Construction Bears Continue To Prevail In Australia

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Includes: FSUGY, FSUMF, SVNWF
by: Richard A. Lee
Summary

Bearish world view continues to hold after January 2019.

The construction sector in Australia continue to falter which can still be capitalized on.

Capital goods are targeted to gain exposure to the construction sector.

Seven Group Holdings Limited has high exposure to construction and mining sectors, with poor relative performance to comparable firms - a short position is recommended.

We hedge away mining risk using Fortescue Metals Group Limited and technicals appear to be conducive to this spread trade.

Introduction

The global economy appears to remain bearish moving further into 2019, which presents some opportunities to short business cycle-sensitive sectors. The construction sector in particular is a strong indicator of a country’s economic health; how consumers behave when purchasing houses and infrastructure projects which are undertaken. As the Australian economy has experienced inconsistent GDP growth relative to its American counterpart, forecasting GDP in the land down under appears to be a logical first step. This is done through the recent release of Australia’s PMI and previous PCI release. We find evidence which suggests that we generate a trading idea involving a short position in the construction sector. When exploring potential firms to short, we find one which has substantial exposure to the construction and mining sectors. The firm’s financial ratios also suggest poor performance. Next, we suggest a hedge in the mining sector as we only wish to be exposed to the construction sector. Technical analysis and price action all point to strong short-term momentum and building long-term momentum. Finally, we suggest stop losses and soft targets to be used when performing this spread trade.

Source: Business Insider Australia

Construction Woes in Australia

The recently released Australia PMI for January has shown a slight increase to 52.5 points on a seasonally adjusted basis, indicating a mild recovery in the Australian economy in the first month of 2019. Within the PMI, we find that the building materials, wood, furniture and other manufacturing products sector has expanded in the previous month, however at a slower rate. Interestingly, the mining sector has benefited from mining maintenance and upgrade projects. We also find that the metal products sector is currently stable, however orders from larger construction customers have slowed, a trend which has occurred since late 2018. Furthermore, the chemicals sector is experiencing a mild contraction, partially reflecting poor performance in construction related products. While the machinery and equipment sector has contracted slightly by 0.5 to 50.9 points in January, it is the first month to have reported difficulties in financing, harming equipment sales. Furthermore, the sector is expected to decline given the lack of building approvals. This makes it a sector of interest to watch when the supply chain is first affected by a lack of demand in construction projects.

Australia PMI January 2019 - Source: The Australian Industry Group

The Australian PCI has remained below the 50-points level for four consecutive months, with the index falling 1.9 points to 42.6 points between November and December on a seasonally adjusted basis; the largest fall in 2018 and at the steepest rate in half a decade. Construction activity has also declined significantly, falling to 35.7 points, the third consecutive month of declines up to December. Overall new orders have also indicated that the declines do not appear to be temporary, with a continued drop in the number by 4.8 to 41.0 points.

Australia PCI December 2018 - Source: The Australia Industry Group

When decomposing the PCI, each construction activity has contracted up to December, with the expectation that they will remain in contraction with the January release next week on Thursday. The level of each activity’s indicator from the lowest to highest are Apartments, House Building, Commercial construction and Engineering construction. This order is the same when measuring the most to least number of months in contraction territory, with House Building and Commercial construction both experiencing five months of consecutive contractions. The lower level of contraction in Engineering construction is unlikely to offset the significant decline in the other sectors, despite engineering accounting for the largest amount of construction activity compared to any other single activity; engineering construction accounts for 43.3% of all construction work performed.

Australia Construction Activity Indices December 2018 - Source: The Australia Industry Group

Forward looking measures of construction do not appear to be merciful either, with new orders for each activity suggesting that performance is likely to remain subdued during the first month of 2019. ABS data is also indicative of this. Australia-wide, building approvals have fallen between November and December on a seasonally adjusted basis in all categories, except for public sector dwelling units (which only accounted for 1.07% of all building approvals). There is a significant drop in approvals of dwelling units excluding houses primarily in the private sector, namely apartment buildings; a 18.59% decrease in approvals. This is similar to the performance of the three states with the largest proportion of building approvals. New South Wales has experienced falls over the last three consecutive months, more recently a fall of 5.48%. Queensland has experienced something similar, with two months of consecutive falls and a recent fall of 1.60%. Meanwhile, Victoria has shown choppy building approval action, with a recent increase of 1.58%. This suggests that future poor performance in construction is driven by softening demand, a common denominator across all construction activities.

Australia Construction Activity New Orders Indices December 2018 - Source: The Australia Industry Group

Stock Views

Construction related capital goods appear to be sensitive to construction related activity, an already highlighted sector of interest to be used to capitalize on poor construction performance. Furthermore, when there is low demand for construction across all activities, construction suppliers are further down the supply chain and will be affected later. Typically, construction financing is affected initially when demand slows, which then trickles down to construction suppliers. This gives traders and investors the opportunity to capture returns which have not been priced into the market yet.

One particular stock of interest is Seven Group Holdings Limited (ASX:SVW), a firm which is highly exposed to Australia’s construction sector. The group’s primary line of business is heavy equipment sales, particularly in the construction and mining sectors. However, the group also has interests in energy and media sectors. When analyzing the group’s revenue, we find that the majority of revenue is derived from the WesTrac Group and Coates Hire. WestTrac Group is the equipment dealer arm of the group, primarily distributing construction and mining equipment and accounting for 76.44% of the group’s total revenue in 2018. Coates Hire is the general equipment hire component of the group, accounting for 20.26% of the group’s total revenue in 2018. While this is problematic, the group also has energy and media investments, which accounts for a collective 28.17% of EBIT, while the WesTrac Group and Coates Hire accounts for a collective 64.78%. This is slightly better in terms of diversification, however the firm is still highly exposed to construction and mining demand. While mining demand appears to be expanding slightly, it is not enough to offset the significant construction demand woes across all activities.

Source: Seven Group Holdings Limited

The projected direction of media investments through the TCF, paper and printing products sector of the Australia PMI suggests that it will hedge out some of the risks in construction and mining, however the sector had previously faced a volatile year in 2018. This does not make this hedge completely ideal for the firm. The energy sector has faced elevated input costs for numerous years, making the group’s energy investment in SGH Energy (100% ownership) and Beach Energy (25.6% ownership) another problematic hedge. When looking deeper into these investments, we find that Beach Energy derives revenue quite evenly between its crude oil and gas and gas liquids operating segments. However, SGH Energy appears to be more focused on natural gas; with larger gas fields, appraisals and prospects compared to its current oil fields. Natural gas is the second largest source of electricity generation in Australia; approximately 21% of total electricity generation in 2017. This suggests only a partial hedge away from the expected woes of construction through energy demands which are not dependent on the business cycle.

Source: Seven Group Holdings Limited

Ratios

For an accurate view of the Seven Group relative to other comparable firms, multiple ratios are considered. The group’s stock performance appears to be relative neutral relative to comparable companies, with a moderate price/cash flow ratio (TTM) of 10.14. However, the group also has a high price/sales ratio relative to comparable companies. This suggests that the additional actions which are used to generate cash for the group is valued less by the market. As a result, a firm’s efficiency and management’s effectiveness need to also be evaluated.

Company Price/earnings (TTM) Price/book value (MRQ) Price/cash flow (TTM) Price/sales (TTM)
Konecranes Abp 28.84 1.98 12.64 0.7669
Duerr AG 16.33 2.7 9.88 0.6444
Bucher Industries AG 16.19 2.21 10.97 1.08
Seven Group Holdings Ltd 13.11 2.08 10.14 1.65
Sumitomo Heavy Industries Ltd 12.51 1.03 7.01 0.5292
Metso Oyj 21.72 2.9 16.29 1.3
Husqvarna AB 18.39 2.36 10.82 0.9958
GEA Group Aktiengesellschaft 20.94 1.76 12.58 0.9121
AGCO Corporation 19.08 1.75 9.58 0.5477

Seven Group Holdings Limited Stock Performance - Source: Financial Times

Firm efficiency ratios appear to coincide with the implications of a lower relative price/cash flow ratio compared to a high price/sales ratio. The inability to effectively utilize its assets nor inventory to generate sales all point towards problems in efficiency, rather than generating sales itself. Conversely, management effectiveness appears to be a strong, with a high return on average assets (TTM). This suggests that management’s control of cost of goods sold is enough to enable an efficient use of assets. However, the firm’s exposure to an inefficient use of asset and inventory to generate sales will be problematic, particularly when the firm’s sales is hit by dwindling demand in Australia’s construction and mining sectors. To further confirm this view, profitability ratios are evaluated.

Company Asset turnover (TTM) Inventory turnover (TTM) Receivables turnover (TTM) Revenues per employee (TTM)
Konecranes Abp 0.8995 2.13 6.51 192,731.00
Duerr AG 1.08 5.44 3.56 251,935.80
Bucher Industries AG 1.15 2.1 5.82 239,040.30
Seven Group Holdings Ltd 0.5914 2.27 7.06 --
Sumitomo Heavy Industries Ltd 0.9776 3.62 3.61 40,889,140.00
Metso Oyj 0.9448 2.59 4.69 247,985.40
Husqvarna AB 1.09 3.57 8.95 2,951,039.00
GEA Group Aktiengesellschaft 0.8283 4.43 3.46 267,968.20
AGCO Corporation 1.15 3.5 9.05 453,034.20

Seven Group Holdings Limited Efficiency - Source: Financial Times

Company Return on avg assets (TTM) Return on avg assets (5 yr avg) Return on investment (TTM) Return on investment (5 yr avg)
Konecranes Abp 2.41 4.89 3.67 9.64
Duerr AG 4.45 6.07 9.24 13.35
Bucher Industries AG 7.62 6.6 11.1 10.27
Seven Group Holdings Ltd 7.4 1.9 8.59 2.24
Sumitomo Heavy Industries Ltd 4.55 3.74 7.61 6.17
Metso Oyj 5.7 5.95 8.91 9.33
Husqvarna AB 5.9 5.59 8.33 7.57
GEA Group Aktiengesellschaft 3.62 4.34 5.59 6.51
AGCO Corporation 2.97 3.77 4.44 5.59

Seven Group Holdings Management Effectiveness - Source: Financial Times

The firm’s low net profit and gross margins suggest that operating costs, interest and taxes have weighed heavily on the firm’s ability to generate profits. This presents the company with greater exposure, particularly with high employee benefits, repairs and maintenance and operating lease rental.

Company Gross margin (TTM) Gross margin (5 yr avg) Net profit margin (TTM) Net Profit margin (5 yr avg)
Konecranes Abp 56.14 46.62 2.67 3.63
Duerr AG 21.88 22.6 4.11 5.28
Bucher Industries AG 50.03 50.25 6.62 6.24
Seven Group Holdings Ltd 47.98 37.94 12.52 3.69
Sumitomo Heavy Industries Ltd 23.96 23.05 4.65 4.19
Metso Oyj 28.74 29.24 6.03 6.98
Husqvarna AB 25.61 28.75 5.39 4.8
GEA Group Aktiengesellschaft 29.85 31.57 4.36 5.9
AGCO Corporation 21.42 21.28 2.57 3.22

Seven Group Holdings Limited Profitability - Source: Financial Times

While the group has a significantly higher payout ratio (5 yr avg) relative to comparable companies, this can be attributed to Australia’s use of the dividend imputation system. This encourages dividend payouts as they are not taxed twice, as opposed to a classical dividend system. However, Seven Group does contain negative reserves, with retained earnings being unable to cover this loss. This suggests that the company’s dividend policy is unsustainable. Either way management decides to proceed, the firm’s capital intensiveness is projected to drive the firm’s share price lower.

Company Quick ratio (MRQ) Interest coverage (TTM) Total debt to capital (MRQ) Payout ratio (5 yr avg)
Konecranes Abp 0.7095 5.76 0.3918 81.28
Duerr AG 1.01 13.38 0.4887 38.67
Bucher Industries AG 1.18 108.33 0.192 39.82
Seven Group Holdings Ltd 0.8965 -- 0.4302 158.51
Sumitomo Heavy Industries Ltd 1.03 59.03 0.1302 29.01
Metso Oyj 1.13 11.32 0.3 75.17
Husqvarna AB 0.8053 5.97 0.3183 61.52
GEA Group Aktiengesellschaft 0.9074 15.55 0.197 52.84
AGCO Corporation 0.6345 10 0.3885 12.55

Seven Group Holdings Limited Financial Strength - Source: Financial Times

Risk Management

With a bearish view on Seven Group Holdings, one still needs to hedge out market risk through beta hedging. One stock which could be used as a hedge is Fortescue Metals Group Limited (ASX: FMG). This is because we wish to hedge out mining sector risk, while being exposed to construction sector risk in Seven Group Holdings. Based on the Australia PMI, we find that mining maintenance activity is still prevalent, despite the slow down in the mining sector. While we also see that China’s Caixin PMI is currently in its second month of contraction at 48.3 in January, poor mining performance is unlikely to eclipse the even poorer performance of the construction sector. This suggests that while both sectors appear to be on the decline, the mining sector is projected to remain relatively resistant and the mining group is likely to be a good hedge. Fortescue Metals Group contains a beta of 1.2924, relative to Seven Group Holdings beta of 1.5458. This suggests Fortescue Metals Group and Seven Group Holdings should be entered into a dollar ratio of 1:0.8361, with a long position in Fortescue Metals Group and a short position in Seven Group Holdings. Beta hedging will eliminate market risk, but due to the nature of the hedge, only mining risk will be hedged away and not construction sector risk. One should be mindful of this.

Fortescue Metals Group Limited Perth Office - Source: Futurespace

Technical Analysis and Price Action

When calculating the historical ratios for this spread trade, we find a 3-month view currently has momentum, with the 20-day simple moving average above the 60-day moving average. While the 60-day moving average is above the 250-day moving average, the 120-day moving average is still below the 250-day moving average. However, the intermediate 120-day moving average is currently on trade to crossover an above the 250-day moving average. When it does crossover, our 12-month view will have fresh momentum for the spread trade to be entered. We can also see that since late 2008, the spread ratio has remained in a channel between 0.15 and 1. This suggests that this relationship is likely to remain, but care must be considered when trading at each extreme ratio value.

FMG/SVW adjusted closing price

FMG/SVW adjusted closing price and simple moving averages

If one has a shorter 3 or 6-month time horizon, one can enter into the trade now, but if one has a longer 12-month time horizon, one can enter into the trade once the 120-day simple moving average crosses above the 250-day simple moving average; which will be any day now.

Stop Losses and Soft Targets

When analyzing the high-low range of the two firms, we find that Seven Group Holdings has relatively higher 3 and 6-month ranges, while containing a lower 1-year range compared to Fortescue Metals. Stop-losses are derived from these ranges for each time horizon. I recommend the use of stop losses 14.88%, 15.86% and 19.41% for 3-month, 6-month and 1-year time horizons respectively. This translates to spread ratios of 0.3152, 0.3116 and 0.2984 for 3-month, 6-month and 1-year time horizons respectively. I have also determined soft targets for each time horizon using a 1:3 ratio of points below the current spread ratio to above the current spread ratio; 0.5357, 0.5466 and 0.5860 for 3-month, 6-month and 1-year time horizons respectively. This is reasonable as the proposed soft targets have historically been reached. As previously mentioned, the spread ratio has historically remained within the channel between 0.15 and 1 since late 2008. This suggests that when the ratio reaches either extreme, it is possible that the ratio will revert and remain within the channel. However, this will depend on fundamental views which are constantly revised while this trade is still on. If your fundamental view of the spread trade is consistent with a breakout when near the ratio of 1, then the trade should remain on. If not, then the trade should be exited.

FMG/SVW channel between 0.15 and 1

Conclusion

The Australian construction sector has performed poorly in recent months and there appears to be no signs of slowing down. I recommend a short in the construction sector to capitalize on this and use the capital goods sector to do this. We find that Seven Group Holdings is highly exposed to both the construction and mining sectors, with only partial hedges in its energy and media investments. The group also has financial ratios which suggest the firm’s projected under performance relative to comparable firms. As a result, I suggest a short position in Seven Group Holdings. However, I also suggest hedging mining sector risk by entering into a long position with Fortescue Metals Group. This should be performed on a 1:0.8361 dollar ratio, Fortescue Metals Group to Seven Group Holdings respectively. Using technical analysis and observing price action, we find that 3 and 6-month momentum exists for this spread trade, while 1-year momentum is currently building. This suggests that if a trader has either a 3 or 6-month time horizon, the trade can be entered now, while a trader with a 1-year time horizon only needs to wait a short time for the 120-day simple moving average to crossover and above the 250-day simple moving average. When the trade is entered, stop losses of 0.3152, 0.3116 and 0.2984 for 3-month, 6-month and 1-year time horizons respectively should be used. The soft targets which should be used are 0.5357, 0.5466 and 0.5860 for 3-month, 6-month and 1-year time horizons respectively. The stop losses and soft targets should be revised when soft targets are reached, and the existence of the trade should be questioned when the ratio reaches close to the upper extreme of the channel. This will depend on the trader’s consistently revised fundamental view and whether it is enough to warrant remaining in the spread trade.

Source: Business Insider Australia

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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