Corporate Reports: Just What The Doctor Ordered

This story features DOMINO'S PIZZA ENTERPRISES LIMITED, and other companies. For more info SHARE ANALYSIS: DMP

By Rudi Filapek-Vandyck, Editor FNArena

Investors better not underestimate what is happening in the local share market this month.

While at face value, the reporting season looks more okay than spectacular, and there are always big misses and beats that capture everyone's attention because of the big moves in share price that follow, underlying the daily media and analyst coverage something very, very important is taking place.

On a net balance, earnings estimates are being beaten by corporate Australia.

This is an important observation given:

1. Prior to the February reporting season consensus had been expecting double-digit profit growth, after four years of either low single digit or negative growth on average for the ASX200;

2. Investors had been pricing in lofty earnings growth projections which had led to the market's Price Earnings (PE) ratio rising to above average value, even when taking into account the January weakness.

Amidst all the talk and projections about a new, sustainable bull market period for equities, this is exactly the type of reporting season that was needed to keep the focus on higher index levels for the remainder of 2014 and, potentially, for 2015.

Not that this means there won't be volatility in between -quite to the contrary, in particular with rising concerns regarding shadow banking and tighter liquidity in China- but earnings reports in most developed markets show margins and profits are making a positive turn, and this time corporate Australia is joining the party.

Below is a chart from a UBS strategy report that was published last week. It shows exactly what is happening in terms of analysts' projections across the globe.

Needless to say; this is positive for equity markets.

It goes without saying not every corporate update has excited investors and supported expectations for ongoing improvement, plus there's still one more week chock-a-block full of corporate releases in Australia, but some conclusions can be drawn already:

1. Witness the imaginary correlation between "economic growth" and "corporate performance". Economic indicators, in particular in Australia, but just as well overseas, are mixed at best but corporate results, on average, are confirming no less than double-digit improvements for shareholders, and this doesn't even mention the improved prospects for more dividends and capital management (more about this below);

2. Consistent strong performers such as Domino's Pizza ((DMP)) and Seek ((SEK)) are proving that a significantly elevated PE is not by default a recipe for shareholder disaster. Both stocks are trading on PEs of 40 and 31 respectively, but further evidence of strong momentum in their respective international operations is going to justify what currently looks like overcooked investor sentiment.

These stocks will no longer become cheap until the growth story succumbs to maturity and by then it will be too late to join. PEs cannot capture what is going on inside these market favourites. Share prices will be a lot higher in three years' time.

3. There's ever more evidence that many of the reliable performers of the past 4-5 years are in for a breather and possibly a de-rating as growth momentum (for them) is slowing. Witness, for example, the many calls that "Coles' momentum has peaked" in the light of Wesfarmers' ((WES)) shares trading on a PE above 20. Healthcare in general has been raising quite a number of such questions, including with regards to Ansell ((ANN)), Cochlear ((COH)) and ResMed ((RMD)). Coca-Cola Amatil ((CCL)) is attracting ever more scepticism.

4. Resources companies are back on investors' radar, in particular those with an attractive cash flow story, including Rio Tinto ((RIO)), BHP Billiton ((BHP)) and Fortescue Metals ((FMG)). Barring an implosion of the Chinese economy, shareholders in these companies will enjoy higher dividends, share buy backs and capital appreciation.

The oil and gas sector is also increasingly turning into a cash flow story, but here the immediate outlook remains full of (more) risks and (more) uncertainties. Oil Search ((OSH)) remains just about everyone's favourite, while Santos ((STO)) and Woodside Petroleum ((WPL)) have as many critics and doubters as they retain loyal fans and supporters.

Bottom line: the yield story in the Australian share market is changing shape; its flavour is becoming more cyclical.

5. For some sectors, the cycle is now turning for the worse. While everybody's still excited about the upswing that's occurring in consumer spending and in building materials markets in Australia and in the US, analysts have been warning about a negative turn for the insurance cycle and it would appear this reporting season is further feeding this view. Expectations remain that Insurance Australia Group ((IAG)) will continue to enjoy high margins but headwinds are building and, in particular in the case of QBE Insurance ((QBE)), risks are building too.

Could this also be the case for wagering? Some analysts are taking the view increasing competition from fixed odds offerings through foreign competitors is pushing local operators in the wagering sector towards a medium to longer term framework of steadfast decline. Advertising and traditional media were supposed to (finally) enjoy a better environment this year, but February has revealed ongoing disappointment from the likes of APN News & Media ((APN)) and Seven West Media ((SWM)) – even though short covering has been an important factor for the sector in February. A bit too early maybe? Or maybe a case of some have probably seen their lows, but not necessarily everybody in the sector just yet?

A similar case can be made for providers of engineering and other services to miners and the oil and gas sector, as well as for IT services for which the upswing is not yet on the cards or so it seems.

6. Top line growth remains tepid, if not elusive for most sectors and companies, but low interest rates, a re-based AUD and cost cutting initiatives and efficiency programs are delivering the goods. This applies as much to the banks, many industrials as to the large iron ore miners. Dividend "surprises" may be less prominent than in the past, but there's still plenty coming towards shareholders' pockets, including extras (Suncorp ((SUN))), increases (Woodside, Fortescue, among others) and the promise of more (Rio Tinto, BHP, Oil Search, and others).

On my observation, the biggest and most prominent upside surprises prior to today, have been delivered by (in no particular order): Seek, Breville Group ((BGR)), Fortescue Metals, Rio Tinto and BHP Billiton, Brambles ((BXB)), Hills Industries ((HIL)), Ardent Leisure ((AAD)), Domino's Pizza and Boral ((BLD)).

Remarkable disappointers, thus far, include Goodman Fielder ((GFF)), Telecom New Zealand ((TEL)), Coca-Cola Amatil, Ansell, Cochlear, ResMed, Woodside Petroleum and Santos.

The Australian share market is trading on an average PE of circa 15. This compares to its long term average of 14.2. However, if current expectations for a double-digit EPS increase to the tune of 13% on average for the present financial year are being met in August, the average PE will drop to circa 13.5, which is below average. Expectations for FY15 are for yet again a year of double-digit increase in earnings per share.

The key difference between this year and next is that resources are expected to do much of the heavy lifting this year, after a couple of years of negative performance, but the pendulum is expected to swing towards industrials from the second half of 2014 onwards.

Finally, and as shown on Citi's measure of investor sentiment below, the share market's key problem at the end of 2013 was that overall sentiment had simply run up too high. The result was unexpected weakness in January and leading into February. Sentiment has now pulled back, but it remains high on historical references.

As things stand today, this may well prove the share market's Achilles heel this year. Elevated sentiment means markets become more jittery and vulnerable to uncertainties and disappointments. Note how gold has staged a background come-back alongside rising focus on troubled investment products and shadow banking vulnerabilities in China, among other things (Venezuela, Ukraine, etc).

(This story was written on Monday, 24 February 2014. It was published on that day in the form of an email to paying subscribers at FNArena).

See also last week's "Boring Today, In Turmoil Tomorrow"

and "Dividend Support, Still Investors' Most Reliable Indicator?" from 10 February, 2014.

Note subscribers have 24/7 access to Stock Analysis, the Australian Broker Call Report and other services that can assist with assessing the local reporting season this month. In addition, FNArena has been publishing, and updating, every day the FNArena Reporting Season Monitor, including a detailed overview in excel (see website).

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