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The Wrap: Second Half Skew, Banks & Contractors

Weekly Reports | Mar 29 2018

This story features AURIZON HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: AZJ

Second half club; banks; Bank Royal Commission; telcos; contractors and supermarkets.

-Earnings outlook for second half of FY18 seen resilient overall
-Banks still expected to return capital despite subdued growth profile
-Significant changes to bank industry practice likely to be proposed by Royal Commission
-Optus the only telco showing better outcomes over the first half of FY18
-Volumes among WA contractors rising with the main upside in major iron ore contracts
-UBS survey suggests Coles is regaining momentum

 

By Eva Brocklehurst

Second Half Club

Deutsche Bank notes ASX earnings forecasts for FY18 have been resilient, as downgrades have tended to come through at this time of the year. The bulk of the support for the market is coming from the resources sector which remains in an upgrade cycle.

Still, the broker concludes the picture is not that bad the rest of the market and moderate growth appears likely. There are the usual concerns that a lot of companies are in need of a big second half in order to hit forecasts in the wake of first half results that were on the lean side. The broker suggests this risk is not really that evident this time.

Stocks that have a higher-than-normal skew to the second half and could potentially be regarded as candidates for downgrades, the broker assesses, include Aurizon ((AZJ)), Amcor ((AMC)), Boral ((BLD)), Domino's Pizza ((DMP)), Mirvac ((MGR)) and Tabcorp ((TAH)). Consensus forecasts also suggest downside risk for Adelaide Brighton ((ABC)), AMP ((AMP)) and Newcrest Mining ((NCM)).

Companies which have the potential for a smaller-than-normal skew to the second half include CSL ((CSL)), REA Group ((REA)), Star Entertainment ((SGR)) and Stockland ((SGP)). The broker adds BHP Billiton ((BHP)), BlueScope ((BSL)) and Rio Tinto ((RIO)) to this list, amid upgrades to spot commodity prices, as well as Monadelphous ((MND)) and WorleyParsons ((WOR)) as upgrade candidates.

Banks

Funding costs have risen in recent weeks for the banks and Macquarie observes this has been driven by a spike in the bank bill-OIS (overnight indexed swap) spread. The spread has widened to around 50 basis points from around 22 basis points in the second half of 2017. This affects banks that have an overweight position in mortgages and loan portfolios that are priced off the cash rate.

The broker estimates that a 10 basis points increase in these spreads reduces bank margins by -1-2 basis points and earnings by around -1%. While negative for short-term returns, the spike in funding costs is not considered structural. Banks are expected to raise mortgage rates to offset this.

The issue is also affecting banks globally, although Macquarie finds the precise reason unclear. One possible explanation could be at the result of tax changes in the US, as this offers corporations an opportunity to repatriate funds which were held overseas. This led to a drop in demand for short-term securities and a widening of spreads.

Macquarie continues to believe bank valuations are attractive at current levels, and while the underlying growth profile is subdued, banks are still expected to return capital to shareholders via special dividends and buybacks.

Banking Royal Commission

The Royal Commission into Financial Services has completed two weeks of hearings involving bank misconduct in the consumer lending area. Indicative findings unearthed a number of breaches of legislation, regulatory guidance and company policy.

Banks are likely to be paying a considerable amount of remediation costs and/or penalties. Ord Minnett suggests National Australia Bank ((NAB)) is likely to be the least affected, as its only case study related to the introducer program for which remediation should be manageable and its own whistleblower policy had brought the fraud to light.

The broker expects significant changes to industry practice will be proposed, which should improve lending standards and provide a further constraint to household credit.

The four main regulators involved in banking oversight appear to the broker to be at cross purposes in fulfilling their mandates, which provides mixed signals for the future of banking regulation in Australia. Ord Minnett does not expect a resolution any time soon and suggests confusion may weigh on already depressed bank valuations in the short term.

While interim findings are not due until September, UBS believes the banks will tighten their standards regarding responsible lending. As banks revert to a full assessment of each credit application and comprehensive credit reporting is rolled out the broker believes this could lead to two potential scenarios.

The first is a credit tightening where assessed household income is reduced and the household expenditure measure (HEM) benchmark is increased over time and the housing market slowly deflates.

The second is a credit crunch where income assessment is tightened and the HEM is lifted significantly to more realistic levels. This could sharply reduce credit availability, especially for lower income households, and may result in an economic downturn.

Telcos

Ord Minnett estimates total industry fixed broadband and NBN penetration were up 81.1% and 31.1% respectively in the first half of FY18. Broadband subscriber additions were below estimates, as digital subscriber line (DSL) subscriber losses were greater than expected, despite the additions to the NBN subscriber base coming in above estimates.

The broker estimates Telstra ((TLS)), TPG Telecom ((TPM)) and Vocus ((VOC)) all lost share while Optus gained. Within the NBN, Ord Minnett notes Optus and Vocus gained share while Telstra and TPG lost. Telstra and TPG lost voice share while Optus and Vocus gained.

Total reported fixed broadband revenues were in line with estimates, at $1.97bn, while total voice revenues of $1.59bn were worse than the broker expected. Optus was the only provider to report better-than-expected outcomes.

Contractors

Ord Minnett finds volumes among contractors in Western Australia encouraging and companies are starting to envisage potential for price rises. In terms of contracts a lot of work is going on at the moment in gold, lithium and other minerals but the main upside for many contractors will be major iron ore contracts.

After visiting 11 contracting companies in Perth the broker notes cost concerns are widespread, with the potential for increasing labour rates as foreign capacity has exited the market and infrastructure expansion is underway on the east coast.

The broker notes, since February, the one-year forward price/earnings ratios of contractors have de-rated by -19%. This could be the result of short-term buying opportunities or the start of an industry de-rating, as valuations are still 38% above the 10-year averages.

In this environment, Ord Minnett prefers those stocks that have earnings upside and undemanding valuations. The broker's order of preference for the sector is RCR Tomlinson ((RCR)) with a Buy rating, followed by CIMIC ((CIM)) and Monadelphous with Hold ratings and then ALS ((ALQ)) and Downer ((DOW)) with Lighten ratings.

Supermarkets

UBS suggests, from its survey of 1100 Australian grocery shoppers over February, that Coles is regaining momentum. This was the main surprise in the survey along with a deceleration at Aldi. Price is becoming a less important driver of expenditure, which is a positive for industry growth and profit.

Shoppers appear to be visiting Coles ((WES)) more often and its share of wallet is increasing. Woolworths ((WOW)) continues to perform well, the broker notes, particularly in fresh, although there are signs its share gains are peaking. Aldi and IGA were both softer.

The survey showed customers were visiting the major supermarket chains more often at the expense of independents and discounters and promotional fatigue is setting in. This results in non-price factors such as loyalty, service and store theatre becoming more prominent.

While Metcash ((MTS)) food & grocery continues to decline, albeit in line with UBS estimates, few catalysts are envisaged for underperformance, given the cost reductions and upside to hardware.

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ABC ALQ AMC AMP AZJ BHP BLD BSL CSL DMP DOW MGR MND MTS NAB NCM RCR REA RIO SGP SGR TAH TLS WES WOR WOW

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