In Brief: REITs, AI, Aussie Adversity & Stock Picks

This story features DEXUS, and other companies. For more info SHARE ANALYSIS: DXS

Weekly broker Wrap: headwinds for Australian REITs; increasing hyperscaler capex to provide cloud-related tailwinds; Aussie hardship survey & stocks picks from the E&C and Chemical sectors

-Lower returns and superior alternatives may weigh on REITs
-Increasing hyperscaler capex to buoy NextDC and Megaport 
-Above-average hardship levels continue for Australians
-Stock picks from the E&C and Chemical sectors
 

By Mark Woodruff 

Lower returns and superior alternatives may weigh on REITs

The Australian real estate investment trust (REIT) sector is unlikely to outperform when broker distribution estimates are under pressure and while alternative investments provide higher returns at lower risk.

Evans and Partners also believes pressures facing the Office sector are unlikely to diminish in the near term and lowers its rating for Dexus ((DXS)) to Neutral.

While equity prices for Australian REITs already assume bearish scenarios for asset valuations, Evans and Partners has greater concerns around increased financing costs.

The broker highlights the risk of further interest rate increases and the lapsing of favourable interest rate hedging, particularly in FY24 and FY25, which has been taken out in prior years.

The various ways management may combat these higher financing costs, unfortunately, all negatively impact on distributions.

If assets are sold, income falls or if hedging is increased higher costs now apply, explain the analysts. Moreover, should REITs pursue developments to grow income, the investment case may no longer make sense at higher discount rates.

Investors, as always have choices, and other investments like fixed income and overseas commercial property markets are currently preferable to Australian REITs, according to Evans and Partners.

Floating rate credit currently offers higher yields at lower risk, while overseas commercial property markets have already corrected and may recover faster, suggests the broker.

Further challenges to REIT performance include less appetite from asset allocators given high volatility and declining income. Also, the analysts caution there may be pressure on direct markets from unlisted funds facing liquidity squeezes.

Preferred exposures in the sector for stocks under coverage by Evans and Partners are Goodman Group ((GMG)), Arena REIT ((ARF)), Hotel Property Investments ((HPI)) and HomeCo Daily Needs REIT ((HDN)).

As the residential cycle may deteriorate again prior to positive impacts from migration, and the share price has recently outperformed, the broker decides to downgrade its rating for Stockland ((SGP)) to Neutral. 

Increasing hyperscaler capex to buoy NextDC and Megaport 

During recent reporting in the US, management at both Microsoft and Google announced increased capex spending to support both artificial intelligence (AI) and non-AI cloud workload demand.

In Citi’s opinion, the required data centre builds and increased servers/AI compute are a medium-term positive for NextDC ((NXT)) in terms of hyperscale demand, and from a connectivity perspective for Megaport ((MP1)), once the capacity is deployed.

Both companies will also benefit from accelerated cloud adoption from AI in the first instance, suggests the broker, with Microsoft noting cloud (and data in the cloud) are key enablers of AI usage by enterprises.

Nonetheless, there may be a shorter-term headwind for Megaport, caution the analysts. 

While both Microsoft and Google are seeing new workloads shift to the cloud, Citi explains there is ongoing moderation of consumption growth as customers optimise their cloud spend.

On the flipside, customers are starting to use Microsoft Azure for some of the new AI workloads, and the broker expects a tailwind for Megaport from increasing multi-cloud adoption.

Above-average hardship levels continue for Australians

Amid higher inflation and rising interest rates, people across all income groups reported above average levels of hardship in the June quarter this year, and an increasing number of people missed a bill or loan payments in most age categories.

While overall hardship levels were above the National Australia Bank’s ((NAB)) Australian wellbeing survey average in all states, Tasmania recorded the biggest jump to 67% up from 41% in the March quarter. SA/NT and WA also recorded hardship levels of 55% and 48%, up from 38% and 37%, respectively.

Over 40% of Australians experienced some form of financial hardship in the June quarter, well above the 36% average and up from 29% in early-2022.

Moreover, around 20% of survey respondents do “not at all” feel on top of their day-to-day finances, or believe they are on track to have enough money to provide for their financial needs in the future. Noticeably more women than men indicated they were not doing very well in all aspects of their finances.

The most common forms of hardship, according to survey respondents, arose from insufficient money for an emergency (24%), while 19% couldn’t cover for food and basic necessities and the same percentage were unable to pay a bill.

Around 30% of people under 50 were unable to raise money for an emergency in the June quarter, double the level in the over 65 group.

The number unable to meet mortgage repayments was unchanged from the survey three months ago at 6%, though rose from 4% at the same time last year. 

The most common type of payment missed was an electricity, gas or water bill. This occurrence rose to 12% from 11% in the March quarter, and from 8% in the previous corresponding period.

Stocks picks within the Engineering & Construction and Chemical sectors

UBS highlights the year-to-date outperformance against the ASX200 for the Engineering & Construction sector due to dependable earnings in a slowing domestic economy.

Moreover, three stocks are expected to reveal EPS growth outlooks of around 20% into FY24 during the upcoming results season.

One of those stocks is Neutral-rated Downer EDI ((DOW)). It’s share price has rallied by 23% year-to-date, compared to the 4% gain for the ASX200, which reflects more favourable weather conditions for the East Coast in the second half, in the broker’s view. Previous project management control issues may have also contributed to a low share price starting point in 2023.

The broker’s preferred, and Buy-rated, picks from stocks under its coverage in the sector are Seven Group ((SVW)) and Worley ((WOR)), whose share prices have rallied by 23% and 13%, respectively, so far this year.

The analysts expect strong earnings growth for Seven Group on the back of strong mining/infrastructure demand, while Worley should experience ongoing momentum in headcount, as well as for order book additions, to help achieve management’s double-digit medium-term earnings growth target. 

Elsewhere in the sector, UBS assigns a Neutral rating to ALS Ltd ((ALQ)) in the expectation of weaker geochemistry volumes and because its 49% stake in pharmaceutical testing business Nuvisan continues to weigh on earnings for Life Sciences.

Neutral-rated Mondalpheus Group’s ((MND)) shares have fallen by -6% in 2023, an outcome the broker attributes to tight WA labour market conditions and ongoing project delays. 

Chemical sector comparison: Orica vs Incitec Pivot 

The Australian explosive businesses of Orica ((ORI)) and Incitec Pivot ((IPL)) are experiencing a unique domestic pricing environment in which competitively priced imports have not yet filled a domestic supply/demand shortfall for ammonium nitrate.

However, Jarden believes investors in the Australian Chemicals sector will find a more appealing risk/reward proposition for Orica compared to Incitec.

Re-contracting prices for Australian explosives is a primary earnings driver for Orica, while Incitec’s exposure is offset by sensitivity to a rapidly falling diammonium phosphate (DAP) price, explain the analysts. It’s felt fertiliser valuations are cheap with good reason.

While lower prices might reinvigorate demand for fertiliser, potential El Nino climactic conditions are expected to depress overall farming production and fertiliser volumes over the next three years.

The broker also allows for Incitec’s gas supply issues at the Phosphate Hill fertiliser plant in Queensland, management uncertainty and the potential for a drawn-out stock demerger process.

On the flipside, recent share price weakness for Incitec limits downside for investors, suggest the analysts, and positive re-rate catalysts would arise either via either a Fertilisers trade sale at an attractive premium or significant buybacks following the sale of the Louisiana-based WALA ammonia facility.

Orica is the largest and most global explosives supplier in Australia and accordingly attracts a valuation premium to its more localised explosives peers, explains Jarden. Nonetheless, Incitec has a relatively similar global explosives presence yet trades at a significant valuation discount.

This disparity is the primary reason behind management’s intended move at Incitec to demerge the Fertilisers business from Explosives, explains the broker.

Jarden initiates research coverage on Incitec with a Neutral rating and 12-month target price of $2.85 and upgrades its rating for Orica to Buy from Overweight, while maintaining its $17.15 target.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms