Portfolio Manager for the DNR Capital Australian Equities Income Portfolio and Fund, Scott Kelly, takes a look at the recent reporting season and focuses on some sectors that are proving attractive for income equities.
Well, there are a number of interesting observations from reporting season. Earnings bounced strongly, up over 25%, albeit off a COVID-disrupted base. Companies delivered more beats than misses relative to expectations and so forward-earnings were revised marginally upwards. There was a very strong recovery in dividends and new capital management initiatives as confidence returns and earnings were bound and balance sheets are in good shape. Big miners paid record dividends on the back of elevated commodity prices. Whilst the focus for the big four banks was on the capital management that was announced, underlying results were actually pretty soft, which doesn’t bode well for the growth outlook there.
Understandably, outlook commentary generally was pretty clouded, given the spread of Delta and the lockdowns around Australia. Inflation remains a key thematic, particularly wages and supply disruption and the jury’s out as to whether it’s transitory or not. M&A activity is spiking, new bids for Afterpay, Sydney Airport and IRIS and BHP and Woodside, obviously, announced their merger plans.
But the key highlight in our mind and an area we actually think has been overlooked by the market were the strong results reported by the insurance and telco sectors. After many years of poor performance, we believe these sectors are now at a turning point.
Well, there are a number of things that are changing. Firstly, the headwinds from the rollout of the MBM will soon be in the revision mirror and Telstra indicated that its result that around 90% of those headwinds have now been absorbed.
Secondly, we believe the tide is turning for Australia’s mobile industry and that follows years of aggressive discounting. We’re now in a very different position with the sector in a state of repair and all three operators are lifting prices and so we see a period of extended market rationality going forward.
Thirdly, the valuation appeal of underlying infrastructure assets is starting to be recognized by the market and that’s been assisted by recent transactions. Telstra announced the sale of 49% of its towers for 2.8 billion or an EBITDA multiple of around 28 times. That’s well ahead of market expectations and they’ll return half of those proceeds in the form of a buyback. Optus is currently undertaking a process to sell its towers. TPG has announced it’s undertaking a strategic review, as has Spark New Zealand.
Fourthly, COVID headwinds are now becoming a tailwind. The industry has not been immune during COVID and international border closures have all but eliminated rhyming revenues. Telstra had indicated that headwind was around $400 million or about 5% of its EBITDA. Other players have reported similar impacts with TPG disproportionately impacted, given it caters more to that student backpacker demographics. So once Australia opens its borders and international travel resumes, we expect that to be a tailwind and contribute to the growth trajectory going forward.
In summary, we believe the telco sector is poised for a period of strong growth. That’s not being reflected in current prices. Telstra is our preferred exposure and the growth trajectory could lead to dividend upgrades, which ironically were being questioned by the market just 12 months ago.
The insurance sector is another great example of an improving industry structure following years of poor performance. With premium rates well ahead of claims inflation and COVID claim risks abating, all three insurers offer attractive upside, albeit our preferred exposures are Suncorp and QBE. Reserve adequacy has also improved across the board, Suncorp in particular, very strong.
In addition, potential leverage to the rising yield curve is not being factored by the market. So with the sector trading on a forward PE of around 14 times, it’s a substantial discount compared to the market. Dividend yields averaging around 5% plus franking, double digit growth over the next three years, really attractive for incumbent seeking investors. Suncorp just paid a special dividend around 8 cents per share fully franked and we think further capital management is likely with balance sheet strong and reserve releases probable over time.
So in our view, the insurance sector offers a far better returns than the big four banks. Lower bad debts and capital returns are positive for the banks during reporting season, but softer margins and higher expenses suggest that underlying growth there is moderating. So with competition intensifying amongst the four majors who are now focusing on the domestic market, Westpac and ANZ in particular struggling operationally, we’re seeing some pretty big discounting in the residential mortgage market.
FinTech companies, obviously, also continue to raise capital and invest to acquire new customers. So looking forward, we see far more compelling upside in the insurance sector compared to the banks.
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