Weekly Broker Wrap: M2 Telecom, Health Care And Financials

This story features SONIC HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: SHL

-Disparities in M2 accounts
-Potential for M&A in radiology?
-Medicare reform possibilities
-Can bank impairments go lower?
-Fund managers prefer insurers
 

By Eva Brocklehurst

CLSA has reservations regarding junior telco M2 Telecomunications ((MTU)). The broker has a problem with the company's accounting methods for acquisitions, which is creating an exponential divergence between underlying and reported profit. The broker was surprised that the $203m paid for the Dodo acquisition will be wholly accounted for as goodwill. This means the value of identifiable net assets is zero. The broker compares such a method with the iiNet ((IIN)) acquisition of Westnet, where 20% of the price was booked to net assets. CLSA also observes that M2's management incentives are based on underlying earnings, not reported earnings. The exponential divergence in the accounting treatment lowers reported earnings and raises underlying earnings.

The broker admits it doesn't like the structure that gives management an incentive to grow by acquisition and gear up the balance sheet. CLSA's fundamental concerns about M2 centre on the absence of operating leverage and margin expansion, despite the numerous acquisitions. This brings into question the quality of the assets acquired. The broker also notes the relatively high leverage on the balance sheet, with twice net debt to earnings, a high ratio for a small telco. The broker also raises the red flag regarding governance issues – the former CEO and founder is still on the board and there's the link between management remuneration and absolute profit growth.

BA-Merrill Lynch observes from the latest Medicare and PBS data that radiology volumes have been stable over the last month, with volume and benefit growing at 5-6% and 6-8% respectively for almost a year. The recent acquisition of I-MED, Australia's largest radiology business, by a Swedish private equity group has re-affirmed the broker's belief that mergers and acquisitions will become the FY14 theme for the sub-sector. This is because of the appealing remuneration models. Having said that, Merrills acknowledges that both Primary Health Care ((PRY)) and Sonic Healthcare ((SHL)) have indicated they do not intend to pursue acquisitive growth in this sub-sector.

The broker believes the federal government has put the health industry on notice for an increased likelihood of reforms, particularly regarding the increase in contributions to health care costs for those who can afford and the need to modernise Medicare, given changing demographics and disease profiles. While there's nothing concrete likely to come ahead of the May budget, Merrills concludes that a lack of pricing uplift, if indexation of GP rates continues for another 12 months, means the only way Primary, the predominant bulk biller, could increase revenue would be to increase volume. Alternatively, the company could seek better monetisation of each patient with non-GP services, but this can be problematic in the broker's opinion.

Ultimately, Merrills expects Primary would maintain a bulk billing approach, reducing the potential growth on offer. If the government mandates a GP co-payment then Primary is seen as more exposed to this risk than Sonic. The broker maintains a preferential Buy rating on Sonic.

How low can bank impairment rates go? That's the question Credit Suisse is asking. Major bank asset quality improved in the December quarter, with impaired percentage credit exposures declining to 0.5%, the lowest in five years. Moreover, the 0.07% decline in the December quarter was the largest quarterly decline in the broker's time series. Business impaireds declined sequentially to 1.21% from 1.38%. Actual losses in the quarter were the lowest in five years. This may well be the bottom. The broker is cautious regarding the prospects for more moderation in bad debts.

From the fourth quarter financial fund managers survey Merrills notes respondents are still overweight on insurers compared with banks and diversified financials. The most popular overweight stocks are Suncorp ((SUN)) and National Australia Bank ((NAB)). Commonwealth Bank ((CBA)) is the most popular for underweight status, by quite a margin. The majority of respondents signalled Macquarie Group ((MQG)) had the greatest capacity to surprise on the upside, while QBE Insurance ((QBE)) was where analysts were most pessimistic.

The premium rate cycle was viewed as the key threat to insurer valuations according to 40% of respondents. Credit quality was the greatest perceived threat to bank valuations, with around 43% nominations, although margin squeeze was still a strong contender, with 29% naming that the greatest threat. Investment markets were perceived to be the greatest threat for diversified financial valuations. Most were comfortable with the capital positions of the banks and insurers. None of the respondents believed dividends were unsustainable, or that they would be cut. Perceptions of dividend growth were stronger for diversified financials. Earnings growth prospects were considered similar across sectors.
 

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