Previewing FY10 Results And FY11 Outlook

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By Greg Peel

Cash is king, says RBS Australia. The analysts recognise this line is a cliché, but in such uncertain times they suggest the “quality” of earnings results is just as important as the quantity. Quality is obviously a subjective measurement, but RBS believes quality can be quantified at least in part by a calculation known as a “cash realisation ratio”.

The analysts want to deploy CRR measurements given cashflow generation is a “unifying force” among companies that cuts through the noise of factors within company reports including one-off items, provisions, seasonal earnings bias and so forth. The CRR is measured as normalised profit after tax (NPAT) plus depreciation and amortisation divided by operating cashflow. It represents the “cash backing” of earnings and thus their quality, RBS suggests.

RBS has applied CRRs to its FY10 forecasts for stocks in the ASX 100 and will recalculate once all reports are in.

The top ten stocks on a CRR basis are Australian Worldwide ((AWE)), Oil Search ((OSH)), United Group ((UGL)), OZ Minerals ((OZL)), OneSteel ((OST)), Goodman Fielder ((GFF)), Myer ((MYR)), Alumina Ltd ((AWC)), Woodside ((WPL)) and DUET ((DUE)).

The bottom ten are MAp Group ((MAP)), Paladin ((PDN)), Intoll ((ITO)), BlueScope ((BSL)), Amcor ((AMC)), CSR ((CSR)), Sims Group ((SGM)), Westfield ((WDC)), JB Hi-Fi ((JBH)) and James Hardie ((JHX)).

BA-Merrill Lynch has been looking at the infrastructure and utilities sector. The analysts expect “very solid” six-month results. Assuming no more “debt events” (such as another European implosion for example), Merrills expects this sector to hold up well through any further market volatility, although it is not so clear as to whether this “defensive” sector can actually continue to outperform.

Those companies in the sector Merrills is looking to for “stand-out” results are AGL ((AGK)), Asciano ((AIO)), MAp Group, Transurban ((TCL)), Australian Infrastructure ((AIX)) and ConnectEast ((CEU)). The analysts particularly like MAP and AIO.

The analysts have these stocks trading at steep discounts to their discounted cash flow valuations, but note that price/earnings and other multiples do look high in comparison to other sectors. This may mean some resistance from the market, but Merrills considers them reasonable “in light of earnings security and likely growth”.

The broker warns, however, that AGL has outperformed the market by 6% since the beginning of June which limits its upside.

Morgan Stanley has considered another so-called “defensive” sector, being healthcare, but suggests regulatory risk undermines such defensiveness. MS has Ramsay Health Care ((RHC)) and Ansell ((ANN)) on Overweight ahead of reporting season believing the market may be too conservative in its earnings forecast consensus. ResMed ((RMD)) is the analysts' preferred growth exposure, but upside appears now to be capped, they suggest.

The new government initiative of pathology centre licensing is a negative for companies in that game, Morgan Stanley suggests. The analysts thus have an Underweight on Primary Health Care ((PRY)) and note that while less exposed, Healthscope ((HSP)) and Sonic Healthcare ((SHL)) remain “vulnerable”.

Morgan Stanley believes expectations for earnings growth for Cochlear ((COH)) are too high following a survey of the implant industry.

From defensive to offensive, or cyclical, Morgan Stanley has also run its ruler over the resources sector.

Companies which the analysts believe have upside risk to earnings results are BHP Billiton ((BHP)), Rio Tinto ((RIO)), OZ Minerals, PanAust ((PNA)), Equinox ((EQN)) and Newcrest ((NCM)). Companies with downside risk are Alumina, Iluka ((ILU)), Fortescue ((FMG)), Macarthur Coal ((MCC)) and Centennial Coal ((CEY)).

Morgan Stanley suggests management outlook from resource sector companies will tend to be on the conservative side given ongoing global uncertainty over European debt and Chinese slowing. The MRRT will no doubt crop up and the Chinese steel price will be seen as a lead indicator with iron ore spot prices now falling.

The analysts nevertheless expect improving share prices for mining companies over the course of the September quarter.

UBS has looked at the Real Estate Investment Trust sector. After considering upside and downside risk to results and guidance, the “always coming” office recovery, debt refinancing obligations, asset valuations, dividend payout ratios and the recovery of funds flow into REIT investment, UBS prefers Westfield and Goodman Group ((GMG)).

Moving on to FY11 guidance and analyst forecasts, UBS suggest margin expectations are a little optimistic. The analysts expect timing will be adjusted to suggest a longer than previously anticipated recovery, such that FY11 earnings forecasts across the market will need to come down by some 5%. UBS does not expect any “huge” downside.

On a sector distribution basis, UBS' strategists are Overweight the mining sector and the industrial cyclicals (media, selected consumer discretionary and selected mining services). They are Neutral on the banks but note banks will outperform in any market bounce.

At the stock level, the strategists' strongest growth/defensive ideas are ResMed, AGL and Crown ((CWN)).

While RBS is looking at cash realisation ratios to assess FY10 results, Deutsche Bank is using profit “run rates” to gauge the outlook for FY11 in the emerging companies (small industrials) sector.

A “run rate” is simply an extrapolation of a previous result. If company XYZ posted $100m profit in the first half of FY10, for example, then its run rate implies a full-year profit of $200m. But Deutsche is using forecast second half run rates to gauge expectations of first half FY11 earnings.

Run rates lose their value for certain specific sectors or stocks where seasonality is a major factor (Christmas for retail, for example). And for cyclicals in general, run rates are not taking into consideration troughs and peaks in cycles. But nevertheless, Deutsche notes most stocks in its coverage universe have run rates below current forecasts. Says Deutsche, “It appears that the market's expectation for earnings growth has improved over the calendar year to date, but remains slightly negative to FY11 earnings growth. If results prove to be closer to run rates than current forecasts, the analysts would expect downward pressure on the Small Industrials index.

Stocks with an FY11 run rate below current forecasts include Ardent Leisure ((AAD)), Crane Group ((CRG)), GWA International ((GWT)), Miclyn Express ((MIO)), Mermaid Marine ((MRM)), Realestate.com ((REA)), Salmat ((SLM)), Spotless ((SPT)), Swick Mining Services ((SWK)), Transpacific ((TPI)) and Wotif ((WTF)).

Stocks with run rates above consensus forecasts include Flight Centre ((FLT)), Bradken ((BKN)) and NRW Holdings ((NWH)).

Leaving off where we began, with RBS, the analysts have had a look at FY11 prospects for the construction and engineering sector.

The upshot is that the roll-off of government infrastructure stimulus coupled with delays to new resource projects in light of mining tax uncertainty have meant a risk to short-term performance. The sector does appear to be recovering, but the recovery is neither uniform nor linear, RBS suggests.

The analysts thus warn of downside risk to current FY11 forecasts in the sector but they nevertheless have a positive medium-term view, looking for performance on a three-year basis.

On that measure, the stocks RBS prefers in the sector are Downer EDI ((DOW)), Transfield ((TSE)), WorleyParsons ((WOR)), Monadelphous ((MND)), United Group, Leighton ((LEI)) and Boart Longyear ((BLY)).

FNArena will bring readers more broker previews as they come to hand.

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