Jamie Nicol

A difficult six months in a number of sectors has led to mixed reporting of Australian listed companies, says Jamie Nicol, CIO, Dalton Nicol Reid.

“Our research shows that 36% of Australian listed companies beat market expectations and 23% of the companies missed market expectation in the current reporting season,” he said.

“It’s important to note that there is a small downgrade of around 0.8% forecast for 2015,” he said.  “Already around 28% of companies have been upgraded for 2015, and 27% downgraded.

Mr Nicol said that it has been difficult to forecast in the current economic climate.

“Offshore markets were impacted by the volatility of the weather, and domestic companies were hit by the federal budget which caused a drop in consumer confidence.”

“While analysts are reluctant to project the difficult trends to continue, they are also reluctant to forecast a large bounce,” he said.  “In a number of our holdings we see analyst’s forecasts as being quite conservative and have been adding to these positions.”

“The underlying backdrop of low yields does make companies returning capital to shareholders seem appealing in the near term, however we are concerned that this strategy is somewhat short sighted.

“We are already seeing a trend where companies with buy-backs (even if small) and special dividends were rewarded – such as Suncorp, Telstra.

“High quality businesses should be able to reinvest capital to generate even greater future returns for shareholder,” he said. “We see the trend of returning capital as somewhat counterintuitive given the current low cost of debt and equity.”

“We are concerned that while the market continues to reward near term yield over longer term growth, most company Boards will be reluctant to invest in future opportunities preferring the short term impact of returning capital.

“So we are actively seeking quality companies where Boards are prepared to reinvest in the business to generate future returns rather than taking the short term ‘sugar hit’ of returning capital – such as Aurizon & Origin Energy. “

“With top line revenue growth remaining scarce, companies with strong business models that demonstrated sustainable growth are being justifiably rewarded (eg Veda Advantage, Iress & Domino’s Pizza).

“A generally sluggish economic backdrop means companies that can generate maintainable growth are likely to continue to be rewarded by the market and we continue to investigate opportunities in this area.

Mr Nicol was optimistic about the continued expansion of domestic housing activity which has continued to expand. “Housing is now settling at a much healthier level of activity following several years of anaemic growth post GFC,” he said. “We have a solid exposure to this area and expect underlying demographics and historical underbuilding to drive returns for quality companies exposed to this sector.”

But Mr Nicol said that mining activity continued to slide with the capex peak on existing projects having passed, and new projects still struggling to get approval.

“The focus has turned to non-residential construction activity to fill the void, but despite much talk at both federal and state government levels, the long lead times and political nature of these projects means real activity is still some way off,” he said. ‘We remain optimistic that the activity levels will eventually pick up in the area and see opportunities for companies such as Lend Lease to participate.”

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Paul Taylor, Portfolio Manager, Fidelity Australian Equities Fund shares his insights from reporting season.

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FY2013 results flat as expected.

Brad Potter, Portfolio Manager and Senior Analyst, Tyndall AM provides his key take-outs from the August company reporting season.

Weak consumer demand, a slowdown in China and a high Australian dollar are just a few issues challenging Australian businesses. To maintain or improve their profit margins companies have needed to cut costs, reduce capital expenditure and improving efficiencies. Is it working?

Benign reporting season – no great surprises

Overall, the company reporting season was benign with earnings coming in close to market expectations.  Around 56% of companies beat expectations. Earnings overall in FY2013 were flat, but up 7% when excluding resource companies, which have fallen substantially because of the decline in commodity prices over the year.

FY2014 earnings forecasts have been lowered as expected in the current environment. Prior to reporting season the expectation was 8% to 10% earnings per share (EPS) growth in FY2014. Those expectations have now been reduced by about 1% or 2% (this is likely to be revised as analysts fine tune their numbers).

Many of the rallies during reporting season were based on ‘no further bad news’ or that the news wasn’t as bad as priced in going into the result – rather than good results. Stocks such as Qantas, Arrium, Origin Energy and UGL were typical of these stocks which had acceptable to probably slightly down results, but were not as bad as what the market was expecting.

Top line growth continues to be weak

The key takeaways from reporting season were very similar to last reporting season. Top line revenue growth continues to be poor. This was expected. Companies suggested things were not getting any worse, which is a positive.

When there is no top line growth companies cut costs. Cost outs were again a major thematic this reporting season across the market. Companies as diverse as BHP, Rio Tinto, AMP, Boral, Coca-Cola Amatil, Fairfax, Toll, Downer and all the banks have cost out and efficiency drives in place in a bid to keep margins flat or improving.

In the case of resources companies, such as Rio and BHP, their large cost-out programs are only just beginning. They’ve slashed their exploration programs, which has saved them between $500 million to $1 billion per annum.  Miners have seen substantial cost inflation over the last decade during this mining boom and they need to pare that back substantially because commodity prices have arguably peaked. They need to cut costs as there are a number of mines in a range of commodities that are now looking unprofitable. This is likely to be an ongoing theme, which provides a poor backdrop for the mining services industry.

Dividends still the flavour of the month

Dividends surprised on the upside again, like they did last reporting season. Payout ratios continued to rise, which reflects a combination of investor appetite for yield in a low interest rate environment, strong company balance sheets, a lack of investment opportunities and/or risk appetite to invest their money. In this environment, the easiest thing for companies to do is pay back excess capital as dividends, especially when they’re being rewarded for it. Therefore dividends again outstripped EPS growth quite substantially this reporting period.

Company outlook statements were guarded

Company outlook statements were quite guarded or non-existent. That’s understandable given the problematic economic environment, exacerbated by the uncertainty of the September Federal election.

Post the Federal election consumer and business confidence, currently at very low levels, should rebound. Companies are not investing at the moment because of this low confidence.  This was clearly illustrated by the low levels of capital expenditure (outside of mining projects that are already in construction) that we saw during the reporting season.

Profit downgrades were quite modest and many CEOs suggested that business conditions haven’t deteriorated further. This reflected a combination of interest rate cuts finally starting to have an impact and the recent decline in the Australian dollar.  Although, that hasn’t had a full impact yet given that the Australian dollar only tumbled in May.

All the banks stated that provisioning levels, while very low, they couldn’t see any issues currently.  That was quite positive, given that investors worry about that on an ongoing basis.

Housing was a strong theme during reporting season. Lend Lease commented that their residential property sales in July were two times higher than March levels and they also had increasing apartment commitments.  Stockland made similar comments about residential land sales, with the run rate in the second half of the financial year the best since 2010. The positive signs have continued with long queues for residential land sales on weekends. The first release of the Barangaroo apartments in Sydney was sold out in three hours and they were all $1 million plus apartments.

James Hardie commented that they’re seeing rising building activity in Australia and New Zealand, which was interesting given we saw more comments from other building materials companies. The company was very positive on the US environment with profit margins over the 20% level, and they’re suggesting that housing is continuing to pick up in the US.

Iluka also made the point that they sold more zircon in the first half of 2013 than they did in the entire 2012, so they are starting to see green shoots in the zircon market. I expect, given the recent positive news out of Europe (one of the biggest consumers of zircon), that may continue. They also commented that the titanium dioxide market, which tends to be primarily used in painting, is turning.

Seven West Media suggested that advertising spending appears to have stabilised. This is a grey area at the moment due to the election period because there is extra advertising spending by the political parties.  A lot of companies peel back their spending during the election period and start after the election. They are now suggesting they’re seeing good interest for commitments post the election, so that’s quite positive.

Companies that provided negative comments included Toll, which suggested activity levels had yet to show any signs of improvement. Fletcher Building also pointed out ongoing weakness in Australia, but commented that New Zealand was going full steam ahead.  At Wesfarmers, Target was quite disappointing, with no signs of improvement, which the market disliked. Echo commented that the weak consumer environment was driving soft conditions on the main gaming floor. Tabcorp made similar comments about the weak consumer environment.

Boral disclosed that activity in Australia remains broadly flat in FY2014, so similar to Toll.  BlueScope had a solid result but their outlook statement suggested that the first half of this year would be flat on the last half, but over the year would be up, thus indicating the second half would be strong. The market was initially disappointed with that, and the stock was punished severely on the day and subsequent days. It has however subsequently recovered. This was a classic example of where market expectations for the stock were very high and when the company didn’t meet those expectations, the stock was sold off heavily.

Mining boom is over

The reporting season didn’t provide any further clarity on the mining boom. My views pre the reporting season haven’t changed. The mining boom is effectively over in the sense that we’re close to the peak of capex.  Commodity prices have also peaked so if that’s the definition of a mining boom then it is finished.  I don’t expect commodity prices to fall in a hole though. I expect them to remain at reasonably elevated levels for the next few years at least, given demand from China is still reasonably strong and so I expect mining companies to do quite well in certain commodities. Rio & BHP for example are making great margins in iron ore.  On the flip side of that, coal companies are really struggling because coal prices have fallen substantially. A number of coal mines have shut down because margins are just not good enough, and there are a number of them really struggling given the low margins.

Gold is another commodity whereby a number of mines have become marginal, even at current prices, just because cost inflation has been so great. Reserve decreases are the likely next shoe to fall.

Highlights for the Tyndall share portfolios?

In our flagship fund, the Tyndall Australian Share Wholesale Portfolio, Twenty-First Century Fox, our largest overweight, was a highlight. They had an in line but quite messy result given the recent split from their publishing assets. Two days later however they had a strategy day where, for the first time, they laid out quite detailed information on their strategy and all their new revenue streams. The market upgraded substantially on that view.  The market, particularly in the USA, has been reluctant to price in these new earnings streams.  The share buyback continues at a meaningful pace and there’s an expectation that once this buyback finishes they’ll start another one.  The stock was up about 5% over the month.

Downer, which is our only exposure to mining services (albeit it’s not entirely mining services as it represents only about 30% of the business), had a solid result, slightly ahead of guidance, which is very credible given the negative sentiment in the sector due to the peaking in mining capex. The company’s mining segment was down but that was offset by other divisions.  It’s been hurt over the last six months because of the ongoing downgrades from other mining services companies, despite the fact that Downer has continually maintained their guidance, which they delivered.  The dividend was ahead of expectations and their cash flow was very strong.  The cost-out program has doubled to $500 million given that they achieved $250 million two years ahead of forecast.  The stock rallied substantially to be up nearly 15% during the month.

Qantas had a strange result in the sense that it was one of those stocks that rallied on the fact the news wasn’t as bad as what the market was factoring in.  Transformational initiatives delivered $428 million to EBIT during the year. They started up the small buyback, it’s continuing and the stock rallied 11% over the month.

Sims Metal’s result was also close to what the market was expecting. All divisions had good results, other than the European division which has been problematic over the last year or so due to governance issues. Operating cash flow was strong. No guidance was given, but Sims is leveraged to the US economy and in particular the housing market and scrapping of automobiles as people trade up cars and white goods as the economy improves. So the stock actually responded very favourably; again I think it was a relief rally with the expectations that it was going to be ugly. The stock was up about 11% for the month as well.

Portfolio positioning

Banks have run hard over the past 12 months or so. We’re underweight banks because we believe they’re expensive despite the attraction for yield.  We have selective exposures in domestic cyclicals, tilted towards housing and residential as we think that’s a reasonable area given the interest rate cuts and hopefully we’re seeing some green shoots at the moment so that’s quite positive.  We also have reasonable exposure to the USA, both from a growing US economy perspective and also a falling Australian dollar.

Conclusion

It was a by and large a non-eventful reporting season, due mainly to many companies confessing or reducing earnings guidance prior. Companies are adapting to the structural changes occurring in the Australian economy as evidenced by the various cost cutting and efficiency programs in place. These initiatives are having a positive impact on company bottom lines, but we now need to see a recovery in top line growth. Lower cash rates, a weaker Australian dollar and resolution of the Federal election, together with signs of stabilisation in the Chinese economy should assist this.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Wholesale Portfolio ARSN 090 089 562 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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Look deeper into results: Hyperion.

Too often investors take reporting season figures at their face value instead of looking deeper to see the real story, says Australian equities fund manager, Hyperion Asset Manager.

As a consequence, they may be making decisions that lead to missed opportunities – whether selling unnecessarily, or missing the chance to buy low in the cycle.

According to Hyperion’s Chief Investment Officer, Mark Arnold, with reporting season just completed the lesson for investors is to be wary of using short term, discrete earnings results as the only – or even the key – indicator of a quality company.

Mr Arnold explained that for Hyperion, when assessing whether or how a results announcement should affect investment decisions, the key question is to not to look at the numbers per se, but at how ‘value relevant’ the information is. That means, to ascertain whether the announcement alters the forecast timing and magnitude of a company’s free cash flow over the long term and/or the general level of uncertainty or risk arising from those cash flow forecasts.

“If reported profit and other related information does not change these factors, then there is no reason for the profit result to have any impact on the valuation of the company or its share price,” he explained. “And it’s important not to forget that looking at results over a number of years can really add value in terms of extra information.”

Mr Arnold went on to explain that market movements outside of reporting season can be relatively more pronounced and can reflect non-fundamental factors such as momentum and speculative activity. Hyperion, as a long-term investor, often discounts these movements if it considers them to be unrelated to the intrinsic value of a stock.

“Sometimes the market can become too focused on short-term or cyclical factors,” he explained. “Look at the massive sell off of Seek Ltd shares during 2008 and 2009 due to concerns about rising unemployment as just one example.

“Having said that, if, during reporting season, the market does drive the share price away from the long-term intrinsic value of a company by ‘over-weighting’ the value relevance of short-term trends, there can be good buying opportunities,” he said.

Mr Arnold finished by saying that reporting season does provide valuable information, particularly in terms of sales and earnings growth and a company’s ability to deliver earnings growth though short-term or cyclical headwinds.

“Nonetheless, at Hyperion, we look for companies with strong and sustainable value propositions, derived from unique and difficult to copy aspects of their products or services. When such a value proposition is present, a company has pricing power, and this gives management the ability to protect long term profit margins and organically grow revenues.

“And that’s the hallmark of a quality company,” he said.

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Recently the Australian bourse has been weighed down by international issues such as a potential China slowdown, European and US debt issues along with local concerns like the high Australian dollar and consumer reluctance to spend.

“Depressed share prices have attracted many investors to companies which are looking like good value now on their price to earnings ratios and dividend yields, but whether their earnings are sustainable will determine their value as an investment. Around 160 of the top 200 companies reporting over the five weeks will provide some valuable insight into this earnings sustainability,” said Mr McCarthy.

For investors, it is also important to be on the alert for companies and industries displaying earnings growth, as this will be a major factor in share price growth.

The last 12 months has seen analysts downgrade earnings forecasts across the board as optimism about a global recovery has faded to concern over mixed economic signals.

“The good news is for the most part any surprises have already been captured in these downgrades so the surprises are likely to be better than expected earnings, albeit with a few exceptions,” Mr McCarthy said.

Indications are also that improved cash flows and reduced debt will mean the potential for capital returns.

“Given a generally cautious investment environment and weak market sentiment, investors will pay particular attention to company views on the outlook for business over the coming year,” Mr McCarthy said.

Sector focus

Consumer Discretionary – focus on outlook statements and strategies to cope with lower sales

Consumer discretionary stocks, particularly retailers, are under pressure from recent downgrades, driven by fears about the activity of consumers in the eastern states and falls in reported retail sales. Recent guidance from David Jones and Myer is pointing to falls in profit of between 0.5 and 5%. JB Hi-fi’s result will attract attention in light of the buyback of 9.9% of its capital earlier in the year. Media stocks are also expected to show modest earnings per share falls.

Investors and analysts are likely to focus on outlook statements and any strategy changes to deal with the current lower level of sales. Of particular interest will be any initiatives to deal with competition from online retailers, especially in light of the recent strength of the Australian dollar.

Sector leader reporting dates: 23/8 Flight Centre, 31/8 Harvey Norman, 16/9 Myer

Consumer Staples – will shed light on consumer activity

Consumer Staples is an important sector as it will shed light on consumer activity. Analysts will carefully examine comparable sales in grocery giants Woolworths and Wesfarmers (Coles). Woolworth’s recent Q4 sales results point to comparable growth around 4%, headline around 6% and profit growth around 6.5%.

Sector leader reporting dates: Coca-Cola 9/8, Wesfarmers 18/8, Woolworths 25/8

Financials – divergence across sector

There are several key aspects to the reports from the financial services sector. Credit growth is in doubt, given conservative consumers and a well-capitalised and cash rich corporate sector. CBA is the only big four bank to report, expected to show a profit increase of 8 to 8.5%. Bank of Queensland is likely to report a 10% drop in earnings due to problems with its commercial property exposures.

Diversified Suncorp could be a strong performer on the back of an improved insurance pricing environment, although its banking business is the likely swing factor. Property groups could diverge, with Westfield’s improved US earnings offset by a strong Australian dollar, and Goodman Group likely to report a large lift from improved development profits.

Sector leader reporting dates: CBA 10/8, Westfield 18/8, Suncorp 24/8, Bank of Queensland 13/10

Materials – heavy bearing on the overall share market

Resource stocks will remain a focus, whether mining or energy related. This group represents around one third of the value of the overall share market and will have a heavy bearing on its performance over the next six months.

Metal and oil prices are at elevated levels, ensuring good revenue flows in US dollar terms. Exchanging this income to Australian dollars is likely to offset this benefit, and will be a focus for investors and analysts. Another area of concern will be cost containment. Project delays due to weather disruption are largely factored in to current share prices, but the effects of wages pressure is less clear.

Sector leader reporting dates: Rio Tinto 4/8, Alumina 11/8, Newcrest 15/8, BHP Billiton 25/8.

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