Weekly Broker Wrap: Rays Of Hope For Oz Equities

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By Andrew Nelson

Last week, the focus of local brokers shifted a bit from Europe and centred more on local issues in the lull to the next Greek election (June 17 is the date). Domestic banks, insurers, builder and miners came to the fore, while there were also a couple of interesting equity strategy reports to take note of.

Australian growth in mortgage credit is at its lowest since the RBS started tracking the trend in the mid-70s. Given mortgage credit accounts for about 50%-60% of overall bank lending, this is becoming an important issue. Goldman Sachs points out that household credit is still unseasonably high, thus the outlook for overall credit growth is lean at the moment.

The broker posed the question: what does this mean for shareholder returns? Given Australia has never seen a real period of sustained low credit growth; it has had to look at other markets to try to see the way forward.

Past examples from the US, UK and Canada show it is possible for banks to maintain and even improve returns on equity (ROE) and assets (ROA) in low credit growth periods.  The broker notes that capital generation should also improve as lending slows down.  However, the broker warns that returns are likely to be inconsistent given the increased amount of bad debts and subsequent funding volatility in such a challenged environment.

Goldmans goes further, saying shareholder returns could be as high as 10%-15% a year if banks are able to maintain ROE and ROA levels, with lenders that are able to pursue growth options offshore – like ANZ ((ANZ)) – being the best placed to maintain higher levels of shareholder returns.  High dividends become more attractive given benefits of franking, although some banks may look to buy back shares instead.

For banks that have a more domestic focus, but boast similar growth options, the broker notes higher dividend yields backed by solid ROEs provide better long-run returns  given dividends, as mentioned above, remain a key component.

All that said, Goldmans notes that a major bad debt shock (hearken back just a few years) could throw all of this reasoning into the heap. The good news is: the broke just doesn’t see this happening again anytime soon, as recent trends have been mild, unemployment data have been good and the RBS is ready to cut as soon as needed. Also supportive is the fact that banks and corporates have learned an important lesson from the last time around, so balance sheets are geared much lower and bank provision coverage is now at much higher levels.

Analysts at Macquarie note that deposits are also becoming much more important for Australia’s major lenders given the increasing volatility in wholesale funding markets.  The broker points out that the global push to increase the stability of the banking systems by mandating debt coverage levels has made increasing deposit levels even more important.

One thing banks have done is to shift toward longer maturity, more stable sources of funding. However, Macquarie notes this shift comes at a cost. In fact, deposit funding is 100bp higher on average than it was pre-GFC levels, while wholesale funds are likely to be more than 160bp over the bank bill reference rate.

The broker notes the May 2012 RBA rate cut showed the first signs of deposit competition easing, which is good news given the little amount of change that occurred after the December rate cut. Yet while this is a positive for margins, the broker doesn’t expect to see a meaningful pullback in deposit competition in the near term given the availability of wholesale funds and with European uncertainty likely to continue.

A team from UBS notes that 3-year bond yields are drawing closer and closer to 2%, although this has little impact, yet, on Australia’s general insurers (GI).  The broker notes that duration matching helps insulate GIs from month to month shocks, while also protecting profits in the following year. However, the companies in question need to sufficiently re-price new business to offset the lost returns. On UBS’s numbers a long-tail book requires 4% for each 1% reduction in yields.

Without such re-pricing, the broker points out that the impact can get ugly real fast, with a 250bps yield reduction over an 18 month period potentially subtracting  9% of Suncorp’s ((SUN)) net profit and 13% of IAG’s ((IAG)) net profit.

Warning bells aside, the broker reckons the drag will be gradual, with positive pricing moves for short-tail lines likely to limit the impact. In fact, the broker’s margin estimates are left largely unchanged. Still, with UBS pencilling in a 100bps yield reduction over the next 18 months, it has pushed through low single-digit EPS downgrades for FY13, affecting IAG, Suncorp and QBE ((QBE)).

A different team from Goldman Sachs pushed through some significant cuts to AUD/USD forecasts last week and the move has had some significant impacts on building materials companies.  While the broker already had the new numbers built in to CSR ((CSR)) and James Hardie ((JHX)) when they recently released FY12 results, the broker has now incorporated the new forecasts into its estimates for Boral ((BLD)) and Adelaide Brighton ((ABC)). 

On top of the FX changes, the broker has also booked some minor downgrades to its domestic housing assumptions for ABS estimates. CSR, JHX and BLD were already re-jigged. Overall, FY12-14 EPS forecasts for ABC and BLD decline 1.0%-2.9% and 1.0%-5.7%, respectively, with the latter also seeing a small dip in target given the size of the cuts.

Citi took a look at domestic mining stocks last week and saw some opportunities for the more brave at heart. Despite the uncertainties of Eurozone fallout and a slowdown in China, the broker points out that global growth has actually held up pretty well despite the escalation of sovereign debt concerns over the past year, with industrial production still growing at around 4%, which is the long term trend rate.

However, commodity prices have retreated by about 25% over the past year, which is more than you would expect given growth has been steady. Citi thinks it could be partly because of the sensitivity of prices at what are reasonably high levels, but it believes the fear of a further deterioration in growth is the main culprit.

Thus with it looking like, at worst, an orderly exit for Greece – or possibly none at all – and with China now working on maintaining growth, Citi thinks there’s a chance global industrial production could continue to grow at or even a little above trend. This would be a much better outcome than commodity prices and resource equities are factoring in, on current numbers.  Thus, thinks Citi, some sort of commodities price rebound seems a reasonable prospect. It wouldn’t take a genius to know that such an outcome would be a boon to the broader equity market.

Analysts at DJ Carmichael also took a look at some the opportunities presenting themselves on the Greek based, sovereign debt risk-off selloff. The broker notes that from the end of 1Q12, the Energy 200 index and the WTI oil price are both down around 12%, while the ASX 300 is only down around 7%.

The broker doesn’t suggest any should jump the gun, noting its own near term energy  sector outlook is  neutral  given  the Greeks will likely continue to trouble us until their elections in June. That said, current weakness has delivered some pretty good buying and/or speculative buying opportunities on a medium term outlook, DJ Carmichael suggests.

Looking at the large cap end of the spectrum, the broker likes Oil Search ((OSH )), while its top  picks  in  the sector  are Jacka Resources ((JKA))  and  Neon Energy ((NEN)).  For more unconventional exposure, DJ Carmichael likes the look of Central Petroleum ((CTP)).

The team at UBS has taken a similar look at the market and given it expects that Greece will not exit the Euro and that more policy action is right around the corner, it sees at least a small bit of respite for equities markets. This will be especially so for stocks exposed to the global cycle.

The broker notes that even quality resource stocks are discounting commodity prices, but with UBS expecting another round of policy initiatives in Europe and evidence of some policy-led  H2 growth in China, the broker expects we should see a Q3 rebound in the resource sector and related businesses.

The broker also sees support coming from the lower AUD and an increasing focus on costs and efficiency, which have been the catchphrases of the sector of late. Thus, UBS expects to see 6% aggregate FY13 market EPS growth versus the market, which currently sits at 12%. With the market currently priced at 10.5x earnings, the broker sees too much discount.

Lastly, Macquarie has taken on a few contrarian views, or Counter Consensus Calls, in the words of the broker.  The broker outlined its reasoning on three of its most high conviction calls, liking David Jones ((DJS)) and Goodman Fielder ((GFF)) very much, and disliking Mesoblast ((MSB)) equally as much.

The broker thinks David Jones is undervalued given ongoing transformation initiatives could improve not only the perception of the company, but also its ability to compete with various online and established multi channel competitors.

Macquarie further thinks Goodman Fielder has been oversold and was much undervalued at 47c when it put its Buy call on the stock. With GFF now the subject to corporate action, underwritten at 60c and with upside to 85c-96c in the event of a takeover or successful restructure, the broker sees plenty of value.

On the other hand, at current levels Mesoblast has a market cap of 15x-20x higher than US peers, but Macquarie – and a few others the broker has spoken with – believes the company is at best comparable to slightly inferior to its peers. Thus, the large premium is very hard to justify. More worrying is the fact the company has yet to publish any human clinical trial data. Not good for a company that does what Mesoblast does, says Macquarie.

 

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