Outlook for the big five

Photo of David Walker, Clime By David Walker, Clime

min read

An analyst’s take on the prospects for CBA, Telstra, Woolworths, Qantas and AMP.

Clime Asset Management outlines its view on some of Australia’s most widely held large-cap stocks.

(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

1. Commonwealth Bank
The purpose of ASX major banks in 2018 is to deliver steady fully franked yields with modest capital growth. In mid-January, CBA traded on a dividend yield of 5.4 per cent and in 2018 the stock should pay over $4.40 in fully franked dividends, in addition to delivering low single-digit earnings growth.

We think CBA is worth $84.00 and should reach this valuation as the uncertainties and concerns weighing on the stock resolve.

Positive catalysts for the stock include the recent announcement of a new CEO, settlement of the fine payable for facilitating money laundering, the pleasing interim result we expect on 7 February, and a special dividend as CBA returns surplus capital to shareholders after divesting non-core businesses.

We disagree with the view that various regulatory, legal and compliance burdens weighing on CBA will break the business model and cause substantial losses of market share. Bad debts expense should remain very low for another year.

CBA is one of the major banks most exposed to mortgages. As households deleverage, mortgage growth will slow from 5-7 per cent to 2-4 per cent and price competition will intensify as banks compete over a shrinking pool of business. The effects on CBA’s interest margins should be offset by declining competition in deposits as banks need less loan funding in this year’s subdued lending environment.

2. Telstra Corporation
We remain long-term bears on Telstra as price competition in mobile intensifies, losses of traditional high-margin business to the NBN accelerate, and capital expenditure requirements to remain competitive in mobile and data continue to mount.

The annual dividend has already been cut from 31 cents to 22 cents and stands to fall further after 2020 in Clime’s view, when the payments Telstra receives from the NBN, each time a customer switches, largely end.

We expect the annual dividend will then be cut to below 20 cents to protect the credit rating. This arguably makes Telstra a yield trap on a four-year view.

On a three-year view, a 6.1 per cent fully franked yield is available in Telstra but the major banks trade on similar yields and are undervalued, so they have more upside, based on our analysis.

We are not writing off Telstra as an investment forever. The telco has 50 per cent shares in fixed line and mobile, and dominant positions in the very profitable corporate, government and enterprise services markets.

The profits from these businesses, together with the group’s $4-billion stream of free cashflow, position Telstra to remain at the forefront of technological change. Cutting the dividend to protect the balance sheet and fund capital expenditure was the right decision.

If Telstra can sustain the fastest download speeds, Australia’s best geographical coverage and lead the rollout of 5G, then it could sustain its current large price premiums to Optus and Vodafone for its services. This outcome is not in the share price.

In our view Telstra is worth $3.60 and of interest closer to $3.20, a 10 per cent discount to value.

3. Woolworths
We like the turnaround under CEO Brad Banducci but see the benefits as all priced in, with Woolworths trading on a price-earnings multiple of 27 times, around $27.

Our valuation is also $27.00, which leaves us neutral on the stock. Woolworths would be more interesting around $25.70, a 5 per cent discount to value, in Clime’s view.

In December the ACCC rejected BP’s proposed acquisition of Woolworths’ petrol station business as anti-competitive. This means it will not receive $1.8 billion of sale proceeds it planned to use to strengthen its balance sheet and reinvest in core businesses.

The imperative to protect the credit rating by reducing debt explains the 40 per cent cut to the dividend between 2015 and 2017. Being barred from selling the fuel business prolongs the problem.

We expect Woolworths’ margins in Australian supermarkets will surprise positively and Big W losses will be less than management’s guidance. Anecdotal feedback was positive on Woolworths’ Christmas trading with ongoing share gains and growth outpacing Coles.

2018 should also see cost savings, working capital improvements and Big W’s turnaround gathering pace after its return to same-store sales growth in the September quarter.

4. Qantas
Qantas shares peaked at $6.53 in October and have trended lower since in response to the higher oil price, the Australian dollar’s appreciation and concerns about overcapacity in the international division as the number of airlines and seats inbound to Australia grows.

The stock had become overbought and the selloff is reasonable. From here we will see if the market becomes too pessimistic.

Balance sheet gearing is at the low end of management’s range. The world economy is accelerating and employment growth in Australia is strong, which should support sales.

Pricing power has returned in the domestic market, as anyone who booked a seat recently would know. Qantas’s domestic seat revenue growth could accelerate to high single digits this year. There are also margin gains from exchanging thirsty B747 aircraft for fuel-efficient B787s. The new Emirates deal has $80 million of upside.

Qantas is well-managed, and we like the strategy, but airline profitability is a function of cyclical, volatile and unpredictable variables beyond management’s control: fuel prices, exchange rates, competition and economic conditions.

This makes valuing airline stocks complex and difficult, another reason they are only for cyclical trading and not for long-term investment.

Shareholders went without Qantas dividends for seven years until 2016, a sign of the balance sheet pressures that can develop in the airline business.

5. AMP
AMP shares are still at levels of January 2003. This outcome is despite compulsory superannuation, tax breaks for super, economic, employment and population growth, and the equity bull market. The All Ordinaries Index doubled over the past 14 years and offshore markets have returned more.

The reasons are AMP’s ownership of capital-intensive, poorly profitable life insurance businesses, intensifying competition, the reluctance of Australians to pay for advice and the discouragement of investors by legislative changes to superannuation, which have also made the industry more complex for operators.

AMP plans to increase investment in higher-growth, less-capital-intensive businesses like funds management, while releasing and recycling capital from its lower-growth businesses like life insurance.

The growth assets seem well-positioned to benefit from favourable domestic and global themes: compulsory super, growing demand for advice, ageing demographics, demand for yield (infrastructure, property) and industry partnerships in China and Japan.

Clime cannot value AMP at more than $5.30. The market is pricing in some of the benefits (higher return on equity, less risk) of an exit from life insurance.

About the author

David Walker is ASX Large-Caps Portfolio Manager at Clime Asset Management.

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