Sydney Wealth Management Update Winter 2023

Winter 2023

Welcome to our latest Wealth Management Update. This edition covers the following topics:

• Legislative changes in FY2023/24 – implications for your super

• Stock spotlight (Santos)

• Australian banking sector update

• Reporting season update – International equities

Legislative changes in FY2023/24 –implications for your super

As we approach the 2023/24 financial year, there are two key changes for retirees to understand:

1. The 50% reduction in minimum pension drawdown rate will no longer apply.

2. The Transfer Balance Cap (TBC) will be indexed.

Keeping abreast of these changes will ensure retirees continue to receive their desired cash flow, in a tax effective manner.

Changes to Minimum Pension Requirements

Superannuation income streams are subject to rules which set a minimum and maximum amount that individuals must withdraw annually from their accounts. These requirements are designed to ensure retirees use their superannuation savings for the purpose it was intended: funding retirement. As a result, retirement savings gradually move from a tax-free to a taxable environment – a positive for Government revenue, but a negative in the eyes of retirees.

During the 2019/20 financial year, the Australian Government temporarily halved the minimum rate across all retirement age brackets. These changes were introduced to provide financial relief to retirees following the severe downturn in financial markets caused by the outbreak of COVID-19. The reduction in drawdown rates preserved account balances, providing them with an opportunity to benefit from the eventual recovery in asset prices. This aided the recovery in retirement balances for many Australians.

This temporary 50% reduction is in place until the end of the current financial year. From 1 July 2023 retirees will be required to meet the standard minimum rates. Those who have been electing to draw the minimum amount will be impacted the most, as they will now need to draw twice as much as they have in recent years. Minimum

The trustee of public offer funds will generally ensure the minimum is met, though members should ensure there is sufficient cash in their pension accounts. This can help avoid being subject to trustee directed sales which may result in an unwanted disposal of an asset. Conclusion

Self-managed super funds (SMSF) members will need work with their advisers to ensure they meet the new minimums. This can be achieved by either increasing regular withdrawal amounts or taking an increased lump sum. It is imperative that retirees meet the minimum pension requirement in each year as financial penalties

1 ‘Changes to minimum annual payments for super income streams’ , ATO, https://www.ato.gov.au/Super/SMSF-newsroom/Compliance/Changes-to-minimum-annual-payments-forsuper-income-streams/ (accessed 29 May 2023)

may apply to those who do not. The ATO may deem that the income stream ceased for income tax purposes resulting in all investment earnings being treated as assessable income for the fund2

Understanding the Indexation of the Transfer Balance Cap

The Transfer Balance Cap (TBC) was introduced by the Australian Government on 1 July 2017 to limit the amount of an individual’s super that can be transferred into a superannuation income stream, once they had met a condition of release. The TBC was initially set at $1.6 million and was intended to prevent individuals from holding excessive wealth in the tax-free superannuation environment

To ensure the TBC keeps its real value over time the TBC is indexed; the cap increases with inflation (all groups CPI), in multiples of $100,000. The first increase arrived on 1 July 2021 with the general TBC increasing by $100,000 to $1.7 million. Based on recent inflation numbers, the general TBC is expected to rise by another $200,000 to $1.9 million from 1 July 20233

However, it must be noted that not all individuals are entitled to the full TBC indexation amount. Every individual has a personal TBC which is distinct from the general TBC. While the general cap will increase to $1.9 million, the ATO will take the following into account when determining an individual’s entitlement to the indexation:

• the financial year when you start your transfer balance account (TBA), and

• your highest ever balance in your TBA.

Individuals are able to access this information via the ATO portal through myGov or their registered tax agent. Below we consider how the indexation would apply across four different situations. As at 1 July 20174:

• Caleb started a pension with $1.6 million and took a commutation of $200,000 on 1 April 2022.

• Gabriel started a pension with $1 million and commenced a second pension of $300,000 on 1 July 2022.

• Kylie started a pension with $1 million and has not commenced any new pensions since.

• Jimmy had a total super balance of $1.5 million but had not commenced a pension as he had not met a condition of release at the time. He will reach age 65 on 1 July 2023 which is when he will commence a pension, with his super balance having since grown to $1.9 million.

2 ‘SMSF minimum pension payment requirement and exception FAQs’ , ATO, https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/SMSF-resources/SMSF-technical/SMSFs Minimum-pension-payment-requirements frequently-asked-questions/ (accessed 5 May 2023).

3 ‘Transfer balance cap indexation’ , ATO, https://www.ato.gov.au/Super/Super-Funds-Newsroom/Reportingand-obligations/Transfer-balance-capindexation/?=Redirected_URL#:~:text=Indexation%20of%20the%20general%20transfer,balance%20cap%20 of%20%241.9%20million (accessed 8 February 2023).

4 ‘Cullen, Anthony, Indexation of the Transfer Balance Cap’ , SuperConcepts, https://www.superconcepts.com.au/insights-and-support/blog/detail/smsf-insider/2023/02/16/indexation-ofthe-transfer-balance-cap (accessed 17 February 2023).

Caleb Gabriel Kylie Jimmy

These examples illustrate how an individual’s personal TBC can differ, ranging from $1,600,000 to $1,900,000.

Conclusion

A superannuation income stream is a highly tax effective vehicle that can be used to provide income in retirement. Both the general and personal TBC’s need to be considered when determining the amount an individual can hold in the tax-free superannuation environment. Careful planning will ensure retirees take maximum advantage of the concessions available.

By Andrew Wilson, Principal | Pitcher Partners Sydney Wealth Management

+61 2 9228 2455

a.wilson@pitcher.com.au

By Karlson Tan, Strategy Adviser | Pitcher Partners Sydney Wealth Management +61

2 9228 2462

karlson.tan@pitcher.com.au

Stock Spotlight (Santos)

We have received substantial interest in the energy sector over the past year following high profile mergers such as the creation of Woodside Energy Group (WDS) from the merger of Woodside and BHP’s energy business as well as a larger Santos (STO) following the takeover of Oil Search in 2021. Here we are highlighting the Santos business, its current performance and our view on the medium-term outlook.

Overview

Santos is a large-scale, predominantly gas producer with operations centred on Australia and Papua New Guinea. The firm both explores for and produces a mix of natural gas, crude oil, condensate and other related energy products.

Its existing projects are long-life and low cost with a free cash flow breakeven oil price of ~$18 per barrel achieved before hedging in 2022. The business has shifted to a sustainable capital return model over time with a 40 per cent of free cash flow target for capital returns in the form of dividends and buybacks. The current period of higher energy prices following the Russian invasion of Ukraine in Feb-22 has seen deleveraging occur with gearing falling to 18.9% by Dec-22 (at the lower end of its target range of 15-25%). Its portfolio is predominantly geared towards gas production with crude oil only accounting for 15% of overall sales.

Recent news

In its first quarter reporting for FY23 the business saw a drop off in first quarter production with 22.2 mmboe (million barrels of oil equivalent) which was 13% lower than the prior quarter due to reduced gas volumes from its Western Australian operations. Its US$700m buyback remains on track with US$464m purchased as of the end of March.

The business maintained its 2023 guidance for production of 89-96 mmboe with a unit cost of $7.25-7.75/boe (barrel of oil equivalent), down from the unit product cost of $7.82/boe achieved in FY22.

Consensus

STO earnings are expected to decline over the next three years until troughing at $0.82 per share in FY25. Key drivers of this are:

• expectations of weaker energy prices due to a mix of transitioning away from fossil fuels and reduced impact of the war in Ukraine, and

• limited new production coming online during this period so negligible volume growth to offset weaker prices.

Consequently, dividends are also expected to be flat over this period. Earnings are expected to pick up in FY26 but there is only a minute handful willing to forecast on this kind of horizon with the variability in energy prices to that point making accurate forecasts highly unlikely.

Source: Bloomberg as of 24 May 2023

As Table 1 illustrates the firm has overwhelmingly positive coverage across sell-side analysts with only one analyst of the current 19 captured on Bloomberg having a lower conviction (hold) call. The average price target is ~$9.00 still suggesting upside from current prices. We caution though that the ultimate profitability will hinge upon energy prices given the limited impact of growth projects coming online in the next two years.

Table 1: Consensus price targets and recommendation snapshot

Source: Bloomberg as of 24 May 2023

Figure 1: Consensus estimates

Our view

At the current price STO shares appear cheap on an adjusted forward price-to-earnings ratio (see Figure 3) with the stock trading at the lower end of its long-term average. However, a similar consideration but on a cashflow basis (see Figure 4 below) suggests the stock is trading in line with its recent average valuation. For the share price to trade materially higher in our view requires either:

• another shock in the form of reduced market supply for a prolonged period; or

• a change in existing energy requirements (Paris Accord etc) that reduces the long-term risk for energy stocks.

Neither option can reasonably be part of a “base case” view. Energy shocks are notoriously difficult to predict given their geopolitical dimensions. Energy stocks are very much anti-consensus for policymakers given the focus on net zero greenhouse gas emission targets. This is likely, in our view, to continue seeing these stocks trade at a discount to what their fundamental earnings or dividend yields might otherwise suggest.

The fact that Santos has much higher exposure to natural gas, a fossil fuel with lower emissions, should be helpful in the sustainability of earnings over the longer term. Natural gas is seen as an important “bridging” energy source given issues with reliability for renewable energy sources for which energy storage has not adequately solved for e.g. reduced wind power generation in periods of calm weather. It is still a source of emissions however and is being treated as such by the market through subdued valuations both domestically and overseas, the latter arguably more so. While there is some attention about its Energy Solutions segment targeting decarbonisation and clean fuel production, this is still a rounding error for the business (4% of EBITDAX in 2022) so remains unlikely to materially shift the valuation higher.

In addition, near term market and economist consensus forecasts suggest pricing headwinds over the next three years continue to be expected. On a consensus view, prices are expected to be gradually declining from the end of this year and approach current spot prices by the end of 2026. Market pricing is more subdued and suggests we approach the 10-year average price for Brent crude by the end of 2026. Either path does not portray an overly bullish outlook for STO earnings. The economic outlook is not especially supportive either with subdued global growth conditions anticipated over 2023 and 2024 which typically bodes poorly for energy commodity demand due to weaker economic activity.

Over the medium term the business still retains attractive fundamentals with its exposure to natural gas as an “energy transition” fossil fuel. Expansion of its Energy Solutions segment would help de-risk the fossil fuel exposure to an extent but needs to grow materially higher from current levels to shift the dial on its valuation. In the meantime, the company is likely to retain profitability thanks to its low-cost operations and return capital to shareholders through dividends and buybacks over the medium term.

Figure 2: Consensus and market forward forecasts for Brent Price (May-23 to 2026)

Source: Bloomberg Conclusion

We would caution though that as a more mature business there is limited scope for increased production in the short run. For new investments to increase production requires much larger scale projects that take time and are also subject to cost-overruns. In the interim this means that there is less scope for increased volumes to offset price weakness which makes STO earnings even more sensitive to changes in energy prices. Given the mixed outlook for energy prices there is less scope for a material rerating than there was during periods such as Mar-20 after the initial COVID-19 selloff in the broader market. We would also expect these shares to be more volatile than the broader market given the sensitivity to oil prices as commodity stocks tend to reflect the volatility of their underlying products if not more so due to gearing and operating leverage.

If a client has a notable overweight to a business such as STO we would suggest that it is prudent to consider trimming the position on risk management considerations given higher volatility than the broader market. That being said, we think the business fundamentals remain intact in the near term and the valuation is not particularly egregious based on current consensus figures (these might surprise on either the upside or downside depending on how energy prices perform).

Appendix

Key for below charts

STO: Santos

WDS: Woodside

BPT: Beach Energy

Figure 3: STO Forward Price-Earnings multiple versus ASX-listed peers (Mar-05 to May-23)

Figure 4: STO Forward Price-Cashflow multiple versus ASX-listed peers (Mar-05 to May-23)

Australian banking sector update

All major banks have now provided first half results for FY23 that offers some insight into current performance. The following article highlights key drivers of bank earnings and offers our near-term outlook for the sector. Our focus is on the major “Big Four” banks comprising Commonwealth Bank (CBA), Westpac (WBC), National Australia Bank (NAB) and ANZ Group (ANZ).

Credit growth

Looking at growth on a headline level we see credit contracting after a sizeable boom over 2020-2022. Said boom was triggered by stimulus programs notably the introduction of lower cost fixed mortgages funded by the Reserve Bank’s Term Funding Facility (TFF). This facility has since lapsed with fixed rate mortgages increasingly expiring and reverting to the now higher variable rate following the shift in RBA policy since May 2022.

New loan creation (in orange) has softened materially as fewer households are willing to take on mortgage debt in the face of an RBA hiking cycle which reduces their ability to borrow. We are still seeing a material uptick in refinancing activity as households increasingly “shop around” for more attractive mortgage rates. This increases turnover between banks and is driving increased competition.

Annual housing loan growth vs prior quarter; split by type (Mar-07 to Mar-23)

Credit growth is expected to remain challenged while interest rate conditions remain elevated in the near term as higher rates have sizeably reduced household borrowing capacity

Credit quality

The current direction on credit quality is supportive to banking margins with arrears (borrowers behind on their mortgage payments) either flat or trending lower. This means lower provisions (cash held aside) are required to protect against expected loan losses. Those funds can instead be redeployed into the business or returned to shareholders through higher dividends and share buybacks

Source: Company filings; CBA reporting is off-cycle so 1H23 is six months to Dec-22 whereas it is six months to Mar-23 for other majors

The outlook is more challenging, however. Growth both domestically and internationally is expected to slow over the course of 2023 and 2024 with unemployment also rising. Those two views would normally weigh on borrowers’ ability to repay their debts. This is because higher unemployment means households will be less likely to maintain their loan repayments leading to loan impairment. Weaker economic growth typically sees businesses struggle due to depressed demand for goods and services which also increased the risk of loan impairment.

Source: Bloomberg consensus as of 8 June 2023

To emphasise this point we see the historical pattern of impaired loans as a proportion of major bank equity. This is contrasted against the return of banks for the next 5 years. As you can see the shares (the blue line) tend to perform best in periods of distress (when loan impairments are rising) as opposed to periods where distress is low.

Non-performing loans as proportion of equity versus Major Bank index returns (Mar-00 to Dec-22)

Non-performingloansasproportionofequityversusMajorBankindexreturns(Mar-00toDec-22)

Big4Non-performingloans(%ofequity)

MajorBankstotalreturnfornext5years(annualised)

In summary, current credit metrics are positive. The outlook however is unclear but likely to see some deterioration as the economy slows and we see a pickup in unemployment. Anecdotally we are already seeing media reports of household finances becoming increasingly challenged with recent RBA hikes exacerbating this trend. It is reasonable, in our view, to expect more provisioning will be required going forward which will detract from bank earnings and dividend growth.

Net interest margin trends

Net interest margin refers to the spread between the income received on loans made by a bank versus the cost of the funds it borrows to make these loans. In recent periods with the uptick in interest rates banks have been able to expand this spread benefitting from their deposit franchise (by repricing loans higher and being slower to change rates on deposits banks can capture that difference in rates as profit).

Looking ahead though as shown in the chart below this impact is expected to moderate with net interest margins anticipated to decline until FY25 at a minimum. This will likely drive bank earnings lower unless offset by an uptick in credit growth which is seeing a challenged outlook as discussed above. This consensus view is informed by increased competition for mortgage volumes amidst a weaker credit environment. Heightened competition has seen some lenders rely on cash incentives and other forms of inducement to win new customers. This however comes at the cost of reducing profitability to achieve top-line growth

Forecast Net Margins (FY22 to FY26)

In summary, while net interest margins have been improving in recent years, we expect this tailwind to be less supportive if not outright reversing in the years ahead which will be a net negative for the major banks by reducing profitability and also, ultimately, dividends to shareholders.

Operational efficiency (cost to income)

Efficiency ratios which measure operating costs relative to revenues and other income are a key driver of overall profitability. Driving greater efficiency can lead to larger profits and ultimately, franked dividends or buybacks that return capital to shareholders.

Currently we have seen sizeable improvement as banks recover from sizeable one-off imposts such as regulatory fines or organisational restructuring. This has helped drive improvement in cost-to-income ratios as shown below.

Source: Company disclosures, PPWM calculations

The current outlook from consensus forecasts is not anticipating material improvement going forward but rather that banks will be able to retain existing savings in their cost structures. One possible downside risk to that view would be larger-than-expected capital spending requirements to upgrade legacy technology infrastructure for example or consumer banking improvements.

Forecast Efficiency Ratios (FY22 to FY26)

The key point though is that going forward this is not anticipated to be a source of “easy wins” for bank profitability across any of the majors. The material improvements are expected to have already occurred. Consequently, it is an area we continue to follow. However, it is not one where we expect material profitability improvements to ensue.

Valuation

On valuation we have a mixed bag. Price to earnings (P/E) ratios see two of the four majors trade at attractive levels versus their longer-term average while NAB sits at a minor premium. Commonwealth Bank (CBA) stands out as a notable exception. That reflects its stronger retail franchise and better execution following the Austrac scandal that claimed former CEO Ian Narev and cost the bank $700m in fines.

On price to book (P/B) ratios the story is somewhat different. Most are trading at material discounts to their stated book value despite the current earnings profile. This arguably reflects difficulties in execution for the other majors that has seen CBA trade at a material premium to peers.

Source: Bloomberg, long-term average calculated from Sep-05 to Jun-23

On this basis we would say the sector appears somewhat attractive with CBA the main exception.

Outlook

Credit growth is subdued but troughing with influx of immigration. Materially higher growth would require interest rates to abate or wage growth to improve both of which are difficult to see happening as accelerating wage growth would likely prompt the RBA to maintain a higher rate policy which would limit the amount of credit households could borrow or afford. Meanwhile credit quality has risks to the downside in the near-term given unemployment is expected to rise and there is an elevated risk of higher credit provisioning required after a period of artificially low arrears

Key profitability drivers include moderating net interest margin trends in the face of elevated competition that are unlikely to be a source of material profit growth. Meanwhile, operational efficiency is one area where there are prospects for further improvement in select banks but difficult to materially shift the outlook given the other headwinds we are seeing.

Finally on valuations this is again company-specific, but CBA would still appear to be overvalued on most conventional metrics in both an absolute (versus history) and relative sense (versus peers both globally and domestic). The other majors are looking more attractive on this basis, but we would caution this view presumes current earnings forecasts are not overly disappointed in which case there is more scope for bank prices to decline.

In summary, headwinds remain in place for the sector, the question is whether these have sufficiently been priced in. Further weakness in bank share prices would suggest a positive on that front but in our view, we are not yet at this point though this could change in the near-term for individual institutions.

By Cameron Curko, Head of Macroeconomics & Strategy | Pitcher Partners Sydney Wealth Management

Reporting season update

International equity portfolio

Note: All figures in USD unless otherwise stated. Results referring to percentage changes (increases/decreases) relate to the previous corresponding period (pcp) e.g. Q4 FY23 results are compared to those of Q4 FY22

Apple Inc (AAPL: US)5

Share price 8/6/23: US$180.57

Result Q2 FY23

Revenue US$94.8b, down 3% on the pcp.

Underlying EPS US$1.52, flat compared to the pcp

• One notable highlight was the 2% growth in iPhone revenue even as the broader industry contracted almost 15% according to some estimates.

• Its iPad and Mac offerings struggled relatively speaking with revenue in both declining more than expected. Management highlighted the difficulty in comparison due to stronger demand fuelled by coronavirus pandemic stimulus.

• The Services business (which includes advertising and App Store revenues) continued to perform well with 5.5% growth in revenue. The wearables business (including products such as the Apple Watch) saw sales decline 1%, albeit still above consensus expectations.

Key points

• On the capital front the company announced its authorisation of $US90b in share buybacks and dividends with its dividend also being raised 4% to US 24c per share.

• Flat earnings amidst declines in some large tech peers saw the business outperform consensus expectations for the quarter. Guidance on forward performance remains elusive however with the gyrations in customer demand and in supply conditions seeing management decline to issue a more detailed outlook for forward performance.

• During the quarter Apple also emerged victorious from its lawsuit with Epic Games on a range of grounds. The key part though is ensuring the App Store fee structure and control remain intact which should support continued growth in its Services business.

• The quality of Apple’s hardware and services franchise remains undiminished in our view with the business retaining much of the revenue and earnings it reaped during the pandemic The business remains much larger than it was in previous spells of economic weakness, and we are monitoring closely to see how impacts overall performance will be given the constraints that higher interest rates are posing for household spending. Thus far the performance has remained strong with high cash generation supporting dividend growth and continued share buybacks which should underpin client returns.

Our comments

• Apple has remained a safe haven for investors to start 2023 notwithstanding the disappointing expectations of a 2.5% decline in earnings for FY23 before a bounce back in subsequent years. This demand has supported the share price but leaves the valuation more challenged notwithstanding the quality of the business.

• The development of ancillary business lines such as services and advertising are playing an important role in continued top line growth. These can lead to macroeconomic exposure (e.g. advertising demand tends to be procyclical) but

also improve profitability given Apple is advertising within its ecosystem that sees other ad providers either locked out entirely or paying a premium for access to its customer base.

• A key part of the Apple thesis has been the increased disclosure of its services segment. This showcases its high and growing profitability with investors willing to pay more for these kinds of recurring earnings streams. An ongoing commitment to strong capital returns to shareholders should serve it in good stead.

Abbott Laboratories (ABT: US)5

Share price 8/6/23: US$100.78

Result Q1 FY23

Revenue $US9.75b, down 18.1% on the pcp.

Underlying EPS $US1.03, a decrease of 40.5% on the pcp.

• Abbott added support to Johnson & Johnson’s remarks over a recovery in elective surgery volumes with management noting that most delayed, nonurgent medical procedures had now resumed, supporting demand for its core medical device business.

• COVID testing sales have fallen more than expected as it is seen as a less pressing public health concern with revenue guidance for COVID tests being lowered to $US1.5b, down from US$2b.

Key points

• The growth in its non-CVOID core business including medical devices is expected to more than offset this decline with the company retaining its profit outlook of $US4.30 to US$4.50 per share for FY23.

• Adjusted earnings per share of $US1.03 per share was 4% higher than consensus estimates of $US0.99.

• The company announced US Food and Drug Administration (FDA) approval of Navitor, its next generation aortic valve implant for people who at high risk for surgical intervention. In other product related news its FreeStyle Libre glucose monitoring system also gained FDA clearance allowing for entrenchment with leading insulin pump manufacturers and improving healthcare for diabetes sufferers.

• We saw confirmation that COVID-19 testing sales are falling with higher-thanexpected deceleration during the quarter

• The long-mooted recovery in elective surgery volumes is paying dividends however with 10% growth in the underlying business in spite of the COVID-19 headwinds.

Our comments

• The guidance for FY23 EPS of US$4.40 (on a midpoint basis) has been maintained and represents a strong overall story. The business had a “sugar hit” from COVID-19 testing sales which are now rapidly declining as the world moves past the pandemic. The development in other business lines is progressing well and should be supportive of strong earnings growth (and dividend growth) over the medium term.

• The company declared its 397th consecutive quarterly dividend and has increased its dividend for 51 consecutive years, highlighting its growth over time and the quality of its operations to continue paying dividends through several recessions over that period.

• Despite headwinds from weaker COVID testing sales, the business remains well-positioned for strong growth over time and investors will benefit from both this and a regular, increasing dividend presenting an attractive total return versus the broader market in our view.

Adobe (ADBE: US)5

Share price 8/6/23: US$439.03

Result Q1 FY23

Revenue $US4.65b, up 9.2% on the pcp.

Underlying EPS $US3.80, an increase of 12.8% on the pcp

• Both revenue and earnings surprised on the upside with revenue growth of 9% slightly above consensus forecasts and underlying earnings per share beating estimates by 3.3%.

• Management guided to underlying EPS of US$3.75 to US$3.80 on US$4.75b to US$4.78b in revenue for Q2 FY23. It also upgraded guidance for FY23 EPS to a midpoint estimate of $US15.45 (up from US$15.30)

• As with other multinationals foreign exchange movements were a big driver of outcomes financially. Revenue grew 9% in the quarter but stripping out currency changes growth was actually 13% implying a 4% headwind from currency movements.

Key points

• An additional 5 million shares were repurchased during the quarter helping to bolster earnings per share growth.

• Business segments saw broad-based strength with Digital Media, Creative and Document Cloud growing revenue 9%, 8% and 13% respectively. Stripping out currency change impacts see these growth rates ratchet higher to 14%, 13% and 16% respectively.

• Adobe’s $US20b acquisition of Figma is also facing additional regulatory challenges with UK regulator CMA launching an initial inquiry. This follows on similar initial assessment in both the European Union and US. None of these have translated into a definitive rejection with management still guiding towards completion by the end of 2023.

• The core Adobe business has picked up momentum with upgrades on the back of this stronger performance seeing the business re-rate from ~20x forward EPS to ~24x since the start of the year.

• Its breadth of tools makes it well-suited to the rise of new or more popular forms of media for creatives and the building ARR book (a further US$410m added for Digital Media alone in Q1 and US$420m expected in Q2) suggest it retains stickiness amongst users.

Our comments

• In summary, the core business is continuing to execute well in balancing profitability while spending for growth and should be able to compound earnings growth above the broader market in the medium term.

• Scrutiny turns to the Figma deal and the near-term overhang on investor sentiment than might occur if it is successfully challenged by regulators. We would expect the deal has reasonable prospects for success given the differences between the two businesses and the relative immaturity of Figma limiting the market share impact should the transaction proceed.

American Water Works (AWK: US)5

Share price 8/6/23: US$147.12

Result Q1 FY23

Revenue $US0.94b, up 11.4% on the pcp

Underlying EPS $US0.91, an increase of 4.6% on the pcp.

Key points

• Management affirmed its EPS range of US$4.72 to US$4.82 with higher revenues from investments in its existing asset base as well as acquisitions

Our comments

expected to underpin the growth trajectory. They also increased the quarterly dividend by 8% consistent with the long-term growth target of 7-9%.

• As part of their strategic plan for the next 5 years (to 2027) the business successfully raised US$1.7b in new equity which helps to deleverage the business in the near term and provides flexibility for new organic investments or acquisitions.

• The core Regulated Business segment grew revenue 10.5% to US$860m in Q1. This was largely driven from a mix of higher utility rates as well as cost recovery for incremental capital spending and acquisitions.

• Acquisitions continue to provide new customers with 1,400 added in the March quarter. The plan with these inorganic opportunities is to gradually transition customers to the applicable American Water rates. A further 1.3m customer connections are in the existing pipeline of opportunities to help fuel the company’s 2023-2027 targets of both earnings and dividend growth of 7-9% p.a.

• Rate reviews (regulatory proceedings to increase water rates for consumers and recover operating and capital spending costs) continue to represent an important driver of revenue and overall profitability. A combination of these and additional infrastructure charges helped drive a US$279m in revenue for the first quarter. Current pending proceedings could add a further US$144m if successfully granted.

• American Water continues to execute well at a fundamental level consistent with long term targets for both dividend and earnings growth.

• The value of its water infrastructure assets including embedded inflation protections has been showcased even in a tougher interest rate regime for the US.

• One near-term risk may be share price sensitivity to further interest rate hikes but infrastructure assets unlike global real estate have proven to be far more resilient in terms of the price investors have been willing to play. The critical value of their assets coupled with the ability to increase prices in line with inflation quickly has been a key driver of the divergence.

Alphabet Inc. (GOOGL: US)5

Share price 8/6/23: US$122.14

Result Q1 FY23

Revenue $US58.07b, up 3.7% on the pcp.

Underlying EPS $US1.17, a decrease of 5% on the pcp.

• Google continued to show signs of greater sensitivity to the global economy with weaker demand and growth in operating expenses translating into missing consensus expectations for earnings (6.3% below) in the March quarter.

• Unfavourable currency movements remained a notable drag with 6% revenue growth for the year to March in constant currency terms, implying a headwind of 2.3%

• Management reacted to investor concerns over cost discipline with $US2.6b in charges incurred to fund workforce reductions (~US2b) as well as a reduced office footprint (~US$0.6b)

• Google Cloud performance remained a positive with an operating profit reported for the Marcher quarter. This was flattered somewhat by a large reduction in depreciation costs as the company extended the estimated useful life of servers and other network equipment. It was also supported by increased operating leverage (fixed costs being spread over a larger revenue base) with sales growing 28.1% for the year to March.

Key /points

• The overall revenue trend in Cloud is still decelerating however (28% in March vs 32% in December) from admittedly high levels suggesting that while customer demand remains present it has still been softening across the industry. Quarter-on-quarter growth to illustrate this point was only 2.1% and management comments suggested more cost-conscious spending plans by customers given the uncertain economic environment

• Alphabet has drawn investor concern over the public interest in Microsoft partner OpenAI’s ChatGPT bot and the competitive threat it might pose with integration in Microsoft offerings such as its Bing search engine. This is a situation we are continuing to monitor but note limited signs of this occurring to date with Google’s distribution advantages (e.g. default on Apple devices) remaining a sizeable competitive edge

• Management provided some additional insight into the use of artificial intelligence (AI) across its business and assisting Cloud customers with its Generative AI offering. Alphabet has secured availability of Nvidia’s new L4 Tensor Core GPU for Cloud customers ahead of other providers.

• The Alphabet group has shown signs of sensitivity to global economic conditions particularly in advertising demand which is unsurprising given the scale of its market position and the weaker economic backdrop globally.

• Google Cloud remains a source of longer-term revenue growth and profitability with an operating profit delivered for the first time this quarter

Our comments

• The quality of the franchise particularly its core Search business remains intact in our view with its distribution advantage key to combating novel threats such as AI-based solutions.

• Cost management efforts are showing some signs that management is finally addressing investor concerns on this front. There is considerably more scope available here to improve business profitability in our view and more may need to be conducted to improve investor sentiment.

Johnson & Johnson (JNJ: US)5

Share price 8/6/23: US$160.26

Result Q1 FY23

Revenue $US24.75b, up 5.6% on the pcp (up 9.0% in constant currency terms).

Underlying EPS

$US2.368, up 0.4% on the pcp (up 3.0% in constant currency terms)

• A stronger US dollar dragged on international business performance, similar to other American multinationals with worldwide sales growth of 5.6%. Adjusting for currency fluctuations however revenue rose 9% over the period.

• International sales were still a source of weakness even after adjusting for currency due to more anaemic growth from Asia-Pacific and Africa regional sales (only growing 4.1%)

• March quarter profitability was ahead of consensus expectations by $0.18, boosted by a recovery in medical procedures and better-than-expected sales from its pharmaceuticals division (its COVID-19 vaccine and Stelara treatment).

• On the positive front, management upgraded its guidance relative to the January position.

Key points

• Underlying sales growth (assuming constant currency among other less material adjustments) is now projected to be 4.5%-5.5%, up from a range of 4%-5% with underlying EPS also upgraded by 0.5% from $10.40-$10.60 to $10.50-$10.60.

• Ongoing lawsuits over the company’s legacy talc products continue to persist with the latest manoeuvre being another attempt to use bankruptcy proceedings to resolve claims. This saw the company take a larger charge to provision for a total of $US8.9b in settlements. The hope is that this subsequent attempt at settlement will decisively conclude the claims.

• Finally, the company saw its Consumer Health division spun off as a new listed entity, Kenvue, in early May ensuring J&J is a focused medical device and pharmaceutical business.

• The business has shown the benefits of its diversified operations in being able to navigate a difficult macroeconomic backdrop and eke out earnings growth.

Our comments

• Our opinion on JNJ as a mature but growing business at a reasonable valuation remains intact. The Kenvue spinoff should bring greater attention on its core franchises and, ideally, support a higher valuation over the longer term as the business moves past both the boons (COVID-19 vaccine) and banes (higher input costs) of the pandemic period in recent years.

• The re-emergence of the legacy talc concerns is an issue that we are monitoring closely given its potential to distract and weigh on investor sentiment until it is adequately resolved.

Microsoft Corporation (MSFT: US)5

Share price 8/6/23: US$325.26

Result Q3 FY23

Revenue $US52.86b, up 7.1% on the pcp

Underlying EPS $US2.45, an increase of 10.4% on the pcp

Key points

• We saw signs of US dollar strength challenges as with other multinational businesses. In constant currency terms revenue grew 10% overall implying a currency drag of 2.9% for the period. Likewise, with underlying EPS if one accounts for currency impact the result was an increase of 14% suggesting a currency drag of almost 4%

Our comments

• Cloud revenue was $US28.5b overall, up 22% (25% in constant currency terms) with highlights including Azure growth of 27% (31% in constant currency terms).

• Sources of business weakness were notable in consumer facing products with Office Consumer seeing revenues rise only 1% (up 4% in constant currency terms) and likewise in personal computing which fell 9% (a 7% decline in constant currency terms).

• Results topped consensus forecasts overall with underlying EPS of $US2.45 versus expectations of $US2.23 while Azure growth of 27% was also above expectations of 26.6%. The result was also supported by stronger than expected demand in its productivity segment (which includes LinkedIn advertising revenues and Office software sales) that saw revenues top estimated by $US0.5b.

• Microsoft is still performing strongly in underlying terms particularly with its cloud business. The signs of sensitivity to the broader economy have persisted since the September quarter with personal computing one obvious point of weakness.

• US dollar strength has also continued as a near-term headwind expecting to detract 2% from revenue growth for the next quarter.

• The bid for US gaming giant Activision continues although opposition by UK authorities may stifle the bid as Microsoft is appealing the veto by British regulator CMA with a verdict due for August or September this year.

• Our overall thesis on the business remains intact with the shift to cloud offering a path to continued earnings growth (even with the slowdown a 27% expansion of Azure revenue is enviable for a business of this size and reach). It also offers returns on capital at a premium to the broader market and a reasonable valuation and remains compelling as an investment in our view.

• Two points of concern abide however, notably valuation and deceleration in its cloud business. On valuation surging interest in OpenAI’s ChatGPT tool have benefitted the company’s share price as people speculate on the potential productivity and other business gains from take-up of ChatGPT-powered solutions This is seeing shares re-rate materially higher and trade near the top of its 10-year range at almost 30x estimated EPS for FY24. This increases risk of a correction should the business disappoint lofty expectations.

• Secondly cloud revenue whilst growing at an enviable rate has been decelerating. While the business has benefited from a structural transition towards cloud solutions the tougher economic environment could see further declines in business IT spend that may see growth decelerate or outright decline.

Nestle

S.A. (NESN: CH)5

Share price 8/6/23: CHF 107.00

Result Q1 FY23

Revenue CHF 23.47b, up 5.5% on the pcp

• Overall revenue growth was impacted heavily by foreign exchange movements, a drag of 4%, while net acquisitions were a minor support, adding 0.3% for the quarter.

Key points

• Organic sales growth was 9.3% for the first quarter of FY23. This was split between a 0.5% decline in real internal growth (RIG, a volume measure) and 9.8% of pricing growth

• Organic growth remained broad-based across both developed (+8.6%, with price hikes, +9.7%, offsetting RIG declines, -1%) and emerging markets (+10.3%, a combination of pricing, +10%, and RIG, +0.3%, effects).

Our comments

• RIG declined 0.5% in Q1, an improvement on the 2.6% drop for Q4 FY22. Demand elasticity has remained subdued with limited signs of consumers downtrading to substitute products according to management. The decline in RIG was also driven partly by capacity constraints and portfolio optimisation efforts (removing higher growing but lower margin products).

• Portfolio optimisation efforts continue with a focus on higher growth and margin products.

• Management confirmed its FY23 outlook for organic sales growth of 6%-8% and an underlying trading operating profit margin of 17% to 17.5%. It also expected underlying EPS to growth between 6% and 10% in constant currency terms.

• Nestle continues to exert strong pricing power, leveraging the power of its brands with fractionally positive volume growth despite the scale of its price hikes

• The business has performed well, given its global scope, in largely containing inflationary pressures in its cost base and also passing on increases to end consumers.

• The resilience of organic growth is still being tested with developed markets weak on a volume basis. The concern is whether consumers is the wake of higher inflation and interest rates globally will continue to tolerate higher prices or pivot into substitute goods. To date the quality of its product set appears to be doing well and allowing the business to sidestep the choice of sacrificing margin by discounting to drive volume growth.

• Overall, the business remains well-placed to continue generating high single digit earnings growth without being overly troubled by inflationary challenges and returning capital back to shareholders in the form of dividends and buybacks.

• One point of concern remains the valuation front which we continue to monitor as we are conscious of not wanting to overpay for a low-growing (but safer) business in the current environment of elevated inflation and interest rates given the potential for a valuation derating if results disappoint. This has moderated with price weakness in the past quarter.

Universal Music Group (UMG: EU)5

Share price 8/6/23: €19.15

Result Q1 FY23

Revenue €2.45b, up 11.5% on the pcp

Underlying EBITDA €0.52b, an increase of 14.7% on the pcp.

• UMG saw top line revenue rise 11.5% for the year to March 2024 or 9.3% in constant currency terms.

• The result was driven by strength in its Recorded Music and Music Publishing businesses.

Key points

• The Recorded Music result was driven by growth in subscription revenue, up 12.7% with physical revenue (CD and DVD sales in Japan and stronger vinyl sales growth) also a surprise, up 32.1%.

• Music Publishing was driven by strength in digital revenue due to streaming and subscription sales growth.

• Adjusted EBITDA (a profitability measure) rose 14.7% or 13% in constant currency terms with Adjusted EBITDA margin expanding 0.6% to 21.3%.

• A new competitive threat emerged during the quarter, namely AI-generated music. The company is looking to block AI platforms from training their models

Our comments

on songs that UM holds copyright over. The worry is that this technology could be utilised to recreate melodies or even artists’ voices sidestepping the industry entirely. This is a new space legally and it remains uncertain how authorities will react going forward. It is likely, in our view, to see some form of new regulation given the potential negative impacts on the sector, both artists and record labels, in the alternative scenario (giving AI solutions free rein).

• Our thesis of Universal Music as a diversified record label able to extract value from different facets of the music industry ranging from live events to streaming (e.g. Apple Music, Spotify) offerings as it benefits from its extensive catalogue of music rights The bounce back in earnings from live events offers an added near-term bonus as a pandemic recovery story as well

• Universal Music will continue to be capital intensive to an extent as it needs to find and develop new artists to bolster its music catalogue. We would also expect some royalty acquisitions over time where the company sees the value in being opportunistic in adding new music royalties as part of its stable.

• AI presents a new potential danger. We believe that some level of compromise will be achieve however given the real detriment that a zero regulations scenario would have for artists as well. In that sense we see it as somewhat analogous to the risk posed by online piracy until the industry found viable options in established platforms such as Spotify, Apple Music and social media.

Union Pacific Corporation (UNP: US)5

Share price 8/6/23: US$200.99

Result Q1 FY23

Revenue $US6.1b, up 4.1% on the pcp

Underlying EPS $US2.67, an increase of 3.9% on the pcp

• Operating revenue growth was driven by higher fuel surcharge revenue and core pricing increases that were partly offset by a negative business mix and volume declines, the latter was down 1%

• Net income was $US1.6b for the quarter and boosted by a one-time real estate transaction.

Key points

• Cost control remains challenged with the overall operating ratio (a measure of operating expenses relative to revenues) falling 2.7% as hikes in wages and other input costs, a 4.6% deterioration, were partly offset by a 1.9% gain from falling fuel prices.

• Management maintained its full year guidance for carloads to exceed US industrial production growth (current forecast of -0.7%, declining slightly more than the -0.5% forecast in January) and pricing growth in excess of inflation.

• Our overall view on the business remains intact

• Arguably more than some other businesses it has seen meaningful challenges from supply chain disruptions, higher labour costs and energy prices.

Our comments

• It has however demonstrated the quality of its moat with pricing power a key lever in countering these impacts and passing them on to the end customer instead of absorbing through lower profit margins. This has been tested more recently but we expect over time that productivity initiatives and the easing of supply chain challenges will support business results going forward. Management guidance for pricing increases in excess of inflation are also illustrative of that pricing power in action.

• Valuation should also be less of a drag going forward with the business trading at 16.3x next year’s consensus earnings forecast, mildly below its longer-term average

• We continue to see Union Pacific as an inflation-protected annuity stream over the longer-term with revenue stability that should support our portfolio with its defensive nature.

Share price 8/6/23: US$223.05

Result Q2 FY23

Revenue $US7.985b, up 11.1% on the pcp.

Underlying EPS

$US2.09, an increase of 16.8% on the pcp

• Visa saw a strong result in Q2 with strength broad-based as all segments saw revenue growth with International Transactions remaining the most material at +24% against the prior corresponding period (down from +29% in the previous quarter). Key to this was a continued recovery in cross-border travel which resulted in cross border volume growth climbing 24%

• The business returned $US2.2b to shareholders in buybacks with a further $US11.8b available for share repurchases.

Key points

• Despite the more negative macroeconomic backdrop payment volumes have held up more generally with a 10% increase excluding currency impacts while processed transactions grew more strongly at 12%.

• Higher wage costs (up 24%) was a notable driver of operating expense growth (up 11%). This was due to an increase in headcount over the past year but is expected to decline in the coming quarters (slowing by 2% - 3% next quarter) with management also flagging its flexibility to reduce staffing if economic conditions deteriorate.

• Looking forward management expects a boost from Chinese travel improving transaction volumes while higher interest rates are also supporting growth in non-operating income (mainly interest on cash balances) that will likely more than offset interest expenses.

• Visa continues to play a role in global commerce as a key payments processor with its duopoly with Mastercard remaining intact.

Our comments

• Travel volumes are a notable boost to overall sales and as travel demand continues to recover it remains a useful upside catalyst in the near-term albeit one whose impact should slow in the coming quarters.

• The business has seen margin expansion more recently in line with the boost in underlying consumer spending further justifying our position as a high-quality exposure to global commerce with strong growth prospects going forward

By Cameron Curko, Head of Macroeconomics & Strategy | Pitcher Partners Sydney Wealth Management +61 2 9228 2415 cameron.curko@pitcher.com.au

This view is general advice only and does not take into account your personal circumstances or finances. If you have further questions, we encourage you to consult with your adviser.

Making business personal

Cameron Curko Head of Macroeconomics & Strategy | Pitcher Partners Sydney Wealth Management +61 2 9228 9173

cameron.curko@pitcher.com.au

Andrew Wilson Principal | Pitcher Partners Sydney Wealth Management +61 2 9228 2455 a.wilson@pitcher.com.au

Karlson Tan Strategy Adviser | Pitcher Partners Sydney Wealth Management +61 2 9228 2462 Karlson.tan@pitcher.com.au

Charlie Viola Partner | Managing Director –Pitcher Partners Sydney Wealth Management +61 2 8236 7798 charlie.viola@pitcher.com.au

Jordan Kennedy Partner | Pitcher Partners Sydney Wealth Management +61 2 9228 2423

jordan.kennedy@pitcher.com.au

Martin Fowler Partner | Pitcher Partners Sydney Wealth Management +61 2 8236 7776

martin.fowler@pitcher.com.au