The Wrap: Packaging; Insolvencies; Commodities, Debt & Banks

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Weekly Broker Wrap: Amcor's upside; covid insolvencies; commodities recovery; public debt, mortgage restrictions; scams

-Amcor trading on attractive valuations
-Transition to green economy not driving the super-cycle
-Ten-year yield of 3.5% a trigger point for questioning debt sustainability
-Next macro-prudential round may focus on limiting high DTI lending

By Mark Story

Packaging: Amcor benefits from above-average volume trends

Solid packaging volume trends across both food and beverage categories bode well for Amcor ((AMC)). The consumer packaging company is benefiting from US and EU monthly rolling three-month food volume growth up 11% and 5% respectively versus the previous period; and US sports drinks and soft drinks up 15% and 6% versus the previous period.

UBS believes these support the organic growth outlook for Amcor, and help offset short-term raw material headwinds. Driven by the recovery in oil prices and supply outages due to the recent US freeze event, Amcor's key input cost, PET resin has increased significantly in the March quarter, up around 50% versus the period prior.

The broker expects the raw material inflation impact for Amcor to be most pronounced in the fourth quarter FY21, with resin pricing likely to moderate through the June quarter as PET production normalises.

When Amcor reports its thrid quarter earnings in early May, UBS expects the company to at very least reiterate its FY21 guidance of 10-14% EPS growth, underpinned by solid organic volume growth, merger synergies and buy-back accretion.

UBS is attracted to Amcor's leading position across key global consumer packaging markets, which helps underpin FY21 earnings per share (EPS) growth of 14% and a solid dividend yield of around 4%.

Looking into FY22/23, the broker expects EPS growth to moderate to around 6%, but notes this could be supplemented by further share buy-backs or M&A given Amcor's surplus free cash flow (FCF) of circa US$450m.

Valuation also appear attractive to UBS, with Amcor trading at a one-year forward P/E of 16x, a 33% discount to the ASX200 Industrials versus a long term average discount of 10%; and a 27% discount to S&P500 versus a long term average discount of 5%.

Insolvencies up: But no tsunami as originally feared

CreditorWatch expects Australia's new insolvency regime (effective 1 January 2021) to open the ‘administration’ flood gates for companies that only managed to stave off going bust due to covid measures, allowing a temporary freeze on trading while insolvent.

What’s compounding the expectant rise in companies entering administration is the end of the JobKeeper wage subsidy that artificially propped up many ‘zombie’ businesses, which without government measures would have otherwise failed. Best estimates by the Australian Securities and Investments Commission (ASIC) suggest an additional 3000 businesses would under normal trading conditions have entered administration after becoming insolvent last year.

Based on a 61% jump in external administrations in February 2021 versus January 2021, CreditorWatch suggests this trend is turning around. While CreditorWatch doesn’t expect the tsunami of insolvencies anticpated last year, the digital credit reporting agency expects to see sustained increases in administration numbers until they reach normal levels.

Given that it’s no longer viable for relaxed insolvent trading rules and artificial stimulus measures to continue, CreditorWatch believes the onus is on businesses to assess their potential exposure to debtors that may be heading towards insolvency.

McGrathNicol Restructuring urges companies to look downstream at their customers and assess their solvency. Equally important, adds McGrathNicol, second-guess if suppliers are still financially viable, and where the risk exposures are within the supply chain.

McGrathNicol expects to see a rise in company-led restructuring through 2021, with stakeholders like the federal government, the Australian Taxation Office and the banks likely to be more willing to support restructuring solutions than in the past.

McGrathNicol is witnessing loan-to-own transactions as a growing trend in restructuring, where the lender takes control of the business using the insolvency process to restart the business and implement a new business model.

Commodities: Super-cycle rhetoric overcooked

Without the industrialisation and urbanisation of an economy like India and/or Vietnam, Commbank’s global economics and markets research team does not believe we are on the cusp of another commodity super-cycle.

While some parallels can be drawn to the great inflation period in the US from 1965-1982, Commbank believes meaningful comparisons with what’s now playing out are seriously overdone. The bank expects it to take several years before the US labour market is tight enough to spill over into faster growth in wages and consumer price inflation.

Having concluded that transition to a decarbonised economy, supply constraints, and reflation are not key to the next super-cycle, the analysts argue that a cyclical recovery better explains the current recovery in commodity prices.

Commodities heavily exposed to the green transition, like lithium, copper and nickel, are most at risk of tightening in the medium term. But Commbank points out ambitious decarbonisation goals are straying significantly from current policy settings, and even in the post-covid world, stimulus measures have not prioritised a green economy.

As a result, Commbank argues that the global transition to a green economy is not the structural driver of a super-cycle today. If the super-cycle expectations are truly baked in, Commbank would have expected capital expenditure as a ratio of cash flow would at very least be rising, rather than falling to its lowest level since 2004.

Commbank believes a green transition will eventually happen. But the bank’s concerned that the speed of the transition may be slower than country ambitions suggest, due to the sizable cost of energy transition and an unclear pathway to decarbonisation.

While not taking action on climate change is too costly for governments and policymakers the greater challenge, argues Commbank, is the sacrificing short to medium term economics for the longer term benefits of acting on climate change now. When looking at the current ‘green’ stimulus to date, Commbank concludes that it is difficult to project that the world is on track for rapid decarbonisation.

Having concluded that supply constraints look more like a risk than a base case, Commbank thinks it’s too early to surmise that supply is incapable of plugging a shortfall later this decade. While a commodity-wide assumption of a short-fall isn’t justified just yet, Commbank concedes that a current covid economic recovery could lead to market tightness in several commodities in the near-term.

The bank can see a stronger case for copper and nickel markets facing supply challenges in the medium term, especially if the world decarbonises quickly.

US public debt: Serviceability in question

With US federal debt expected to rise to around $35tn in 2023, UBS questions whether the corresponding debt-to-GDP ratio – which rises from its December 2020 level of 129% to 133% at the end of 2023 – is simply too high.

This metric scales debt by the size of the economy by comparing a stock (debt level) with a flow (GDP). One way to think of it is to take the discount stream of future income to compare to the stock of debt.

But while comparing the debt/GDP ratio over time for this purpose implicitly assumes the discount factor is roughly stable, UBS reminds investors during the last 40 years Treasury yields have trended sharply lower.

In lights of these dynamics, the broker argues that a more appropriate measure of debt sustainability is interest-expense-to-GDP, which since 2003 has been well below the early 1990s peak.

UBS projects this ratio through 2023 using interest expense as a percentage of public debt — the average cost of debt. The measure is highly correlated with the 10 year nominal rate.  

By roughly translating 10 year yields to interest service costs, the broker concludes that if the 10 year returned to 2019 yield levels of 2.4%, interest expense as a share of GDP would go to 3.4% at the end of 2023. UBS notes that this level is well below the 4.7% peak observed in 1991.

Under UBS’s projections of GDP and further fiscal stimulus, the broker calculates that if the 10 year yield went to 3.4%, the interest-expense-to-GDP ratio would roughly equal the 1991 peak. While a yield of 3.4% is not in UBS’s forecasts, the broker concedes that given the 10 year hit 3.2% as recently as 2018, it is clearly possible.

Given that in 1991 there was not a strong view that public debt was too high, UBS takes a 10-year yield of around 3.5% as the point where sustainability should begin to be questioned, not the tipping point where it becomes a problem.

UBS also reminds investors that even Chair Powell in a recent interview echoed similar sentiment when, he stated: "Given the low level of interest rates, there's no issue about the United States being able to service its debt at this time or in the foreseeable future."

Banks: Different macro-pru solutions now required

While the risk of macro-prudential tightening has increased in Australia in light of rising house prices and very low interest rates, JPMorgan expects any action taken by the regulator APRA to be more nuanced than previous efforts, especially with interest-only and investor lending both under control this cycle.

At a recent Banking Summit, APRA Chairman Wayne Byres did not see cause for immediate alarm. Speaking specifically on risks in the housing market, Chairman Byres made it clear APRA has no mandate to target the level of house prices, or to improve housing affordability.

Byres also noted that while household debt levels are undeniably high, serviceability of debt is being supported by historically low interest rates.

Nevertheless, assuming the pace of house price growth continues, JPMorgan expects APRA action later this year. Having concluded that low interest rates in tandem with government support for first time buyers are driving house prices higher, the broker concludes a different package of solutions is now required.

JPMorgan envisages future APRA actions potentially involving either a focus on limiting high debt to income (DTI) lending, and/or increasing focus on loans approved with slim net income surpluses (NIS).

Commenting on APRA’s previous macro-prudential measures – including the 10% investor growth cap in December 2014, followed by a 30% of flows cap on interest-only lending in March 2017 – JPMorgan noted that the major bank share prices traded down -2% to -4% in the days immediately following the implementation of these restrictions.

However, within a couple of weeks share prices were broadly unchanged from levels immediately prior to the announcements. In both cases, the broker notes banks used this as a repricing event, with net interest margin benefits helping to offset lower loan growth versus the absence of any macro-prudential initiatives.

JPMorgan expects system housing credit growth to increase to around 5%-6% in FY21-22, with the major banks growing at 3.6% on average in FY21 and 3.8% in FY22 – losing share to Macquarie Group ((MQG)) and second-tier banks.

LVR: A new point of customer differentiation

While front book (new mortgages) pricing on higher loan to value ratio (LVR) loans has probably reached the low point, Macquarie suspects banks are progressively differentiating customers based on their LVRs (as do the UK banks). Despite the process requiring better systems, and bringing with it social implications, Macquarie notes that a differentiated approach to product pricing appears to be in its infancy.

The broker also suspects that with a large proportion of the back-book (existing mortgages) having low LVRs, there’s an ongoing risk to mortgage margins and profitability over the medium term.

After a prolonged period of little differentiation among customers, Macquarie is witnessing banks starting to use differentiated product pricing (owner-occupier versus investor) and more recently, LVR-based pricing.

Using the UK experience – where materially lower rates are offered for lower LVR mortgages – the broker concludes that should a similar margin differentiation to UK banks (across products) hypothetically fully flow through Australian banks’ portfolios, there’s a likely 5-20bps impact to group margins.

Westpac ((WBC)) would be the most impacted while ANZ Bank ((ANZ)) would be the least impacted. However, given the product and regulatory differences, Macquarie doesn’t expect pricing differential in Australia to reaching the levels in the UK, and views it as an additional headwind contributing to mortgage margin compression and lower returns.

Given that the flow into high LVR loans has been increasing, with 80%-plus LVR mortgages accounting for around 42% of mortgage flow, the impact of differentiated pricing is likely to be much smaller than estimates would suggest. However, Macquarie notes that given the increased proliferation of fixed loans, customers may be more inclined to shop for deals when their fixed rate expires, and their LVRs may be lower at that point.

Furthermore, if some of the recommendations from the ACCC were to be implemented, the broker suspects back-book customers with low LVR may be more inclined to switch if the rate differential was attractive.

Commenting on the banking sector overall, Macquarie retains a Neutral sector view, with preference for the regionals over the majors. While stretched valuations and longer-term headwinds make it difficult to be bullish about the bank sector, the broker recognises the relative appeal of banks in the current environment with its preferred exposures being Bendigo & Adelaide Bank ((BEN)) and ANZ.

Investment scams to top $100m

While data acquired by UK-based Finbold indicates Australians lost $65 million to investment scams in 2020, the losses are projected to surge 51.9% in 2021 to $100 million. With the ACCC recording over $14 million in payment redirection scam losses by businesses already this year, Finbold is also projecting annual losses of around $100 million.

Highlighting a link between digital transformation and the coronavirus pandemic on the increase in scams, Finbold’s report suggests different forms of scam losses are expected as fraudsters exploit new ways to prey on victims.

For example, with advancements in technology, scammers continue to deploy sophisticated hacking, including new phishing techniques that include spoofing. Scammers are also increasingly leveraging social engineering and impersonating individuals and organisations to steal credentials and money.

Equally concerning in light of sophisticated hacking, Finbold notes that despite the pandemic not being fully contained, more people will still turn to digital platforms for managing finances.

The top five scams in Australia in 2020 highlighted with the Finbold report include: Investment fraud (39%), dating and romance (23%), false billing losses (11%), or $19.32 million, threats to life and arrests (7%), and remote access scams (5%).

Commenting on the current outlook of scams and the future, the research report highlighted a notable uptick, with the first two months of 2021 already accounting for around 30% of last year's value.

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