Reporting Season Approaching: Get Set For Some Big Announcements

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Rudi Filapek-Vandyck, Editor FNArena

It is not very fashionable among the local Kommentariat to say this, but the August reporting season in Australia is about to unleash some horrible financial outcomes .

Companies including BHP Billiton ((BHP)) and Rio Tinto ((RIO)) will present big falls in (semi-)annual profits. Others like Monadelphous ((MND)) should still do OK, but will have to refrain from giving any guidance for the year ahead due to an overload in uncertainty.

Above all, the upcoming reporting season may well be characterised by multiple significant write-downs, and not only amongst smaller and mid-tier mining companies.

The announcement by Treasury Wine Estates ((TWE)) on Monday that the company is to take a hit of $160m pre-tax in order to help clean up its inventories with aged and excess wine stock for the challenging US wine market is best regarded as an early warning shot of what is likely to come in spades over the coming two months.

The inventory write-down was hinted at in a research report by Credit Suisse on Friday.

Here's the opening sentence of the story in FNArena's Australian Broker Call Report on the day: "Underperform. Credit Suisse thinks Treasury Wine has not yet accomplished the objective to re-align US wholesaler inventories and US stock surplus was likely exacerbated as FY13 closed".

On Friday, investors weren't genuinely paying attention just yet, with the shares closing mildly lower. On Monday, after the official announcement was made, there was no escaping the consequences with the share price tanking more than 11%.

Investors might want to pay extra attention to early signals inside broker research reports and elsewhere this season. It will get ugly at times.

What is at stake is the ubiquitous question whether weak share prices for weak performing sectors have by now accounted for all or most of the negative announcements that are yet to come out in the open. A report by Wilson HTM Investment Group zooms in on resources stocks with the observation that 54 stocks out of a researched total of 110 are presently trading well below net asset value. Does this make them a buy on grounds of undervaluation?

Of course not. It merely suggests Mr Market is already anticipating what I just reported; there will be impairments and these will impact on what exactly is the real net asset value for these companies. Don't take my word for it, here's what Wilson HTM analyst Cameron Judd has to say about this: "In our view, the risk of potential impairment charges in the upcoming reporting season for Australian miners is high".

Remember the story we published a few weeks ago about how Citi analysts had calculated that, globally, only 10% of gold miners was still operating on positive cash earnings at a gold price of US$1300/oz? That price is even lower today. Market rumours have it that Barrick Gold, one of the majors in the industry, has put the "For Sale" sign up for all of its assets in Australia.

Prior to Treasury Wine Estates' announcement, Newcrest Mining ((NCM)) had already announced lay-offs and some $6bn in write-downs. Arrium ((ARI)) has taken a hit of $480m. Kingsgate Consolidated ((KCN)) has written down $300m. It is but anyone's guess where exactly the tally will stop by mid-September, or whether that will be the end of it.

One thing that should be on every investor's mind is that, as a general rule, investors usually underestimate the capacity for a cascade of bad news to simply generate even more bad news. In the current context it is well possible, for example, that continous downgrades to commodity price forecasts (Macquarie again cut forecasts on Monday) have been priced in to the max, which make share prices appear cheap on the surface. But what about impairments? Debt covenants? The costs of laying off staff and closing down operations? The need to repair balance sheets?

The Australian Securities and Investment Commission (ASIC) seems to have already identified the problem with the carrying value of assets on companies' books, as ASIC flagged weeks ago already it would more closely scrutinise companies' financial reporting from the angle of asset valuations this reporting season.

Wilson HTM has identified six candidates in the resources sector that could well be announcing impairment charges, while also carrying a large debt burden: Arrium, Discovery Metals ((DML)), Galaxy Resources ((GXY)), Mirabela Nickel ((MBN)), Nexus Energy ((NXS)) and Paladin Energy ((PDN)).

Another sector that seems poised to generate some big surprises, both positive and negative, are Australia's discretionary retailers. BA-Merrill Lynch released a sector update on Monday, and below is the key paragraph from that report:

"We believe that most retailers are covered for the majority of their FY14 currency exposure at around parity. We believe that a 10% fall in the AUD (to $0.90) could lead to FY15 EBIT downgrades of 4-19% across the consumer discretionary names, if the increases to COGS [costs of goods sold] cannot be fully offset through pricing growth."

Companies seen as most at risk by BA-ML analysts are Harvey Norman ((HVN)) and Myer ((MYR)), while those companies seen as best placed to deal with currency impacts and pressure on margins are OrotonGroup ((ORL), Super Retail ((SUL)) and Premier Investments ((PMV)).

By the way, there will be other victims of FX hedging programs that now look so out of touch with AUDUSD barely staying above 90c. Think ResMed ((RMD)). Think Cochlear ((COH)).

While a weaker AUD and further cash rate cuts by the RBA support the notion that better times lay ahead for Australian equities, it is far too early yet to become complacent about the risks that are lurking among the weaker sectors in the share market. Which is why some of my Weekly Insights stories recently carried titles such as "Thou Shalt Not Ignore Risk" and "Australia Remains Hard Work". Within this context, I think it's but appropriate to repeat a recurring theme from investors' feedback over the first six months of the calendar year:

Amazing how a relatively small part of the portfolio can have such a big (negative) impact.

Of course, there will also be plenty of good news stories around. In general terms, and this has been my view for a long while, the strong and the outperformers will once again reveal as to why they deserve the high multiples they are trading on. You know the names by now: Flight Centre ((FLT)), Carsales.com ((CRZ)), REA Group ((REA)), Tox Free Solutions ((TOX)), Amcom Telecommunications ((AMM)), Cash Converters ((CCV)), etcetera

Some of the strong might face increased scrutiny about their lofty PE multiples in light of what likely lies ahead in terms of growth, such as CSL ((CSL)) and Invocare ((IVC)). This would also have applied to Telstra ((TLS)), but for now any doubt about growth for Telstra will be negated by the prospect of higher dividends in the year(s) ahead.

In my view, the key themes for the upcoming reporting season can be best summarised via two bullet points:

– the strong will show why they are strong and why they are truly deserving of investor confidence
– the weak will reveal their vulnerability, opening up a window for some serious negative announcements

Don't forget, price action from here onwards will be all about FY14 and how those prospects/valuations change by what is yet to be announced in August.

According to research conducted by analysts at Goldman Sachs, the following stocks should be regarded as "high risk" because the odds are in favour of them announcing some disappointing results: ALS Ltd ((ALQ)), APN News & Media ((APN)), Boart Longyear ((BLY)), Cabcharge ((CAB)), David Jones ((DJS)), Fairfax Media ((FXJ)) and Ten Network ((TEN)). Note ALS went in a trading halt on Monday, pending an announcement.

The following companies are, according to the same research by Goldmans, at risk of surprising to the upside: ResMed ((RMD)), Wesfarmers ((WES)), Ramsay Healthcare ((RHC)), Super Retail, and Flexigroup ((FXL)).

According to the team of Quant analysts at Macquarie, the following stocks now rank highly for positive outperformance in the month ahead: REA Group, TPG Telecom ((TPM)), Flight Centre, Aristocrat Leisure ((ALL)), CSL, Telstra, ResMed, Amcor ((AMC)), ANZ Bank ((ANZ)) and Singapore Telecom ((SGT)).

The following names are more likely to underperform: Newcrest Mining, Boral ((BLD)), AMP ((AMP)), ASX ((ASX)), WorleyParsons ((WOR)), Alumina Ltd ((AWC)), Oil Search ((OSH)), Rio Tinto ((RIO)), Qantas ((QAN)) and New Hope Coal ((NHC)).

A reminder that positive dividend surprises are usually rewarded with sustained outperformance in the months post the reporting season, while negative surprises usually lead to prolonged underperformance. In an earlier report, quant analysts at Macquarie identified the following names for a likely upside dividend surprise in August: JB Hi-Fi ((JBH)), Carsales.com, Flight Centre, Sirtex Medical ((SRX)), Magellan Financial Group ((MFG)), Breville Group ((BRG)), REA Group and Domino's Pizza ((DMP)). On Macquarie's calculations, the average reward for an upside dividend surprise is an excess return of 6% over the six months following the financial report.

More likely to surprise to the downside in terms of dividends include, according to Macquarie Quant: Ausdrill ((ASL)), Fleetwood ((FWD)), Transfield Services ((TSE)), Emeco Holdings ((EHL)), NRW Holdings ((NWH)), Kingsgate Consolidated, Evolution Mining ((EVN)), UGL ((UGL)) and Bradken ((BKN)).

Credit Suisse strategists had earlier combined potential for upside and downside surprises with potential mis-pricing in share prices. Remarkable is that they, too, found discretionary retailers are likely to provide both upside and downside surprises this reporting season. Should make for a lot of volatile share price action in the industry next month.

To avoid all miscommunication regarding CS's graphic overview below: downside mispricing implies the likelihood of a negative surprise triggering a negative share price response. Bottom line: not everything that looks cheap at face value is automatically immune against further share price weakness. Something worth to keep in mind, surely?
 

(This story was written on Monday, 15 July 2013. It was published on the day in the form of an email to paying subscribers).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

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FNArena At The Trading & Investing Expo in Sydney

– I will be presenting at the upcoming Trading & Investing Expo in Sydney (Friday 19 and Saturday 20 July at the Sydney Exhibition Centre). Investors can download free tickets to the event, courtesy of FNArena. Simply click on the following link: http://sydney.tradingandinvestingexpo.com.au/visitor/register and when prompted, enter the promotional code FNARENA. Your free tickets will be emailed to your inbox. FNArena will also host a stand at the Expo.

– I will also present at the Trading & Investing Expo in Melbourne, August 23-24 (where FNArena will equally host a stand) – ticket promotion to follow

– Later in the year, I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

– I will probably give my final presentation for the calendar year in front of ATAA members in Canberra in late November

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