The death of magical thinking

Magical thinking has died for one simple reason: the cost of capital. For more than a decade, interest rates had been declining. Debt got close to being free only a couple of years ago.

And free money makes people believe in magic.

Source: Bloomberg, Longwave Capital. 

We have seen a decade of speculation and financial engineering start to unwind in the space of two short years. In the financial year just reported, the interest expense bill was 33% – more than a billion dollars – higher for small caps in the index than it was in F2022. Historically, peak interest expense at listed companies happens around 12 months after official interest rates peak due to interest rate hedging and other lags in the system. Given where interest rates have been for the average of the past few financial years, and are currently above those levels, equity holders are going to give up more of their operating profits in the next year as well.

Reporting season gave us a good look at how companies across the market are performing. We estimate around 50% of the EPS downgrades through reporting season were due to higher expected interest costs and 50% due to slightly weaker operating conditions. Overall EPS downgrades were around 2% at the index level – hardly a recessionary outcome.

Impacts of higher interest rates: We saw many examples of higher interest rates in these results.

• Upward pressure on property cap rates (downward pressure on valuations) in the A-REITs, reversing a decade of upward revaluations,
• A number of A-REITs are also starting to flag leverage levels (debt to assets) approaching covenants. A tricky issue to resolve given their equity trades at a discount to NTA and asset values are likely to keep falling in many sectors,
• Small cap lending businesses may have benign customer defaults for now, but the impact on profitability of increased funding costs is anything but. As wholesale funding rates reset higher, and the RBA Term Funding Facility matures, the negative net interest margin impacts were flagged as significant in F24,
• Levered yield-based stocks such as NZ Telco infrastructure company Chorus (CNU), are hit on both sides, as higher interest expenses eat into the cash flow available for distributions and the yields they offer look less and less competitive relative to higher risk free interest rates. Chorus was also hit by inflation in their maintenance capex estimate – which was NZ$161m in F2022 and expected to be NZ$230m in F2024, further reducing cash flow for distributions.

Source: Bloomberg, Company Accounts, Longwave Capital. 31 August 2023

Management Execution: one of the starkest differences in management execution was the performance of Boral (BLD) relative to Fletcher Building (FBU). In order to get price increases to stick, significant management of sales teams is required and BLD delivered where FBU floundered. These execution differences are a large part of why Boral EPS estimates have been upgraded 48% so far this year and FBU have been downgraded by 25%. Unfortunately we own FBU and not BLD.

Source: Bloomberg Consensus EPS estimates: 31 Dec 2022 to 31 Aug 2023

Consumer Discretionary / Retail: a clear takeaway was the softening of the consumer, less so in many of the results reported (as relief from lower freight rates helped gross margins) rather in the more recent trading comments. Cost-of-doing-business inflation (aka wages) are going to be a challenge in F2024 if the consumer stays weak. Interesting comments from CBA and Qantas Frequent Flyer showed ostensibly where the weakness was most apparent (demographically in the 18-34 year olds, and sectorally in Beauty, Clothing and Homewares). But sometimes companies can out-execute the macro, and Lovisa (LOV), Super Retail (SUL) and Accent Group (AX1) all delivered solid results. Quality of earnings continues to deteriorate for market darling Breville Group (BRG), a risk not reflected in the share price.

Tourism and Leisure: One area where spending remains robust, and intentions are also holding up, is in travel. Comments from Corporate Travel (CTD), Flight Centre (FLT), Tourism Holdings (THL) and Webjet (WEB) all supported the view that recovery to pre-pandemic spending levels is on track. For CTD, WEB and THL in particular, investments made when competitors were weak are paying off – with the market expecting F2025 earnings (EBIT) to be 100% or more higher than reported in F2019 for all three companies.

Source: Company Accounts, CapIQ Consensus Forecasts for F2025E (31 August 2023).

Technology: There were some promising examples of management getting costs under control and putting some of these businesses in a sustainable position. Probably most impressive was Megaport (MP1) but Life 360 (360), Redbubble (RBL) and Bravura (BVS) are all making progress. There are many other tech stocks – mostly microcaps these days – who are today a shadow of what they promised investors they would be in 2021. The magic for these companies is gone.

The biggest surprise to the market was IRESS (IRE), who finally revealed the true and parlous state of both the business and the balance sheet. It has taken new management 10 months to get their head around what is needed, and it is much worse than they thought in April when they last updated the market in detail. The list of issues within the business appears to be many: across product, technology, line of business focus (divestments now underway), carrying values and a stretched balance sheet. Management noted that paying dividends significantly greater than free cash flow and funding from increasing debt is not sustainable. Seems obvious but was rarely questioned in prior years. Enterprise software turnarounds (such as Bravura and Nuix), can take time to execute. What on the surface looks like a sticky, annuity business with pricing power can in distress uncover bad acquisitions, huge technical debt, bloated costs, and unsatisfied customers. Competitors (and there are always competitors) are acutely aware of the appeal of sticky annuity revenues and are ready with newer shinier offerings to win away business.

Source: Bloomberg Consensus EPS estimates: 31 Dec 2022 to 31 Aug 2023

The issues at IRESS have been building for many years, and Data Centre (DC) assets which underpin the businesses and market values of NextDC (NXT) and Macquarie Technology (MAQ) contain similar long term, unpriced risk. Data Centres are REITs in almost all forms but one – the risk of obsolescence. We learned last month that Scale (older DCs are too small), Cooling (AI GPUs need liquid cooling, which requires a different specification at construction of a DC) and Efficiency – known as Power Usage Effectiveness ratio (PUE) all conspire to make 10 year old Data Centres unable to participate in the current wave of Hyperscaler growth, and old Data Centres are likely to mature and decline far faster than any office building, shopping centre or industrial shed. For now the market is willing to look past this and pay 2-3x book value.