The Wrap: Property, Contractors & Kaufland

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Weekly Broker Wrap: property; contractors; Kaufland; Royal Commission; general insurance; and Appen.

-Sales growth at shopping centres could slow further
-Ord Minnett wary of holding contractors with expensive valuations
-Kaufland's fresh food credentials likely to lift competitive intensity
-Bank Royal Commission: credit tightening or crunch?
-QBE regains competitive position in insurance broker survey
 

By Eva Brocklehurst

Property

Residual sales growth at shopping centres may slow further as specialty retailers allocate capital to technology and logistics to capture online growth. On this front Morgan Stanley observes that sales at the most productive shopping centres are growing at the greatest rate, while those assets that have not been redeveloped in the past five years have experienced the greatest slowing in sales growth.

This highlights increased capital needs for maintaining a competitive position as consumers become increasingly selective. The rising proportion of maintenance capital expenditure being included in development capital expenditure will also reduce the value that is being created and put pressure on gearing.

The broker suggests demand for regional and fortress malls may not be as deep as previously expected and there may be better opportunities in offshore markets.

Vicinity Centres ((VCX)) is considered good value while the scope for self-help remains high, with the potential clarification of the strategy in May providing a positive catalyst. Stockland ((SGP)) could also unlock latent value from clarifying its strategy in May.

Meanwhile, Mirvac ((MGR)) remains the most exposed to weaker residential sentiment, in the broker's opinion. Scentre Group ((SCG)) has the highest quality but also the most rapidly ageing portfolio and remains most reliant on ongoing increases in asset values.

Contractors

Ord Minnett suggests there is a 1-2 year runway before the peak of the infrastructure cycle is likely to be reached. Expectations for stocks, nonetheless, are relatively high and many are trading at near previous peak PE valuations.

The broker remains wary of holding those stocks trading on expensive valuations, unless very confident of earnings upgrades, but acknowledges there is an argument that activity levels could remain elevated for a number of years.

In the current environment Ord Minnett prefers those stocks with lower relative valuations and/or geographic diversity. A Buy rating is maintained for RCR Tomlinson ((RCR)) while Boral ((BLD)) is rated Accumulate. Adelaide Brighton ((ABC)), CIMIC ((CIM)) and Monadelphous ((MND)) are rated Hold and ALS ((ALQ)) and Downer EDI ((DOW)) are rated Lighten.

Kaufland

Morgan Stanley suggests that high labour costs, store rentals and low competitive intensity, as well as high margin structures, enable another supermarket discounter to prosper in Australia. Kaufland is expected to enter the Australian market late in 2019/early 2020.

The business has strong fresh food credentials that the broker expects will lift the competitive intensity even further. This is likely to lead to reduced prospects for margin expansion and a sector PE de-rating.

Unlike Aldi in its initial phase, Kaufland prioritises fresh food and while there are some similarities, Morgan Stanley notes the customer proposition is also different. In recent years supermarket margins compressed as proactive price investment was undertaken to narrow the price gap to Aldi.

Near term, the broker expects food deflation to moderate because of faster cost growth for imports, and as the majors look to protect their profit pool. This should not be extrapolated long-term, Morgan Stanley warns, as the pricing gap to Aldi and Kaufland is likely to increase the potential for price investment.

The broker maintains an Overweight rating for Metcash ((MTS)) despite the increased competitive intensity in fresh food, because of a stronger performance from self-help initiatives and a lower percentage of sales generated from fresh food. Valuation is also considered attractive and the balance sheet flexible.

Royal Commission

UBS mulls plausible downside scenarios for the A-REIT sector, given the Royal Commission on Financial Services is likely to recommend higher levels of due diligence in order for banks to comply with responsible lending laws.

In one scenario, a credit tightening, the broker assesses that, as banks move to responsible lending over time, credit would be constrained and borrowing capacity reduced around 30-40% in FY19.

The implications for A-REITs in this scenario suggest retail income growth slows to 1% from 2-3% and residential settlement volumes are down around -15%. The the most affected stocks would be Mirvac and Stockland.

In the second scenario, in which income assessment is tightened materially and credit availability is sharply reduced, home loans are likely to fall -25% and -10% in FY19 and FY20 respectively, and there is large downside risk to house prices.

In this instance, where the commission creates a credit crunch, retail A-REIT income growth is forecast to slow to 0-1% and residential settlement volumes drop -40%. In such a case the broker would revise down sector earnings by -5-8% for FY20-21. Those most affected by this scenario are Lend Lease ((LLC)), Mirvac and Stockland.

Credit Suisse notes the Royal Commission will focus its next public hearings on wealth advice and platforms, with two weeks of hearings starting April 16. In May, the focus will be on business lending. The first round highlighted lapses in bank behaviour and this is expected to drag on sentiment until the final report.

Hence, increased legal and preparation expenses will be a cost headwind for the banks in FY18. Nevertheless, the broker envisages clear value in the longer term for bank stock investors as banks improve their reputation.

General Insurance

In analysing insurance broker survey data with regard satisfaction, Macquarie notes Insurance Australia Group ((IAG)) and Suncorp ((SUN)) held relatively flat positions, while QBE Insurance ((QBE)) regained its competitive position network. Broker satisfaction with the top five insurers rebounded to long-term average in November 2017 versus the five-year low recorded in May.

Macquarie believes these metrics are strong predictors of future premium growth. QBE improved on every product but had the lowest and second lowest satisfaction from brokers for the home and personal motor products respectively. Macquarie concludes that these products are non-core and should be divested.

The survey noted an increasing number of interactions were being transferred to call centres as insurers sought to streamline distribution. The report suggests this mix could be a predictor of future broker satisfaction. On average broker satisfaction is around 25% higher in correspondence with an insurer through business development management rather than a call centre.

Appen

Overall, Bell Potter makes no changes to forecasts for artificial intelligence company  Appen ((APX)) but does refined the comparable used in relative valuations. As a result of this change the 10% premium has been removed and a -5% discount applied. The broker's forecasts remain consistent with the company's guidance range for 2018 EBITDA of $50-55m.

Bell Potter expects Appen to at least reiterate 2018 guidance next month at its AGM and there is some chance of narrowing the range towards a higher end, or even an upgrade. At the target price of $11 the total expected return is around 29% so the broker upgrades the recommendation to Buy from Hold.

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