ASX Market Update 26th October 2020

ASX200 (XJO)

· The XJO closed -9.80 points or -0.16% for the week. Our high was 6,248.30 on Monday and our low was 6,100.60 on Thursday.

· Our highs + close on Monday are the highest the XJO has recorded since we hit our lows in March.

· The XJO is -7.74% for the calender year, -13.90% from our highs and +35.66% from our lows based on Friday’s close.

Market Commentary

The markets sit in a wait and see mode as the looming US election is keeping everyone at bay. As we draw closer there is a lot more data from swing states suggesting Trump is making solid ground. Voter registrations in the key state of Florida suggest new voter registrations favor republicans 2:1. This does not fit the ‘Blue Wave’ narrative the betting and polling markets would have us believe. I have said all along that as long as we avoid the contested election scenario then equity markets will be fine. Obviously for markets in the short term I feel the ‘Blue Wave’ is the most bullish as stimulus is larger and processed quicker + China relations improve. Tax reforms are a concern, but I feel the democrats will be focused on the virus and recovery too much to concern themselves with this for some time. I believe Trump is going to get a second term believe it or not. This smells a lot like 2016 when most mainstream data suggested a Clinton landslide yet certain models and select data suggested otherwise. I feel we are getting the same again. Markets likely chug sideways until the election next week.

Outside of the election market influencing news was hard to come by. Chinese GDP data came in around consensus with 4.9% growth seen in the third quarter. As I wrote to you last week it’s business as usual in China and it looks like there will be little to upset the apple cart coming from their direction. Virus numbers continue to rise in the EU as partial lockdowns take place. ICU and death figures remain low, so I feel if this remains the case, we don’t get the full-on lockdown mode we saw earlier this year. Back in Australia all states, except for WA, have vowed to have their borders open by Christmas which should see a domestic tourism boom take place during the holiday period.

An incredibly quiet week it must be said. We did get a few quarterly production reports + earnings updates so we will cover a few of these below.

Company News

Iluka Resources (ILU)- Shares fell almost 49% yesterday as its iron ore royalty’s business demerged and listed on the ASX as a separate entity. Deterra Royalties (DRR) is now listed on the exchange and it carries the royalty assets from the BHP South Flank iron ore operations. The royalty is 1.232% of the revenue from the aforementioned mines. I will take a closer look at DRR later.

Bluescope Steel (BSL)- BSL shares rose 11% on Friday as the steel products producer upgraded it guidance for the first half of the 20/21 FY. It expected EBIT to come in 30% higher to $340mill during the FY21 first half on the back of better steel spreads, Australian construction, US automotive + US housing.

Cochlear (COH)- Updated markets on current conditions at its AGM on Tuesday. For Q1 FY21 implant revenue was 94% of the same time last year showing a decent recovery after the pandemic forced operations to cease. Developing markets have seen low single digit growth in implant volumes whilst in undeveloped economies they are still down 40%. China surgeries are growing but elsewhere it remains very subdued. Services revenue remains at 86% of Q1 last year, but demand for upgrades is expected to be strong given the release of new products recently. Acoustic revenue is 89% of this time last year. COH also mentioned it will invest more into R&D this year to set themselves up for FY22 and beyond. The market took the update as a positive and it saw COH jump +2.3% on the day but it finished the week up 5.5%.

BHP Group (BHP)- Released Q1 quarterly production figures which saw iron ore volumes +8% (YoY), Oil -9%, Copper -4%, Met Coal +4%, Energy Coal -17% & Nickel +3%. Most production was down on the June20 quarter as they saw a lot of shutdowns due to maintenance but compared to this time last year, they are well up. Iron Ore is obviously the big one, which came in higher than expected. There were no great surprises here and most analyst forecasts have not moved on the back of it.

Woodside Petroleum (WPL)- Third quarter production/sales came in as expected. Production was +2% to 25.3MMboe and sales were +10% to 26.7MMboe. Sales revenue was down 9% to $699mill from Q2 2020 and a massive 42% from Q3 2019. Over for the first three quarters WPL produced 75.4MMboe which was 18% higher than last year. WPL was encouraged by the Asian LNG spot price which has recovered to $6.50MMBtu after falling close to $2MMBtu during the heigh of the pandemic. However, this is well off the $10+ prices we saw last year. Prices for Q4 are expected to be much stronger.

Santos (STO)- Also reported its third quarter figures with production at 25.1MMboe, a record for STO, and up 22% on last year. Quarterly sales were at $797mill, +2% on quarter. FCF generated was $143mill for Q3 and $574mill for the year. Breakeven prices for STO without hedging are $US25 per barrel and less than $20 with. Net debt was at $3.7bill and gearing is 33.6%. Whilst I am bearish short term on oil/gas there is a strong reasoning to get behind domestic Australian gas as prices are far more stable, demand is very high & supply is in deficit. STO delivers this exposure with much more of its sales headed into the Australian market v WPL, hence its outperformance. Something to look further into.

Deterra Royalties Ltd (ASX: DRR) $4.60

As mentioned above DRR is the result of the Iluka Resources demerger of its royalties’ company onto the ASX. DRR’s only business is the royalty’s revenue it derives from BHP Groups South/North Flank iron ore production assets. It earns 1.232% of all revenue from these projects FOB. This is the first royalties-based business to list onto the ASX, but globally its hardly a new concept. There is 50+ royalty companies listed on foreign exchanges with a 336% return over the last 10 years or $56bill increase in market cap during that time. DRR is the first of its kind on the ASX with a $2.4bill market capitalization. ILU decided to demerge and list DRR as a separate entity to help realise valuation. ILU will retain 20% ownership of DRR. A few other facts to consider:

· DRR intends to payout 100% of NPAT to shareholders as dividends.

· It plans to diversify and gain royalty exposure to other minerals moving forward. Probably Gold.

· It is not required to commit any capital to the projects it derives royalties from

· The mine life of the projects is 30+ years

· EBITDA margin of 90%+

· Exceptionally low cost and debt (net $14.2mill) structure with potential high gearing capacity

· Royalty is AUD based

· Gains $1mill (one-off) payments per 1mill tonne increase in production

· $85mill in FY19 revenue

· 55mill dmt of production in FY19

· Production set to increase to 139mt pa as of 2023

· $40mill debt facility in place

Bull Case

· Iron Ore demand is expected to remain strong for the long term

· High correlation to rising iron ore prices

· Very low-cost structure with high margins

· No capital expenditure to be provided to royalty assets

· DRR exposure is probably in the best mining jurisdiction in the world

· BHP is a top tier global miner

· Future earnings growth via increased production

· Exceptionally low debt with high gearing capacity

· Exposure to resources with the high capital expenditure

· Looking to diversify minerals exposure

· DRR paid quarterly in arrears by BHP thus better exposure to iron price rises

· Based on FY19 NPAT of $54.5mill DRR shareholders would have received 10.31cps in dividends last financial year. This is a yield of 2.24% fully franked @ $4.60ps

· Based on the table above the consensus EBIT for DRR in 2023 is $143mill ($65 iron ore, 0.70 AUD). This would equate to roughly $99.98mill in NPAT and a 18.92cps dividend to shareholders or 4.11% yield at today’s price.

· On a slightly more bullish case, and one I think is more appropriate, I feel using an iron ore price of $US75t and AUD of 0.70 is more accurate. This would equate to approx. $118.2mill NPAT and a 22.36cps dividend. At today’s share price that’s a 4.86% yield fully franked.

Bear Case

· Single commodity exposure at the moment

· Earnings have a high correlation to iron ore price means there could be large downside.

· Earnings also have a high correlation to AUD movements.

· Earnings exposed to production increase delays and suspensions (weather, strikes, political)

· EV/EBITDA evaluation is at the top end compared to peers

· Iron Ore prices trading at close to all time highs and prices are forecast to fall over the next 12 months

· Other mineral exposure will be acquired via debt and thus increasing costs

· Share price could be volatile dependent on iron ore prices

Summary

On initial inspection DRR seems a tad on expensive side with a lot of exposure to the downside of the iron ore price. Even based on 1H FY20 numbers its yield sits at a forecast 2.5%. When compared to BHP 5%, RIO 6% & FMG 8%+ yields it is a case of why would you bother? However, I feel the stock is now being priced for 2023 and beyond when production increases to 139mt and conservative yield jumps to 4.11% fully franked. There would also be likely share price appreciation during that time, thus the investment case looks a lot better on that basis. Plus, you must remember the returns of BHP/RIO/FMG provide are based on their business as a whole and not just one project. They are overly complex when compared to DRR thus can be subject to a lot more volatility. DRR’s returns are purely based on revenue earned from one project’s production FOB. This puts them at a huge advantage and a lot easier to forecast. DRR’s earnings are highly predictable. Then you can add any diversification into other minerals, probably Gold, and DRR becomes incredibly attractive. I feel for investors seeking high yields in two years’ time DRR puts up a strong investment case even at current valuations. It gets even stronger on any major corrections in share price. I also believe there will be share price appreciation once DRR’s structure is better understood by Australian investors as it is a new concept. I would look gain a starter position now with the strategy to top up on any dips or improvement in the iron ore sector.

In closing I would summaries DRR by saying there is value and income there for the patient.

Artificial Intelligence, Machine Learning & 5G

Whether you are aware of it or not we are at the dawn of massive revolution in technology and the way we live our day to day lives. I like to think of it as the third wave of our networked global community that started with the dot com era, the dawn of the internet. The second phase began shortly after and was the start of the automation and robotics era. Robots took over our production lines and automated simple tasks for us to make our daily lives better. For me, the third phase is the era of Artificial Intelligence (AI), Machine Learning (ML) and the fifth generation of our cellular networks (5G). These obviously build upon one another, but this third phase I feel will impact us most in our every day lives. We already experience it on a basic level with chat bots assisting us on the web through to Netflix suggesting movies for us to watch. Soon enough we will have driverless cars coming to pick us up to take us anywhere we wish. All through the push of a button on your smart phone.

Its an exciting era to live in when a machine can learn and ultimately think for itself, just as long as it doesn’t become self-aware (any Terminator fans out there?). There is money to be made investing in this space at such an early stage, but where do we start? My thoughts are it does not lie with the end products themselves but the companies who lay the groundwork for such technological advances. I compare it to the pick and shovel makers during the gold rushes last century that made most of the money when compared to the gold prospectors themselves. I am referring to the semiconductor sector, the companies that will make the GPU/CPU chips behind these processes. A few facts you may not be aware of to further enhance this view are:

· The AI Chip market is currently valued at $US7.8bill and is expected to grow to $108.6bill by 2026.

· Autonomous driving chip market expected to be worth $US8bill by 2026 with 18mill driverless vehicles to be on our roads by then.

· The machine learning market is worth $US7.3bill now and expected to grow to $30bill+ by 2024

So how do we get exposure to the semiconductor industry in Australia? Unfortunately, the landscape is quite thin as we are not blessed with the Intel, AMD, NVIDIA, TSM, Qualcomm or even the SOXX semiconductor ETF listed on the ASX. I have a few ideas below that will help us gain exposure here in Australia.

ETFS ROBO Global Robotics & Automation ETF (ASX: ROBO) $73.00

This ETF was listed by ETF Securities only a few years ago and passively tracks the ROBO Global Robotics and Automation Index via 86 holdings by an equal weighted allocation. Management fees are 0.82% per annum and the fund is about $150mill in size now. There is a 47% allocation to companies in the US and 20% to those in Japan. To qualify for the index 40% of a company’s revenue has to come from one of the included sub-sectors. It has names such as NVIDIA, iRobot & Qualcomm and covers the AI, automation, robotics, semiconductors and 5G themes we are after. In fact, 10% of all revenue within the ETF comes from the 5G space. It has performed extremely well over the last year providing a 26.54% return to investors.

Betashares Global Robotics and Artificial Intelligence ETF (ASX: RBTZ) $12.62

Listed by Betashares and managed by RBC, RBTZ is a more concise ETF when it comes to the exposures we are looking at. Again, it is a passive fund but with only 31 holdings and roughly $72mill in size. It tracks the Global Robotics & Artificial Intelligence Thematic Index which requires that most of a company’s earnings have to come from one of the index’s subsectors as opposed to ROBO whereby a large portion had to be attributed to it. Management fees are around 0.57% per annum and it has returned 32.11% over the last year. Roughly 10% of the fund is exposed to semiconductors but of course it has all its exposure in AI, automation and robotics. More heavily weighted to Japan this one with 43.3% exposure there, 34% in the US and a surprising 13% in Switzerland. Top companies within the fund include NVIDIA, Renishaw & iRobot. It also has a healthy forecasted yield of 4.2%

What most people are not aware of is that China is forecasted to account for almost 25% (currently 15%) of all semiconductor manufacturing capacity by 2030. This is compared to the US’s 10% and South Korea’s and Taiwan’s 20% each. It will make it the biggest player in the space by that time. The below ETF gives you great exposure to these Asian semiconductor manufacturers.

Betashares Asia Technology Tigers ETF (ASX: ASIA) $10.46

Not concentrated upon that AI, automation & robotics theme but rather tracks the 50 largest technology and online retail stocks (ex-Japan) in Asia. This includes Alibaba, Baidu, Tencent and JD.com. However, 20% of the fund is dedicated to semiconductor manufacturers which is the main element we are chasing and includes names like Taiwan Semiconductor Manufacturers, Samsung & Semiconductor Manufacturing Inc. Management costs are 0.67% and it has returned 58.98% in the last year but is the smallest ETF of the lot at $34mill in size. A different way of gaining exposure to our target sector but effective none the less.

Finally there is one stock I would suggest will get you exposure to AI & ML and I have spoken at length about them before.

Appen Limited (ASX: APX) $34.60

Specialises in AI using its systems to help annotate, label, sort and improve client data to be used in their own machine learning models for things such as chat bots, virtual assistants, and bettering e-commerce penetration. Is creating a large moat around its business with its unique IP. I spoke at length on them during my earnings season round up but to summarise their first half results revenue +25%, NPAT +20%, FCF +$51mill, $126mill in cash and no debt. Its aiming for $125-$130mill in EBITDA for FY20. Its probably my favourite tech stock on the ASX and feel it is a great entry price at current levels. If you want my in depth look at it please let me know.

That is enough from me this week. Hope you have enjoyed my take on Artificial Intelligence & thoughts on DRR. Felt both were good to cover as they are unique investment propositions with incredibly positive outlooks. No technical round of the XJO this week as its much the same story as last. I doubt we wont get a definitive move until after the election. Only 6 trading days to go until the big day.

I will be on ausbiz.com.au tomorrow (27/10) at 11:20am CST for those who wish to see my mug on your screens. I hope you all have a wonderful & safe week ahead and I hope to speak with you all soon. Go Crows!

heath@hlminvestments.com.au

0413 799 315

Important Notice

Any advice in this article should be considered General Advice only and does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.