The Wrap: Trade Deal, China, Demergers, Consumer Spending

Weekly Reports | Jun 18 2021

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Republished to correct statement that post demerger, Woolworths and Endeavour will most likely be ASX20 and ASX50 companies respectively, which was incorrect in the initial story published earlier today.

Weekly Broker Wrap: Trade deal with the UK, China consumption softens, Woollies calls time on drinks, consumer spend shift

-Aust/UK FTA viewed as a boot-camp for future UK trade deal negotiators
-Growing concerns pro-growth macro policy in response to China’s prolonged domestic weakness could backfire
-Competition for household savings expected to become fierce

 By Mark Story

Trade deal on training wheels

Given Australia accounts for just 2% of UK exports and 1% of UK imports, the speedily constructed trade deal between the UK and Australia is understood to have very limited economic implications for now. But according to DBRS Morningstar, the inherent value embedded within the yet to be inked deal is the opportunity it provides the UK to gain experience in negotiating trade deals.

As well as this being the first free-trade agreement (FTA) the UK government has negotiated "from scratch" after Brexit, and Morningstar suspects the conflict-free trade deal with Australia will also be one of the easiest. While far from perfect, Morningstar suspects the Australia/UK trade deal is all important dummy run going into more difficult trade deals, especially with the US.

Morningstar also suspects a larger implication of the deal could be that it helps the UK join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). This outcome would open more export markets to the UK.

While Australia supports a UK membership of CPTPP, Morningstar notes this would require additional trade negotiations, which could be more difficult to negotiate than the trade agreement with Australia.

Key highlights of the trade deal include tariff-free trade for all British goods, access to Australian government procurement contracts for British companies, and greater recognition of UK professional qualifications across many Australian sectors.

The trade agreement also provides protection from competition to some other industries, particularly to British farmers. The agreement is also expected to boost the UK services industries, which accounted for 56% of the total exports to Australia in 2020, while enhanced access could also be favourable to British tech companies.

China: Weaker consumption outlook

With the pace of covid vaccinations in China rising markedly in May and remaining elevated so far in June, the prospect of reaching herd immunity in the country this year has increased. While this could bolster consumption in the second half, Oxford Economics thinks prolonged domestic weakness could create a policy dilemma for Beijing.

Oxford is concerned that a more pro-growth macro policy in response to prolonged domestic weakness could increase financial risks and leverage rather than contain them.

Household consumption recovery remains fragile with the latest holiday spending data showing that spending was still -25% below pre-pandemic levels in June. Real retail sales grew 10.1% year-on-year in May after expanding 15.8% year-on-year in April.

According to Oxford’s estimate, sales grew 2.1% month-on-month, which is not enough to offset the -4.9% contraction in April. The recent covid outbreak in Guangdong is also weighing on near-term consumption outlook.

But Oxford suspects consumers will eventually become more comfortable with public health conditions and their own economic situation.

While credit growth decelerated further in May, Oxford still expects domestic demand to gain pace beyond the current soft patch, but admits headwinds are very strong. Oxford also expects improved profitability and business confidence to support corporate investment.

But the economic forecaster is concerned corporate investment may not not improve fast enough, and the other types of investment slow more than expected.

Meanwhile, the recent rise in producer price inflation (PPI) is creating headwinds for Chinese corporates and will likely squeeze profitability in downstream industries and dampen corporate investment. Oxford thinks cost pressures are unlikely to rise a lot further, though the risk remains significant.

International commodity prices are expected to stop rising soon as supply picks up in the coming months and other bottlenecks are resolved.

Overall, consumer price inflation remained subdued, registering 1.3% year-on-year in May. While pork prices fell back to mid-2019 level, fuel prices surged 21.3% year-on-year, and core (non-food, non-energy) inflation stood at a modest 0.9% year-on-year.

However, producer price inflation accelerated to 9% year-on-year in May from 6.8% y/y in April, which Oxford attributes mainly to the recent surge in commodity prices globally. As price increases are highly concentrated in mining and heavy industry, Oxford thinks it’s unlikely the recent surge in producer prices will lead to uncomfortably high CPI inflation or large increases in China’s exports prices.

While China’s exports are also facing near-term headwinds, Oxford thinks strong global economic recovery should support the country’s export outlook and industrial production through this year.

Demergers: A win-win for parent and spin-off entity

Wilsons data reveals that over the last ten years, demergers have typically seen the spin-off entity perform more strongly, by around 2x, than the parent entity over a 12 and 24-month period. The longer the timeframe from demerging, the stronger the performance differential tends to be.

As a case in point, Macquarie Atlas Roads, which was spun out of the now delisted Intoll Group early in 2010, and nowadays operating as Atlas Arteria ((ALX)), is up 155% in the last 24 months.

Two other examples include Orora ((ORA)), which split from Amcor ((AMC)) in December 2013 and Scentre Group ((SCG)) which split from Westfield ((URW)) a month later:

In the past 24 months both spin-offs are up 94% and 69% respectively. By comparison, in the last 24 months the parent companies Amcor and Westfield are up 41% and 60% respectively.

Overall, Wilsons data proves convincingly that demergers in Australia typically create value for both the parent entity and the spin-off. Both companies usually outperform the market in the year post the demerger, and Wilsons expects the current demerger of liquor business, Endeavour, from Woolworths ((WOW)) to achieve the same outcome.

Woolworths is proposing to separate Endeavour’s 330 hotels and 1300-plus liquor stores (Dan Murphy’s and BWS) and shareholders will vote on the split today. Assuming the demerger proceeds, eligible shareholders will own an equal number of shares in two separate ASX-listed companies.

Post demerger, Woolworths will emerge as a pure-play food retailer with 1200 supermarkets in A&NZ and a balance sheet in a net cash position (ex-property leases). As per Wilsons commentary, this opens the door for capital management and several new investment initiatives designed to provide growth optionality/mitigation against potential technological disruption of the core supermarket business.

Post demerger, Woolworths and Endeavour will most likely be ASX20 and ASX50 companies respectively.

Wilsons also expects the removal of Endeavour – one of the largest gaming machine owners in Australia – from Woolworths to improve the supermarket operator’s relative Environmental, Social, Governance (ESG) rank within S&P/ASX50 companies. Conversely, the broker expects Endeavour as a stand-alone hotel operator and distribution business to benefit from a more focused management and capital allocation policy.

Wilsons expects the pending recovery in volumes post covid to provide an earnings recovery into FY23. The broker also thinks Endeavour could trade on a premium multiple given the quality of its properties, the relative security of cash flow, and growth prospects.

Wilsons argues the long-term growth aspects of Woolworths are marginally lower post demerger. However, overall, Woolworths is seen as a business that can grow core supermarket revenue at around GDP levels, equating to mid-high single-digit earnings growth over the medium term.

With $2bn of franking credits, Wilsons believes the potential for an off-market buyback or special dividend by Woolworths at the upcoming FY21 results is elevated.

Consumer spending: Next shift is underway

According to Deloitte Access Economics research, while consumer spending is expected to grow strongly in 2021-22 as households draw down on savings, retailers will have to compete for consumers’ dollars as more opportunities for spending open up.

Deloitte’s latest quarterly Retail Forecasts reveals Australian retail spending surged through most of 2020-21 with consumers left with little else to spend on through the pandemic.

The strong outlook for spending relies on households drawing on any war chest of savings as fiscal stimulus measures unwind and income growth remains muted. All states but Victoria are expected to have retail spending growth above 4% for 2020-21 with the big winners being Western Australia, Queensland and New South Wales.

However, Deloitte expects the retailers that profiteered from a restricted economy are likely to face headwinds in this new financial year. Categories that boomed last year, including supermarkets, specialty foods and liquor, apparel and household goods, all contracted over the March quarter.

While growth in retail spending is expected to reach a decade high of 5.9% in 2020-21, after such a large surge, the forecast for 2021-22 growth is a more modest 0.9% gain. Deloitte expects non-food industries to likely experience the greatest slowdown in retail spending into 2021-22, especially apparel and household goods retailing.

Deloitte’s notes March quarter data show the spending shift is already underway. The easing of restrictions and a need for social contact is supporting eating out and other activities at the expense of other retail spending.

Cafe spending is expected to perform more strongly than Deloitte estimated last quarter at the expense of supermarket spending which is expected to weaken further.

But despite a slowdown in spending growth over 2021-22, with the international borders still closed, and city-wide lockdowns still happening, Deloitte believes retailers can still expect sales to remain well above pre-covid levels.

The savings built up by many over the past six months are expected to play a pivotal role in supporting spending going forward.

While March quarter household disposable income remained strong, growing by 3.4%, Deloitte is witnessing the driver shifting from government support to employment growth. But given the withdrawal of fiscal support, Deloitte also expects disposable income growth to slow for the remainder of the year.

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