Weekly Broker Wrap: Cyclicals, Banks, Consumers, Grocers And El Nino

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-Oz cyclicals seem reasonable
-Business increases debt market use
-Dilution possible in consumer stocks
-Inflation rewards supermarkets
-El Nino event troubling for farm sector
 

By Eva Brocklehurst

Deutsche Bank thinks valuations are now reasonable for Australian cyclical stocks. Earnings forecasts are holding up, with the broker expecting growth around 8% for FY14. This stability is considered a marked change from the past few years when there were lots of downgrades. Cyclical industrials don't appear cheap on a price/earnings basis but the broker thinks they offer upside as earnings normalise from cyclical lows. Meanwhile, resource stocks are considered cheap, trading a little below the 10-year average on a price/earnings ratio around 13.25 times. Moreover, businesses are reporting the best conditions since mid 2011 and sentiment in the non-resource economy is getting back to trend. This supports the domestic cyclicals, in Deutsche Bank's view. Employment growth is also improving and this points to more household spending.

In this scenario the broker's preferred stocks are Toll Holdings ((TOL)) and Asciano ((AIO)) which provide value and exposure to the inventory re-stocking cycle. Boral ((BLD)), BlueScope ((BSL)), Stockland ((SGP)), Lend Lease ((LLC)) and Harvey Norman ((HVN)) are liked for earnings growth resulting from housing market leverage. Also, Nine Entertainment ((NEC)) and Crown Resorts ((CWN)) are preferred for exposure to the general economy. Nine is considered cheap, with exposure to consumer spending on services. Rio Tinto ((RIO)) and BHP Billiton ((BHP)) offer value in Deutsche Bank's view, arising from cost cutting and improved free cash flow, with leverage to better global growth.

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Citi observes none of the traditional signals for business credit are yet positive. What's holding business credit back? Business credit outstanding is still 5% below 2008 levels and yet the economy is now 30% larger in nominal terms. The broker notes non-mining capex intentions continue to fall and working capital needs are still shrinking. One more positive aspect is that banks have taken share from non-bank providers. Bank lending to businesses is now growing around 4% per annum, double the 2% growth of business credit across all lenders.

Citi observes that the impact of Basel III on loan pricing is driving more highly-rated corporates to the debt market, taking about 3% per annum from business loan demand in recent years. This is significant as only a small part of debt issuance comes from Australia and here the major banks have strong roles as lead managers. Nonetheless, leakage to overseas securities means these banks are reduced to a minor role in any issuance led by an overseas bank. Another pressure on major banks in lending to business is the return of foreign banks, with this segment's share rising by 2% to 19% over the last two years. Commonwealth Bank ((CBA)) and National Australia Bank ((NAB)) have born the brunt of this impact while, in contrast, ANZ Bank ((ANZ)) has steadily built its business lending share. Given this lacklustre demand for new business lending Citi retains a preference for the two largest mortgage lenders, where demand is growing. Usher in Commonwealth Bank and Westpac ((WBC)).

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BA-Merrill Lynch notes consumer stocks globally are struggling for growth. Of the largest four in Australia that the broker covers, Wesfarmers ((WES)) is forecast to grow 3% in FY14 and Woolworths ((WOW)) 4.8%. Coca-Cola Amatil ((CCL)) is forecast to go backwards by 25% in FY14 and Metcash ((MTS)) backwards by 13.2%. Each of the four have been soft in growth terms, despite heavy capital expenditure over the past three years. Each have spent well over twice the capex to depreciation ratio, which the broker notes is bad for shareholder returns, particularly in a low-growth environment. If these companies continue with their current strategies Merrills thinks future dilution to shareholder returns is possible, retaining Underperform ratings on all four. In contrast, the broker observes some of the smaller companies are forecast to deliver double digit earnings growth, such as JB Hi-Fi ((JBH)) and Super Retail ((SUL)). These two are the exceptions in a lacklustre consumer sector, in Merrills' opinion. Hence, they have Buy ratings.

Australian supermarkets may be facing fierce competition but the industry is attractive, in UBS' opinion. Over the past few years food price inflation has outpaced cost inflation, suggesting gross margins continued to rise. The broker's supplier survey suggests dry grocery prices will rise by 2.3% over the next 12 months, well ahead of the average 0.5% projected lift in the past three years. With inflation returning to the market, the broker expects grocers will outperform. UBS estimates a 1% lift in inflation drives a 3% lift in grocery earnings. Woolworths is considered the best exposed to this rising inflation and the broker has upgraded the stock to Buy as a result. Woolworths derives 80% of earnings from Australian supermarkets. Metcash also benefits with over 90% of earnings from grocery but, being a wholesaler in the middle of a turnaround, there's considerable execution risk. Wesfarmers' derives around 45% of earnings from supermarkets (Coles) and the broker retains a Neutral rating on that stock.

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The Bureau of Meteorology indicates there is now a 70% chance that an El Nino will develop during the winter. This event refers to extensive warming of the central and eastern tropical Pacific Ocean and typically correlates with lower than normal rainfall across eastern and southern Australia in the second half of the year. It's not clear cut. There are times when a weak El Nino results in widespread drought and times when a strong El Nino has a relatively modest impact. Nevertheless, Commonwealth Bank's analysis shows that in the eleven El Nino events recorded since 1970 none were associated with above-trend wheat yields across the east coast.

 For Australia's farm sector an impending El Nino is not a good signal, as subsoil moisture reserves are already below average across much of eastern Australia. The potential adverse effect on 2014/15 agricultural production is significant in the CBA analysts' view, particularly for central NSW to southern Queensland. Winter grain and oil seed production is typically lower during El Nino and diminished winter and spring pasture affects the livestock sector. There is also negative implications for irrigated production such as rice, cotton, horticulture and dairy in the following season as a result of below-average run off. The following summer crops can also be below average after an El Nino develops because of reduced subsoil moisture levels.
 

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