The Wrap: Retail, Utilities And Renewables

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This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies.
For more info SHARE ANALYSIS: HVN
The company is included in ASX200, ASX300 and ALL-ORDS

Weekly Broker Wrap: consumer weakness and retailers; A-REITs, Amazon and Canada; utilities and electricity; renewables.

-Headwinds for the consumer sector unlikely to abate
-Amazon faces tyranny of distance in Australia, as seen in Canada
-Little relief envisaged from higher electricity retail prices in the medium term
-Further substantial renewable investment required to replace Australia's aged infrastructure
 

By Eva Brocklehurst

Consumers And Retailers

Australian consumption expenditure grew at 3.8% in the March quarter, which may be a surprise, given weak anecdotes across the retail sector. The reason, Citi explains, is because households have had to spend more on health, insurance, utilities and petrol.

Headwinds are unlikely to abate and the broker envisages a -2-3% downside risk to discretionary retail spending over the next year. Meanwhile, household income grew 1.8% in the quarter, slowing from a 3.0% average over the past year.

Of greater concern, in the broker's opinion, is the fact that the household savings rate fell to 2.8% in the March quarter from 4.9% a year ago. Without a reduction in savings, consumer spending growth would have been two percentage points lower. The broker finds it hard to be bullish on retailing with such a weak backdrop. Citi retains Sell ratings on Harvey Norman ((HVN)) and JB Hi-Fi ((JBH)), which are susceptible to slower trends.

Morgan Stanley is also becoming more cautious about falling incomes, cost-of-living inflation and broadening credit rationing. The broker envisages few catalysts for a re-rating of the retail sector as earnings risks are elevated. The broker suggests avoiding stocks exposed to the weakening housing cycle such as Harvey Norman, JB Hi-Fi and Wesfarmers ((WES)) and prefers stocks exposed to offshore earnings such as Treasury Wine ((TWE)) and Domino's Pizza ((DMP)).

Specifically, Credit Suisse believes electronics retailers are facing increasing challenges from competitive delivery economics at scale, as well as downward pressure on delivery fees, higher promotional expenses and stranded costs. The broker believes JB Hi-Fi is exposed if the market moves quickly to online retailing of electrical goods. This is because of the company's low online capability and the potential cash impact of closing stores.

Credit Suisse suspects rapid growth in online would properly result in the business having to undertake a significant and potentially disruptive series of changes as well as a costly store restructure.

Harvey Norman would appear more exposed from its high cost of doing business and need to spend incrementally more on marketing to defend sales revenue, in the broker's opinion, yet, the company's $2.2bn Australian investment property portfolio is a significant defensive asset. The broker has an Underperform rating for JB Hi-Fi but upgraded Harvey Norman to Neutral from Underperform recently because of significant share price weakness.

A-REITs, Amazon And Canada

Shaw and Partners analyses the impact on Australian Real Estate Investment Trusts (A-REITs) from Amazon's presence in Canada to obtain some indication as to what Australia can expect. This is because the two countries have similarities such as large land masses and low population density. Online penetration remains relatively low in Canada as in Australia and bricks & mortar retail still accounts for the majority of sales.

Amazon is the dominant e-commerce player in Canada with an estimated 8.3% of the online market, well below its estimated 46% of the share of the US market. The broker observes retail asset values appear to be holding up in Canada yet relative retail supply per capita is higher than in Australia, although both are much lower than in the US.

The broker observes competition from incoming supermarkets appears to have had a bigger impact on margins in Canada than Amazon has. Gross supermarket margins have trended lower, as is the case in Australia.

Amazon does not offer its Prime Now service in Canada and its 2-3 day delivery is limited to certain products in certain areas. Given Australia's landmass, heavy traffic and poor infrastructure in major cities, Shaw and Partners expects Amazon will struggle to roll out 1-2 hour deliveries here.

Amazon appears highly reliant on third-party logistics for its distribution in Canada. This suggests that its new requirements for a logistics base in Australia may not be that great and it will, at least initially, rely on third-party providers such as Australia Post.

To date, Amazon has rolled out its grocery service but not its fresh food service in Canada. The broker is not certain as to why, but suspects there may be challenges around supplier agreements, distribution networks and costs that play a part.

Utilities And Electricity

Forward electricity prices have continued their downward trend while the cost of gas generation continues to set prices. Citi expects short-term prices to fall in FY18 once government policy is defined. Both AGL Energy ((AGL)) and Origin Energy ((ORG)) have increased discounts at the end of the financial year and the broker notes this is a common move to boost reported customer numbers.

With wholesale electricity earnings at around more than 70% of AGL's profits, the fall in prices is considered a clear negative for the business and the broker has recently downgraded to Sell. Origin benefits from higher spot prices although government intervention limits the upside. Citi observes government interventions will likely weaken the market power of Origin Energy as the only large player with gas.

Renewables

Morgan Stanley believes high forward pool prices and rational passing of price rises of around 10% to retail over the coming year underpin a positive near-term outlook for both AGL and Origin Energy. This is expected to eventuate even with a demand response.

Wholesale electricity prices are at record highs because of rising gas costs and the closure of coal-fired base-load plants. All but one of the 3.8GW of publicly-announced new plants being built are intermittent renewables, and the broker believes there will not be much pool price relief ahead.

Morgan Stanley acknowledges there is unprecedented uncertainty around the future direction of pool prices. As rising energy prices will be a material economic headwind for Australia the broker warns government intervention is the key risk.

Yet more supply does not necessarily lead to lower pool prices, the broker contends, and suggests investors should closely monitor the potential new entrants in thermal generation, such as high-efficiency, low-emission coal or gas, as well as large-scale battery installation costs, new rules and emissions targets and political pressure on high end-user prices.

Canaccord Genuity notes three quarters of Australia's coal-fired power stations are operating beyond their original design life, and reliability or availability of these plants is expected to deteriorate while maintenance costs increase.

Meanwhile, the current building up of renewables does not offset the closure of Hazelwood power station nor meet the current renewable energy target. Significant further investment is required to replace Australia's aged infrastructure if electricity prices are going to normalise. The broker believes these developments take time and elevated prices are likely for the next three or more years, and beyond if the closure of Liddell is not handled appropriately.

The flow of low-cost capital to renewable energy developments has increased markedly in Australia this year but the broker is not convinced that 9% equity rates of return are sustainable for undeveloped renewable projects with contracted offtake, and this is a clear threat to smaller developers that have a higher cost of capital. This could create development opportunities for Infigen Energy ((IFN)) and Tilt Renewables ((TLT)), in the broker's opinion.

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