Corporate Strategy Weekly Radar Update

Week ending Friday 8 June 2012 (theme: Oz pipeline and skills)

Highlights Insights

Financial Services The Super Sector faces a $121m levy to start in 2012-13 to fund the SuperStream Federal reforms which are to deliver $1b efficiency gains a year: it will cost $4 per account across 33,000 super accounts. Response to RBA cash rate cut (-25bps): ANZ: -25bps, CBA and NAB: -21bps, Westpac: -20bps IAG confirms the closure of internet distribution brand Buzz launched in 2009 to attack online where SUN's Bingle operates. ANZ institutional banking highlighted that higher funding costs and capital requirements are pushing them to switch away from traditional business lending (to fall to 20% from 37% of revenue mix) to transaction fees earned from providing 'value added services' (investment products, structured lending, derivatives, FX, trade, etc) (to grow from 62% to 79% of the revenue mix). Lloyds Banking Group is offloading a large package of distressed Australian property loans in a further clean-up HBOS purchase: selling the $1.3bn portfolio of loans to a Morgan Stanley and Blackstone JV less than 50% their original value. Other industries Shell announced the closure of its Clyde refinery in Sydney in Sept: facility to be converted into a fuel import terminal. Caltex also has a review of its Australian refining facilities underway, with a decision expected within the next six months. QANTAS profit downgrade: international losses to double to $450m: Merill Lynch estimate a Group net loss of $223m in FY12 o On the business development front Qantas is looking to exploit the FIFO mining workers rotations which is estimated to be a $1.5b market in annual sales by the ABS. Echo (ex Tabcorp) chair John Story was forced to resigned under pressure from James Packer who wants Jeff Kennett appointed, illustrating a trend of rising activism from industry magnates. BHP Billiton is keeping a close eye on commodities prices before approving major growth projects (outer harbour at Port Hedland and expansion of Olympic Dam copper-uranium mine). Gloucester Coal and Chinas Yancoal Australia merge to create the largest independent listed coal miner in Australia: the biggest investment by a Chinese state-owned company in Australias coal industry.
Australian Government - Global

After a period of rumours about a S&P downgrade of Australia's AAA rating, the rating agency confirmed it saw 4 strengths supporting Australia's AAA ratings: "1) strong fiscal position, 2) resilient flexible economy, 3) mature stable institutional settings, including RBA + Treasury, 4) sound credit quality of banks, which is important given the banks role in funding Australias current account deficits. The RBA cut the official cash rate by 25bps to 3.0%, citing modest domestic growth and uncertain international outlook. Future movements will reflect a slower China+ EU issues. However GDP rose at its fastest annual rate in 4 years: +1.3% in the March qrtr (beating analysts forecast of +0.6%) with annual growth at 4.3%. Key contributors: retail (household consumption +0.9%,) and mining driven investment (engineering construction +1.1%) offset by -0.5% drop in net exports. Unemployment marginally rose to 5.1%: attributed to the encouraged worker effect, ie increased participation rate. Spains downgraded to BBB by Fitch (more on EU in next radars) China cuts interest rates for the first time since 2008: sign the economy is slowing quicker than the government intends.

Buzz: IAG commented as the end of an 'experiment', however analysts view it as an attempt to repel challenger brands in a motor market that IAG dominates (with NRMA). Analysts also note that despite the motor sector being relatively flat in recent years, challenger brands have increased market share from 6-9%, which is prompting the question of Bingles strategy within SUN. ANZ's shift echoes Westpac's recent declared focus on deposits and less on lending. Banks Institutional divisions now face the challenge that big companies can access capital markets at cheaper rates than them due to a higher risk premium on Financial Institutions post GFC. Lloyds illustrates the pattern of European lenders who retreated from the Aus. loan market to free up funds to deal with the EU crisis: a question is whether it has left a gap in the Aus market and who is underserviced? (hypothesis: SMEs) The oil refineries closures illustrates the challenges of downstream as crude oil prices and the AUD remain high and larger Asian refineries produce big volumes at lower cost. Oil companies are moving away from the downstream ('manufacturing') and 'vertically disintegrating' to focus on the more profitable distribution (illustrated by supply chain changes, partnering with retailers (e.g. Woolworths, Coles). This 'manufacturing vs distribution' dichotomy is also key for GI and Life (product, underwriting, distribution, claims) and we will monitor the direction the industry will take. The decision to split QANTAS between international and domestic business is echoed by the difference between the $450m loss and the FIFO (domestic) sales which are to grow +27% by 2017: Qantas and Virgin are both competing for that prize of charter contracts with the mining companies, and has evolved into the sophisticated provision of the same services as regular commercial lines (frequent flyers, etc) BHP highlights the feedback loop between commodity prices and the decision to invest: expansion plans were announced when iron was more than $US190 a tonne. It is now $US135: BHP will not invest below a certain 'break even' point (~$US100): it also shows that the fluctuation of commodity prices are probably more a key driver in investment decisions than the various current 'political' debates on mining. S&P confirmed that a re- rating would only happen if "there was significant weakening in the credit quality of the banks involving heightened borrowing costs and or restricted access to offshore funding such that govt support may be required. Bank liabilities would have to be at risk of migrating to the sovereign balance sheet. Australian metrics illustrate a increasing tension in the public debate (coined as 'the great unhinging/whingeing' by journalists): despite green macro-KPIs, confidence is down: o A relevant issue for our industry which taps into consumers' confidence (and risk aversion). Echoing Bobby Kennedy who famously commented in 68 that "[GDP] measures everything except that which makes life worthwhile", whilst Australia scores highly in 'objective' measures (strong GDP, #1 in the OECD better-life index, it ranks low in 'employees working very long hours' (31/36 countries) and 'time spent to leisure' (27/36). o A UNICEF study also shows that social entitlements raised in the past decade but distributed in cash as opposed to investments in services, resulting in higher stress for people when faced with education and Health decisions.

Appendix: another perspective on Australian competitiveness and growth from a cost and skills angle As previously discussed the growth of Australia's GDP (+1.3% in March Qrtr beating +0.6% expectations) is underpinned by resources Recent headlines on importing workers in mining (Gina Rinehart) and the Business Council of Australia (BCA) reporting that "high costs could kill big project" is an invitation drill into the 'State of the Nation' in skills and costs, and ask what the status is in Financial Services... 1 - Australia has an unprecedented pipeline of $921b of committed and prospective investment 80% of the pipeline is new construction opportunities in large-scale projects mostly in resources and infrastructure projects rather than maintenance of Break down of major project status (A$ bn) existing infrastructure. Utilities, Electricity Generation: 6% Mining, oil and gas projects are the single Education, Health, largest category: 45% of projects by value. Other Community (incl. Finance): 12% Possible: Transport: 31% (including tentative highServices: 6% Under construction: $279b (30%) speed rail plans). $384b (42%) Education, health and community Total pipeline: $921b Transport: services: 6% 31% Under consideration: Utilities and electricity generation: 6% Mining,
$192b (21%)

Committed: $66b (7%)

Oil, Gas: 45%

Source: Deloitte Access Economics

Investment and export as % of GDP

2 - These projects are likely to underpin GDP and employment growth for some years to come and are expected to make Australia "the most investmentintensive economy in the OECD." The investment pipeline, if delivered, is expected to drive long-term changes to Australias economy: o to drive future exports, o which in turn will provide a greater proportion of Australias GDP (up to 30% by 202122), o ... which is to trickle down to the incomes of Australians.

3 - The nature of the projects themselves is also dramatically changing: Magnitude: the largest completed single project in Australia was Pluto stage 1 ($14b) dwarfing the Snowy River Scheme that would have been only $8b in todays dollars: 9 projects underway or about to commence are larger than Pluto, ranging from $43b to $15b Location: the other issue is the disconnect between their location North West of the 'Brisbane Line' vs where most of Australia's workforce lives This is forcing companies to use fly-in-and-out workers and rapidly adopt new technologies (such as Rio control centre in WA) employing an IT workforce which is likely to create even more competition with the white collar job offers of the South East. "know thy country's CAPEX's location (location location...)"
Ichthys gas field NW shelf gas hub
Gorgon LNG Pluto LNG Curtis LNG Gladstone LNG AP CSG-LNG

Wheatstone LNG

North-west of the Brisbane Line (Brisbane -Adelaide) 53% of the projects 20% of Australias workforce
BHP Olympic Dam

The IMF notes that Australias GDP growth is dependent on the realisation of those 4 - Key risks could prevent the delivery of this pipeline: investments, and also believes that a majority of those projects is "funded by strong 'Costs' and 'Skills shortage', 'Timeliness of delivery', multinationals that do not have problems accessing funding so growth in Australia 'Drop in Investments' should not be impacted by "the downgrades happening everywhere in the world" The BCA argues that if Australia is to maintain wages note: by "everywhere" it is assumed the IMF means EU and US because an Asian growth, we will have to improve labour productivity downgrade would clearly have consequences and become a high-wage, high-productivity nation. 5 - But what exactly is the magnitude of the skills Shortage? 6 - the 'cost' of doing projects is also an ongoing debate: the BCA An original angle is the actual number of occupations in shortage compared generic projects in Australian and the US to conclude that listed by DEEWR (Dept of Employment) doing business in Australia has become prohibitive.
Shortage of engineering professions has surged

However a closer examination of the very sources quoted by the BCA (International Construction Costs Survey 2012) reveals that in fact costs in Australia dropped between 2008 and 2011 (-1% to build a large shopping centre, to -18% to build an airport terminal). In fact the reason of those high ratios is the rise of the AUS-USD rate: a clear concern for international investors who want returns in USD. However it is not due to an inherent rise of Australian costs. Besides, it is impossible to fully compensate the AUD rise by an equal and opposite proportionate fall in wages, which will leave the debate open for more political arguments (ranging from slowing the boom to altering IR laws).
2

Looking at Financial Services, the 'equivalent' of this CAPEX is the pipeline of various core banking projects in flight to replace the decades-old platforms which all of Australias major banks have relied on for some time 7 - Using the Big4 as a proxy to spot IT trends... Pre 2009 2010 2011 2012 2013 Multi year timeframe (5 year horizon). 2009 NAB-CBA around $900m investment. Roll out of the Core platform Transformation of 1st release of Westpac planning to spend up to $1.8 b on ComSee/SAP transition bankers front-end Core - deposits infrastructure and some business enhancement SAP / core to the complete or complete Accenture subsidiaries near complete (e.g. mortgages) without replacing core banking. (CommSee) ANZ will not invest in Australian core system and 1s step: redirect cash to grow in Asia instead. Progressive drops of functionality (Waves 1-4) Mobilisation UBank on Oracle 8 - looking at an international tally between 5 of NextGen All new products on new platform by end FY12 Oracle regions, Australian Big4 are clearly leading the cost compression: China's lower cost is obviously explained by lower wages. Focus on Front WBC/SGB Multi1st Consolidation systems brand operating of WBC/SGB 9 - FTEs are the other factor Financial Companies WBC / SGB model in place platforms and will look at to improve their productivity system operations (est.) integration Banks cut staff in the late 90s when they closed branches, whilst insurance FTEs grew in line with Reorganisation Target core No plan to roll out core banking systems in Australia away from banking insured assets until the GFC: Finacle replaced systems inherited through independent platform live acquisition of RBS assets in 6 Asian countries in 2009. Finacle / Analysts warn that up to 10,000 jobs could be lost business units in Asia Fiservs ICBS (aka Signature) platform is among them. Infosys across the finance sector in coming years due to increase in outsourcing and credit deleveraging. Average cost to income ratios across 5 regions for the past 5 years. FTEs trends in Banking and Insurance (Australian numbers are an average of the Big 4)

Trends in Australian labour productivity growth and Economic Cycles

Early 1980s crisis Early 1990s Crisis Dot com

GFC

2000s Boom: decreasing productivity 1990s Boom: increasing productivity

10 - Another systemic angle is the hypothesis that a new productivity growth cycle is likely to occur underpinned by a new wave of integrations and Technology innovations: Horizontal (further bank and insurance mergers) is unlikely given the concentration of the market. However further vertical integration (Larger FS companies partnering with 3rd parties is likely (Technology, repair centres such as SMART, personal finance companies, absorption of brokers under regulatory pressure, etc). The hypothesis of Technology innovation is supported by both the obvious macro-trend of the consumerisation and diffusion of IT (eg. mobile devices) and by the incentive organisations have to realise benefits from their mentioned IT investments. 11 - The forecast of "top employing occupations, job prospects and future growth" shows that: Future employment growth for the next 5 years to 2016 is positive for insurance, money market and statistical clerks and insurance agents, while .. .. bank workers are expected to experience a decline. However this table only recognises occupations with ANZSCO codes, so new areas are becoming increasingly important to banking and financial institutions and are not well represented, eg collateral management, portfolio compression and carbon related activities trading, analysis, advising, aggregation and management. Source: Department of Industry Innovation, Science, Research and Tertiary Education, 2011