Corporate Strategy Weekly Radar Update

Week ending Friday 1 June 2012 (theme: An Australian moment?)

Highlights Financial Services Superannuation: AustralianSuper (largest industry super fund) is backing a proposal for government-guaranteed housing supply bonds which it says could bring billions into the not-for-profit social housing sector. State govt can no longer afford public housing while institutions are looking for long-term, steady investments. The Super industry is also marked by a fight between BT (Westpac) and Count Financial (acquired by CBA this year): BT is believed to have to have poached 10Count practices, targeting 20 more. BUPA signed an exclusive partnership with Healthscope giving BUPA policyholders discounts at Healthscope hospitals & facilities GE Capital is targeting aggressive growth in specialist commercial mid-market and consumer lending markets where banks are not dominant. GEC Australia reduced portfolios from $43bn to $10bn during the past 4 years while multiplying ROC by 3. Response to investor day: see appendix. Wesfarmers (1) Insurance is looking to buy more brokers as an avenue for growth despite still recovering last year's disasters. Other industries o Wesfarmers (2) Target will need $40m in restructuring charges, impacting earnings of this traditionally profitable division (targeted at online, supplying chain), tarnishing the Coles turnaround of the past 3 years. However WES portfolio will smooth it out to deliver $3.6bn EBIT this FY (+12.4% on 2011). However interestingly the $2.2-2.4bn capex mean WES will have to borrow to pay dividend. ACCC is allowing NBN to pay Optus $800m to destroy its internet cable network (25,000km coax, 7000km optic fibres, 496,000 customers) leaving Telstra in position of monopoly. Australian Government - Global Observers warn that the current surge in govt bonds is pushing down bond yields at a time when investors abandon equities could trigger capital losses (May 2012 was the ASX worse month in 2 years: -7.28%). Whilst usual safer, bond value can plunge if rates (yields) move up, which will happen if the recession intensifies (as yields price risk). The AFR gives the example of the latest AU 10-year govt bond at a coupon of 5.5%. Yield is ~3.06%. A 1% rise in that yield to 4.06% would cause capital loss of 7.4%. Retail sales unexpectedly fell in April for the 1st time in 10 months (decrease spending at department stores and on household goods), boosting the RBA scope to resume rate cuts. Contradictory trend: construction which rose 5.5% in Q1 from the previous 3 months, outpacing the 3% forecast by economists. However this boost is entirely due to WA (+38.8% surge): every other state posted falls in construction, particularly for housing. Similarly Aus private CAPital EXpenditure rose +6.1% in Q1 beating consensus of 4%: +28.3% year-on-year. But again due to mining. Spanish PM insists his country will not need an international rescue to meet the 19bn bailout to rescue Bankia. Yes vote in Irish referendum to EU fiscal pact & austerity measures (so far ratified by Denmark, Greece, Slovenia, Romania, Portugal) China is putting measures to boost growth as Purchasing Managers Index (PMI) fell to its lowest this year (50.4 vs expected 52): the new stimulus could be 2 trillion yuan ($320bn) in several packages (~4% of GDP). Beijing also announced direct currency trading with Japan (goal of yuans internationalisation) EY-Inspire study evaluate Mental illness in young men aged 12-25 costs the Aus economy $3.27bn per annum. The Federal Govt bears 31% of it (services). 9m working days are lost per annum. Men with mental illness have a reduced earning potential by $559m per year Insights Superannuation: Institutional funding into the not-forprofit social housing sector is seen as a key option to return to 1996 share of the market: closing the gap needs 20,000 new social low-cost rental dwellings /year for 10 years at a cost of about $7bn a year. A govt guarantee would lower the investment risk profile more like a govt bond, lowering returns required. The fight CBA-Westpac illustrates trends in Super: o It shows that despite the depressed sharemarket, the govt 9% guarantee ensures the $1.3T industry increases in size. Its fastest growing sector (30% of Assets) is the SMSF "natural habitat of financial planners". o Trend of financial planners seeing benefits in becoming part of a larger group. Some analysts argue that "truly independent advice was exaggerated, particularly given the extensive use of commissions and rebates from product providers". Reforms - end of commissions, more disclosure - are also favouring being part of a larger structure to deal with the various requirements. o Banks are also in a position to pay to swallow the smaller fishes: acquiring planning groups and their clients isthe quickest way to expand their distribution. BUPA: unusual agreement to play favourites between a health insurer and health service operator. Is this precedent in Health a sign of things to come in GI? GE Capital says the commercial mid-market remains a key target because they are "nimble and better built for the current volatility": 27,500 businesses, 1.4% of the Aus market, 30% of all business revenues and employees and about 20% of borrowing and deposits. GE plans to grow volumes by 14% and regain the share lost after Wizard was sold to Aussie Home Loans in 2008 (via new products such as Gem-branded Visa card or a Mastercard for Coles in February). A segment also targeted by other providers Wesfarmers Insurance is Australias 5th largest insurer. Currently absorbing costs from last year (NZ EQ, QLD floods). Underlying margins on the mend: FY12 earnings affected by reserves from the NZ EQ. Lower interest rates affect investment returns, re-insurance costs rising. o In line with the industry, WES Insurance raised premiums to recoup losses: +8.4% in Aus, +11% in NZ. o Strong growth of Coles Insurance Motor and Home (100,000 policies sold, 50% sold online, ahead of target) Critics argue that the Optus cable could be extended to 1.4m households and oppose the destruction of an asset which costs have already been sunk. Australian Trends: see appendix Spanish officials expected plan of issuing Bankia directly with government bonds, which the bank could lodge as collateral with the ECB in return for cash. The plan would have allowed Spain to sidestep raising funds for the bailout on bond markets which have pushed its borrowing rates near record highs. This was refused by the ECB who demands proper capital injection. Countries that have not ratified the EU pact by March 2013 won't be able to access the euros bail-out fund (European Stability Mechanism ESM), clause imposed by Germany, to 'force' a Yes vote. This is the first time Beijing has allowed a currency other than the US dollar to be swapped with the yuan. Inspire is 'Brighter Futures' partner: potential initiatives?

Appendix 1: An Australian moment*? Further snapshots of the business and economic cycle Taking a longer view on economic indicators confirms the pattern of economic and business cycles.
Whilst it is agreed that Australia avoided the GFC + EU Sovereign debt crisis (Real GDP growth remained positive and unemployment rate remained low band), the Standard Deviation of unemployment rate shows a clear double spike in 2007-12, the ASX also trends downward since the 2009 rebound

1981-83

1990-91

dotcom

GFC + EU

1981-83

1990-91

dotcom

GFC + EU

1 - By those measures we are clearly in the 4th contraction cycle since 1980, albeit with limited damages
Australian GDP Growth Rate
3.0 2.0 1.0 0.0
Dec-1980

Real GDP Per capita GDP

Oct-1989

Oct-1994

Oct-1999

Apr-1987

Apr-1997

Apr-2007

Apr-1992

Apr-2002

Oct-2009

Oct-2004

Jan-1986

Jan-1996

Jan-2001

Jan-2006

Sep-1984

Jun-1983

-1.0 -2.0

Mar-1982

ASX All Ordinaries Share Price Index

1990

1995

2000

2005

2010

Capital Expenditure (ie. business investment) released this week gives insights in the 2-speed pattern driving the economy
2 - the CAPEX surge comes from 'Mining'... CAPEX: 7 estimates + actuals year-to-date Mining boom mark I commenced in 200304 and continued until the global financial crisis, and mining boom mark II which Australia is currently experiencing. Interrelated features of mining boom mark II: Higher terms of trade Higher AUD exchange rate as commodity exports rise Pressure on domestic manufacturing and trade-exposed sectors Parts of non-tradeable services (eg transport) likely to grow slowly Sectors aligned with mineral resources to grow Mining boom mark II shares those features but differ in several ways: Economy now closer to full capacity: less room for further expansion Tighter access to credit for business. Cautious consumers saving more (spending less on 'other sectors'): hence multi-speed economy: mining vs 'other' sectors While terms of trade are to remain high, a fall is in prospect; meaning that the surge in growth and govt revenues that occurred when the terms of trade increased in mark I might not be repeated in mark II. The resource sector is also recomposing: LNG Gas (60% of new capex) eclipsed iron ore (10% of total investment), and coal (7%) 4 - absolute dollars show the patterns of the Boom Mark I & II Completed Projects, June 1998 to April 2012 (total costs and average capital costs 201112 dollars)

Mining

Other industries

3 - ... whilst 'Manufacturing' and 'Other Industries' CAPEX are back to late 90s levels Capex as % of GDP

Jan-2011

Jan-1991

Jul-1988

Jul-1998

Jul-2008

Jul-1993

Jul-2003

mining boom mark II mining boom mark I

(*): in reference to George Megalogenis' latest book, The Australian Moment http://www.penguin.com.au/products/9780670075218/australian-moment

A further insight comes from the Productivity indicators

5 - Sources of growth have changed significantly: population growth accounted for 3/5, whilst labour participation detracted as falling average hours worked more than offset the decline in unemployment rate and rise in the labour force participation rate over the decade. Sources of growth in Australian real Gross Domestic Income (rather than GDP: GDI includes terms of trade) 1990-2010 6 - A closer examination by sector shows that Mining productivity diminished in the last decade, whilst services (including Banking and Insurance) grew more slowly. The increase in admin and support services can be attributed to 'reforms' in those sectors in the 2000s. Labour productivity growth by sector, 1990s and 2000s

Immigration is good for productivity

Drop in productivity due to mining (and services)

the terms of trade will be sustained by Asia but growth is more limited

7 - A further insight comes from the surge in Capital Deepening (roughly more expensive equipment with a lesser corresponding rise in wages) at the expense of Multifactor Productivity (more sustainable increase in living standards: unlike capital deepening it is not paid for by sacrificing consumption - which Australians dont like to do, or by servicing capital inflow - way most recent investments have been funded. Labour Productivity Growth Cycles

8 - In the 2000s, after the end of the productivity boom of the 1990s, growth came mainly from a housing and consumption boom, financed by bank credit, who themselves funded lending by borrowing on offshore wholesale capital markets. Unlike the Productivity Boom, the Debt-Funded Housing Boom was not sustainable, and would have ended without the timely arrival of the China-led resources boom (terms of trade in red). Components of Real Gross National Income Per Capita Growth

A contrarian moment: despite (or because of) the various 'dips' all those indicators point to a new cycle of growth once the EU sovereign debt is sorted: it is not a matter of 'if' but 'when' - notwithstanding short term pain is expected
Euro-zone stocks are in the 14th consecutive month of outflows. Since 2010 when Greeces debt issues became clear, European shares have dropped 18% and Americas have risen by the same amount. But even if there is no clear end to teh crisis, there comes a point when all the bad news is reflected in the price, and contrarians are turning bullish: such as flagged by The Economist Simply being cheap is no guarantee that equities will rise in the short term, however... ... there are clear future prospect of growth" 44% of pan-European corporate profits are generated outside Europe. 24% of European profits come from emerging markets, roughly 2x the exposure of US companies to the developing world. This diversification is not a coincidence. European companies have already endured a decade of sluggish growth and have sought out markets elsewhere (for production as well as sales). Besides It is estimated that 8 macro trends could increase global GDP up to $27 trillion by 2020
Common consumer soft innovation (IT, iPads) Militarization following industrialization. As economic power tilts toward Asia, military power will shift as well. Chinese defence spending is trending upward Advanced economies to refurbish and expand critical infrastructure Next billion consumers Developed: countries: Aging populations, Healthcare reforms Developing nations: Growing social infrastructure education, healthcare Growing demand for oil natural gas, grains, proteins, fresh water and extracted ores Developing economies catching up Next innovation wave: nanotechnology, genomics, artificial intelligence, robotics, etc

Advanced economies adjusting to age

In Australia the outstanding question is what type of industry changes will take place (eg. company consolidations) that usually follows a down cycle (the topic for a future memo...)
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Appendix 2: High level Summary of Analyst Reactions to investor day

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