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The Wrap: Health, Banks & Salary Packaging

Weekly Reports | Jan 19 2018

Weekly Broker Wrap: Private health insurance; housing; banking; online; and salary packaging

-Pressure on private health insurer margins likely to grow
-High levels of new dwelling completions expected to weigh on prices
-Lack of leverage to growth but banks still benefiting from favourable margin trends
-Rise of online takeaway food aggregators pressure urban shopping centres
-Valuation discount still required to capture the risk for salary packaging operators

By Eva Brocklehurst

Private Health Insurance

Ord Minnett suggests the tougher approach from the government on insurer price rises may lead to margin pressures in FY19 and nib Holdings ((NHF)) may suffer less than Medibank Private ((MPL)). Approaching an election year, the broker expects there will be pressure to achieve increases below 4%.

Both companies experienced margin expansion in FY17, with inflation running behind premiums. This gap is likely to disappear, or even reverse in FY18, as below-industry increases from April 2017 for both listed companies are reflected in FY18 results, while both insurers have some cost reduction programs that could partially offset this.

Macquarie's analysis suggests claims growth is tracking below historical levels. The broker expects a weighted average premium increase of 3.85% for Medibank Private and 3.80% for nib versus a sector increase of around 4%.

The broker expects the industry to receive ongoing support from government policy to ensure that sufficient young people retain private health insurance and support sustainability. The expectation for continued below-trend claims growth supports the broker's estimates for a Medibank Private margin for FY18 of 8% and nib of 6.1%.

Premium rate increases signal as much about claims volatility as the direction of profits, in the broker's opinion, and a narrowing of premium rate variation supports the view that claims volatility is reducing for the sector.

Housing

Recent data signal that house prices in Sydney as well as at the national level have already stopped falling. Macquarie suggests it very likely that prices at the national level are now again rising modestly.

As always, there are large differences between locations and the type of housing. The broker does not expect a repeat of the bounce that occurred in 2016, as that year witnessed 50 basis points of reductions to the official cash rate, while this year there is likely to be speculation regarding the timing of eventual rate rises.

Banks have also become more discriminatory in terms of their lending. The broker believes rising interest rates will eventually be a major stumbling block for housing prices and periods of broad-based falls in dwelling prices are much more likely in the medium term.

UBS observes the size of the retracement in housing activity and price growth, particularly dwelling commencements, is less than previously expected. This suggests that the full impact of macro prudential tightening is having more of a negative impact on lending and prices for established housing than for new housing. The broker agrees the historical trigger for a sharp reduction in housing activity are increases in official rates.

As UBS expects the Reserve Bank to maintain steady rates until 2019. Amid the expected rebound in approvals, forecasts for dwelling commencements are upgraded to 200,000 in 2018 and 185,000 in 2019. Nevertheless, with activity concentrated in high-rise developments, GDP-basis dwelling investment is still expected to fall. The broker calculates that, even under its base case, the high ongoing level of completions/supply in coming years should weigh on prices.

Banking

The banks will have a challenging outlook as the housing market slows, UBS adds. Net interest margins will come under pressure from competition as well as from switching. Moreover, the impending Royal Commission is an area of material uncertainty while mortgage mis-selling and responsible lending risks are a growing concern. The broker expects Australian banks to continue to lag peers given the regulatory risks and lack of leverage to global rates and growth.

While the underlying earnings growth profile is subdued, Macquarie expects the banks to return capital to shareholders via special dividends and buybacks. The bank sector is now trading at around a -30% discount to the industrials and the broker envisages relative value at current levels.

Macquarie upgrades Westpac ((WBC)) to Outperform and elevates the stock to its preferred exposure. Growth will be constrained by the highly leveraged household sector while margin will be affected by competition, the broker acknowledges. Yet, on a short-term view there is relative value as banks continue to benefit from favourable margin trends and benign credit conditions. Macquarie also envisages scope for banks to reduce expenses.

Online

Citi has a cautious outlook for the online media sector, concerns over rising costs and the potential for the reversal of volume growth trends. The sector is also trading near-record price/earnings multiples. The broker downgrades forecasts for earnings per share for Domain ((DHG)) and REA Group ((REA)), pushing back listings growth assumptions, and factoring in higher costs growth for Domain.

Estimates for Carsales.com ((CAR)) have been upgraded on expectations of stronger growth from Korea. The broker's only Buy rating in the sector is Trade Me ((TME)). Seek ((SEK)), after benefiting from four years of strong cyclical volume growth, is expected to slow.

Online takeaway food aggregators are growing rapidly in Australia, providing convenience and choice. Morgan Stanley examines the economics for aggregators, restaurants, consumers and drivers and concludes that efficient integrated operators such as Domino's Pizza ((DMP)) will remain relevant.

Australia is a relatively underdeveloped market for online delivery, with penetration at 10% versus the UK at 34%. The market remains fragmented, unlike other industries such as online classifieds which tend to be dominated by one major player. The broker's analysis of the economics shows restaurants need more than 50% of sales to be incremental or they suffer lower profits after signing up with an aggregator.

The economics of online aggregators and delivery suggests there is pressure on shopping centres in dense urban areas. These typically have a lower scope to host delivery services, being multi storey, site-constrained assets. In contrast, more convenience-based assets in remote areas are less exposed to the threats. In this way Stockland ((SGP)) may be benefiting via its food "pad" sites located outside of its malls. The broker notes Scentre Group ((SCG)) is not as defensive in this regard.

Salary Packaging

McMillan Shakespeare ((MMS)) and Smartgroup ((SIQ)) were supported in 2017 by a strong operating environment and Credit Suisse notes the stocks were up 60% and 86% respectively for the year. Hence, the broker wonders whether enough risk has been priced in. While acknowledging it may have been too quick to downgrade long-standing Outperform ratings, valuations are still recognised to be at a level where it is appropriate to ask the question.

Credit Suisse accepts traditional regulatory risk remains low and the political appetite for change is weak. Nevertheless, the broker points out there is a difference between no risk and low risk. These companies have a monoline dependency on one part of the tax code and carry inherent risk. In the broker's opinion a valuation discount is needed to capture this risk.

There is a chance the high profitability which these two enjoy attracts attention, either from a regulator or from an employer seeking greater benefits for employees. The broker asks whether novated leasing, being extremely profitable, is perhaps overly so, given it relies on tax legislation. While expecting a positive outlook the broker believes valuations are fair and retains Neutral ratings on both stocks.

McMillan Shakespeare offers slightly better valuation support whilst Smartgroup has greater scope for upgrade.

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