Industrials Priced For Disappointment, Construction Stalling

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By Greg Peel

The analysts at Deutsche Bank are looking forward to the result season providing indication of momentum from six-monthly results, despite most reports being for the full year. June half profits are expected to be up 25% on the June half '09, with earnings per share lagging at 16% as a result of dilution from capital raisings. The June half '09 was the low point in the cycle, Deutsche suggests.

The local earnings season has just begun, but results to date have at least been “reasonable”, says Deutsche. The pre-season “confession session” seemed a bit downbeat but actually profit warnings have been fewer than in recent years. Nevertheless the resources and banking sectors are likely to steal the limelight with industrials looking a lot more muted.

Reporting seasons are particularly revealing for industrial stocks nevertheless, Deutsche notes, given resources sector results are mostly dependent on commodity prices and three of the Big Banks report on a different cycle. Rolling global economic fears surrounding Europe's austerity, China's tightening and the failing recovery in the US has meant the local market is already pricing in weak results. The industrial sector's price/earnings is currently around 13x – below the 15x level (historical average) reached at the end of 2009.

De-rating has been quite widespread across sector components, Deutsche notes, but in some cases this may mean guilt by association and thus possible upside surprise. The ongoing PE discount suggests further downgrading of the cycle, which may be “too pessimistic”. Commodity prices and the Aussie dollar are rising, so equities may start to catch up.

Looking at the market as a whole, BA-Merrill Lynch strategist Tim Rocks suggests the market PE is currently above its 20-year historical average. This means earnings results will be crucial given expectations of 21% earnings growth in FY11. Downward revisions have already begun, and a 10% net revision would bring the PE back to average.

Despite the strong earnings growth forecast, Rocks notes Australia's earning growth momentum is actually “the worst” of all major countries. Yet on valuation, Australia lies in the middle. Europe is the centre of concern while Australia is seen as resilient, but all of the UK, France, Germany and Holland have lower valuations and higher earnings growth momentum than Australia.

Which again makes earnings season crucial, because either Australia is simply overvalued (and this despite the ASX 200 underperforming the S&P 500 over the past month) or the market has become too nervous.

In the case of the latter, Rocks suggests the sectors of gaming, media and diversified financials are offering “pockets of value”. There are also individual stock names trading at more than a 25% discount to their pre-GFC ratios which Rocks singles out for attention. They are Tabcorp ((TAH)), Tatts ((TTS)), and Aristocrat ((ALL)); Fairfax ((FXJ)), Ten Network ((TEN)) and Seek ((SEK)); and Bank of Queensland ((BOQ)), Bendigo & Adelaide Bank ((BEN)), Suncorp-Metway ((SUN)), Insurance Australia Group ((IAG)) and QBE Insurance ((QBE)).

Outside of those three sectors, Rocks notes similar discounts are being suffered by Harvey Norman ((HVN)), Billabong ((BBG)), Primary Healthcare ((PRY)), Sonic Health Care ((SHL)), Toll Holdings ((TOL)) and Brambles ((BXB)).

DJ Carmichael has also looked into the industrials sector, and specifically the construction industry following recent surveys from the Australian Industry Group (construction PMI) and the Housing Industry Association.

Much attention in Australia is given to the manufacturing PMI (which was quite positive in July), with a passing glance to the services PMI (which is struggling under the 50-neutral point between contraction and expansion) and little to the construction PMI. Yet Australia manufactures little, has a limited services sector outside finance, but has been building an awful lot, particularly in the mining and energy sectors.

Unfortunately, however, outside of the resources sector construction activity is muted now that government infrastructure stimulus is winding down and the housing market remains in the doldrums. The construction PMI dropped to a 12-month low of 43.3 in July with commercial building struggling at 35.3 and engineering little better at 36.2. In both cases, anything under 50 means contraction.

Not helping construction plans has been ongoing uncertainty over the MRRT, albeit there now seems to be a lot more negative talk than there is delayed projects. In two week's time the uncertainty surrounding the MRRT will clear given either there won't be one (Coalition win) or concessional tweaking will follow (Labor win).

We entered FY10 expecting a flat year, with FY11 seen as the year of rapidly returning strength. But with the global economy throwing up all sorts of doubts in the second half FY10, now the FY11 call is looking a bit premature.

BIS Shrapnel agrees, notes DJ Carmichael, as it is forecasting a waning of construction work in FY11 until private sector funding recovers to hit its straps in FY12 before an FY13 “boom”. Mining and energy related construction in Queensland and Western Australia has carried us through FY10, but FY11 will see a lag period before the next round of projects begins ramp-up in FY12-13.

DJ Carmichael is thus not too concerned about a flat FY11, suggesting low activity will reflect deferral of projects, not cancellation. The analysts note many resource companies have already announced the reinstatement of their capital expenditure plans, which will begin to flow through next year.

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