Weekly Broker Wrap: Here Comes Earnings Season

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By Greg Peel

“It's not surprising,” suggested the Citi equity strategists last week, “the coming earnings reporting period is being viewed anxiously”.

There have been a couple of early birds, but basically the bulk of Australian listed companies provide six-month earnings results over the month of February, most of which are interims but there are a growing number of full-years as well. The number of reports each day are heavily weighted to the last weeks of the month. Ahead of each season it is typical to endure a “confession session” in which those companies expecting to miss guidance decide it best to get a warning out there to minimise the market backlash on the day. Upgrades are rare given upside surprises are well received on the day. Typical of such confessions were Christmas-time severe warnings from retailers JB Hi-Fi ((JBH)) and Billabong ((BBG)) and insurer QBE ((QBE)).

Deteriorating capital markets, weak commodity prices and sub-par consumer spending over the six months are just some of the elements that might be causing market anxiety, Citi suggests, and even the wet and cold east coast weather of late will be a point of concern. Yet the strategists don't believe we're about to see the “bloodbath” that might be feared. Earnings estimates have been falling steadily for eighteen months now, including in the past few months, and at only 5% growth expectation for FY12 it's fair to conclude that estimates are now a lot more realistic than they have been.

Citi is not expecting a lot for FY12 either but believes FY13 estimates may be a bit more resilient. In the meantime the strategists have to admit there remain clouds over some stocks, with possible downside surprises coming from Harvey Norman ((HVN)), JB Hi-Fi (again), Macquarie Group ((MQG)) Seven West Media ((SWM)), Treasury Wine Estates ((TWE)) and Wesfarmers ((WES)). There's not much scope for upside surprise, but Citi has flagged Ansell ((ANN)), Boart Longyear ((BLY)), Graincorp ((GNC)), James Hardie ((JHX)) and Orica ((ORI)) as possibles.

Goldman Sachs notes the uncertain backdrop has led to fewer companies providing actual guidance in recent times – they're under no obligation – which leaves analysts a little out in the cold and thus a bit more cautious. Goldmans nevertheless agrees with Citi's suggestion that a lot of the downside earnings risk is now priced in, noting the forward PE of 11.5x for industrials is a full standard deviation below historical averages.

Having said that, Goldmans suggests 28% of stocks under coverage have downside risk on reporting against only 9% with upside risk. In the former camp are Alumina Ltd ((AWC)), Bendigo & Adelaide Bank ((BEN)), Commonwealth Bank ((CBA)), Cochlear ((COH)), CSR ((CSR)), David Jones ((DJS)), Harvey Norman and Transfield ((TSE)). In the latter camp are Crown ((CWN)), Goodman Group ((GMG)), Iluka ((ILU)), Orica, Stockland ((SGP)) and Westfield Retail Trust ((WRT)).

Goldmans' recommended portfolio currently exhibits a modestly cyclical bias, and for solid earnings growth the strategists like Amcor ((AMC)), Brambles ((BXB)), Wesfarmers, News Corp ((NWS)), Computershare ((CPU)) and Stockland, and for mining/China stimulus they like BHP Billiton ((BHP)), Rio Tinto ((RIO)), Sims Group ((SGM)), Orica, Asciano ((AIO)), United Group ((UGL)), Woodside ((WPL)) and Oil Search ((OSH)).

UBS also has a bias towards selected industrial cyclicals along with the resource and resource services sectors. The strategists are Underweight industrial defensives which they believe to now be too expensive, are Neutral on banks while the domestic backdrop remains weak, and see no value in holding government bonds.

New additions to the UBS model portfolio are Downer EDI ((DOW)), Toll Holdings ((TOL)), Woolworths ((WOW)) and Woodside at the expense of ASX ((ASX)), Lend Lease ((LLC)), Origin Energy ((ORG)), Seven West Media and Wesfarmers.

The UBS quant analysts have also weighed in on the act. We now talk constantly of Australia's “two speed” economy and UBS suggests upcoming company results will reflect this in a “two speed” result season. Those sectors faring better should be resource services, general industrials and healthcare and those faring not so well should be consumer sectors and financials. The analysts suggest the market will be looking out for financial statement quality, value and earnings revisions to drive outperformance.

[Note: “Financial quality” refers not just to a healthy balance sheet but to the “quality” of earnings. Earnings based on solid and consistent revenues and cashflow conversion, for example, equals good. Earnings improved by desperate cost cutting, one-off profits or a lower tax rate, for example, equals not so good.]

UBS also joins in the FNArena mantra in suggesting dividends will matter in this world of slower growth. Many Australian companies are carrying excess franking credits so those companies offering full franking can provide investors with a “free kick”. And the quant guys have thrown their “surprises” hat into the ring as well.

On the potential upside surprise side (using quant number-crunching rather than fundamentals) they have Flight Centre ((FLT)), Primary Healthcare ((PRY)), Sonic Healthcare ((SHL)), Dexus Property ((DXS)), DUET ((DUE)), Sigma Pharma ((SIP)), AGL Energy ((AGK)), Boart Longyear and Carsales.com ((CRZ)). On the downside they have Downer EDI, Ten Network ((TEN)), Seven West Media, Woodside, SEEK ((SEK)), Transpacific Industries ((TPI)) and Aquila Resources ((AQA)).

For potential buybacks or special dividends, the analysts are looking to JB Hi-Fi, Flight Centre, Carsales.com, SMS Management ((SMX)) and Rio.

Looking at metals & mining specifically, Citi notes that 2012 to date has been the “year of confession” with both analyst and company estimates being reined in. Six Australian companies have downgraded guidance to cut average earnings estimates by 9% while thirteen companies have had their consensus earnings forecasts cut by 10%-plus. The good news is that the “bullish fat” has now been removed, Citi suggests, meaning forecasts are a lot more realistic. On that basis, investors are in a better position to assess “value” with the “value trap” largely removed.

Globally, consensus sector earnings are down by 20% for the current and next years and consensus commodity price forecasts are at or below spot, Citi notes. Absolute next year forecasts are back to 2007 levels. Locally, average target prices for the miners have come down 8% and the average upside to target has fallen to 34% from 46% – still hefty but more achievable, Citi believes.

There may yet be some downgrades to come, particularly from those companies moving to production ramp-up, Citi warns. Those at risk include Bathurst ((BTU)), Lynas ((LYC)), Discovery ((DIS)) and Sandfire ((SFR)). On the other hand, Citi likes the volume growth names as well as the unloved turnaround stories, which include PanAust ((PNA)), Fortescue ((FMG)), Atlas ((AGO)), Regis ((RRL)), Whitehaven ((WHC)), Resource Generation ((RES)) and Rio. Citi's global analysts also include Rio in their list of preferred global mining names.

With Australia's gold producers now having reported their December quarter production results, Credit Suisse has updated its gold sector preferences. Newcrest ((NCM)) is a given because of its growth opportunities, but beyond that CS believes Alacer Gold ((AQG)) was the victim of a market overreaction to weaker 2012 production guidance. The analysts see 22% upside potential for Alacer and with significant growth potential forecast over the next five years, this is their key pick.

Among the explorers, Ampella Mining ((AMX)) just suffered a target price downgrade from Credit Suisse following some complex metallurgical test results suggesting lower than expected recoveries. However, the analysts continue to see value, with the lower target price still some 35% above AMX's current trading price.

Macquarie was last week championing the local energy sector, but strictly on a shorter term basis. The analysts are bullish the near term picture for global oil and gas on a balance of emerging market demand, limited short term supply growth and the potential for further Middle East tensions. Into this environment, they note, will arrive Australia's timely first delivery of new LNG projects.

Australia's locally listed LNG players have seen their combined weighting in the ASX 100 triple over the past eight years, notes Macquarie. Yet while other sectors “grapple with unprecedented global economic uncertainties”, the LNG sector's medium term earnings growth profile looks set to outpace all others. On that basis the analysts expect that weighting to continue to trend higher.

Development risks are substantial in the LNG space, but Macquarie sees those as well priced in on an average 26% discount to valuation at current prices. With $1 billion set to be spent on “the most exciting drilling program in recent memory”, the analysts foresee plenty of newsflow in 2012 to keep the market interested. They subsequently have Outperform ratings on all the LNG biggies – Santos ((STO)), Oil Search, Origin and Woodside.

But here comes the but. In the longer term, Macquarie expects rising energy prices to be supported by rising costs, making the analyst more cautious on the longer term prospects for LNG.
 

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