Rudi’s View: February Reporting Season Blues

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By Rudi Filapek-Vandyck, Editor FNArena

Australian investors haven't experienced an indisputably positive reporting season in years and indications are February 2016 is not going to break the trend. Instead, analysts are more concerned about the ongoing potential for more surprises to the downside while lamenting an overall environment of tepid sales growth in combination with rising costs and the fact the focus of most companies has been on cost control for a while now, seems to suggest there is less potential for upside surprises.

Credit Suisse believes such an environment implies the few standouts that will be able to genuinely knock market forecasts on the head will be highly sought after. Credit Suisse is hoping a number of the High PE champions from the past years might slightly disappoint and see an initial over-reaction to the downside, thus opening up buying opportunities in long term growth stories that won't be broken by a slight miss in February.

Market strategists at Macquarie, however, are concerned that a potentially negative reporting season (a la August last year) might remove short term valuation support and allow indices to fall to lower levels amidst global angst and uncertainties.

In terms of valuations, the Australian share market remains heavily polarised, with some sectors trading seemingly at beaten-down, bargain-basement price levels (but only if estimates don't change) whereas solid, reliable growth stories are enjoying large premiums. The latter is of concern to some analysts as there seems little room for disappointment.

As such, the February reporting season looks like it might turn out to be a close copy of the August season last year, with big share price reactions both to the upside and to the downside, but with an underlying bias towards more negatives than positives. This month there will be lots of negatives, in particular in response to lower-than-expected bulk commodity, metals and energy prices. Projects will go on care and maintenance, impairment charges will be taken, dividends will be reduced or scrapped altogether, capex budgets will be cut, and tough questions will be asked about management's plans for the future.

Some investors might be brave enough to take a punt that all of this has already been anticipated and priced in, but analysts are less certain. They certainly see more room for negative surprises. Or for short-term positive surprises that simply won't stand the test of time. One big question mark hovering above mining and energy stocks is whether 2016 truly marks the bottom of the downward spiral. Even so, most strategists seem convinced analysts' forecasts for 2017 are too high, implying these sectors still haven't seen the last of the earnings downgrades just yet.

Dividends, believe it or not, are still expected to grow further, possibly even faster than profits, continuing the trend from recent years. But there will be cracks in the investing-for-income story, with a widely anticipated dividend cut to be announced by BHP Billiton ((BHP)), the first cut in over ten years from the Big Australian, with major oil and gas producers expected to do the same. Despite these cuts, resources companies are expected to pay out more than 100% of net profits in dividends to shareholders this financial year. Clearly, boards are reluctant to disappoint shareholders too much, while at the same time keeping their fingers crossed for better times ahead.

What about the banks? Most banks report outside regular reporting season and the one major reporting interim financials this month, Commbank ((CBA)), is widely considered the least chance for a dividend cut, but market expectations are heating up for dividend reductions by ANZ Bank ((ANZ)) and by National Australia Bank ((NAB)), probably later in the year. Bendigo and Adelaide Bank ((BEN)) also reports this month and analysts will be keeping a close watch on "quality" and "net interest margin (NIM)".

Dividends and yield will remain at the forefront of investor focus also because analysts are anticipating solid growth numbers with ongoing increases to reliable, cash-backed dividends from traditional bond proxies, being real estate trusts (A-REITs) and infrastructure owners such as Sydney Airport ((SYD)), Transurban ((TCL)) and Macquarie Atlas ((MQA)). More importantly, perhaps, the odds for serious negative surprises from these sectors are considered negligible.

There will still be special dividends too. Adelaide Brighton ((ABC)) apparently carries too much cash even though operationally there seems little relief. Insurance Australia Group ((IAG)) is also believed to be on the cusp of starting a three-year cycle of special dividends (or other forms of capital management). Suncorp ((SUN)), on the other hand, might be about to stop promising ongoing specials. Genworth Mortgage Insurance Australia's ((GMA)) loss of its Westpac contract has also opened the door to capital management initiatives.

All in all, indications are the Australian corporate story remains one of little growth, lots of yield and with lots of headwinds. The broader macro picture still weighs most upon large cap companies with the Top20 index continuing its underperformance in January. The weaker Aussie dollar is likely to show up as a negative too as FX hedges run off and importers find it difficult to pass on higher input costs. Interest costs are on the rise as well.

Analysts have continued lowering forecasts in the lead-in to this reporting season. The average EPS growth projection now sits deep in the red for FY16, but that's to be expected with the carnage we've seen in the resources space. But even so, ex-resources EPS growth remains low (banks are low too) and while FY17 and beyond are still showing fairly robust projections, the general expectation is forecasts must and will come down, starting this month. On Goldman Sachs' assessment, earnings expectations for Australian companies are now at their lowest point since the GFC, and falling.

(Source: Macquarie)

What other themes are likely to dominate?

1.) Buybacks. The following companies have either already announced, or are potentially in a position to announce, share buybacks: Asaleo Care ((AHY)), Amcor ((AMC)), Ansell ((ANN)), Aveo Group ((AOG)), Aurizon ((AZJ)), Boral ((BLD)), CSL ((CSL)), Computershare ((CPU)), Downer EDI ((DOW)), Dexus ((DXS)), Fairfax Media ((FXJ)), Genworth Mortage Insurance Australia ((GMA)), GWA Group ((GWA)), JB Hi-Fi ((JBH)), James Hardie ((JHX)), Karoon Gas ((KAR)), Mineral Resources ((MIN)), Nine Entertainment ((NEC)), Orica ((ORI)), Sims Metal ((SGM)), Sigma Pharmaceuticals ((SIP)), Seven Group ((SVW)) and Seven West Media ((SWM)) – with thanks to Macquarie for compiling the list.

2.) Capital raisings. JP Morgan analysts in their update on Mineral Deposits ((MDL)) inserted the following sentence: "Balance sheet concerns will likely require a funding event". In layman's language: this company is one candidate to return cap in hand to investors for an extra share placement. Shareholders should expect to be heavily diluted. Unfortunately no analyst has as yet compiled a list on all potential candidates for additional capital requirements, but small miners and energy companies with too much debt would be logical candidates, as will be larger peers including Origin Energy ((ORG)) and Santos ((STO)) if prices stay this low. Banks remain prime candidates too, but the general expectation is they will be given time to absorb the matter through dividend reinvestment policies rather than through a repeat of last year's shock capital raisings.

3.) Cost reductions. Low prices for bulks, metals and energy are forcing producers, and their suppliers and contractors, into a relentless and ongoing race to the bottom in terms of costs and margins. Outside these sectors, many an industrial already conducted its cost reduction programs in years past. This is why analysts are sceptical about further potential for positive surprises at a time when top line growth remains a tough ask.

4.) Reduced dividend pay-out ratios. Dividend payout ratios in general are at elevated levels and while this by no means implies they cannot possibly rise further, increasingly cracks will start appearing, also given the ongoing tough operating environment. Investors will have to be prepared for boards deciding to lower the payout ratio. Candidates for such a move either in February or in the year ahead include ALS Ltd ((ALQ)), ANZ Bank ((ANZ)), AusNet Services ((AST)), Aventus Retail Property Fund ((AVN)), Bank of Queensland ((BOQ)), Cromwell Property ((CMW)), CSL ((CSL)), Fantastic Holdings ((FAN)), Fairfax Media ((FXJ)), G8 Education ((GEM)), Iluka Resources ((ILU)), Kathmandu ((KMD)), Mortgage Choice ((MOC)), National Australia Bank ((NAB)), Platinum Asset Management ((PTM)), Sonic Healthcare ((SHL)) and Transurban ((TCL)).

Note the list contains no less than three banks, as well as market darlings CSL and Transurban. In numerous cases this can be seen in consensus forecasts already and thus investors might be excused for assuming this might already be priced in today's share prices. Investors should also note a reduction in payout ratio does not automatically imply a reduction in dividend (Transurban comes to mind).

Sectors of interest this month:

– Healthcare services: Investor attitude is changing towards this once super-safe defensive growth sector in the Australian share market. Many stocks in the healthcare space are now considered less robust and share price weakness has ensued. Both analysts and investors are trying to separate the chaff from the wheat. This February reporting season will provide additional insights to switch stocks preferences either way. The thematic has also gripped the private health insurers. CSL remains (nearly) everybody's favourite, except for its valuation. Nobody likes a piece of Primary Healthcare ((PRY)), except, maybe, because of its cheap valuation (but with a chequered track record attached to it).

– Retailers: no inflation and a weaker AUD are turning into serious headwinds for many a retailer, but then some in the sector are enjoying seldom seen boom times, supported by strong Christmas sales. Analysts are expecting a world of contrasts to be revealed this season. Already we saw disappointment from GUD Holdings ((GUD)) and Lovisa ((LOV)). Virtually nobody thinks the worst is now behind for Woolworths ((WOW)). Sector favourites, at a considerable gap from the rest, are JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)); both are at a distance followed by stocks such as Super Retail ((SUL)) and Wesfarmers ((WES)).

– Property (REITs) and Infrastructure: traditionally ultra-boring sectors that have reincarnated post-GFC as solid protectors of shareholder funds offering healthy balance sheets, reliable cash flows and solid growth. Analysts are anticipating both sectors will continue to stand out this February reporting season through solid operational performances, further dividend increases and a lack of genuine negative surprises. Sydney Airport, believe it or not, is widely considered a prime candidate to still deliver a positive surprise on the back of Chinese tourism and airlines filling more seats.

– Wealth managers and diversified financials: volatile, weaker financial markets are not a boon for financial companies, including the wealth managers. Lots of question marks are now being asked about Macquarie Group ((MQG)), and the likes of Magellan Financial ((MGF)) and Platinum Asset Management ((PTM)) have been de-rated. UK-based Henderson Group ((HGG)) seems everybody's favourite in the sector.

– High PE stocks: Since listing, APN Outdoor ((APO)) has sharply outperformed the broader market and even post some January share price weakness, the Price-Earnings (PE) ratio still sits around 22x. While many observers get cold feet when looking at the sizeable valuation premium that is being priced in for market darling growth stocks such as APN Outdoor, fearing what could possibly happen in case of disappointment, those in favour continue to point at the favourable structural growth path that should keep the operational momentum positive and strong for years to come.

UBS reported this week: "Companies with multi-year, structural growth profiles are few and far between in the current market. We forecast 10% compound earnings growth for APO over the next 2 years (FY16-18) with current industry trends implying upside risk to our forecasts".

Others have nominated Domino's Pizza ((DMP)) as one favourite to deliver yet another upside surprise this month (FY16 PE 64x). One High PE sector that will be on many an investor's radar is telecom services. From Telstra ((TLS)) to TPG Telecom ((TPM)) to Vocus Communications ((VOC)) and many smaller players inside the domestic telecommunications sector; it is hard to make a case any of these stocks looks cheaply priced on short term valuation metrics. But analysts continue to see robust growth numbers with plenty of cash flows and room for further investment, M&A and capital management.

Potential positive and negative surprises:

In the lead-in to every reporting season analysts try to identify which stocks are poised for either a surprise to the upside or more likely to deliver a nasty surprise to the downside. On my observation from recent years, they are often correct, though not always. Occasionally, different analysts might contradict each other. Below are some of this year's nominations:

Citi

Candidates for a positive surprise: Aconex ((ACX)), Bendigo and Adelaide Bank ((BEN)), Cochlear ((COH)), Crown Resorts ((CWN)), EclipX ((ECX)), Harvey Norman, JB Hi-Fi, McMillan Shakespeare ((MMS)), Myer ((MYR)), Oil Search ((OSH)), Pacific Brands ((PBG)), Patties Foods ((PFL)), Skycity ((SKC)), Super Retail, Sydney Airport, Tabcorp ((TAH)), Tatts ((TTS)), The Star Entertainment Group ((SGR)), Treasury Wine Estates, Wesfarmers, Woodside Petroleum

Candidates for a negative surprise: Amcor ((AMC)), Ansell ((ANN)), Ardent Leisure ((AAD)), Arrium ((ARI)), Asaleo Care ((AHY)), Billabong ((BBG)), Beadell Resources ((BDR)), BC Iron ((BCI)), Boart Longyear ((BLY)), Coca-Cola Amatil ((CCL)), Healthscope ((HSO)), Independence Group, InvoCare ((IVC)), Macquarie Group, Monadelphous ((MND)), Mount Gibson ((MGX)), Origin Energy, OZ Minerals, Paladin Energy ((PDN)), Sandfire Resources, Western Areas and WorleyParsons ((WOR)).

CLSA

Candidates for a positive surprise: AGL Energy ((AGL)), BWX ((BWX)), JB Hi-Fi, SAI Global ((SAI)), Sydney Airport, TPG Telecom and Treasury Wine Estate ((TWE))

Candidates for a negative surprise: Primary Healthcare, Sonic Healthcare ((SHL)) and Woolworths

Macquarie

Candidates for a positive surprise: Cimic ((CIM)), Evolution Mining ((EVN)), Fortescue Metals ((FMG)), Genworth Mortgage Insurance Australia, Medibank Private ((MPL)) and Qantas.

Candidates for a negative surprise: Alumina Ltd ((AWC)), BHP Billiton, Cromwell Property Group, Independence Group ((IGO)), Mincor Resources ((MCR)), Nine Entertainment ((NEC)), OZ Minerals ((OZL)), Woodside Petroleum ((WPL)) and Western Areas ((WSA))

Macquarie (Quant)

Candidates for a positive surprise (in declining order of probability): Carsales.com ((CAR)), JB Hi-Fi, Domino's Pizza, CSL, Super Retail, Mirvac Group ((MGR)), Automotive Holdings ((AHE)), ARB Corp ((ARB)), Goodman Group ((GMG)) and Charter Hall Retail ((CQR))

Candidates for a negative surprise (in declining order of probability): Austal ((ASB)), AWE Ltd ((AWE)), Whitehaven Coal ((WHC)), Independence Group, Western Areas, Sims Metal (SGM)), Primary Healthcare, Mesoblast ((MSB)), Spotless Group ((SPO)) and Karoon Gas ((KAR)).

Morgans' High Conviction Stocks for February:

– Sydney Airport
– Qantas ((QAN))
– ANZ Bank
– 360 Capital Industrial Fund ((TIX))
– Corporate Travel ((CTD))
– GBST ((GBT))
– Vitaco ((VIT))

All shall be revealed in the approx four weeks ahead.
 

(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.)  

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