Company reporting season is a volatile time for share prices so watch out in February as it could be a wild ride on the markets.
During this year’s reporting season, company reports and commentary will be analysed with microscopic precision as investors look for signals over the rate and extent of any further deterioration in earnings.
A further souring of the earnings cycle will mark the unwinding of the ASX index earnings which doubled between 2003 and 2008. Most analysts expect this to be the first of three reporting seasons where each new report is expected to be worse than the last.
Most investors already expect the worst – and much of the bad news has already been priced-in. Over-optimistic analyst numbers will probably do little to boost confidence.
According to Citi Smith Barney analyst Graham Harman, 2009 will be a year where the risk of companies becoming loss-making or insolvent is much higher than normal.
Already, Citi is witnessing the weakest period of earnings revisions on record, with earnings downgrades from large-cap and small-cap stocks outnumbering upgrades by a ratio of more than two to one.
In addition to ‘normal’ downside arising from the economic slowdown, Harman expects the incidence of ‘random earnings’ accidents to be abnormally high.
While Harman believes a 20 per cent EPS downside is on the cards, Citi’s valuation models suggests that market EPS falls of around 25 per cent have already been priced in. While he expects the profitability of the Australian market (“ROE”) to remain well-above historical averages at 16 per cent (and cycle lows), his bottom-up expectation for core industrial companies EPS growth for 2009 is currently -3.6 per cent.
Unsurprisingly, Citi’s earnings expectations for “industrials” S&P/ASX200 ex-Resources) have now gone well into negative territory with Harman expecting -5.7 per cent EPS growth for fiscal year 2008/09 – with a reacceleration of industrial earnings in the numbers for 2009/10, to 6.1 per cent EPS growth. And while the EPS growth for the resources sector has decreased over the last four months, at 23.6 per cent, it still compares favourable with previous years.
So which stocks or sectors have the potential to impress? While there will be few places to hide, Harman favours companies with relatively resilient revenues and a high variable cost component. These include: Pure-play REITs (i.e. without stgelopment arms), gaming, general insurance, telcos, selected healthcare (like CSL, and Sonic Healthcare Limited). He also favours retail stocks like JB Hi Fi and Harvey Norman which firmed into Christmas against the backdrop of government consumer stimulus.
But of all the risk factors confronting earnings, it’s negative operating leverage – as deteriorating revenue presses down on fixed costs – that worry Harman the most. He argues that if revenue grows at 5 per cent and costs (boosted by a weaker currency) grow at 6 per cent, and margins are 5 per cent – this would translate to a 14 per cent decline in profit.
At the sector level, deteriorating revenue has universally impacted diversified miners, stgelopers, media, wealth managers and life insurers – plus cyclicals in the steel and building materials, retail and transport space.
According to Harman, specific stocks with a high ratio of fixed-to-variable-costs that may have more of a negative revenue leverage problem include: Perpetual Limited, AMP, AXA, Bluescope Steel Ltd, Boral Ltd, Premier Investments Ltd, Harvey Norman and Pacific Brands Ltd.
“Companies we believe have a better chance of finding some relief from a greater variable costs profile include: Toll Holdings Ltd, Brambles Ltd, Sims Metal, Paperlinx Ltd, Worley Parsons Ltd, Boart Longyear Ltd, and David Jones Ltd,” says Harman.
Other risk factors for earnings downside cited by Citi include: downward pressure on prices as Australia leaves the inflation hump behind, over-reliance on (financial crisis-linked) deal-flow for revenue, working capital pressure, falling asset valuations and currency.
With the possible exception of Amcor Ltd and Toll Holdings, which have held-up relatively well, Harman recommends avoiding exposure to high revenue cyclicality going into this reporting season – even where share-price falls seem to offer good value.
When it comes to working capital pressure and bad debts, Harman recommends investors keep a watchful eye on: Fortescue Metal Group, Sims Metal, Boral Ltd, Pacific Brands Ltd, and Ansell Ltd.
In a typical recession, the dollar amount of Australia’s index dividends falls by about a third. Unsurprisingly, Harman also warns of significant downside risk for dividends in 2009 (of up to 33 per cent) as companies increasingly target payout ratios rather than a dollar amount (of dividends).
But with dividend yields at 6 per cent and cash rates, (in Citi’s view) heading to 3 per cent by Easter, he says equities will still be attractive, even post dividend cut.
On a comfort scale for cash-flow and dividend cover, he’s more comfortable with holding: Toll Holdings, Brambles Ltd, AGL Energy, Origin Energy, Amcor Ltd, Leighton Holdings, Premier Investments Ltd, Woolworths, JB Hi Fi, CSL, Cochlear, and Sonic Healthcare.
Harman says the risk for stock-pickers next month is that the down-draft has yet to catch up with stocks that deliver reasonable results. That’s why he says commentary will be as important as the numbers.
“It’s too early in the cycle for banks and too late in the global bubble for resources,” says Harman. “The key this reporting season is capital preservation, and general insurance is getting some benefit from lower cash rates, without the negative impact of the economic cycle that banks deliver.”
Earnings expectations above consensus
– Downer EDI Ltd
– Foster’s Group Ltd
– OneSteel Ltd
– PaperlinX Ltd
– Primary Health Care Ltd
– Ramsay Health Care Ltd
– STW Communications Group
– Sonic Healthcare Ltd
– Sigma Pharmaceuticals
– Sky City Entertainment Group
– Santos Ltd
– WHK Group Ltd
Source: Citi Smith Barney