Weekly Broker Wrap: Earnings Season Previews

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

By Andrew Nelson

As the Australian reporting season approaches, local brokers have started to shift a greater proportion of coverage to domestic equity issues, releasing a number of stock ideas, model portfolio changes and reporting season outlooks.

We start our review with Macquarie, where analysts shifted from what is a common preference for Rio Tinto ((RIO)) to BHP Billiton ((BHP)) on Friday. In making the switch, the broker cited what it sees as a more diversified portfolio, with earnings that offer a better exposure to later-cycle commodities.

The broker added Rio to its list of Macquarie Marquee Ideas last year and since then it notes a fairly steady run of global macroeconomic deterioration that was sparked and then fanned by a widespread downturn in commodity prices. Shares in the company have underperformed by nearly 30% over that period.

This has Macquarie thinking that a switch into BHP right now is probably the right move despite having to lock in the losses on Rio. What the broker likes the most is BHP’s copper exposure, which it sees as especially attractive given the increase in infrastructure spending in China over the current half.

BHP’s petroleum exposure is also a mitigating factor in support of Macquarie’s new found preference for the stock. Lastly, the broker is attracted to the group’s strong exposure to iron ore and while noting Rio has a stronger portfolio in this aspect, it thinks the headwinds facing the company’s aluminium business will cap any near to mid-term iron ore upside.

The broker explains that just about everything iron-ore-related has of late fallen out of favour, but with the horse already bolted, it thinks it’s probably a little too late to quit on the diversified miners at this point. Add to that a fairly supportive medium-term commodity price view, and Macquarie sees significant potential for a near-term recovery.

Goldman Sachs calls its favourites list the Structural Leaders Focus List, which it explains is a selection of 15 companies it sees as best placed to sustain returns on capital over the next 3-5 years based on industry positioning. Since its inception in November 2010, the broker claims its list has outperformed the ASX200 by 2.9%.

This month, the broker’s top Focus List stock is Worley Parsons ((WOR)). On its analysts’ numbers, the broker sees some attractive levels and multiples, with the stock trading at better than a 15% discount to its historical five-year average P/BV (price/book value), EV/EBITDA (enterprise value/earnings), and DCF (discounted cash flow) valuation.  

Seven of the 15 stocks on the broker’s Focus List are currently rated Buy. These include Iluka ((ILU)), BHP, ANZ Bank ((ANZ)), Bradken ((BKN)), Worley Parsons, Brambles ((BXB)) and Super Retail ((SUL)). Goldmans thinks that BHP and Bradken look the best, with both trading on heavily discounted multiples.

Taking a look at UBS’s model portfolio one sees a similar strategy to Goldman Sachs, with UBS also firmly long on higher quality value stocks and short on low quality expensive stocks, at least through the reporting season.

However, the broker does note that in the current environment, outperformance will not be delivered on strong performances so much as by being driven by avoiding the mines and torpedoes.

The Buys on the broker’s Long List include Charter Hall ((CHC)), Emeco ((EHL)), Nufarm ((NUF)), Origin ((ORG)), Primary Health Care ((PRY)), Stockland ((SGP)), United Group ((UGL)) and Woodside ((WPL)). The worst performers on the broker’s short list include OZ Minerals ((OZL)), Ten Network ((TEN)), Transpacific ((TPI)), Virgin Aust. ((VAH)), Perpetual ((PPT)), Leighton ((LEI)) and QBE ((QBE)), to name a few.

Ahead of the impending FY reporting season, analysts at Deutsche are turning a bit skittish about the recent resilience of domestic indices. Post a 7% push through June, the broker notes the ASX200 is now only 2% away from its year-end target. However, given the composition, ie banks and defensives did all the work, the broker is concerned about the lack of progress on the cyclical front.

Deutsche goes on to say that the seemingly complete lack of interest in cyclicals does not say much about confidence in the longevity of the recent upturn, pointing out it looks a lot like the March/April run, which we all know ultimately faltered.

However, the broker doesn’t see much petrol left in the tank for defensives and seriously doubts whether they will be able carry the load much longer. PEs are all too high and while the broker admits bank valuations still look reasonable in absolute terms, it is adamant that cyclicals are going to have to start pitching in if the market is to continue its recent momentum. But don’t hold your breath.

The broker is also troubled by current consensus forecasts, which it notes continue to predict a substantial earnings bounce in FY13 across most sectors. Deutsche just can’t see this happening. Until these forecasts look a little more realistic, the broker believes any sort of rally in cyclical stocks will be unlikely.

This view has the broker expecting to see the run of downgrades to FY13 forecasts continue over the course of the reporting season, which in turn will likely weigh on sentiment. However, there is at least the chance of a silver lining. The broker expects the data from China and the US will start improving in a few months, which could begin with policy response from Europe, the US and China over the next few weeks.

Macquarie holds a similar view to Deutsche on the prospects of this reporting season, noting that if anything, the deterioration in forecast growth is even more broadly spread than it was for FY11. The broker predicts yet another reality check of this current long, grinding cycle and its impact on profit growth.

Dividend delivery against forecasts will be the odd man out, given the currently unprecedented focus on yield. With yields and the hope for them to be key, the broker thinks investors will be desperately looking for signs that this seemingly never ending run of earnings weakness and forecast disappointment is about to turn.

Yet while revenue growth remains important to EPS delivery for all sectors, Macquarie believes earnings margins will be crucial. Margins meeting with expectations will be seen as a significant and positive outcome compared to disappointment on the margin line, or worse, negative margin growth. 

Based on these views, Macquarie has built a list counter consensus calls that include Woodside, Sims Metal ((SGM)) Rio and Primary Healthcare, which are all tracking below consensus FY12 EPS forecasts. The broker’s Leighton FY12 EPS forecast is also a standout, as it is tracking at the bottom of the current guidance range.

Lastly, we switch back to comments from Goldman Sachs and its Emerging Companies Focus List, which has also undergone some recent renovations. One of the main changes is the removal of Oroton ((ORL)). While the Buy call is maintained on long-term growth prospects, the broker thinks the market will take a cautious stance on the stock given a soft consumer spending outlook, Asia start-up losses and a looming Polo licence renewal.

REA Group ((REA)) is the big, new addition to the broker’s list, as it offers significant earnings growth on the back of ongoing growth in online classifieds. The broker is generally positive on the pace of migration from print classifieds to online, especially in the real estate category, as it sees this as the least mature in terms of migration from print to online.

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