Rudi’s View: August Results – First Blood

This story features NEWCREST MINING LIMITED, and other companies. For more info SHARE ANALYSIS: NCM

In this week's Weekly Insights:

-August Results: First Blood
-September Index Rebalancing (Updated)
-Conviction Calls
-FNArena Talks
-Australian Banks Worried (Behind The Curtains)

By Rudi Filapek-Vandyck, Editor FNArena

August Results: First Blood

The August corporate results season is officially more than one week old, but the FNArena Monitor still only contains 11 updates. A lack of sufficient qualified accountants, apparently, pushes the bulk of corporate releases in Australia into the final two weeks of the month.

But the opening salvo this year, including the preceding fourth quarter updates by miners and energy producers, has already provided some valuable insights which might prove prescient of what is yet to be unveiled over the coming three weeks.

So let's start with some of the insights that should come in handy as Australian investors prepare for the seasonal tsunami in corporate updates.

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Members of the Australian Shareholders Association (ASA) in Busselton, WA ^(*) looked a bit puzzled when I told them in May this year: you do realise that producers of copper, gold, oil & gas, and other commodities are themselves heavy consumers of diesel, steel, water, power, and other commodities?

That reality soon started to show up in quarterly production updates from miners and energy producers. And one sector on the ASX that has been heavily hit are the local gold producers, if only because gold has largely traded sideways this year, apart from a temporary spike as Putin's army crossed the border with the Ukraine.

Rising costs when the price of your main output refuses to spike higher can only mean one thing: margin pressure, and lower profits.

Post-April, the sector has had a rough time. While the return of market optimism in July has seen many share prices rallying off their lows, most prices are still nowhere near the levels witnessed earlier this year. Shares in Newcrest Mining ((NCM)), by far the largest producer in this country, are still trading some -35% below their $29-peak in April.

And so it was, when sector analysts at Canaccord Genuity updated their modeling and forecasts at the end of July, a lot needed to be accounted for as higher costs translate into higher investments for those companies looking to expand and into higher operational expenses when running daily operations.

Consider the following incomplete list of price increases the industry is dealing with:

-Diesel costs up 60% on average in WA
-Steel prices are up 60% from one year ago
-Freight costs can be up to 400% higher
-Costs for drilling have increased by 15-20% in recent months

No surprise thus, running higher operational costs and capex estimates through its modeling, Canaccord Genuity's valuations reduced by -24% on average for explorers and developers and by -26% for producers.

The Canadian firm specialises in small and micro-cap companies in Australia. When peers at UBS reviewed the sector last week, the average damage was a lot smaller as UBS restricts its research and coverage to larger-cap producers. But with no sustainable uptrend predicted for the price of bullion (not anytime soon), the underlying conclusion is pretty much the same:

"…tempered growth ambitions, continued operating and inflation headwinds combined with our reduced price deck means stocks are not as cheap as they look."

Make no mistake, amidst universal, broad-based sector weakness, there are always opportunities for investors, and both teams of sector analysts have their favourites, but the real message seems to be: rigid selection is key.

Not every share price that has fallen represents a great opportunity for mid- to longer-term investing. The challenge for investors is to identify the real gems and the real quality in a basket that is full of pretenders.

For what it's worth, UBS's favourites are Northern Star Resources ((NST)) among the large caps, because of the company's strong organic growth pipeline, and Gold Road Resources ((GOR)) among small caps. UBS analysts advise investors should focus on strong balance sheets, low risk growth and newer mines with a good runway and optionality still ahead.

Canaccord Genuity's sector favourites are Bellevue Gold ((BGL)), De Grey Mining ((DEG)) and Predictive Discovery ((PDI)). All three have rallied off their June-July low.

Macquarie's favourites are Northern Star, Silverlake Resources ((SLR)) and Gold Road Resources among producers, as well as Bellevue Gold and De Grey Mining among juniors in the sector.

Says Macquarie:

"Though sequentially softer gasoline prices should take some sting out of headline inflation, underlying inflationary pressures continue to broaden and momentum in core services prices does not yet show any sign of letting up."

As well as:

"We think it premature for the market to be anticipating a Fed pivot."

The latter suggests those 20%-plus share price moves for the likes of St Barbara ((SBM)), Bellevue Gold, Resolute Mining ((RSG)) and Regis Resources ((RRL)) might look premature once the market's focus changes back to on-the-ground dynamics and a likely persistence by the Fed to tame inflation with aggressive rate hikes.

It goes without saying, the cost-inflationary pressures that have dogged the gold sector this year equally apply for commodity producers elsewhere, as also shown by June-quarter trading updates released by sector heavyweights BHP Group ((BHP)) and Rio Tinto ((RIO)), as well as by the half-year report already released by the latter.

The one commodity producer that also released financial results, other than Rio Tinto, Canadian iron ore producer Champion Iron ((CIA)) equally disappointed last week, and higher-than-anticipated costs proved one important contributor. Its share price weakened some -45% since the beginning of April, and has staged a mini-rally in August after initially selling off on the quarterly financials.

OZ Minerals ((OZL)) -more copper than gold- equally disappointed with its quarterly update in July, but the share price recovered ahead of BHP Group launching an unsollicited, "opportunistic" take-over bid for the company on Monday. Completely predictable, the news has reinvigorated momentum in share prices for other copper/gold producers such as Sandfire Resources ((SFR)) and 29Metals ((29M)).

Combine all of the above and the take-away message for investors might be that sharply weaker share prices may have already discounted a lot of the bad news, at least in the short term, but cost inflation remains a problem and is creating wide divergences inside sectors. As far as OZ Minerals goes: this company is widely seen as a quality operator. Probably no coincidence then it has been on BHP's radar, instead of other, more cheaply priced, lesser quality alternatives?

BHP's take-over attempt also shows August this year won't just be about bottom line-financials and forward looking guidance. Analysts are expecting at least some commentary about a bonus dividend from Woodside Energy ((WDS)), while Origin Energy ((ORG)) should continue its share buyback.

Woodside is also still looking to sell down its Scarborough project, while Santos ((STO)) might soon announce new ownership for its non-core asset in Alaska, and potentially for its equity in PNG LNG too.

Note to us all: the threat of economic recession has not dissipated. The odds are actually shortening that Europe and the USA will join the UK in the months ahead.

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Another sector that has equally landed under close scrutiny are local real estate investment trusts, A-REITs.

The early part of the earnings season saw both Centuria Industrial REIT ((CIP)) and Centuria Offce REIT ((COF)) releasing FY22 financials and while the former met forecasts and offers optimism now the share price has weakened significantly year-to-date, the latter disappointed and sees investors and sector analysts continuing to adopt a more cautious approach.

What both REITs have in common is management at each trust has adopted a cautious approach regarding the rising cost of debt, which could become somewhat of a sword of Damocles hanging over this sector for the year(s) ahead.

In simple terms, the market has taken what seems a rather dire view as to how high the weighted average cost of debt (WACD) can rise up to over the coming three years. While more optimistic sector analysts can thus see "value" in the sector, others think the market's pricing seems but a realistic scenario.

The underlying sentiment seems similar as with gold miners and commodity producers in general: not every weakened share price is offering a great opportunity; it remains necessary to distinguish the wheat from the chaff.

The real estate analyst at Barrenjoey, Ben Brayshaw, is among the least enthusiastic. He thinks REITs will meet FY22 forecasts in August, but the outlook is for reduced growth, reduced profits, and reduced payouts for the sector on average. Issues range from rising costs, to deflating property markets, to the threat of less consumer spending, to still struggling office assets, to less opportunities for acquisitions, to higher headwinds from servicing debt.

Regarding the latter, Barrenjoey points out those REITs carrying the highest debt costs in Australia include GPT ((GPT)), Centuria Industrial REIT, Charter Hall Long WALE REIT ((CLW)), Dexus ((DXS)), Shopping Centres Australasia ((SCP)), Charter Hall Social Infrastructure REIT ((CQE)), and HomeCo Daily Needs REIT ((HDN)).

In addition, Barrenjoey is cautious on the FY23 outlook for Mirvac Group ((MGR)) and Stockland ((SGP)).

REITs were firmly in focus throughout week one, with Bunnings landlord BWP Trust ((BWP)) mid-week reporting "strong fundamental performance" and "prudent positioning", but given BWP just about always trades at a sizeable premium versus the rest of the sector, analysts simply cannot get excited, and this includes the perceived risk-profile for the trust.

Here one of the most interesting pieces of analysis has been released by Citi which has attempted to rank the local sector in accordance with a lower-than-average or above-average risk profile. Turns out, BWP Trust is one of the least risky options among local REITs, at least on Citi's assessment.

Scentre Group ((SCG)), Charter Hall Social Infrastructure REIT, Shopping Centres Australasia, and Charter Hall Long WALE REIT have been ranked near the upper side of the risk ladder, echoing similar comments published by peers elsewhere.

There's one thing all sector analysts seem to agree upon, and that is that sector leader Goodman Group ((GMG)) is in great condition, is most likely to continue reporting admirable financials and growth, and, on Citi's ranking, represents the lowest risk profile among peers in Australia. Even Barrenjoey's Brayshaw agrees on this.

The offsetts include a premium valuation (which is easily explainable through Citi's assessment), constant calls the stock looks overvalued by your typical value-investor, and a non-attractive dividend yield of circa 1.6% – a direct consequence of having been accepted as a premium, quality operator in recent years.

The sector as a whole is often described as a beneficiary of higher inflation, but the first three financial results this season have already proved this narrative is too simplistic for general purpose.

Already, though, there is an underlying sentiment that genuine quality will reveal itself this month, and I like to think this won't be limited to REITs.

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The first week also saw two asset managers releasing FY22 results and the outcome could hardly have been more different.

In one corner we find Janus Henderson ((JHG)), struggling, and struggling heavily to keep investor funds from departing while share markets in general are likely to face ongoing subdued momentum as the threat of economic recession continues to loom large.

In the other corner sits Pinnacle Investment Management ((PNI)), the umbrella group that includes affiliates such as Firetrail Investments, Hyperion Asset Management, Metrics, Plato Investment Management and Solaris. Readers might recognise a few of the very active advertisers and sponsors behind industry events.

Clearly, Pinnacle is enjoying much more popularity than its peers this year, making the impact from sector-wide selling on its share price pre-FY22 release looking extremely silly. But as everyone can see from the price chart, the market has not hesitated to correct that situation in a heartbeat.

Maybe the take-away message here is that individual strength can overcome general sector malaise.

The stand-out observation is that just about every analyst thinks local asset managers remain poised for continuing rough times, with the possible exception of a few, including Perpetual ((PPT)), Pinnacle and Navigator Global Investments ((NGI)). The latter, however, has never been fully embraced by local investors since its listing on the ASX pre-GFC.

Just about everyone is looking for more bad news from fallen angel Magellan Financial ((MFG)).

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FNArena will start daily updating its Corporate Results Monitor: https://www.fnarena.com/index.php/reporting_season/

The Monitor also includes a four weeks forward-looking calendar (scroll down).

^(*) Zoom presentation for Busselton, WA:

The video can be viewed through FNArena Talks on the website: https://www.fnarena.com/index.php/fnarena-talks/2022/05/30/2022-outlook-when-cash-is-king/

The presentation slides can be dowloaded via the Special Reports section on the website (scroll down):

https://www.fnarena.com/index.php/analysis-data/special-reports/

September Index Rebalancing

Three weeks ago, Weekly Insights reported on Wilsons' predictions for the September index rebalancing that Standard & Poor's will announce on Friday, 2nd of September.

Those initial forecasts have now been updated with the likely addition of Vulcan Steel ((VSL)) and Neuren Pharmaceuticals ((NEU)) to the ASX300, on top of the 13 candidates identified in July. Having by now also been identified as possible removals: Fineos Corp ((FCL)), Resolute Mining, and Starpharma Holdings ((SPL)).

For the ASX200, Wilsons now believes both Pointsbet Holdings ((PBH)) and Clinuvel Pharmaceuticals ((CUV)) are shaping up for removal in September while Spark New Zealand ((SPK)) is a low-probability inclusion, assuming Life360 ((360)) will be removed.

For the ASX100, Tabcorp ((TAH)) is now ready to be replaced with Shopping Centres Australasia ((SCP)), predict the analysts, while Virgin UK ((VUK)) -previously nominated for removal- is now seen as likely to stay included.

No changes are expected for the ASX50 or the ASX20.

The initial report from three weeks ago, is below.

ASX/S&P Index Rebalance Predictions

The next rebalancing of local share market indices is not due until September but this doesn't stop analysts at Wilsons already reflecting on and publishing predictions of which stocks might get booted out or included.

With some indices, like the ASX300. currently running below capacity there's anticipation September will see a noticeable catch-up with more inclusions than exclusions.

Wilsons is expecting 13 new members for the ASX300 in September, and given six vacancies this forecast only requires seven removals.

Most likely fresh inclusions, on Wilsons' assessment, are Boss Energy ((BOE)), Mincor Resources ((MCR)), Ebos Group ((EBO)), Neometals ((NMT)), Ventia Services Group ((VNT)), Grange Resources ((GRR)), Australian Clinical Labs ((ACL)), OFX Group ((OFX)), Maas Group ((MGH)), Macquarie Telecom ((MAQ)), Seven West Media ((SWM)), Arafura Resources ((ARU)), and Argosy Minerals ((AGY)).

Those believed will be booted out in September are: AVZ Minerals ((AVZ)), PPK Group ((PPK)), Nuix, AMA Group ((AMA)), BWX ((BWX)), Redbubble, and Dubber Corp ((DUB)).

The ASX200 will already see one change on Thursday this week when soon-to-be-acquired Uniti Group ((UWL)) is to be replaced with West African Resources ((WAF)).

Wilsons sees five more probable changes in September with all of Charter Hall Social Infrastructure REIT ((CQE)), Johns Lyng Group ((JLG)), Capricorn Metals ((CMM)), Genworth Mortgage Insurance Australia ((GMA)) and Sayona Mining ((SYA)) poised to replace AVZ Minerals, Zip Co, City Chic Collective ((CCX)), EML Payments and Life360 ((360)).

As far as the ASX100 goes, Wilsons is predicting one probable change with nib Holdings ((NHF)) as a replacement for Virgin Money UK ((VUK)).

It is also possible that Shopping Centres Australasia ((SCP)) replaces Tabcorp ((TAH)), while still an option, but at this stage labeled as "unlikely" are the inclusions of TechnologyOne and Charter Hall Long WALE REIT for which Star Group Entertainment ((SGR)) and ARB Corp ((ARB)) would have to lose their spot.

As per usual, there are likely no changes to be announced for the ASX50 or ASX20 with Wilsons ascribing an unlikely chance for replacement of respectively Lendlease ((LLC)) with Lynas Rare Earths ((LYC)) and of James Hardie ((JHX)) with South32 ((S32)).

Historically, any changes to the ASX200 have the largest impact as institutions often cannot own stocks that are outside of that index. Also, when a stock moves inside the top100 it officially becomes a large cap, meaning institutional small cap investors are forced to sell it in-line with their mandate.

Standard & Poor's is scheduled to announce the September changes on Friday the 2nd, to be implemented two weeks later, on Friday the 16th, after the close of the market.

Conviction Calls

Stockbroker Morgans' Best Ideas currently comprise 33 individual ASX-listed companies. In alphabetical order:

-Acrow Formwork and Construction Services ((ACF))
-AGL Energy ((AGL))
-Aristocrat Leisure ((ALL))
-BHP Group
-Challenger ((CGF))
-Corporate Travel Management ((CTD))
-Dalrymple Bay Infrastructure ((DBI))
-Dexus Industria REIT ((DXI))
-Eagers Automotive ((APE))
-GQG Partners ((GQG))
-Healius ((HLS))
-HomeCo Daily Needs REIT
-IDP Education ((IEL))
-Incitec Pivot ((IPL))
-Jumbo Interactive ((JIN))
-Karoon Energy ((KAR))
-Lovisa Holdings ((LOV))
-Mach7 Technologies ((M7T))
-Macquarie Group ((MQG))
-NextDC ((NXT))
-Nufarm ((NUF))
-Pro Medicus ((PME))
-QBE Insurance Group ((QBE))
-Reliance Worldwide ((RWC))
-ResMed ((RMD))
-Santos
-Seek ((SEK))
-South32 ((S32))
-TechnologyOne ((TNE))
-Transurban Group ((TCL))
-Treasury Wine Estates ((TWE))
-Webjet ((WEB))
-Wesfarmers ((WES))

FNArena Talks

As has become a pleasant and enjoyable tradition, your editor was interviewed by Livewire Markets co-founder James Marlay last week ahead of the August reporting season.

The video (28 minutes) can be freely viewed through YouTube:

https://www.youtube.com/watch?v=bmFqS6iS_pc

Australian Banks Worried (Behind The Curtains)

The managing director of specialised daily news medium Banking Day, Ian Rogers, posted the following notification on LinkedIn on Monday:

"Banking Day is hearing that the most candid versions of the outlooks prepared by the economics impresarios at the biggest banks are way more dour and pessimistic than those presented for public consumption so far.

"Bank boards will be listening, and provisioning levels this profit season are going to be hiked, big time, for the hard landing ahead."

As one would expect, the post has quickly initiated a debate about what is likely, and less likely, to happen in Australia in the year ahead.

(This story was written on Monday 8th August, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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