The Wrap: Oz Property, M&A, Oz Pathology, Travel Agents

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Weekly Broker Wrap: Oz property’s inflection point, acquirers make hay during covid, clear covid-testing winners, Flight Centre re-rated

By Mark Story

-Offline/bricks & mortar retail shut out of future growth in turnover
-Since covid, opportunistic/strategic acquisitions have seen average control premiums double
-Reopening of international travel could see Australia maintain a 200,000/day covid testing rate in FY22
-Credit Suisse upgrades Flight Centre on rapid progression in vaccination rollouts

Oz property: Pandemic winners take all

BIS Oxford Economics notes the pandemic was an inflection point for online shopping, which at its height was growing by almost 80% year-on-year.

While the latest data shows a still-robust online growth rate of 26%, the forecaster notes that even an annual growth rate of roughly half (14%) is sustained over the next 10 years, that will be sufficient to soak up all the forecast growth in retail turnover.

In other words, there would be no growth available to the offline, or bricks & mortar sectors. Once the pandemic effects are worked through, Oxford expects a return to key challenges facing retail, which in addition to the threat from online shopping, include changing consumer spending patterns.

Oxford notes recent lockdowns present a severe blow to the retail property market after a strong but only partial recovery.

The forecaster expects continued pressure from downsizing struggling anchor and specialty tenants, negative leasing spreads, higher incentives and vacancies, and rising capex requirements, combined with softening yields from FY26 to result in 10-year internal rates of return (IRR) of 4% to 7%.  

Oxford believes this realisation goes a long way to explaining why landlords are working so hard to try to capture some rent from online sales that are processed or collected (through click & collect) in shopping centres. The forecaster also expects the pace of growth to progressively slow to less than 10% and hence become a major constraint on shopping centre income growth.

However, not all shopping centres will be affected equally. Oxford expects a firming of yields for regional and sub-regional shopping centres over the next few years and is witnessing evidence they have already ceased softening.

Oxford forecasts around a 40 basis point firming in regional and sub-regional yields to 5.3% and 6.5% in FY25. The forecaster also expects the re-rating of neighbourhoods to be sustained and yields to firm to 5.8%.

However, Oxford expects rising bond rates to push yields higher from FY26 to 5.7% to 7.0%. On this basis, the forecaster expects capital values to record solid gains between FY23 and FY25 before a flat to falling profile to 2031.

There are two key reasons, explains the forecaster, why these dynamics are likely to play out.

Firstly, the yield premium over the long bond rate had blown out prior to the coronavirus and there is some ‘latent’ firming from that source as the premium adjusts. Secondly, the wave of investment funds looking for a home in property and the industrial sector – currently in strong demand – is too big for the size of the sector. 

While Oxford expects a solid rebound when restrictions are lifted, the forecaster expects it will take four to five years for pre-virus incomes to be regained in regional and sub-regional centres.

The forecaster believes lasting damage has come from negative leasing spreads that have an impact for the term of the lease. Adding insult to injury, Oxford also suspects the lifting of lockdowns and reopening of borders will encourage travel and other services spending, hence dampening retail turnover growth.

Overall, Oxford is also forecasting a rise in online market share from 13% to 27% by 2031. Unless captured in ‘click & collect’ the forecaster notes this will leave in-store turnover growth -1.8 percentage points annually weaker than aggregate turnover growth (just 1.3% annually).

All this leads Oxford to a very modest long-term outlook for net operating income of only 1.2%-1.3% annually on average once they have recovered from the near-term setback.

M&A: Acquirers capitalise on distressed capital markets

Research by mid-tier accounting firm RSM Australia suggests the average control premiums acquirers were willing to pay above the traded share price – to gain a controlling ownership interest in an ASX listed company – virtually doubled during the pandemic.

Since covid was declared a global pandemic, which led to significant falls in global equity markets, RSM has observed a rise in control premiums driven by opportunistic or strategic acquisitions.

A "control premium" is implied by the amount of share price offered by a suitor above the current share price.

RSM calculated the implied control premium as (offer price – share price) / share price, based on the closing share price of the target company at twenty, five, and two days before and following the announcement of the offer.

The study revealed that, during covid, average control premiums grew from 32% in the 2019 calendar year to 61% in the 2020 calendar year. This marks a significant divergence from the long-term Australian average over the 15.5-year period of 34.7%.

RSM, which has been analysing takeovers and schemes of arrangement since 2005, notes that control premiums experienced their sharpest rise in April and May 2020, when economic uncertainty was at its peak and acquirers took advantage of the distressed capital markets.

Key factors influencing control premiums, highlighted in the company’s most recent study, include industry sector, consideration and transaction type, timing within the economic cycle, the size of an acquirer’s existing investment in the target, and market cap.

Metals and mining organisations witnessed the highest number of transactions over RSM’s 15.5-year study period. Given that cyclical or volatile sectors collectively represent virtually half (48.4%) of all transactions, the net effect, concludes RSM, could be control premiums in the Australian market having greater variability over time.

However, it was healthcare and telecommunications companies that commanded the highest pre-bid control premiums (48.6%), followed by IT and software companies (44.1%).

The study reveals that scrip deals, which offer ‘relative’ consideration, continue to attract lower premiums than cash-only deals, for which consideration is absolute. Similarly, the study also highlights a strong negative correlation between market cap and the level of control premium paid.

RSM attributes a significantly lower average control premium in NZ (18.6%) over the 15.5-year period, to the uncontested nature of many takeovers in that market. The company also notes lock-up agreements – used to reduce uncertainty and minimise the risk of a competing bid – as opposed to schemes of arrangement which are increasingly popular in Australia – may allow lower premiums to be offered by a bidder.

With interest rates remaining low and companies holding significant cash reserves following a capital raising spree during covid, RSM expects M&A activity to be high in Australia and NZ through FY22 and beyond.

Oz pathology: Two key listed beneficiaries

With Australia looking to reopen the borders when it reaches 80% double dose vaccination rates, Credit Suisse expects PCR testing rates – which have risen over four times the daily average rate from the prior 12 months – are likely to maintain or rise from these high levels. [PCR = polymerase chain reaction]

Credit Suisse notes while Australia is currently conducting 8 tests per 1000 people per day, a base for daily testing rates could be 2-4 tests per 1000 people (50-100,000 daily tests) as Australia learns to live with covid over the next 12 months.

However, assuming a level of 40 million overseas arrivals/departures is re-established in the medium term, as was the case pre-pandemic, and that every traveller needs to do one test both before departure and on arrival, Credit Suisse suggests this could add around 100,000 covid tests per day.

Credit Suisse believes the net effect of these assumptions creates a perfect storm for key players in the pathology sector. As a result, the broker’s base case assumptions lead to FY22 earnings forecast upgrades  of 45% for Healius ((HLS)) and 9% for Sonic Healthcare ((SHL)).

Credit Suisse’s conservative base case – which makes no changes to earnings estimates for any of the other divisions – assumes Sonic and Healius each earn $940m in covid testing revenue in Australia in FY22 – versus $300-350m in FY21 and $140m in FY23.

The broker’s base case revenue assumptions are based on Healius and Sonic holding 18-20% market share of PCR testing market, and assume the former has a slight step up in market share versus FY21 rates.

Credit Suisse is factoring in Australia conducting 200,000 daily PCR tests on average in first half FY22, falling to 125,000 tests in second half FY22 and 44,000 tests in FY23.

However, if full international travel assumptions are also factored into Credit Suisse’s testing forecasts, the broker suggests Australia could maintain the 200,000 daily PCR testing rate throughout all FY22 and falling to 160,000 in FY23.

Overall, the broker believes covid testing has provided both Healius and Sonic with strong balance sheets to pursue M&A and provides further upside to their medium-term earnings outlook.

Despite risks, including volatility in covid testing rates and reimbursements and the impact to the base businesses, the broker retains Outperform ratings on both Healius and Sonic, with the target price increasing to $5.50 from $5.35 and to $46.50 from $45.00 respectively.

Travel agents: Flight Centre emerges as favoured stock

While Credit Suisse continues to remain upbeat on travel recovery prospects and suggests an overweight position on the sector at large, a recent review of listed travel agents under coverage has resulted in the broker recommending a rotation.

Based on an increased line of sight on Australia re-opening, Credit Suisse has upgraded Flight Centre ((FLT)) to Outperform from Neutral. While Flight Centre was Credit Suisse’s least favoured travel company previously, due to onerous government-imposed travel restrictions, rapid progression in vaccination rollouts and a better-than-expected breakeven opportunity have elevated the stock to the broker’s preferred travel pick.

Credit Suisse thinks the corporate division has been a steady gainer of market share. The broker also believes that post a relaxing of travel restrictions, high demand, a lower cost base, limited at-scale alternatives, and increased travel complexity, result in Flight Centre being an attractive operationally levered way to position for the Australia re-opening.

While the re-opening will be challenged by individual states, the broker believes with Australia’s most populous state NSW leading an agenda on re-opening based primarily on vaccination targets, the Australian travel opportunity improves.

As a result, Credit Suisse expects Flight Centre to be the largest beneficiary of near-term news flow amongst the listed travel agent names within the broker’s coverage.

While Credit Suisse makes no changes to earnings estimates, the broker is now basing its target price solely on a sum-of-the-parts (SOTP) valuation, which increases the target price to $19 per share from A$18.

It’s the broker’s view that in the initial recovery the Flight Centre share price will trade based on near-term earnings, given the uncertainties on the longer-term outlook, and may take years until the full extent of the leisure division store network changes will be understood.

Meanwhile, while Credit Suisse recognises that both Corporate Travel Management ((CTD)) and Webjet ((WEB)) also have potential near-term drivers, the broker, for now, has downgraded both stocks to Neutral from Outperform.

Given an undemanding valuation, upside to FY23 consensus due to client wins and release of demand, and with more M&A, the broker had a bullish outlook on Corporate Travel following the full-year result.

While these drivers remain, Credit Suisse’s revised thinking is that if the broker’s top-of-the-market travel recovery estimates are indeed accurate, it will still take time for the market to see enough proof-points given the delta variation is delaying some of the expected travel recovery.

While the share price has continued to rise over this time, the broker still sees upside in the share price, particularly if M&A occurs, but now expects the path to take longer than previously anticipated. The broker has made no changes to earnings estimates and the target price of $23 remains unchanged.

Credit Suisse notes while there is still material upside to consensus estimates and share price if Webjet can achieve its -20% cost reduction initiative, with a targeted 62% B2B division earnings margin, the broker takes caution fully modelling this upside.

Looking into 2022, the broker expects a good improvement in the primarily domestic Australia B2C division but notes the bedbank division has a large profit skew to the six months to September. As a result, the broker suspects investors may have some time to wait to see the full benefits of market share and margin potential.

But even if management’s margin target does prove attainable, Credit Suisse expects it to take time for the market to have sufficient proof points to fully incorporate it.

Nevertheless, the broker still sees upside in the share price, particularly as share gains and strong margins are likely evidenced in certain regions at certain times. Primarily driven by the B2B division, Credit Suisse improves its FY22 earnings expectation from a -$3m loss to a positive $8m.

The broker’s FY23 estimates remain unchanged, and the broker's target price increases to $5.70 from $5.20 following the better-than-expected near-term recovery and cash flow outcome.

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