The Wrap: Telcos, Restructuring And Cobalt

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Weekly Broker Wrap: Oz economy; Ord Minnett re-initiates on telecoms sector; positive data for Woolworths; increased numbers of companies restructuring; the year of cobalt.

-Core inflation expected to under-shoot Reserve Bank's targets
-Structural changes in telecoms presenting opportunities
-Successful restructuring could lead to outperformance
-Cobalt demand growing while supply growth is stagnant

By Eva Brocklehurst

Oz Economics

Credit Suisse believes stagnation in the economy is the likely scenario in 2017, owing to weakness in business capital expenditure and fragility in residential investment. The delayed effects of macro prudential and exchange-rate tightening are expected to manifest in the current year. Nevertheless, with no incremental tightening effect visible to prevent a moderate recovery in 2018, the broker expects around 2.5% growth in that year.

Credit Suisse expects core inflation to under-shoot the Reserve Bank's targets. The trimmed mean of CPI inflation is expected to slow to 1.3% per annum by 2018. The broker does not believe there will be a sufficiently large, timely or sustained fiscal stimulus to prevent the central bank from cutting the cash rate further and forecasts the RBA to cut cash rates at least twice in 2017 and again in 2018.

Telecoms

Ord Minnett resumes coverage of the telecommunications sector, noting structural changes present opportunities. The broker believes the tailwinds in the mobile market are strong and assumes a three player market as its base case. Increasing data usage and mobile device proliferation should support growth in the industry.

In the NBN, margins are likely to continue coming under pressure for the incumbents, but this creates an opportunity to invest in operators such as Vocus Communications ((VOC)), for which growth is expected to accelerate over the next 4-5 years. The broker expects faster speeds and higher data limits to offset pressure on pricing. Ord Minnett initiates on Vocus with a Buy rating and $5.25 target.

Telstra ((TLS)) is rated Accumulate with a $5.45 target. Telstra is facing the strongest headwinds in the industry as the NBN is expected to reduce earnings by $2-3bn annually. The broker believes downside from the NBN is already priced in and a high dividend yield and modest valuation should provide support.

TPG Telecom ((TPM)), while being one of the more cost efficient operators in the industry, is expected to sustain compressed margins from NBN migration and new entrants potentially pressuring pricing and market share. Furthermore, its mobile ambitions in Australia and Singapore are uncertain. Ord Minnett initiates with a Hold rating and target of $6.65.

UBS observes a key feature of the results for Optus was an acceleration in net additions in mobile in the December quarter. The broker's question is whether the increased number of subscribers was driven by an acceleration in the market or a gain in market share.

Optus has stated it is winning incremental subscribers and share in regional Australia on back of its network investments. The company has also sustained increased uptake of its EPL mobile content services.

The broker notes the other aspect to the result was a significant step-up in the cost of sales in the consumer segment. The read-through for Telstra from the Optus result is difficult but the net additions for Optus appear to have accelerated and this suggests to UBS, at the very least, that Telstra's mobile share gains have plateaued.

Supermarkets

The first half result from Shopping Centres Australiasia ((SCP)) provides a positive data point for Woolworths ((WOW)) as that company's supermarkets occupy around 75% of the property group's portfolio. Of interest to Deutsche Bank is disclosure that supermarkets sales increased 2.0% year-on-year in November and 2.4% year-on-year in December. Meanwhile, the data suggests Big W is still doing it tough.

The data is in line with Deutsche Bank's channel checks on suppliers, which signal that Woolworths experienced an improving sales trend over the December quarter. Industry feedback suggests Coles ((WES)) sales growth has slowed, so the recovery for Woolworths may be even more acute than what the numbers suggest.

Deutsche Bank currently forecasts second-quarter food like-for-like sales growth of 1.5% for Woolworths and expects improvement over the longer term as execution gets better.

Restructure

Credit Suisse observes an increase in the number of Australian companies that are restructuring. Many of the candidates are the types of stocks that previously performed well during earnings expansions and are low-valued. They are also under-earning and cyclical, the broker observes. Successful execution of the restructuring should be yet another reason why they may outperform.

In 1999 only 15% of the ASX 200 reported a restructuring expense while Credit Suisse notes, in 2016, more than 25% did. The broker observes that, over the last 20 years, the pace of restructuring accelerated after poor years for the equity market and slowed after buoyant years.

Around 50 companies are reporting a restructuring expense in 2016. The broker lists 17 restructuring candidates for 2017 and they trade on a median price/earnings ratio of 14, a distribution yield of 4.6% and a free cash flow yield of 7.1%.

The 17 trade at a discount to the market but are expected to be considerable growers of free cash flow. Unlike previous years this list is underweight commodity companies.

The dominant theme of the current restructuring is "post-acquisition cost synergies". The list includes ANZ Bank ((ANZ)), Aurizon ((AZJ)), Automotive Holdings ((AHG)), Boral ((BLD)), Crown Resorts ((CWN)), Computershare ((CPU)), Fairfax Media ((FXJ)), Henderson Group ((HGG)), IOOF ((IFL)), JB Hi-Fi ((JBH)), Metcash ((MTS)), Myer ((MYR)), Origin Energy ((ORG)), Speedcast ((SDA)), Treasury Wine Estate ((TWE)), Vocus Communications ((VOC)) and WPP AUNZ ((WPP)).

Cobalt

2017 may be the year when cobalt hits the spotlight. Macquarie observes prices have accelerated to levels last seen in 2011 and, with demand from the recovery in the portable electronic sector and supply growth stagnant, this price rise can be fundamentally justified.

China has almost no domestic supply and is highly reliant on the Democratic Republic of Congo for its cobalt. Moreover, the prioritisation of higher quality battery development by the Chinese government may open up the new energy vehicle market to greater cobalt penetration, the broker contends. There are still risks, both technological, in terms of demand, and geopolitical, in terms of supply.

Macquarie observes cobalt tetroxide prices in China have roughly doubled in RMB terms since mid-2016 which suggests battery demand has been improving. Part of this may be to do with a wider industrial recovery, as cobalt has always tended to benefit from a maturing of such recoveries, when the industrial consumer is feeling more confident.

Cobalt is distinct among peer metals in that roughly half of current consumption is in battery manufacture. While lithium is often thought of as the key battery material, this sector only accounts for around one third of total demand and may only reach cobalt's current levels on a 5-10 year view, Macquarie notes.

As in many other markets, cobalt has limited new supply coming on stream. Refined output in countries such as Australia, Russia and Zambia are well down on levels a decade ago.

The reliance on the DRC, a country where geopolitical risk is rising after a period of relative stability, is also dependent on the copper price, as much of the DRC cobalt supply comes as a co-product with copper.

With a steady down-trend in copper prices until October last year investment in the DRC was limited and certain existing assets sustained supply declines. DRC copper output has been stagnant for the past three years and 2017 is expected to continue this trend. Macquarie expects some growth in 2018-19.

The broker believes the fundamental outlook for cobalt is improving in 2017 and a sustained deficit and draw-down on stocks is expected through to the end of the decade.
 

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