Weekly Reports | Apr 21 2017
Equity strategy; food inflation; banks and mortgages; Amazon the company killer; Afterpay.
-Equity markets still offering value versus very low competing interest rates
-Food inflation returns but more difficult to push with weak income growth
-Crackdown on mortgage financing practices expected to affect bank loan growth
-Morgan Stanley flags looming Amazon threat for retailers
By Eva Brocklehurst
UBS notes Australia's current market price/earnings (P/E) multiple of 15.3x is modestly above average but not out of line with the current global multiple. The broker notes the Australian market is still trading at a modest discount to its long-run price to book ratio. Nevertheless, the market ex resources is now around its post-tech bubble highs.
As is the case globally, while the P/Es are on the high side UBS argues the market could still be considered cheap compared with what are still very low competing interest rates. The broker increases its ASX 200 target because of higher earnings estimates for 2017 and 2018 but remains aware that this is mostly driven by the mining sector.
The broker believes that the upside in a 6-12 month view is limited as a central case, although global conditions for equities should stay reasonably positive. With a 5% dividend yield and bond and cash rates still unattractive, equities appear the superior option in the broker's opinion.
Anaemic growth in household income and the rolling out of Aldi stores is likely to dampen supermarket earnings and, while food inflation is returning, Morgan Stanley recommends not getting too excited. The broker's observation of Woolworths ((WOW)) pricing data shows that a number of products on discount have reduced considerably in the March quarter and more prices are rising than are falling.
Rising levels of food inflation have historically led to faster sales growth for the supermarkets and margin expansion for both Woolworths and Coles ((WES)). The broker suspects that the food inflation this time will be more difficult to push through to consumers, and consumers will downgrade to lower-priced and private-label products.
Morgan Stanley also warns of costs growth accelerating over the next year given higher energy prices and labour costs.
Nevertheless, the broker believes food inflation is a net positive and Metcash ((MTS)) will be the largest beneficiary. The business is effectively a price taker and is the most leveraged to food inflation. The broker believes the discount the market is placing on the company's food & grocery business is too high.
For Woolworths, Deutsche Bank also expects a continuation of momentum shown in the second quarter. As Easter shifts to the final quarter of this financial year versus the third quarter of the prior financial year, it will create a drag on overall sales that will be made up in the subsequent quarter.
The broker forecasts growth in Australian Food sales at Woolworths of 3.2% in the March quarter.This comprises a 50 basis points drag from Easter and a 50 basis points space benefit. The broker's channel checks suggest the market remains competitive but rational and Woolworths has continued to outperform Coles.
Morgan Stanley believes recent developments fundamentally alter the Australian mortgage market. For the first time in a decade the broker notes a combination of more onerous capital rules, higher mortgage rates, tighter lending standards and credit rationing. The outlook for the banks features higher margins but lower loan growth.
The broker believes current multiples ignore the risk of unintended consequences. While Morgan Stanley lifts forecasts for earnings per share in FY18 by an average of around 3.5%, credit rationing is expected to increase the probability of a weaker economy and higher non-housing loss rates next year.
The broker now expects the major banks investment property loan growth to drop to around 1% in FY18 because of the new interest-only loan and the restrictions on high-risk lending. The broker forecasts total Australian housing loan growth to slow to around 4.5%. ANZ Bank ((ANZ)) is the least affected of the major banks and Commonwealth Bank ((CBA)) the most affected. The Broker retains an Overweight rating on ANZ with an Underweight rating on CBA.
UBS notes, domestically, the Reserve Bank of Australia is increasingly concerned about the vulnerabilities of household debt and the housing market. This comes with a backdrop of weak income growth. The central bank has highlighted that some riskier types of borrowing, such as interest-only lending, remain prevalent, although indicators of household stress currently are contained.
UBS expects regulators to continue to monitor developments carefully and consider further measures if necessary. The broker believes the RBA will maintain a hold on official rates going forward and suspects regulators will use macro-prudential policy tightening to target rising household debt rather than a hiking of the cash rate.
Citi suspects an unprecedented crackdown on Australian mortgage financing practices will have a multi–pronged effect on the sector. This will include slower mortgage growth and more mortgage re-pricing. Owner occupiers are expected to be unaffected, to reduce disruption and limit the risk of popping rather than deflating the perceived housing bubble.
The broker believes capital requirements are comfortable and the banks are expected to largely source additional capital internally or organically, rather than from external sources. Valuation remains a chief concern, especially among the mortgage-centric banks. Citi maintains a Sell recommendation on Westpac ((WBC)) and CBA.
Morgan Stanley observes the consumer discretionary sector is among the worst performing in the year to date, with 24 of the 37 constituents underperforming the ASX200. Cyclical factors largely explain this but the broker envisages headwinds to consumption growth in the form of weak income, softening employment conditions and a peaking in the apartment construction cycle.
Outside of this, there is Amazon. Morgan Stanley dubs the business the "country killer". Amazon already turns over around $1bn in sales in this country by shipping from overseas. For context, the broker notes total annual retail sales in Australia are about $300bn. Amazon's impact on retailing, digital content, supply chains and business-to-business transactions globally is considered astonishing.
Amazon is now the biggest non-food retailer in the UK at nearly double the revenue of its closest rival. While digital competition is not new to Australia, and local retailers have mostly adapted to varying degrees of success, Morgan Stanley believes Amazon is the real digital monster.
For Australian investors Amazon appears more a threat than an opportunity as retail landlords, retailers and light industrial supply chains appear at risk from its physical arrival. The one stock that may benefit is Goodman Group ((GMG)), which already works with Amazon and appears poised to benefit from increased supply chain complexity. Morgan Stanley rates the stock Overweight with a price target of $8.20.
Afterpay ((AFY)), a financial technology company offering the ability to buy goods and services on a simple instalment plan, has impressed Bell Potter, delivering total merchant sales 19% ahead of estimates. The company now accounts for around 3% of all online sales in Australia and around 15% of Australian on line fashion retail transactions.
The company is gaining traction in stores, with a total of 3700 retail merchants on stream. The broker observes the product is gaining mainstream acceptance and appears set to grow at a rapid rate. Bell Potter upgrade revenue estimates by 8.8% and 7.6% for FY17 and FY18 respectively. The broker expects the company to be profitable for FY17. A Speculative Buy recommendation is unchanged. Target is $4.24.
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