Yet More Reporting Season Previews

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This story features COCHLEAR LIMITED, and other companies.
For more info SHARE ANALYSIS: COH
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

BA-Merrill Lynch is expecting the Australian FY10 results season to be sufficiently benign, with actual results falling close enough to net 8% earnings growth predictions. Revenues are expected to fall 3%, which Merrills also agrees with. If anything, says, Merrills, forecasts are relatively conservative.

Not so the case for arguably the more important element of the season, FY11 guidance. Analyst consensus currently has earnings growing 24% in the period with significant margin expansion – a figure which is “absurd” according to the broker's equity strategists and “simply not achievable” in an environment in which global economic growth is receding.

Just to recap, ahead of and during the season we will be provided with reports from broker equity strategists, stock analysts, and quantitative analysts. The three groups take three different approaches to stock valuation.

Equity strategists value on a “top down” basis. They begin by forecasting global trends and thus GDP, break that down into country performance expectations, then break the country into sectors, and finally the sector into stocks in terms of earnings performance.

Stock analysts value on a “bottom up” basis. They begin with an individual stock, crunch the numbers and apply fundamental view points in order to reach a target price and rating. Stock analysts specialise in one sector at a time only, meaning that when they suggests a stock will “outperform” the index they really have no idea what their colleagues are saying about other sectors. Yet in theory, not all sectors can outperform together.

Quant analysts, as I noted last week, are the sort of boffins who each year write a purely statistical and totally non-subjective computer model for the office footy tipping comp, and usually come stone motherless. The same approach is applied to stock valuation such that no fundamentally subjective interpretation can taint the view, but rather historical numbers are used as a guide for complex computer models. Quants are usually better at tipping stocks than they are at tipping footy results.

Of course the missing link here is technical analysts – those who study chart patterns and read tea leaves and generally besmirch fundamental factors as being irrelevant. The net result from a group of technical analysts is usually around 50/50. Me – I carry a coin.

Merrills equity strategists have “stress tested” net stock analysts earnings forecasts for FY11 and determined them to be 15% too high. They suggest a figure of 66% expected growth for the materials sector is the stand-out, given that would be reduced to 17% if commodity prices fell (although they don't say by how much). The consumer and industrial sectors are also suggesting downside risk, says Merrills, with the trend of downgrades in insurance, transport and healthcare also at risk of continuing.

The strategists particularly warn that ASIC has recently been querying the high level of intangible assets on balance sheets, putting pressure on auditors to realistically assess such things as goodwill. One third of Australian companies boast intangibles greater than 40% of net assets, Merrills notes.

On the positive side, the strategists have come up with a list of stocks which may surprise to the upside, these include Cochlear ((COH)), Ansell ((ANN)), AGL ((AGK)), APA Group ((APA)), JB Hi-Fi ((JBH)), Coca-Cola Amatil ((CCL)) and Asciano ((AIO)).

Citi economists have also weighed in the argument – there's another mob with a view.

Citi's economists suggest current FY10 earnings forecasts look to be a function of expected higher sales on lower cost bases, which is in direct contrast to Merrill's 3% lower sales consensus. They note that stock analysts are looking to materials, media and transport for a healthy dose of better sales on lower costs, and agree except for transport.

The sectors exhibiting the best sales and profits momentum going into the results season are mining, media and retail, notes Citi. Construction and utilities are exhibiting the least.

Citi also notes that analysts are expecting sizeable cost savings to still be a function of FY11 earnings, but suggests such expectations may prove optimistic in a slowing global economy, and in a local environment of labour market tightness and inflation pressure.

Morgan Stanley stock analysts do not expect any great surprises to come out of the Small Caps sector this season. They see earnings as coming in in line with guidance, but warn that FY11 guidance is unlikely to be helpful to investors looking for some clarity. FY10 guidance has been patchy, given various global uncertainties that are still with us.

And so on to the quant analysts. The teams from both Macquarie and RBS have been hard at it, feeding numbers into their different models to come up with a list of stocks they conclude might surprise to the upside, and to the downside.

Macquarie has looked at recent earnings revisions, earnings certainty, price momentum and the Macquarie Sentiment Indicator to devise its lists. Potential positive surprises within the ASX 100 may come from (in descending order) Seek ((SEK)), Goodman Group ((GMG)), Coca-Cola Amatil, Challenger Financial ((CGF)), Lend Lease ((LLC)), Amcor ((AMC)), United Group ((UGL)), Stockland ((SGP)), West Australian News ((WAN)), Cochlear, and APA Group.

Potential negative surprises may come from AWE ((AWE)), Aquarius Platinum ((AQP)), Primary Health Care ((PRY)), ERA ((ERA)), Downer EDI ((DOW)), Paladin ((PDN)), IAG ((IAG)), Sims Metal ((SGM)), Aristocrat ((ALL)), Sonic Healthcare ((SHL)), Brambles ((BXB)) and Qantas ((QAN)).

RBS has developed a model which is good for picking negative surprises, but not positive. With a recent success rate of around 65%, RBS is happy with its formula of using a “positive skew” going into reporting season as an indicator of overvaluation. The quants include elements such as analyst earnings revisions and forecast dispersion within the model.

On that basis, RBS suggests negative surprises may come from Biota ((BTA)), Pacific Brands ((PBG)), Ausenco ((AAX)), Paladin, Sigma Pharmaceuticals ((SIP)) and ROC Oil ((ROC)).

On some unstated other basis, RBS suggests positive surprises may come from Eastern Star Gas ((ESG)), Bradken ((BKN)), Atlas Iron ((AGO)), Goodman Group, Mt Gibson Iron ((MGX)) and IRESS ((IRE)).

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