Corporate Strategy Weekly Radar Update

Week ending Friday 31 August 2012 (Theme: US Fiscal Cliff vs Corporate Earnings) Highlights and Insights (now combined for easier reading) Financial Services Suncorp highlighted that the current Qld CTP pricing regime is unsustainable and is negatively impacting competition amongst insurers. The Motor Accident Insurance Commission has refused to permit price increases, despite the negative impact of falling bond yields on investment income, a key means of funding future claims in long-tail classes. o Bond yields have been highlighted as one of the biggest challenges to Suncorps (and other insurers) medium term outlook, particularly for longer-tail classes such as CTP and Workers Compensation in addition to the Life business, and is likely to remain a trend for the foreseeable future. Crop insurers in the US, including QBE, Munich or Allianz, are facing record agricultural losses as drought devastates corn and soya crops. Analysts predict underwriting losses of $US18B (estimated overall loss ratio of 2.5), with private sector insurers facing losses of ~$US4-5B. o Because of those weather conditions, a new world food crisis is predicted. The World Price Index for food commodities jumped an alarming 6% in July (compared to June), cereal prices +17%. The risk in 2013 is a repeat of 2008 with riots in 30+ countries. NAB Chairman Michael Chaney added to the call for a review of the banking sector, suggesting a greater role for superannuation funds in funding wholesale banking needs e.g. through the development of corporate bonds. This follows concerns regarding the funding challenge for the banking sector once business confidence returns and credit growth resumes ING Banks Canada business has been sold for $US3.1 to Scotiabank, to reimburse the GFC bailout. ING is also divesting from its life insurance business in Asia. ING Direct Australia is now the only wholly owned bank of ING Direct outside of Europe and stands out as a potential offload. o Acquirers face a $10B funding gap between loans and deposits. Left-field contender could be Sony Bank currently studying feasibility for an online retail bank in Aus. ING Direct AU chief Vaughn Richtor denies any move (he just returned from Asia) and launches a new super product next week. Bank branch numbers have grown 1.2% this year to 5636: strongest growth in 3 years. Number of financial institutions which APRA classifies as 'banks' also rose, includes 6 credit unions & building societies which converted to mutual banks o Notable trend given investment in online & mobile services. Conversions to mutual banks reflect credit unions move to improve perception of security from consumers. Perpetual outsources 100 IT jobs in a $68m 5-year deal with Japanese firm Fujitsu. (small technology team kept in-house to focus on governance and vendor management) Trying to turn around 57% fall in net profit to $26.7m due to markets conditions and low investor confidence. Perpetual also plans to cut $50m in annual costs by 2015 by selling its mortgage business (-580 FTE). Other industries Harvey Norman: net profit fell 31.6% to $172.5m in FY12 after margins collapsed: due to double-digit deflation, widespread industry discounting and weak sales o Analysts blame costly destination stores as more consumers shop online. The franchise model was a strength to incentivise 'owners' in period of growth, but makes it harder to control costs and is more vulnerable when sales decline: eg. the level of 'tactical support' received by franchisees in the form of rent and marketing relief to keep some afloat more than doubled to $124m. Other industries (continued) Apple won a patent lawsuit against Samsung, who is ordered to pay more than ~$1B for infringement. Samsung shares dropped 7.5%: biggest single-day drop in 4 years. o The win is a validation of Apples intellectual property and strengthens its dominant position in smartphones and tablets; but it also shows that the IT war is now moving 'mainstream' with legal disputes: sign of a 'maturing' sector Virgin Australia reversed last year's loss and posted a pretax profit of $82.5m in FY12, with revenue growing 19.8%, yields (average ticket price) up 12.2% and the international business delivered a solid profit ($35.4m before interest and tax). Target of 20% of domestic revenue from corporate and govt accounts has been achieved, a year ahead of schedule. o Virgin's focus is now on efficiency and expansion of the Velocity program to counter Qantas frequent flyer. Virgins strategy targets the Qantas dominant high yield customer base. How much of the turnaround is due to Qantas IR and whether the gains are sustainable is to be seen.. Grocon is engaged in a dispute with the CMFEU because the construction company has refused to agree to union appointing safety officers who can stop work on a site by citing safety issues. The union is also locked in a dispute with Abigroup at the Queensland Childrens Hospital site Brisbane involving the use on non-union contractors. o IR, Immigration and the Carbon Package have defined Australian politics since the mid-2000s. IR had slightly 'dropped off the radar' since the Coalition acknowledged the end of WorkChoices. Calls for IR reforms re-started in the past year (with the Qantas lockout) but mostly driven by 'intellectual' economic productivity considerations: these disputes are likely to put the agenda back on the table in a more sensationalised manner, as a test to the government as well as to the Coalition who wants to reopen the debate without the political stigma attached to WorkChoices. Unilever (400 brands incl. Lipton, Ben & Jerry's, Dove, Lux, Omo, Surf, Rexona) sees return to poverty in Europe and is adopting strategies used in developing countries to drive profitability: incl. smaller packages and low-cost brands. o Their European revenues grew by just 0.2% in Q2, compared with +16% in emerging economies. An important insight on how companies adapt to lower growth Macro Economy, Politics and Regulation The Govt announced it will drop the $15 carbon floor price and link with the EU ETS from 1/7/2015, creating a single market. (The AU COs price started at $23/ton in July 12) o There is a high risk that given the EU economy produces less industrial output (ie fewer emissions) and given free permits (UN Clean Development Mechanism CDM credits) were overallocated, the price of carbon will fall making the scheme ineffective on 2 fronts: 1) not decarbonising the industry, and 2) also creating a budget shortfall because of lost revenue from the sale of emissions permits. It should be addressed with a binding quantitative limit on the use of CDM credits. The EU also plans to cancel permits to push the CO2 price up. However in the current arrangements, some Australian polluters could actually make a profit if they reduce emissions below baselines used to calculate assistance in Australia, sell their $12 AU permits on the market and use $4 international permits to offset emissions

Snapshots of the week: Disconnect between the looming US 'Fiscal Cliff' and 'Outperforming Corporate Earnings' Bernanke speech at Jackson Hole this weekend (debrief next week) is an opportunity to zoom on the looming US 'Fiscal Cliff' 1 - The US fiscal cliff is approaching fast 2 - However some in the US are wondering if they shouldn't just jump off the cliff...
Jump off the cliff Potential GDP without crisis

Actual GDP projection

The fiscal cliff refers to hundreds of billions of dollars in tax increases and spending cuts set up under Bush-Obama scheduled to automatically take effect on January 1, 2013, unless the divided Congress intervenes. (total is $1.2 trillion over 10 years) The Congressional Budget Office (CBO) estimates such fiscal tightening would cut GDP by 0.5%, with the hit concentrated in the H1, and increase unemployment to 9% from 8.3%: around 2 million people.

Jump off the cliff

Those partisans of a 'laissez-faire' approach believe the US can bring the national debt under control in the medium term - albeit at a significant short term social cost -, simply by doing nothing.": They argue that "answer to the deficit problems is staring us in the face." There argument is that despite a recession - or 'scalpel' as they see it as a remedy- in the short term, the long-term prospects for the US economy will be 'un-hurt': in 2022, the economy will be bigger than if tax cuts are extended, Americans will own a larger share of economic output, deficits will be much smaller (0.9% of GDP vs. 5.5%), and the national debt will be $8 trillion smaller. Of course such a radical option sounds like political suicide: a 4-year presidential cycle is out of sync with such a deep 5-10 year recession. However this 'worst case scenario' is insightful as it gives a measure of the spectrum across which US candidates will have to play Furthermore, putting it in parallel with the US corporate earnings reinforces the disconnect that business and political leaders are facing Whilst economic and social prospect are dear, the US corporate earnings on a bull rally A conterintuitive economic trend of the past years has been the outperformance of the US stockmarket and Corporate earnings While the US economy has suffered an L-shaped recovery, US corporate profits have enjoyed a Vshaped recovery. Since bottoming in 2009, the US economy has grown at an annualised rate of only 2.2% Yet in the same period, corporate After-Tax Profits have grown at an annualised 14%. As a result, the corporate profit share of GDP reached 10.8% in the March Qtr, almost twice its 6% average since the early 1950s. The profit share is now higher than the previous peak of 10.3% reached prior to the GFC in the March quarter of 2006. So how has America managed to grow earnings so strongly, while its economy has struggled? Partly because profits are highly cyclical and have benefitied from solid foreign sales due to a cheap US dollar. Also because ofstringent cost cutting on the home front: US productivity has actually grown during the GFC. Of course, with slowing sales from China and Europe, and limits to how much productivity improvement can be obtained from existing workers, US profits seem likely to underperform growth in the economy at some stage. Beyond our need to understand the forces at play in the US given our exposure to the global economy,... ... this example, seemgly distant from our geography and line of business, is actually serendipitously relevant to Australian leaders. How to communicate on the disconnect between 2 realities: healthy corporate earnings (such as CBA and SUN this year) vs tighter economic conditions requiring rationalistion of the workforce and repricing of products? A challenge business leaders will need to overcome in the current Low Growth period if they want to avoid 'Eastwooding' Talking to an empty chair worked for Clint at the Republican Convention as he customers, politicians and media commentators... pretended to have a dialogue with an imaginary Obama, but 'Eastwooding' (as the 'meme' is now known) isn't recommended to businesses