Weekly Broker Wrap: Weakness Follows Through

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– Nickel forecasts increased
– Oil forecasts decreased
– Capex delays
– Iron ore forecasts increased
– Media downgrades

By Greg Peel

Even if this weekend does bring a comprehensive plan that all and sundry agree will end the turmoil in Europe, it doesn't necessarily mean we can all say “Thank God that's over” and assume no damage has been done. Whatever the plan for Europe, there is little disagreement the outlook for European economic growth from here is flat to negative as accompanying fiscal measures impede economic activity.

US economic data have been encouragingly more positive lately, which means the world's largest economy may not fall back into recession after all. Growth from here will nevertheless remain sluggish in the face of persistently high unemployment. Europe remains an important export market for the US, albeit the real growth is in emerging markets. But Europe is China's biggest export customer, so falling demand from Europe can only have a trickle-down effect all over the rest of the globe. This includes Australia, where reduced demand for Chinese exports will weigh on Chinese demand for resources, notwithstanding any restocking phase.

It is with this in mind that analysts continue to rein in their forecasts for commodity prices, currencies and stock indices. As noted in last week's Broker Wrap, analysts do not move forecasts every day but rather wait until substantial spot price shifts and economic growth forecast changes force such adjustments. Hence the downgrading rolls on.

Before we get to last week's round of downgrades, we can start on a positive note. Credit Suisse's base metal analysts last week cited a number of reasons why they see stronger nickel prices from early 2012.

The cost of nickel pig iron production in China has now blown out to the point less efficient smelters must either shut down or start cutting back on production, Credit Suisse suggests, before they fall into negative cashflow. Nickel project expansions outside of China have yet again fallen short of targets, and many are struggling with new, technically challenging production techniques. Overcapacity for stainless steel production in China remains an issue, but excessive production in 2010 has been countered in 2011 such that production now better reflects actual demand.

In light of this view, CS has lifted its average nickel price forecasts (all US$/lb) to 9.75 (up 5%) in 2012, 10.60 (18%) in 2013 and 10.90 (28%) in 2014 despite reducing its previous 2011 forecast to 8.60 (-15%). The current spot price is 8.54. The result is a reduction in FY12 forecast earnings for Australian nickel producers of an average 14%, offset by an average 50% increase to FY13-14 forecasts. The net result is that valuations are raised 24%.

CS further notes nickel producer share prices have led the recent stock pullback, falling by a much greater degree than spot nickel prices. The analysts thus retain their Outperform ratings on PanAust ((PNA)) and Mirabela ((MBN)), and have lifted Western Areas ((WSA)) to Outperform.

That's where the good news ends for now.

Much has been made of the large expansion plans and capital expenditure intentions of the Australian resources sector in the years ahead, which have not only underpinned expectations of GDP growth but have, until last month, been the main driver of RBA hawkishness. However experience suggests that when uncertainty creeps into the global economy, resource companies play it safe by delaying such expenditure. It's not such a big deal for mining companies to postpone projects, but it does impact on the companies that rely on those projects for annual revenues – the engineering and construction contractors.

JP Morgan regularly surveys Australian contractors to gauge the state of the market through the broker's Contractors Expectations Index. That index is currently negative, the analysts report, albeit larger contractors have begun to become more positive than smaller contractors. The LNG, iron ore and coal sectors still offer a wealth of work ahead, but current economic conditions and strong cost headwinds means project delays which are pushing JP Morgan's FY12 earnings expectations out to FY13.

The bottom line is that of the six contractors in the broker's sector coverage universe, only UGL ((UGL)) scores an Overweight rating. JPM has all of Downer ((DOW)), Leighton ((LEI)), Lend Lease ((LLC)) and Transfield ((TSE)) on Neutral, while the previously high-flying Monadelphous ((MND)) scores an Underweight.

JP Morgan analysts have also been busy reassessing their oil price and Aussie dollar assumptions and thus their oil & gas sector earnings forecasts. The analysts' forecast average prices for Brent crude across 2012-13 have come down 7% while their AUD forecast falls 2% in 2012 and rises 2% in 2013.

Resultant forecast earnings downgrades in the sector are significant, while resultant valuation reductions are more modest at 1-5%. Despite the downgrades JPM believes the sector is undervalued and among the large caps prefers Santos ((STO)) which rates an Overweight. JP Morgan's ratings are sector specific, and the offset is an Underweight rating for Woodside ((WPL)).

Macquarie's oil price assumption cuts have been more severe, albeit it all depends on from where you start. The Macquarie analysts have reduced their Brent crude forecasts by 19% in both 2012 and 2013 based on a weaker outlook for developed economies into 2012. Equivalent forecast earnings downgrades for the sector follow.

Macquarie nevertheless retains a positive longer term global view, noting that spare crude production capacity remains tight at only 5% with a great reliance on Saudi Arabia. Weaker demand in developed markets will be overcome by rising demand in emerging markets, the analysts believe.

Unlike JP Morgan, Macquarie rates all its stocks in its coverage universe against the index rather than the relevant sector. Given the analysts' positive longer term view and recent share price weakness, only one of the fifteen oil & gas producers under coverage does not score an Outperform rating and Nexus ((NXS)), rated Neutral, has its own unique problems. Preference, however, goes to Santos and Oil Search ((OSH)).

While Macquarie's resource sector analysts have been busy cutting forecasts, Macquarie's equity strategists have also been in on the act. Following on from Goldman Sachs' ASX 200 forecast reductions the week before, Macquarie has brought down its twelve-month target to 4559 (last close 4205). This compares to Goldmans' new end-2012 target of 4725. Macquarie's forecast implies a total shareholder return of 14.0% of which 5.7% represents dividend yield.

Macquarie has also been busy reassessing its high conviction calls on individual stocks, which it calls its Marquee Ideas. Three changes occurred last week, with Virgin Blue ((VBA)) going in in place of Echo Entertainment ((EGP)).

The prompt for Virgin's inclusion is draft approval from the ACCC for the carrier's planned alliance with Singapore Airlines which the analysts see as de-risking Virgin's earnings recovery. Meanwhile Echo's inclusion had been based on the relaunch of Star City casino and that has now occurred. Macquarie has also removed New Zealand's Sky City Entertainment ((SKC)).

Expectations of slower global economic growth have not just impacted on Australia's resources sector, but also on its media sector. Last week this Wrap noted reduced GDP forecasts for Australia from Goldman Sachs and the GS media analysts have translated the downgrades into lower expectations for advertising growth, to the point where they now expect an “ad market recession” in FY12.

The end result is that Ten Network ((TEN)) has been downgraded to Hold from Buy to join Hold ratings for Fairfax ((FXJ)) and Seven West Media ((SWM)). The analysts' forecast for Australian unemployment to reach 6.0% by mid next year means Seek ((SEK)) attracts a Hold rating, while a weak New Zealand economy contributes to APN News & Media's ((APN)) downgrade to Sell.

Having began on a positive note, let's end on one as well.

UBS analysts have also been reviewing their commodity price forecasts, last week marking to market for September quarter. While clearly this involves some reductions, the analysts' most material forecast change is for iron ore. UBS has lifted its 2012-14 iron ore forecast prices by 12-14% to reflect declining exports out of India, and this translates into 5-30% forecast earnings upgrades for Australia's iron ore producers. Earnings also get a bit of a kick from a trimming of the UBS AUD assumption.

The broker's pure play preferences are Fortescue Metals ((FMG)) and Gindalbie ((GBG)), while in the diversifieds UBS is not Robinson Crusoe in preferring Rio Tinto ((RIO)) over BHP Billiton ((BHP)).

While many commentators are now becoming nervous about the extent and speed of last week's global stock market rally, which has featured short covering and light volume, UBS believes markets had become too oversold and that the rally can run further. The UBS strategists are swinging away from defensive stocks, which have outperformed in the sell-off, and suggest the resources sector and its related service sector are the best bets.

Domestic cyclicals are also showing signs of bottoming, the strategists believe, though structural headwinds persist. Hence UBS remains relatively Neutral on such sectors but retains a “small” Overweight on banks with the headwind of subdued credit growth.
 

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