The Wrap: Stimulus 2.0, Biotechs & US Taxes

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Federal government expected to announce more measures; future looks bleak for retailers and retail REITs; competition intensifying in the biotechnology sector; a Biden victory may mean more taxes

-Budget deficit to soar even higher with more stimulus measures expected
-Retail REITs to see lower rental income in the future
-CSL: No longer the only fish in the biotechnology pond
-Slowdown in domestic pricing momentum for general insurers
 

By Angelique Thakur

Fiscal deficit: Up, up and away

Government support has been critical in helping Australia through the pandemic. About $140bn has already been spent by the federal government, but these measures are due to expire in September, Morgan Stanley reminds investors.

Looking at the recent lockdown in Melbourne, which has slowed down a recovery, Morgan Stanley expects the government to announce a second phase of measures when it announces its economic update on July 23.

The measures, expected to amount to about $40bn, may be two-pronged, speculates Morgan Stanley.

They will be targeted towards supporting businesses impacted by restrictions on the one hand (through a more targeted form of JobKeeper, among other ways) while providing further stimulus in the form of increasing permanent unemployment benefits or tax cuts on the other, the broker suggests.

Morgan Stanley also believes this time the focus will likely be towards providing growth stimulus as the economy has recovered partially from where it was in April.

These measures are less than the support given during the first wave, yet round up to a significant amount and are expected to take the FY21 budget deficit to a record -$180bn.

That is a whopping 9% of GDP and an increase of -$20bn over the broker’s previous estimate. Morgan Stanley forecasts a budget deficit of -3-4% for FY22-23.

Retail Malls: Declining rental incomes

Morgan Stanley believes the pandemic has fundamentally changed the way we shop and has accelerated the evolution of retail and shopping malls to some extent.

Online shopping penetration is a case in point where the virus has quickened the pace of penetration of online shopping.

While foot traffic has increased to 80-100% of pre-covid-19 levels since mid-May, Morgan Stanley is sure shopping centres will not have the same earnings power in the post-covid-19 era.

One of the ways this is visible is through the huge difference in consensus forecasts for retail landlords like Vicinity Centres ((VCX)) (dividend distribution estimates range from $0.056 to $0.12) and Scentre Group ((SCG)) (funds from operations estimates range from $0.189 to $0.262).

Many major department stores and discount department store chains are expected to close down in the medium term.

New tenants will come in but this could take time. Morgan Stanley analysts estimate both Scentre Group and Vicinity Centres could lose about -7.5% of their rental income as compared to pre-covid-19.

The shift towards online may also force a rethinking of the value of a store. Australia’s share of online retail rose to 7% in early 2020 and the broker expected it to touch 10% by 2022-23.

However, the pandemic may have quickened the pace somewhat and the broker thinks if this continues, it could spell more trouble and potentially take off another -5% in rental income for the two REITs.

Social distancing is the third factor that poses downside risks to businesses like food and beverages, cinemas and gyms. These risks will intensify if social distancing continues for another six to twelve months.

Food and beverages constitute about 12% and 10% of income for Scentre Group and Vicinity Centres respectively and could result in landlords having to give longer-term rent abatement.

Overall, the two REITs will face rent declines of up to -15-18%, on the broker's estimates.

Morgan Stanley prefers Scentre Group whose malls are generally located in areas with higher population density and stronger population growth along with higher incomes.   

Vicinity Centres' malls have a larger exposure to Victoria with fewer malls having a turnover of more than $500m/year as compared to Scentre Group. Morgan Stanley als finds the latter has an older and less redeveloped portfolio.

Morgan Stanley rates Vicinity Centres as Underweight while preferring Scentre Group (Overweight).

Downside risks for retailers

Citi notes Australian consumer spending has been focused more towards retail for the last four months, helped no doubt by the stimulus measures of the government.

The broker expects this to continue for another month or so, but then expects the pace of spending to slow down substantially.

Citi thinks this slowdown will likely be led by three factors. The first pertains to more stimulus measures expected to be announced on July 23.

Retail spending by households in supermarkets and the likes was helped by circa $12bn in government stimulus in the June quarter and Citi expects stimulus to households of about $20bn this time along with a program similar to JobKeeper at another $20bn.

However, if the measures announced during the update are less than $50bn for the December quarter, the downside risk to consensus earnings will increase.

Household spending, and in turn spending on retail, has also been propped up by superannuation withdrawals of about $18bn. Citi feels the ceasing of super withdrawals may lower household cash flow by -3-6%.

The third factor hampering retail spending is the recovery seen in non-retail spending. One of the reasons retail spending saw a boost was due to limited spending options in non-retail avenues on account of the pandemic.

Those areas are expected to recover and will impact retail sales growth over the next year.

Citi sees downside risk to consensus earnings forecasts to the tune of -1-6% for discretionary retailers with gross margins being at higher risk in housing-related categories.

The broker is cautious on Wesfarmers ((WES)) and Lovisa Holdings ((LOV)) and also acknowledges earnings risk for Harvey Norman Holdings ((HVN)).

Biotechnology: Game on

Bell Potter suggests CSL ((CSL)) may not remain the proverbial king of the Australian biotech jungle for long. In fact, the broker considers the sector itself to be in the middle of a golden age.

Some other names doing the rounds which have caught the broker’s fancy are Mesoblast ((MSB)) and Opthea ((OPT)), along with medical device developers like Oncosil Medical ((OSL)) and Avita Therapeutics ((AVH)), as well as Volpara Health Technologies ((VHT)).

Bell Potter highlights that each of these companies, with the exception of Volpara, carries a Speculative rating for now due to the lack of historical data to support projections.

Even so, valuations attached to some late-stage drug developers and especially those with multiple drug candidates are jaw-dropping, according to the broker.

One of them is Genetic Signatures ((GSS)), a diagnostics company with its proprietary platform technology – 3Base.

The company provides test kits for diseases including gastrointestinal disease and respiratory disease (including covid-19) among others. Bell Potter expects Genetic Signature’s target market to grow to US$10bn by 2026.

Growth drivers include expansion into Europe and US markets and covid-19 which has increased the company’s penetration and customer acquisition in international markets and may lead it to profitability earlier than expected in FY21.

Bell Potter rates Genetic Signatures as Speculative Buy.

Kazia Therapeutics ((KZA)), Bell Potter’s most recent addition to its coverage, develops a chemical entity called paxalisib for treating glioblastoma.

Interim results from a phase II study look promising and the broker expects the next update in early 2021. The drug has also been included in the international platform study GBM Agile and will start recruiting patients to the approval study later in the year.

Bell Potter rates Kazia Therapeutics as Speculative Buy.

Mesoblast is an allogeneic regenerative medicine company with one of the most diversified pipelines and many products in the late stage. In fact, the company has already secured a spot in the ASX200 driven by a number of positive developments and share price appreciation, highlights Bell Potter.

The company is on its way towards its first FDA approval for Remestemcel-L with launch in the US expected in the last quarter of FY20. This drug is also used to treat Acute Respiratory Distress Syndrome (ARDS), a lung disease, and has been useful for ventilator-dependent covid-19 ICU patients.

The broker thinks Mesoblast could become profitable in FY21 and rates it a Speculative Buy.

Volpara Health Technologies is a medical technology company focused on early breast cancer detection using artificial intelligence. The business model is based on Software as a Service (SaaS) and Volpara is the only organisation with such a comprehensive product suite, giving its earnings a "defensive" tinge.

Volpara Health Technology is rated as Buy.

Oncosil Medical is a drug developer in its commercial stage and expected to start generating revenues from the second half of 2020 at the rate of $25,000 per patient.

Its first product deals with treating locally advanced pancreatic cancer

The company received the CE Mark in April 2020 after a successful clinical trial and expects to launch in Europe in the second half and in Australia and the Asia Pacific in early 2021.

Oncosil Medical is rated as Speculative Buy.

Opthea is a Melbourne-based biopharmaceutical company developing therapies for the treatment of eye diseases and its drug OPT-302 may have the potential to improve efficacy in treating wet age-related macular degeneration.

Bell Potter considers the company a strong candidate for takeover/partnering and notes it was also recently included in the ASX300 index.

The broker rates Opthea as Speculative Buy.

General Insurers: Shoring up defences

Morgan Stanley reports general insurers to be building earnings buffers to help deal with covid-19 claims. These buffers are in the form of savings from lower motor claims for Insurance Australia Group ((IAG)) and Suncorp Group ((SUN)) and benign catastrophe costs for QBE Insurance ((QBE)).

On the flip side, the broker expects domestic pricing momentum to slow down with policyholders hesitant to absorb premium rate increases in a recession, with the skew towards personal/SME customers not helping the insurers.

In fact, Morgan Stanley’s June premium index saw motor pricing decrease by -17% year on year in the June quarter (versus an increase of 2.5% in the March quarter).

Both IAG and Suncorp are tilted more towards personal customers, translating to a subdued gross written premium growth in FY21-22, Morgan Stanley notes.

Morgan Stanley thinks QBE’s higher exposure to larger corporates and exposure to the US markets makes it better placed to protect its top line and be able to increase premium rates as compared to IAG and Suncorp.

QBE is expected to be hit by business interruption claims in the UK, but the insurer has reassured this will be limited to -$75m by reinsurance, reports the broker.

Morgan Stanley believes liability and financial lines claims will take longer to settle and braces for a meaningful impact on the group in FY21.

Between 2008-20, the general insurance industry has witnessed a consistent increase in catastrophe losses and even during drier weather, Australia has seen meaningful catastrophe losses in the past 12-13 years.

Morgan Stanley highlights while all the three insurers face risk from rising catastrophe losses, Suncorp is the most exposed.

The broker reveals both IAG and Suncorp have risks centred around Sydney, Melbourne and Brisbane which means a single event can trigger disproportionate losses. QBE on the other hand is less exposed to Australia.

The broker points at rising reinsurance costs for all three general insurers but notes IAG’s main catastrophe program has a multi-year quota share reinsurance cover which decreases pricing fluctuations from annual reinsurance renewals.

Suncorp’s reinsurance cost rose in July while its earnings have become more volatile and exposed to weather events, comments Morgan Stanley.

The broker prefers QBE (Overweight) and IAG (Overweight) and is Underweight on Suncorp.

US: Taxing times ahead

“A person doesn't know how much he has to be thankful for until he has to pay taxes on it.”- Ann Landers

A report by T.RowePrice suggests that If former Vice President Joseph Biden wins the US election, it may mean higher taxes.

Biden has indicated an increase in personal and corporate taxes in order to finance programs like social security, health care, green energy among others.

His tax plan aims at restoring many provisions that were in effect before the passage of Trump's Tax Cuts and Jobs Act 2017 or TCJA, which will lead to net tax earnings of US$3.8trn over 10 years, T.RowePrice estimates.

While the corporate tax rate would increase to 28% from 21%, it would still be below the 35% rate during the pre-TCJA era.

Some of the other changes to corporate tax proposed by Biden will affect companies that generate offshore profits and businesses with profits of US$100m or more.

On the personal tax front, Biden’s tax plans target the highest income earners and those who derive their income from investments. T.RowePrice suggests the changes will revert tax rates to the pre-TCJA rate of 39.6%, impacting earned income above US$400,000.

Those in the top tax brackets will feel the heat with the former Vice President planning to phase out the qualified business income (like income from qualified real estate investment trust dividends) deduction of 20% for filers with a taxable income of above US$400,000 and increase taxes on long term capital gains and qualified dividends.

T.RowePrice estimates the rate increases will reduce S&P500 company profits by -9%-11% with some industries benefiting from the increased spending.

Earnings per share for utilities will be less impacted as taxes are passed on to the customers but the broker notes these companies could be subject to the minimum tax rate provision which will put pressure on customer bills for utilities’.

T.RowePrice suggests the two most important factors impacting Biden’s legislative agenda will be the state of economic recovery and the coronavirus.

Higher infections and a deepening crisis would necessitate another deficit funded stimulus bill while putting any tax rate increase on the back burner until the economy becomes more stable.

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