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The Wrap: Miners, Steel, Healthcare, G8 Education

Weekly Reports | Jan 20 2017

-Miners increasingly awash with cash
-Potential nasty surprises for healthcare
-China's steel reduction supports iron ore
-UBS previews reporting season for emerging companies
-G8 Education a potential turnaround story 

By Rudi Filapek-Vandyck

Focus On Capital Management

How times have changed. It was only a year ago analysts and investors were speculating on which resources stocks might be about to breach debt covenants, and Whitehaven Coal ((WHC)) featured often on top of the list.

Now the boot is firmly on the other foot and the sector is enjoying almost unprecedented piles of cash flowing into miners' bank accounts, while those same analysts and investors are trying to figure out just how long exactly can this purple patch continue?

Now the biggest question in the sector is what to do with all that cash? Analysts at Citi point out the answer will be different for each miner. For example, BHP Billiton ((BHP)) likes to stonewall its single A credit rating, while Fortescue Metals ((FMG)) is aiming to reduce gearing to less than 40%. South32 ((S32)), on the other hand, is debt free and doesn't want to hold more than US$500m in cash.

So many options, so many possibilities.

On our observation, analysts have already started speculating about whether Rio Tinto ((RIO)) might pay out extra dividends, or maybe conduct a share buy back, why not both?

Analysis by Citi has identified Whitehaven Coal as the one with the biggest luxury problem. Key question: is the company first aiming at reducing debt to zero or will it start rewarding shareholders sooner?

Healthcare: Potential Surprises

It's not what we know that defines the year, it's what we don't know is about to happen. 2016 would be the perfect example.

Healthcare analysts at Morgan Stanley applied the principle to the sector in Australia and came up with five possible unaccounted for scenarios; only one would be a positive.

First the potential negatives:

1. A much stronger USD against EUR and GBP. While a stronger USD/AUD is beneficial for US profits, weakening currencies in Europe act as a negative. Ansell ((ANN)), for example, derives some 25% of revenues from Europe. For CSL ((CSL)) the percentage is 24% and for ResMed ((RMD)) the number is 29% of revenues. By the way: I think Ansell is not a healthcare stock, but that's a discussion for another time.

2. CSL and plasma collection cost inflation. It is the analysts observation plans to expand plasma collection centres would, if all executed, imply stronger growth than the market. This raises the prospect of over-supply. In the short term, however, Morgan Stanley notes the market is more likely to stick with the view that CSL stands out as a key beneficiary from mis-steps and supply chain issues among its competitors.

3. It is the analysts view that substantial capacity expansion in some of Healthscope's ((HSO)) key markets has compounded the earnings impact of volume weakness, but thus far, nobody else seems to be paying attention.

4. Cochlear ((COH)) shares are trading on lofty multiples but what if key competitor Advanced Bionics starts fighting back in 2017, grabbing back lost market share?

And here's the potential positive surprise:

5. Market rumours about a potential break-up of Primary Health Care ((PRY)) would, if executed, prove to be a positive for shareholders.

All in all, it is the analysts' view the healthcare sector was punished in 2016 for trading on too-high multiples. The severity of the relative underperformance is unlikely to be repeated in 2017, in their view, though any of the above mentioned scenarios can still have a major impact.

China Steel Reductions

China remains hell-bent on reducing steel production capacity and iron ore prices still trade above US$80/tonne. Go figure!

However, explain commodity analysts at UBS, things are not as contradictory as they might seem. China has an estimated steel manufacturing capacity of some 1.12bn tonnes per annum. The sector only produces 810m tonnes (UBS estimate). This implies idle capacity of no less than 310m tonnes.

To put that latter figure into context: idle capacity in China is larger than actual steel production in the USA and Europe combined.

For obvious reasons, when authorities target further reduction in capacity, it has no impact whatsoever on the steel sector's demand for iron ore and other inputs such as nickel, molybdenum, scrap steel, metallurgical coal, etc.

Ironically, suggests UBS, when idle capacity is closed China's steel sector becomes healthier, enjoying higher utilisation, higher margins and higher steel prices, which supports iron ore pricing. On UBS's projection, China's total steel production will remain stable (810m tonnes) for 2017. The government in Beijing reported 80m tonnes in capacity was closed in 2016.

Emerging Companies

Reporting season is approaching and analysts at UBS have dusted off their crystal ball and reviewed what's likely in store for "emerging companies" (their definition) in Australia for the season.

Cutting directly to the chase, the analysts have identified a few names that might disappoint with their financial performance as well as with their outlook. At risk of delivering such a double negative in February, according to UBS, are GBST ((GBT)), InvoCare ((IVC)), Monadelphous ((MND)) and TOX Free solutions ((TOX)).

The numbers are higher for companies likely to deliver a double positive: a2 Milk ((A2M)), Alumina Ltd ((ALU)), AMA Group ((AMA)), Bapcor ((BAP)), Costa Group ((CGC)), Cleanaway Waste Management ((CWY)), Freelancer ((FLN)) and freshly listed Ingham's Group ((ING)).

In more general terms, stocks in the emerging companies space that UBS likes for the year ahead include Adairs ((ADH)), AMA Group, EclipX ((ECX)), Gateway Lifestyle ((GTY)), Infomedia ((IFM)), NextDC ((NXT)), TFS Corp ((TFC)) and Tassal Group ((TGR)).

Turnaround Potential At G8 Education

The new guy in charge of analysing childcare centre operator G8 Education ((GEM)) for stockbroker Ord Minnett has taken the view that new management seems poised to surprise the market, which would not be too difficult a task, one reckons, given the long history of negative surprises and perennial disappointments this former market darling has been accumulating in years past.

We note the share price has swiftly recovered from levels below $3 last year, but shareholders remain underwater if they bought in between April and August last year, not to mention the share price once upon a time was way, way, way higher.

Jules Cooper, as the new guy in charge at Ord Minnett is named, believes if the new CEO's strategy comes to fruition, there could be material upside from the current share price. Unsurprisingly, the present share price is not seen accounting for any such positive outcomes.

The analyst draws optimism from a likely stabilisation in margins, the arrival of the new CEO and from the fact that small improvements in occupancy rates can potentially support a double-digit increase in operational profits and valuation for the shares. Ord Minnett has thus suitably upgraded to Accumulate (in between Buy and Hold) with a new price target of $3.78.

The latter might surprise as the shares are currently trading around $3.62 which is not that far off the target, but then Jules Cooper is still not sure what exactly the future might bring. His advice is investors should make a clean assessment of the company and keep an eye out for early signals of improvement.

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