article 3 months old

Of Strength And Weaknesses

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Mar 01 2012

By Rudi Filapek-Vandyck, Editor FNArena

At least one market observer (BA-ML strategist Tim Rocks) has labeled the February reporting season in Australia "the worst in years" and there is a lot in favour of such a dire assessment.

Despite heavily discounted expectations in the months leading up to the event, ASX-listed companies have once again proved unable to beat market expectations. Instead, downward pressures on profit margins mostly outweighed the positives, previously noticeable growth in dividends has stopped abruptly (some like AMP ((AMP)) and IOOF ((IFL)) were forced to cut) and those companies with enough free cash flow showed a remarkable reluctance to follow through with capital management initiatives.

Also remarkable: whereas in previous periods miners and energy companies provided some offset vis-a-vis the persistent absence of growth in the industrials space, this time around they joined the queue of disappointments. BHP Billiton's ((BHP)) interim report showed negative growth*. Fellow-miner Rio Tinto ((RIO)) still reported growth but disappointed due to lack of more hand outs to shareholders.

Both Santos ((STO)) and Woodside ((WPL)) equally showed rather subdued profit momentum despite a much stronger pricing environment for crude oil. Newcrest Mining's ((NCM)) half-yearly results did beat the market, forcing analysts to lift their projections, but less than a week later the company had to issue a profit warning due to unexpected operational problems at its Lihir gold mine in Papua New Guinea.

Fortescue's ((FMG)) report was rain affected and thus missed the mark, though analysts remain confident about the company's ambitious growth plans. It was a similar story among many second-tier miners and energy companies.

All in all, earnings per share (EPS) expectations for the current fiscal year have now dropped to circa 3% (from 19% one year ago) while projections for FY13 now imply 14% growth. This does not mean the Australian share market is now looking towards better times ahead. These numbers merely suggest the negative momentum in underlying growth expectations that has kept the ASX200 in a bind since early 2010 is likely to persist for longer.

With the Reserve Bank reluctant to lower interest rates, the banks ready to not pass on any interest rate cuts to their customers, the Australian dollar persistently high, the property market weak, the consumer cautious and the labour market amongst the tightest in the world, there is very little to assume the overall dynamic for Australian profit margins is about to improve significantly. Maybe the bounce in US economic data has further to go than I am at present willing to consider. Maybe the Chinese authorities will turn more accommodative in a few months' time. Maybe the European recession will prove short and shallow.

There is, as per always, room for positive surprises in the months ahead, but -fair is fair- both history and the general context suggest the risks remain to the downside for Australia's profits this year and next. Investors should note a rather large number of companies missed the mark in February, but held on to their guidance for the full year. These companies need a bumper performance between today and the end of June, increasing the risk for follow-up disappointments in August. Analysts at Macquarie have already launched a label for these companies: "the second half club".

On Macquarie's analysis, it would appear industrials stocks are likely facing the biggest challenges this half to June. Also, investors should note that, overall, profit and dividend forecasts for REITs have proven the most resilient this month.

Returning to Tim Rocks' assessment, this February reporting season marks in many ways new lows for Australian companies. Take profit margins, for instance. Analysts at Goldman Sachs have conducted a detailed analysis of operational margins for ASX300 industrial companies. Their assessment is that overall margins deteriorated for the second period in a row. Moreover, on Goldman Sachs' calculations EBITDA margins (earnings before interest, depreciation and amortisation) for industrials in Australia have not been this low since the mid-nineties – this despite a reduction in depreciation and amortisation on the back of lower investments made in capex and opex post the GFC.

At Macquarie, where analysts keep track of earnings forecast revisions, it has been established the current period of downgrades to earnings estimates is likely going to outlast the GFC-term that started in 2007 and lasted for 23 months. On Macquarie's assessment, the current period of downgrades continuing to outweigh upgrades is today 22 months old.

Macquarie does see a few positives. The net balance between downgrades and upgrades to forecasts in February is less negative than in the previous months (a skeptic would say that's because all the big cuts had already been made before the reporting season). It'll be interesting to see what happens to forecasts for FY13 in the weeks and months ahead.

All in all, and this one should put to bed once and for all the "enigma" as to why the US share market has performed so much better since the rally of 2009, the current trend suggests the average EPS growth in Australia in FY12 may not be able to remain above zero by August. This means total growth in average EPS in Australia off the lows in FY09 might just beat 10% – over three years combined! In comparison, US companies have achieved growth of 125% during that period with profit margins, dividends and profits for shareholders today higher than what they were in 2007.

Tim Rocks points out current analysts' forecasts imply Australian companies ex-materials and financials can turn 5% estimated sales growth in FY13 into 12% earnings growth. It seems but a fair assessment that unless the overall context changes dramatically in the months ahead, downgrades to forecasts will continue to outweigh upgrades. Mining companies are poised to feature prominently on weather-impacted production volumes, lower than projected commodity prices and a stronger than anticipated AUD.

Maybe one good illustration of how this reporting season has turned out to be is through the observation that the eight stockbrokers daily monitored by FNArena have over the past four weeks issued 35 positive recommendation changes against 120 negative revisions. This translates into nearly four downgrades for every upgrade. (This in a market believed to be cheap on historical comparisons).

It's not all but bad news though. Closer examination of released profit updates in February shows there are pockets of strength in Australia. The first observation that stands out is that medium to smaller sized companies seem to be coping better with current market dynamics than many of the blue chips in Australia. This observation is supported by the fact that positive surprises this month are predominantly situated among providers of services to miners and energy companies, among telcos, among food and beverages companies and among discretionary retailers.

As far as the retailers are concerned, there is an element of beating expectations that had overshot to the downside, but regardless, companies such as Breville ((BRG)), Super Retail Group ((SUL)) and Fantastic Furniture ((FAN)) have been among the more solid performers for many years in this battle-hardened sector. Otherwise, how investors completely failed to pick online travel services providers on the back of the strong AUD and continued increases in outbound travels remains a bit of a mystery with Flight Centre ((FLT)), Webjet ((WEB)) and peers amongst the stand-out performers this month, alongside positive surprises from both Virgin Blue ((VBA)) and Qantas ((QAN)).

Food and beverages companies also showed their intrinsic strength with results from Warrnambool Cheese ((WCB)), Patties Foods ((PFL)) and Little World Beverages ((LWB)) blowing away market expectations. Note that others in this sector such as Domino's Pizza ((DMP)) and Coca-Cola Amatil ((CCL)) failed to beat expectations, but they delivered strong results nevertheless.

Telstra's ((TLS)) result proved not enough to keep the share price rally going, but others in the sector managed to surprise, including Amcom Telecom ((AMM)) and Big Air ((BGL)).

A special mentioning goes out to the service providers to miners and energy producers. The likes of Monadelphous ((MND)), Ausdrill ((ASL)), NRW Holdings ((NWH)), Lycopodium ((LYL)), Ausenco ((AAX)), Miclyn Express ((MIO)), Qube Logistics ((QUB)) and Boart Longyear ((BLY)) are clearly enjoying the unprecedented boom in global capex from the big miners and oil and gas producers, and it is keeping the risks to the upside for most companies in this segment. This makes the few disappointments just as much a stand-out as the many positive surprises.

So watch out for Industrea ((IDL)), GR Engineering ((GNG)) and Boom Logistics ((BOL)) because they all failed to impress in arguably the best trading environment this segment is going to enjoy for decades to come (if not ever). The only stockbroker that covers Matrix Composites & Engineering ((MCE)) in the FNArena database, JP Morgan, was unimpressed with the company's interim report this month. The price target has now fallen to $3.33.

Also, Transfield Services ((TSE)) didn't repeat the disappointment from August last year, which (finally) put some oomph under the share price, but the stock is under threat from being removed from the ASX100 by Standard and Poor's this Friday and this could trigger temporary weakness for the share price. Bradken ((BKN)) also disappointed, but both investors and analysts have granted management the benefit of the doubt.

Given the strong supportive boom-times these companies are enjoying (probably for 2-3 years out into the future) it is very likely market forecasts will continue lagging actual momentum, suggesting analysts will continuously have to play catch-up just as they did in the years 2003-2007 for resources companies. Which I why I maintain the risks remain to the upside for this segment of corporate Australia, with share prices likely to remain elevated for much longer (and ultimately to reach for much higher levels than is now thought possible).

Some smaller players in the finance sector, including Flexigroup ((FXL)) and Credit Corp ((CCP)) have also used this month to show their intrinsic strength.

All in all, the gap between the weaker parts of the share market and the stronger parts has probably not been as wide and as pronounced since the nineties when Australia endured Keating's infamous recession the country simply had to have. Investors looking to add exposure to the stronger parts of the local share market will have to pay extra-attention whether most of the near-term upside isn't already reflected in today's share prices. This consideration seems particularly appropriate for the likes of Domino's Pizza, Monadelphous, Little World Beverages and Campbell Brothers ((CPB)).

Also, the category of companies which I described as "All-Weather Performers" in last year's e-booklet "The Big De-Rating"* may not have shot out the lights this reporting season, but these companies continue to show resilience and strength. Among the ones that are not yet trading on elevated valuations are McMillan Shakespeare ((MMS)) and Amcor ((AMC)).

Trying its best to return from the doldrums is Cabcharge ((CAB)), as well as Skilled Group ((SKE)), Automotive Holdings ((AHE)), The Reject Shop ((TRS)) and Downer EDI ((DOW)).

On the weaker side, media companies have continued taking the lead to the downside this month, in particular print and TV, with exception of globally diversified News Corp ((NWS)). Customer relations service provider Salmat ((SLM)) is now also building a rather disturbing legacy of profit disappointments, while accountancy software developer Reckon ((RKN)) uncharacteristically disappointed this month.

Note there are no mentions of OneSteel ((OST)) or Gunns ((GNS)) as I specifically zoomed in on better than anticipated results that were strong in itself and that caused forward estimates and valuations to rise. The likes of OneSteel and Gunns have become prime targets for momentum traders on volatility-inspiring announcements. These are not suitable targets for investors with a longer term horizon, looking for strength to protect their capital in addition to generating positive returns.

And yes indeed, I failed to mention the banks. As explained in last week's story, the divergence between the "strong" and the "weak" also applies to the banks where CommBank ((CBA)) and ANZ Bank ((ANZ)) are now the wounded leading the crippled. Banks have virtually fallen to ex-growth, which will last for a while, and which will make their above average dividend yields the sector's main asset. In a market that is, on balance, more dominated by weakness than by strength, that is not necessarily a bad thing.*

(This story was originally written on Tuesday, 28 February 2012. It was sent out to paying subscribers on that same day.)

* As accurately predicted by myself in 2011
* The e-booklet "The Big De-Rating. A Guide Through The Minefields" is exclusively available to all paying subscribers. If you haven't as yet received your copy, send an email to
* See last week's Weekly Insights "A Few Truths About Australian Banks"


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