The Wrap: M&A, Apartments, Housing, Telix Pharmaceuticals, Afterpay/Square

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Weekly Broker Wrap: M&A drive, apartment uptick, housing’s lifestyle-driven diaspora, Telix’s product pipeline, Afterpay/Square’s global non-bank reincarnation

-Boardrooms pivoting towards the recovery phase and relative valuations are key drivers of heightened M&A activity
-High-density residential activity expected to grow by over a fifth during next two years
-Heightened demand for housing away from major city centres unlikely to reverse post-covid
-Afterpay represents Square’s first move of scale to monetise opportunities from both consumer and merchants

By Mark Story

M&A: What’s driving the current boom?

Despite being in the middle of a global pandemic, merger & acquisition (M&A) activity has accelerated meaningfully through 2021, and Wilsons estimates that around 5% of the market cap of the ASX200 is under pending or formally announced M&A since January 2021.

During previous M&A cycles activity peaked at circa 20% of (ASX200) market cap being acquired, and with conditions for deal-making unlikely to slow near term, Wilsons expects an annualised run-rate of 10%.

Adding to these estimates were takeover approaches for Sydney Airport ((SYD)) and Afterpay ((APT)) witnessed over the past month, with the latter being the largest deal in Australian corporate history (by equity dollar amount).

Past M&A cycles have often coincided with a peaking of both economic and market cycles. However, this time around Wilsons suspects the M&A cycle has the potential to be more enduring, especially within industries facing long-dated structural challenges and the need to right-size businesses or reposition into the right sectors.

Wilsons believes the improving business cycle – with boardrooms across the country now pivoting towards the recovery phase — and relative valuations are two key drivers of heightened M&A activity. As a case in point, the broker cites Santos’ (STO)) bid for Oil Search ((OSH)) which was driven by a desire to lift production growth post-2024/25 when Santos’ volume growth slows.

Then there’s the $8.25 bid from a group of industry super funds (led by IFM) for Sydney Airport, which Wilsons suggests is a clear example of private investors taking a much longer-term view, despite concerns about the near-term earnings outlook.

While Wilsons also attributes heightened M&A activity to the disruption factor – typically the threat of technological or regulatory change – and shareholder activist pressure, the broker thinks Environment, Social, Governance (ESG) factors could be a significant driver of M&A over the next decade.

For example, the broker cites BHP Group’s (BHP)) speculated divestment of its petroleum assets as reflecting further pivot from ‘old world’ carbon-intensive commodities, while social issues were behind Woolworths' ((WOW)) spin-off of Endeavour Group ((EDV)).

Wilsons screened the ASX 200 across three measures: Earnings yield above risk-free 3%, free-cash-flow (FCF) yield in the top quartile of the ASX200, and relative share price performance year-to-date on the bottom quartile of ASX 200, to identify the most potentially attractive M&A candidates.

Based on Wilsons' analysis only five stocks received ticks in all three of the above-mentioned boxes: Scentre Group ((SCG)), NRW Holdings ((NWH)), Deterra Royalties ((DRR)), AGL Energy ((AGL)), and AMP ((AMP)), which has already attracted acquirer interest this year.

While Wilsons' screen is a simple guide to what companies could hold appeal to an acquirer, the broker notes Crown Resorts ((CWN)) and Challenger ((CGF)) have also received acquirer interest this year. For the former, land and property values significantly underpin the share price, and Wilson notes the latter could benefit from additional scale.

Other companies which did not meet at least two factors of Wilsons screen, yet still regarded as M&A potential candidates by the broker, include: The a2 Milk Company ((A2M)), Ampol ((ALD)), APA Group ((APA)), United Malt Group ((UMG)), and Treasury Wine Estates ((TWE)).

Meanwhile, when looking at M&A currently in play, Wilsons is confident the takeover of Afterpay by US-based payment giant Square will proceed.

Similarly, the broker believes Sydney Airport is leaving the door open to further discussions with the current suitor IFM (or other parties).

Apartments: Investment attractiveness improves

While apartments were the biggest driver of the previous national residential construction upturn, the sector fell into a funk two years ago when investors took flight due to additional taxes, and stricter lending practices.

As a result, oversupply in some markets saw activity over FY19 and FY20 down -27% and -21% respectively, and since then pandemic uncertainty has suppressed apartment activity by a further -8% in FY21.

However, the apartment market appears to be climbing out of the abyss with first half 2021 high-density dwelling approvals exceeding expectations, up 15% on the previous period. BIS Oxford Economics is forecasting high-density residential activity to record 20% growth in FY23 and 25% in FY24.

While inner Sydney and Melbourne rental markets were hit hardest by the collapse in overseas migration, almost all other major markets have tightened, with rental vacancy rates dipping below 1% for most cities.

While national gross unit rental yields have held firm at between 4% and 5% for more than a decade, the sub-2% returns on fixed income means the yield premium accruing to units has never been this high. Adding further attraction, the boost to rents is acting to sustain yields with standout markets like Perth and Darwin up 15% and 20% respectively year-on-year in July 2021.

For households that have increased savings and benefitted from rising wealth throughout the pandemic, Oxford believes recent developments – plus low borrowing costs and Australia’s economic rebound — have boosted the case for residential property as an investment option.

What’s also adding to the attractiveness of apartments, adds the forecaster, is the boom currently underway in commuter rail investment. A series of transformative projects scheduled to come online over the next five years, including the Sydney Metro (stage 2), Cross River Rail in Brisbane, and the Melbourne Metro Tunnel Project, are set to draw out increased infill residential investment, including above station developments.

Oxford expects any increase in property values and rents, courtesy of increased convenience and connectivity via new public transport nodes, to provide a significant incentive for developers to press forward with developments in surrounding areas.

However, inner-city in-fill areas aside, Oxford notes that a shift in demand towards lifestyle locations, and the normalisation of working from home, have seen the recovery of apartment approvals in 2021 focused within middle and outer-ring capital city areas and regional centres.

Unsurprisingly, net internal migration to regional areas also reached a series high in first quarter 2021. Centres close to capital cities such as Newcastle, Wollongong, Geelong, and the Gold and Sunshine Coasts are key benefactors, and Oxford expects this trend to hold for the coming years.

As a leading indicator for new apartment construction, the forecaster sees the notable upswing in the volume of new apartment projects currently marketing across Australia as a positive sign for the sector. Fuelling this upswing, adds Oxford, is a further trend improvement in pre-sale interest, but this assumes the impact of lockdowns on demand proves to be transitory.

At the state level, efforts to reignite demand include Victoria and the ACT introducing stamp duty exemptions for owner-occupiers purchasing off-the-plan apartments. The latter has also waived stamp duty on new apartments within Melbourne City Council that have not sold for twelve months or more.

Oxford also expects overseas migration – which is expected to lift back to a trend inflow of 250,000 people from FY24 – to further boost the current strong upturn in apartment construction. The forecaster expects annual high density starts to grow 50% to near 50,000 dwellings by FY24.

Housing: High-rise units out – peri-urban locations in

National property buyer’s agency network BuyersBuyers expects the trend to more flexible work arrangements and working from home –evident within the Australian economy before the pandemic – to continue well into 2022.

The buyer’s agency suspects these trends will have become so entrenched within another 12 months that they are unlikely to fully reverse. While office occupancy is expected to pick up again when international borders reopen in 2022, the buyer’s agency suspects more office employees are likely to work a hybrid model comprising 2 or 3 days in the office a week and the remainder from home.

What’s also unlikely to reverse, adds BuyersBuyers is the covid-induced desire to have a housing market foothold in more desirable lifestyle locations.

As a case in point, the buyer’s agency is receiving increased levels of enquiry from buyers seeking peri-urban locations — zones of transition from rural to urban land use — away from the major city centres, yet still within a reasonable travelling distance.

Recent data gathered by RiskWise Property Research also suggests coastal markets have fared best of all since the pandemic began. The property researcher notes top performing markets over the past year were Byron Bay, Sunshine Beach (Noosa), and Buderim, while Orange and Mittagong have also been exceptionally tight.

Meanwhile, RiskWise is also witnessing underwhelming investor appetite for high-rise units, where rental markets have been particularly soft over the past year, especially in inner-city Melbourne. As a result, the property researcher notes a corresponding reduction of dwelling approvals for units of four storeys or above, far below their previous market peaks experienced several years ago.

With net overseas migration expected to remain low at least until second quarter FY22, RiskWise urges investors to be wary of markets with a high volume of supply in the pipeline, especially inner-city Melbourne.

Telix Pharmaceuticals: FDA approvals pending

With the company’s first major product release on the cusp of approval in several major markets including the US, Bell Potter has initiated coverage on Telix Pharmaceuticals ((TLX)) with a Buy (Speculative) rating and a target price of $8.00, suggesting 44% upside to the current price.

A pharmaceutical group specialising in the development and commercialisation of radiopharmaceuticals for the imaging and treatment of certain cancers, Telix has partnered with radiopharmaceutical giant Cardinal Health for the US market.

Bell Potter believes the major short-term catalyst for the stock includes the company’s first major product approval of Illuccix for molecular imaging of metastatic prostate cancer for both initial staging and biochemical recurrence, due in September 2021.

The company has filed for registration in 17 countries in total with the addressable market value across the US and Europe estimated at US$900m.

Illuccix is expected to be the first prostate cancer imaging agent of its kind designed for commercial application to use the radioisotope 68Ga1. Bell Potter expects the drug to generate in excess of $90m in its first full year of commercialisation (being 2022).

The broker expects Illuccix to be the first in an extensive product pipeline, with the second and related product for renal cancer imaging nearing completion. It’s understood there are no radiopharmaceutical competitors in this market and the approval study, ZIRCON, is approaching completion by the end of 2021.

The drug was awarded Breakthrough Designation by the US FDA and Bell Potter expects approval in 2023.

In addition to the imaging products, Telix and others have developed the first generation of radiopharmaceuticals intended for therapy. With the development of radiopharmaceuticals for therapy still in its infancy, Bell Potter believes Telix is exceptionally well positioned to leverage its technology in the development of new products and applications over many years.

While other developers including Novartis have competing therapies, the broker believes Telix’s products are highly differentiated and superior either in efficacy or cost to those currently on market or close to approval.

Bell Potter notes Telix’s ability to achieve profitability is dependent on a number of factors, including its ability to complete successful clinical trials, obtain regulatory approval for its products, and successfully commercialise them in key markets.

If there are delays to the expected approval timetable, the broker expects the company to continue relying on shareholders to fund the business.

Afterpay/Square: The next global non-bank giant?

Given that it promises to blur the lines between consumers and merchants, Wilsons believes the pending takeover of Australia’s Afterpay ((APT)) by US-listed fintech Square has the potential to create a global non-bank financial giant.

Afterpay is expected to add 10% to Square’s revenue base from 2022, with shareholders receiving 0.375 Square shares per Afterpay share and owning around 20% of the combined business.

With no global fin-tech company having successfully linked both sides of commerce divide, the broker suspects a ‘third horizon to monetise’ exists for Square. This opportunity, explains Wilsons, is predicated on a combined Afterpay-Square entity offering everything from merchant hardware, payments, merchant services, lending, investing and loyalty within a single platform.

The broker notes Square’s merchant offering is already morphing from a simple payments system to an ecosystem of financial services, while the company’s Cash App is a substitute for a bank account for many younger customers.

In Wilsons' view, Afterpay represents Square’s first move of scale to monetise this opportunity and believes the company can take its cue from Afterpay’s pioneering approach to a payments system offering BNPL, while also lead generation for its merchants.

Wilsons believes the combination of Afterpay and Square could be incredibly powerful given that the former is long top-tier large global merchants, and the latter is underweight large merchants.

Similarly, the broker adds Square needs to continue to build out its Cash App with new functionality and notes BNPL is the fastest growing area within payments. Square has previously talked about the Cash App as having a $US60bn opportunity from 100m customers.

On the flipside, Wilsons also notes given that Afterpay needs more resources, the BNPL service will benefit from greater governance, global expertise, and capital.

Overall, the broker concludes the prospects for owning Square remain attractive, especially in light of the high growth disruptive opportunity it presents, which is a clear challenge to the traditional banks.

Wilsons believes investors are only partly attributing any value to what the third horizon of success could look like for Square. The broker believes a combined Square/Afterpay could be worth well in excess of the current combined market cap of $US160bn.

As well as reducing the share price volatility that has plagued Afterpay over the last 12 months, the broker also expects this outcome to decrease the stock’s sensitivity to potential capital raisings.

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