Weekly Broker Wrap: Economy, Consumers, Supermarkets, Focus List And Health Care

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-Income recession more likely
-Retailer confidence improves
-No logic in supermarket space race
-Citi adds Transurban, Veda exits list
-Health care valuations seen stretched

By Eva Brocklehurst

Economy

Australia is in one of those periods when talk of recession is heightened. Commonwealth Bank economists note a weak GDP number, concerns over China's growth and market malaise in other commodity producers has encouraged some to put the odds of a recession as high as one in three. The last recession – technically two consecutive quarters of negative growth – last occurred in the early 1990's.

Some of the arguments appear weak on closer examination and the economists suspect Australia will dodge the bullet again. One major factor is that with official interest rates at record lows, monetary conditions are very stimulatory and it is difficult for the economy to slide into recession in this case. Moreover, the cash rate at 2.0% is well above the near-zero settings in the major economies and can be cut further. The Australian dollar has also fallen to levels which should assist growth and support incomes.

Mining capex peaked in 2012 and the economists do not believe Australia is approaching a "capex cliff". The decline to date has been around 2.0% of GDP and is roughly mid cycle. The economists also note this recent mining construction boom was different, in that it was dominated by LNG. Around half of LNG capex went on imports. So in GDP growth terms there is an automatic 50% offset to falling capex from lower imports.

The one real risk, the economists contend, is an "income" recession. The evidence includes real gross domestic income per capita, which has been falling for some time. Income weakness brings a focus on cost containment as households and businesses defer spending. This also encourages the pursuit of yield and capital gain. Asset price inflation creates "bubble" risks and the composition of balance sheets becomes riskier. Exposure to economic shocks or policy changes is increased.

Consumers

Citi observes improved confidence among Australian retailers over the past 18 months. In analysing the FY15 results the broker observes more stores are being opened but, on average, earnings margins are flat. The stronger store growth is in hard goods, consistent with faster industry-wide growth. While three quarters of retailers revealed positive like-for-like sales growth, only 20 out of 37 surveyed reported earnings margin expansion.

There is early evidence of rising operating costs and some need to invest in IT, stores or staff to maintain sales momentum. The falling Australian dollar has been dealt with well, the broker contends, and currency hedges have helped, as has reduced tariffs in clothing and footwear.

Supermarkets

Australian consumers are increasingly buying groceries online, yet online penetration in this area is only 2.3%. Morgan Stanley observes this stems from the fact it has been more expensive to buy online, especially as delivery costs have been onerous. However, delivery costs are falling and this is improving participation rates. The broker forecasts online food retail penetration to rise to 3.3% by FY18, but still below the current UK penetration rate of 5.8%.

The problem is store-based retailing has far higher fixed costs, such that the impact of consumers switching online is a headwind to supermarket profitability, as margins are diluted. Margins that the supermarkets generate from online sales are likely to be significantly lower than store margins. Morgan Stanley's online food models indicate Coles ((WES)) and Woolworths ((WOW)), combined, have 74% share compared with a 66% share of the broader market.

The shift online is a boost to revenue for the pair because, generally, the independents, Aldi and Costco do not operate online. Hence, the broker argues, in this context, that supermarket space expansion should be below population growth to reflect the growth in online.

Buy Ideas

Citi has added Transurban ((TCL)) to its Australasia focus list. Veda Group ((VED)) has been removed. The broker, having recently upgraded to Buy, considers the long-term potential of Transurban is intact and the current share price offers an attractive discount to valuation. The stock offers compound growth of 9.5% in distributions over the next three years. While retaining a Buy rating for Veda the broker notes the company has received a bid from Equifax at $2.70 a share, hence its its removal from the list.

Citi's focus list contains 10-15 stocks which are Buy rated and have sizeable liquidity and market capitalisation. The lists includes Aristocrat Leisure ((ALL)), ANZ Bank ((ANZ)), Challenger ((CGF)), Iluka ((ILU)), Incitec Pivot ((IPL)), QBE Insurance ((QBE)), REA Group ((REA)), Spotless Group ((SPO)), Stockland ((SGP)), Tatts Group ((TTS)) and Transurban.

Health Care

Fundamentals in the Australian health care sector no longer support stretched valuations, in Morgan Stanley's view. FY15 results were generally weaker than expected and the FY16 growth outlook is soft. CSL ((CSL)) provides growth guidance of 5.0%, in line with the broker's estimates, but the consensus outlook appears to ignore the slowdown in the core franchise. Morgan Stanley finds unit growth weak for Cochlear ((COH)) as N6 upgrades in FY15 provide tough comparables for FY16.

Ramsay Health Care ((RHC)) disappointed with its outlook for FY16 and FY15 ended a string of beating expectations, the broker observes. Meanwhile, Healthscope ((HSO)) delivered on its prospects but, again, disappointed in terms of margins. No guidance on its negotiations with the hospitals was provided. Sonic Healthcare ((SHL)) still has lingering issues with pathology while Morgan Stanley is still awaiting the FY16 outlook and a visible strategy from Primary Health Care ((PRY)). Ansell ((ANN)) has signalled the FX headwinds are worse than initially expected and the broker estimates underlying growth of 2-8% in FY16.

ResMed ((RMD)) appears more positive to the broker, having laid out a robust FY16 platform. Small caps such as Monash IVF ((MVF)) and Virtus Health ((VRT)) disappointed. Their multiples are accommodating a "no growth" scenario but Morgan Stanley observes, if Medicare Benefits Schedule data turns positive, then both will outperform. For Sigma Pharmaceuticals ((SIP)) and Australian Pharmaceutical Industries ((API)) the regulatory risk may be understood but the broker believes challenges remain.

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