Noosa Mining Investor Conference

February Reporting Season 2025 has kicked off. The February reporting season offers a crucial window into corporate Australia's health, with company-specific performance taking precedence over macro considerations. While earnings and share prices have shown remarkable resilience since the August reporting period, the focus shifts to companies' ability to maintain margins and drive growth amid subdued trading conditions, particularly as earnings growth moderates in FY25.

With a modest earnings outlook companies have been forced to adapt to the softer trading environment. Our focus in February is on companies and sectors that continue to see margin resilience and positive earnings trends. Large caps is another area to monitor given historically high valuations and strong performance over the past 12 months. Last August demonstrated that high expectations and in-line results might not be enough. The recent swing in the AUD will also complicate FY25 earnings and those exposed to currency fluctuation could see earnings volatility around the result.

In The Month Ahead this month, we highlight three companies from our key results to watch: Pinnacle Investment Management (PNI), Superloop (SLC) and Lovisa (LOV).

Pinnacle Investment Management (PNI)

RESULT: 5 FEBRUARY 2025

We expect outperformance driven by performance fees

We expect a strong result from PNI, driven by a combination of higher FUM through the period and strong performance fee contribution. We expect PNI can outperform consensus expectations based on higher performance fees. Key numbers include underlying 1H25 NPAT (forecast +105% on pcp to A$61.9m); and affiliate profit share (forecast +82% on pcp to A$68.1m).

Core flows and leveraging Horizon 2 spend

Current momentum and the outlook for flows is always in focus. We expect confident commentary from PNI, in part supported by new affiliates (e.g. Lifecycle). Horizon 2 spend has ramped up in recent years (primary driven by Metrics) and the market will be looking for some commentary or evidence that returns are starting to materialise.

Cashed up and ready

PNI has ample ‘dry powder’ following an equity raise in Nov-24. Commentary on the early performance of recently acquired stakes and the pipeline will be in focus.

Superloop (SLC)

RESULT: 21 FEBRUARY 2025

FY25 outlook

SLC expects FY25 underlying EBITDA of $83–88 million. We estimate $35.8 million for 1H25 (41% of full-year earnings), slightly below market consensus of $38 million (as of Jan 17, 2025). Since guidance was set in Feb 2024, there’s potential upside. One-off $5.5 million expenses in 1H25 include legal fees from ABB’s failed takeover and costs for acquiring Optus/Uecomm fibre assets (finalising by Mar 2025). A Vostronet earnout will also impact cash flow. Despite this, we expect net debt to decline slightly.

NBN subscribers (organically and Origin originated)

We forecast SLC will deliver slightly fewer NBN net adds in 1H25 (+31k yoy to 354k) vs +33k yoy in 1H24. This is due to our assumption that SLC has prioritised the material Origin migration. This assumption could prove conservative. Origin is, by our maths, the largest single EBITDA driver in FY25. We expect Origin to have ~155k NBN subscribers at year end, noting some of the Origin labelled ‘subscribers’ include voice products which SLC does not provide. We also assume organic growth in Origin is relatively slow in 1H25 due to the migration from ABB onto SLC. This should hopefully re-accelerate above its historical ~4.5k monthly net adds in early 2H25, although this is not within SLC’s control.

Business

The business segment remains challenged (NBN/macro driven price erosion), but we should still see some growth and are optimistic competition should settle in the latter half of CY25. We await clarification on the industrial logic around the Optus fibre acquisition which is likely largely back-haul cost avoidance for Smart Commmunities, and also provides SLC with the ability to more efficiently bring to market new product innovations (revenue upside).

Lovisa (LOV)

RESULT: 24 FEBRUARY 2025

Double-digit growth in earnings to continue

We see Lovisa’s half year result as an opportunity for it to remind investors of the growth in earnings it continues to deliver. We forecast a double-digit increase in revenue and income, all organic, driven by ongoing network expansion and higher gross margins. Our EBIT forecast of $93.1m is largely in line with consensus and represents 14% growth on 1H24. We forecast LFL sales of +1%. We expect the store count to have risen to 939, a net increase of 39 over the half, including 12 since the AGM trading update. This is clearly below the rate of expansion achieved in recent periods but maintains the positive long-term trend. We forecast a further increase in the gross margin to 81.5%. Lovisa’s results have seen some wild share price reactions in the recent year. We don’t expect a repeat in February, but the combination of a high P/E and high growth forecasts is always a potent mix.

The pace of expansion is due to accelerate

The key theme in the result will be the sluggishness of recent store rollout activity. The net addition of 39 stores we forecast for 1H25 falls 26% short of 1H24 and 55% below 1H23. In fact, if our number is right (and we are in line with consensus), it will be the slowest half year for network expansion since 1H21. Investors are justified in asking what’s going on. A key reason, in our view, is the need for Lovisa to consolidate after an extended period of very rapid growth in the US. The other reason is more nuanced. Lovisa has entered a large number of brand-new markets in the past two years. Its modus operandi is to spend around 24-36 months in any new market to become familiar with customers, landlords, competitors and price points before proceeding to expand. If we’re right, this is the calm before the storm and the pace of growth is about to get a whole lot faster.

We think it gets better from here

We think 2H25 will be a better (relative) period than 1H25. We forecast 63 net new store openings in the second half, with LFL sales growth picking up to +3%, despite comps getting more difficult. Earnings are always weighted to the first half (Christmas, BFCM and all that) but the 61/39 skew we forecast for FY25 tilts more to the second half than in any year since FY22.

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In recent weeks, there has been much discussion about the inflationary effect of Trump tariffs. This is sparked by Donald J. Trump's proposal of a 10% revenue tariff. Interestingly, the idea of a 10% revenue tariff was first discussed during his first term. At that time, it was considered as a potential source of additional revenue to offset the Trump tax cuts enacted during his first term.

The challenge in passing finance bills in the U.S. lies in the legislative process. Finance bills can only be easily passed if they are reconciliation bills, meaning they have no effect on the budget balance. When a finance bill does not affect the budget balance, it requires only a simple majority in the U.S. Senate to pass. However, when a finance bill increases the budget deficit, it requires at least 60-votes in the Senate, making such bills much harder to pass.

During Trump's first term, the administration found that by reducing certain tax write offs or tax cuts for specific states, they could pass the overall tax bill without effecting the budget balance. This allowed significant tax cuts for individuals and a major corporate tax cut, reducing the U.S. corporate tax rate from 35% to 21%. Now, as Trump seeks to cut corporate taxes again—this time from 21% to 15%, matching the German corporate tax rate—he needs additional revenue to balance the bill. This is so he can pass it as a reconciliation bill, requiring only 51 Senate votes. This has led to renewed discussions about the 10% revenue tariff.

In contrast to the European Union, where a value-added tax (VAT) would be a straightforward solution, implementing a VAT in the U.S. is effectively impossible due to constitutional constraints. A VAT would require unanimous agreement from all states. This is impossible in practise. So, the idea of a 10% revenue tariff has resurfaced.

Critics, particularly within the Democratic Party, have argued that such a tariff would be highly inflationary. However, when questioned during confirmation hearings, Trump's Treasury secretary nominee, Scott Bessent, referencing optimal tariff theory, explained that a 10% revenue tariff would increase the U.S. dollar exchange rate by 4%. We note that this would result in a maximum inflationary effect of 6% only if 100% of domestic goods were imported. Given that only 13% of domestic goods are imported, the actual inflationary impact would be just 0.8% on the Consumer Price Index (CPI). This makes the tariff effectively inflation neutral.

This idea was discussed by a panel of distinguished economists at the American Economic Association Convention in January, including Jason Furman, Christy Romer, Ben Bernanke, and John Cochrane. Cochrane noted that historical instances of tariff increases, such as in the 1890s and 1930s, did not lead to inflation because monetary policy was tight. He argued that the inflationary impact of tariffs depends entirely on the Federal Reserve's monetary policy. If the Fed maintains a firm stance, there would be no inflationary effect.

Trump's current plan is to pass a comprehensive bill that includes the Reciprocal Trade Act, corporate tax cuts, and the 10% revenue tariff. Peter Navarro, in a CNBC interview on 21 January, estimated that the revenue tariff could generate between $US350and$US400 billion, offsetting the cost of the tax cuts and making the bill feasible as a reconciliation measure.

With the Republican Party holding enough Senate seats, the legislation could pass by the end of April. The inflationary impact of the tariff, estimated at 0.8%, can be easily managed through moderately tight monetary policy by the Federal Reserve.

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Today, I want to discuss the challenges the Reserve Bank of Australia (RBA) faces in cutting rates. To do this, I’ll explore our model of Australian short-term interest rates, and how its components interact. A key focus will be the relationship between inflation and unemployment, and how this relationship makes it particularly difficult for the RBA to now lower rates.

Our model of the Australian cash rate is robust, explaining just under 90% of the monthly variation in the cash rate since the 1990s, when the cash rate was first introduced. The model’s components include core inflation (not headline inflation), unemployment, and inflation expectations.

Interestingly, statistical tests show that unemployment is even more important than inflation when it comes to predicting what the RBA will do with the cash rate. This is because of the strong, leading relationship between Australian unemployment and core inflation.

To illustrate this, I’ve used data from the past ten years up until December, which shows the relationship between unemployment and inflation in Australia. The data reveals a Phillips curve, where inflation tends to fall as unemployment rises. This relationship begins to work appears almost immediately, though there is a slight delay of about 3 to 4 months before its full effect is felt.

We look at the data from 2014 to the end of 2024. When unemployment is around 4%—which is where it has been for the past few months—we can predict that core inflation should be around 3.7%. Currently, core inflation is 3.5%, which aligns closely with what we would expect given the unemployment rate. This suggests that the current level of inflation is consistent with current unemployment levels.

Unemployment vs Inflation

2014 to 2024

However, the RBA’s target inflation rate is between 2 and 3%, with a specific target of 2.5%. To achieve this target, unemployment would need to rise from its current level of 4% to around 4.6% or 4.7%. Historical data, such as from 2021, shows that with an unemployment rate of around 4.6%, inflation can be brought down to 2.5%. Therefore, to reduce inflation to the RBA’s target, the unemployment rate would need to increase slightly—though not drastically. If unemployment were allowed to rise to around 4.6%, it would create enough excess capacity in the economy to put downward pressure on inflation, which would take about 3 to 4 months to materialise.

If the RBA were able to allow this rise in unemployment, inflation would decrease to around 2.5%, and the RBA could cut rates. Current rates are at 4.35%, and under this scenario, we could expect them to drop to the low 3.0% range perhaps even lower. This would represent a fall of around 100 basis points from current levels.

Unfortunately, the situation is complicated by fiscal policy. The current Treasurer, Jim Chalmers, has been expanding employment in sectors like the National Disability Insurance Scheme (NDIS) and other areas of the public service. This fiscal stimulus is preventing unemployment from rising to the level needed for inflation to fall. As a result, unemployment remains stuck at around 4%, and inflation remains too high for the RBA to cut rates.

In terms of job vacancies and other labour market indicators, we would have expected unemployment to rise higher by now. However, Treasurer Chalmers is committed to keeping unemployment low ahead of the election, which is why we find ourselves in this position.

The government’s fiscal policy, aimed at maintaining a low unemployment rate, is preventing the necessary adjustment to bring inflation down.

If I input the current levels of inflation, unemployment, and inflation expectations into our model, the estimated cash rate should be 4.45%. This is 10 basis points higher than the current cash rate of 4.35%.

The Australian Government seems intent on maintaining the unemployment rate at 4% ahead of the election. If it does so, Inflation will remain too high for the RBA to cut rates.

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