Weekly Broker Wrap: Slowly, Slowly Grinds The Recovery

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-Recovery will be slow in 2013
-Mid cap resources making headway
-Opportunity in software
-Tough times in healthcare

By Eva Brocklehurst

Domestic recovery is coming, slowly. CIMB has launched a semi-annual survey of its analysts to see how their macro views are tracking. A domestic cyclical recovery seems to be in the early stages but the momentum is fairly weak. Firms are focused on reducing costs. CIMB notes cost reduction has been weak in the basic materials sector, but this could be changing with Boral’s ((BLD)) announcement of staff cuts. Retail, food & beverage and infrastructure sectors have also been less aggressive on costs. The mining sector has an improved outlook for margins, given a combination of cost mitigation and stronger demand. CIMB says business conditions are unchanged, or have weakened, for the small-cap stocks exposed to domestic housing and consumer spending.

Of course any meaningful dip, say 10%, in the Australian dollar would have a large positive effect on earnings for S&P/ASX 200 companies in the broker's coverage. Miners would have the most to lose from further appreciation of the Australian dollar and transport and infrastructure stocks would see relatively little impact, CIMB notes. The analysts believe 36% of investors are neutral on the market, while 35% are underweight and 25% overweight. Large-cap diversified miners are seeing a pick-up in demand and some margin expansion. However, the broker is seeing the mid-cap iron ore, uranium, zircon and rare earths stocks (led by iron-ore miners) making up the most ground. Demand in the mid-cap coal and gold sector is relatively weaker.

The market will be fighting to sustain the rally in the year ahead, BA-ML contends. While small caps rallied in 2012, resources were a weak spot. Despite this, small-cap valuations are still attractive to the broker, but investors need to be selective. Small-cap industrials are attractively valued at a 1% discount relative to the broader market, despite a vast majority of quality stocks having re-rated in 2012. Industrial goods & services dropping materially within the index. Preferences are for energy over resources. Mining services have run too hard and consequently the broker downgraded Bradken ((BKN)) and Sedgman ((SDM)) to Underperform. Super Retail ((SUL)) is considered a quality play and other BA-ML favourites include Automotive Holdings ((AHE)), Ainsworth ((AGI)), Henderson ((HGG)) and Technology One ((TNE)). Goldman Sachs also favours Henderson with a Buy rating.

Goldman Sachs sees positive markets ahead and early signs of a turn in flows, which should deliver earnings upgrades. Models have been adjusted to reflect the strength in equity markets during the December quarter. However, the size of earnings upgrades depends on each stock's leverage to markets. Again, the theme is selective. In financial services the broker sees AMP ((AMP)) with the lowest leverage and BT Management ((BTT)), Henderson and Perpetual ((PPT)) with the highest. In summary, the broker is Neutral on AMP but sees upside in the AXA synergies. BTT is Neutral rated, with a downside in the UK slowdown. Henderson is a Buy, as mentioned, IOOF ((IFL)) is Neutral while Perpetual is rated a Sell.

The year has started with a triumph of hope over earnings, at least in building materials and steel, according to JP Morgan. The sector has enjoyed a particularly strong performance over the past six months, outperforming the ASX 200 by 20%. Drivers of this strength are the growing expectations for material cost cutting at Boral and Fletcher Building ((FBU)) and the ongoing momentum in the US housing recovery for Boral and James Hardie (( JHX)). The broker believes Boral and Fletcher share prices are ahead of the rationalisation prospects and so has downgraded both to Underweight from Neutral. On the FNArena database Boral got the rounds of the kitchen this week. The stock received two rating upgrades (Deutsche Bank and Credit Suisse) to Buy and two downgrades to Sell (CIMB and JP Morgan). Upgraders cite the reduced costs while downgrader CIMB takes a more cynical view of the longer term impact.

In contrast, the US housing recovery is seen gathering momentum and a strong order book raises Hardie to Neutral from Underweight for JP Morgan. Adelaide Brighton ((ABC)) remains Overweight and is JP Morgan's preferred pick in the sector. The broker notes ABC is trading at a deep discount to the sector on most valuation metrics, as well as offering a relatively defensive cash flow profile. However, on FNArena's database, BA-ML takes a dimmer view, expecting growth to slow. It has downgraded the stock to Underperform from Neutral. For JP Morgan, CSR ((CSR)) remains in Neutral and Deutsche Bank and Macquarie's ratings concur. After hitting an all-time low in July last year, CSR has staged a strong rebound, based on an improved aluminium price and JP Morgan sees limited upside to the current share price.

Macquarie has taken a snapshot of Christmas trading trends to see the outfall for retailers. The first two weeks in December were particularly weak but it was a strong Boxing Day clearance through to the first week of January. Hot weather drove air-con and refrigeration sales. Seasonal appliance sales were seen up in excess of 40% in December and refrigeration sales grew high single digits. Department store feedback favours Myer ((MYR)) over David Jones ((DJS)) at Christmas, Macquarie said. Due to the significant improvement in weather in December and trade feedback indicating over 40% improvement in seasonal appliance sales during the month, Macquarie upgraded Harvey Norman ((HVN)) earnings estimates for FY13 by 4.7%. The remainder of the Christmas trading feedback was largely in line with expectations and no other significant changes were made to earnings or valuations of the other discretionary retailers.

Morgan Stanley can see pockets of opportunity in a tough software industry exposed to soft corporate and government expenditure. CSG's ((CSV)) turnaround and Reckon's ((RKN)) expected growth profile stand out. However, job vacancies and business confidence continue to languish. Morgan Stanley says industry feedback from both IT providers and client firms suggests pressure on budgets and uncertain project timing. Individually, CSV has rallied 22% from its late September low and the broker's 80c targets reflects a 10% upgrade to FY14 earnings estimates a re-rating towards industry peers. Consulting and services stocks like SMS Management ((SMX)), Oakton ((OKN)) and ASG Group ((ASZ)) face negative first half earnings momentum due to soft demand and increased uncertainty relating to delays and deferrals. Morgan Stanley cut SMX earnings 9% for FY13 estimates but expects it is best positioned to take advantage of any rebound in demand.

UBS notes that the Australian healthcare sector is unlikely to repeat its 2012 performance this year. Sector earnings risk is low but improving demographics are now factored in and price catalysts are scarce. Upside is seen in any broader market weakness and stock specific events. In view of the fact the next Australian federal election must be held by November domestic healthcare service providers such as Primary ((PRY)), Ramsay ((RHC)) and Sonic ((SHL)) are quite exposed. UBS suspects there won't be unnecessary policy change/confrontation this year. On FNArena's database BA-ML has singled out Primary as a Buy, at high risk, noting synergies with the Symbion merger are starting to deliver. Australian names deriving revenues globally, such as CSL ((CSL)), Cochlear ((COH)), ResMed ((RMD)), Sonic, Ramsay, Ansell ((ANN)) and Sirtex ((SRX)) are all likely to confront similar headwinds and Europe has never been tougher, UBS maintains.

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