Weekly Broker Wrap: Bank Yields Less Secure

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By Andrew Nelson

Local brokers took on a broad range of domestic topics last week. Of note were comments on our local banks, property and housing, the healthcare sector and a few yield ideas from Credit Suisse and Goldman Sachs.

Yield investing has become a real hot topic over the last few months as investors struggle to find ways to extract value from underperforming share markets. One of the dividend and excess capital paying cornerstones of the average Australian portfolio is the Australian banking sector. However, JP Morgan sees some storm clouds on the horizon for those counting on high payouts from domestic banks.

The broker notes pro-forma Basel 3 Core Tier 1 ratios are now approaching 8% and with banks now operating at higher capital levels, the capital intensity needed for growth increases, making buy-backs far less likely.

Why?

Because maintaining higher capital ratios means absorbing a higher level of deductions and managing a more even balance between housing and business credit growth, which will consume more capital in the future than what we can see today.

That means even dividends are not a sure thing if loan losses escalate, as one of the main functions of the new regulatory environment is to preserve capital in a downturn scenario via earnings retention, better known as lower dividends.

While the broker admits slightly lower margins, or slightly higher costs may not in themselves be enough to limit dividend prospects, JP Morgan believes banks will not be in a position to keep paying at current levels if there is meaningful decline in reported earnings that arises via an increase in loan losses, as APRA probably won’t want to see capital released via high dividends during a period of stress.

Thus while Australian banking is probably the most preferred sector in the current environment, which in itself may provide some protection during what is shaping up to be a less than rosy reporting season,  valuations are full in the stockbroker's view,  which normally tends to cap share performance.

Given such an outlook, the broker prefers the more defensive exposures in the sector like Commonwealth Bank ((CBA)) and Westpac ((WBC)).

Goldman Sachs has a few dividend ideas of its own, singling out companies it thinks are able to not only sustain current dividends, but grow them over the next few years. The broker has paid special attention to earnings risk over the coming years and earnings growth strategy, as well as balance sheet strength and capital management strategy.

With this in mind, Goldman Sachs thinks ANZ Bank ((ANZ)), United Group ((UGL)), Tatts ((TTS)), Woolworths ((WOW)), CFS Retail ((CFX)) and Coca Cola Amatil ((CCL)) offer the most upside.

Next we look at the prospects of the Australian real estate sector, with UBS reporting last week that over the next five years the total amount of stock of office space in the Sydney CBD will increase by around 400,000sqm.  Noting over the last 20 years there has only been a supply increase of 870,000 sqm, the current 5-year forecast is more than double the normal rate.

The broker notes this is far from a positive trend given demand is fairly subdued, meaning the currently high vacancy rates are likely to remain the norm in the foreseeable future. In fact, UBS notes that for Sydney vacancies to remain below 10% by 2017, about 70k sqm per year will need to be taken up. Such an outcome seems a bit farfetched, given the historic net absorption is around 60k.  Given this, the broker predicts increased vacancy levels and therefore rising incentives to support rents.

The Melbourne office market is a slightly different story than the Sydney market, notes UBS. Absorption rates have been much better than Sydney over the last five years, averaging at around 100k sqm a year. However, in the current environment with an increasing amount of space moving to developments, the broker is starting to see some cracks in its vacancy forecasts.

What to do? Well, UBS likes ING Office ((IOF)) and Commonwealth Property ((CPA)), citing respective yields of 8.6% and 8.2%, with both boasting near 7.5% discounts to Net Tangible Assets (NTA). That said, the broker readily admits the office sector is facing increasing headwinds in a tough environment and advises investors to be no more than market weight on Dexus ((DXS)) and Mirvac ((MGR)) and to keep away from GPT ((GPT)), as it has the highest proportion of office based balance sheet assets in Sydney.

There was some good news for the domestic housing market last week according to analysts at Goldman Sachs recovery, who have made some significant upward revisions to their Australian domestic housing construction numbers. With housing starts in the March quarter hitting their lowest point since June 2001, the broker believes Australian housing activity must be close to a cyclical low, with its key leading indicator indicating a strong recovery from CY13.

The broker thinks the stocks in the best position from an earnings leverage and industry positioning perspective to benefit from a pick-up in housing completions and market turnover are Boral ((BLD)) and Fletcher Building ((FBU)) from a building materials perspective. Also looking good are Stockland ((SGP)), Mirvac and Peet ((PPC)) from a REIT perspective and Alesco ((ALS)) and Dulux in housing products.

Goldman Sachs also thinks Queensland banks are in the best position to benefit from improving housing and subsequent credit growth activity. Increased activity in the domestic housing market helps Suncorp ((SUN)) and Bank of Queensland ((BOQ)) best given 75%-80% of their mortgages are held in the states with the best recovery forecasts, QLD and NSW, notes the broker.

There is even more good news for the materials plays coming from the US, with the broker noting the majority of US housing indicators are demonstrating continued improvement. US analysts for the broker have thus also upgraded US housing starts forecasts. The view sees the broker shift from a defensive stance to one that prefers stocks with more leverage to the predicted recovery.

The problem for James Hardie ((JHX)) is that the broker thinks the current share price is already discounting a significant US housing recovery. CSR ((CSR)) remains structurally constrained, while the broker notes Adelaide Brighton ((ABC)) has the least amount of leverage to a housing recovery, so the potential for additional upside is limited.

The broker believes Boral offers the most significant exposure to both potential US and Australian housing recoveries. While admitting there is a certain amount of near-term earnings risk, JP Morgan still believes the current risk/reward picture looks attractive.

Credit Suisse saw some good news for health care stocks come out of the US last week, with the Centers for Medicare and Medicaid Services (CMS) putting out some fairly robust expenditure forecasts to 2021. The broker notes the report indicated some very high volume growth levels, with around 30m more Americans expected to be insured.

Also helping matter is the fact that the US is presumed to undergo some sort of economic  recovery in the years ahead, while the population, in general, is ageing, which means more care will be needed per capita. All in all, CMS forecasts that healthcare as a % of US GDP will rise from 17.9% in 2010 to 19.6% by 2021, with total healthcare expenditure projected to increase by 5.9% a year out to 2021.

So, how does this all pan out for Australian healthcare providers? The good news for ResMed ((RMD)) is that durable medical equipment expenditure is also expected to increase by 5.9% a year out to 2021, with out-of-pocket costs expected to remain at around 54% of total outlays through 2021.

The good news for Sonic Healthcare ((SHL)) is that physician and clinical services expenditure is projected to grow at a rate of 5.6% a year, with an influx of newly insured patients arriving from Obamacare from 2014, which should significantly increase GP visits and thus lab referrals.

Hospital care expenditure is projected to grow at 5.8% a year, which is positive for Cochlear ((COH)), while prescription drug expenditure growth is expected to be at 6.0% as more people will have insurance, which the broker notes is a positive for CSL ((CSL)).

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