The Wrap: Telcos, Insurance, REITs, Wealth Platforms

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Weekly Broker Wrap: Telcos upside; supermarkets margin gap; insurance catastrophe blowout; US tax, wealth platforms; BNPL; beef

-Telstra/TPG forecast to enter period of strong cash flow
– Online grocery retailing could reach 15% of market by 2026
– Reinsurance pricing forecast to rise again on July 1
– Passive yield stocks offer attractive valuation

By Mark Story

Telcos: Earnings inflection for Telstra/TPG

UBS' Buy ratings on Telstra ((TLS)), with a $3.70 price target, and TPG telecom ((TPG)), with a  $7.60 price target, are premised on the broker’s expectation that both stocks could be entering a period of strong sustained free cash flow (FCF) generation. Underscoring UBS’ outlook is the expectation of an underlying earnings inflecting though to FY23.

Given the recent underperformance of TPG Telecom following ex-chairman David Teoh's resignation, the stock is the top pick within UBS’ telecommunications coverage. However, the broker sees a higher degree of risk to its forecasts.

UBS also remains positive on Telstra and has increased its medium term (FY25+) dividend per share (DPS) forecast to 17cps.

The broker’s view for both Telstra and TPG is premised on industry returns inflecting and sustaining over the medium term. But with the strong free cash flow outlook, UBS notes there may be an incentive to compete on price to take market share at some stage in the medium term.

Key drivers

Numerous factors contributing to this outlook are a relatively rational mobile competitive environment, the removal of NBN headwinds (including costs associated with NBN migrations & running parallel ADSL networks), and a rebound in covid-induced headwinds. Then there are additional drivers, including optionality from NBN bypass/other 5G business cases, and cost reduction programs (including TPG-Vodafone merger synergies).

UBS expects capital intensity to fall following the completion of 5G network rollouts. Having investigated the cash flow profiles for Telstra and TPG over the medium term, UBS sees potentially six years of sustained FCFs significantly above earnings from FY23 in the absence of growth investment opportunities.

Telstra

While UBS understands the importance of Telstra's dividend, particularly for retail investors, the broker thinks the telco should resist the temptation to permanently move to a FCF-based dividend framework. This is because spectrum auctions beyond explicit forecast years (FY28-FY30) may require significant cash outlays (dependent on the structure of these licences, including the duration/terms of payments).

The broker also thinks its unlikely sufficient franking credits can be generated to sustain a fully franked dividend above earnings per share (EPS) over the medium to long term. Then there’s the issue of financial flexibility which UBS suggests should be maintained to allow Telstra to invest in new growth opportunities should they arise.

The broker notes that with the proceeds from any potential sell-down in TowerCo to be utilised for a combination of debt reductions and share buybacks, a transaction could simplistically be seen as swapping financial leverage for operating leverage. By proportionately capitalising TowerCo's leases, the broker believes the value accretion from any partial TowerCo sell-down should be measured against a share buyback financed by debt involving an equivalent increase in leverage.

Even relative to UBS’s bull case TowerCo sale scenario ($5.4bn enterprise value), the broker estimates it may be slightly (less than 1%) more EPS accretive for Telstra to undertake a share buyback. However, UBS acknowledges this does not factor any potential value uplift to Telstra’s share price due to the equity market valuing these assets on a higher multiple.

5G-led earnings upside

UBS expects Telstra to be the first to benefit via direct 5G monetisation in the consumer segement. Given its excess network capacity, the broker expects the benefits to TPG Telecom from 5G are potentially more long-dated and fixed wireless access (FWA) led. UBS also notes that TPG should eventually benefit from a much stronger post-covid rebound relative to peers.

The broker believes investors are still largely valuing Telstra on a dividend yield (~16c DPS on a 5% net dividend yield), which the broker suspects undervalues the telco infrastructure assets, and does not fully capture incremental improvements in the earnings outlook.

When it comes to TPG, UBS thinks investors should focus less on the short-term covid-induced earnings dip, and evaluate the telco on a normalised earnings profile. The broker thinks TPG can lift 2020 earnings (EBITDA) of $1.8bn back to over $2bn by 2022.

Supermarkets: Online and offline margin gap to close

Macquarie believe online grocery retailing can reach 15% of the market by 2026 if current growth trajectories are maintained. This channel is significantly margin dilutive, with delivery and pick-up costs dragging down profitability.

However, the broker believes online margins can be improved by automation, monetising a fat tail of stock keeping units (SKUs), lowering wastage, monetising virtual shelf space, and driving click & collect.

Macquarie expects Woolworths' ((WOW)) faster rollout of its network and its proximity to customer to provide the group a formidable platform to defend its market position.

However, the broker believes Coles ((COL)) extensive product offering (60,000 SKUs), freshness of product, and near perfect levels of order fulfillment should lead to significant customer satisfaction. But this assumes the group can convince customers to come across once the system becomes operational in 2023.

Online profitability

Macquarie now believes online groceries have the potential to be as profitable as the offline channel if well managed and alternative ways of monetising the network are utilised. The broker notes that recent performance of Coles' ((COL)) Ocado-based customer fulfillment centre suggests volume and monetising virtual shelf space are the key ingredients to a profitable online channel.

The current margin differential between online and bricks & mortar supermarket margins is around 500bps. Macquarie notes that online offerings at present don’t have the scale to fractionalise pick-up costs. Customers are also reluctant to pay either for delivery, or pay higher prices online than in-store.

However, Macquarie believes Ocado demonstrated with its FY20 results that a number of key drivers could close the gap versus traditional bricks & mortar supermarket retailing margins. Key drivers the broker is referring to include: A mix of higher gross margin through wider pricing on a fat tail of products, higher turnover fractionalising pick-up costs, lower spoilage rates delivered by efficient inventory management, and charging manufacturers for virtual shelf space.

While Macquarie expects it to take years to be able to pick a winning online strategy, the broker believe that the partnership with Takeoff affords Woolworths a significant head start with embedding customer behaviour and lowering the cost of serving online customers. Once the full offering from Ocado is operational, Macquarie also expects Coles to be better equipped to retain online customers.

Insurance: Catastrophe budget blowout

While new home pricing retained around 7% year-on-year growth in the March-21 quarter, Morgan Stanley thinks insurers need to sustain this pricing given rising catastrophe costs and reinsurance.

Both Insurance Group Australia ((IAG)) and Suncorp Group ((SUN)) are now likely to exceed their FY21 catastrophe budgets, with Morgan Stanley estimating FY22 catastrophe budgets of $700m for IAG (up $40m year on year) and $980m for Suncorp (up $30m year on year).

However, the broker sees risk that IAG’s catastrophe budget rises by even more, given it has exceeded its budget by more than Suncorp in recent years, which had a large rise in FY21.

Morgan Stanley notes that IAG and Suncorp have both been using aggregate covers in recent years to stabilise their catastrophe costs. The broker thinks reinsurance pricing will rise again on July 1, particularly on loss-making Australian aggregate covers which are an issue at a global level.

Based on the broker’s index, domestic motor pricing on new policies increased just over 5% year on year in the March-21 quarter, up from around 4.5% in the December-20 quarter. While this is driven mainly by the recent normalisation in motor loss outlook with a rebound in driving activity. Morgan Stanley thinks insurers may also be pulling the pricing lever in motor to make up for rising input costs in home.

The broker has Equal-weight ratings on both IAG and Suncorp , and price targets of $5.00, and $11.10 respectively.

REITs: Passive yield stocks, attractive valuations

Based on its evaluation of strategic opportunity versus relative valuation, Jarden initiates coverage on seven passive/rent-collecting REITs, and assumse coverage of Homeco Daily Needs REIT ((HDN)) with the 12-month target price rising to $1.55 from $1.50.

The broker has a Buy rating on Centuria Industrial REIT ((CIP)) and Homeco Daily Needs, Overweight on Shopping Centres Australasia ((SCP)), Charter Hall Social Infrastructure REIT ((CQE)) and Arena REIT ((ARF)), Neutral on Centuria Office REIT ((COF)), Underweight on Aventus Group ((AVN)), and a Sell rating on BWP Trust ((BWP)).

Jarden prefers exposure to non-discretionary retail through Homeco, Shopping Centres and Charter Hall Retail ((CQR)), based on these stocks' ability to boost growth with developments and acquisitions.

The broker likes the Childcare/Social Infrastructure thematic and favours Arena for its development-based approach and Charter Hall Social Infrastructure for broadening into the wider social infrastructure space.

Jarden also prefers exposure to commercial through Centuria Industrial, which the broker expects to benefit from the strong growth in logistics/e-commerce/supply chain efficiency theme.

After -5% year to date underperformance for the sector, Jarden believe passive yield stocks offer attractive valuation, with 14% weighted average total shareholder return (TSR), 5.8% dividend yield and 4.2% 3-year compound annual growth rate (CAGR) in funds from operations.

Also adding to attractive valuations is strong support from demand for real assets, ample balance sheet capacity to invest in value-add acquisitions or developments, and downside risk protection from the potential for restructuring and/or potential M&A activity.

Despite concerns around rising bond yields, Jarden acknowledges that the recent rise in bond yields has not helped sector performance. But the broker highlights that bond yields are still well below five- and ten-year average levels.

Jarden also believes the exceptional low levels of recent bond yields was never reflected in valuations.

The broker also notes that spreads of sector cap rates and dividend yields over bond yields remain high, and that demand for real assets seems unaffected by the recent moves in yields. Jarden expects the sector to benefit from rising inflation if this is the driver behind rising bond yields, and ultimately remains cautious on the outlook for growth and inflation, supporting its lower-for-longer thesis.

While the A-REIT sector has underperformed the S&P/ASX200 by -4.25% over the last three months and 7.5% over the last six months (despite strong earnings and upgrades to forecasts), Jarden believes this is mainly driven by the significant increase in US and Australian ten-year bond yields since their trough in August 2020.

The broker also notes that demand for real assets seems unaffected by the recent rise in bond yields, and based on recent transactions, the demand and pricing for Australian real assets remains at record high levels. If inflation is the driver behind higher bond yields, Jarden expects the sector to benefit.

While Jarden doesn’t expect a significant increase in structural inflation beyond the current covid recovery, the broker notes that the sector/asset class has historically been a good inflation hedge in a rising growth environment.

REIT Fund managers

Due to them being well capitalised, with significant operating leverage, and growing appetite for alternative assets, Jarden believe it's a good time to be investing in fund manager REITs.

Also underscoring Jarden’s preference for active REITs over passive REITs in the current environment is the strong demand for real assets returning in Australia as we cycle covid lows — $12bn was transacted in the fourth quarter 2020 versus $14.4bn combined for the first quarter, second quarter and third quarter 2020.

As a result, the broker is initiating coverage on Centuria Capital Group ((CNI)) at Overweight and resuming coverage of Home Consortium ((HMC)) at Overweight (was Neutral).

This accompanies Jarden’s recent initiations on Charter Hall Group ((CHC)) and Goodman Group ((GMG)) with Buy and Underweight ratings respectively remaining unchanged. While pricing looks elevated on face value, the broker believes the significant tailwinds and scalable and repeatable business model will drive outperformance.

Jarden prefers exposure to the REIT fund managers through Charter Hall Group based on superior funds under management growth.

Aussie equities: Little to fear from US tax hike

Macquarie suspects the positive impact of higher US infrastructure spend on industrial metals could outweigh the negative from a US tax hike for listed Australian stocks.

Assuming US president Joe Biden increases the US corporate tax rate to 25% from 21%, Macquarie assesses the ASX Industrials earnings per share impact at 0.6% compared to a near -3% headwind for the S&P500.

Everything else being equal, as the tax hike becomes more likely, Macquarie expects to see some US earnings per share (EPS) downgrades. However, the broker expects some of these downgrades to be offset from higher infrastructure spend.

Based on their high US exposure, Macquarie estimates a tax hike to 25% could cut EPS by -3% or more for the following ASX stocks: Austal Ltd ((ASB)), Appen ((APX)), James Hardie ((JHX)), Aristocrat Leisure ((ALL)), Incitec Pivot ((IPL)), Janus Henderson ((JHG)), Cochlear ((COH)), Breville Group ((BRG)) and Resmed ((RMD)).

Macquarie notes Biden’s infrastructure plan supports industrial metals – notably steel (construction and transport infrastructure) and copper (power infrastructure and electric vehicles). For this sort of exposure, the broker’s strategy portfolio has positions in BHP Group ((BHP)), Mineral Resources ((MIN)), OZ Minerals ((OZL)), Bluescope Steel ((BSL)) and Seven Group Holdings ((SVW)).

Macquarie also notes that the positive EPS impact for resources from higher US infrastructure spending might more than offset the EPS headwinds from a US tax hike. As higher US infrastructure spending supports industrial metals prices, the broker also expects it to be a support for the Australian economy and the Aussie dollar.

This provides another reason, concludes Macquarie, to favour domestic industrials over offshore earners.

Wealth platforms: Re-ratings for Hub24 and Netwealth

Following the removal of pricing overhang from the sector, plus an encouraging near-term outlook for flows, Macquarie has upgraded wealth management platforms Hub24 ((HUB)) and Netwealth Group ((NWL)) to Outperform from Neutral. The re-rating follows ANZ Bank’s recent decision providing twelve months’ notice to Netwealth ahead of terminating their current agreement for interest paid on pooled cash accounts.

Macquarie expects a more rational pricing environment going forward, with cash spreads to be clawed back as rates increase over the medium-term.

While it’s still unclear what rate the platforms will receive at the end of their current agreements, Macquarie notes current market rates would imply a -50bps reduction (RBA cash rate +45bps), which has driven the broker’s mid-teens earnings downgrades in FY23.

Should deposit competition intensify over the next twelve months, Macquarie believes it is possible platforms will be able to negotiate rates above the current RBA +45bp currently being factored in.

While there may be some further downward pressure on deposit rates in the near-term, Macquarie sees scope for deposit competition to re-emerge later this calendar year. This is expected to be driven by the RBA ceasing its term funding facility and with credit growth likely to increase from current levels.

Macquarie notes that for every 10bp increase in cash spreads, Netwealth’s earnings would increase by 4-5%, with Hub24 seeing a 6% uplift (due to a lower earnings base and lower earnings margin).

The broker expects the platforms to see margin expansion as cash rates begin to increase again, with the 40bps absorbed from the last two cuts recovered in the next two increases. Macquarie Economics' forecasts are for rates to start to increase from the first quarter of 2023.

While the timing of this is important for when cash spreads will increase, Macquarie notes that delays have a muted impact on its terminal valuation.

BNPL: Call for level playing field

In its review of the 46 submission responses to the regulatory architecture review of Australian payments study (commissioned by the Australian government in October 2020), Macquarie noted that those respondents who mentioned buy now pay later (BNPL) as part of their submissions were looking for more government regulation within the sector.

In part of their submissions in response to a Payments System Review Issues paper issued by the Australian Government Treasury, 63% of stakeholders referenced BNPL, highlighting the topical nature of the payments system.

Over a third (34%) of stakeholders recommended less self-regulation versus current levels, while only 28% were pro self-regulation.

While a third of the submissions made critical commentary on BNPL – the largest critique being lack of regulation creating an uneven playing field – 7% of the respondents had views which were pro-BNPL. Other critical comments also related to merchant fee pressure, BNPL debt and not empowering true greater economic choice.

Commenting on the lack of a level playing field within its submission, National Australia Bank noted that new entrants to Australian payments such as BNPL are not typically subject to the same self-regulation and independent regulatory standards.

Within other submissions, the Financial Rights Legal Centre noted that BNPL providers are thriving in a regulatory black hole, and the inability for merchants to allow surcharging for this payment option is distorting the market.

As highlighted in its report “Afterpay: Buy Now Pay 2030”, 24 March 2021, Macquarie expects to more pain before gain for the BNPL industry as a whole. Beyond industry consolidation, the broker sees increasing regulatory pressure as one of the pain points which need tackled before industry recovery longer-term.

Beef: Supplies at critically low levels

As historically low breeding cattle numbers slowly recover on the back of much-improved seasonal conditions, Rabobank believes Australia has a once-in-generation opportunity to shape the future of its beef industry. Within a recently released report, titled Green Grass and Empty Pens, the agribusiness banking specialist expects the outlook for the year ahead to be characterised by very limited cattle supplies. 

While this will provide strong support for cattle prices, it also means ongoing scarcity for restocking and fattening, plus challenging capital efficiency, with many plants and feedlots running below capacity.

Bank analysis of regional conditions around Australia – undertaken for the report – showed rebuilding of herds and restocking of properties underway. However, restocking is not consistent across the country, with parts of Queensland and northern Australia having been unable to increase breeder numbers through the course of 2020.  

The report notes that extremely low breeding stocks will severely limit Australian cattle slaughter, (forecast to be down -6% on last year) with the nation’s beef exports expected to drop -5%. Live export numbers are also forecast to decline by the same percentage due to low availability of cattle.

Domestic market

While limited cattle supplies and favourable seasons are expected to provide a strong foundation for cattle prices, Rabobank expects them to ease through 2021 as some of the urgency of producer restocking demand recedes.

Rabobank also expects domestic consumption – expected to account for 29% of Australian beef production in 2021 – to remain relatively steady in 2021, after a decline in per capita beef consumption of -12% over the past two years.

Exports

With low supplies, higher prices, an appreciating currency and reduced access to China, Rabobank claims Australian beef faces significant headwinds globally.

For example, export volumes to China – impacted by high Australian beef prices, low supplies and trade tensions – are likely to see a larger decline than the more stable and established markets of Japan, South Korea and the US.

While long-standing markets like Japan and South Korea are expected to maintain import volumes of Australian beef in 2021, Rabobank expects to see stronger competition from the US, which is likely to increase exports throughout 2021.

Live exports

Based on Rabobank’s seasonal outlook, live cattle exports will also be constrained by reduced cattle availability and higher prices in 2021. While export numbers to Indonesia, which fell -31% in 2020 are expected to recover, Rabobank expects volumes to Vietnam to decline from the large numbers seen in 2021.

However, the bank expects Vietnam to continue to play a significant role as a live export destination for Australia.

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