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The Wrap: BNPL, Oz Travel, Oz Banks, Property

Weekly Reports | May 28 2021

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Weekly Broker Wrap: BNPL competition hotting up, corporate travel rebound, banks poised to splash more cash, listed property & the WFH dilemma

-It’s not prohibitively expensive/difficult to replicate Afterpay's product
-Flight Centre most at risk from Qantas' cut to commissions
-Corporate travel bookings now at 85% of 2019 levels
-Capital management a key upcoming catalyst for major banks
-74% surveyed favour a hybrid model of working

 By Mark Story

BNPL: Afterpay & Zip Co under fire

Given the relatively lower barriers to entry into the BNPL sector, UBS has run a ruler over key players from a competitive standpoint in search of those most exposed to downside risk from newcomers. Much of the broker’s concern relates to the sustainability of market leader Afterpay ((APT)).

Afterpay's ((APT)) product has clearly resonated strongly with consumers and management has executed well so far. The company dominates the Australian market with 67% of underlying sales in the December 2020 half, and in the US is the number two player (39%) behind market leader Affirm (45%).                                                                                                 

If the company’s economics hold as it scales, UBS thinks it is possible for Afterpay to generate a return on equity of 55%-plus.

However, the broker has for some time recognised the downside risk of competition eroding such returns, and these concerns underscore the Sell thesis UBS reiterates on Afterpay, witha well-below-consensus target price of $37.

Simply put, the broker’s Sell thesis on Afterpay is predicated on the market’s ignorance or market mispricing of the capital required to fund future growth, and the risks around competition, regulation and execution.

While in the US competition exists from the likes of Affirm, Klarna, PayPal, Quadpay and Sezzle ((SZL)), here in Australia, competition is also emerging from Commbank ((CBA)) and PayPal's planned entry.

What concerns UBS the most about Afterpay is the cost of BNPL versus other forms of payment. The broker notes BNPL providers' all-in costs are significantly higher than other transaction types in Australia, and especially those of Afterpay.

While Afterpay's product is presented as free to consumers who pay on time, the company contractually prevents merchants from passing on its cost to customers. In other words, it is a transfer of the cost of financing from the consumer to merchants.

In the broker’s view this creates a distortion which significantly influences consumers' choice of payment method. Given Afterpay's systemic cost is multiples of other payment types with economics that generate an excess return, UBS concludes that competition is likely.

Regulatory intervention also poses a potential risk, with the broker concluding it would open up the opportunity for even more competition given it would allow a free market to operate in the BNPL sector.

Bottom line is UBS does not think that it is prohibitively expensive or difficult to replicate Afterpay's product. The broker notes, the balance sheet value of Afterpay's Core Technology & PPE was $69m at June 2020, excluding investment that has been expensed rather than capitalised. In full year 2020, UBS estimates that Afterpay's underlying operational expenditure base around $232m.

But Afterpay isn’t the only large player that UBS has competitive concerns about. For Zip Co Ltd ((Z1P)), the second largest player in the Australian market (22%) the broker sees a threat that similar products to CBA's free 'Pay in 4' product may emerge.

The broker notes this a risk to Zip Co’s 'QuadPay anywhere' product where users incur a $1 instalment fee.

As a result, UBS has lowered income margin assumptions for Zip Co over the medium term and has lowered the price target from $6.75 to $5.60. The UBS base-case scenario factors Zip Co more than doubling its A&NZ customer base from full year 2019 to full year 2025. Internationally, the broker assumes 4% population penetration in US and 3% in the UK with underlying sales per customer of $1,070 annually.

UBS raises questions over whether Afterpay and Zip Co will be able to match PayPal's reach. The broker expects the impact of PayPal's 'Pay in 4' product which is offered at no additional cost to merchants – with a take rate that is approximately half that of Afterpay's – to be significant.

UBS notes, PayPal's global merchant reach was almost 400x that of Afterpay and 750x that of Zip Co as at December 2020. The broker also highlights PayPal's marketing spend of $2.7bn in calendar year 2020 compared with Afterpay's $108m and Zip Co’s $30m.

Oz Travel: Corporate travel re-emerging

JPMorgan can’t see the decision by Qantas ((QAN)) to reduce commissions paid to travel agents from 5% to 1% from July 2022 having a material impact on either Corporate Travel Management ((CTD)) or Webjet ((WEB)). However, the broker expects the announcement to have a much greater effect on rival Flight Centre ((FLT)) with around with around 2.9% of group totoal transaction value (TTV) at risk.

Underscoring JP Morgan’s key assumptions is the broker’s analysis of Flight Centre’s first half 2020 results which include: A&NZ typically being 63% international, with Qantas being 15% share of the company’s corporate A&NZ international TTV but lower for leisure. Then there’s 30% of corporate travel which is unmanaged and commission-earning, while 100% of leisure is commission earning.

Managed business travel is a program that manages the booking, budgeting, analysis and travel policy performance. However, under unmanaged business travel programme, organisations allow their business travelers to manage their own travel within a set company travel policy.

By Comparison with Flight Centre, the broker concludes that both Corporate Travel and Webjet only have 0.2% of TTV at risk. Webjet’s disclosure of supplier rebates makes this analysis slightly easier with the company reporting 7.5% of group revenue from supplier rebates.

JPMorgan assumes 30% relates to airline commissions and within that 12.5% is Qantas’ share, which is in line with the broker’s assumptions for Flight Centre’s leisure business.

By comparison, the broker’s key assumptions in this analysis of Corporate Travel’s calendar year TTV include: A&NZ is typically 40% international, Qantas is 15% share of the company’s A&NZ international TTV, with 20% of corporate travel being unmanaged and commission earning.

While there is a high level of uncertainty around what overrides may look like on the resumption of international travel, JPMorgan suspects these conceivably rise, offsetting the impact of Qantas’s recent announcement.

On the positive side for the agents, the broker thinks competitors could see the decision by Qantas to reduce commissions by 80% as an opportunity to grow market share. But on the negative side, JPMorgan suspects this could serve to re-base payments to the industry lower.

In the broker’s recent discussions with Flight Centre, the company has indicated that commission discussions with other international carriers have resulted in broadly flat to up outcomes.

Meantime, with border openings remaining “an unknowable event’, Corporate Travel’s high exposure (around 60%) to domestic travel is a key driver of JPMorgan’s Overweight rating on the stock. Equally encouraging, the broker notes the company’s exposure to the US and UK, where vaccination programs are much further ahead than Australia.

Given vaccinations will almost certainly be a key factor in the re-opening of borders and establishment of bilateral bubbles, the broker believes this places Corporate Travel in a strong position. While at the depths of the pandemic corporate travel was a key unknown, it has since resumed with indicative data points now looking promising.

Qantas announced that corporate activity is back to 75% of pre-covid levels, and Corporate Travel reported that as of the week commencing 12-Apr-21, total A&NZ bookings were 85% of 2019 levels.

Specifically on Australian borders, JPMorgan believes this is a key risk for Flight Centre which is the broker’s least preferred stock in the travel and leisure sector. The broker believes the prospect of other airlines following Qantas and cutting international commissions by 80% is another key uncertainty, making Flight Centre incrementally more difficult to justify as an investment.

Oz banks: $22bn to be returned to shareholders

While first half 2021 results were strong and largely as expected, especially when headwinds from lower markets income are stripped out, capital management remains a key upcoming catalyst for major banks.

Due to the positive impact from more favourable credit risk migration, which drove lower credit risk density, the bank’s capital ratios at half year were appreciably ahead of JP Morgan’s estimates.

Credit risk weighted assets growth averaged -3% for the banks September year end. However, ANZ Bank ((ANZ)) was less than this, due to institutional run-off.

All of the majors now sit comfortably ahead of APRA’s minimum tier one capital requirement of 10.5%, with an average capital surplus of around 8% of market cap (based on 11% minimum).

Commenting on timing of possible capital management, Westpac ((WBC)) indicated it would likely wait until APRA has finalised its new capital rules, while National Australia Bank ((NAB)) suggested it could act before this.

JP Morgan expects Commbank ((CBA)) to be the first to lead off, with an announcement likely at its full year 2021 result in August.

Over the next 3 years, JP Morgan thinks the banks could return up to $22bn to shareholders. The broker expects Commbank and Westpac will do much of this through tax-effective capital management (including structured off-market buybacks), while ANZ and NAB’s returns will be substantially through on-market buybacks.

The major banks' guidance on target payout ratios include: ANZ targeting long-term payout ratio of 60% to 65; NAB’s future dividends to be guided by a payout ratio range of 65-75% of cash earnings; Westpac sustainable payout ratio 60-65%: and Commbank’s long-term full year dividend payout range remains 70-80%.

Given the decline in returns throughout the industry, especially in the current low rate environment, JPMorgan thinks lower payout ratios are justified.

Beyond the long-term cost outlook, which has already attracted a lot of attention, the other notable development at half year highlighted by JPMorgan was mounting evidence to suggest that competition in the SME sector has started to intensify, particularly from Commbank.

Historically, NAB has dominated this part of the market, which JPMorgan has viewed as one of its key differentiating factors. While NAB has said it is confident it can protect its share, at the very least the broker thinks it is at greater risk now than it has been in the past.

Major bank economics teams expect weaker business lending growth relative to housing growth in financial year 2021 and calendar year 2021, despite very strong business confidence survey readings.

The major banks easily outperformed the ASX200 through the May reporting round, and are now trading on a PE of 15.3x, which is more than one standard deviation above its five-year average.

Listed property: Employers/employee tug-of war-over WFH

Macquarie’s latest Recruiter Survey reveals a notable discrepancy between what employers and candidates want. Survey results indicate that 74% of candidates would prefer a hybrid model of working (with three days in the office preferred), while only 2% want to work in the office full time.

By comparison, only 56% of employers favour a hybrid working model, while 32% prefer employees to come into the office full time. While candidates are accepting lower remuneration packages for flexibility, employers are encouraging staff to return to the office.

While the preference for candidates to work from home has increased over the past three months one positive for landlords, notes Macquarie is only 8% of candidates wanted to work from home full time.

Given the relatively tight skilled labour market, Macquarie suggests employers will need to be less rigid in their thinking around working in the office to attract talent. Highlighting the need for greater flexibility, the latest Property Council of Australia survey indicated physical occupancy in the Sydney CBD is currently 59%, which is not expected to improve materially over the next three months.

Greater flexibility is now the most cited reason influencing physical occupancy, which is a shift away from the health/safety concerns of calendar year 2020.

Macquarie expects office space requirements to reduce given this increased flexibility. However, given that the decision maker remains the employer, the broker expects the absolute level of handbacks to more likely to be on their terms.

While the cyclical recovery in demand appears stronger than Macquarie’s expectations in January, the broker is cautious on becoming too exuberant in relation to the impact on vacancy/rents. Key risk remaining space handbacks from larger employers as the transition to work from home continues.

Macquarie continues to expect vacancy to remain between 12-14% in the Sydney CBD. The broker’s preferred office exposure is Charter Hall Group ((CHC)), Outperform, given the long weighted average lease expiry (WALE) of its portfolio and upside for an improvement in equity inflows for its office funds. The broker also has Outperform recommendations on Dexus Property ((DXS)) and Mirvac Group ((MGR)).

Meantime, in Melbourne a vacancy of 14.3% compares to 3.4% pre-covid levels. The majority of the vacancy changes were driven by a cyclical reduction in demand as economic activity slowed over 2020. This has pushed incentives up to 31% in Sydney and 34% in Melbourne, with anecdotal evidence suggesting incentives are 3-5% higher in each market.

Looking forward, Macquarie expects supply completions to drive vacancy increases through calendar year 2021.

In Sydney and Melbourne, workplace visitation is down ~28% and -31%, respectively, when compared to February 2020. Based on Macquarie’s data, the recovery in Sydney appears to have slowed over recent months.

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