Weekly Reports | Nov 22 2019
Weekly Broker Wrap: Australian banks; Australian casinos; China; Costa Group; private hospitals; and private health insurance.
-Australian bank boards edge towards reining in management rewards
-Despite cautious outlook lack of supply discipline among Chinese steel makers evident
-Extended drought likely to jeopardise Costa Group's water levels
-Incrementally positive trends continue for Ramsay Health Care
-Margin headwinds continue to build for private health insurers
By Eva Brocklehurst
Boards on Australian banks have moved to appease investors by reducing the performance rewards for management. Poor structures, accountability and criteria have been directly linked to serious issues in the sector since the GFC.
Citi considers 2018 was the low point for sector remuneration. Inappropriate remuneration structures were central to the conduct issues identified by the Hayne Royal Commission.
The findings have forced APRA (Australian Prudential Regulatory Authority) to address the issues, although Citi notes there has been open resistance two key proposals such as (1) 50% of variable remuneration should be based on non-financial measures and (2) 60% should be deferred for at least seven years.
The broker asserts remuneration structures need reforming and better transparency and less board discretion is the only way forward. Yet Citi is cautious about the willingness to correct scorecards via board discretion and notes a lack of transparency still prevails.
Citi remains cautious about the outlook for the Australian casino industry as around $4bn of total expenditure is being deployed to projects that are delivering returns below the cost of capital.
Moreover, following a very challenging FY19, the outlook for the Australian VIP market remains tough. Citi forecasts a return to growth in FY21 with Crown Resorts ((CWN)) more leveraged to a potential recovery.
The domestic consumer is likely to be the driver of Australian casinos, accounting to 50-60% of earnings and valuation and a recovery is underway following fiscal and monetary stimulus, in the broker's view. On a relative basis, Citi prefers Crown Resorts over Star Entertainment (SGR)) given relatively superior asset quality and an undemanding valuation.
Almost all industry participants Morgan Stanley met on a trip to China were fairly bearish, particularly on the property market. An economic slowdown has been widely acknowledged but little mention was made of trade tensions.
Views regarding demand centred on low growth. The main risk is a slowdown in property starts. High property prices and a shift to rural buyers are making sales more difficult, while developers have financing difficulties and need to keep building and selling to generate cash, hence the elevated level of new starts.
Despite the cautious outlook for demand, the broker encountered a lack of supply discipline in the steel industry. Although total capacity is still falling, effective capacity could increase over 2019-21, as idle capacity is used in swaps. Moreover, Tangshan-based steelmakers were finding ways to increase capacity at existing plants.
The mills are sustaining lower iron ore inventory versus the usual 20-40 days, not wishing to buy in a falling market. Near-term demand has the potential to turn out better than the steel mills expect and, hence, Morgan Stanley suspects a re-stocking cycle may be on the way.
Tangshan steelmakers generally expect the iron ore price to fall to US$70-75/t by the end of the year, although Morgan Stanley suspects a US$90/t price is more likely.
Macquarie also spent time in Tangshan, the biggest steel city in China, and agrees the sector appears strong at present given the fall in inventory, although few believe the situation will last. The broker agrees feedback was generally cautious about demand. The broker notes policy makers are expected to lower the GDP target to 6.0% next year, allowing activity to moderate.
This is not expected to create significant issues in employment, and conditions are supported by increased fiscal expenditure, finance support to industry and a more flexible exchange rate. Nevertheless, in the long run, structural change in Chinese demographics suggests to Macquarie a further slowdown in growth is inevitable.
Credit Suisse believes Costa Group ((CGC)) is at a critical juncture. An extension of drought into the next rainy season jeopardises yields for 12-18 months. A -10% reduction in citrus yield equates to -$26m in revenue and, the broker notes, competitive advantages only count for so much when volumes are in decline.
The price per million litres of water is increasing at 9% per month and average spot prices hit $940/ML recently. The Bureau of Meteorology outlook is for a 20-30% chance of median rainfall and an 80% chance of temperatures in excess of the median until February 2020.
However, the company's 2020 guidance is underpinned by a moderate improvement in water levels and, if the drought continues into the first quarter of 2020, this implies a severe deterioration in dam levels, Credit Suisse points out. Moreover, the broker is sceptical a crop portfolio can be diversified in such a way or to such an extent that production volatility from weather extremes can be avoided.
APRA data show benefits paid to private hospitals were up 6.4% in the September quarter. Private hospital episodes increased 4.2%. Benefits paid for private patients in public hospitals grew 1.1%. While the growth in quarterly private hospital benefits is positive for operators, such as Ramsay Health Care ((RHC)), UBS points out the question remains as to who will ultimately pay.
Presumably, insurers will be seeking a higher level of premium increases from the government and, if this is not forthcoming, it will probably result in more stressed contracting negotiations with hospital groups.
JPMorgan points out leakage to the public system remains subdued as the number of private patients treated in public hospitals fell again. This highlights efforts made to slow this trend appear to have been effective.
However, this has not led to a noticeable pick-up in episode growth in private hospitals, which suggests a portion of patients treated as private in the public system were never reasonably going to be treated in a private hospital.
Macquarie suggests the data highlight incrementally positive trends relative to the prior quarter. The broker believes deployment of capital for Ramsay Health Care at several of its largest sites will support above-industry growth in the near to medium term. Moreover an improved tariff environment in France and the UK will support growth in FY20.
A sharp uplift in claims inflation over the September quarter has compressed industry gross margins to 13.3%. With affordability still an issue, and resulting in falling participation in private health insurance, UBS believes these margin headwinds will continue to build and lower premium rate rises are likely from April. Net margins could fall further, to 2.4% in FY21.
Health fund membership grew sequentially in the September quarter, although membership relative to the population continued its downward trend, JPMorgan notes. The downward trend seems to have levelled out but the broker remains wary of the downgrading of cover, which is less visible.
The data suggest to the broker that premium inflation is now running behind claims inflation, noting the pressures identified by the listed insurers appear to be broadly shared across the industry. This means that all may struggle to push through 3% price increases.
The main positive is that margins are higher for the listed insurers versus peers so the pain can be sustained for longer. Credit Suisse agrees, noting the industry was hoping for a large decline in gross margin in order to convince the government of the need for higher premium rate increases.
While a squeeze is happening the broker suspects it is not enough to force premium rates higher. Credit Suisse also suggests the APRA data demonstrate the cycle has peaked for private health insurers and the question is now about how hard and fast the cycle unravels, and when is the time to consider getting back into the listed stocks.
The broker maintains Underperform ratings on both listed insurers, believing the near-term risk is skewed to the downside and the medium-term risk unclear. Macquarie also expects Medibank Private (Underperform) and nib Holdings (Neutral) will outperform peers although margin contraction appears likely in FY20.
The broker notes the Lifetime Health Cover loading that was introduced in 2000, which penalises those joining the private health insurance system later in life, now finds itself in a conundrum.
The number of those joining the system is less than the number of existing policyholders paying the loading that are finishing their penalty period of 10 years, or are leaving the system altogether. The broker calculates, should this trend continue for the next 12 months an additional -100 basis points of margins could be removed from the industry.
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