if we look at the drivers of that consensus view was that the US housing market would contract about 20% last year. It actually declined by about 6% in terms of new construction starts. And the other real positive from our point of view was we saw James Hardie market share accelerate and come in well ahead of expectations.
Typically Hardie will aim to grow their revenues or their volumes about 4% ahead of the market and they've been doing about eight to 9% growth ahead of the market over the last year. And their margin performance was far superior to what the market expected as well just given strong cost control by management.
Looking forward to the important thing from where to from here. As Neale mentioned, we do see rate cuts coming through sometime over the next six or 12 months or so, and that's starting to play into the psyche of the US consumer. Our calls with builders in the US, speaking about quite positive conditions into the spring selling season. We're seeing some tailwinds for Hardie from a new construction point of view.
As we do see rate cuts later in the year, we hope that to be a tailwind in the repair and remodel sector as well, which has been challenged through 2023. We think it's flattening out about now, but we do see tailwinds there over the next six and 12 months and beyond. From evaluation perspective, PE multiple a year ago was about 18 times for James Hardie. Today it's about 23 times. And that's broadly in line with its pre-COVID average where it traditionally traded in that 20 to 25 times PE.
It still looks very sensible when you look at the overall industrials complex in the market today, trading just shy of 24 times earnings. And particularly when you overlay our view that James Hardie can continue to grow earnings in the double-digit range as they continue to take market share in the US and Australia.
As always we'll be focused on earnings and we continue to really focus on our channel checks into their customers and competitors and suppliers in the US and we'll keep close to that as the spring selling kicks off. It's good that it's off to a strong start, but ultimately it's going to be the earnings that will drive the share price from here.
Jonas Daly:
Great, that sounds like a very solid position in the portfolio and one that's probably going to be there for a little while. But anything else on changes to the portfolio? Anything that is worth highlighting?
Brad Clibborn:
Yeah, I might talk about A2 Milk, that's one that we've added into the portfolio over the last three to six months. A2 is the owner of the A2 Platinum Infant formula brand. The majority of their sales are into China and they sell both an English label product via the cross-border e-commerce channel and they also sell direct in China via their China label registered product into stores, mother and baby stores, supermarkets and online as well.
We rewind back to early COVID, A2 had some major issues. They sold way too much inventory into the channel, which really killed earnings and took multiple years of clean up. They've had a new management team in place for the last three and a half years that have been working on fixing up their go-to-market channels for A2. And we've been closely monitoring the progress of the new CEO, David Bortolussi, since his appointment. And over the last two years have been meeting regularly one-on-one with that management team to build conviction around their execution. What didn't change through the missteps they took was the brand remained very strong in China and has continued to gain market share.
And if we look at where they're positioned today, they've made significant changes in the distribution channels, meaning that A2 is now much closer place to its customers and has much more control over its distribution. Makes it a much more sustainable business model. They've significantly increased the reinvestment rate in the business. Marketing was about 11% of sales back in FY20. And now it's 16.5% of sales and they've increased marketing 40% to $260 million. Significant increase in investment in the brand.
The other increase in investment, prior management had total disregard for new product development. And the new team has really focused in on new product development and will have their first new products coming out in the June quarter this year. All of this has given us confidence in quality of management and the go-to-market channels.
The infant formula market in China has been declining over the last 18 months due to some headwinds from a decline in the birth rate. The demographics do suggest some mild longer-term headwinds in new births, but that was really exacerbated by the COVID lockdowns in China. This saw quite dramatic change in birth rate over the last few years and we expect to see some recovery from that over the next couple of years, which should see some stabilisation in the infant formula market in China.
Importantly, we do see a strong earnings growth opportunity for A2 over the medium to longer term from further market share gains. A2 today has about 7% market share in the Chinese infant formula market. But if you break that down in English label, there are about 20% market share, largely sold via the Chinese e-commerce platforms. In the domestic China market, they're only 3.5% market share and that domestic China label market is about 85% of the overall market, so it’s significant market size where they've had strong market share gains. Their share in that category is up 50% over the last two years. We continue to see them gaining momentum and expanding their distribution, taking market share in the China label segment as well.
They reported results in February, it was a strong result with revenue 3% ahead of consensus and EBITDA about 10% ahead of consensus. It shows that they're getting traction are in the changes that the management team's made over the last several years.
And lastly, just to finish on A2, they do have a really strong balance sheet with net cash of about $900 million, which is almost 20% of market cap. And we think there's opportunities for them to deploy that over the course of the next six to 12 months. And that should have helped them to accelerate new product development as well. That's a new one in the portfolio that's had a good result through February.
Jonas Daly:
Excellent and sounds like a great growth story there. And just on that growth story, we are here today with Doug Macphillamy who does focus on the Emerging Companies fund at Bennelong. It's a fund that many may not know about, but it really is focused in on that small company side, micro caps if you like, of those stars of the future in the Australian stock market.
I'm going to embarrass Doug a little bit here and just talk about his performance being number one over five years in the recent Rainmaker survey to the end of December 2023. But over the one year, outperformed the index by 14.36%. Five years, 14.53% and then since inception of 10.99%.
That's well done on the numbers there, Doug. But today look, I'd like you to give us an update really on how the portfolio is currently positioned, and how it fared in reporting season as well.
Doug Macphillamy:
Yeah. Thanks, Jonas. Look, as always from the smaller end of the market, there was a wide dispersion in performance. Suffice to say though, I think we're back to being in a stock pickers market. It was a good month for the Emerging Companies fund. It was up 6.3% in February versus I mean the small ords are up closer to 1.7%.
In terms of some consistent features we found across businesses that we follow closely, the top lines were generally pretty volatile, reflecting a mixed macro backdrop. Gross margins held up a bit better than expected in terms of discipline on discounting and freight costs easing.
Companies in general are doing a pretty good job managing their cost base. But when I go back to how we look at things in our process at BAEP, we do tend to focus on businesses with strong competitive positions which provide that pricing power to better manage cost inflation,and we did see that come through in companies in the portfolio. And cashflow across the board improved significantly with a lot of working capital unwind playing through.
Looking at the portfolio, I can put the better performers into three buckets. Higher PE stocks that delivered in line with or ahead of already high expectations. An example there being Ordinate. Consumer discretionary stocks that beat some very low expectations. A good example there was Universal Store. And stocks that got the basics right in terms of top line growth, good operating leverage, strong cashflow, clean accounts, and delivering on guidance.
And a couple of examples there that really shone through were PWR Holdings and Jumbo Interactive. What you'll notice I think there is that there were no themes or concept stocks in the list. We are back to fundamentals driving share prices.
Jonas Daly:
Thanks, Doug. And just as far as reporting season go, are there any examples of stocks that you'd like to mention?
Doug Macphillamy:
I mentioned Ordinate upfront, so I'll kick off there, Jonas. The company delivered a record revenue EBITDA and cashflow result. Top line growth of 48% was 11% ahead of market expectations. EBITDA growth of over 100% was about 20% ahead of market expectations.
The core audio business continues to deliver really well and they're starting to get some strong initial traction in the video side of things. Improved operating leverage was a feature in the results and is expected to continue from here. And full year guidance, while it remains unchanged with gross profit growth of 24% to 32%, the strength of that first half result really does position them well in my opinionand I continue to feel like that guidance looks pretty conservative at this point. In terms of one stock which got the basics right, PWR Holdings is certainly worth a call-out. The result came more or less in line with consensus expectation, but it did show a nice combination of top line growth, cost control, and margin improvement over the period.
The core business continues to do well in Motorsport and OEM-related segments. But what was really encouraging was some improved traction in the emerging technologies segment. We've seen revenue in that division move from $6 million in the first half of FY22 to $8 million in the first half of FY23, to $16 million in the first half of FY24 just reported.
Financials are clean as a whistle and cash conversions over 90%. The balance sheet is debt-free and they continue to not only deliver strong results in the near term, but they've added quite a bit of capacity in Australia, the US, and the UK, which should underwrite growth in the medium to longer term. That's one we still remain quite positive on.
Jonas Daly:
Great. Thanks, Doug. Well, that's a really interesting sector too that you're covering because there's not a lot of research on those individual stocks, so to have that within the fund is definitely an advantage. Look, guys, I'll wrap up there. Look, thank you very much for a very detailed update. Thank you to all the listeners' overall support for BAEP. If anyone would like further information, we also have our dedicated account directors that can set up any follow-up meetings from today. Look, thanks again and have a great day.
