Weekly Broker Wrap: Oz Economy, Profits, Drought, Housing, Hardware, Hospitals And Insurers

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

-Low non-financial profit growth
-Drought in a vulnerable economy
-Westpac move may impact housing
-Operating theatres key to performance
-Online earnings forecasts diverging
-Insurance margin correction factored in
 

By Eva Brocklehurst

Australian Economy

Financial conditions suggest to Citi that Australia’s economic growth is weak. The influence of lower official interest rates is waning and the recent moves by Westpac ((WBC)), if followed by other banks, could work to tighten conditions. The broker cites recent sales activity in the property market which supports a view that house price growth has peaked.

The broker forecasts GDP growth at 2.3% by the end of 2015 and averaging 2.4% over 2016. Citi suspects the Reserve Bank will shave 25 basis points off its growth forecasts in its November statement on monetary policy.

Corporate Profits

Non-financial company profit share of GDP has declined by over 3.5% since 2011, Citi maintains. Lower commodity prices are not the only reason for the weakness as, stripping out mining profits, the decline is still noticeable and the profits have underperformed the US. Citi suspects this could, at least partly, reflect lower productivity growth. Consensus has profits recovering strongly, at around 10%, in 2017 whereas Citi is more cautious, expecting around 6.0%.

The broker believes the longer-term outlook is predicated on how successfully the economy re-balances and diversifies its export base. Still, the broker believes the combination of low profit growth and high dividend pay-out ratios is toxic for investment spending and should maintain the prospect of further easing from the Reserve Bank.

Drought

Goldman Sachs wonders whether drought will be the straw that breaks the camel’s back for Australia. A rare combination of an intense El Nino event in the eastern seaboard is coinciding with a strong positive phase for the Indian Ocean temperatures which has occurred on only seven other occasions since the 1950’s and is consistent with severe deficiencies in rainfall and high temperatures.

Currently, government forecasts assume flat farm production in 2015-16 compared with the median decline of 20% during a drought year. Goldman notes, fortuitously, the severe droughts of 2002-03 and 2006-07 coincided with robust economic growth.

While identification of a drought does not in itself provide a rationale to ease monetary policy it appears to the broker that, in a period where non-farm growth is already below trend and inflation contained, it may be sufficient reason to warrant additional monetary easing.

Housing & Property

Morgan Stanley believes the 20 basis point increase to Westpac’s mortgage portfolio will put a dent in housing sentiment. New investors face higher rates and tighter lending standards and this strengthens the broker’s belief that the housing boom has peaked. Already, there is evidence of softening auction clearance rates and investor activity, amid weaker house price forecasts.

Morgan Stanley’s forecast for a looming oversupply to housing makes the prospect of rental growth and capital gains particularly uncertain. This is all part of what the broker believes is a deliberate macro prudential strategy to rein in the housing market.

Against this backdrop the broker believes there is limited re-rating potential for the residential Australian Real Estate Investment Trusts (A-REITs).  Based on Morgan Stanley’s analysis, interest rates are the dominant driver of house prices and house price growth is the key driver of Mirvac Group ((MGR)) and Stockland ((SGP)), in terms of their free funds from operations.

The two stocks have de-rated over the past 6-9 months. Hence, the broker expects further de-rating is questionable, given merger & acquisition pre-conditions are strong, balance sheets can support buy-backs and there are supportive distribution yields.

Hardware

Hardware retailing sales are robust, with the strongest growth in Sydney and Melbourne, Morgan Stanley observes. At a recent industry conference the broker noted the shift to multi-residential developments is creating a headwind for the sector because these developments are large enough to source product offshore and bypass the retail/wholesale channel in Australia.

Participants at the conference also signalled to Morgan Stanley that Bunnings market share is being understated at around 18% and it is more likely closer to 40-50%, given the Wesfarmers‘ ((WES)) owned business overstates its addressable market.

Morgan Stanley notes the general view that margins at Bunnings have held up despite like-for-like sale growth because of the extent of new store openings, as the business over-services customers in the first six months of opening. As sales increase and customers become aware of where products are within stores, labour is reduced and, hence, margins improve.

Packaging

Morgan Stanley has initiated coverage on the Australian paper and packaging market with a counter-consensus Cautious industry view. The broker expects structural headwinds will cause Amcor ((AMC)) to underperform while progressive reallocation of capital will mean Orora ((ORA)) outperforms.

Amcor has been rewarded in recent years for its defensive characteristics and high returns but delivering the earnings required to support its premium multiple and value-creation target is becoming harder, Morgan Stanley maintains. In contrast, Orora has a largely unencumbered balance sheet and potential to deliver upside through optimisation of its capital allocation strategy.

Australian Online

Pure online classified companies such as Carsales.com ((CAR)), Seek ((SEK)) and REA Group ((REA)) have experienced two years of price/earnings de-rating although Citi notes they are still trading above the historical valuation lows experienced just after the global financial crisis. Meanwhile, Fairfax Media ((FXJ)) and Trade Me ((TME)) have re-rated recently.

The broker finds REA Group the most attractive in value terms, despite a premium multiple, while Carsales.com, Seek and Trade Me are seen trading near peak relative valuations. At the same time most earnings expectations have been deteriorating, with Seek suffering the largest downgrades but Fairfax enjoying incremental upgrades in earnings expectations. Citi now observes a large divergence in earnings growth expectations across the sub sector.

Private Hospitals

The efficiency of operating theatres is a key component in the overall financial performance of a private hospital, Credit Suisse contends. The broker’s analysis suggests Ramsay Health Care ((RHC)) generates 35% more earnings per operating theatre than does Healthscope ((HSO)), for several reasons. These include higher case payments, lower operating costs and more efficient processing of patients, as well as more complex surgical patients which generate higher earnings per case.

The broker believes a reduction in operating costs through procurement and workforce de-leveraging is achievable for Healthscope in the short to medium term and this should facilitate a modest uplift in earnings. Other factors citied above are harder to achieve, Credit Suisse acknowledges, and benefits accrue over a longer term.

Insurance

UBS finds more widespread evidence of personal lines claims inflation and modest price increases. Commercial lines appear soft, still. The broker believes, while the picture is mixed, a healthy underlying correction in margins is now reflected in FY16 estimates. Even if margins trough at 20-30% below their peak, with a subsequent 10% hit to earnings, this could increasingly be tolerated by investors.

Challengers have pulled back share in the highly contested motor class, to 12.7% from 13.4% in the broker’s previous review. While the challengers continue to generate superior growth at 18% compared with 3.4% for Suncorp ((SUN)) and 0.4% for Insurance Australia Group ((IAG)) there are some signs of consolidation, UBS observes.
 

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