Weekly Broker Wrap: Growth Investment, Turning Points And Margins

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This story features BHP GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: BHP
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

-Growth investment versus cash flow?
-Transport infra spending growing
-Turning point for insurers?
-More retail insolvencies expected
-Telco mobile margins turn higher
 

By Eva Brocklehurst

To allocate or give back? That is the question regarding capital in the mining industry. Deutsche Bank has analysed what it means for the big diversified miners. Deferring high return, but unapproved, growth would increase near-term cash flow but result in a significant drop in cash flow and earnings after 2016, and a 15% drop in valuations. There's no getting around it. Mortgaging the future by deferring projects will come at the expense of value and future cash flow. Despite concerns over further capital investment, the broker suspects that Australia's diversified miners, BHP Billiton ((BHP)) and Rio Tinto ((RIO)), can invest and grow dividends at the same time.

Deferring growth would increase free cash flow yields by two percentage points over the next three years, or US$3 billion per annum, in Deutsche Bank's estimation. Beyond those projects that are currently being executed, which represent around 20% of the broker's company valuations, there are numerous high returning growth projects which should attract capital. This next wave of projects represents 13% and 18% of the broker's BHP and Rio Tinto valuations respectively and generates an average return of 20% for both companies with pay-backs of just 7-8 years.

The broker hastens to add that this is not a pitch for deferring or slowing down high returning growth, but doing so would significantly reduce capex. Rio's capex would drop to US$5bn by 2015 and BHP's to below US$10bn by FY16. Reductions are underway anyway, as projects are completed. BHP will likely announce a FY14 capex budget between US$17-18bn, including a further US$4bn of spending on US onshore tight oil. Rio Tinto's capex guidance for 2014 will likely be unchanged at US$13bn, including capex for Pilbara 360 and the Oyu Tolgoi.

What about infrastructure? The view that Australian resources capex will peak in 2013 appears a consensus call to Credit Suisse. Resources capex accounts for around 45% of Australian engineering & construction activity. The outlook for the remaining 55% of this expenditure out to 2015 is based on aggregated data and feedback from industry. Transport spending plans stand out. They are expected to reach new levels in 2015 at $35.4 billion, or 2% above 2012, as major projects ramp up, primarily in NSW. In contrast, there is a weak outlook for utilities, where spending on power and water is forecast to be $13.1bn in 2015, 28% below 2012. In this scenario, Downer EDI ((DOW)) and Lend Lease ((LLC)) are considered oversold by the broker, while there is downside risk for Leighton Holdings ((LEI)).

Downer EDI has a dominant market position in Australian roads maintenance and is the broker's top pick. Trading on an FY14 price earnings ratio of 7.8 times and a 6.2% yield, Credit Suisse thinks the stock offers compelling value. Lend Lease's price has also slumped since June and the broker considers the selling overdone, given the company's earnings composition. As for Leighton, while the stock has a weighted exposure to transport capex, Credit Suisse does not expect this to offset the expected decline in the Australian construction, which represents around 50% earnings, as well as the weakness offshore.

For general insurers, early warning signs of a cyclical turning point are starting to mount and Deutsche Bank suspects reinsurance costs and top-end commercial property rates will head south. There is the temptation to time the peak but the broker thinks there's little reward for doing so. As usual, catastrophe experience remains the key swing item for reported profits in the sector. Deutsche Bank is not going into weather forecasting per se but suggestions that more neutral conditions will persist through the 2013/14 summer are seen as potential upside risk for profits.

A low inflation environment over the near-term, as the economy slows, could also see prior year reserve releases remain above long-term levels. This was already signalled in Insurance Australia Group's ((IAG)) FY13 result. Reported profits could therefore remain above underlying levels near term. Despite good reasons to remain upbeat, the broker doubts the sentiment will last past 2014. In particular, downside risks to the sustainability of returns in home insurance are seen.With earned premium rate rises tracking ahead of inflation in 2013, return on equity in home insurance is on track to reach 30%. Deutsche Bank sees scope for increased competition from the banks, where group ROEs average 15-18%, and from Challenger Financial ((CGF)) brands looking to supplement a growing foothold in motor insurance, and from retailers such as Coles ((WES)) and Woolworths ((WOW)).

Despite weak retail sales in Australia over the past three years, less than 2% of retailers became insolvent. Debt levels are quite low, at 10% below the peak levels from 2008. Data from the major banks shows less than 0.2% of lending to retailers is more than 90 days overdue. Citi estimates the banks have 250-300 retailers on a credit watch, across an industry with 145,000 retailers. Within four years of opening stores, more than 61% of retailers leave the industry. Only one in twenty exits as the result of insolvency. The bulk are mergers/takeovers, retirements, or simply giving up.

Citi expects more exits and insolvencies over the next three years, as retail conditions remain difficult. Small, under-performing retailers are more likely to leave, and those that stand to benefit the most from rationalisation are Premier Investments ((PMV)) and Specialty Fashion ((SFH)). Their bargaining position with landlords is expected to improve.The supermarkets are likely to see the smallest benefit as the segment is already highly concentrated.

Finally, telcos. Following five years of declines, to 26.6% in FY12 from 31.8% in FY06, margins on mobiles have turned around, with operators taking action to offset revenue declines. Goldman Sachs expects earnings and cash flow margins to continue rising on the back of cost cutting, lower handset subsidies, control of the upgrade cycle and increased data revenue. The broker's' pricing survey estimates a $50 annual cut to handset subsidies translates as 4% growth to industry earnings and 3%, 5% and 9% respectively to Telstra ((TLS)), Optus ((SGT)) and Vodafone Hutchison ((HTA)) mobile earnings.

Telstra is well placed to drive mobile margins higher and Goldman has raised earnings estimates out to FY15 to reflect this. Vodafone's cost cutting has been notable and it positions the company for positive free cash flow in the medium term. This is positive for the industry as a whole, Goldman believes, as it reduces the risk of Vodafone embarking on an aggressive customer acquisition strategy to drive scale and profitability.
 

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