The Wrap: Demergers And The Oz Economy

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Weekly Broker Wrap: demergers; Oz economy; housing; rates; Aussie dollar; media; and automotive.

-Spin-offs tend to perform better over the medium-longer term
-Adjustment of housing supply to lower demand likely to extend into FY20
-Rate hike expectations continue to be pushed into late 2019
-US dollar nearing cyclical peak suggests downside limit for Oz dollar
-Citi expects AP Eagers to be the best automotive performer in 2018
 

By Eva Brocklehurst

De-mergers

Since 2000 there have been a number of demergers, enabling some businesses to flourish after being overshadowed by their larger listed parents. Of the 17 de-mergers that took place since 2000, DJ Carmichael Research calculates that, after two years, 73% of the spin-offs were trading higher, a similar percentage to the parent. The parents, however, recorded a median return of 9% versus the spin-offs with a median return of 28%.

DJ Carmichael notes, in the short term, spin-offs tend to underperform, as investors with small holdings offload positions, particularly where the pro rata allocation is small. The new entity also frequently requires capital that has not been previously forthcoming from the parent.

Still, the research shows that, over the medium-longer term, these businesses perform well. Also these spin-offs tend to be preferred by investors versus initial public offerings, as there is usually an established track record.

Newly listed Coles ((COL)) is expected to be a stable and defensive business, generating strong free cash flow and likely to attract income-seeking investors, in the analysts view, as management has a pay-out target of 80-90%.

Parent Wesfarmers ((WES)) is likely to become more cyclical and growth-oriented with Bunnings, Officeworks, department stores such as Kmart and Target ,as well as the industrial businesses, although now more exposed to the housing downturn on the east coast. DJ Carmichael expects both companies will perform reasonably well over time.

Oz Economy

Australia's economy for the year to June, 2018 grew 3.4%. This was the fastest pace of GDP growth since September 2012 and above the 20-year average of 3.1%. St George Bank economists expect this will slow to trend in 2019. Business investment growth has also lifted following a period of weakness and the drag from the unwinding of the mining investment boom is easing.

Government spending has supported growth and this should continue in the year ahead, with a focus on health and education. Public infrastructure investment is also expected to be a driver of growth. Meanwhile domestic inflation is subdued, with conditions similar to other advanced economies.

Without a significant pick up in wages growth, the economists find it difficult to foresee inflation rising convincingly. Inflation is not expected to reach the middle of the Reserve Bank's 2-3% target over the medium term.

Housing

The main theme to Australia's economy is a slowing housing market. A gradual but persistent decline in house prices is expected in 2018 and 2019, concentrated in Sydney and Melbourne. Heavy demand for dwellings is also fading, as regulatory measures and tighter lending conditions reduce foreign buyers.

Citi expects the adjustment of housing supply to the reduced demand will extend into FY20, and house prices will remain under pressure for another 12 months. The housing situation will be a drag on economic growth for the next two years, in the broker's opinion.

Citi has Neutral ratings for Mirvac ((MGR)) and Stockland ((SGP)) as both have been sold off on housing concerns. The broker forecasts a -20% decline in volumes for both Lendlease ((LLC)) and Mirvac and -13% for Stockland from FY18-21.

Rates

Financial markets have continued to push out expectations for a rate rise. Markets are estimated to be incorporating an 80.2% probability of a rate hike by the end of 2019. US dollar Libor rates have also lifted sharply over recent months, increasing funding costs for Australian financial institutions that are borrowing abroad.

Citi suggests a correction in housing is likely to make the RBA more cautious about acting on a tightening bias and the first tightening of rates is unlikely until the end of 2019. The broker considers the current policy mix runs the risk of prolonged house price deflation, and remains on the look-out for trading opportunities in Australian dollar short/intermediate rates.

St George economists observe household consumption is lacklustre and the savings rate indicates households may struggle to sustain expenditure without ongoing robust jobs growth. Moreover, high household debt and the slowing housing market will mean consumers remain reluctant to spend.

Citi also expects retail sales growth will deteriorate as the positive wealth affect fades. The broker expects like-for-like sales growth to slow for the likes of Bunnings and turned negative in electronics. Citi retains Sell ratings on JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)).

Aussie Dollar

Downside risks to the global economy continue, amid trade tensions between the US and China. The direct effect of tariffs is not expected to have a material impact on economic growth but rather dent global confidence. The robust US economy has been a major prop to the US dollar and yield differentials have widened as US long-term bond yields have increased rapidly.

In February, the US 10-year yield rose above the Australian equivalent for the first time since the 1990s. This has weighed on the Australian dollar. Yet, St George economists expect momentum in the US economy will slow as the positive impact of fiscal stimulus wanes. This indicates the US dollar may not be far from its cyclical peak, signalling a limit in Australian dollar depreciation.

The economists expect that, over the course of the next year, trade developments will be the major uncertainty for Australian dollar forecasts. The Australian dollar is expected to end 2018 at US72c and 2019 at US70c.

Media

UBS observes advertising booking data for October was very soft, partly because previous Octobers were particularly tough comparable periods. In 2016 AFL and NRL finals fell in October rather than September and in 2017 advertising expenditure benefited from the same-sex marriage debate.

In October 2018 all media declined. Metro TV declined -6.5%, regional TV -1.7% and digital -26.1%, although late bookings are still to come in the latter and could turn this number positive. The broker also cautions that the correlation of the data to reported revenue growth is loose outside metro TV.

A number of advertising sectors were also weak, with food and produce down -27%, banks down -33%, insurance down -18% and restaurants down -19%. Meanwhile, Nine Entertainment ((NEC)) enjoyed a share of more than 40% of the TV advertising market in the first quarter, a share which has continued into October.

Automotive

The latest VFACTS data shows domestic new vehicle sales remain under pressure. Since June 30, 2018 national new vehicle sales are down -5%, with NSW the weakest state. Morgans believes the full impact from recent risk-based finance pricing, following the ban on flex financing, is yet to be felt.

AP Eagers ((APE)) has guided to net profit of $126-130m in 2018 and the broker is pleased the results from its automotive and truck retailing businesses are forecast to be slightly ahead of FY17, given current industry pressures.

Morgans expects the company's automotive result is likely to be the best from the segment in the current year. Automotive Holdings ((AHG)) is expected to provide a weak trading update at its AGM.

Morgans believes the company is being battered by headwinds because of its stronger exposure to the NSW market and the capital intensive refrigerated logistics business. The broker retains Hold ratings on both stocks but maintains a preference for AP Eagers.

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