(June 3): How many bridegrooms get to introduce his grandchildren? Well, I did, last Monday. And Selamat Hari Raya to all our Muslim friends. Now, to the article for the week. Why home and Mickey Mouse?
The tense trade war standoff between the two largest economies in the world will keep markets on the back foot, until there is greater clarity. Emerging-market stocks and currencies have, so far, borne the brunt of the selloff, as is to be expected. Investors tend to flock to safer assets when there are greater uncertainties.
Bellwether indices in Hong Kong and South Korea have lost 8.7% and 7.5%, Singapore is down 7.6% and China’s Shanghai Composite index fell 5.9% so far in May. By comparison, US stocks have fared slightly better, with both the Standard & Poor’s 500 (S&P 500) index and Dow Jones Industrial Average down 5.5% over the same period.
There is probably as good a chance that the trade war will get resolved amicably as it will escalate. The ball, I believe, is now in the US’ court. China appears to have drawn a line in the sand with the sharp state media ramp-up in rhetoric, particularly when it comes to the country’s technology ambitions.
It is impossible to predict what President Donald Trump will do next. Analysts and markets are still pricing in a “cooler heads will prevail” scenario. Much hope is being placed on the possible meeting between the two presidents at the G20 summit in Japan this month. Make no mistake, should the situation take a turn for the worse, there will be a lot more pain in financial markets.
Subdued inflation — driven in major part by competition and productivity gains from technological innovations — has allowed central banks to keep interest rates historically low this late in the cycle, thereby extending its life. If the tariff war morphs into a full-blown tech war, however, it could be a game changer.
The ban on Huawei Technologies has already sent global semiconductor and tech stocks into tailspin. More critically, it would push back the rollout of 5G networks worldwide by several years and, with it, the realisation of the Internet of Things, including autonomous vehicles.
Given prevailing risks, I believe the US market will fare comparatively better in the near-medium term, underpinned by corporate earnings growth — and low-bar expectations.
According to data provider FactSet, of the 97% of companies in the S&P 500 that have reported results in 1Q2019, 76% have beaten market expectations on earnings, slightly above the five-year average of 72%. Earnings are now expected to decline by just 0.4% for the quarter, compared with projections for a 4% drop before the start of the reporting season.
One key takeaway is that US consumers are in pretty good shape, even if they are somewhat reticent in spending freely, owing, perhaps, to prevalent narratives on the global economic slowdown and trade war uncertainties.
In fact, the Conference Board’s index for consumer confidence surged in May, and is now hovering near the highs of 4Q2018 and last seen in 2000. Another survey by the University of Michigan also indicated consumer sentiment at the highest level since January 2004, albeit taken before the latest flare-up in trade talks.
To be sure, companies have cautioned uncertainties as to the actual impact of higher tariffs (on Chinese imports) on pricing for goods over the coming months. I believe that consumers can absorb any price increases reasonably well, underpinned by a strong labour market — with the unemployment rate at 50-year lows and wage growth gaining traction. The average US household debt-to-GDP has been declining since the peak of 98.6% in 2007, now at 72.3%, while debt servicing as a percentage of disposable income has dropped to a multi-decades low.
The three consumer-related stocks I have recently acquired — Disney, Home Depot and Builders FirstSource —reported solid 1QFY2019 results.
Home Depot
Revenue for Home Depot, the world’s largest home improvement retailer, was up 5.7% y-o-y to US$26.4 billion ($36.4 billion) in 1QFY2019 ended May 5, 2019. This is on the back of a 3.8% increase in customer transactions and 2% increase in average ticket.
In fact, revenue growth would have been stronger if not for the deflation effect of significantly lower lumber prices from a year ago. Meanwhile, margins were similar to those in the previous corresponding quarter. Net profit was up 4.5% y-o-y, after deducting slightly higher effective tax rates.
Home Depot has delivered consistent earnings growth since 2010 and rewarded shareholders with higher dividends each year. For the current financial year, the company raised dividends by 32% to US$5.44 a share, underscoring management confidence in future earnings. This is equivalent to a payout of about 55%.
The company will continue to benefit from healthy US consumer spending, a resilient housing market and low mortgage rates. New-home sales are being capped by the lack of homes being built, owing partly to rising labour and material costs. Nonetheless, demand remains robust, causing home prices to trend higher. Statistics indicate that more than half of homes in the US are more than 40 years old, the oldest on record. This, along with rising home equity, bodes well for the home remodelling and improvement industry.
The bulk of Home Depot’s revenue is US-centric — with 87% of the total number of stores located across the country, with the remaining in Canada and Mexico. Meanwhile, the direct impact on cost of goods sold from higher tariffs on Chinese imports is relatively minimal, estimated in the low single digits.
It is interesting to note that, while US retailers reported mixed results in 1Q2019, almost all have cited relatively robust consumer spending. Department stores fared poorly, mainly because they failed to adapt to structural changes in how consumers shop. Case in point: Walmart, Target and Home Depot have done well by investing in digital platforms and fulfilment infrastructure, including the popular same-day store/locker pickup options.
Builders FirstSource
The investment thesis for Builders FirstSource is similar to that for Home Depot. The company is one of the largest suppliers of structural building materials in the US, catering for professional homebuilders and sub-contractors for new residential construction as well as the repair and remodelling market.
Its shares rose sharply immediately after the company reported stronger-than-expected 1Q2019 results. Sales declined 4% y-o-y to US$1.63 billion, mainly because of the slump in lumber prices. Volume sales were in fact up 6.8% y-o-y while sales for value-added products were up 10%.
As a result, adjusted earnings before interest, taxes, depreciation and amortisation grew 22.2% to US$100.9 million from the previous corresponding quarter while adjusted net income was up 44.2% over the same period, from US$27.6 million to US$39.8 million. Its balance sheet strengthened, achieving management target leverage ratio between 2.5 and 3.5 times — the ratio was reduced from 4.6 times in 1Q2018 to three times in 1Q2019.
Moving forward, Builders FirstSource intends to increase its market share, which could include strategic acquisition of other companies along the value chain to increase its geographic reach and enhance economies of scale.
Walt Disney
Our investment in Walt Disney too has performed well, up 13.6% since our recent acquisition. The company is a strong proxy of consumer spending on entertainment with its integrated studio, theme parks and resorts as well as merchandising businesses.
Disney has put in place the building blocks for growth for the next five years, including the important transition to streaming. Investor confidence surged after the company disclosed details for its streaming service, Disney+, slated for launch on Nov 12. The package is priced very competitively at only US$6.99 a month or US$69.99 for a year. By comparison, Netflix packages range from US$8.99 to US$15.99 a month.
In addition to the huge catalogue of content from both Disney and recently acquired Twenty-First Century Fox, Disney+ will have exclusive rights to stream all of its new studio releases starting with Captain Marvel. It also unveiled plans for a series of exclusive original content based on franchises under the Mouse House’s stable, including Star Wars and Marvel.
Disney recently gained full control over another streaming provider, Hulu, after it acquired AT&T’s 10% stake and inked a deal with Comcast to buy its 30% share in five years’ time. This gives Disney the option of bundling Disney+, ESPN+ and Hulu, an attractive package for would-be subscribers.
The company’s 2QFY2019 ended March 30 results beat market expectations for both top and bottom lines. Revenue rose 2.6% to US$14.9 billion, boosted by a 4.5% increase in parks, experiences and consumer segment while the decline in media networks stabilised.
Disney is estimated to spend US$24 billion for parks, resorts and cruise ships over the next five years, with new attractions planned for all six of its theme park resorts. Star Wars: Galaxy’s Edge, the biggest expansion in Disneyland history, is set to open in California on May 31and in Florida in August.
Studio entertainment saw a 14.6% y-o-y decline, owing to the timing of releases, but the company has a very strong slate of movies for the rest of this year, including Toy Story 4 and The Lion King. Avengers: Endgame, released in April, is currently the second-highest grossing film of all time. Incidentally, this movie will stream exclusively on Disney+ starting from Dec 11.
Looking ahead, Disney will sacrifice some short-term profitability to invest in Disney+, which is projected to break even by 2024. Strategically, however, it would put the company in a much stronger position in the global entertainment industry.
Northrop Grumman
Government military spending could be counter-cyclical and relatively unaffected by the trade war. Northrop Grumman is the fourth-largest aerospace and defence contractor in the world and a leading player in the drone market.
The company reported a 22% increase in revenue in 1QFY2019, taking into account contributions from Orbital ATK, acquired in 3QFY2018. Net profit was up just 3% y-o-y, after adjusting 1QFY2018’s results for differences in treatment for pension costs. Nevertheless, Northrop raised its full-year guidance slightly, following the latest results.
Last year, the global military budget reached new heights since 1988, against the backdrop of increasing geopolitical tension as well as a rising threat from extremist militias and intercontinental ballistic missiles (ICBMs).
After falling from 2010 to 2015, US defence spending has risen every year since — from US$586 billion in 2015 to a budgeted US$716 billion in 2019. The Trump administration has proposed total spending of US$750 billion for 2020.
The US spending for defence is already larger than the next six biggest spending countries combined, including China, Russia, Saudi Arabia and the UK. Military spending is the second-largest component after social security in the US Federal Budget. Defence spending may well continue to rise, for critical modernisation programmes as well as investments in next-generation technology and weaponry to counter the improving military capabilities of Russia and China.
A core programme from the military budget is the Ground Based Strategic Deterrent System — to overhaul 400 ageing missiles and their supporting infrastructure estimated to cost more than US$100 billion over a decade. Northrop and Boeing are the two primary contenders. Northrop boosted its prospect by acquiring Orbital ATK, one of only two US manufacturers of solid rocket motors used to propel the ICBMs.
Northrop reported net awards totalling US$12.3 billion in 1QFY2019, increasing its order backlog to a record high of US$57.3 billion. The company has generated positive free cash flow in each of the past 10 years, which totalled US$2.6 billion in 2018. It expects to maintain this level of cash generation in the current year — estimated at US$2.6 billion to US$3 billion — which will be supportive of more share buybacks and dividend payouts.
Dividend per share has risen every year since 2009, by a compound annual growth rate of 12% to US$4.70 in 2018, with an average payout of just about 29%. Dividends will rise further to US$5.28 a share this year.
My Global Portfolio slipped 0.6% this week, better than the MSCI World Net Return Index’s 2.2% loss. This pared total returns to 2.7% since inception. Nevertheless, the portfolio is still outperforming the benchmark index, which is up 1.1% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
This story appears in The Edge Singapore (Issue 884, week of June 3) which is on sale now. Subscribe here
