Insights

Understanding Small Cap Trends

Since the outset of 2022, small-cap stocks have been navigating a challenging terrain. The Small Ordinaries index has witnessed a decline of 22%, exacerbating further when excluding resource companies. This downward trend extends to the Small Industrials index, plunging by 24%. The disparity between small and large-cap industrial firms has widened, echoing levels last seen in 2014 and nearing a 20-year low.

Despite prevailing headwinds, there are glimmers of optimism on the horizon. With interest rates approaching cyclical peaks and economic fundamentals showing signs of improvement, there's cautious optimism in the air. Moreover, early indications suggest a shift in investor sentiment, accompanied by stabilised trading volumes, hinting at a potential turnaround.

Flight Centre

With everyone travelling post COVID, Flight Centre’s earnings are quickly recovering and we recently upgraded the stock to a BUY recommendation with a A$26.25 price target. Flight Centre (FLT) was founded in 1982 and has grown since to then to have company-owned operations in 23 countries and a corporate travel management network that spans more than 90 countries and is the fourth largest in the world.

Flight Centre didn’t waste a crisis during the COVID travel downturn. It used this period to transform its business model. Its Leisure business will have a materially lower cost base in the future as it has reduced its store count by over 50% and has diverted this business to lower cost operating models including online channels, independents and home-based agents.

It is rightly now focused on the high growth and high margin luxury segment of travel following its acquisition of Scott Dunn (UK, US and Singapore). Flight Centre’s agents are now more productive thanks to the new systems it put in place during COVID. Leisure is benefiting from pent-up demand and consumers prioritising travel spend over other retail categories. As airline capacity returns and airfares come down, we expect this will support further strength in demand for travel as it becomes more affordable.

FLT has the greatest risk, reward profile of our travel stocks under coverage. The risk is centred around execution given its changed business model, while the reward is material if FLT delivers on its 2% margin target. If achieved, this would result in material upside to consensus estimates and valuations. FLT is now targeting to achieve this margin in FY25.

Consensus assumes 1.5% margin and Morgans assumes 1.7% margin. We wouldn't be surprised if Flight Centre upgraded its FY23 earnings guidance further in June/July as May and June are the company’s biggest trading months. Cash flow is strong, especially as tax losses accumulated during COVID mean it won’t be paying tax for years, and this might lead to capital management.

In short, with greater confidence in the travel recovery and the benefits of Flight Centre’s transformed business model starting to emerge, we think the company is now at the cusp of an earnings upgrade cycle which may continue for the next few years and drive a material rerating in the share price.

Super Retail Group

With the cost of living crisis weighing heavily on consumer confidence, investing in discretionary retail stocks is a tricky undertaking at present, but there are some good opportunities for those with a longer-term time horizon. Super Retail Group (SUL) is a case in point. Super Retail is the umbrella organisation with four of the best known general retail brands in Australia and New Zealand; Supercheap Auto, rebel Sport, BCF and Macpac.

With a network of more than 700 stores and a number of high traffic websites, it has incredible reach to the domestic consumer. Sales spiked during COVID, given consumers had more time on their hands for leisure pursuits close to home. Even since COVID, demand has been resilient with sales over the past few quarters surprising investors on the upside.

The resilience of sales reflects the low average transaction value (90% of products are priced below $100) as well as a massive 10 million loyalty club members. Super Retail’s brands lean into the leisure pursuits of the Aussie consumer and it would be a very severe downturn indeed that would see many of us stop spending on fishing, footie and floor mats.

Many people see Super Retail as a mature in terms of its store rollout opportunity, but we think network augmentation is on the agenda. The group has invested in new concepts stores such as rebel rCX and BCF superstore (large format store) to great success. These stores are, in some respects, pushing back the boundaries of the customer experience and have led to a significant uplift in store revenue.

Not to be left out, Supercheap Auto has started a programme of store refreshment, with a series of locations converting to the Generation 4 format. There is more to come. Super Retail has net cash to fund ongoing store capex and we also see potential for capital management in the form of a special dividend or buyback. We think this could be announced at the upcoming result in August.

Whilst discretionary retail is somewhat out of favour, and consumer sentiment is at near record lows, we think that as inflation starts to moderate and the RBA stops tightening rates, the tide will turn and investors will seek out exposure to high quality retailers, with good trading liquidity and upside to earnings expectations. Super Retail is a great place to start.

Objective Corporation

Objective Corporation (OCL) is a best-in-class specialist software business, servicing the public sector and highly regulated industries. The business designs and develop Enterprise Content Management (ECM), regulation workflow, and Planning and Building Solutions, which are central to the day-to-day operations and workflow management of various government organisations within Australia, New Zealand and the UK.

Because of this defensive customer base, the company has strong recurring revenue and low levels of churn. Global Public Sector software spend is anticipated to grow at a low double-digit rate over the near term as governments look to streamline workflow, improve security, and modernise legacy IT infrastructure. We see Objective as being a beneficiary of this trend.

The launch of Objective’s new Nexus and Build products, as well as expansion into new under-represented and materially larger markets such as the US and UK, should unlock opportunities for annual recurring revenue growth over the medium term, with the company showing positive early adoption and interest from customers.

Objective has seen a strategic reset in its earnings in FY23 as it looks to prioritise subscription licencing revenue growth, streamline deployment of its solutions, and invest in product and sales support functions. Whilst this has recently weighed on the company’s share price, we believe Objective should be well positioned to see long-term revenue growth rates and margins return in FY24 and beyond.

The company is also strongly capitalised and well positioned to take advantage of M&A opportunities as private market technology valuations have contracted, which in our view could add incremental scale and scope for long-term growth.

Dalrymple Bay Infrastructure

Dalrymple Bay Infrastructure (DBI) owns the long-term lease to the 85 mtpa Dalrymple Bay Terminal (DBT). DBT is an open access export terminal located in central Queensland servicing relatively captive coal export mines in the Goonyella rail system. Approximately 80% of the coal processed through the terminal is metallurgical coal, which is a critical input to steelmaking. We like DBI for its yield, defensive attributes, and growth potential.

DBI recently hosted its AGM, where it provided first-time distribution guidance for the 12 months from 1 July 2023. Guidance was for annual DPS growth of 7% to 21.5 cps (paid quarterly), which is equivalent to the CPI escalation of the base element of DBT’s Terminal Infrastructure Charge. At current prices, this implies a cash yield of around 8% (and the distribution will likely be partly franked).

Furthermore, DBI reaffirmed its expectation to grow DPS by 3-7% pa for the foreseeable future; our expectation is that the growth in the distribution will be linked to the CPI tariff escalation. We think the distribution yield and growth guidance is attractive given the numerous risk mitigants that support its payment. DBT is protected from volume risk via 100% take-or-pay contracts combined with revenue socialisation (protects DBI from customer payment default or contract expiry).

Even in the case of a weather event damaging the terminal DBT will likely continue to be paid. Direct operating costs of the DBT are a 100% pass-through to the mining companies that use DBT, so only limited cost exposure at the DBI corporate level. Inflation is mitigated via annual CPI escalation of revenues. Interest rate and refinancing risks are mitigated via hedging and staggered debt maturities (albeit DBI’s debt service costs are expected to increase over time).

In most companies, increasing sustaining capex is seen as a negative as it is a drain on free cashflow without providing additional earnings. However, DBI earns additional high margin revenue as it commissions non-expansionary capex projects. This is a growth driver for DBI given it will require increasing amounts of sustaining capex (it is c.40 years old and operates in a marine environment).

DBI has committed to c.$280m of sustaining capex which when commissioned in 2027/28 we expect should add c.14% to EBITDA. DBI is also considering the 8x expansion of terminal capacity, albeit has indicated that it won’t proceed with the development without take-or-pay contracts underwriting an attractive return on the investment.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

With nearly 12 months in office, Labor handed down its Budget amidst a commodity price boom and multi-decade high inflation. The 2023-24 Budget largely follows those that have gone before, taking a small step toward balance sheet repair but generally favouring fiscal expansion. Tonight’s key announcements reaffirm the commitment to support the vulnerable through cost-of-living relief while childcare measures aim to boost workforce participation.

Due to a fortunate situation of strong employment growth and commodity prices, a vastly better fiscal position provides a margin of safety for the government to increase expenditure. $14.6B has been committed to cost-of-living relief measures, including energy rebates, Medicare rebates and a boost to Jobseeker forming the centrepiece of the government’s plan to insulate the economy against a backdrop of declining growth and elevated inflation.

Measures will be targeted towards low-income households to avoid worsening inflation. However, there is no meaningful attempt to tackle structural pressures from NDIS, aged care and healthcare which has seen growth outpace inflation over the past few years.

With this government needing to stamp their economic credibility, we think this Budget represents a step in the right direction. And given the RBA has its sights set on reducing demand, fiscal policy will need to provide immediate support if the economy stutters. In summary, the measures announced today broadly support equity market sentiment.

Cost of living relief over fiscal repair

At the headline level, a small surplus of A$4.2b is expected in 2023-24 (+0.2% of GDP) improves upon the A$36.9b (4.5% of GDP) deficit predicted at the October Budget. That said, deficits are expected over forward estimates as commodity prices are forecast to ease. Three core principles guide this year’s Budget. Firstly, to offset cost-of-living pressure for the vulnerable.

Second, spending restraint in key categories health and social security. And third to reprioritise long-term spending in infrastructure and defence. Rising debt is an outcome of this year’s budget, the capacity for the economy to absorb higher interest repayments will be tested over the next few years if employment conditions or commodity prices end up less favourable.

Treasury’s forecast for gross debt rises from A$923b in 2023-24 (35.8% of GDP) to A$1,067b in 2026-27 (36.5% of GDP). However, Australia’s fiscal position remains in much better shape than global peers. This leaves some dry powder should current economic conditions deteriorate.

World Gross Debt-to-GDP (Consensus Forecasts and Treasury Estimates)

Incrementally positive for equity markets

taking everything into account, some fiscal restraint, targeted spending, and measures to address workforce participation should provide investors confidence that the government is taking a safe approach to managing the budget.

Importantly for the market, a small surplus and few inflation-inducing spending measures should also reassure investors that a slowdown is possible without making abrupt changes to fiscal policy. We see support for the AUD as the fiscal position remains stronger than peers despite the incremental step-up in fiscal spend.

Few consumption levers pulled this year

A feature of previous Labor Budget’s such as one-off cash payments, big increases to welfare and tax offsets were notably absent. Instead big spending programs were replaced by targeted relief to jobseekers and low-medium income households.

So this will not provide the sugar hit to retailers we’ve seen over the past few years coming out of COVID. But equally, targeted support to the vulnerable should also limit the downside risks to consumption.

Budget assumptions – setting a low bar for next year

Key commodities are assumed to decline from elevated levels over four quarters to the end of the March quarter of 2024: the iron ore spot price is assumed to decline from a March quarter 2023 average of US$117 to US$60/tonne; the metallurgical coal spot price declines from US$342 to US$140/tonne; the thermal coal spot price declines from US$260 to US$70/tonne; and the LNG spot price declines from US$16 to US$10/mmBtu.

AUD is expected to remain at 67c through the forecast period. Net migration is expected to be 400,000 in 2022-23, 315,000 in 2023-24 before reverting to trend 260,000 in 2024-25.

Our thoughts

The Budget announcements reinforce our view that fiscal support will not be withdrawn hastily. However, the government still lacks the determination to bring about significant structural reform, chiefly around productivity, environment and innovation. The lack of genuine long-term reform has been an unfortunate feature of recent budgets.

In our view, the budget is unlikely to bring about significant revisions to corporate earnings, however the ongoing commitment to support the vulnerable parts of the economy while also demonstrating some fiscal restraint will underpin market sentiment and support earnings confidence. Resources, Energy and Financials have benefitted from resilient economic activity and the inflation dynamics.

Household balance sheets remain in good shape which should continue to support consumption. We also see upside risk to dividends if economic conditions hold. We prefer a targeted portfolio approach favouring quality (strong cashflow and market position), sectors linked to higher inflation (Energy, Resources) and select cyclicals (CTD, QAN, WEB, TWE, VNT).

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

The constant chatter earlier this year in relation to a proposed raft of superannuation and tax changes mercifully quietened in the weeks before this year’s Federal Budget. All in all, it was a very low-key Budget in respect to wealth management matters.

Superannuation

From 1 July 2026, employers will be required to pay their employees’ super at the same time they pay their wages, thus enabling employees to track their entitlements to make sure super contributions are being paid on time and in full. By having an employee’s super paid at the same time as their wages, an employee will undoubtably have enhanced retirement benefits due to the compounding benefits of super being paid more frequently.

An investment of $27 million is also being set aside in 2023-24 for the ATO to improve data capabilities, including matching both employers and super fund data at scale. A further $13.2 million will also be available to the ATO to consult and co-design a new ATO compliance system which will proactively identify instances of under or unpaid super in near-real time.

From 1 July 25, under the previously announced “Better Targeted Superannuation Concessions” proposal, earnings on balances exceeding $3 million will attract an increased concessional tax rate of 30%. Earnings on balances below $3 million will continue to be taxed at the concessional rate of 15%.

There was no mention in the Budget papers that the $3 million threshold will be indexed, nor does it address other contentious matters raised during the consultation period such as taxing unrealised gains. (The Budget papers allude to a ‘valuation method’ for defined benefit pensions but details are yet to be released.)

Also note the Transfer Balance Cap threshold will index to $1.9 million on 1 July 2023. Similarly, the Total Super Balance limit will index to $1.9 million on 30 June 2023 due to higher inflationary figures.

There was no mention of the 50% reduction in minimum pension factors continuing beyond this financial year so it is highly likely the minimum percentage factors will return to normal from 1 July 2023.

Small Business

Businesses with annual turnover of less than $50 million will have access to a bonus 20% tax deduction for eligible assets supporting electrification and more efficient use of energy, from 1 July 2023 until 30 June 2024.

Up to $100,000 of total expenditure will be eligible for the incentive, with the maximum bonus tax deduction being $20,000 per business. Assets that support electrification include heat pumps, electric heating or cooling systems, batteries, or thermal energy storage.

Eligible small businesses will also be provided with cashflow relief by halving the increase in their quarterly tax instalments for GST and income tax in 2023-24. Instalments will only increase by 6% instead of 12%.

Businesses with a turnover of $10 million per year will be able to temporarily increase the instant asset write-off asset threshold to $20,000 between 1 July 2023 and 30 June 2024.

Home Ownership

Eligibility for the First Home Guarantee and Regional First Home Guarantee will be expanded to any 2 eligible borrowers beyond married and de facto couples, and non-first home buyers who have not owned a property in Australia in the preceding 10 years.

Australian Permanent Residents, in addition to Australian citizens, will be eligible for the Home Guarantee Scheme.

Welfare Recipients

Expanding access to Parenting Payment (Single) - in September, eligible single parents will receive Parenting Payment (Single) until their youngest child turns 14. The current cut off age is 8 years old. The current base rate of Parenting Payment (Single) is $922.10 per fortnight. This compares to the JobSeeker Payment base rate of $745.20 per fortnight.

• This equates to an additional $176.90 per fortnight payment for a single parent up to when their youngest child reaches 14 years of age.
• Eligible singe parents with one child will be able to earn an extra $569.10 per fortnight, plus an extra $24.60 per additional child before their payment stops.

The base rate payments of JobSeeker, Austudy and Youth Allowance and rent assistance will increase by $40 per fortnight to eligible people.

A higher rate of JobSeeker will also be available to recipients aged 55 years and over who have received the payment for 9 or more continuous months (currently applicable to those 60 and over).

Payments will continue to automatically index to reflect changes in consumer prices.

The maximum rates of Commonwealth Rent Assistance will increase by 15%. This works out to be $31 per head per fortnight.

Aged Care

An interim increase of 15% to modern award wages will be allocated for many aged care workers. As stated in the Budget papers, personal care and support workers earn $34 per hour on average, which is about 25% less than the average worker.

An investment of $166.8 million will also be provided to support older Australians who wish to remain at home for longer, providing an additional 9,500 home care packages.

Increased funding will be made available to deliver aged care services to Aboriginal and Torres Strait Islander Elders, enabling them to remain connected to their communities.

Paid Parental Leave Scheme

From 1 July 2023, Parental Leave Pay and Dad & Partner Pay will combine into a single 20-week payment. A new family income test of $350,000 per annum will be introduced.

The Government is also committed to increasing Paid Parental Leave to 26 weeks by 2026.

Taxation

The planned Stage Three tax cuts are on track to commence on 1 July 2024. This includes raising the upper threshold for the 30% tax rate from $120,000 to $200,000 and removing the 37.5% tax band completely.

Proposed 2024/25 Marginal Tax Rates

Our best ideas are those that we think offer the highest risk-adjusted returns over a 12-month timeframe supported by a higher-than-average level of confidence. They are our most preferred sector exposures.

Additions: Strandline Resources (ASX:STA).

Removals: Endeavour Group (ASX:EDV) and PeopleIn (ASX:PPE).

Large cap best ideas

Commonwealth Bank (ASX:CBA)

The second largest stock on the ASX by market capitalisation. We view CBA as the highest quality bank and a core portfolio holding for the long term, but the trade-off is it is the most expensive on key valuation metrics (including the lowest dividend yield). Amongst the major banks, CBA has the highest return on equity, lowest cost of equity (reflecting asset and funding mix), and strongest technology. It is currently benefitting from the sugar hit of both the rising rate environment and relatively benign credit environment.

Westpac Banking Corp (ASX:WBC)

We view WBC as having the greatest potential for return on equity improvement amongst the major banks if its business transformation initiatives prove successful. The sources of this improvement include improved loan origination and processing capability, cost reductions (including from divestments and cost-out), rapid leverage to higher rates environment, and reduced regulatory credit risk intensity of non-home loan book. Yield including franking is attractive for income-oriented investors, while the ROE improvement should deliver share price growth.

Wesfarmers (ASX:WES)

WES possesses one of the highest quality retail portfolios in Australia with strong brands including Bunnings, Kmart and Officeworks. The company is run by a highly regarded management team and the balance sheet is healthy. We believe WES’s businesses, which have a strong focus on value, remain well-placed for growth despite softening macro-economic conditions.

Macquarie Group (ASX:MQG)

We continue to like MQG’s exposure to long-term structural growth areas such as infrastructure and renewables. The company also stands to benefit from recent market volatility through its trading businesses, while it continues to gain market share in Australian mortgages.

Treasury Wine Estates (ASX:TWE)

TWE owns much loved iconic wine brands, the jewel in the crown being Penfolds. We rate its management team highly. The foundations are now in place for TWE to deliver strong earnings growth from 2H22 over the next few years. Trading at a material discount to our valuation and other luxury brand owners, TWE is a key pick for us.

CSL Limited (ASX:CSL)

A key portfolio holding and key sector pick, we believe CSL is poised to break-out this year, a COVID exit trade, offering double-digit recovery in earnings growth as plasma collections increase, new products get approved and influenza vaccine uptake increases around ongoing concerns about respiratory viruses, with shares offering good value trading around its long-term forward multiple of ~30x.

ResMed Inc (ASX:RMD)

While we expect the next few quarters to be volatile as COVID-related demand for ventilators continues to slow and core sleep apnoea volumes gradually lift, nothing changes our medium/longer term view that the company remains well-placed as it builds a unique, patient-centric, connected-care digital platform that addresses the main pinch points across the healthcare value chain.

Transurban (ASX:TCL)

TCL owns a pure play portfolio of toll road concession assets located in Melbourne, Sydney, Brisbane, and North America. This provides exposure to regional population and employment growth and urbanisation. Given very high EBITDA margins, earnings are driven by traffic growth (with recovery from COVID) and toll escalation (roughly 70% by at least CPI and approximately one-quarter at a fixed c.4.25% pa). We think TCL will continue to be attractive to investors given its market cap weighting (important for passive index tracking flows), the high quality of its assets, management team, balance sheet, and growth prospects.

QBE Insurance Group (ASX:QBE)

With strong rate increases still flowing through QBE's insurance book, and further cost-out benefits to come, we expect QBE's earnings profile to improve strongly over the next few years. The stock also has a robust balance sheet and remains relatively inexpensive overall trading on 8x FY24F PE.

Aristocrat Leisure (ASX:ALL)

We have three key reasons for being positive on ALL. They are: (1) long-term organic growth potential. ALL is better capitalised than many of its competitors and has what we regard as a strong platform to continue investment in design and development in both its land-based gaming and digital businesses; (2) strong cash conversion and ROCE. ALL is a capital-light business despite its ongoing investment in Gaming Operations capex and working capital. It has a high level of cash conversion and ROCE; and (3) strong platform for investment. ALL has funding capacity for organic and inorganic investment in online RMG, even after the recent buyback. Its current available liquidity is $3.8bn.

Mineral Resources (ASX:MIN)

We have three key reasons for being positive on ALL. They are: (1) long-term organic growth potential. ALL is better capitalised than many of its competitors and has what we regard as a strong platform to continue investment in design and development in both its land-based gaming and digital businesses; (2) strong cash conversion and ROCE. ALL is a capital-light business despite its ongoing investment in Gaming Operations capex and working capital. It has a high level of cash conversion and ROCE; and (3) strong platform for investment. ALL has funding capacity for organic and inorganic investment in online RMG, even after the recent buyback. Its current available liquidity is $3.8bn.

South32 (ASX:S32)

S32 has transformed its portfolio by divesting South African thermal coal and acquiring an interest in Chile copper, substantially boosting group earnings quality, as well as S32's risk and ESG profile. Unlike its peers amongst ASX-listed large-cap miners, S32 is not exposed to iron ore. Instead offering a highly diversified portfolio of base metals and metallurgical coal (with most of these metals enjoying solid price strength). We see attractive long-term value potential in S32 from de-risking of its growth portfolio, the potential for further portfolio changes, and an earnings-linked dividend policy.

Santos (ASX:STO)

The resilience of STO's growth profile and diversified earnings base see it well placed to outperform against the backdrop of a broader sector recovery. While pre-FEED, we see Dorado as likely to provide attractive growth for STO, while its recent acquisition increasing its stake in Darwin LNG has increased our confidence in Barossa's development. PNG growth meanwhile remains a riskier proposition, with the government adamant it will keep a larger share of economic rents while operator Exxon has significantly deferred growth plans across its global portfolio.

Seek (ASX:SEK)

Of the classifieds players, we continue to see SEEK as the one with the most relative upside, a view that’s based on the sustained listings growth we’ve seen over the period. The tailwinds that have driven elevated job ads (~210k currently, broadly flat on the robust pcp) and strong FY22 result appear to still remain in place, i.e. subdued migration, candidate scarcity and the drive for greater employee flexibility. With businesses looking to grow headcount in the coming months and job mobility at historically high levels according to the RBA, we see these favourable operating conditions driving increased reliance on SEEK’s products.

Xero (ASX:XRO)

XRO is a high quality cash generative business with impressive customer advocacy and duration. Over the last 12 months rising interest rates and competition have made things harder for Xero. However, we see the current short-term weakness as a rare opportunity to buy a high quality global growth company at a discount to the life time value of its current customer base.

Telstra (ASX:TLS)

After a major turnaround, TLS has emerged in good shape with strong earnings momentum and a strong balance sheet. In late CY22 shareholders vote on Telstra's legal restructure, which opens the door for value to be released. TLS currently trades on ~7x EV/EBITDA. However some of TLS’s high quality long life assets like InfraCo are worth substantially more, in our view. We don’t think this is in the price so see it as value generating for TLS shareholders. This, free option, combined with likely reputational damage to its closest peer, following a major cybersecurity incident, means TLS looks well placed for the year ahead.

Qantas Airways (ASX:QAN)

QAN is now our preferred pick of our travel stocks under coverage given it has the most near-term earnings momentum. Looking across travel companies globally, airlines are now in the sweet spot given demand is massively exceeding supply. QAN is trading at a material discount compared to pre-COVID multiples, despite having structurally higher earnings, a much stronger balance sheet, a better domestic market position, a higher returning International business and more diversification (stronger Loyalty/Freight earnings). The strong pent-up demand to travel post-COVID should result in a healthy demand environment for some time, underpinning further EBITDA growth over FY24/25. QAN’s balance sheet strength positions it extremely well for its upcoming EBIT-accretive fleet reinvestment and further capital management initiatives (recently announced a A$500m on-market share buyback at its 1H23 result). There is also likely upside to our forecasts and consensus if QAN achieves its FY24 strategic targets.

Morgans clients can download our full list of Best Ideas, including our mid-cap and small-cap key stock picks.

Unveiling Top Picks for May 2023

This month, we sifted through all of these ideas to select three that we believe are particularly worth highlighting. They are the rail freight operator Aurizon, the biotechnology company CSL, and the data centre business NEXTDC. You can get a sense for the diversity of our analysts’ best ideas from these three alone!

NEXTDC

NEXTDC (NXT) is Australia’s largest independent data centre operator. They have invested billions of dollars and over a decade building 12 live data centre with more on the way. Their business model has, in our view, significant competitive advantage. Most people haven’t heard of NEXTDC but they are probably using its services indirectly. NEXTDC’s status an independent co-location provider means its crucial to Australia Digital economy.

Anyone using Microsoft, Amazon, Google and thousands of other clouds and applications is probably accessing them from a NEXTDC data centre. It’s the go-to place for digital connectivity and this is why thousands of partners and businesses (including Morgans) pay NEXTDC to help host their servers. Its high quality business and crucial infrastructure means NEXTDC is an attractive and relatively high growth digital infrastructure investment.

Growth of the digital economy will continue for decades and NXT is a beneficiary of this growth. The company recently signed their largest ever deal with one of the Global Cloud Service Providers. For confidentiality reasons NXT is not able to name some of its larger contract wins but based on publicly available facts with think it is probably Microsoft. The contract is likely to generate billions of dollars in revenue over its lifetime which could be more than 15 years.

Despite this being a record contract win, we expect there are still more to come over the next 6-12 months. NEXTDC have built significant inventory and management say they do not build inventory speculatively. Refer to our latest note for details but we think they could sign another 3 substantial customer contracts and if this happen the share price could appreciate materially. We have an Add rating on NEXTDC and it’s our preferred telecommunications investment.

Aurizon

Aurizon (AZJ) is Australia’s largest rail freight operator. It operates a regulated coal track infrastructure network in central Queensland, which makes up around half of its earnings. The rest of Aurizon’s earnings come from coal haulage contracts in Queensland and NSW and an expanding Bulk business that moves everything that isn’t coal and owns the Darwin-Adelaide railway. Aurizon bought One Rail last year and the costs of funding the acquisition, as well as the effects of wet weather on its rail operations, meant the first half result was weaker than the market had expected and the share price responded accordingly.

We think the extent of the share price decline was unjustified as the nature of Aurizon’s take-or-pay and regulatory protections means the underlying downgrade to this year’s EBITDA forecast was much less than the headline implied ($10-40m, rather than $50-80m).

So we think Aurizon’s share price fell further than it should have done after the interim results. Looking past this year, earnings look set to rise (unless there’s a repeat of this year’s unfavourable weather). We see a high likelihood of Aurizon receiving a regulated revenue uplift of around $125m in FY24 and most of this drops straight down to EBITDA. Even accounting for higher interest costs, the net positive impact will be material.

On top of this, we expect the revenue yield pressures that have affected the Coal haulage business to cease, with yield now closely linked to the contracted CPI escalation. As if this wasn’t enough, Aurizon will have ploughed about $1.85bn into its Bulk business and we’d expect to see a good return from this investment coming through by FY25.

Investors used to see Aurizon as a solid business with a good dividend and the opportunity for share buybacks. Of course some investors were disappointed when Aurizon reduced its dividend and stopped its buyback to fund its purchase of One Rail, but the likely earnings improvement over the next couple of years should justify your attention. We think the FY25 dividend might deliver a yield of about 7% (which grosses up to about 10%) at the current share price.

CSL Limited

While arguably a leading specialty pharmaceutical company and global vaccine manufacturer, CSL Limited (CSL) was not a ‘COVID beneficiary’, as its core plasma-based products (i.e. those derived and separated from the straw-coloured liquid portion of blood) were constrained on tight supply, a lengthy product cycle (9-12 months) and higher costs.

But as we transition out of the pandemic, the company is becoming a ‘COVID exit’ trade, standing at an inflection point where plasma collections have turned the corner, posting record 1HFY23 levels (+36% on pcp; 10% above pre-COVID) and are poised to propel plasma-based products and improve margins on growing fixed cost leverage and moderating cost inflation.

We view additional earnings contributions from recently acquired Swiss specialty pharmaceutical company Vifor, which is tracking to plan with integration going well, along with solid performance from Seqirus (seasonal influenza vaccine business), which has seen a significant pandemic impacted boost in demand, all reflected in a solid FY23 outlook (NPAT +13-18%).

Importantly, management is confident in a return to “sustainable growth”, pointing to internal efforts and a Vifor-expanded R&D pipeline in the “best shape it has ever been” (up c70% on pcp), with the majority late-stage programs (Phase 3 to registration/post-registration), well dispersed among core therapeutic areas, and fuelled by modest spend (10-11% of revenues).

Management estimate that at least 10 compounds (c20% of the total R&D pipeline) have the potential to be ‘standard of care’ for the targeted patient group. With c17% annual earnings growth estimated through FY25, undemanding valuation (30.9x vs 33.5x 10 year mean forward PE), this ‘COVID exit’ trade is a clear standout and represents a core portfolio holding.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

• We preview the 1H23 reporting season, with expectations of solid-to-strong 1H23 growth but with a weakening earnings outlook from 2H23 onwards.
• Of the retail-skewed banks, we view WBC as having a greater risk/reward profile than CBA (highest quality and ROE, stretched valuation, lowest yield). Of the business-skewed banks, NAB has higher ROE than ANZ, but ANZ has greater valuation support albeit with greater M&A risk.

Likely 1H23 reporting season thematics

Net interest income generates c.80% of revenue for the sector. APRA has released monthly credit and deposit data (with ANZ having the stand-out growth). Hence, the key uncertainty is the net interest margin (NIM) (+/-5bps NIM = +/-5% cash EPS). The rise in the average RBA cash rate in 1H23 should provide a sugar hit to NIM. However, watch for the trajectory – CBA and BOQ said their NIMs peaked in October – as price competition, deposit switching, higher wholesale funding costs, and weakening terminal cash rate expectations impact the outlook.

The banks will publish first-time Common Equity Tier 1 (CET1) capital ratios under APRA's revised capital adequacy framework. Based on indications from the banks, we expect meaningful CET1 ratio increases that indicate surplus over the targeted minimum of 11% (post-dividends). This provides opportunity for additional capital management and/or further insulation against a weakening economy.

We expect cost inflation will be evident, both through opex (e.g. wage growth and vendor inflation) and upward normalisation of credit impairment expenses (note BOQ indicated business lending asset quality deterioration in its 1H23 result).

Our DPS forecasts are around or below consensus expectations, albeit still targeting solid increases. On our forecasts and at current prices, ANZ is yielding 6.5%, CBA 4.5%, NAB 6.0%, and WBC 6.7% (all fully franked).

Forecast Changes

Earnings and dividends adjusted mostly for moderated NIM outlook (revised RBA cash rate and swap rates) and updated asset/liability growth (re APRA data).

CET1 capital ratios adjusted upwards to reflect potential benefit of APRA's revised capital adequacy framework applicable from Jan-23.

Investment Insights

ANZ (HOLD): Recent loan and deposit market share growth (but at what returns?). Lowest low rate fixed rate loan exposure. Leading institutional banking franchise. Greater diversification into US$ and NZ economy. Valuation support and attractive yield. Cautious re M&A (NOHC implications) and tech transition to a digital bank.

CBA (HOLD): The largest and highest quality bank, with a loyal retail investor and customer base. Highest return on equity (supported by buybacks) and lowest cost of equity. Leading technology. Cautious re: largest fixed rate loan cliff exposure, weakest valuation support, and lowest dividend yield.

NAB (HOLD): Recent slowing of loan growth. Leading SME relationship banking franchise. Increased simplification and improving digitisation in personal banking. Meaningful improvement in ROE that is in excess of cost of equity. Attractive yield and buyback. Cautious re step-up in costs and weaker valuation support.

WBC (ADD): Greatest potential improvement in ROE (vs relatively low risk profile) via cost-out targets, business exits, rates leverage, efficiency lift (including regulatory capital reduction), and lifting loan growth. Valuation support and strong yield. Cautious re ability to deliver transformation and market share improvement.

Catalysts

1H23 results: ANZ (5 May), NAB (4 May), and WBC (8 May). CBA Q1 trading update (9 May). Key economic data releases and RBA policy cash rate changes. Monthly APRA and RBA lending and deposit balance and interest rate data releases. ACCC, Federal Treasurer, and Queensland Government decisions re: Suncorp Bank acquisition by ANZ.

Risks

Interest and inflation rates. Credit risk (key considerations being unemployment and value of collateral). Competition for loans and deposits. Regulatory risk. Liquidity and funding risk. Execution, cost benefit, and scalability risks of digital bank transition. Cybersecurity.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.