Reporting Season – The Scorecard

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This story features BHP GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: BHP
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

By the end of last Friday in excess of 95% of corporate earnings by market capitalisation had been reported, sufficient enough for equity strategists to conclude an overall scorecard. Something around three fifths of listed companies reported their full financial years earnings FY10, while the balance reported first half 2010 earnings. This does not include another small group of companies which account on a year-end basis other than June or December.

From a nominal point of view, it looked like a cracker of a season. Unfortunately the popular media can see no further than headline profit results and how they compared year-on-year, for fear of confusing themselves or their audience. Australian companies, and subsequently stock analysts, tend to focus on the headline number even though it can tell a misleading story. FY10 profit results showed an improvement of around 27% on average on FY09, but then FY09 was all about a GFC.

What is important to shareholders is not how much profit a company made, but how much of it translates to a return for the shareholder. This is measured in terms of both earnings per share (uncrystallised return) and dividends per share (realised yield). Headline profit comparisons fail to acknowledge, for example, dilution of the shareholder base through capital raisings in the period. And within the headline profit itself, analysts are often caught out by increases/decreases in the cost of funds (interest expense on debt) or effective tax rates which are difficult to accurately predict.

Assessments of a reporting season scorecard thus focus not on profit but on earnings per share. FY10 was a year in which many companies raised additional capital and cut or suspended dividend payments. Debt levels were reduced where possible and cash was retained as a provision against the uncertainty of what lay ahead. Balance sheets were not only “repaired” but in many cases they were bolstered to a conservative level. It's a pity this didn't happen before the GFC rather than after it, and now that it's happened companies run the risk of being downgraded by analysts for having “lazy” balance sheets. You can't really win in this game. And hindsight is a wonderful attribute.

Various brokers have made their assessments of the season, and if we want to be general we could say results were largely in line with expectations in that about half the pool missed earnings forecasts and the other half beat them. This depends, of course, on what a particular broker's forecasts were beforehand. Perhaps it's best to look at Bloomberg's consensus figures which show 45% of companies exceeding consensus and 55% falling short.

Bloomberg's split allows no measure for “in line” results, such that every company had to have either beaten or missed. One presumes this then can come down to a matter of mere dollars. And there is no quantification of the dispersion around expectations. Macquarie has looked at it another way (based on its analysts' own forecasts, not consensus).

Taking a result of 5% or more outside of forecasts, Macquarie suggests 62 companies posted positive earnings surprises while only 39 posted negative surprises. One might presume this should imply the Australian stock market would be up over the course of the season, not down as it is. But then external influences (eg Wall Street etc) aside, what is important is not so much the FY10 result as the FY11 guidance. Stock markets are leading indicators, so while a bad “miss” on a result will usually mean a stock market de-rating for example, a good result tempered by uninspiring guidance from management is also enough to also spark a sell-off given analyst forecasts have to be downgraded.

Companies are not obliged to provide quantified guidance, as in specific FY11 earnings targets. This season many chose not to citing simple uncertainty of what at least the first half of FY11 has in store. No point in picking a number for the sake of it and disappointing the market down the track. But companies are basically forced to provide an “outlook”, no matter how anecdotal, given no news will always be construed as bad news.

As far as the net earnings scorecard for FY10 is concerned, analysts suggest earnings before interest, tax, depreciation and amortisation (EBITDA) rose by around 10% over the period, with a big weighting to the second half, while final earnings per share (EPS) rose by only 2%. But as noted, this was about in line with expectations given this time last year analysts assumed FY10 would represent the slow stumble out of the GFC.

At that same time, nevertheless, forever optimistic analysts had assumed FY11 would be a boom year when an economic rebound would drive substantial earnings growth off the low FY09-10 base. What they weren't foreseeing then, however, was a European debt crisis or a Chinese forced slowing or a post-stimulus slide in a tenuous US economy. Nor were they prepared for the extent of consumer retreat or the oft-talked about “cash on the sidelines”, which is true for both investors and corporations. Uninvested cash does not make for enhanced returns on capital.

In short, they were a bit over-optimistic. Managements, on the other hand, have tended to the cautious side in providing FY11 guidance. You can't blame them given the current state of the global economy combined with the end of stimulatory interest rate settings in Australia. Managers will, for the most part, tend to the conservative side. It's better to ultimately beat a low-bar guidance range than it is to miss a high-bar range. Stock markets will always weight their punishment towards profit downgrades.

The end result is that analysts have been forced, post results, guidance and outlooks, to reduce their FY11 profit forecasts by around 3%. It must be noted, however, that this is off a 25% consensus FY11 earnings growth expectation ahead of the season, so it's not really a disaster. But it implies a downward adjustment to share price valuations nevertheless, which is what we have seen.

The other point to consider is that Australia's listed corporations can be divided into two distinct categories – “Resources” and “The Rest”. While the net EPS forecast for FY11 might still be over 20%, Macquarie notes that The Rest's component is only 12.4%.

And all analysts agree that that 12.4% figure remains under threat. In the near term, equity strategists are anticipating further downgrades.

The good news for shareholders is that corporations have at least felt relieved enough post-GFC to start to do something with their excess cash. As a result, dividends have been either restored or increased and many capital returns in the form of special dividends or share buybacks have been instigated. Others have taken the opportunity to pursue acquisitions, not all of which have been well received. BHP Billiton's ((BHP)) swing at Potash is one example.

CommSec notes 83% of companies reporting full-year results issued a dividend and 40% represented a lift in dividend over last year.

CommSec also sums up the FY10 season quite nicely:

“Investors would look at the situation quite positively. Companies are earning money again, dividends are back in vogue, balance sheets have strengthened and companies are sitting on a pile of cash. Analysts may have wanted more but they under-estimated the conservative mood of Aussie consumers and over-estimated how quickly economies like the US and Europe would bounce back from the global financial crisis.”

Macquarie would argue the consumer is actually not quite as scared off as assumed, noting all of Westfield ((WDC)), Wesfarmers ((WES)), JB Hi-Fi ((JBH)), Myer ((MYR)), David Jones ((DJS)) and Woolworths ((WOW)) provided results and /or outlooks which suggest improving trends.

In terms of surprise results across the market, UBS suggests the most surprisingly positive came from Challenger Financial ((CGF)), Leighton ((LEI)), Brambles ((BXB)), Coca-Cola Amatil ((CCL)), Sims Metal ((SGM)), News Corp ((NWS)), United Group ((UGL)), Woolworths and Fairfax ((FXJ)).

The most surprisingly negative results were posted by Billabong ((BBG)), Telstra ((TLS)), Computershare ((CPU)), James Hardie ((JHX)), Primary Health Care ((PRY)), OneSteel ((OST)), West Australian Newspapers ((WAN)), WorleyParsons ((WOR)) and Downer EDI ((DOW)).

Deutsche Bank notes that those companies reinstating or lifting dividends include BlueScope ((BSL)), Boart Longyear ((BLY)), and Wesfarmers while buybacks were announced by Woolworths and CSL ((CSL)), among others. Companies showing a preference for acquisitions included BHP, Computershare, United Group and Boart.

Deutsche expects these themes to continue through FY11 providing potential earnings upside for a range of companies.

JP Morgan and Citi both continue to be worried about ongoing risk to earnings forecasts in the near term. JPM nevertheless suggests the banks have less earnings risk than other sectors and boast a firmer valuation basis. Citi notes the market is now trading on an average FY11 price/eaqrnings of 11.6x and yielding 5.1% which the strategists suggest is “good value” even if there are downgrades to come.

UBS notes forecasts are drifting lower rather than being cut dramatically and agrees that the forward PE is undemanding, even though The Rest are trading at 12.2x. But UBS sees the market struggling in the face of US economic weakness.

Goldman Sachs is a bit more upbeat, suggesting FY10 completed one half of a recovery story while FY11 should see the other half. In the first half, earnings results were achieved through cost reductions but were not supported by any reasonable growth in revenues. GS sees domestic trading conditions improving over the period as companies leverage off lower fixed costs with improved revenues.

The FY10 earnings season began rather poorly but redeemed itself to a great extent on the run home. One thing that must be kept in mind is that many stock analysts out there have never experienced a recession and recovery as a stock analyst. The last real recession in Australia was in 1992 and we didn't come rocketing out of that one in a real hurry either. The 2003 recession in Australia was shallow and swift and while the 2008-09 recession in Australia wasn't one, it was, and is, if you take out Resources. So it's quite new territory for many of our number-crunchers.

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