By Jihad Jhaveri, Kagiso Asset Management Equity Analyst

South African hotels are expected to face testing times ahead as the industry grapples with major overcapacity challenges against a backdrop of an on-going sluggish global economy.

The current overcapacity situation in the local hotel industry, concentrated in the top end of the market (four and five star hotels across the country) is largely due to industry players possibly over-estimating economic prospects and definitely underestimating total concurrent industry capacity expansion. Going forward, it could take a few years for the industry to absorb the excess capacity.

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By Abdul Davids, Kagiso Asset Management Head of Research

Multinational media company Naspers has been at the forefront of identifying trends in the global media sector, particularly from 1986 onwards, and yet has managed not to bet the company in the process - instead managing cash flows from existing businesses to fund its foray into new ventures.

Naspers was founded as “Die Nasionale Pers” in 1915 and is therefore the oldest media group in South Africa. It has a wide range of operations across Africa, Europe and Asia in electronic media (pay-television, internet and instant-messaging subscriber platforms and related technologies) as well as in print media (publishing, distribution and printing of magazines and newspapers).

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By Abdul Davids, Kagiso Asset Management Head of Research

The domestic equity market’s recent declines, most notably in the resources sector, should not come as a surprise, given current valuations and p:e multiples. Unfortunately, there is potentially more pain to come.

Currently, there is a dichotomy in the market in terms of the rating between the three key sectors: Resources are almost in a growth market orientation with investors expecting significant earnings growth and rewarding resources companies accordingly, whereas industrials and financials are effectively still being beaten down because of poor earnings growth in the last 12 months, which Kagiso Asset Management believes is unlikely to recur.

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Kagiso Asset Management Head of Research Abdul Davids

View on double dip recession in the second quarter of 2010
“I think recession is probably a very harsh word. What we are hopefully seeing is some sort of a pullback. There are a lot of factors that have driven markets to recent highs and I think the removal of some of the stimulus packages we have seen will impact on the market.

The extent of those impacts in terms of severity and the likelihood of recession is unclear and therefore it’s difficult to say with confidence that we are facing a double dip recession. However, the removal of some of the factors that have driven commodity prices and equity markets to recent highs from their lows of December 2008 will have an adverse impact on equity markets.”

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Regulatory risks have recently been at the centre stage in the mobile telecommunications sector with a specific focus on major developments in interconnected rates and subscriber registration.

The weak performance by MTN over the last six months can partially be explained by increasing concerns around regulation in the sector and the potential impact on the business.

It is worth highlighting that, over time, one should expect further regulatory intervention as markets mature and as African governments increasingly adopt telecommunication policies of the developed world.

This has important consequences for mobile operators in developing markets. In particular, it is worth highlighting that in the absence of explicitly modelling the impact of regulation on each market, one will tend to over-estimate sustainable profits.

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The last two years (2008 to current 2010) have been an exceptionally volatile time for global equity markets as well as for the local equity market.

The period can be divided into the following stages:

• a commodity supercycle fuelled by China and concurrent banking crisis in the West
• the spread of the banking crisis globally
• the meltdown in global financial markets, post the collapse of Lehman Brothers
• a massive rebound rally from oversold levels, following the unprecedented global government intervention in the form of fiscal and monetary stimulus

Currently, equity markets are in what can be described as the start of the “reality bites” period, absorbing the cost of the unparalleled global fiscal and monetary stimulus. Looking ahead, global markets are likely to experience a choppy performance against a background of a tough economic environment for at least a couple of years.

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South African sugar producers strongly positioned for growth post EU sugar market reforms

Rubin Renecke: Equity Analyst - Kagiso Asset Management

Following major structural shifts in the global sugar industry in the form of European Union (EU) sugar market reforms, local sugar producers Illovo Sugar and Tongaat Hulett are robustly placed for growth.

In both cases, credit needs to be given to the management of both companies for having had the vision to position themselves optimally for the EU reforms by anticipating excess demand that would be required by the EU and therefore by setting up the necessary infrastructure to meet this demand.

Both Illovo and Tongaat have actively increased production over the last few years and are set to continue to do so in order to benefit from the EU reforms. Both groups are also examples of companies that have strong earnings and growth potential from current levels and yet trade at reasonable multiples to the rest of the market.

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Abdul Davids: Head of Research - Kagiso Asset Management

A positive view on the gold price does not necessarily translate into a positive view on South African gold mining companies. In fact, there are a number of compelling reasons why South African gold stocks are not great investments and why alternative ways to invest in gold are well worth considering.
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Jihad Jhaveri: Equity Analyst - Kagiso Asset Management

“New vehicle sales for July continued their positive year-on-year trend seen over the past few months. The passenger vehicle category accelerated strongly year-on-year while commercial vehicle sales slowed down.

However, due to the base effects the growth rates are less meaningful than the actual level of car sales. From the chart below we can see that vehicle sales are still 41% lower than their 2006 peak. Companies that have restructured for lower production levels will be benefiting from the year-on-year increases in car sales, whilst those with cost structures geared up for 2007 type levels, including some of the motor manufacturers, are still feeling the pain.

[View total vehicle sales]

Abdul Davids: Head of Research – Kagiso Asset Management

“Latest results for the financial year to March are solid despite the strong rand cutting into offshore operations. Overall however, the focus on dollar revenue was problematic for Naspers (which reports in rand), cutting into revenue growth.

Margins from the pay television business came in very high despite competition coming into the market (with the African pay television operations doing fantastically well) while the internet businesses has put in a strong performance (operational profit was 49% higher, coming in at R2.4 billion from R1.6billion), masked to an extent by acquisitions made. The internet business is expected to make an increased contribution to the bottom line for Naspers in the future.

The print business was the disappointing area although cash flows there are still reasonable.

In summary, Naspers has put in a good performance with South Africa still providing a solid foundation from which management is deriving significant cash flows. In addition, the group’s balance sheet continues to look very healthy.”

Satish Gosai: Head of Trading – Kagiso Asset Management

“Producer price inflation (PPI) rebounded strongly in May, rising to 6.8% year-on-year from 5.5% year-on-year in April. Despite the steep increase, the PPI was below the consensus estimate of 7.2%. On a month-on-month basis, PPI increased by 0.2% (from 1.5% month-on-month previously), with positive contributions from paper and paper products, basic metals and electricity. This was countered by a negative contribution by the agriculture category.

PPI food at both agriculture and manufacturing levels remains negative, posing no immediate risk to consumer food inflation, falling to -4.9% year-on-year from -3.2% year-on-year in April. PPI agriculture food fell further, to -4.9% year-on-year, while manufactured food inflation declined by 1.3% year-on-year from -1.7% year-on-year in April. The outlook for consumer price inflation (CPI) food inflation therefore appears benign.

The relatively strong currency will further add impetus to CPI remaining within the Reserve Bank’s target range of 3% to 6%. There is therefore no risk of higher interest rates in the short term.”

Gavin Wood: Chief Investment Officer – Kagiso Asset Management

“The latest Kagiso PMI Index, which dropped sharply to 51,1 (from 55,2 in April) - its lowest level since November - was a shocker. The sharp fall in the Kagiso PMI, which the earliest overall indication of activity within the manufacturing sector, is particularly concerning due to the employment component of the index falling significantly. If this trend continues, next month’s Kagiso PMI, which may be impacted negatively by the Soccer World Cup and related productivity declines, could signal a swing back to manufacturing recession territory.”

Satish Gosai: Head of Trading – Kagiso Asset Management

“Global markets were in turmoil over the past week on elevated concerns surrounding Greece and other European countries. One key measure to focus on in the US is the VIX index, which is a risk gauge that measures the market’s perception of risks in the current equity market environment.
This index has jumped substantially in the past week, adding 86% in the first week of May and closing at 40.95 on Friday. This is the highest recorded weekly jump in its history, including the sub prime mortgage crisis. The jump in the VIX reflects heightened global volatility as investors fear the direct impact of Greece potentially defaulting and that the Greek situation is a precursor to similar future scenarios for other European countries with similarly large deficits. This would be disastrous for the global economy.

At the height of the credit crisis, this index reached a level of 80.06. The VIX has since trended lower, touching 15.58 in mid April, a level not seen since 2007. The long-term average on the VIX index is approximately 20% and moves over the past week have pushed this index significantly past these levels. The local market was no different with the SAVI index (a comparable index in South Africa) rising to 30.03 on Friday, a 31% increase from a week ago.”

Jihad Jhaveri: Equity Analyst & Portfolio Manager – Kagiso Asset Management

“April 2010 passenger vehicle sales are looking strong at 28% growth year-on-year although bearing in mind that a year ago sales were at a low point (due to the global financial crisis). Strength is also coming through on the light commercial side (up 28% year-on-year), where we are seeing solid volumes. In terms of market share, Volkswagen is doing very well gaining market share mostly from Toyota. Looking at exports, Volkswagen, which is the biggest exporter ahead of BMW and Toyota, is also doing well. Toyota exports are particularly disappointing given that they had geared up to be the largest vehicle exporter in South Africa.”

Jihad Jhaveri: Equity Analyst & Portfolio Manager - Kagiso Asset Management

‘We’ve come out of a bit of a downturn and retailers haven’t really been affected on earnings.’

‘Looking back at the entire downturn, another source of surprise has been the fairly aggressive store roll-outs. That’s not characteristic of previous downturns. It’s more the case for Truworths and the other clothing retailers and to a lesser extent Shoprite and Woolworths.’

‘Margins are very high relative to history. When margins are compressed and then you go into recovery, you have that magnification effect on earnings, which we don’t see happening going forward.’

Click here to view a summary of our latest conference presentation: Opportunites in the SA Equity Market.

Click here to view our latest conference presentation: Opportunites in the SA Equity Market.