Several Emerging Themes For Australian Earnings Season

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

-Margin growth a key metric
-Positive for international industrials
-Asset values under scrutiny
-Few upgrades expected
 

By Eva Brocklehurst

The time has come, the walrus said, to talk of many things … in this year's wonderland of upcoming Australian company earnings reports.

JP Morgan has surveyed companies that have the potential to surprise. Uncertainty this time around is reduced, with 21% having the potential to surprise on the upside and 33% with potential to surprise on the downside, in JPM's view. This is low compared to the survey's historical averages. Over the last three years there have been some depressing downgrades. Resources enjoyed a boom heading into 2011 but since then earnings have witnessed substantial downgrades. JP Morgan notes average forecast earnings growth has dropped to 5.9% for the S&P/ASX200 industrials. To the broker it appears analysts have been dampening FY13 forecasts and increasing FY14 forecasts correspondingly.

JP Morgan has singled out Rio Tinto ((RIO)) as offering an attractive earnings opportunity. The stock stands out in that it has a wide range of earnings estimates, which implies a higher chance of earnings surprise. The focus will be on operating costs, as the company is under pressure to deliver the significant cost reductions it has been promoting. The other issue is guidance regarding iron ore projects, as the expansion of the company's Western Australian iron ore operations has been the source of much debate and will have implications on the forecast capex.

Some stocks listed by JP Morgan which have potential to announce capital management initiatives, such as launching new buy-back regimes, include Amcor ((AMC)), CSL ((CSL)), REA Group ((REA)), ResMed ((RMD)), Suncorp ((SUN)) and Westfield ((WDC)). Those that may possibly look to raise additional equity are many, but include Ardent Leisure ((AAD)), AMP ((AMP)), APN News & Media ((APN)), Cardno ((CDD)), Computuershare ((CPU)), Dexus Property ((DXS)), Evolution Mining ((EVN)), Goodman Fielder ((GFF)), Investa Office ((IOF)), Origin Energy ((ORG)), OZ Minerals ((OZL)), Paladin Energy ((PDN)), QBE Insurance ((QBE)), Sonic Healthcare ((SHL)) and Transfield ((TSE)).

For Macquarie, a low growth environment means weakness across all sectors and it will come down to whether stocks deliver on guidance. Overall, the market's FY13 earnings guidance reflects the weakest growth since the depths of the GFC and, in large part, resources are contributing to the drag. Ex resources, market earnings are expected to lift around 5% in FY13, which Macquarie describes as a "grinding" increase over FY12's 1.7% . If delivered, this will be the highest growth seen since FY07. If mining services is excluded, then FY13 earnings growth estimates lift to over 6%.

It all highlights a major shift by companies to cutting costs in order to drive earnings growth in the face of weak sales growth. Macquarie has analysed the last five years and notes this economic cycle has produced weaker demand for longer, which means margins are of greatest importance. Significantly, this time 69 stocks out of 153 are forecasting positive sequential half-on-half earnings growth.

Those with sequential growth forecasts greater than 10% include QBE, Flight Centre (( FLT)) Oil Search ((OSH)), Ansell ((ANN)), Primary Health Care ((PRY)), Aurizon ((AZJ)), Telstra ((TLS)), Carsales ((CRZ)), ResMed, Sonic Healthcare, Perpetual ((PPT)), REA, Telecom NZ ((TEL)), IOOF ((IFL)), SEEK ((SEK)), AGL Energy ((AGK)), Nib Holdings ((NHF)), Brambles ((BXB)), WorleyParsons ((WOR)), Amcor, Computershare, SAI Global ((SAI)) and Origin Energy.

Looking at margin growth, the key performance metric in the current low demand environment, 70 companies out of 153 are forecasting higher margins half-on-half. There are 47 expecting expansion of one percentage point or higher. In the ASX100 these include Fortescue Metals ((FMG)), Westfield, Aurizon, Treasury Wine ((TWE)), QBE, Perpetual, AGL Energy, Charter Hall Retail ((CQR)), Rio Tinto, Bendigo & Adelaide Bank ((BEN)), Commonwealth Bank ((CBA)) Telstra, ResMed, Slater & Gordon ((SGH)), GPT ((GPT)), Arrium ((ARI)), REA, Ansell, Tabcorp ((TAH)), Computershare, Origin, Brambles, Sonic, Flight Centre, BHP Billiton ((BHP)), Crown ((CWN)) and Primary Health.

Ex ASX100 they are Acrux ((ACR)), Atlas Iron ((AGO)), Peet ((PPC)), Magellan Financial ((MFG)), Beach Energy ((BPT)), Mineral Resources ((MIN)), Flexigroup ((FXL)), IOOF, Austbrokers ((AUB)), Aurora Oil & Gas ((AUT)), Whitehaven Coal ((WHC)), Carsales, SAI Global, Ainsworth Gaming ((AGI)), Navitas ((NVT)), iiNet ((IIN)), Stellar Resources ((SRZ)) and Toxfree ((TOX)).

The notable group is those expecting earnings margins to be higher against both the prior half and the prior corresponding period by at least 1ppt, i.e. those that have lifted margins across each of the last three halves. They are Fortescue, Westfield, Aurizon, Mineral Resources, Atlas Iron, Charter Hall Retail, Flexigroup, IOOF, Rio Tinto, Bendigo & Adelaide, Carsales, ResMed, GPT, Arrium, REA, Ansell, Tabcorp, Computershare, iiNet, Commonwealth Bank and Toxfree.

Macquarie believes it is too early to suggest a sustainable earnings upgrade cycle is emerging but downgrades may have found a trough. While a number of industrial stocks have issued profit warnings, the majority have been in the mining services/contractor area. This is in sharp contrast to the indiscriminate earning downgrades seen over the same period leading into the FY12 reporting season.

The most positive outlook this time is the international industrials, as they have higher earnings expectations for FY13 and beyond. When mining services/contractors are excluded this group offers over 7.1% FY13 earnings growth, based on guidance. Macquarie prefers those most strongly leveraged to improving US earnings, as they are not only exposed to the improved global economic growth but should also benefit from a lower Australian dollar, as the earnings are translated back into Australian earnings in FY14. While these international industrials are well supported by revenue growth, the domestic industrial sector remains an earnings margin story. Qantas ((QAN)), Insurance Australia ((IAG)) and Woolworths ((WOW)) are expected to make the largest contributions to FY13 earnings growth for this group.

In terms of net interest expense, resources companies are expected to show strong rises. Most of the rises reflect acquisitions. Around half of the sector's overall lift in the half year is driven by a $301m increase in BHP's net interest expense. Others with large net interest expense growth include Fortescue, Rio Tinto, Newcrest Mining ((NCM)) and Woodside Petroleum ((WPL)). The overall market gearing is expected to be slightly higher than FY12, at 41%, but does reflect a full 10 percentage points increase in the interest expense levels in the resource sector.

Miners' asset values will be under scrutiny. CIMB expects more write-downs. OZ Minerals ((OZL)) and Evolution Mining have just announced expected write-downs, adding to Newcrest's write-down of $5-6bn announced back in June. Companies which have a book value that exceeds the broker's fair value estimate include Whitehaven Coal, and Rio Tinto's and BHP's respective thermal and coking coal divisions. OZ Minerals also may not have written down enough. Atlas Iron is at risk. Both Whitehaven and Atlas Iron have material debt. At this point CIMB does not believe write-downs will have an immediate impact on these two but will limit the ability to renegotiate debt facilities in the future. Fortescue has relatively high net present value (NPV) versus book value of 3.2 times but high gearing masks the risk to write-downs.

New Hope Coal ((NHC)), in contrast, has little risk of a write-down in the current season and the stock has a large cash pool to generate value. Perseus Mining ((PRU)) is seen under pressure, similar to Oz Minerals. CIMB estimates Perseus' NPV is 30% higher than net assets and current market capitalisation is 31% below the book value of assets. The current 44% discrepancy between market capitalisation and asset book value will be a cause of concern for Mount Gibson ((MGX)) this reporting season. On a more positive note, CIMB has Sandfire Resources ((SFR)) at the top in terms of both NPV/book and price/book ratios, reflecting the value generated by the high-grade Doolgunna deposit. Given a relatively short remaining mine life of seven years at Doolgunna, adding further low assets to extend portfolio mine life will be the next challenge to ensure current ratios are maintained.

Credit Suisse believes the negative earning outlook, with further downgrades likely, could mean a downgrade of 8% in total for Australian market earnings. The broker favours defensive and quality stocks over cyclicals. Having said that, Credit Suisse is wary about being too negative on resources because of a looming inflection point. At some stage price/earnings expansion will kick in. The broker's model suggests key drivers of the Australian economy in equal measure are commodities and credit. Credit flows drive sectors such as retail and housing and commodities drive mining and related construction.

With slowing world growth and lower commodity prices are driving forecasts for earnings downgrades among miners, Credit Suisse notes a more hidden correlation between world growth, commodity prices and domestic cyclical earnings. Sector price/earnings movements can overshadow movements in earnings around major turning points. Therefore, knowing the driver of market earnings revisions does not always point to the best sector allocation. Hence, the broker remains underweight on those domestic cyclicals which could indirectly suffer as world growth slows, commodity prices fall and unemployment rises. This means mining services, retailers, builders and banks.

It won't be all that bad, in Citi's view. The broker doesn't expect earnings estimates to hold up as they did in February, but they should not be subject to downgrades to the extent they were a few seasons back. The broker suspects "confession season" has limited the surprises to FY13 market earnings and it's FY14 earnings expectations that could come under pressure. Moderate downgrading of FY14 would probably be a reasonable outcome in Citi's view.

There are few expectations of earnings upgrades, save domestic general insurance and rail transport. Some of the large defensive sectors such as real estate property trusts (A-REITs), telecoms and banks are likely to meet earnings expectations so there's not much fear of disappointment from those fronts. There's a lot less of the market at risk of significant downgrades, except in the areas where conditions have been toughest, such as building materials, contractors, media and retailing. Here, Citi thinks estimates for FY14 remain the most significant risk.

Surprises could come from the mining sector, amid efforts to boost cost savings, while energy stocks are all about project execution and growth options. Positive surprises are most likely to come from Insurance Australia, Suncorp, Aurizon, Commonwealth Bank, Telstra and TPG Telecom ((TPM)), in Citi's view. These are in sectors where the earnings are considered reliable. Boral ((BLD)), Fletcher Building ((FBU)), David Jones ((DJS)), Boart Longyear ((BLY)), Echo Entertainment ((EGP)) and Fairfax ((FXJ)) are at risk of disappointing investors, in Citi's view. Most of the surprises are related to earnings but some could be promising stronger dividends. In this camp are Commonwealth Bank, Insurance Australia and Suncorp.

All up, in a subdued environment cost savings should help limit the earning downgrades. Citi expects reporting margins should rise after falling to the lowest levels in over a decade for industrials and approaching the lowest in a decade for resources. Moreover, lower interest rates may be taking longer than usual to benefit earnings, which seems partly due to the delayed depreciation of the Australian dollar. Citi thinks downgrades should start to abate in time if interest rates come down further in coming months.
 

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