Weekly Broker Wrap: The Aussie, Wesfarmers, Pharma Stocks And The Genworth IPO

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

-$A demand unlikely to wane
-CLSA prefers Wesfarmers
-Constrained growth in pharma
-Genworth IPO not so cool for CLSA

By Eva Brocklehurst

What will it take to push the Australian dollar lower? The currency has defied many analysts over recent years, surprising with its stubborn strength. Macquarie considers this resilience reflects an ongoing structural shift in the sources of demand for the currency and sustainability for commodity prices, as opposed to the 1990s and early 2000s. It also reflects the higher-than-usual differential between Australian official interest rates and the rest of the developed world.

Over the past decade the Australian dollar has appreciated by 50% in trade weighted terms, reflecting the boom in demand for resources. This is not all. Macquarie considers the currency is also underpinned by a fundamental shift in investor demand, reflecting the decoupling of Australian interest rates from other developed markets. The inflation-fighting success of Australia's central bank has driven inflation expectations lower and led investors to re-assess the relative risk in the Australian economy. This demand Macquarie expects to be sustained in coming years as a result of a less volatile and more robust commodity price cycle, relative strength of Australia's financial economy and attractiveness of Australian assets to a growing Asian middle class – to name a few factors. The Australian dollar may not be a major reserve currency but Macquarie notes it is gaining prominence as a well supported, relatively stable store of wealth.

Macquarie considers Australia has been among those economies affected by the US Federal Reserve's escalation of quantitative easing, driving demand for higher yielding Australian assets. This is particularly in the case of government bonds, which the analysts note reached an historical high at 78% foreign-owned in 2012, before edging back to 68% in late 2013, still well above the long-term average of 47%. Will a scaling back of QE have the opposite effect? Macquarie's not so sure. Recalibrating models to account for the impact of QE suggests other fundamental drivers of the currency remain very evident. The analysts calculate that to arrive at a US82c forecast for the Australian dollar by year end would require an iron ore price around US$85/t, coking coal at US$100/t and thermal coal at US$70/t!

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CLSA prefers Wesfarmers ((WES)) to Woolworths ((WOW)). Woolworths may have matched Coles for the first time in 4.5 years in terms of quarterly like-for-like sales growth but CLSA thinks Coles can deliver at more than twice the rate of Woolworths, as it penetrates further into fresh categories and improves supply chain efficiencies. Wesfarmers is further advantaged by its Bunnings chain. The broker notes that hardware store's format has proven best in class and remains underpinned by a significant store roll-out that looks likely to provide 9% compound earnings growth rates.

In contrast, Woolworths' Master business is stalling. Masters' March quarter figures imply average sales per store declined by 9%, and CLSA does not think guidance for breaking even in FY16 will be met. Last but not least, Woolworths is trading at a premium to Wesfarmers despite offering less than half the rate of of earnings growth, on CLSA's calculations, so the Buy signal is entrenched for Wesfarmers.

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Goldman Sachs expects revenue in the pharmaceutical wholesaling industry to remain flat over the next two years because of Pharmaceutical Benefits Scheme price cuts for a number of high volume products which have lost patent protection. Wholesalers will need to maintain a strong focus on growing over-the-counter and private label offerings to offset this. In terms of Australian Pharmaceutical Industries ((API)) Goldman has increased FY15 and FY16 earnings estimates on better sales from Priceline and better gross margins from a reduction in discounting. The broker retains a Sell rating as, while Priceline is improving and cost control is encouraging, the aforesaid pressures from the PBS and a competitive retailing environment should limit underlying earnings growth.

There's no change to Sigma Pharmaceuticals' ((SIP)) Sell rating either. Sigma is in a position to grow ahead of the market, in Goldman's view, given its faster growing customer base and the strength of key customer, Chemist Warehouse. The company's conservative balance sheet also means it can support capital management and potential acquisitions. Again, the combination of PBS price deflation and challenging trading for customers is expected to constrain the rate of earnings growth over the next 2-3 years.

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Leading lenders mortgage insurer (LMI) Genworth's US parent is putting its Australian business up for initial public offering (IPO). CLSA is cool on the idea. The IPO is being presented as an earnings recovery story. The company expects recent premium increases and a subsequent improvement in loss ratios will generate improving returns. CLSA thinks the recent increase in high loan-to-volume ratio business and a booming housing market do more than offset any premium increases and three to five years from now loss ratios will deteriorate.

The broker also questions the returns, given the elevated levels of capital required to run a mono-line insurer. At 11% return on equity – the only way the broker believes one can value the stock – FY15 fair value sits at $2.44 in the broker's calculations, which equates to an IPO price of $2.20 today. At an issue price of $2.20 the stock is considered a Buy but this is the low end of the indicated offer price. At the mid point of $2.55 the broker would assign an Underperform rating.

What compounds the problem for CLSA is that, while there is a future in the lenders mortgage insurance market and the incumbents have it easy, Genworth is at the mercy of a client list which has the financial strength and capital base to carry mortgage insurance risk on their own balance sheets – the big banks. Hence, until Genworth breaks this nexus, and CLSA questions whether it will, it's likely investors will not achieve returns commensurate with the earnings volatility and risk they will run.

So what is lenders mortgage insurance? It's a necessary insurance enabling Australians to own their own homes and can generate excellent risk-adjusted returns. The downside is that it can be volatile and when losses occur they can be huge. CLSA notes this class of insurance can deliver nine years of excellent ratios only to have them wiped out in one disastrous event. Two players control this market in Australia, Genworth and QBE Insurance ((QBE)), and expansion equates to system loan growth. Sector players can only increase value by keeping a rein on pricing and costs. Forward pricing the risk of an asset bubble can have pitfalls, although CLSA thinks insurers have done a good job recently and been conservative in approach. There is the temptation to release profit after a few good years but insurers, and investors, need to stay focused on underlying risk. So, the sector demands lots of investor patience. Capital too, reflecting the volatility of the risk.
 

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