Week Ending 15.02.2019
- The housing market is perceived as the greatest risk to the domestic economy by most international economists, while even the locals now flag a longer term drag from the fall in house prices.
To summarise previous commentary, the economic impact of house building activity is different to the change in house prices. The approval data has imbedded the downward momentum in activity that will show through in GDP. This is far from a surprise given what was widely seen as overbuilding in the inner-city apartment sector, particularly in Victoria. Further, the restrictions on investor lending have been in place for over two years.
The other part of the story that has been fully visible is the rise in house prices relative to income which, after a short hiatus in the mid-2000s has been on a sharp upward trajectory for 20 years and taken household debt levels to global highs.
The claim now is that the restrictions on bank lending have resulted in the deeper than expected decline in prices. CBA believes that it has been the demand for credit that has been the primary cause, rather than supply. In their view, the tightening standards result in shorter term restraint, whereas the prolonged fall in credit is increasingly a function of a reluctance to borrow. Their evidence is based on the number of loans, down 10% for owner occupiers over the past year. In their view, tightening standards would be most visible in the value of loans. Naturally, the two have a relationship; borrowers who wanted high value loans are no longer applying. CBA’s own data is that the maxiumum borrowing capacity of its customers has been broadly stable, as well as minimal change to average loan size and approval rates.
Therefore, at the heart of the malaise is firstly the rise in house prices to unafforable levels and now the fall in house prices with expectations of further declines.
The discussion on lending restrictions further ingores other factors. Foreign investment has waned due to changes in stamp duty and tighter controls. The election uncertainty and potential tax changes are cause for pause. Finally, rental returns were already low a year ago and rental growth based on the CPI is only 0.5%, with press reports of falling rent in Sydney not increasinly common.
Assuming employment conditions are largely stable, CBA believes their modelling implies a further 5-6% fall in aggregate prices, with Sydney and Melbourne bearing the brunt from their heady peaks.
The supportive factors are relatively well known – population growth, stable employment (which will likely get some imputes from the election) and low interest rates. In the near term, tax treatment is a swing factor. Longer term, migration matters more and foreign buyers are an important marginal source of demand. These are political issues largely unrelated to credit availability.
In responding to the global view that our housing market is akin to the experience of Ireland, Spain or the US in 2008-2010, the offsetting factor is the recourse nature of our mortgage market, the current capital position of the banking sector and the willingness of policy to respond. We may be wrong, but it seems unlikely that housing alone will cause a recession in Australia. It requires global conditions and other factors as well. The other side, however, is that housing excess does leave Australia much more vulernable than in previous economic cycles.
Fixed Income Update
- In light of a new NAB bank hybrid, we examine the market and the likely influences on pricing.
NAB has come to the market with a new ASX listed bank hybrid (NABPF) as a rollover to the maturing NABPA’s. The call date is at 7.25 years which will make it one of the longest dated hybrid. The most recent issues done by Westpac and CBA were both in the 5year maturity bucket. Despite the long maturity and potential changes to franking credits this new deal has met with strong demand. Order books are said to have exceeded A$1.5bn at the tighter margin of +400bps (price talk was +400-420) from rollovers and new money demand.
To evaluate this security, we have looked at the pick- up over the maturing NABPA as well as pricing of other major bank hybrids of similar term in the secondary market. For existing NABPA holders, this new security offers an additional 0.80%p.a. running yield return for the 7year risk. There is no other hybrid this long, but extrapolating out the curve of existing hybrids, the NABPF comes in at fair value given it also incorporates a new issue premium of 0.25% above the curve. At a margin of +400 and with BBSW at ~2%, it provides investors a franked running yield of ~6%, considered attractive in this low interest rate environment. This form of evaluation only reflects relative value, with the next question is being whether the hybrid market is currently fairly priced for risk?
Major Bank Preference share credit curves
The impact of the upcoming federal election brings with it the potential changes to franking credits and is expected to impact 10-20% of hybrid holders. When the policy was originally proposed the market shifted the pricing of these securities lower, with the longer dated hybrids offering an additional 0.60% for this risk. Assessing whether this is adequate compensation is a judgement call.
Other contributors to pricing will be the supply of hybrids. The expectation of higher capital requirements, enforced by APRA, may lead to the issuance of more capital over the next 5 years. Preliminary discussions suggest that the major banks will need to issue additional AT2 securities (subordinated bonds) which sit above bank hybrids in the capital structure. In theory, this additional debt will weigh on hybrid prices, although we note the lengthy timeline of this playing out.
Changes to major banks capital structure - % of risk weighted assets
Offshore, this week’s non-call by a Santander Coco (European hybrid) highlights the rights of an issuer to not redeem at the first call date if it is not economical to do so. Domestically a major bank not calling a hybrid at the first call date is unlikely, but caution remains warranted. On a positive note, many are of the view that major bank hybrids will have a credit rating upgrade this year. While ASX listed securities do not have an explicit rating, the major’s hybrids (in the wholesale market) are rated BB+ by S&P. If upgraded they will move to an investment grade rating of BBB- or higher.
- For conservative mandates we prefer a portfolio of shorter dated bank hybrids (within 3 years). However, noting the difficulty in finding supply, for others we suggest that longer dated hybrids (such as the new NABPF’s) can be included as part of a portfolio that holds shorter dated securities, but maintaining an average maturity within 3 years. A blended approach using staggered maturities (call date) will alleviate reinvestment risk, reduce overall portfolio volatility and still allow for some extra pick up in yield as generated by the longer securities.
- Retailers JB Hi-Fi (JBH) and Super Retail (SUL) announced sound first half numbers, with valuations reflecting a soft consumer environment.
- Lotteries proved a winner for Tabcorp (TAH) although the gaming group has had less luck with wagering.
- Headwinds are abating for Amcor (AMC) as it begins to cycle raw material inflation and subdued volumes. The Bemis acquisition is the next leg of growth
- CSL has upped its guidance, although this wasn’t sufficient for investors looking for even more.
- Carsales.com’s core business is tracking well, although weaker advertising spend from car manufacturers hurt in the half.
- Telstra’s (TLS) medium term outlook will be shaped by the success of 5G and a possible nbn writedown by the Government.
- Suncorp’s (SUN) insurance trends were similar to IAG. Higher reinsurance costs now will be incurred, impairing margins.
- Transurban’s (TCL) ability to fund its forecast distribution profile will be monitored closely in coming periods.
- Unibail-Rodamco-Westfield (URW) focuses on de-levering the company's balance sheet while navigating the challenging retail environment.
JB Hi-Fi (JBH) produced another commendable result given rising headwinds to its business, with earnings growth of 5% and a similar lift in its dividend. Like for like sales growth was recorded across its three core divisions (Australia, NZ and the Good Guys) despite cycling a tough comp in its core brand, although a sales update for January indicated further slowing in momentum. Margins were steady as gross margin expansion offset a rising cost of doing business. While Amazon is yet to make a discernable impact on its business, the narrative for the stock has morphed into concerns over a weakening domestic consumer as house prices continue to decline. The forward P/E should be expected to remain subdued in this environment, with investors compensated by a healthy 6% yield. We have the stock in our model equity portfolio as a high-quality value play in the market.
JB Hi-Fi Australia Sales Growth
Super Retail (SUL) is another higher quality retailer reporting a credible half year performance. While operating two relatively stable divisions (auto and sport), its outdoor leisure format continues to be challenged by competition, with the BCF brand posting a 22% decline in earnings. The jury remains out on management’s recent expansion in this category with Macpac. Trading in the early part of the 2019 calendar year has been solid (the 8% like for like growth in sports retailing being the highlight). However the update was overshadowed by a $43m charge after it uncovered the underpayment of retail managers over the last six years. A forward P/E of 10X also reflects the consumer risks, although the stock is less exposed to the Amazon and housing downturn threat.
Tabcorp’s (TAH) half year was a mixed bag, albeit somewhat messy given the integration of its Tatts acquisition. The positives were the strong growth in its lotteries division, which benefited a run of jackpots, driving increased sales (a factor that cannot be relied to be repeated next year) and an increase in the projected synergies to be realised from Tatts.
The greater focus, however, was on the larger wagering business. Tatt’s UBET business suffered as it was transitioned to the Tabcorp brand and a high level of promotional activity (e.g. bonus bets and money back offers) from Tabcorp and its competitors led to a compression in margins. The hope is that the competitive environment will ease as the impact of regulatory change (such as point of consumption taxes) hurts the offshore corporate bookmakers to a greater degree. Currently, the stock offers synergy-driven earnings growth in the medium term and a quality defensive earnings stream from its lotteries division, although a more cautious approach is perhaps warranted given the wagering environment.
Packaging company Amcor (AMC) was one of the more disappointing companies of last August’s reporting season, and investors would have received some comfort from this half year report. Some of the issues that plagued AMC last year are subsiding, proving to be short term cyclical hurdles, including elevated rate materials inflation, emerging markets growth and volumes in a key North American customer.
A volume and pricing recovery is now in prospect, with this rolling into the benefits from its strategic acquisition of Bemis, a transaction which is expected to be finalised in coming months. While the price paid for Bemis was viewed as high, AMC’s track record in creating value from such acquisitions provides confidence. We recently added AMC to our model portfolio on an appealing valuation and improving outlook.
CSL was a victim of its own success during reporting periods, with a modest negative share price reaction. While the company now expects full year profit to be at the higher end of its range, analysts had been anticipating an upgrade to what was viewed as conservative guidance. The highlights were ongoing strong demand growth for its products and a profitable result from its acquired flu vaccines business.
The primary negatives were high cost growth and temporary weak albumin sales into China on disruptions to supply. After a positive P/E re-rate through to September in 2018, CSL fell back towards a more palatable valuation in the latter part of the year and now trades on 29x forward earnings. This is now broadly in line with its average over the last three years and the stock may again be deserving of this P/E premium given its ability to grow amid a difficult broader environment.
Carsales.com (CAR) was likewise caught up in the growth de-rate that occurred in the final quarter of 2018. Additionally, however, the company is beginning to face some cyclical headwinds in parts of its business. This has been evident in its revenue from car manufacturers’ display advertising on its website (-16% in the half), along with a tightening in credit that has hurt its Stratton financing unit. This overshadowed ongoing good trends among dealer and private car ads in the half, with revenue growth again helped by higher ‘premium’ ad sales.
The result from its international investments was also good, albeit these earnings remain a smaller part of the overall business. FY19 is now expected to represent a pause in earnings growth before again picking up over FY20/21. Looking through the cyclical issues, CAR is likely appear on the radar of growth managers, with the stock now on 19x FY20 earnings.
Carsales.com Display Revenue
Telstra’s (TLS) result was broadly in line with expectations, although the stock was weaker on a softer dividend payment. The company continues to work through a period of significant change, primarily driven by the rollout of the nbn, but also with the capital spend of its 5G mobile network. Its mobile business is currently underpinning group earnings, and while subscriber growth was solid in the half, a further decline in average revenue per user (ARPU) underlined the competitive pressures in the industry. The short term picture remains challenged; core earnings declined at a double digit rate in the half and this trend will likely continue until the nbn impact is fully reflected in the business.
The potential upside is from a return to profit growth with 5G as customers pay more for access and the hope that nbn will be written down by the Federal Government, which would be beneficial to the margins of resellers. The big question mark remains the dividend profile; of the 8c for the half, 3c was a ‘special’ from one-off nbn payments. The challenge for the company will be to rebuild the earnings base so that this remains sustainable.
As with IAG last week, Suncorp’s (SUN) result was hurt by higher catastrophe claims emanating from Sydney’s hailstorms in December. The insurer has now taken steps to increase its reinsurance cover, a cost that will hurt margins but provide additional earnings certainty while addressing a key concern for investors that its existing arrangements were inadequate. Lower investment portfolio earnings also contributed to the weak insurance result, but this was offset by the ongoing positive premium pricing trends that have been evident across the industry.
Meanwhile, SUN’s banking division has been facing similar headwinds to the major banks and flat profitability was a reasonable outcome, albeit assisted by a low bad debts charge. Finally, a step up in group cost out targets were a positive. As previously noted, the stock is the value proposition of the domestic insurers and there is a near-term catalyst of a capital return once it completes the sale of its life insurance business.
Suncorp: Motor Insurance Growth
Transurban’s (TCL) half year was slightly below par, primarily due to softer traffic numbers than forecast. Underlying EBITDA growth of 10% was driven by average daily traffic growth of 2.7% across its network of toll roads, while 5% distribution guidance for FY19 was unchanged, with ‘mid-single digit growth’ also projected for FY20. Despite a slowing distribution growth profile valid concerns, are emerging over TCL’s ability to fund these payments and hence operating cash flows will be under a greater spotlight in coming periods. For this half, distributions were not fully covered by cash. TCL points to its large ongoing pipeline that will underpin the growth and project delivery will become important. As with other defensive interest rate sensitive stocks, TCL has rallied over the last few months and is again trading towards the upper end of its valuation range.
Transurban: Project Pipeline
Unibail-Rodamco-Westfield (URW) continues to navigate testing retail conditions with FY2019 net profit guidance 8% below the 2018 financial year result. The weak result was due to delayed developments affecting the timing of income and a tougher environment in the UK and the US (particularly in the regional mall portfolio).
The strategy is split into two periods for the next five years. Since the integration of Unibail-Rodamco and Westfield in June 2018 the focus has been on a deleveraging strategy via asset sales. The group aims to sell approximately €4 billion of European assets to reduce its loan to value ratio 30-40% reduced from 35-45% (37% at end FY18). This will have a negative impact on earnings for the first 2 years of the business plan. This is then to be balanced out by continued operating income growth expected to be between 4% and 5%. The stock trading at an approximate -24% discount to its NAV and a yield of 7.7%, which represents a payout ratio of 94%. Whilst this presents an attractive yield the uncertainty on earnings due to lowering the debt ratios and the headwinds associated with retail still remain.
Next week is the busiest of reporting season, with the following companies scheduled to release results:
Monday: Altium, Ansell, NIB Holdings, Brambles, Smartgroup
Tuesday: Seven West Media, BHP, Oil Search, Monadelphous, Blackmores, IOOF, Cochlear
Wednesday: Fletcher Building, Corporate Travel Management, Seven Group, Woolworths, WiseTech, Steadfast Group, Scentre Group, A2 Milk, APA Group, Spark New Zealand, Stockland, Crown Resorts, Charter Hall Retail REIT, WorleyParsons, Domino’s Pizza, Sonic Healthcare, Sims Metal Management
Thursday: Sydney Airport, Platinum Asset Management, Perpetual, Nine Entertainment, Santos, Webjet, Star Entertainment, Infigen Energy, Flight Centre, Iress, Mineral Resources, Qube, Southern Cross Media, Iluka Resources, Coca-Cola Amatil, MYOB, Origin, Wesfarmers, Alumina, Qantas, Viva Energy
Friday: Invocare, Mayne Pharma, Charter Hall Group