04 May 2018


by Peter Little

April saw the rhetoric and anxiety around global trade wars ease as US President Donald Trump’s focus shifted to sanctions. Seven Russian oligarchs with close links to the government, their companies, 17 Russian government officials and a bank were slapped with sanctions, ostensibly as punishment for Russia’s involvement in the Syrian war. Trump is also unlikely to extend Iranian sanction-relief at the upcoming mandatory review in May. US interest rates ground higher, but unlike the spike experienced early in the year when wage inflation surprised, the latest rate sell-off has been a grind higher with rising commodity prices expected to drive inflation. US 2-year government bond yields are now as high as they’ve been since before the onset of the global financial crisis (GFC) in 2008.


US 10-year bond yields breached 3% for the first time since the 2013 taper tantrum, though their rise has been less steady than the shorter-term rates. This, as concerns around the length of the current economic cycle, the impact of quantitative easing (QE) in Europe and Japan and the increase in the issuance of shorter-term debt by the US have impacted the long-term US interest rates.

Rising US rates dragged the dollar higher, arresting a slide that’s seen the US currency fall against other major currencies for over a year. The British pound was softer with continued Brexit uncertainty and economic growth and inflation coming in below expectations.

US Brent crude oil rose comfortably back above $70/bbl during the month, aided by concerns around the supply impact of potential Iranian sanctions, surprising drawdowns in US oil and gasoline inventories during the month and rhetoric from the Saudis about targeting $80/bbl prices.

S&P companies started reporting 1Q18 earnings in April with around 60% of S&P 500 companies posting results during the month. The impact of tax cuts and sustained US dollar weakness drove earnings over 20% higher relative to 1Q17 (for the companies that have reported) – more than 6% ahead of expectations. Tax cuts and currency weakness should sustain earnings growth for the remainder of 2018, but with 1Q18 out of the way, 12-month earnings forecasts now start to incorporate 1Q19, which is expected to see the return of midsingle digit growth as the tax and currency impacts fade.

Global equities delivered positive returns for the first time in three months. European stocks were up strongly during the month, with the euro weakness providing some relief for their export-heavy corporates. Emerging markets were also generally stronger (with the exception of sanction-affected Russian stocks) – India led the way with a recovery from its recent slump. Amongst the sectors, energy companies were the standout performers and the yield-sensitive consumer staples companies continued their slide (the S&P 500 Consumer Staples Index is now down 11% YTD)

S&P 500 (ex-energy) earnings growth

Anglo American

The current environment appears supportive for commodity prices:

  • Supply growth of key commodities is constrained.
  • Capex levels out of the major miners remains low vs. historic levels.
  • Miners are instead allocating capital towards debt reduction, share dividends and buybacks.
  • This stage of the economic cycle often coincides with increased global demand, inflation and commodity prices.

This outlook combined with attractive valuations supports a bullish view for the basic materials sector. Accordingly, a position has been built in Anglo American.

Despite its strong share price performance from its lows at the end of 2015, Anglo American continues to trade at a discount to its global peers. This may partially be attributable to a “South Africa” discount. The valuation gap has started to narrow as positive political changes in South Africa and a more welcoming stance from the South African government towards the mining sector allays investor concerns. After generating c. $6 bn of free cash flow in 2017, Anglo has outlined its first priority to be continued debt reduction (debt was down 41% YoY for FY17), followed by cash returns to shareholders. There continues to be skepticism around the sustainability of iron ore and coal prices – key contributors in the Anglo portfolio. This is reflected in the divergence between spot and consensus earnings for both Anglo and the sector as a whole. Market consensus estimates continue to imply commodity prices that are lower than spot.

Given the industry and economic outlook outlined above, we believe the threat to commodity prices is more likely to come from diminished demand rather than a ramp-up of supply.

At current valuations, we believe investors are being paid more than well to take the risk. We estimate Anglo American to trade at a mid-teen free cash flow yield at present. Whilst the business warrants a discount to the broader market, a free cash flow yield that is more than triple that on offer from broader global market averages is compelling.

Sleep Number

Sleep Number reported Q1’18 numbers that fell short of expectations with EPS coming in at 0.52c vs 0.56c – reflecting a YoY decline of 7%. Despite expectedly flat revenue for the quarter, gross margins were softer YoY as the company continues to consolidate its supply chain operations and transition to a new, more cost-efficient product line. The share sold off by almost 20% over the next few days, despite management re-iterating their guidance for FY’18 EPS at US1.70 – US$2.00 and FY’19 EPS at US$2.75. We believe this is a gross over-reaction by the market, and that the broader thesis remains intact when looking through inter-quarter “noise”. We continue to expect a 2-yr IRR in excess of 20 – 30% from these levels, with a bear-case price target of US$41 and a bull-case price target of $49.


Facebook has been in the press for all the wrong reasons recently, with revelations that Cambridge Analytica scraped Facebook users’ data for nefarious uses in influencing US elections resulting in investor concern that punitive regulatory fines could be imposed on Facebook for failing to adequately protect the privacy of its users’ data, or worse, that users and advertisers alike would abandon the platform in large numbers. These worries were enough to send the share price 20% lower from its $193 peak on 1 February by late March. However, the group’s Q1 results released on 25 April were sufficient to allay the latter two concerns – at least for now. Facebook’s group user numbers continue to rise at 13% on a year on year basis, and importantly were still up 3% on a sequential (Q4-17 – Q1-18) basis. Perhaps more impressive was the fact that monetisation – via advertising revenues – of this user base continued to accelerate from prior quarters, with revenue per user lifting 30% year on year. This resulted in total revenues growing by close to 50% on a year on year basis.

Facebook had flagged in its FY17 results that costs would grow 45-60% in FY18, and they undershot this figure in Q1 (+39%), implying either some conservatism in the guidance or back-end loaded cost growth. Nevertheless, the margin contraction we had been expecting for FY18 did not play out in Q1, with operating margins expanding 500bps and EPS ballooning by 63% in Q1. Consensus earnings expectations for FY18 have been upgraded following this result.

None of the above is to say that Facebook’s business model does not face risks – we believe the regulatory environment will become tougher for them, fines could be levied and the company will no doubt need to toughen up its privacy settings in favour of users and invest costs (as guided) in security. However, the growth premium this business used to enjoy has steadily eroded, to the point where the stock now trades on a sub-20x forward earnings multiple. For a technology company of this scale delivering growth at this pace, we believe the valuation has become compelling and factors in many risks. It should also be noted that approximately 8% of the market cap is in net cash, which earns minimal returns.

Figure 1: Facebook 12-month forward P/E multiple (estimated)



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