Weekly Impressions

The key company announcement during the week in Australia came from Woodside Petroleum, that it had provided Oil Search a confidential and non-binding proposal to merge through a scheme of arrangement.  Under the proposal, Oil Search shareholders would receive all scrip consideration of 0.25 Woodside shares for every Oil Search share and become shareholders in the combined entity.  Discussions between the two companies are still at a preliminary stage.

The preliminary offer valued OSH at a 13% premium to their price immediately prior to the announcement.  OSH’s main asset is its 29% interest in the PNG LNG Project, a liquefied natural gas (LNG) development operated by ExxonMobil PNG Limited.

I recommend that investors avoid Woodside for four reasons. 

  • Mergers & Acquisitions 101 says that acquirers that make all scrip bids perform poorly on average.  This might reflect the fact that insiders engage in market timing; issuing capital to fund expansion or acquisitions when they believe that their scrip is expensive.  Woodside’s share price has fallen by around 30% in the past year, so it is unlikely that its insiders believe that it is timely to use their scrip as currency.  But immediately prior to Woodside’s announcement, Oil Search had fallen by 25% over the past year, so in their wisdom, Woodside’s insiders clearly believe that their target asset now represents a bargain.
  • Investors however are yet to be convinced of the rationale for the proposed deal.  The combined market value of the two companies is 2% lower than immediately prior to the announcement.  Woodside clearly needs to do more to convince investors of the synergies that it can extract from managing Oil Search’s assets.
  • If the synergies between the two companies are thought to be limited, investors will be sceptical of any purported diversification benefits, particularly in an era of renewed corporate focus.  The company already ranks close to the top quartile of ASX200 companies based on Evidente’s proprietary score of agency costs (see table).  The complexity of the firm will only increase if the deal proceeds thanks to the size of Oil Search.  Moreover, management will be distracted trying to integrate the two businesses. 
  • Woodside ranks in the bottom quartile of ASX200 companies based on earnings revisions (see table).
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The key macro data points for Australia were the modest fall in the unemployment rate to 6.2% in August and 5% decline in consumer sentiment.  At present, this is little cause for alarm; the 3 month moving average of consumer sentiment has been at or below current levels three times in the past four years.  Each episode proved to be temporary (see chart).  The renewed volatility in financial markets has likely impacted on the short-term psychology of the household sector.

The renewed weakness of consumer sentiment in recent months and associated poor performance of listed discretionary retailers during this time has challenged my positive view on the sector.  Despite weak growth in household disposable incomes, there are a number of macro tailwinds that should benefit the sector. 

  • The household savings ratio remains high, comparable to levels that prevailed in the late 1980s.  There is scope for households to become a little less prudent, and consume more out of their current income.  
  • Retail spending on household goods and clothing, footwear & personal accessories continues to trend up (see chart).  Department store sales are the only discretionary retail category that has flat-lined in recent years due to structural challenges facing those business models. 
  • But even sales at Myer and David Jones should benefit from a third macro tailwind; the renewed depreciation of the Australian dollar.  The lower dollar makes it more expensive for retailers to import items, particularly those that are paid for in US dollars.  But the competitive effects are likely to be powerful.  The lower dollar will lift the likelihood that a number of global department store retailers - some of which entered Australia at a time when the Australian dollar was closer to parity with the US dollar - do not further expand their presence in Australia, and even exit the country altogether.  Moreover, the lower dollar discourages the migration to online purchases.
  • Consumer spending and psychology is expected to benefit from further monetary stimulus as the RBA seeks to support consumption and dwelling investment at a time when the economy is on the precipice of a capex cliff.

There were two noteworthy communications from the RBA during the week, from Mr Philip Lowe (Deputy Governor) and Ms Luci Ellis (Head of Financial Stability). 

  • Mr Lowe highlighted that although the declines in the China's stock markets would have a limited impact on the country's growth prospects, the elevated volatility and authorities' attempts to restore stability had drawn attention to four key structural challenges facing China: the necessary shift from capital investment to consumption; liberalisation of markets for the key inputs of production including labour, capital and energy; demographics of ageing; and the strains and distortions of a still heavily regulated financial system.
  • Ms Ellis highlighted the importance of residential and commercial property in Australian bank lending.  The two account for over two-thirds of banking lending in Australia, much lower than in the United States (see chart).  Despite the importance of residential mortgages on Australian banks' balance sheets, during the crisis, non-performing assets rose sharply for commercial property and business lending.  These are now comparable to levels that prevailed prior to the crisis (see chart).