Weekly Broker Wrap: Earnings Confessions Season Is Near

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 – Risk-off for markets
 – Value sectors in the Australian market
 – Confession season for corporate earnings
 – Small Cap preferences updated
 – Citi reviews its metals and mining expectations

By Chris Shaw

BA Merrill Lynch has developed a Global Financial Stress Index (GFSI), which represents a measure of stress in financial markets. By using the index BA-ML has developed a Critical Stress Signal to detect when markets move into risk-off mode.

In the broker's view the GFSI CSS signalled markets had entered risk-off mode on April 11. In terms of what this means for the Australian market, BA-ML's research shows the domestic market traditionally outperforms the US when the GFSI CSS is triggered. In part this reflects the shock-absorbing nature of the Australian dollar, which tends to depreciate during periods of stress.

Under such periods of risk-off BA-ML notes banks underperform resource stocks, while defensives outperform and small miners underperform. The latter is due somewhat to small miners being takeover targets in better times but losing this premium when times turn tougher, as well as the fact the ability of such stocks to raise capital becomes tougher as financial markets come under pressure.

Citi suggests many of the most sold down stocks of last year have recovered somewhat this year as equities improved. With valuations now closer to normal ranges this increases the risk some of these stocks are increasingly at risk of fading and potentially rolling over again. This is because further gains are likely to require signs of respectable earnings growth, predict the analysts.

Looking at where the market currently offers greater earnings growth potential, Citi suggests looking beyond the banks and resource sector so those sectors where growth is picking up and where share price are not yet overvalued.

For Citi this means the general insurance, engineering and construction and healthcare sectors. This leaves Citi's sector preferences in order as financials ex banks/REITs, industrials, resources, banks, REITs, consumer sectors and defensive sectors.

Citi's review means some changes to its recommended portfolio, with Suncorp ((SUN)), Insurance Australia ((IAG)), Boart Longyear ((BLY)) and CSL ((CSL)) being added, while Dexus ((DXS)), Myer ((MYR)), Seven West Media ((SWM)) and Lend Lease ((LLC)) have been removed from the portfolio.

Goldman Sachs has in turn focused on the so-called confession season for earnings, noting around 25% of annual profit warnings since 2000 have come during the months of May and June. From current forecasts of 6% earnings per share growth for industrials in FY12 the expectation is this number continues to trend lower, this reflecting still tight domestic financial conditions.

A review sees Goldman Sachs list its stocks in the ASX100 with both the largest downside earnings risk and the greatest upside risk heading into May and June. The former includes Atlas Iron ((AGO)), Asciano ((AIO)), ASX ((ASX)), Alumina Ltd ((AWC)), BHP Billiton ((BHP)), Boral ((BLD)), CSR ((CSR)), Caltex ((CTX)), Fortescue ((FMG)), Fairfax ((FXJ)), Harvey Norman ((HVN)), Incitec Pivot ((IPL)), JB Hi-Fi ((JBH)), Lend Lease, Myer, National Australia Bank ((NAB)), Qantas ((QAN)), QR National ((QRN)), Sims ((SGM)), Seven West, Sydney Airport ((SYD)) and Transurban ((TCL)).

Stocks with the greatest upside earnings risk in the view of Goldman Sachs include CFS Retail ((CFX)), Campbell Brothers ((CPB)), CSL, Crown ((CWN)), Downer EDI ((DOW)), Dexus, Graincorp ((GNC)), Iluka ((ILU)), Monadelphous ((MND)), Macquarie Group ((MQG)), Orica ((ORI)), Oil Search ((OSH)), PanAust ((PNA)), Spark Infrastructure ((SKI)), Santos ((STO)) and Woodside ((WPL)).

Following a review of its quantitative analysis model, Credit Suisse suggests investors at present should be long quality stocks, long value plays and neutral on momentum plays. Quality plays should do well given there are material hard landing risks, while value should do well given de-leveraging pressures are not yet out of hand.

On the other hand, momentum factors have so far failed to pick up the recent inflection point in the global growth cycle and will probably miss the next major inflection point as well.

With respect to sector allocation Credit Suisse prefers high yielding defensives to cyclicals given expectations of slower growth ahead, while rate-sensitive cyclicals are preferred to mining stocks given better relative value.

Under such a screening process Credit Suisse notes high yielding defensives such as Telstra ((TLS)), Stockland ((SGP)), Challenger ((CGF)), Tabcorp ((TAH)) and Metcash ((MTS)), banks such as Bendigo and Adelaide ((BEN)), National Australia Bank, Westpac ((WBC)), ANZ Banking Group ((ANZ)) and Commonwealth Bank ((CBA)), and consumer discretionary stocks such as JB Hi-Fi, Myer, Seven West Media and Fairfax dominate the long-end.

In the short basket are metals mining and energy stocks such as Alumina Ltd, BlueScope ((BSL)), Oil Search, Santos, Atlas Iron, Newcrest ((NCM)), OZ Minerals ((OZL)) and Sims as well as selected US dollar exposures such as James Hardie ((JHX)), News Corporation ((NWS)) and ResMed ((RMD)).

According to Citi, the equity market rally in March means value is now harder to identify in the small industrials end of the market, as current earnings multiples appear to paint a true picture of value. In relative terms the current multiple for the sector is below average levels of the past 10 years, which suggests further relative outperformance is possible.

Factoring in recent price movements, Citi has removed Forge ((FGE)), Henderson Group ((HGG)), Super Retail ((SUL)) and Sandfire Resources ((SFR)) from its top picks list, while Mirabella ((MBN)) has also been removed given less conviction on the part of the broker. Ratings for Forge, Henderson Group and Sandfire have all been lowered in recent weeks to Neutral from Buy previously, while GWA Group ((GWA)) has also been downgraded by Citi; to Sell from Neutral. 

To replace these stocks Citi has added Flight Centre ((FLT)) and Adelaide Brighton ((ABC)) to the list of key small cap calls, the rest of the list being Miclyn Express Offshore ((MIO)), McMillan Shakespeare ((MMS)), NIB Holdings ((NHF)), NRW Holdings ((NWH)) and Southern Cross Media ((SXL)) among the industrials and Medusa Mining ((MML)), Resource Generation ((RES)) and Regis Resources ((RRL)) among resource plays.

A Buy for Credit Suisse among small cap plays is Webjet ((WEB)), which has recently guided to FY12 earnings growth of at least 18%, up from at least 10% previously. On the back of this guidance Credit Suisse lifted its earnings forecasts and reiterated an Outperform rating on the stock, expecting further gains as growth continues to come through over the next 12 months.

Despite its positive view, Credit Suisse doesn't list Webjet among its top five small caps, which are made up of Alliance Aviation Services ((AQZ)), Mermaid Marine ((MRM)), Carsales.com ((CRZ)), SAI Global ((SAI)) and Flexigroup ((FXL)).

Deutsche's review of emerging companies has focused on stocks where there may be a 2H12 earnings skew and or a cyclical recovery is factored in FY13 forecasts. This gives a list of stocks offering earnings risk in coming periods and a list of companies offering potential earnings upside.

Among companies in the former category, Deutsche suggests Salmat ((SLM)) has the most risk to consensus forecasts and guidance given still tough operating conditions. Emeco Holdings ((EHL)) also offers some risk from the potential wet weather impact on operations in Queensland and northern New South Wales, while Bradken's ((BKN)) risks relate to the timing and execution of any increases in output.. The latter was confirmed by a profit warning from company management last week.

If retail conditions don't improve there are risks around earnings expectations for Pacific Brands ((PBG)) given around 80% of Deutsche's forecast earnings growth in FY13 is tied to a cyclical recovery, while it is a similar story for Spotless ((SPT)) in that a large portion of expected earnings improvement is related to an improvement in market conditions. For Navitas ((NVT)) the risk is any delay to a recovery in any of the group's divisions.

Deutsche has Hold ratings on all of these companies with the exception of Bradken, which is rated as a Buy.

With respect to companies offering upside earnings potential Deutsche includes Flight Centre given continued strong international travel numbers and easier comparable numbers in the second half of FY12.

Also included is Skilled Group ((SKE)) given scope for further improvement in key labour markets, while digital media is seen as a driver of stronger earnings for STW Communications ((SGN)). All three stocks are rated as Buy by Deutsche Bank.

Post its review of the emerging companies Deutsche has revised its top picks. Among the emerging company cyclicals the broker now prefers Ardent Leisure ((AAD)), Flight Centre, Programmed Maintenance ((PRG)), Prime Media ((PRT)), Skilled and Transpacific Industries ((TPI)). Both Adelaide Brighton ((ABC)) and GWA ((GWA)) have been removed from the broker's top picks among the cyclicals.

In the mining services sector Deutsche likes Ausenco ((AAX)), Ausdrill ((ASL)) and NRW Holdings, while also among the broker's top picks are SAI Global and IOOF Holdings ((IFL)).

In the view of Goldman Sachs the likelihood of a depreciating Australian dollar relative to the US dollar has risen. Given this, the broker has reviewed stocks to ascertain those companies with the most significant earnings sensitivity to a movement in the currency.

Among industrial stocks, Goldman Sachs suggests those with the highest positive earnings per share (EPS) impact in a depreciating AUD/USD scenario as measured by largest to smallest impact are OneSteel ((OST)), Select Harvests ((SHV)), Incitec Pivot, CSR, Aristocrat Leisure ((ALL)), Sims, Matrix Composites ((MCE)), Bradken, Macquarie Group, Campbell Brothers, Treasury Wine Estates ((TWE)), Orica and BlueScope. 

Among resource stocks the largest EPS impacts on the same basis according to Goldman Sachs would be felt by Independence Group ((IGO)), Kagara ((KZL)), Whitehaven Coal ((WHC)), OZ Minerals, AWE Ltd ((AWE)), Western Areas ((WSA)), Energy Resources of Australia ((ERA)), Aditya Birla ((ABY)), Mount Gibson Iron ((MGX)), Sandfire and Evolution Mining ((EVN)). 

Of those companies reporting in US dollars, Goldman Sachs sees the largest impacts of a depreciating AUD/USD as being felt by Brambles ((BXB)), News Corporation, Ansell ((ANN)), James Hardie, ResMed, Computershare ((CPU)), QBE Insurance ((QBE)) and Boart Longyear. 

Goldman Sachs has also assessed those stocks with the highest negative correlation of total excess returns to AUD/USD changes, this list comprising Woolworths ((WOW)), CSL, ResMed, CFS Retail ((CFX)), Westfield Group ((WDC)), SP Ausnet ((SPN)), Coca-Cola Amatil ((CCL)), SingTel ((SGT)), Telstra, Spark, Tatt's Group ((TTS)), Amcor ((AMC)) and BWP Trust ((BWP)).

Citi has also reviewed expectations for the metals and mining sectors, its analysis showing low cost producers and those that deploy capital efficiently remain the preferred exposures. Citi expects industrial commodity prices in general will be somewhat range bound over the medium-term, while precious and base metals are preferred to the bulk commodities.

Within the commodities spectrum, Citi's key picks are in palladium, nickel and gold on the bullish side, while the broker remains bearish on both copper and silver.

Changes to Citi's commodity price assumptions mean adjustments to earnings estimates for resource stocks under coverage, though there have been no changes in ratings. Key picks listed in Australia remain BHP and Rio Tinto.

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