Weekly Broker Wrap: Which Retail & Building Stocks Are Returning To Favour?

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-Department stores well placed for upturn
-Supermarkets expanding too fast
-Wesfarmers' retail and dividends attractive
-Which building materials stocks benefit most?
-Competitive market in gambling
 

By Eva Brocklehurst

Which stocks are best placed as consumer appetites grow?  Morgan Stanley analysts think we're past the worst of  the retail cycle as the drivers of recovery are improving. Underpinning this recovery is the housing market, equity market, interest rates and consumer confidence. Retail sector growth will probably be limited to 3-4% per annum as non-retail categories take a greater hold on consumer wallets. Best placed in discretionary retail are the department stores as they are adapting to cope with the new retail environment, optimising networks and online offerings. David Jones ((DJS)) is the broker's top discretionary pick. Morgan Stanley finds the retailer is under-earning against local and global peers but has the potential to double earnings over the next five years with private labels, store optimisation and online growth. Myer ((MYR)) is also attractive, and an improving top line performance and cash flow shows the company's strategy is working, in the broker's view.

Supermarkets on the other hand haven't had to face the online challenges of the likes of Myer and David Jones and this sector is over-confident. Morgan Stanley believes Woolworths ((WOW)) and Metcash ((MTS)) are overvalued. Part of the problem is that supermarkets are embarking on what the broker describes as irrational store roll-outs. Very bullish plans have been outlined. Morgan Stanley finds retail space growth is 3.5% per annum over the next three years, well ahead of population growth of 1.6%. Incremental returns will be therefore be reduced as new space is not as productive as existing space.

Over-capacity also increase the risk of more price-based competition and the broker suspects a price war could easily develop, robbing the industry of growth and returns as the majors take bites off each other. Wesfarmers ((WES)) is a bit different as it has a wider reach, with Bunnings and Kmart as well as Coles supermarkets. It also has the advantage of being a strong dividend provider and many brokers expect this dividend should grow significantly over time.

BA-Merrill Lynch comes down hard on supermarkets too but is more bearish on the general outlook. The analysts at Merrills think the situation is likely to get worse before it gets better. The high Australian dollar is pressuring Australian business and unemployment is expected to increase over the year. Wesfarmers, Woolworths and Coca-Cola Amatil ((CCL)) have been spending heavily and pursuing growth that doesn't exist, in Merrills' view. Here again, Wesfarmers gets away with it because of strong cash generation. The broker expects dividends to increase to $2 a share in FY14 and free cash flow after dividends is expected to be a positive 22c a share in FY14.

Coca-Cola Amatil generates less cash but Merrills lauds the stated intention to cut back on capex in FY13 and FY14. Coke dividends are also expected to increase, after a sizeable increase in FY12. Woolworths remains the least preferred because, and here Merrills closes ranks with Morgan Stanley, the company is spending too much on growth, such as new stores, renovations and new business. Merrills finds Woolworths unappealing as an investment despite a very strong domestic supermarket business.

Goldman Sachs expects a more sustained recovery in the areas which drive retail spending as we stride through FY14 and FY15. This broker, too, prefers Wesfarmers and has downgraded Woolworths to Sell because of a much more modest earnings growth outlook. As for discretionary retail stocks, the broker recently upgraded Harvey Norman ((HVN)) to Buy and has a Sell rating on David Jones. The difference? Harvey Norman is more leveraged to a strong recovery in the building cycle. 

UBS is on this tangent too, noting housing is picking up and this benefits retailers in two ways. Firstly, via selling items used in new houses such as hardware, note Bunnings, and appliances, note Harvey Norman. Nevertheless, the broker finds these retailers that are directly exposed to increased housing activity only deliver modest upside. The second way is related to the high correlation between house prices and consumer confidence. Further analysis suggest that those retailers offering high earnings leverage to improving sales, via a housing-driven lift in sentiment,  are the best way to play the ball. The broker's preference on this basis is Myer and Premier Investments ((PMV)), owner of Just Jeans, Jacqui E, Peter Alexander and Portmans stores. Here, every 1% surprise in FY14 revenue would deliver earnings uplifts of 2.9% and 3.3% respectively on UBS estimates.

It stands to reason that improved housing starts will support building materials stocks, such as Boral ((BLD)), Adelaide Brighton ((ABC)) and James Hardie ((JHX)) but CSR ((CSR)) is not in the same league this time, as the company's exposure to aluminium prices will have a negative impact, UBS maintains. The picks are Boral and Adelaide Brighton. In terms of Fletcher Building ((FBU)), UBS finds the stronger NZ dollar reduces the NZ earnings impact too much, whereas the likes of Boral offers leverage to housing both in Australia and the US. James Hardie is well exposed to the US but UBS believes the share price is too expensive. In contrast, CSR and Fletcher are considered fair value. Adelaide Brighton recently revised earnings lower. The broker does worry about the medium term but is comforted by the fact that the stock has a low price/earnings ratio and forecasts are undemanding.

Goldman Sachs has taken a look at what's changed in the gaming business. For the March quarter, gambling advertising was up 19.8%, making it one of the fastest growing advertising categories. This is even more significant in the context of an overall legacy ad market that declined 2.4% in the quarter. Rising advertising spending highlights a competitive market. In the broker's view this reflects competitive wagering and sports betting and companies striving to grow share in an increasingly crowded space. TV dominates. Tabcorp ((TAH)) is the most exposed to rising advertising costs as corporate bookmakers are one of the major drivers behind the increase in ad spending. Managing the business to contain costs may see pressure mounting on Tabcorp's market share, in Goldman's view. The broker's preference is for Crown ((CWN)) in the gambling stakes.
 

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