Weekly Broker Wrap: The Outlook For Australian Equity Investing

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-Restructuring to drive value
-Industrial stocks look stretched
-Cyclical stocks not expensive
-Tourism sector upbeat
 

By Eva Brocklehurst

Australia and China have something in common. Both economies are retreating from an investment binge and the process will weigh on growth in the years ahead, according to Credit Suisse. In terms of Australian company sales, these will slow too and there is limited scope to raise margins. The analysis from Credit Suisse suggests investors should focus on those companies prepared to help themselves, specifically which companies are expected to restructure their asset bases in the near future.

Corporate profitability in Australia is already high by historical standards and growth is expected to be slow. The options for cutting costs and raising profitability further are limited. The traditional drivers of revenue such as emerging market industrial production and domestic economic activity are not expected to provide the impetus over the next year or so. China is moving away from being investment-led and, in the same vein as Australia's slowing mining investment, the transition is unlikely to be smooth and will result in lower growth. So, it's all about low-growth investing. Credit Suisse lists companies which are expected to embark on significant restructuring to drive value independent of the broader economy. This means these companies will become more streamlined, require less capital and could benefit from a re-rating.

The case of Caltex ((CTX)) is conversion to a less volatile, capital light business. Brambles ((BXB)) is de-merging the Recall document storage business to concentrate on the pallets business. Amcor ((AMC)) is de-merging the Australasia & Packaging Distribution business. The company will then have an under-leveraged balance sheet with the option to acquire more growth. Telecom NZ ((TEL)) is selling AAPT, the Australian business, and Credit Suisse believes AAPT will be better off in the hands of a local owner. Telecom's management could then return the proceeds to shareholders. UGL ((UGL)) is de-merging the DTZ property business. DTZ is growing rapidly, unlike the remaining engineering segment, which could be a target for a merger once it's separately listed. Finally, National Australia Bank ((NAB)) is expected to eventually sell its UK business, Clydesdale Bank. A successful spin off could help create up to $4.5bn in value for shareholders, according to Credit Suisse, although the timing of the divestment remains uncertain.

UBS thinks the Australian industrial stocks, ex financials, are looking stretched. The absolute price/earnings ratio has risen to 16.9 times and is around 13% above the long-run average. The stocks also look expensive relative to the broader Australian market and to global peers.The question is whether the current high valuations signal an earnings upswing over the next couple of years. There is certainly some expectation of that factored in but the broker found that the return on equity (ROE) for the sector was not particularly depressed while margins appear quite normal in an historical context. It's hard to make a case for earnings expectations being too low or that there's upside for returns and margins beyond FY14.

There's plenty of stocks with below average returns and/or margins concentrated in the mid cap segment, which are relying on a cyclical upturn that is yet to happen.The potential upside appears concentrated among mid cap cyclicals such as Qantas ((QAN)), Boral ((BLD)) Toll ((TOL)), Harvey Norman ((HVN)) and Aristocrat Leisure ((ALL)) to name some. These are turnaround stocks, in the broker's view, that are battling tough conditions so there is a risk of disappointment.

Cyclical stocks are fairly valued, not expensive, in Deutsche Bank's opinion. Cyclical industrials have re-rated strongly over the past year and no longer trade at the 5-10% discount to defensives that was the case for several years. Instead they trade at a 5% price/earnings premium. The broker continues to see value because the medium-term outlook has brightened considerably and suspects expensive evaluations are taking account of backward looking analysis, which is lumbered with a poor earnings environment that's been in place for the past 5-6 years. Deutsche Bank expects 14% growth for cyclicals in FY15 and FY16 compared to 6-8% for defensives, making cyclicals relatively cheap. OK, the broker does expect some mild downgrades could be possible but, even so, a reasonable earnings growth gap should persist between cyclicals and defensives. Deutsche Bank thinks that years of resource-dominated growth has led to pent-up demand elsewhere. Housing and business capex have not known growth for five years and consumer spending trends are the worst in 50 years. 

Some attractive cyclical industrials that are considered cheap on a 12-month forward price/earnings basis are Downer EDI ((DOW)), Orica ((ORI)), Lend Lease ((LLC)), Myer ((MYR)), Challenger ((CGF)), Automotive Holdings ((AHE)) and Southern Cross Media ((SXL)). Those offering value on the basis of strong growth forecasts for FY15 include BlueScope ((BSL)), Macquarie ((MQG)), Crown ((CWN)), Sims Metal ((SGM)), Adelaide Brighton ((ABC)) and Flexigroup ((FXL)). In terms of low margins relative to history, where these could rise significantly, Deutsche Bank lists BlueScope, Boral, Crown, Tabcorp ((TAH)), Sims, Navitas ((NVT)) and Fletcher Building ((FBU)).

Citi attended its own recent Australian investment conference and notes the retailing industry theme involved an acceptance of a changing landscape. Grocery customers are still price conscious, leaving little option other than to manage costs and improve products. In discretionary retailing with the growth in online and the arrival of more global brands in Australia, differentiating the offering was considered critical. In property, the residential market is seen picking up but at an uneven geographical spread. There is strength in inner Sydney but this not representative of the national picture. Building activity demand is reasonable but also uneven across cities and regions. Mining company presentations highlighted varied conditions. Mining services noted some easing in cost cutting and fewer reductions in the scope of works, pointing to some stabilisation, although the focus remains on lifting efficiency.

Tourism was upbeat. There was agreement that conditions were improving and the outlook was good. Outbound travel by Australians was expected to persist at high rates, more so because of cheaper airfares, enhanced by low-cost carriers, than the high Australian dollar. Inbound travel was also picking up, from the US as the economy improved, amid some positive signs from the UK and Europe. Media continues to find the going tough. On the media panel, the executives confirmed there had been no improvement in advertising spending in recent months and only some stronger interest around events next year provided any encouragement. The infrastructure panel emphasised the need for new approaches towards projects, to ensure that required infrastructure was put in place in coming years. The plans of the new federal government were considered encouraging.

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