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Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Shani Jayamanne: So today we have a guest from our equity research team, Angus Hewitt. Angus has been on this team for over four years and around eight years at Morningstar.

LaMonica: And Angus covers a lot of stocks that get investors talking. Quantas, a2 Milk, Treasury Wine, Star Entertainment Group.

Jayamanne: He's also known for the puns he's able to fit into our analyst reports and notes.

LaMonica: Recently, when Star was set to pay less tax due to a change in levies, Star Entertainment, the house wins tax reprieve and profitability is flying back for Air New Zealand.

Jayamanne: He was also quoted in the AFR recently saying, anyone that sells a discretionary good or service wants to talk about how their discretionary good or service is the least discretionary of discretionary goods or services.

LaMonica: Wow. Well, I guess if you're going to do the job, you might as well have some fun doing it.

Jayamanne: Exactly right. I guess as much fun as an equity analyst can have. And Angus and I often catch up in the office and one of my favorite analyst anecdotes he has told me is that he covers Inghams, which of course is the chicken supplier, and at the investor day for Inghams, they bring out trays of chicken nuggets and other crumbed varieties of chicken.

LaMonica: Okay. That's interesting. You are of course obsessed with chicken.

Jayamanne: Yes.

LaMonica: Mostly chicken nuggets. But I guess if most people had access to an equity analyst, they would probably ask what the best opportunity in their coverage is.

Jayamanne: Well, we've got plenty of time for that today. So enough about the man behind the analyst reports. Let's run through what we're going to cover in today's episode.

LaMonica: So today we're going to ask Angus to give us a rundown of his coverage. As we mentioned, there are names in there that get a lot of tongues wagging. So, we want to get his thoughts on the future prospects of these companies.

Jayamanne: And then we want to speak a little bit about how he comes to a fair value. We speak about fair value a lot on this podcast. And that's because fair value is the final output of the analysis that our equity research teams do. And it is what we think an equity is worth.

LaMonica: And understanding what an asset is worth is the key behind successful long-term value investing. It's being able to find quality investments at reasonable prices. So, we'll take a look under the hood of how our analysts get to this final number.

All right. So, Angus, Shani and I did a little introduction of you during the introduction of the podcast, but we want to give you a chance. So maybe do you want to talk a little bit about your career at Morningstar and maybe just summarize the companies that you cover?

Angus Hewitt: Sure. Yeah. So, I started at Morningstar in 2015. I was working with a bit of software we provide fund managers and advisors before eventually moving into equity research in 2017, initially as an associate working across a variety of sectors before picking up the coverage list I have now. It's a pretty diverse list. I broadly considerate consumer cyclical companies. It ranges from automotive to airlines, gaming to food and bev. It could be a pretty noisy list at times. I've been referred to as the controversy analyst. But it's an interesting list for sure.

LaMonica: Okay. So, you mentioned consumer cyclical. And we've obviously heard a lot about inflation and cost of living going up. I guess how has that impacted some of those consumer cyclical companies that are in your coverage?

Hewitt: Yeah. Cost of living is certainly a pain point for a lot of people. And spending in discretionary categories is suffering as a result. So, this ranges from things like international holidays to a new Toyota Hilux to smaller things like fluffy dice or lamb chops. Some of this discretionary spend is foregone completely, while some is just substituted for cheaper alternatives in what's known as trading down. So maybe this is swapping an international holiday with a domestic holiday or swapping lamb chops for something cheaper like chicken nuggets.

It's really clear for automotive retailers, automotive spare parts retailers like Bapcor. So Bapcor's Autobarn business or Super Retail Group's Supercheap Auto for that matter, we're really seeing the dichotomy there. So, these businesses are primarily exposed to the do-it-yourself consumer. And they're seeing a deceleration in discretionary sales like seat covers and subwoofers. But the maintenance-related, the failure-related parts, things like oil filters and spark plugs, continue to perform really strongly.

Discretionary spending is about half of Supercheap and Autobarn's bonds earnings by our estimates. But with Bapcor, most of its business isn't Autobarn. The vast majority of its business comes from its trade and its specialist wholesale business. These businesses primarily sell non-discretionary, maintenance related automotive parts. Maintenance can be delayed to some extent, but it can't be forgotten completely. There's also a bit of an element of countercyclicality as people choose to maintain their existing car rather than buy a new car.

The other factor you have is the savings rate. So, during lockdowns, Australians saved – compared with what you would expect just looking at long-term savings rate, Australians saved significantly more money during lockdowns than you would expect, something to the tune of $250 billion or so. And you're also seeing pent-up demand. So, pent-up demand, pent-up savings during the pandemic has clashed with constrained supply for things like air travel. So, we're looking at availability of aircraft, availability of parts, availability of labor or new cars, the availability of semiconductors to actually deliver new cars. So, we're seeing pent-up demand and constrained supply, which is leading to just tremendous profitability at airlines and at new car retailers like Eagers Automotive. But we expect competition to return as supply constraints ease both in new car sales and in air travel. And we expect margins to suffer as a result.

LaMonica: All right. So, Angus, one of the things that you mentioned was of course travel. And that has me thinking about Qantas. So, Qantas is a company that's in your coverage universe. And we've seen a lot of very negative news about Qantas. So, everything from – well, I don't need to go through the litany of different things that have happened to Qantas, but certainly damaged their reputation. And the share price is not doing great right now. So, what do you see from a longer-term perspective? Is this just short-term noise? Or do you think Qantas is actually in a difficult position?

Hewitt: A lot of the negativity surrounding Qantas at the moment boils down to two main points, cost and service. And it's probably been exacerbated a little bit by their record profit result. Cost is elevated. Like I mentioned before, the mismatch between supply and demand is leading to expensive tickets. And on the service point of view, it's really fallen short of expectation. So service is a pretty broad term, but I'm talking about things like flight delays, cancellations, even just the quality of the planes that people are flying in has led to really poor experience despite the premium people are paying. And this isn't all Qantas's fault. A lot of airlines are facing these pressures, but the spotlight shines a bit brighter on Qantas as the dominant carrier.

From a valuation point of view, we expect costs to return to the business. They cut right back during the pandemic, and they probably had to. But arguably, they've underinvested for some time, particularly when you look at their aging fleet. So, Qantas has a fleet of more than 300 planes. And this fleet requires significant capital expenditure to maintain. And the delays in cancellations in new aircraft deliveries during the pandemic has only made this worse. So, in addition to eyeing down a mountain of CapEx, the new CEO, Vanessa Hudson, has also announced a renewed focus on service, which is going to lead to higher costs. Potentially, this was going to have to happen already as competition returns among carriers.

LaMonica: And I guess airlines in general – so you mentioned a couple things. And I think it was Warren Buffett that said, like, the way to create a small fortune is to invest a big fortune in an airline. You've talked about some of these problems, right, that there's obviously a lot of capital expenditure that needs to go into maintaining an airline. I think historically, fares have bounced around a lot. I mean, what's your message to investors about Qantas? Is this a good opportunity?

Hewitt: From an earnings point of view, we think this is about as good as it gets for Qantas. We expect pricing competition to return as supply constraints ease. And airlines in general lack economic moats. And there's a lot of reasons for this. You used the Warren Buffett quote before. High capital intensity, low barriers to entry, and very volatile inputs like fuel. But from an evaluation standpoint, Qantas is trading a little bit cheap at the moment. We think the negative sentiment surrounding the airline has probably gone a bit too far and shares are trading at a level that's not – it's not an absolute bargain. It's probably in 3-Star territory, but still cheaper than what we think is fair value.

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LaMonica: All right. So maybe another name that you cover that a lot of people are very interested in is a2 Milk. And I think it's sort of historically been kind of a crowd favorite with retail investors. And of course, a2 is a lot about China and of course demand that comes from China. And so, I know just from reading the media and some of your research reports, there have been reports that the Chinese are slowly migrating towards Chinese label infant formula. And traditionally, there'd been this demand for foreign formula, just because some of the food safety issues. So, is this a trend that you see continuing into the future? Has it impacted your fair value of a2? I guess what do you think the prospects are for that company?

Hewitt: a2 has really repositioned itself here. It was initially selling English label infant formula to China via daigou, which is a reseller channel. But there was a lot of volatility in this market. And this all sort of came to a head in 2021 when persistently high inventory levels were written off because reordering was stifled from a lot of their key corporate daigou partners.

The reason for this was pretty clear. If resellers started putting a2 on sale, it hurts the a2 brand. a2 is first and foremost a brand business. And we think a strong brand like a2 is increasingly crucial in this competitive environment. Its investment in marketing and distribution is increasing to support the brand equity. You mentioned what we think is actually a free ride foreign players were getting. So, the infant formula scandal in 2008 from a local manufacturer in China meant that foreign players were preferred by Chinese consumers for the simple virtue that they're foreign. We think that product safety for all manufacturers is now a given, and the country of origin no longer moves the dial for customers. So, while these tailwinds of consumers preferring foreign brands are no longer blowing, we think a2 has still managed to carve significant brand equity beyond merely its country of origin. So, we think that despite that headwind, a2 can continue to take share in the ultra-premium Chinese label business.

The other hurdle they have at the moment is demographics. The absolute number of births in China is declining. Decades of the one child policy and a strong preference for parents to have sons has meant that the population of Chinese women in their 20s continues to decline. And the two child and three child policies that subsequently came haven't had much of an impact. But despite all this, a2's share in Chinese label infant formula continues to grow. So, I've got some numbers here. In mother and baby stores, value share sits at 3.4% from 3% in 2022. Domestic online 3.3% from 2.5% in 2022. So, you can see that they're actually growing their share despite the pressures that we're seeing in the market itself.

LaMonica: Okay, that sounds like good news. My parents actually had a one child policy as well, which also worked out disastrously. So, it's not just China that's impacted by that. But I've talked about a couple names that I'm interested in. What I think a lot of listeners are interested in is of course opportunities. So, if you look across your full coverage list, a very diverse list, as you said, what is an opportunity right now based on certainly price to fair value and your other assessments of the company?

Hewitt: We've already spoken about a2, which is a really good opportunity. But I might touch on SkyCity, which is a casino. SkyCity's main property is the Auckland casino. It also operates the Adelaide casino and a few other smaller casinos in New Zealand. And really what we're seeing at the moment is regulatory headwinds weighing on SkyCity chairs. They've got a short-term suspension of the New Zealand casino license, probably happening this year. The Adelaide casino license is under review. And there are significant uncertainty around the size of the AUSTRAC civil penalty that SkyCity Adelaide is going to pay. We're expecting it to be about 50 million New Zealand dollars. Regulatory and compliance costs are up sharply, and we expect most of this to be permanent with a step-up in headcount.

Despite all these headwinds, we think pessimism is overlooking the fundamental strength of SkyCity's underlying properties. They're enjoying significant revenue and earnings growth now that pandemic restrictions are over. And the long dated and exclusive license in Auckland, which underpins SkyCity's narrow moat rating, means it should benefit from the continued recovery in New Zealand tourism. Capital intensity is also set to ease. So, about a billion dollars in major projects across Auckland and Adelaide is coming to a close. And we expect capital spending to ease right back and potentially open up for higher dividends moving forward.

LaMonica: All right. So, we've covered a troubled airline, some sort of cow without a1 – whatever, I don't remember. We did an episode on it, and I don't even remember what it is – genes. And we've covered casinos. So, this is going pretty well.

One thing that we always talk about at Morningstar, and I thought this would be a good opportunity, is we talk about fair value a lot. And of course, our analysts, yourself included, calculate, estimate a fair value for shares that you cover. Maybe could you talk a little bit about fair value. And I guess for listeners that think how does somebody sit down and try to estimate what something's worth, what do you guys do? What's that process?

Hewitt: Conceptually, it's really simple. We estimate how much cash a company can generate between now and the end of time. Add this all together. And after discounting for time value of money, so a dollar tomorrow is worth less than a dollar today. Add all this together and you have a valuation. Divide that by the number of shares and you have a fair value estimate. So, the concept is simple. Getting this right is where it gets hard.

Star Ratings are generated on the back of fair values based on the discount or premium to the fair value with a model generated uncertainty. So, we think that something like SkyCity should require a higher margin of safety before people look at buying it than something like a lottery company which is much more consistent. Does that answer your question?

LaMonica: No, no.

Hewitt: I'm not sure how much you want me to go into it. There's a lot of input to a fair value estimate.

LaMonica: Absolutely. And I guess the question is fair values change, so what are some of the drivers that would change a fair value?

Hewitt: Yeah. So, there's a lot that can change a fair value. In short, it's a change in our forecasts or a change in any of the inputs. So, if we think that maybe their cost of capital has changed, the discount rate that we're using. It could be an acquisition they've made or a divestment they've made. It could be how much capex they're going to spend. Or it could even be nothing. So, all that's equal, over time fair values should rise just due to time value of money.

LaMonica: Okay. I think that's personally helpful, hopefully helpful for all of our listeners. So, as I said, we covered a lot of interesting things, interesting companies, and certainly the way that our analysts go about thinking about valuing those companies. So, I just wanted to thank you, really appreciate you joining, and certainly really appreciate everyone listening. So, any suggestions for shows, send them to my email, it's in the show notes, and of course, any comments, we would love those in our podcast app or in your podcast app.

 

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)