Key Takeaways
- Australia's diverging consumer profiles are clouding the outlook for inflation, interest rates, and retail demand.
- Rated commodity companies should absorb elevated capital expenditure (capex) and price weakness from China's economic slowdown.
- Office REITs are striving to repair balance sheets and defend ratings against falling valuations and anemic demand.
- Cost inflation persists as the key risk to burgeoning infrastructure and mining capex plans.
The narrow path to a soft landing is in view for most of corporate Australia. High, albeit moderating, inflation is playing a key role and revealing a two-speed consumer profile: older generations are spending; younger people are cutting back.
We expect most of our rated issuers, which represent primarily the largest Australian corporates, to benefit from agile operating strategies, strong balance sheets, and leading market shares as they navigate tougher operating conditions. But for some sectors, such as office REITs, the landing will be much harder.
Retail And Consumer: Fragile Consumers Keep Pressure On Corporate Margins
Uneven consumer demand and strong immigration flows are adding to the challenges for the Reserve Bank of Australia to contain inflation and provide interest rate relief.
Older consumers continue to spend, supported by strong equity and housing markets and higher savings rates.
Conversely, there is a weaker underbelly of consumers, whose consumption patterns reflect the effect of higher rents, mortgage rates, and shelf prices. The government's offer of tax cuts and stimulus measures are unlikely to be a solution to all problems.
Chart 1
In these conditions, the range of products and prices of Wesfarmers Ltd. (particularly its low-price retail business Kmart) continue to appeal to financially burdened consumers. Additionally, growth in at-home consumption will continue to support supermarket operators Coles Group Ltd. and Woolworths Group Ltd. as consumers look to save. Labor costs, spending on anti-theft technology, and consumer preferences for cheaper products, will, however, maintain pressure on prices and margins. Regulatory scrutiny will also limit retailer pricing flexibility.
Lottery Corp. Ltd. (TLC) is proving that cost-of-living pressures fail to deter the habitual nature of lottery customers. TLC's consistent cash flow and resilience through economic cycles contrast with other gaming operators, such as SKYCITY Entertainment Group Ltd., which are battling weak consumer sentiment and intense regulatory scrutiny.
Post-Pandemic Inventory Rebalancing Nears Inflection Point
The restocking cycle should slowly gather momentum over fiscal 2025 (year ending June 30), following meaningful inventory destocking over the past 18 months. Businesses have been trying to clear a backlog of inventory built-up during the pandemic to manage supply-chain bottlenecks.
Packaging company Amcor PLC and supply-chain logistics company Brambles Ltd. are signaling volume improvement and normalization of stock levels among their retail and manufacturing customers.
However, some issuers, such as biotechnology company CSL Ltd., are still working through bloated inventories. Similarly, soft demand and supply gluts, beyond the typical seasonal cycles, are eroding earnings and margins for agrochemical company Nufarm Ltd.
Additionally, geopolitical uncertainty, particularly in the Middle East, is disrupting global shipping routes and driving up shipping costs. Supply-chain costs are also increasing in part because of the rush of U.S. importers trying to get products from China ahead of the U.S. general election in November, and because of ongoing port congestion in Singapore.
Weaker consumer demand may of course stymie the momentum to restock. We expect corporates to be increasingly cautious in their purchasing decisions over the next 12 months.
Commodities: Price Weakness To Test High-Cost Miners
The weak Chinese property market and uncertain economic outlook remain key risks for Australian miners, particularly in iron ore. High-cost operators remain the most exposed: some higher-cost iron ore mines have a value-in-use cost of more than US$95 a metric ton.
However, the major operators such as Fortescue Metals Group Ltd., Rio Tinto PLC and BHP Group Ltd. have the cost positions and balance sheet capacity to absorb further steep falls in price without jeopardizing the ratings on them.
Prices for commodities such as aluminum, copper, and gold continue to trade at robust levels amid persistent demand and patchy supply. Strong demand for gold, fueled by inflation and macroeconomic uncertainty, is driving strong earnings at gold miner Northern Star Resources Ltd.
Similarly, favorable oil and gas prices continue to generate robust cash flow for oil and gas producers Woodside Energy Group Ltd. and Santos Ltd. How they balance growth aspirations with financial policy objectives will be a key watchpoint. As capex profiles remain elevated over the next few years, the possibility of downward pressure on ratings could intensify, particularly if prices remain sluggish or costs at growth projects blow out.
Investments by oil and gas companies in the transition to renewable energy sources are also moderating as they seek to balance investment returns against higher capital costs. Despite delays in climate-related investment, engineering and construction company Worley Ltd. remains well positioned to benefit when projects gather pace.
Chart 2
REITs: Declining Valuations Should Prompt Buyer Return
Many of our rated office funds are counting on asset sales over the next 12-18 months to maintain rating and covenant headroom. These landlords have been wrestling rising interest costs, elevated capex, investor redemptions, and declining asset valuations at a time of structural and cyclical weakness in demand for office space.
We consider secondary-grade office assets most at risk as tenants consolidate their space requirements into prime quality, energy-efficient office buildings.
We believe strategic shifts, capital recycling, and growing confidence that interest rates have peaked, should help to broaden the pool of office asset transactions over the next 12 months. Further valuation declines should help buyers and sellers meet on price.
Chart 3
The strategies, they are a-changing. The earnings composition of some of our rated diversified REITs are heading into a state of transition.
Stockland continues to reposition its portfolio to the residential sector by recycling proceeds from non-core divestments into residential development projects. This positions the company well to benefit from an under-supply of housing in Australia where migration and strong employment are stoking solid demand.
Dexus and GPT Group have announced plans to significantly grow their funds management businesses. This involves leveraging their existing portfolios and skillsets to improve returns and reduce capital intensity. For creditors, we expect the declining proportion of earnings from high quality rental income to be offset by stronger credit metrics. This should mitigate risks to credit quality.
Secured funding could offer covenant relief. Domestic banks continue to be broadly supportive of the commercial property sector. We do, however, expect some REITs that issue unsecured debt but face diminishing covenant headroom to consider secured financing. This would allow issuers to alleviate covenant pressure and lengthen debt maturity profiles, which have diminished over recent years as they obtained shorter-dated unsecured bank debt financing.
Infrastructure: Rising Capital Investment In A Tough Environment
We expect a steady rise in infrastructure capital investment after a year of restraint. We anticipate high capex across all infrastructure sub-sectors except rail and seaports. After a pause, in which balance sheets are refreshed, we project further toll road projects to be undertaken. Nevertheless, the availability of contractors and resources could be strained, given several large government transport projects are planned or under way in Melbourne and Sydney.
The impact of inflation, particularly on labor, will mean most infrastructure entities now have higher cost structures. While these entities are typically structured to pass-through costs, these come with timing lags. As such, this may compress margins for assets that have inherently high leverage.
Growth aspirations mean our focus will be on managing execution risks of capital projects. Difficulty in securing fixed-price offtake contracts and a shrinking contractor base could see higher costs that make it challenging to meet expected project returns. Our rated entities retain sufficient flexibility in their project pipeline or dividend philosophy to manage potential balance sheet risks. The challenging environment means that in some cases, such as unforeseen contractor risk or cost overruns, shareholder support may be warranted.
Regulated utilities and the unregulated power sector have elevated capex plans. This is to aid their plans to transition to renewable energy sources over the next five years. AusNet Pty Ltd., Ausgrid Finance Pty Ltd., and Transgrid (unrated) are among entities looking at large capex. Snowy Hydro Ltd. is undertaking its Snowy 2.0. Pumped Storage Power Station project. This may consequently cause delays in energy transition timelines.
Chart 4
The return of traffic at rated airports leads us to expect growth of 1%-4% over the next two to three years. Most rated airports are planning multiple modular projects to meet long-term growth. Traffic, particularly international, has rebounded strongly, and is close to pre-pandemic levels at most airports. Most projects will be linked to pricing agreements with airlines.
Brisbane Airport Corp. Pty Ltd. and Perth Airport Pty Ltd. have major terminal-related plans over the next three to five years for long-term growth, while Melbourne airport (Australia Pacific Airports Corp. Ltd. is evaluating the timing for a third runway.
The rail sector faces elevated competition. We have revised to negative the rating outlook on Pacific National Holdings Pty Ltd. due to intense competition among peers and from the road sector. Aurizon Operations Ltd. is yet to break even on its intermodal segment. Competitive pressure has squeezed margins. Contract renewal and pricing pressure could hurt margins in the next two to three years. This could cause some divestments and consequent restructuring of markets in the sector.
Transurban Group is set to face macroeconomic headwinds. Inflation-linked toll charges have dampened traffic, but an offsetting factor is the wind-down of capital works. We see a short pause in capex before new major projects are announced, particularly in New South Wales.
Softer consumer demand will cause some slowdown at ports. We project volume growth of about 1%-5% at both NSW Ports and Port of Brisbane. However, these entities have strong property rental income, which, together with inflation-linked tariff increases, should support steady earnings growth. Capex is generally modest in this sector, which might still permit reasonable shareholder distributions without affecting credit quality.
Costs remain high and consumer demand is slowing. For corporate Australia that's a tough mix. Margins are holding up--for now.
Writer: Lex Hall
Related Research
- Pacific National Outlook Revised To Negative As Weak Operations Erode Headroom; 'BBB-' Ratings Affirmed, Sept. 1, 2024
- Wesfarmers' Diversified Portfolio Supports Strategic Growth, Aug. 29, 2024
- Port of Newcastle Investments (Financing) Pty Ltd. Upgraded To 'BBB-' On Stronger Financials; Outlook Positive, Aug. 29, 2024
- Fortescue Fiscally Fit For Investments, Aug. 28, 2024
- Woolworths Earnings To Improve In 2025, Aug. 28, 2024
- Coles To Maintain Business Strength In 2025, Aug. 27, 2024
- Legacy Project Issues Weigh On CIMIC, Aug. 25, 2024
- Woodside To Walk A Growth Funding Tightrope, Aug. 26, 2024
- Spark New Zealand Capital Management Key To Ratings Stability, Aug. 22, 2024
- Brambles Can Absorb Shareholder Friendly Actions, Aug. 21, 2024
- Santos' Progress On Growth Projects Is Reducing Execution Risk, Aug. 21, 2024
- Vicinity Centres' Acquisition To Reduce Rating Headroom In Short Term, Aug. 20, 2024
- GPT Can Accommodate Strategy Tweak, Aug. 20, 2024
- Amcor On Course For Earnings Revival As Destocking Relents, Aug. 18, 2024
- Telstra's Mobile Business Offsets Enterprise Segment Weakness, Aug. 15, 2024
- Goodman Group 'BBB+' Rating Affirmed As Development Earnings Grow; Outlook Stable, Aug. 12, 2024
- Ammonia Pivot To Push Woodside's Financial Envelope, Aug. 6, 2024
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
| Primary Credit Analyst: | Sam Playfair, Melbourne + 61 3 9631 2112; sam.playfair@spglobal.com |
| Secondary Contacts: | Paul R Draffin, Melbourne + 61 3 9631 2122; paul.draffin@spglobal.com |
| Parvathy Iyer, Melbourne + 61 3 9631 2034; parvathy.iyer@spglobal.com | |
| Richard P Creed, Melbourne + 61 3 9631 2045; richard.creed@spglobal.com | |
| Aldrin Ang, CFA, Melbourne + 61 3 9631 2006; aldrin.ang@spglobal.com | |
| Craig W Parker, Melbourne + 61 3 9631 2073; craig.parker@spglobal.com |
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