The Wrap: Real Estate, Defence And The Fertiliser Outlook

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Weekly Broker Wrap: Fresh real estate perspectives, small-cap defence stock updates and the global fertiliser outlook.

-Positive for residential real estate, office concerns easing and caution on Melbourne malls
-Two top picks in the small-cap defence sector
-Citi’s bullish view on the global fertiliser outlook

By Mark Woodruff

Real Estate: Fresh perspectives

In the early stages of a post-covid world, some fresh real estate perspectives from Morgan Stanley alleviate some concerns around suburban offices and highlight that residential intentions remain bullish. There is, however, another reason to be cautious on retail mall landlords, when they have high exposure to Melbourne/Victoria assets.

Of the office workers surveyed by the broker, 28% flagged that their employers have taken up more space since returning to work from covid versus 25% who have taken less, suggesting office pessimists may be too bearish.

As most respondents work in metro (rather than CBD) offices, the broker lifts its rating for Centuria Office REIT ((COF)) to Overweight from Underweight and raises its target price to $2.70 from $2.05.

The REIT is a suburban office pure-play, and with occupancy already low at 92.3%, it’s thought the trough has passed. It is trading on a circa 7% dividend yield, which is amongst the highest in the broker’s coverage universe. This is despite the stock offering less earnings uncertainty than other structurally challenged sectors (eg retail), and the REIT having the potential for consensus upgrades, should management execute on re-leasing vacant office space.

With work-from-home preferences only lifting 0.8 days per week, Morgan Stanley sees limited ability for corporates to give back (rationalise) office space, and therefore sees minimal risk from corporates adopting a 'hub and home' model.

Regarding residential, unless operating/financing conditions change materially, the broker thinks the backdrop is positive for the likes of Stockland ((SGP)) and Mirvac Group ((MGR)). Both are rated by the broker as Overweight with price targets of $5.00 and $3.30, respectively.

The survey confirms that the strong market momentum in 2020/21 is driven by underlying demand, rather than government stimulus, paving the way for further growth in FY22. Of buyers surveyed, 30% want to purchase within the next 12 months, up from 21% in Morgan Stanley’s 2020 survey. Whilst this is not as high as the peak of last cycle (38%, in 2017), it does indicate that the market is back to a 'normalised' level.

In terms of product preferences, there is a strong movement towards land and apartments, and away from established detached dwellings, suggesting affordability is a key consideration. This plays into the strengths of Mirvac and Stockland.

The broker notes the bounce-back is still largely driven by owner-occupiers, rather than investors. Of the respondents who said that they intend to purchase within the next 12 months, 57% were intended owner-occupiers, versus 43% investors. This split is in line with 2020 responses.

Morgan Stanley is cautious on retail REITs in general, but has an Underweight rating on Vicinity Centres ((VCX)) and GPT Group ((GPT)), due to 40%-50% of their retail portfolio being exposed to malls in the greater Melbourne area. Extended lockdowns may have altered consumers' shopping habits, or at least mean the recovery period will take longer than for other states.

In the survey, a higher proportion of Victorians now intend to shop online 'significantly more', or 'some more', in a post-covid world compared to other states. This was across all categories including homewares, fashion and electronics. The current NSW mobility restrictions, however, pose further downside risks to all retail landlords.

An increase in online shopping will have the potential to impact leasing spreads across the retail REITs upon the expiry of each lease. As such, whilst covid-related relief deals may have only been temporary, it could be some years before rental income reverts to pre-covid levels for the landlords.

Morgan Stanley estimates it could be three years before GPT Group, Vicinity Centres and Scentre Group’s ((SCG)) retail income gets back to pre-covid (ie FY19) levels. And even then, rental receipts would still be -10%-15% below the pre-covid trajectory, assuming income would have grown at 2.5% per year.

The broker lifts its GPT Group price target to $4.70 from $4.37, largely due to bringing the REIT’s office assumptions into line with the other office owners under coverage. The analyst's target prices for Vicinity Centres and the Underweight-rated Scentre Group are both unchanged at $1.59 and $2.98.

Small-cap defence sector: Two top picks

Citi recently reviewed pertinent news items and forecasts leading into the reporting season for its two top picks in the small-cap defence sector. Austal ((ASB)) is number one, followed by Electro Optic Systems ((EOS)).

The broker forecasts FY21 earnings (EBIT) of $112m (consensus $118m) for Austal, which is at the lower end of the guidance range. Should the Australian government waive penalties related to delays in the Cape Class program, given force majeure circumstances, there could be upside to these forecasts.

It’s believed the company could use its strong cash position to either pursue acquisitions, continue investing in existing facilities, pay down debt or pay dividends. A final FY21 dividend of 3.5 cents is expected. The broker has a Buy rating and $3.35 target price for the company.

Recent news articles indicate Australia plans to domestically manufacture guided missiles in collaboration with the US, with the federal government initially investing $1bn on the plan. This could provide Electro Optic Systems with a potential opportunity to leverage its laser technology for guided missiles. Citi notes the company's recent success with high-powered lasers.

The broker forecasts first half earnings (EBIT) of $3m, excluding foreign exchange and interest income, which compares with a -$16m loss a year ago. Over FY21, earnings of $5.5m are forecast, in-line with the mid-point of guidance and broadly consistent with consensus.

The company is expected to have $79m net cash (excluding leases) at the end of the first half.  Over FY21, the analyst expects the cash position to improve further driven by conversion of contract assets, and the delivery of remote weapon systems to the Australian Defence Force.

Cit currently has a Buy rating and $5.15 target price for Electro Optic Systems.

Citi’s bullish global fertiliser outlook

Citi has maintained its bullish view on the global fertiliser outlook. So far, urea prices are up around 90% year-to-date, diammonium phosphate (DAP) is up circa 50% and potash is up 40%, driving fertiliser and explosive prices. Furthermore, on the fertiliser feedstock side, Citi has raised natural gas price forecasts in all major regions.

Incitec Pivot ((IPL)) remains highly leveraged to fertiliser prices and explosives volumes and Citi lifts its 12-month target price to $3.00 from $2.90. The broker upgrades FY21 and FY22 earnings (EBITDA) by 15% and 4%, primarily driven by sustained elevated ammonia spreads (ammonia – gas price). Citi expects these higher spreads should drive upgrades in FY21/22 consensus earnings.

Compared to the first half, Australian dollar DAP and urea prices are up around 50% and 60% with the Australian dollar-based US ammonia gas spread up around 80%.

A key risk to the broker’s Buy call is the operational recovery path at the underperforming US Waggaman ammonia plant.

For Orica ((ORI)), the broker believes the impact is mixed and leaves both earnings estimates and its $15.40 target price unchanged, given ammonium nitrate volumes are ticking up, while the price remains subdued.

Both Orica and Incitec Pivot have significantly underperformed North American peers on a six and twelve month basis.

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