The Wrap: Rates, A-REITs And PNG LNG

This story features SCENTRE GROUP, and other companies. For more info SHARE ANALYSIS: SCG

Weekly Broker Wrap: RBA cash rates; Amazon & CPI; A-REITs; PNG LNG; Bell Potter initiates on Cyclopharm

-PIMCO does not expect RBA to start hiking rates for at least 6-12 months
-The main impact of Amazon likely to be on Australia's CPI
-Brokers observe retail A-REIT rental growth turns negative, office on the rise
-Goldman Sachs highlights PNG as a key area for cost-competitive LNG growth
 

By Eva Brocklehurst

Cash Rate

PIMCO stands by its belief that the new neutral in relation to Australia's cash rate is about 3%. Over four years ago (and again this week) the Reserve Bank of Australia explicitly referenced 3.5% as an estimate of the neutral nominal cash rate.

As a result PIMCO expects interest rates will be significantly lower than in other historical cycles. Moreover, Australian households have raised their debt levels since the GFC, taking advantage of lower mortgage rates, and borrowing rates have started to increase for certain cohorts because of regulatory changes.

PIMCO suspects an important inflection point may be approaching. Borrower confidence is dominated by the level of lending rates and recent changes in house prices. PIMCO believes this will limit the flexibility to increase official rates.

Hence, the start of any official rate hike cycle in Australia is not expected to be likely for at least 6-12 months. Global economic dynamics expected to be in place at the time suggest to PIMCO that there will be an increased probability of volatility in economic growth.

The level of the Australian dollar will be key in this scenario. The depreciation of the Australian dollar since 2013 has assisted the economic transition in Australia but PIMCO notes that it it has also appreciated by over 15% since early 2016.

Amazon And CPI

The arrival of Amazon in Australia late in 2018 is expected to challenge many retailers, and may be enough to impact the broader economy, UBS asserts. The main impact is expected to be retail price disinflation.

While there are concerns that this could lead to a slump in retail sales for incumbent retailers and hurt employment, UBS highlights the sector's share of consumption has already declined for decades to a record low. The main impact is expected to be on the CPI.

UBS estimates that each 0.5 percentage points slowing of Australian retail price growth will reduce the CPI by around 0.15 percentage points. Amazon should slow retail prices and online business subtract up to around 0.25 percentage points from the CPI over time.

Moreover, pressure on the retail sector is colliding with an unfolding correction in housing and record low household cash flow. This is expected to limit the Reserve Bank of Australia's willingness to join global central banks with a more hawkish outlook, and UBS suspects it raises the risk of a delay to current estimates for a normalising of rates from late 2018.

A-REITs

After considering the threat from Amazon in more detail, UBS believes the risks to Australian real estate investment trusts are priced in. As a result the broker upgrades Scentre Group ((SCG)), GPT ((GPT)) and Vicinity Centres ((VCX)) to Buy from Neutral on valuation grounds.

The broker believes Australian landlords are well-positioned to compete, considering the retail space per capita, favourable demographics and the evolution of retail assets in Australia.

The broker expects online sales penetration to increase to 19% by FY23 from the current 11%, ex food. Taking into account increased levels of online penetration in a 3% retail sales growth environment, around 1.75% per annum of specialty sales growth is anticipated over the next five years.

In this environment the broker forecasts 1.5-1.7% comparable net operating income growth, versus the current 3%, and suggests this indicates re-leasing spreads of -8-10% by FY20.

Morgan Stanley notes retail rental growth has turned negative, down -4% during the June quarter in regional malls across Sydney and Melbourne, as incentives remain stable at 13% and 5% respectively.

The broker acknowledges the dangers of extrapolating one quarter's data but believes the statistics do seem to support indications of downside risks to landlord income from softening expenditure growth and rising online penetration, which in turn is putting downward pressure on retailer margins and rents.

Reports have suggested that retailers are successfully negotiating lower rents with landlords and this provides evidence for the broker that the balance of power is shifting towards the tenant. Meanwhile, office rents are rising and Melbourne has overtaken Sydney for the strongest rental growth, confirming the broker's preference for office over retail.

Retail A-REITs are becoming increasingly attractive on a relative basis but Morgan Stanley suspects that retail book values understate real capital expenditure, and transactions could become even more limited as potential purchasers reassess post capex returns.

The backdrop is also driving demand for logistics facilities, as retailers try to improve efficiencies, and signals to the broker that underlying retail asset returns could lag both the office and industrial segments for some time.

Goldman Sachs calculates cash yields on premium Sydney and Melbourne CBD assets are in the 3-4% range at current valuations. This is considered precariously close to the cost of new debt, leaving little accretion from acquisitions.

The broker has reviewed the capital growth of office assets against the number of years held and finds the long-term compound growth rate is typically very low, attributed to the fact that large capital expenditure is required to maintain competitive assets over time, and this is typically a sunk cost which maintains rents rather than being valuation accretive.

Goldman Sachs believes the window to capture growth is limited and prefers Mirvac's ((MGR)) developments to create value, versus direct asset purchases and/or waiting for leasing activity to derive better earnings and distribution growth.

PNG LNG

PNG is one of the few areas globally where Goldman Sachs believes LNG exports will be cost competitive with the Henry Hub-linked US LNG price. The broker believes the next phase in PNG may be relatively lower in terms of costs because of brownfield economics.

Moreover, highlands gas tends to be liquids-rich and the government is intent on supporting the gas industry as the economic impact is transforming a largely undeveloped country.

Oil Search ((OSH)) remains a cornerstone player in any PNG expansion, with meaningful stakes in all major provinces. The PNG government is a major shareholder in the company which the broker believes is also key to fast-tracking LNG.

If the market does not recognise this value, Goldman Sachs highlights that the stock ranks the highest in its Asia-Pacific upstream coverage as attractive for merger & acquisition potential. PNG is also the highest quality asset location for Santos ((STO)) and one of two key growth options for the company, the broker notes.

Cyclopharm

Cyclopharm ((CYC)) owns the intellectual property and is the exclusive supplier of a system for functional lung imaging. The technology is primarily used for diagnosis of pulmonary embolism (blood clots) in the lung.

This potentially fatal condition is difficult to diagnose without imaging and the technology, Technegas, meets the need, particularly in patients that are contra-indicated for CT scans.

Bell Potter initiates coverage with a Buy recommendation and valuation of $1.13. Despite consistent revenue and growth in underlying profitability, the company is expected to report an operating loss from FY17-19, after including the cost of the clinical trial.

The broker notes the company is not a biotechnology stock or drug developer and its status as a medical device company has been well established.

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.

Click to view our Glossary of Financial Terms