February 2022 Result Season: The Wrap

Download related file: FNArena_Reporting_Season_Monitor_Feb_2022

The February 2022 result season has proven to be the second best in the history of the FNArena Corporate Results Monitor, following a record February 2021. But that has done little to assuage investor sentiment.

-Second highest beats to misses in February 2022 season
-Supply challenges the season’s main feature
-Negative market sentiment
-Record cut to target prices

By Greg Peel

With the February result season now complete in 2022, the FNArena Corporate Result Monitor, which has been building throughout the month, is now complete and published in its final form here (see attached).

Guide

The table contains ratings and consensus target price changes along with brief summaries of the collective responses from FNArena database brokers for each individual corporate result, and an assessment of “beats” and “misses”. Australian corporate results tend to focus on the profit line, with all its inherent potential for accounting vagaries, tax changes, asset write-downs and other “one-off” impacts. FNArena has focused mostly on underlying earnings results (more in line with Wall Street practice) as a more valuable indicator of whether or not a company has outperformed or underperformed broker expectations. There is also a level of “quality” assessment here rather than simple blind “quantity”.

The Monitor summarises results from 350 major listed companies covered by FNArena database brokers. By FNArena’s assessment, 151 companies beat expectations and 72 missed expectations, for a percentage ratio of 43/21 or 2.1 beats to misses. The aggregate of all resultant target price changes came in at a net -2.4% fall. In response to results, brokers made 56 ratings upgrades and 43 ratings downgrades.

The first FNArena Corporate Result Monitor was published in the August season of 2013. See table:

Unusual Times

One year ago, the February result season proved to be the “best ever” in terms of company results beating analyst expectations, compared to those missing. The beat-to-miss ratio came in at 3.7, compared to a previous high of 1.9 in August 2020 and a seven-and-a-half year average of 1.5.

From end-February to end-August 2021, the ASX200 rallied 13%. From end-August 2020, the rally was 24%. On the strength of those moves, it appeared another strong results season was in the offing.

By contrast, the December quarter 2021 saw the ASX200 rally all of 1.5%. The quarter began with NSW and Victoria in delta lockdowns, which were subsequently lifted during the period. State lockdowns/border closures came and went, except in Western Australia, where the border remained firmly closed.

While the February 2021 results season was the “best ever” in terms of the stats, it was in reality a somewhat misleading result due to four factors.

Firstly, most companies were still refraining from offering guidance given covid risk, meaning analysts were in the dark and inclined to post conservative forecasts.

Secondly, analysts did not know just what JobKeeper benefit companies enjoyed. Thirdly, analysts were taken aback by the the extent of cost-cutting companies managed in the face of lockdowns, which can be a positive step (better earnings) but also a negative one (lower revenues), and lastly, analysts were caught out by the extent of the online retail boom, which again could be seen as both positive (new customers) and negative (pull-forward of demand).

Jumping forward to the February 2022 season, we can claim it to be the second best ever season (since August 2013) on a ratio of 2.1 beats to misses, compared to 3.7 a year ago and an average of 1.5.

But once again, there are extenuating circumstances.

Supply

Supply constraints driven by global covid lockdowns and illness were already evident last year, but were not seen as too much of a threat initially on the assumption once vaccines started to make their mark, the problems would ease. This was certainly the stance taken by central banks as inflation started to run amok.

But along came delta, and the situation deteriorated. It was only in January the Fed woke up to high inflation as a lingering reality, while the December quarter featured ongoing supply constraints, labour shortages and surging freight costs.

One sector that was particularly impacted was that of Australian resource companies and the contractors who service them. While there were issues in Queensland and NSW, it was the closed WA border that caused the most heartache, given reliance on FIFO workers who simply weren’t allowed into the state.

Stock analysts were well aware of the issues, which had already been noted in September quarter production/sales updates but more so in December updates (posted in January). For a vast number of ASX companies – not just miners/drillers – a beat or a miss was driven by that company’s capacity to successfully combat supply issues and those which were unable.

While the ability to pass on surging wholesale costs to consumers was one way companies were able to offset the earnings impact, another strategy became apparent in cash flow numbers.

As the Guide above notes, beats/misses are not just about reported profit. Underlying earnings are a better guide, but other metrics such as free cash flow can also be considered important depending on the nature of the business. Hence, while several companies posted underlying beats, they simultaneously posted huge misses on cash follow expectations.

Is that a bad thing? Well it does feed into capital management (eg dividends) and ongoing investment or M&A opportunities. But the big cash flow misses were all about companies beefing up their inventory levels in the face of supply constraints in order to maintain a sustained level of service to their customers.

The days of “just in time” inventory management are now long gone.

For the most part, immediate investor reaction to these big cash flow misses was negative on the day. For the most part, subsequent broker reviews declared such a strategy to be sensible. There were several examples of stocks being sold off on the day, ahead of brokers calling the result a “beat” despite a big cash flow miss.

Macro Backdrop

The December quarter may have seen the ASX200 crawl up a net 1.5%, but the month of January brought a -6.4% plunge due to the Fed’s policy about-face. Investor sentiment was nervous as the February result season began.

As it was, the index posted a net 1.1% gain from January 31 to February 28, but that included a 6.7% rally from January 27 to February 22. Note that falls are measured from the top down and gains from the bottom up, hence gains have to be greater in percentage terms than falls to get back to the starting point.

From February 22 to 25, the index fell -4.2%. Up to the final week of February, about 130 of the 350 stocks reviewed by FNArena brokers had reported, meaning 63% of companies reported in that final week (plus Monday 28). The bulk of the season’s reports followed the Ukraine invasion.

In a volatile market, it is difficult to assess investor reaction to company results. A company beating on the day can still be sold off, unable to overcome the overwhelming macro mood. A stock that misses can be trashed.

And we saw plenty of that happening.

Off Target

While the season may have provided a “second best” 2.1 ratio of beats to misses, this is not the statistic that stands out. The season also featured a net -2.4% cut to broker target prices (simple average).

Doesn’t sound like much you say, but consider that it’s only the second time since August 2013 a net target reduction has followed, and that was only -0.1% in February 2019. The average is a 2.8% increase, so -2.4% is clearly an outlier.

How do you match a 2.1 beat/miss ratio with a -2.4% reduction in target? In February 2021, the 3.7 ratio was met with a near record 5.0% increase.

First note that there is a natural bias to any season’s target price update on what brokers call a “roll forward” of forecasts. Forecast periods are typically five years, and at the end of each season another year’s (or half-year’s) forecast is tacked on to the end. Assuming earnings growth over time, that new forecast is added to a discounted cash flow valuation and the stocks’ value rises.

But the biggest impact on said discounted cash flow valuation, particularly the further out in time you go, is the rate at which analysts discount those cash flows back to today’s dollars, known as the “risk-free rate”. The rate used is typically the ten-year government bond yield, on the basis that that is the risk-free instrument one could invest in rather than the risky stock market.

Thus in order to be ahead on your equity investments, you have to at least beat the ten-year yield.

Analysts do not simply take the prevailing yield as the benchmark, but rather they forecast a yield based on their own assumptions. For two years the RBA cash rate has been zero, and still is, but in anticipation of rising rates ahead, the ten-year yield has risen over 25 basis points in a year to be above 2%.

Hence, one feature of this season’s standard “roll forward” has been an increase to the broker’s risk-free rate assumption, which not only reduces the new period’s value in today’s dollars but every other period along the way.

Suffice to say this season brought beats of broker forecasts and enthusiastic commentary matched by head-scratching cuts to target. The above is one reason.

Another reason could be construed as a bit of a cop-out by analysts. But this would be to suggest analysts should have known Putin would invade Ukraine before anyone else did, or that the Fed would not just shift its policy as it did in January (foreseeable), but completely reverse it (surprise).

Some target cuts this season were put down simply to a “lower market multiple”, or perhaps more specifically a “lower sector multiple”. A multiple refers to the price/earnings (PE) ratio expressed as, for example, 15x.

When market sentiment turns sour investors sell first and ask questions later. Thus the P in PE falls and drags down the multiple long before the impact on E is felt. On the double-whammy of Fed policy and Ukraine, market multiples across the globe have taken a hit in 2022.

As I suggested, it seems a bit of a cop-out if an analyst lowers a target price simply because the stock price has fallen. One might be moved to ask “well what good are you then?” But if sentiment has swung and a previous target price seems just too far away to be recovered in the near term, analysts have little choice but to take sentiment into account.

Finally, valuation adjustments, leading to lowered target prices, were also driven in some case by aforementioned cash flow misses, implying an impact on near term earnings forecasts (lower E). Again, such target cuts may have belied a broker calling a beat, retaining a Buy (or equivalent) rating or even upgrading its rating.

Looking Ahead

Yes, well you tell me.

It appears now that if we haven’t actually conquered omicron yet, it’s under control, to the point restrictions have eased, and blow me down, the WA border is open again. All things being equal we might assume the supply constraints and labour shortages plaguing (pardon the pun) the December quarter will now start to ease.

In the December quarter, despite the challenges, the Australian economy grew 3.4% — the fastest quarterly rate since 1976. On an annual basis, GDP was up 4.2% in 2021.

The impact of omicron will nevertheless not hit the numbers until the March quarter result, which we won’t see until June.

Even if supply challenges ease as omicron eases, it will not have the hoped for impact on inflation because on the inflation front, there’s a new kid in town, called Vlad.

Mathematically inflation numbers should have been easing in 2022 as we cycle the big jumps of 2021, and easing supply challenges would have helped, but soaring commodity prices as a result of the war/sanctions have killed off any notion.

The price of oil alone is an economy killer.

Fortunately, the Australian economy relies on selling rocks to the world. Hence, the Australian stock market as a whole has a counter to ongoing high, and even further rising, inflation due to commodity price increases. But commodity price increases hit every other sector, and every consumer.

Given a -6.6% fall in the ASX200 year to date, and the counter provided by the resource sectors, the question is one of whether the risk factors of rising interest rates and a war are priced in. History suggests investors should sell on the threat of an invasion and buy on the actual invasion.

But in no war since the Second has a nuclear threat been this real. At this stage, perhaps only a coup d’etat in Moscow can bring this mess to an end.

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