Treasure Chest: Hefty Earnings Downgrade Risk In FY14

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-Substantial downgrade risk in FY14
-Consumer sector high risk
-Gaming forecasts justified
 

By Eva Brocklehurst

There's a club. At least that's how brokers describe it. The second half skew club, those stocks heavily dependent on earnings growth in the second half in order to meet guidance/expectations. CLSA has  identified a substantial increase in membership this year, although the criteria are slightly different to that of Credit Suisse.

Credit Suisse screens for stocks which have a skew to the second half that's more than 5% above the average reported skew over the past five years. To confirm exposure the analysts are surveyed for a fundamental opinion about whether the company can achieve the predictions. The list provides a means whereby active portfolio managers can compare positions to make sure there is not undue exposure to the risk. There is both upside and downside risks in this regard.

So, the stocks that make up Credit Suisse's list for downside risk – in that earnings are highly skewed to the second half and there's a risk they won't make the grade – are SMS Management & Technology ((SMX)), Wotif.com ((WTF)), Fleetwood ((FWD)), Sandfire Resources ((SFR)), Goodman Fielder ((GFF)), Fortescue Metals ((FMG)), Mt Gibson Iron ((MGX)) and Cochlear ((COH)). Specifically, Goodman Fielder's risk lies with unplanned disruptions, something frequently encountered in Credit Suisse's experience. This can have a material effect on profitability.

Sandfire Resources has production weighted to the second half and recent milling problems may reduce FY14 expectations, although the company itself provides no earnings guidance. Credit Suisse acknowledges that because miners are driven by sales and commodity prices, looking for typical skews is not a valid approach. Moreover, with the iron ore price under pressure, all June half iron ore stock forecasts are expected to find it hard to meet expectations. Hence, the inclusion of Fortescue and Mt Gibson in the list.

Cochlear's earnings, when the foreign exchange rate movement is factored in, do not normally show a material second half seasonality. It was the AGM commentary that suggested earnings would be materially skewed to the second half. Credit Suisse thinks there's some downside risk to guidance. Fleetwood posted weak first half results and did not provide full year guidance. Credit Suisse retains a view that the forecast risks are extremely high for manufactured accommodation and recreational vehicle industries.

Wotif.com has historically had a weighting to the first half, given the demand for travel around Christmas. Recently this first half skew has flattened and there has been a relatively even split. The latest interim result was weak and, while the company did not provide explicit guidance, the broker thinks the negative trends are unlikely to reverse. SMS Management has a weighting to the second half because of a typical strong uplift in demand in the fourth quarter form federal and state government expenditure. Recently this trend has not held up and to date there has been no strong evidence of a recovery. Thus Credit Suisse sees downside risk to guidance.

There's one stock with upside risk that stands out – Macquarie Group ((MQG)). Here the magnitude of the second half skew is achievable, in Credit Suisse's view, as the Sydney Airport ((SYD)) transaction in January will crystallise a $228m gain. The company did not upgrade guidance at the first half result but the broker suspects it may overshoot.

CLSA screened on two criteria at the stock level, expectations of accelerating earnings growth and accelerating sales growth. Given the large membership of the second half club, and recent pressure on commodity prices, the risks are pointing to growth forecasts generally being too high.

CLSA expects downgrades to forecasts to start hitting the headlines around May. Downgrades to forecasts in May 2013 numbered the second highest outside of the GFC, mostly involving those stocks that did not reduce estimates enough after the interim results and/or expected an acceleration or rebound in the second half. In 2013, the broker notes 70% of the companies in the second half club were downgraded during the May confessions. Furthermore, CLSA notes more than 55% of ASX200 companies expect growth to accelerate in the current half. Historically, these companies account for more than their fair share of downgrades.

The three that stand out are Cochlear, Toll Holdings ((TOL)) and Southern Cross ((SXL)). The CLSA analysts are sceptical that Cochlear can speed up its turnaround, while there's pressure on Toll's core business and a dependence on new contracts. The broker sees no reason for a return to material growth in the second half. The risks for Southern Cross, meanwhile, are increasing, with metro ratings suggesting that both revenue and costs could be at risk.

In terms of the sectors, consumer staples has the largest number of companies forecasting faster growth in the second half. This worries the broker, as this is a sector with supposedly defensive earnings. Consumer discretionary ranks third. The biggest change is in the materials sector. Last year almost two thirds of this sector delivered accelerated growth in the second half. This time around, with pressure on commodity prices, the analysts expect the majority will report slower growth in the second half. Others with a high risk of not measuring up are AGL Energy ((AGK)), JB Hi-Fi ((JBH)), Origin ((ORG)) and Super Retail ((SUL)), in CLSA's view.

Utilities AGL Energy and Origin very much need a strong second half, according to CLSA. Both rely on hot summer conditions and new gas sales to reach their forecasts. JB Hi-Fi and Super Retail are part of the consumer discretionary sector and, while the outlook is improving, the consumer confidence measures are not and the broker doubts there's enough momentum for the stocks enough to live up to expectations.

There are growth estimates that may prove to be too conservative. CLSA observes those outside the second half skew have historically accounted for a higher percentage of upgrades. Stocks which feature in this scenario include Aurizon ((AZJ)), Commonwealth Bank ((CBA)), Challenger ((CGF)), Fletcher Building ((FBU)), Goodman Group ((GMG)) and Insurance Australia ((IAG)).

There are some interesting variations on the theme. BlueScope Steel ((BSL)) ranks as one with the greatest acceleration expectations but, given the increasing demand from single family housing, a benefit from a falling Australian dollar and strength in US non-residential construction the broker is not concerned. Gaming stocks are also well represented in the second half club but the broker believes their forecasts can be justified.
 

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