Jodie Saw:
Hello and welcome to our podcast for June 2024. My name is Jodie Saw, the head of retail and wholesale distribution at Bennelong Funds Management. And today, I'm joined by the BAEP investment team, including Mark East, CIO and founder of the firm, Neale Goldston-Morris, senior analyst on economics and market strategy, and Brad Clibborn, portfolio manager and senior analyst. Gentlemen, thanks for joining us here today.
Neale, I might just start with you for an update on the global macro side. In our last podcast, you indicated stronger earnings which have been coming through, but also the persistent inflation. How has that view evolved since our last update in March?
Neale Goldston-Morris:
Thank you, and welcome everybody. Yes, last time we spoke to you, we suggested that global growth would be more than acceptable, particularly in the US, and that companies would continue to achieve earnings upgrades, particularly if they had pricing power through new R&D-based product. And we've seen that with the Magnificent Seven, et cetera.
Rolling forward to today, the picture is pretty much similar, certainly as far as the US is concerned. Its growth continues to be strong between 2 and 3%. The better companies are getting earnings upgrades because of new and better product, et cetera. So, that rolls on. Believe it or not, even Europe has joined in that growth. And most of Asia, ex-China has as well. So if you like, in the overall globe, things continue to be pretty good as far as economic backdrop and the ability of companies to deliver earnings with upgrades as well.
There are two exceptions unfortunately now. One is China. It seems to be muddling through. In other words, yes, manufacturing and its exports are doing quite well, but housing continues to be the anchor holding it back. It makes commodities at least volatile. And as we said three months ago, we maintain a very underweight to the resources sector in all our portfolios. Very underweight indeed. The other one that's slipping is unfortunately Australia itself. Our growth is now 1% or less. The private sector is being squeezed by high rates. But also, governments that are making life more difficult for the private sector with more regulation and bureaucracy, et cetera, et cetera. So, our portfolios remain very underweight to Australia, very overweight to the US as the converse. And we would anticipate further earnings downgrades in Australia, mainly in that consumer-facing area in particular.
Now, the cost of the global growth is that any rate cuts continue to be deferred, as we suggested three months ago that they would be. It looks like probably first quarter next year before the first rate cuts, at least in Australia, and maybe late this year in the US. But either way, all are fair way out and consumers are going to have to be patient as far as that is concerned. And real relief on that front really won't come until the second half of next calendar year, because the elections intervening in Australia and the US for that matter.
That aside, in an overall sense, the picture remains constructive, at least for quality companies. And remember with our portfolios, they are based upon lowly geared, strong balance sheets coupled with management that are willing to invest in new and better product to R&D on a continuing basis. Not just an on/off process, something that's embedded in their DNA if you like. You get that pricing power from that, together with the better exposures like US, then those earnings upgrades should continue.
Jodie Saw:
Thanks Neale. That was a great update. We might now just turn to Mark East for more on the bottom-up. Mark, can you provide a few comments on the portfolio positioning and the performance of the funds over the last quarter?
Mark East:
Sure. Thanks Jodie. Consistent with Neale's overall macro view, the portfolio is concentrated into high quality companies with large exposures to the US.
On performance, following a good finish to 2023 and a good start to '24, performance has been tougher over the last few months. The key detractors have been James Hardie, a stock we had significantly reduced prior to its recent underperformance, IDP Education, and Credit Corp. Brad will talk about some of these stocks a bit later on.
Two of the key contributors to performance over recent period have been A2 Milk, Goodman Group, and Fisher & Paykel Healthcare. A2, we covered in depth in our March podcast. So, I'll focus on Goodman and Fisher & Paykel.
Goodman released its third quarter results in early May, and this included an upgrade to its FY24 earnings guidance from 11% growth to 13% growth. The upgrade was driven by the delivery of performance fees in second half, which built upon the strong development profits of the first half. Longer term, the stock has been driven by their data center development pipeline. Data centers under construction now account for 40% of their 12.9 billion work in progress. Data center demand has been driven so far by the rapid increase in cloud computing, with the future demand driver to be AI. Goodman has a proven ability to buy and develop property for its optimal use case. The area where they have stood apart in the data center development area, however, is the sourcing of power. Energy availability is the key constraint in delivering new data centers. Goodman's power bank continues to grow. It now sits at 4.3 gigawatts across 12 major international cities. Stock has performed strongly and has clearly benefited from its data center developments being a key part of the AI value chain.
On Fisher & Paykel Healthcare, that's been a positive contributor over recent periods also. Performance has been driven by a number of factors. Firstly, the company delivered a strong FY24 result in May, which included 8% constant currency revenue growth. They've seen momentum return to the hospital business following a rebasing of sales post COVID. Hospital, new apps grew 13%, with management guiding to return to mid-teens new app growth for FY25. They also delivered strong growth, 16% growth, in the home care business. And that's guided to remain at 10% growth for FY25. This growth is driven by the rollout of some new masks. And these masks, the Solo and the Nova Micro will be rolled out globally over the course of FY25. They've also seen an improvement in their margins as elevated freight costs abate and the company's focus returns to manufacturing and operational efficiencies after being solely focused on meeting demand in the very busy period over COVID.
Over the medium term, one of the drivers of revenue growth will be new products. I mentioned the new sleep masks before. They were released by the company's home care business. On the hospital side of the business, a relatively new market for the company's anesthesia, where it makes about 10% of its sales. This is related to the growing opportunity to reduce the risk of patient's oxygen levels dropping to dangerous levels while undergoing sedation or general anesthetic for surgical procedures. We've done a number of industry calls here with medical professionals in this area, and this work suggests that the delivery of oxygen via high flow nasal cannula can be superior to the current standard of care, with fewer complications.
At the result in May, the company issued guidance for the upcoming FY25 year of EPS growth of 17 to 36%, which was well received by the market.
Jodie Saw:
Thanks Easty. That's a really good summary there. And now, passing over to you Brad. James Hardie did very well through 2023. So, perhaps if you could give us an update there, and comments on how we've been managing the position.
Bradley Clibborn:
Thanks Jodie. Yeah, after a strong 12 months of performance through 2023, we have seen the Hardie share price pull back over the last three months or so, and it's detracted from performance through that period. But I do think this is a good opportunity to talk through a live example of our investment process and how it drives our portfolio decisions.
The key differentiator of our investment process that we talk to with clients, is our very high volume of industry and company meetings that we do, which are then backed up by third-party data sources that we purchase as well. That high frequency of meetings means we have a constant pulse on demand and competitive dynamics coming from customers, competitors, and suppliers of the companies we follow. For Hardie's alone, we did over 190 meetings in 2023. Our systematic approach to collecting the data from those meetings and triangulating that with our other data sources that we purchase allows us to feed that into company earnings and have a constant updated view on where we think demand and company earnings are tracking.
If I go back to our podcast in early March, I mentioned that our calls with customers through January and February indicated the new construction market in the US was quite strong. The early parts of spring selling had performed really well based on feedback. And consistent with our calls over the last several years, from a competitive point of view, Hardie's continued to perform very well and customer relationships were strong.
As we got into later March and early April, we did see mortgage rates tick up meaningfully in the US, as inflation, our fears started to increase. And so, as we went through those calls and continued to do them in March and April, we did see more mixed feedback coming from the builders on those new construction demand dynamics. And it started to feel like demand was arguably flattening out. At the same time, the data sources we get on the repair and remodel market in the US continued to remain subdued, and that's a very important market for Hardie. And lastly, what we saw through April was, one of Hardie's key cost inputs, being pulp, started to increase significantly in price.
So, in quite a short space of time, in four weeks or so, we saw demand trends flattening out and input cost increasing. So, we took the view that we no longer saw earnings upside to consensus. At the same time, the PE multiple had rerated to around 23 times, which is not expensive in this market, but towards the upper end of the historic 20 to 25 times PE ratio that Hardie's traded. So just given that risk-reward, we did take the decision to meaningfully reduce the active weights in the portfolios for James Hardie through that April or May period. And active weights were reduced in the order of around 50%.
Just to be clear, we continue to be positive on the medium and long-term prospects for Hardie in the US, in their market share gains and earnings growth potential. This was an adjustment to align portfolio positioning to near-term earnings, expectations and risks.
As we came into the Hardie result in mid-May, FY24 result landed about where consensus was expecting and in line with guidance. But the guidance for the year ahead for financial year 2025 was around 10% below consensus. And the key difference where management guided and where consensus expectations were was really a difference in view on market volumes. Hardie has guided their volumes to be flat for the year ahead, whereas the market was expecting about 5% volume growth. We have seen earnings downgrades in the order of 10% on the back of that, and the share price pull back in line with those earnings downgrades.
If we think about where we sit today, Hardie does remain a holding in the portfolio. It's a lot smaller than it was three months ago. We still believe the market share opportunity in the US is material and should continue to drive long-term earnings growth for the company. We'll continue to do our high frequency of channel checks to keep a pulse on demand. And we do believe, as interest rates come down, likely in 2025, in the US, that that should be a tailwind for the US housing market and James Hardie as well. So, we'll ensure that we continue to do that work and ensure the portfolio is at the best position to benefit from that.
Jodie Saw:
Great. Thanks Brad. There's been a lot of media headlines and noise around IDP Education. Would you mind walking us through that, what's been happening there and the outlook for the company?
Bradley Clibborn:
IDP, it has been a volatile 12 months for the stock. Management's executed really well in what's been quite tough conditions from a cyclical point of view, as they've faced policy changes relating to immigration in their key destination markets for higher education, being Canada, the UK and Australia.
There has been a number of recent developments relating to some of those policy settings. Early in 2024, Canada introduced caps to reduce student volumes by around 30% in 2024. Those policy settings are now well understood and the process for implementing them have been put in place. So, we feel like the environment around Canada is now better understood and known.
We've had a positive update from the UK over the last month. There was an expert panel conducting a review of post-study work rights on behalf of the government. And the outcomes of that review actually recommended to maintain the existing settings for students to go and work in the UK after they finished their degrees. And the government's actually adopted those recommendations and decided not to make any reductions or tightening of the policy settings. So, that's definitely a positive development on the UK.
Australia has had a lot more noise in the media around immigration as we head into an election next year. The government has floated the idea of putting in place student caps, different to the way Canada has gone about it. But we think that the recent changes they've made around Visa acceptance rates has already made a lot of the changes to volumes that the government is after there.
Given we've had some improved clarity around the policy settings over the last month or two, IDP management did provide an update to the market last week. They've guided FY24 earnings to be in line with FY23. That was only slightly below consensus expectations.
But it's worth pausing and reflecting on the cyclical versus structural elements of that result. We look at their student placement business, which is the key driver of growth, looking to the five years ahead. The volumes for FY24 are expected to grow 15 to 20% based on that guidance. And this is in a market that we estimate has declined by about 10% year-on-year. So, IDP has outperformed the market growth in the order of 25 to 30%, which is very material market share gains. Today, we think IDP still only has around 10% market share globally in student placements. So as we look forward with that strong momentum in their market share runway, they continue to invest in the business to continue to drive growth in market share. We see that business being well-placed to take market share and drive earnings growth for the company.
On the English testing side of the business, volumes were soft in the second half of the financial year, particularly in India. And that reflects the soft sentiment and uncertainty in the policy settings. Students couldn't make decisions given the lack of policy certainty, so they weren't doing their English tests to prepare for going abroad to study.
In response to the tougher market environment, IDP also announced a cost out program last week as well. They've removed 6% of their global workforce by finding efficiencies in their back office and overhead costs. That will allow them to continue to invest in demand-generating activities while protecting margins in FY25.
So, this cyclical downturn for the education sector has been quite severe. And also slightly unusual, in that we've had all three major study destinations tighten policy at once. However, we do feel we're getting to a point of having some better visibility on the policy settings. And that will dictate the volumes for the year ahead. So, we do see FY25 as being that the cyclical low point for IDP.
They continue to have a strong market position, they continue to have a strong balance sheet, and continue to invest in technology and their footprint to grow market share and differentiate their offering versus competitors. So, we continue to believe the growth runway for the company over the medium and long-term looks attractive.
Jodie Saw:
Fantastic. Thanks Brad. That was a really good update there. Are there any further comments you'd like to add?
Bradley Clibborn:
Yeah. Just maybe one last point to wrap up, Jodie. As Neale touched on earlier, it's important to reiterate, our investment philosophy and process remain unchanged. Over the long term, share prices follow earnings. So, our focus really is on building a portfolio of companies that have high quality, have strong long-term growth prospects, and where we believe their earnings prospects are under-appreciated by the market. We look for those companies that have a track record of investing in R&D, investing in new products and investing into their brands so that they have strong pricing power and an opportunity to take market share globally over time. The portfolio delivering that earnings growth above the market is ultimately going to drive returns over the longer term for our investors.
If we look at the portfolios today, the EPS growth over the next two to three years is around 12 to 15% per annum, depending on which of the portfolios you look at. This compares to the ASX 300 that's got a three-year forecast earnings growth of around 5% per annum. So, the portfolios do have superior earnings growth. If you look at 12%, compound over three years, that equates to around 40% cumulative earnings growth over that period, which is quite material. So, we'll continue to do the work and make sure our companies are executing and delivering on the earnings growth expectations. And ultimately, that's what we believe is going to drive returns.
Jodie Saw:
Fantastic. Thanks there, Brad. Also, thank you to Mark and Neale for your updates today. Some really good insights there. The team have just provided a lot of information here today. But for more details on stocks, investors can go to our recent quarterly report or to our new monthly investor report, which includes further commentary on markets, portfolio review and portfolio outlook. Thank you to everybody for listening in today, and thank you to our investors for your support. Have a great day.
If you enjoyed this podcast or want to know more, please visit our website bennelongfunds.com. And subscribe to receive our regular insights. Or contact us directly for more information.
