Weekly Broker Wrap: Overvalued Aussie Banks; Small Engineers Reviewed; Resi Building Pick-Up

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

-Major banks overvalued?
-Bank asset quality improving
-Small cap engineers hold up
-Small cap retailers affected by discounting
 

By Eva Brocklehurst

Australia's major banks are overvalued by about 20%. This is CIMB's view. The bank registry data suggests foreign investors were the marginal buyers of these stocks in recent months and valuations for foreign investors may have been lifted by very low global risk-free rates. Rising global bond rates and the weaker Australian dollar would, therefore, be a threat to foreign demand for bank shares. This scenario underpins CIMB's Underweight call on the major Aussie banks.

CIMB is not impressed with the return on equity figures for the banks and has attempted to get a handle on what is driving the excessive valuations. The required returns for most offshore investors, especially those investors using the yen as a base currency, are much lower than for Australian investors. Foreign investor valuations are tied to low bond yields and many do not hedge currency risk. As US Federal Reserve chairman, Ben Bernanke, starts to jawbone the market into accepting a reduction in US central bank asset purchases, the US dollar has rallied and bond yields have risen. Australian interest rates, meanwhile, are expected to stabilise, or perhaps even fall. Lower rates may reduce the risk-free rate for foreign investors even more but, in the most likely scenario, the reduced yield gap between Australian and US rates should cut demand for Australian investments and in doing so reduce the demand for major bank stocks.

Looking inside the Australian banks, Goldman Sachs finds asset quality trends are improving. The sector's ratio of non-performing loans to exposure at default in the first half of 2013 fell to 95 basis points, from 103 bps in the second half of 2012. The decline was predominantly driven by lower numbers of impaired assets. Most industry exposures saw a fall in the ratio. Goldman has updated bank exposures to the mining services sector, given the pressures in this business as a result of a reduction in resources business. The analysis found mining services exposures represented less than 0.5% of exposure at default, with National Australia Bank ((NAB)) having the highest exposure at $2.8 billion and Commonwealth Bank ((CBA)) and Westpac ((WBC)) the least at less than $2 billion.

Goldman expects ANZ Bank ((ANZ)), CBA and Westpac will have combined bad debt charges at 10% below mid cycle levels in FY13. Despite this, the market is currently paying an 11% premium to the 15-year average price to underlying earnings multiple for these three banks. This is not sufficiently discounting the ongoing weakness in the non-mining side of the economy, in Goldman's view. Valuations for NAB are seen as more supportive, suggesting NAB should trade at an 11% discount to peers, versus the current 19% discount. This is why Goldman maintains a Buy rating on the stock.

The greatest exposure the major banks have is to the retail & consumer industry, some 49% of their total exposure. Here, CBA has the biggest slice with 60% of total exposure. Next is business & property services, a 10% combined exposure with NAB having the greater part, 11% of the total. This industry remains the worst performing for the major banks, but non-performing loans did fall to 2.4% of exposure at default in the first half of FY13, versus 2.7% in the prior half.

NAB's UK exposure has meant it has not experienced the same level of improvement in business & property as have the others whereas Goldman believes Westpac has done an excellent job of managing property exposure, which dramatically expanded as a result of the St.George acquisition. Westpac's non-performing loan ratio has fallen to 2.9% from a peak of 4.8% in March 2011. Mining, agriculture, forestry & fishing comes in at a distant third, at 4% of total exposure. Here too, NAB has the larger share, with 6% of total exposure. ANZ is the one of the four with the highest non-performing loan ratio, at 3.3%, and Goldman suspects it has a higher impaired exposure to this industry segment.

JP Morgan has reviewed earnings estimates for the small cap engineering, mining and energy sector stocks. This is to reflect what the broker believes is the "new normal", as major Australian projects are completed over time. Key Overweight stocks include Cardno ((CDD)) and Ausenco ((AAX)). Fleetwood ((FWD)) is Underweight.

Cardno is preferred because it is leveraged to a broad-based US recovery with around 50% of sales generated in the US. Consulting is inherently more defensive and Cardno is the only engineering player that does not build, so has limited project construction risk. Also, the company is well placed to benefit from increased regulatory codes and environmental compliance. Environmental services form a large part of Cardno's sales. The other Overweight stock, Ausenco, is preferred on a relative basis as it operates in lower cost countries, with 80% of sales generated overseas. It is also one of the better capitalised small cap stocks with hardly any debt. It is highly diversified across commodities yet has no Australian iron ore exposure. As for Fleetwood, the share price is under pressure and JP Morgan thinks there is more pain to come near term.

The broker is Neutral on most of the others in the group, namely Miclyn Express ((MIO)), Matrix Composites & Engineering ((MCE)), Programmed Maintenance Services ((PRG)), WDS ((WDS)) and Norfolk Group ((NFK)). In the case of Miclyn and Norfolk, these are in the midst of corporate action and there is no material upside to the current price. Programmed has an uncertain FY14 outlook while the broker is cautious about WDS' exposure to demand for coal work. Value may be emerging for Matrix but the risks are too much at present for the broker to be confident.

Small cap retailers were under Deutsche Bank's microscope recently. Kathmandu ((KMD)) outperformed peers in the third quarter of FY13 and does not face the near term headwinds that other small cap apparel retailers face. There are multiple earnings growth drivers and like-for-like sales upside. The company is also structurally better positioned compared with peers and, hence, Deutsche Bank comes out with a Buy rating on this company.

The inventory discounting that's largely expected to follow from Target's ((WES)) announcement of an inventory overhang this winter will filter through to the smaller caps. Myer's ((MYR)) stocktake sale will concern Premier Investments ((PMV)) and Pacific Brands ((PBG)), whereas Target's inventory is a concern for Specialty Fashion ((SFH)) and Pacific Brands, in the broker's view. The lower Australian dollar should help vertically integrated retailers as it reduces consumer purchasing power globally, but hedging policies create a lagged impact on the cost of goods sold for US dollar purchases. Deutsche Bank does not expect the full impact for Kathmandu, Premier Investments, Pacific Brands and Specialty Fashion until 2015 and the quantum is impossible to estimate.

Citi's May survey of Australian residential home builders has shown more than three quarters of the 39 respondents intend to build more homes in FY13 against FY12 while 62% reported an improvement in orders compared with six months ago. The analysts emphasise the sample size was small, and confined to the four states Victoria, NSW, Queensland and Western Australia, but more than half were confident about activity levels in the next 12 months and only 11% had a negative view. The biggest challenge facing the residential housing sector is economic conditions, both domestic and international.

Citi found that owning a strong brand portfolio is strategically important in getting solid market share in various products. It's a case of… leading brands lead. The so-called category killers dominate market share. GWA Group's ((GWA)) door brand, Gainsborough, is an example, enjoying market share of around 76%.  The number of brands are increasing, suggesting more imports. Overall, GWA's broad brand portfolio appears to have weakened. Caroma – bathroom fittings – is perhaps the most resilient. DuluxGroup ((DLX)) brands were stronger than expected. Perhaps because of the company's greater focus on renovations against new building.
 

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