Australia | Jan 30 2012
By Andrew Nelson and Rudi Filapek-Vandyck
There simply is no room for discussion on the topic: most securities analysts and investment strategists at stockbrokerages and investment banks have returned from their Christmas holidays with a more positive outlook for equities this year. Traditionally, the month of January is a rather quiet one as most analysts prepare for the upcoming reporting season in February, when company updates are being absorbed into earnings and valuation models, leading to re-assessments on Buy-Hold-Sell ratings and re-adjustments to valuations and price targets.
Last week was shorter than usual because of Australia Day celebrations and research reports from the main stockbrokerages in Australia were, non-surprisingly, thinner than usual, especially on Friday, the Day After The Event. In terms of common themes for the research published during the week, much of it was dedicated to the building materials sector and to mining service providers. Both sectors, stockbrokers say, should be looking towards a good year ahead in terms of new orders, margins and profit growth.
Much like the year just gone, it looks like mining services firms will be blazing the trail to higher earnings in 2012. At least that’s the case with analysts’ comments from UBS, who expect the sector to outperform the broader market. Citing continued, robust demand robust and tight capacity, the broker predicts that gross margins are set to break out, which should lead to a run of positive estimate revisions as the year progresses.
Simply put, stocks in the sector are on average cheaper than they were this time last year. The broker is predicting solid share price performance from most in the sector, which it believes will be driven by a combination of rising valuations on the back of upward estimate revisions.
UBS notes that on average, the sector is trading at a discount to historical P/E levels. Given the current market, the broker thinks this just isn’t right and notes that if one were to apply historical P/E’s, then we would see some real upside to current share prices.
Then there’s the demand dynamic. UBS points out that there is more than $200bn worth of capex on the cards for the resources sector this year and given current supply is constrained, the broker estimates the sector will experience continued margin growth over the year. In fact, if earnings margins positively surprise by only 1%-2% in FY12-13, the broker notes its EPS estimates would increase by 10-20% on average.
A key subset of mining services is drilling services providers and here is where Bank of America/Merrill Lynch (BA-ML) chimes in with their good news. Much like UBS, BA-ML think the drilling companies must be looking down the barrel of a good year given all of the capex that is in the pipeline.
In fact, BA-ML notes the major miners are increasing budgets for 2012. Junior miners are cashed up after learning how to rein in costs over the GFC, followed by what was a pretty good earnings year in 2011. Furthermore, the broker expects that metal prices will remain at premium to production costs, thus encouraging exploration and, subsequently, drilling.
While both brokers agree 2011 was a good year, they note there was some significant expense in tooling up after a few tough years. That meant that while work was steady, costs were higher, especially in servicing legacy contracts written in tougher times. Given the amount of work in hand, capacity will be tighter and combined with lower operating costs, both brokers predict a significant margin break out.
BA-ML likes Swick Mining Services ((SWK)), Boart Longyear ((BLY)), Campbell Brothers ((CPB)), Imdex ((IMD)), and Ausdrill ((ASL)) as margin recovery stories. UBS has singled out NRW Holdings ((NWH)), Macmahon Holdings ((MAH)) and Bradken ((BKN)) based on combination of fundamentals such as management quality, growth prospects, gearing and valuation, while it notes all three are likely to benefit from currently cheap valuation metrics.
Credit Suisse took a look at the domestic coal miners this week and while it has cut its near term coking coal price assumptions by 5% due to slightly weaker global demand and increasing supply, particularly from Australia, it still sees upside in the sector.
The coal price cuts weigh the most on Aquila Resources ((AQA)), Cockatoo Coal ((COK)) and Gloucester Coal ((GCL)) given their focus on PCI and semi-soft coking coal. The broker notes that Aquila and Cockatoo especially are highly sensitive to changes to coal prices given their smaller comparative output.
At the same time, CS has only trimmed its thermal coal forecast by just 1% given a warmer than expected weather in the northern hemisphere. However, this is pretty much offset by the broker’s view that demand will remain strong given demand from China and India is expected to remain strong.
Thus the broker is decidedly positive on the outlook for the Australian coal sector, noting producers are continuing to generate healthy margins and the outlook for coal prices, short term aside, remains relatively robust.
The broker’s Top picks are Cockatoo Coal and Stanmore Coal ((SMR)), noting both stocks are substantially undervalued right now given they are trading at a 40% discount to a risked valuation despite there being a number of near-term catalysts to drive the share price higher.
CS also sees a bit of continuing light for Australian Building Materials companies, bravely predicting a recovery, albeit a choppy one, is forming in the US housing market. The broker reports its US housing start assumptions have lifted by an average of 4% over FY12–14 after a recent review by its US Homebuilding and Building Products team.
Some of the emerging trends the team took note of was a steady, if subdued trend of improving employment reads, record affordability in the US housing market given the falls of the past four years and prices that seem to be bottoming. Together these trends are helping to lift new home demand from admittedly depressed levels.
However, one of the biggest barriers to a US housing recovery is the need to work through a massive distressed property pipeline. The broker notes that more than five million homes are either in foreclosure or are more than 60 days delinquent. This means foreclosures and distressed sales are still setting the prices in many regional markets. This fact continues to weigh on home prices in general and reduces the incentive for homebuilders to develop or consumers to renovate.
That said the broker still sees the seeds of recovery sprouting and notes there is hope for further US Government intervention, which would help to speed up the process of working through foreclosed and distressed homes, lifting some of the pressure on pricing.
Credit Suisse has moved to increase its US housing starts assumptions and this combined with a revision of other key assumptions see average earnings upgrade of 5.0% for James Hardie ((JHX)). While helpful, the broker notes that the near term valuation is still stretched and the broker only sees value only emerging after a clear recovery takes hold and there is subsequent proof of the company’s ability to generate strong margins again. For the time being, CS has kept James Hardie at Underperform.
BA-ML is a little more downbeat on the Australian housing market, but its negative assessment is only short term. The broker is predicting another 5% decline in house prices through 2012, driven by a cautious consumer and household deleveraging. Yet by the end of 2012, Merills thinks prices will stabilise, supported by rate cuts, improving consumer sentiment, an undersupplied market and tight rental conditions.
The broker notes that those negative on the housing market often argue that after the steep increase in house prices over the last decade across the nation (less so in Sydney), prices will need to fall considerably to return to historical valuation levels.
The team at BA-ML disagrees, however, saying that in many sub-markets, such as discretionary holiday locations near major cities, prices have already corrected by up to 50%. Look at some of the major city markets and you’ve got much stronger fundamentals, like jobs and population growth. This means more diversified demand, and thus shallower price declines. And when you figure in the broker’s expectation for only a modest rise in unemployment, the pressure should be nowhere near enough to spark a big run in distressed selling.
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