Where we took profits and losses in 2023

2023 was a big year in the financial markets. Global stock markets have outperformed expectations, avoiding a feared recession in the US and showcasing resilience in the Australian economy (among developed economies) amidst aggressive rate hikes. The UK and Japan displayed economic resilience, while China faced concerns, leading to mixed economic data. Hong Kong and Chinese stocks declined, with the Hang Seng index down 16% year-to-date.

The impact of inflation and interest rates took centre stage with central banks adjusting policies to mitigate economic downturn risks. We also made big moves into sectors from fossil fuels, uranium, and gold. The commodities space faced challenges, particularly in lithium, nickel, and copper. That said, we made efforts to improve the composition of the portfolio by trimming exposures in some sectors.

In 2023, we published 13 sell or sell-half recommendations, with 7 seeing decent to impressive gains and the remainder registering losses in various degrees. Any returns noted below include dividends. Our calls by stock are provided below in chronological order:

Tower New Zealand

Tower New Zealand was re-added to the portfolio in 2021 after successfully managing its post-GFC and Christchurch earthquake issues. We noted then that new management has proven to be forward-looking having ramped up investments in digitising operations and even enhance margins. Dividends also made a return after a 5-year hiatus.

It ultimately proved to be a lacklustre exposure with more challenges of earthquake claims (this time in Canterbury), flooding in Auckland among other issues (higher reinsurance premiums) caused gains from digitization to evaporate. With increased uncertainty, we opted to cut our losses with a sell recommendation booking a -20.5% dip in value.

Perenti Global

Perenti Global is a long-tenured exposure having been part of the portfolios since 2007. It has evolved over time but its recent performance has proven to be disappointing with the shares trading in a prolonged ‘consolidation’ (i.e. sideways), practically going nowhere. On the fundamentals, earnings were not impressive especially given risks it is exposed to (think geopolitical risks in Africa such as in Burkina Faso and Ghana) and an increased debt load. With concerns about uncertainty and the rising debt in an inflationary and interest rate environment, we opted for a clean break and locked in an unimpressive (due to its tenure) 21.3% gain.

ARB Corporation

ARB Corporation was another long-tenured exposure, added into the portfolio back in 2011 due to its impressive track record, solid distribution network and steady expansion. It was also reasonably priced yes poised for growth – a rare mix of growth and value.

However, in 2023, management flagged inflationary pressures and the resultant hike in costs and sales decline. Combine that with supply chain disruptions impacting the expansion into the US, we believe that it was better to make an exit as growth is likely to take further hits. We netted a solid 232.6% gain from this exposure.

Domain Holdings

Domain Holdings became part of the portfolio in 2017 after separating from Fairfax. Because of its unique place in the real estate market where it offers residential and commercial property marketing services through various listing portals as well as transaction services and provides data and technology services to real estate agencies. It was also attractively priced making a solid value case for the shares.

Its tenure in the portfolio, however, lacklustre largely moving in a broad consolidation. Its financial performance was also lacklustre with rising interest rates impacting prospects in the real estate market. In light of the weak outlook and lacklustre long-term performance, we opted to exit at a small loss.

Blackmores

Blackmores, after being flagged in Traffic Lights, was added to the portfolio in March 2020 at the start of the pandemic to ride the potential of the supplements market. Aside from the opportune entry point, the company has had a solid track record of growing sales over the years.

Almost three years later, we opted to exit with the COVID trade not panning out as expected with the various product lines proving to be ultimately a ‘discretionary’ spend while inflationary pressures started to impact profitability. However, the technical decision to exit proved too early as the company was eventually acquired by Kirin at ~$91.71/share plus a special dividend of ~$3.29/share. In any case, we at least locked in a gain of 14.6%.

Adore Beauty

Adore Beauty was another unusual addition to the Australasian portfolio based on the shifting trend in shopping behaviour – the move to online shopping for beauty and personal care which was a large addressable market. The company had a decent balance sheet with good leadership as well as a solid 13% market share in the online space.

It ultimately proved to be another disappointing exposure with the company not living up to expectations. Sales continued to decline while the active customer base has dropped some 9%. It didn’t help that the company was unable to post growth during COVID when most transactions were done online and this is in spite of new brands like Dior and Huda Beauty. We recommended an exit to free up tied up cash to invest in better opportunities elsewhere.

Medibank Private

Medibank Private was also another long-term exposure added to the portfolio on the back of its market leadership, favourable industry dynamics as well as expected productivity and profit growth post-privatisation.

Over the years, it proved to be a steady compounder but a major cyber incident coupled with lacklustre financial performance made us review the exposure. Weak investment in cyber security is a major risk especially for a financial firm where trust is paramount – losing customers and regulatory will just be the first of many issues. That said, the company also experienced setbacks to growth pre- and post-COVID prompting a speedy sell recommendation locking in a solid 116.9% gain.

Catapult

Catapult was another relatively young exposure to the portfolio having joined around February 2020 due to its market leadership in a growing sector. We also saw opportunities from its ‘evolution’ towards a Software-as-a-Service model.

Despite that, performance proved to be elusive despite its status as a disruptor in the field of sports analytics with the company unable to navigate financial challenges and increased costs. Given the unfavourable macro environment (higher interest rates and inflationary pressures), we believed that resources would be better used elsewhere and we recommended a sell.

Platinum Japan Fund

The Platinum Japan Fund was another solid exposure to the portfolio but was originally meant for the Global Funds product. Due to its domicile in Australia, it was transferred to the Australasian portfolio.

Given its mismatch with the overall theme, we opted to cease coverage as there were simpler alternatives such as the iShares MSCI Japan ETF or other more concentrated exposures in the Global Equities portfolio.

Bubs Australia

Bubs Australia was another solid niche exposure added around the height of the lockdowns where we saw solid performance with demand for its infant formula remaining strong while management inked new supply agreements with major retailers. The solid technical ‘picture’ (then) coupled with improving fundamentals further supported our case.

Despite its solid product offerings, the unnecessary Boardroom drama and continued delays in securing the all-important regulatory approvals in both the US and China were the last straw. We opted to cut losses and as a ‘vote’ of no confidence for the remaining leadership, we recommended a sell.

Mincor Resources

Mincor Resources was first added to the portfolio back in August 2020 largely on its Kambalda Nickel project which (then) had been operating for over 5 years and producing 14,000 tonnes of nickel per year. We saw the exposure as a solid one and aligned well with dual demand from both the steel industry and burgeoning EV sector. The exposure here was a solid one during its tenure and even surged to a high of $2.84 (initial buy at $0.745).

However, the company was eventually acquired by Wyloo Metals and we posted a recommendation to accept the $1.40 cash offer. The overall return was a solid +87.9%.

Sky Network TV

Sky Network TV was a ‘turnaround’ exposure added in late 2018 as managements efforts to improve operations and financials were beginning to show. We also noted that the company was adapting to the changes in consumer behaviour by adopting internet-friendly access and satellite-delivered content. The valuations were also, then, attractive.

However, its tenure in the portfolio proved to be disastrous as a quote by Warren Buffett perfectly captures the issue “when a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.” The changing landscape has proven too difficult for management especially with the looming threat of streaming services. We opted to cut our losses as the company is unlikely to beat ‘bad economics’.

Bank of Queensland

Finally, we turn to the Bank of Queensland. Over its long tenure in the portfolio, it has not recovered to its pre-GFC levels due to various issues but was kept due to its solid ability to provide a steady income aside from acting as a diversifying exposure due to it being a regional bank.

The ultimate decision to exit, however, was a consequence of souring outlook with management flagging continued challenges to FY24 as cost pressures continue to impact earnings. It also doesn’t help that the bank’s performance did not match with the rising interest rates which, when it eventually starts to come down (perhaps as early as next year) will result in further price pressure as the bank’s margins would fall. We opted to lock in a modest (due to its tenure) 56.7% gain.

2023 reflections

Global stock markets have performed better than feared in 2023 as a widely expected recession for the US economy was avoided without the negative knock-on impacts that would typically have entailed. The Australian economy has also proved resilient in an aggressive rate-hiking cycle. Most other major countries have been on the same page to varying degrees, although individual stock market performances have varied. As of mid-December, the S&P500 is an impressive 23% higher, in large part thanks to a stellar performance from the Magnificent 7 (the Nasdaq 100 has zoomed more than 51% higher) but enjoying broadening support from other pockets of the market over the past few weeks.

On home shores, the benchmark S&P/ASX200 is up a tad over 6%, supported by a solid advance over the past six weeks, recovering from a challenging September and October trading period.

The ride for investors hasn’t always been smooth, though, with bouts of volatility during the year. Touching on a few, there was a banking crisis scare early in the year prompted by US regional banks. Losses on cryptocurrency investments, sharp downturns in the value of bond portfolios and commercial real estate investments, and runs on bank deposits triggered the collapse of the likes of Silvergate Bank, Silicon Valley Bank, Signature Bank and First Republic Bank.

The resulting waves played a key role in the failure of Credit Suisse, one of Europe’s largest banks, forced into a shotgun marriage with UBS. Fears of contagion from the banking crisis hit financial stocks hard and rippled across other sectors. A broader and deeper banking crisis was likely averted as the Federal Reserve stepped in. A group of larger banks, led by JPMorgan Chase, stepped in to provide further support. Ultimately, the broader market impact was relatively short-lived. While not immune, Australian banks were relatively insulated from the turmoil due to diverse customer bases combined with substantial capital and liquidity standards in place. The financial sector in Australia, dominated by the banks, has advanced approximately 3.9% year-to-date.

We moved our recommendations on the big banks (NAB, WBC, ANZ) back to hold in early 2023 as we anticipated pressure on the sector from rising expectations of potential soured debts from very low cyclical levels as more Australians rolled over from low-cost mortgages. In addition, as the economy slows, system loan growth has plumbed lower levels, and the banks have been intensely competitive in the mortgage market while the tailwind from interest rate rises began to taper. The big banks delivered solid results, dividend increases and share buybacks but have traded in a range. Our buy recommendation on QBE fared well in 2023 thanks to the firming premium cycle and improving investment returns. The latter tailwind is still flowing through, but we are beginning to see fading investor interest as markets look forward. We will be revisiting our recommendation on the stock in early 2024.

Hopes that the Ukraine war would be resolved never really looked even close to unfolding. Sadly, the world was in for more geopolitical turmoil after the shock Hamas attack on Israel and the subsequent ongoing war. Energy markets endured another spike, albeit a brief one. Crude oil prices have quickly corrected to the downside on signs of discord within OPEC+ and as US oil producers have ramped up production. The energy sector in Australia is one of three sectors in the red YTD, down 4.3% at the time of writing. We have recommended Woodside and Santos as buys, although our timing regarding crude oil prices has been disappointing. We see considerable value in the sector for patient investors, given very undemanding valuations and as fossil fuels appear positioned to remain an essential part of the energy mix for a long time. News that Santos and Woodside are in merger discussions reignited some interest in the names over the past few weeks.

Uranium prices have continued to ascend in 2023, and the structural set-up looks favourable for years to come. Supply has effectively lagged demand for years, as prices plummeted following the Fukushima disaster in 2011. Until now, demand has been filled by existing inventory, but with energy security and the green transition growing in importance, there has been a renaissance in plans for new reactors to come online over the next decade.

We recommended Paladin Energy (PDN) as a new buy in August, followed by a buy recommendation for the Global X Uranium ETF (ATOM) for those seeking exposure to the same theme without the specific company risk. Both recommendations are away to a strong start.

Recently, the chronic underinvestment in new uranium supply over the past several years has been undergoing a positive momentum swing, but there continues to be a shortfall. This scenario caters to an energy-hungry world seeking carbonless, reliable base electricity capacity, with uranium a potential key to meeting what the world is seeking. We continue to view this area favourably for investment opportunities heading into 2024.

Inflation and interest rates have again dominated investor attention in 2023. Here, the developments have been about as positive as investors could have hoped after beginning the year with inflation at very elevated levels.

Inflation has headed notably lower globally (although it is still running well above many central banks’ target pace), and central banks have been able to take their foot off the pedal with interest rate hikes. Elevated inflation heading into 2023 saw consumers enduring a cost-of-living crisis while companies passed higher costs onto customers. Harsh medicine via interest rate hikes lifted borrowing costs for corporates and consumers.

The big worry was this would tilt economies into recession. The US economy has shown remarkable resilience, avoiding recession and faring reasonably well overall, albeit with pockets of weakness. In Australia, a similar theme has played out. We have seen an economic slowdown but avoided recession, and the job market has held up better than feared.

Australian GDP expanded 0.2% QoQ in the September quarter, well below expectations for 0.4% growth and slowing from 2Q23. That marked the slowest expansion in a year as household consumption stalled. Fixed investment grew slower, and net trade was a drag as exports fell for the first time since the March 2022 quarter. We note that migration supported GDP, as on a per capita basis, GDP shrank by 0.5%. Meanwhile, annual GDP growth was 2.1%, ticking up from 2.0% in 2Q23 and above forecasts of 1.8%.

Australia’s GDP change (QoQ)

The slowdown in quarterly GDP growth buoyed stocks as investors believed the RBA would be done with rate hikes and began betting on cuts in late 2024. Local bond yields fell across the curve.

Inflation in Australia has proven stubborn, seeing the RBA respond by lifting the cash rate to its highest level in 12 years, at 4.35%. The last 25bps hike came at the November meeting, following four months of being on pause. As widely expected, the RBA left rates unchanged at the year’s final meeting in early December.

In good news for mortgage holders, the monthly CPI data released by the ABS in late November showed annual inflation eased to 4.9% in October, down nicely from the 5.6% pace in September and well below the 5.2% the market was expecting. This marked a welcome reversal after the annual CPI reaccelerated in August. The cooling was helped by softer increases in transport prices and housing, along with several other categories.

Australian CPI (YoY)

Combined with the slide in retail sales reported earlier that week and the other soft data points we have since seen, the RBA should feel comfortable staying on the side-lines at upcoming meetings. Indeed, traders have increasingly begun laying bets on when the first cuts will come in 2024. We caution against expecting a rapid pivot. We anticipate the RBA to remain data-dependent and that officials will continue to do some tough talking. Inflation remains too high, although the impact from the last rate hike has yet to flow through in the numbers. In addition, a slowdown of immigration should ease demand pressures on the economy, although it may lead to a bout of weakness in the housing market. We suspect inflation levels will likely remain elevated at levels such that the RBA will stay on pause in the first half, likely with rate cuts to be on the table in late 2024.

The recalibration of interest rate path expectations has seen the real estate sector rally over the past two months, given the heavy dependence of the business model on debt and what we viewed as undemanding valuations in many instances. We conclude the year with buy recommendations on Mirvac and National Storage REIT, both of which participated in the rally. The real estate sector has recouped losses from earlier in the year to be 9.4% higher YTD at the time of writing. The sector looks well placed to perform well in 2024. We also have hold recommendations on Scentre Group and Vicinity Centres. These are quality exposures, and Australian consumer spending has held up better than feared. Both companies are improving the asset mix within their portfolios.

Another sector that rallied on the shift in interest rate expectations is technology, the best YTD performer, up more than 28%. Another element that has supported the sector in 2023 is the explosion of AI on investor radars. While AI is nothing new, the emergence of generative AI, spearheaded by ChatGPT, has been a game-changer for interest in the possible commercial potential in the years ahead. This interest drove much of the stellar performance of the Magnificent 7 on Wall Street and has had a ripple effect on Australian-listed stocks, albeit with many having a more adjacent exposure. Still, combined with the change in interest rate expectations, many in the sector have surged. We expect AI to continue to be a popular theme in 2024, although we anticipate investors to be more focused on seeing tangible results rather than hype.

The heavyweight materials sector has benefitted from elevated iron ore prices in 2023. Indeed, these have surprised on the upside significantly despite China’s embattled property sector. Supporting iron ore prices has been a steady stream of supportive rhetoric from Chinese authorities throughout the year, and some firm stimulus has been announced, even if the benefits for the Chinese economy have been muted to date. This price action has supported BHP, Rio Tinto and Fortescue, all of which are recommendations within the research portfolio. The materials sector has gained 9.1% year-to-date.

Gold prices hit a record high of US$2,150 per ounce in early December, although had retreated to around US$2,035 per ounce at the time of writing. The All Ords Gold sub-index has returned approximately 23.4% for the YTD as heavyweight exposures such as Northern Star and Evolution Mining have rallied. We still see significant value in the sector at current levels and retain buy ratings on those two stocks.

The picture elsewhere in the commodities space has been rather bleak overall. Underlying lithium prices have tanked for much of the year as investors fretted the uptake of EVs will slow amid sluggish global economic growth as these are big ticket items. Despite a spate of M&A news flow in the sector, many Australian lithium players, such as Allkem and IGO, have retreated. Nickel has had a brutal year, and copper has fallen, albeit been rangebound in 2H23. Exposures in these areas and some other metals have endured a challenging patch.

Elsewhere, consumer staples -3.9% and utilities -3.9% were two of the three sectors below water, while healthcare +0.3% is barely in the green. Industrials are up around 8.9%, while telcos have added 10.3%. We note this has been without the help of Telstra, though, which has fallen a tad over the past year. For much of the year, the rise in interest rate expectations was a headwind, but Telstra has failed to join the rally over the past couple of months as traders rotated into more cyclical names. The improving backdrop for Telstra’s mobile business continues to underpin our expectation of robust cash flows and dividend prospects.

We provided much traffic light coverage over 2023 and made seven new buy recommendations over the year. When discussing our positive view on uranium, we previously touched on two above – Paladin Energy (PDN) and the Global X Uranium ETF (ATOM). We added business payment solution provider Tyro Payments (TYR) as the company reported a maiden profit, marking an inflection and turning point. Tyro is now generating robust cash flow from its POS electronic payments business. The technical picture is supportive.

Coal miner New Hope Corporation was another new buy recommendation, noting that despite coal prices having corrected sharply from the spike amid the pandemic, they remained elevated. We highlighted the appeal of the Bengalla and New Acland sites producing high-calorific-value (HCV) coal, sought after by utilities, giving better burn results than lower-HCV coal. Meanwhile, the Maxwell mine produces metallurgical (met) coal and commenced operations in the June quarter of 2023.

Graincorp was a recent addition, and we are drawn by the company’s strong market positioning, appealing valuation and our expectation of a favourable price outlook for wheat. Mirvac was our other recommendation. We like fading headwinds on the macro side from interest rate expectations and several company-specific attributes. Mirvac has a stellar track record of consistency and growing dividends, a crucial attractiveness of Mirvac through the cycle. An element we are excited about in the coming years is the opportunity to ramp up residential and benefit from a boom in residential development across the country. This is sorely needed to address the chronic housing shortage.

Signing off for 2023, we would like to thank all Members for their continued support and wish all a safe and happy Christmas and a prosperous New Year.

Best regards,

Fat Prophets

Disclosure: Interests associated with Fat Prophets hold shares in NAB, WBC, ANZ, TLS, GNC, TYR, WHC, PDN, ATOM, NHC, BHP, RIO, WDS, STO, NST, EVN, MGR.

Speedbump

Shares in master franchisee – and largest franchisee outside the US – Domino’s Pizza Enterprises (ASX.DMP) continued to be under greater pressure after the release of a ‘strategy update’ wherein management will streamline operations but also exit some unprofitable markets. To be fair, this move was not a complete surprise given the inflationary and other cost pressures coupled with increasing competition post-COVID reopening.

However, DMP’s value comes from being a solid defensive exposure in a portfolio given that we’re not totally out of the ‘recession’ woods yet. The solid value offerings should still make it a worthy choice for consumers should a ‘soft landing’ not materialise (increasingly likely). The company’s solid track record of innovation and operations discipline will also keep it an attractive investment in years to come.

In the meantime, we maintain our Hold recommendation on Domino’s Pizza Enterprises (ASX.DMP) for Members with exposure. DMP will remain firmly held in the Fat Prophets portfolio.

Turning to the charts, DMP shares broke to the downside after the trading update and even hit a new 52-week low at $47.50. However, bottom fishing pushed the stock back up to close a hair below the $44.56 support level. The downtrend is also confirmed by the fact that we see a ‘death cross’ – where the 50-day (red) moving average (MA) crossed below the 200-day (green) MA – back in mid-March.

From this vantage point, the selling pressure is likely to let up in the coming weeks provided no new low is formed – this is also reflected by the fact that the share price has moved substantially far from the 50-day (red) moving average and assuming reversion to the mean, a rebound is becoming increasingly likely.

Now onto the updates:

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FY23 Trading Update

DMP announced a series of strategic initiatives that is expected to result in a short-term hit BUT lead to substantial savings. This update was quite a surprise with many expecting a more moderate change, but, recent trends in the QSR (quick service restaurant) industry do make this sizeable development unpalatable but necessary for long-term health.

First off, DMP announced the plans to exit the loss-making Danish market by the end of the year. A bit of a recap, DMP entered the Danish market in 2019 after the local franchisee struggled to perform in the region after entering receivership amid loss of public trust due to food safety violations.

At the time, this was a no-brainer move considering DMP’s solid track record of turning around operations but, as the saying goes, “you win some, you lose some” and in this case DMP failed to turn around the substantial loss of trust from the public despite drastically improving the quality of operations – even receiving numerous awards for food safety.

With the damage done, DMP has decided to close the 27 stores in the country with upfront costs expected to fall between $20 million and $26 million but this should eventually lead to EBIT improvements of $12 million starting FY24. We also see this manoeuvre to be a prudent one considering that Denmark only accounts for a tiny 0.7% of the company’s global footprint.

The pizza market in Europe has proven to be a tough nut to crack with the UK counterpart Domino’s Pizza Group (also covered in the Global Equities portfolio – for Members without access, please reach out to customer service to upgrade your subscription) having historically struggled in the continental market due to various factors such as higher labour costs, different consumer preferences to highly entrenched local players.

Source: DMP Presentation

Next, on the subject of store count, DMP has announced plans to optimise the corporate store network. DMP is a master franchisee which allows the company to run stores or also franchise to prospective external operators – a business that allows for rapid expansion at minimal capital outlay.

So far, DMP has about 3,827 stores while directly operating around 913 stores. The planned change here involves closing around 65 to 70 underperforming locations while transferring about 70 to 75 stores to other franchisees – all measures to reduce operating costs but also free up some capital. The total impact would reduce 15% to 20% of corporate-owned stores with cost savings to hit around $16 million to $20 million per year. There will be upfront costs of between $50 million and $55 million, though.

The third update is the planned closure of legacy commissaries and IT assets in Southeast Asia. One of the factors that support rapid growth for DMP in the past few years was the rapid expansion to Asian markets. The various acquisitions in the region, though, mean that there were entrenched operations and janky IT systems that no longer make sense after integrating to the DMP group.

That said, management is planning to close various commissaries in Asia (Taiwan, Malaysia, Singapore & Cambodia) as well as legacy IT systems which have become obsolete in the wake of ‘new gen’ “OLO” (OnLine Ordering) systems (think: Uber Eats & DoorDash).

The costs here are expected to be around a modest one-off $10 million to $12 million with EBIT benefits of around $5 million to $7 million per year.

Finally, the last strategic initiative is to streamline core operations. The massive change in DMP’s business model in the last few years (from largely Australia-focussed to a global one) has made management rethink the business model. With a more global-centric business, DMP can leverage the much larger scale to unify IT systems to other business practices that can be scaled.

Though this is rather vague, the fact that DMP now operates in multiple regions make changes too complex to cover in one sitting. The most important development, however, is the fact that management expects EBIT cost savings of around $20 million per year starting FY25.

All in all, we’re pleased with these updates from management and cost savings of around $50 million to $59 million should improve margins which have been under pressure on the back of high inflation post-COVID.

Trading Update

Aside from the changes with operations, management also hinted at improving sales trends for the 2H23. According to the report, 4Q23 sales are up 2% on an underlying basis and is better than overall 2H23 result which was flat. The key takeaway here is that the market has now absorbed the price increases and that underlying growth should continue.

Management also kept the long-term store count target of 7,100 by 2033 unchanged.

Disclosure: Interests associated with Fat Prophets hold shares in DMP.

In better health

Although Sonic Healthcare shares have pulled back from 52-week highs, they have staged a nice ascent in 2023 and we believe the recovery has much further to go, with a solid fundamental outlook.

The earnings ‘hole’ from lapping those bumper results amid the pandemic has faded and we foresee a robust earnings outlook for the coming years. Surgeries and GP visits have further to recover, with positive implications for Sonic’s business, adding to what are already positive secular trends. The Federal budget was an incremental positive.

Sonic is in a great position to continue to bolster organic growth via acquisition as covid-testing was a cash bonanza helped Sonic deleverage the business materially, leaving Sonic with plenty of dry powder for new deals. Indeed, since our last review, Sonic has announced another bolt-on (more on that below). Meanwhile, the defensiveness of the broader healthcare industry is likely to attract more investor interest in the tough economic times looming. Sonic is one of the higher-quality businesses within the sector.

We continue to have confidence in the long-term prospects for Sonic, with the business very well managed. We upgrade our rating on Sonic Healthcare to a buy for Members with no exposure.

Turning to the charts, SHL had an impressive run surging from 52-week lows in mid-February to 52-week highs in just two months. Since peaking in April (see above), SHL has seen some profit-taking with the shares trading in a downward trading channel. Still, SHL is forming a ‘bull flag’ – typically a continuation pattern where profit-taking activity pushes the stock lower before breaking out to the upside. A prudent buying strategy would be to attempt to enter either (i) at the bottom of the flag (i.e. support levels) or upon breakout of the upper band.

Since our last coverage (in early April), Sonic announced in late April that it had signed a binding agreement

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to acquire one of the leading clinical laboratories in Duesseldorf, Medical Laboratories Duesseldorf (MLD). Sonic noted the “highly efficient” hub-and-spoke infrastructure (we like this feature as well) of the business around its 24/7 Duesseldorf central laboratory.

MLD is expected to generate revenues of approximately €50 million in FY2024 and employs about 300 staff, including 13 pathologists. The acquisition price tag of €180 million is reasonable, in line with similar transactions. Sonic continues to exercise solid financial discipline with these acquisitions, key for the business model. The transaction is being funded through a combination of existing cash and debt facilities. A benefit is that Sonic reported most of the purchase price is tax-deductible in Germany over a 15-year period as goodwill amortisation.

The deal is expected to be immediately accretive to earnings per share (EPS), with a return on invested capital (ROIC) that exceeds Sonic’s cost of capital. The financial benefits are set to increase thanks to multiple synergy areas across infrastructure and operations. We note that this deal follows closely on the heels of the earlier announced deal to acquire Diagnosticum, one of the largest clinical and anatomical pathology laboratory groups operating in Southeast Germany, around the city of Dresden. That €190 million deal had many similar characteristics, and it seems Sonic is continuing to make a big push in Germany.

The low levels of gearing provide a strong platform to boost M&A when appropriate and Sonic has been finding some modestly sized deals that fit the bill.

Source: Sonic Healthcare

We believe in coming quarters the likelihood of at least a significant economic slowdown in Australia will see more investors attracted to the defensive nature of the core Sonic business, with healthcare being among the least cyclical sectors – when one has a healthcare problem, they tend to address it, if possible.

The underlying drivers for the base business remain structurally positive and organic growth will continue to be bolstered by acquisitions going forward.

We rate Sonic Healthcare as a buy for Members without exposure.

Disclosure: Interests associated with Fat Prophets hold shares in Sonic Healthcare.

Mobile bill pain for consumers is Telstra’s gain

Telstra shares have been strong gainers year-to-date, extending gains from 2022 thanks to several factors, spearheaded by positive financial traction and the increase in dividends. In our view, there is significant optionality for the monetisation of the InfraCo business, although we may have to wait until late 2023 or beyond for a decision here.

With mobile price increases on the way and all the signs of a more rational pricing market in mobile enabling Telstra to leverage the company’s leading position, we retain our positive stance and buy rating on Telstra for Members with no exposure. We suggest patience and buying on the dips given the solid gains YTD and the (justified) premium price-to-earnings multiple.

Telecommunications has become an essential service and thus should be resilient during a downturn. Meanwhile, there is secular growth in data usage and Telstra has opportunities to grow revenue in newer areas like IoT as we increasingly move to a digital world.

Telstra enjoys a leading position in the oligopolistic Australian telecoms market given the heavy investment in its network. At the time of the interim report, Telstra’s 5G network covered 81% of the population and was on track to hit 85% by mid-2023.

After years of bearing the brunt of the financial hole from the NBN and price wars in mobile, the environment is sunnier for Telstra. The annuity cash flow from the infrastructure leasing deal (i.e., ducts, pits, exchanges) with NBN is indexed to inflation. Meanwhile, Telstra has dramatically simplified its mobile plans (cutting costs) and pushed through price increases, which combined with higher customer numbers has lifted the financial performance for the key mobile segment.

To recap, in 1H23 mobile showed continuing growth, with revenue up more than 9%, supported by higher average revenue per user (ARPU) and subscriptions. Post-paid handheld ARPU was up by 4.5% to $50.47 per month, a welcome development. Combined with more subscriptions, mobile earnings grew by 13.6% to $2.2 billion to be a highlight within the group results.

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Even higher ARPU is on the horizon as Tesla earlier announced a higher-than-expected 7% increase in post-paid mobile and mobile broadband prices to arrive in early July. That is going to equate to about $3 – $6 dollars depending on your plan. That followed an earlier announcement that pre-paid costs would be lifted by up to a hefty 20% in some cases. More will likely be on the way in the future, as consumers have become used to price rises. In addition, the recent results and commentary from Optus owner Singtel suggest that the more rational pricing environment has legs. Meanwhile, the return of roaming is positive, as is the flow of immigrants back to Australian shores.

Turning to the charts and TLS shares have been on a robust uptrend since September 2022. The uptrend was also confirmed by a ‘golden cross’ – where the 50-day (red) moving average crossed above the 200-day (green) moving average (shown above) More recent price action, however, shows momentum is slowing down with the share price failing to breach above the 4.40 levels and recent price has inched closer to the 50-day MA. At this point, keep a close eye on TLS to see whether the 4.30 level and 50-day MA will hold.

Summary

The solid performance of the core mobile business helped offset the lacklustre performances of some other areas like Enterprise. International revenue was another highlight though, thanks to the Digicel Pacific acquisition last year. As members may recall, group EBITDA rose 11.4% to $3.8 billion and NPAT surged 25.7% to $934 million.

Source: Telstra

The key win for many was the nudge upwards in the fully franked interim dividend to 8.5 cents per share from 8.0 cents.

Excellent cost discipline has been supportive. Will Telstra return to steady growth in dividends? While only time will tell, we are encouraged by the more rational pricing environment and continued excellent operational execution with material progress in the T25 strategy. These are supportive of a return to modest dividend growth, although we would caution about expecting too much on this front. Nonetheless, we view Telstra as a core position and see significant optionality in the monetisation of InfraCo.

We retain our buy rating for Telstra for Members with no exposure. We recommend being patient and buying on dips.

Disclosure: Interests associated with Fat Prophets hold shares in Telstra.

Prices Take Some Back

Rio Tinto has revealed a reversal in its numbers for 2022, following falls in underlying and statutory earnings, and across all its reporting lines. While the balance sheet continues to be a key standout feature it was regeared but remains pristine. Shareholders saw the annual dividend near halve while no special was paid. The following table shows a summary of Rio Tinto’s key 2022 reporting lines (EBITDA – earnings before interest taxation depreciation amortisation):

Source: Rio Tinto

Despite the falls, we rate the result as satisfactory, given prices primed the numbers, while we gave weight to Rios’ operations delivering and clawing back just a tad on the pricing impact. We believe Rio set the table with its 2021 record results to endure a turn around and are only disappointed that a longer term value view was not considered at that time i.e. an on-market share buyback. We are also comfortable that 2023 guidance numbers were unchanged from Rios’ 2022 operational result.

Underlying EBITDA, that better reflects the ongoing operations by removing unrelated to 2021 one-offs and segments for sale, reported a 30.3% year-on-year (yoy) fall, to US$37.7 billion for 2022. The factors impacting underlying EBITDA are shown in the following chart (in US Dollars):

Source: Rio Tinto

Lower prices for Rios’ product offerings, as Members can see from the above chart, drove the result, subtracting US$8.1 billion in 2022 (2021: +US$17.5 billion). The move in commodity prices reflected a stronger US dollar over the year that pressured prices while trading conditions remained relatively robust. This result reflects the cyclical nature of resources, and the lack of control Rio has over prices.

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The negative US$8.1 billion pricing impact was driven by all of Rio’s key product offerings, with segment contributions shown in the following chart (US$/m):

Source: Rio Tinto

Iron ore and Rio’s key product offering was the primary drive, as Members can see from the above table, subtracting US$9.2 billion (2021: +US$11.6 billion). Rio saw its 2022 average realised iron ore price fall 26% yoy, to US$106.1 per tonne. The negative US$700 million (2021: +US$1.9 billion) contributed by copper was a result of a 5.0% fall yoy in Rio’s average realised copper price, to US$4.03 per pound. A feature was the US$900 million added by aluminium on a 14.9% yoy rise in Rios’ aluminium price, to US$3,330 a tonne. We have a positive view across the broad commodities spectrum for 2022, previous government spending programmes continue to ripple into the global economy, China reopens from its COVID zero policy and sticky inflation are all tailwinds. We expect a weaker US dollar, influenced by debt that continues to spiral higher and narrowing interest rate differentials to peer currencies will see the greenback as a major tailwind in 2023 for commodities.

The factors controlled by Rio in the above EBITDA chart, shows Volumes and Mix and a feature of the result, contributed positive US$600 million, compared to negative US$583 million yoy. The contributors to the result are shown in the following chart (in US$/m):

Source: Rio Tinto

For Rios’ key product offerings, pleasingly, as Members can see from the above chart, the majority were in positive territory, with iron ore and aluminium standouts, while copper dragged in 2022. Iron ore was a positive US$524 million compared to negative US$894 million from a year earlier. Aluminium made a positive US$364 million impact compared to a positive US$258 million from a year earlier. Copper was a negative US$15 million swinging from a negative US$169 million in 2021. Briefly, we considered Rios’ operational result for 2022 was upbeat with some hidden gems. We expected 2022 operations would deliver a negative impact on Rios’ financials.

Net operating costs rose 6.4% yoy, to US$34.8 billion, with inflation and market driven costs had a US$3.5 billion negative impact on Rios’ EBITDA line in 2022. Energy costs of US$2.1 billion and general inflation pressures of US$2.0 billion were key contributors. Controllable costs had a negative US$900 million impact on the EBITDA line. On unit costs, Rio reported a 14.5% jump yoy in its Pilbara iron ore costs, to US$21.30 per tonne and is guiding 2023 to be in the range of US$21.00 to US$22.50 per tonne.  Copper C1 unit costs surged 49.7% yoy, to US163 cents per pound and is guiding 2023 to be in the range of 160 cents to 180 cents per pound.

The daily chart movements of RIO show resistance has developed at the $128.00 level with the price declining to test the initial breakout level at $116.00. Current price movements remain below the 20 day moving average and above the 200 day moving average

On revenues of US$55.6 million representing a 12.5% yoy fall, Rio reported a fall of 37.9% yoy in underlying net earnings, to a US$13.3 billion and reported net earnings of US$12.4 billion, representing a 41.1% fall yoy. Underlying net earnings excluded US$820 million of US deferred taxes, movement closure estimates of US$178 million and a gain of US$331 million on the sale of the Cortez royalty. We consider these exclusions acceptable adjustments to reconcile Rios’ underlying 2022 net earnings result to net earnings.

Capital expenditure for 2022 fell 8.1% yoy, to US$6.8 billion and was split US$600 million to growth, replacement US$2.2 billion and US$3.9 billion to sustaining. We have no concerns over its modest capital spending programme.

Rio is forecasting capital expenditure of US$8.0 billion for 2023. Rio has provided guidance for 2024 and 2025 in the range of US$9.0 billion to US$1

Net operating cash flow fell 36.3% yoy in 2022, to US$16.1 billion. Weak commodity price movements drove the lower result for the year. Rio used this cash flow to sustain its operations and ultimately reward shareholders.

Rios’ balance sheet geared up in 2022, with a move back to a net debt position from a small net cash position in 2021. As of 31 December 2022, Rio reported a net debt of US$4.2 billion compared to a net cash of US$1.6 billion from a year earlier. The following chart shows net debt:

Source: Rio Tinto

As a result, Rio’s gearing ratio rose 1,000 bps to 7.0% as of 31 December 2022 from -3.0% from a year earlier. This read is substantially below Rios’ targeted range of 20% to 30% and proves it with the opportunity to regear if value from such spending warrants this action. Cash as of 31 December 2022 stood at US$6.8 billion and gross debt at US$11.1 billion. We have no concerns over the structure of the balance sheet.

Shareholders saw a cut in the dividend for 2022 to US$4.92 per share fully franked, which was well below the US$10.40 per share paid for 2021 but did include a US$2.47 special dividend. Rio indicated that its total cash returns to shareholders for 2022 was determined on a 60% payout ratio for the year. This years’ payout level is at the top end of the Boards’ targeted range of 40% to 60% of underlying earnings. We are pleased with the US$8.0 billion paid to shareholders in 2022.

With in the monthly view of RIO, significant support at $86.00 is identified, while the underlying chart price remains within an up trend and the price remains above the 12 month moving average

Rio Tinto experienced lower commodity prices in 2022, that delivered a softer set of financials for the year. We are pleased Rio Tino was able to deliver on the operational front in 2022 that was a partial offset to the negative pricing impact. We believe commodity prices will remain firm over 2023 and will continue to deliver a tailwind for Rio Tinto. With the share price sitting just below record highs this view may already be captured in the share price.

Consequently, we continue to recommendation Rio Tinto as a hold.

Disclosure: Interests associated with Fat Prophets hold shares in Rio Tinto.

Pineapple on the Pizza

On the release of 1H23 results Domino’s Pizza’s share price has declined sharply. We digest the results and review our recommendation.

The Daily view of DMP highlights the breakaway gap towards the major support level of $49.60, current price movements remain within the multi month consolidation range between $49.60 and $75.0.

From the beginning when Domino’s pioneered the phone app for ordering pizza they have remained on a consistent expansionary mission to increase store fronts across the globe. Late 2022 Fat Prophets FAT-AUS-1100 reported Domino’s were conducting a A$150m capital raise to buy out the remainder of Domino’s Pizza Germany. The company maintains a 10 year outlook for over 7000 store fronts by 2033. Current projections include over 3000 extra stores or over two times the current market size in Europe and 3000 stores throughout Asia again over two times the current market size.

Source Domino’s

Domino’s 1H-23 revenues in the Euro region have increased 0.9% against the other Australian New Zealand segment -0.1% and the Asia segment revenues declining -12.5% , resulting in an overall 4.3% total revenue decline.

Source Domino’s

The overall performance is being impacted by the surge in inflationary pressures particularly in Germany with the latest YoY inflation reading accelerated to 8.7%, with central banks responding by lifting interest rates, the cost pressure on business and the consumer is beginning to take its toll.

Although network sales came in 1.3% higher

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the reduced customer counts has resulted in decreased food volumes leading to higher costs managing inventory.

As a result the company has passed on higher delivery and food production costs with the outcome a reduction in Domino’s customer counts, and a significant move to store pick up against using the delivery service, management have stated this has not met expectations with the decline including online sales of A$1.52b also -4.5% against 1H-22. Same store sales declined an average -0.6% primarily attributable to lower performance in the Japanese market, sales revenue from Japan also being impacted by the 12.6% weaker Yen v’s the AUD.

Net Debt increases by $95.8m vs. FY22, as a result of the Malaysia and Singapore acquisitions and dividend payment, partly offset by $163.2m net capital raising.

Current net debt is A$666.5m resulting in a Net leverage ratio of 2.1% remaining well within the company’s banking covenant. In addition, Domino’s completed a Capital raising of $163.2m net, during H123, to be used primarily to fund the acquisition of remaining shares held by Domino’s Pizza Group plc in the German joint venture this is forecast to complete 2H-23. The earlier capital raising also in part funded the Malaysia and Singapore acquisitions for A$10.1m.

Looking at the Asia segment sales increased 3%, the newly acquired markets in Malaysia and Singapore are performing at expectations, with Management intending to apply high volume marketing mentality to store operations.

Within the Australian New Zealand network sales came in marginally lower by 0.3% to A$687.3m. Going into 2H -23 the company has stated commodity and labour increases are anticipated going out to FY-24 with the focus on short-term energy prices.

The Monthly view of DMP indicates the current price decline has moved back to test the long term up trend line, current price has moved below the 12 month moving average, currently the stock remains with a primary up trend.

In the current economic cycle management remain confident the strategy of building improved performance through marketing to increase customer counts and sales is sound.

We hold the view fast food sales will remain a staple in the global diet and make the point the industry as a whole will be working through this current inflationary cycle. Currently the company is moving prices higher and expanding offerings to maintain customer numbers.

We maintain our Hold recommendation for Members with exposure. Domino’s will remain in the Fat Prophets portfolio.

A new beast

Woodside Energy (Woodside) has reported its operational numbers for 2022 and for the first time included the annual numbers for BHP Petroleum. The change is profound, with comparatives for the year reflecting this and supports our belief the acquisition is a major game changer for Woodside. Certainly, records fell in 2022 with overall production and product offerings reporting substantial changes while revenues added to the list. Pleasingly, Woodside reported a beat on an adjusted 2022 guidance. The following table shows a summary of Woodside’s key operational numbers for 2022 (LNG – liquid natural gas, NGL – natural gas liquids, boe – barrel of oil equivalent, M – million):

Source: Woodside

As Members can see from the above table, the changes on the Woodside Petroleum only 2021 numbers were profound, and we expected nothing less. We see a key takeaway in the acquisition being the production scale Woodside now boasts. We have not rated the result but are pleased 2022 guidance was pipped to the topside and was a feature amongst many. Woodside will report a bumper 2022 financial result, when it reports on 27 February 2023.

As Members can see from the above table, overall production for 2022 came in at a record 157.7 million boe, representing a rise year-on-year (yoy) of 73% on the Woodside Petroleum only 2021 outcome. The following table shows annual production on a boe basis (2021 and back are Woodside Petroleum only outcomes):

Source: Woodside

Members can see from the above chart, the scale up the additional BHP Petroleum production brings to Woodside. Pleasingly, and a feature was 2022 production coming in ahead of an adjusted guidance for the year of 153 million boe to 157 million boe. Individual product offering guidance for 2023 will be provided with the release of Woodsides’ full year financials on 27 February 2023. Woodside singled out a strong performance by its operations in the December quarter 2022 as the key driver.

Guidance for 2023 is forecast to be in the range of 180 million to 190 million boe and was unchanged. Again, the scale up is apparent with Woodside reporting an initial 2022 production guidance, as Woodside Petroleum only, in the range of 92 million boe to 98 million boe.

LNG production for 2022 rose 20.3% yoy, to a record 85.1 million boe. The following chart show annual LNG production:

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Source: Woodside

Woodside reported higher LNG production for the North West Shelf (NWS, Woodside’s interest 30.47%) and Pluto LNG (Woodside’s interest train 1 – 90%, train 2 – 100%), while Wheatstone (Woodside’s interest 11.84%) reported a fall. NWS and Pluto reported increase of 45% and 15.2% respectively, to 29.7 million boe and 46.2 million boe. Wheatstone printed a 9.8% fall to 9.2 million boe. Following the completion of the BHP Petroleum merger, Woodside lifted its interest in Pluto train 2 to 100% from the original 51% and this increase primarily drove the LNG result.

Oil and condensate production for 2022 was the real beneficiary of the merger with BHP Petroleum. The following chart shows annual oil and condensate production:

Source: Woodside

Oil and condensate production leapt by 123% yoy, to 38.7 million barrels. Woodside picked up exposure to the Gulf of Mexico through the merger with BHP Petroleum. This new exposure equated to 14.7 million barrels of oil and condensate being added to the 2022 result from this source. New exposure to Bass Strait added a further 2.6 million boe.

Revenue was the end beneficiary and was a standout feature from the 2022 operational results but was not all of Woodsides’ own doing. The following chart shows annual revenue:

Source: Woodside

Revenue hit a record US$16.6 billion, following the reporting of a yoy surge of 139%. Operations were an obvious contributor on the BHP Petroleum acquisition, while a higher realised energy price was the “icing on the cake.” On top on the BHP Petroleum leverage, Woodside reported a higher average portfolio price of US$98 per boe, representing an 8.9% yoy increase. On the operational data, Woodside will report a bumper full year 2022 financial result that will show positive volume and price variances. Going forward, we have a positive view on energy prices for 2023, on growing demand and muted supply responses.

The daily chart of WDS indicates the price has remained above the 20 day simple moving average, as the daily resistance level set during August 2022 is broken to the upside. In this short term view the daily trend is up

Woodside carries a hedge book of 21.8 million boe covering 2023 production with an average price of US$74.50 per barrel. Given the Brent price is currently trading around US$85.67 a barrel, at the average price the position is not profitable. Woodside also maintains a special hedge over part of its Corpus Christi LNG volumes to 82% for 2023 and 29% for 2024. We consider both positions to be prudent risk management hedges.

Woodside opened the purse in 2022, reporting rising capital and exploration spending over the year. Exploration and evaluation spending surged 44% yoy, to US$465 million, with capital expenditure jumping 52% yoy, to US$4.0 billion with the focus on oil and gas properties acquisitions, which jumped 79% yoy, to US$3.9 billion.

The monthly chart shows price movements of WDS indicate a breakout from the longer term down trendline. Current price movements remain above the 12 month moving average with the price retesting the $39.60 resistance level set during 2018. The underlying primary trend for WDS is up

Armed with our positive outlook for energy over 2023 and especially natural gas and its derivative LNG. Woodside has the swelled asset base, we believe, to deliver LNG into what we see as an expanding energy market over an extended period of time. Importantly, Woodside has retained the financial capacity and holds prospective assets to leverage into our scenario over this period. The full year operational results were a bumper and have reinforced our view of Woodside.

Consequently, we continue to recommend Woodside Energy as a buy for Members who have no current exposure to the stock.

Disclosure: Interest associated with Fat Prophets holds shares in Woodside Energy.