Weekly Broker Wrap: Worries Grip Brokers As Earnings Season Ramps Up

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-Life insurance problems hard to fix
-Squeeze on Oz industry with gas shortage
-Which are the best Oz super consumer stocks?
-Which are the worst?
-Low rates not all that good for banks
 

By Eva Brocklehurst

There's no quick-fix solutions to life insurance. JP Morgan believes it may take time to restore profitability in the life insurance industry. Hence, volatility will reign. The broker notes sharp earnings declines for many risk insurers, citing AMP ((AMP)), where operating margins have fallen to 6% in the first half from 20% of premiums in 2009, while growth in premiums stayed strong. Four issues are highlighted. These include increased lapses which triggered write-downs in capitalised up-front commission and other costs earlier than expected, a worsening claims experience in disability income because of greater incidence and longer duration, aggressive group insurance prices and, lastly, late reporting and deterioration in trends in group total permanent disability claims.

Guaranteed renewability of life insurance polices and high capitalised up-front commission make life insurers prone to difficulties, in the broker's view. There is more competition in insurance than other financial markets and the industry used to benefit from mortality improvements to offset. This benefit has slowed materially. JP Morgan notes industry lapse rates appear to have been deteriorating since 2008, in part from aggressive new business pricing, a more price savvy consumer and planner practices that churn more business. Solutions? Short term this rests with customer retention initiatives and price increases. Longer term the fixes may come from industry agreements on changing planner remuneration on new business. Either way, inroads into the problems will not be made quickly.

Construction and industry will face the first squeeze when it comes to gas supply shortage on the eastern seaboard. East coast gas demand is set to triple in the next three years, driven by the start-up of three LNG developments in Gladstone, Queensland. During the initial years these projects will be short of gas and, having had billions of dollars sunk into development, they are highly incentivised to buy additional volumes to maximise utilisation. BA-Merrill Lynch believes this situation will result in a price shock. The broker believes that, with LNG currently selling at around $14/gigajoule, and short run marginal costs of an LNG development at less than $4/GJ, the LNG projects can afford to pay over $10/GJ during ramp up. While that level of pricing may be short lived the impact on commercial and industrial users should not be understated.

Merrills thinks there are negative implications for a hike in gas prices across domestic building materials and chemicals, where the ability to pass through costs is limited. Companies flagged on this basis include Incitec Pivot ((IPL)), Orica ((ORI)), CSR ((CSR)) and Adelaide Brighton ((ABC)). In terms of gas utilities, Origin ((ORG)) is the broker's preferred stock in light of the potential tightness for gas. Legacy and equity gas positions, with limited exposure to price rises, are sufficient to underpin around 60% of the company's 160PJ/year requirement, even in 2020. In contrast, AGL Energy ((AGK)) has 50% covered, inclusive of its undeveloped Gloucester project, so the position is relatively weaker, although around 40% of sales are low margin commercial and industrial customers.

UBS is worried about FY14 for building materials companies. Trend growth in approvals is yet to translate into sales. Boral ((BLD)) offers leverage to a falling Australian dollar and improving housing in Australia as well as growth in the USA and remains the preferred stock. CSR has the same factors underpinning the broker's Buy rating. Strength in New Zealand should support Fletcher Building ((FBU)). The broker has tested for the accuracy of building material company earnings forecasts and found that analysts estimates were good for those that were growing steadily but poor when it came to turning points in earnings. The prior year's earnings remain the best indicator of future earnings, it seems. In detail, Boral and CSR earnings were the hardest to forecast and Adelaide Brighton the more accurate.

Merrills is worried about the Australian consumer. The outlook appears worse based on recent anecdotes. Nor is it just retail sales. A larger portion of household income is being spent on services and this broadly is crowding out discretionary retail spending from consumption. The gap between household income growth and the rise in the cost of living has narrowed significantly. As a result the broker sees stocks with exposure to the rising Chinese middle class as the way to play.

In what Merrills refers to as the consumer super sector – gaming, media, telcos, healthcare are included – the key performers are Crown ((CWN)), Treasury Wine Estates ((TWE)) and CSL ((CSL)). Crown will benefit from exposure to the gambling market in Macau. Chinese middle classes are a high margin market for wine. CSL? There is growing demand for health care in China and one third of the company's albumin sales are already derived from this country alone. Telstra ((TLS)) is seen as the defensive play. The company has minimal direct exposure to China but does own 74% of Hong Kong wireless operator, CSL New World. As consumer spending increases so too will travel and Hong Kong remains a key destination for mainland Chinese. Increased inbound roaming will boost mobile revenues for the likes of the Hong Kong telcos.

Merrills notes comments from McDonald's about Australia being a key area of weakness in the June quarter. So which stocks will suffer most in the consumer super sector? Merrills thinks Myer ((MYR)), Harvey Norman ((HVN)), Tabcorp ((TAH)) and Cochlear ((COH)). Retailers Myer and Harvey Norman are obvious examples of companies suffering from a cautious consumer, while Tabcorp's outlook is expected to be constrained by a tough competitive environment. Cochlear is engaged in a structural slowing, in Merrills' view, and needs to enter the clinic channel in developed markets at a lower return on equity and this has reduced the broker's confidence in value upside.

Westpac ((WBC)) capitulated on discounting heavily on new mortgages with its reduction to mortgage rates of 28 basis points, larger than the Reserve Bank's recent cut to the cash rate of 25bps. Credit Suisse believes the strategy to shore up market share by discounting only new mortgages failed anyway. The move by Westpac confirms to the broker that stemming entrenched market share losses through pricing requires both front and back book discounting, including perhaps tiered front book discounts to attract larger sized loans.

Credit Suisse observes that, while there are some clear benefits associated with lower cash rates such as accelerating the pace of credit growth and alleviating borrower solvency concerns, there is also a dark side for banks. Features of this include accelerated amortisation of lending portfolios through scope for higher mortgage prepayments, endowment margin compression with a lower rate earned on free funds and the temptation for banks to practise extensive loan forbearance. In terms of the latter, Credit Suisse senses that the lessons of the early 1990s might have been somewhat over-learned by the major banks, with at-the-margin banks showing too much forbearance on existing impaired assets. The broker refers to a Bank of England study that suggests that, by suppressing corporate default rates, forbearance might also contribute to an under pricing of risk in financial markets.
 

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