While the gems such as Rio Tinto and Woolworths shine, the property trusts are bathed in red ink and the ”Bad Boys” such as Allco and ABC Learning are shaping up to deliver the proverbial bloodbath, the most vital characteristic of this reporting season is the deterioration in profit forecasts.
Stock prices swing on profit forecasts so this is not good news. The pain is not across the board however. Resources profits have come in ahead of analyst estimates and there is the odd bright spot among the industrials such as JB Hi-Fi, Coca-Cola Amatil and Bradken.
On the whole though, a little over halfway through the earnings season, the growth numbers are listless and indicate increasingly tough trading conditions in most sectors. Outlook statements are subdued and most are cautiously predicated on the fate of the economy.
The likes of Qantas, Brambles, Suncorp, AXA and Wesfarmers have proved disappointing. But it is worth distinguishing between market expectations and actual results and forecasts. It is often the case that a stock rallies on a hundred million dollar loss or tumbles on a record profit, as Woolies did yesterday after reporting a 26% rise in net profit to $1.62 billion.
It is also worth bearing in mind that last year marked the peak of a long profit cycle and as companies tend to beat market estimates on the upswing in the cycle so profits tend to lag expectations on the way down. The corporate ruse of guiding the analysts to a cluster of estimates around a nice, smooth double-digit rise in earnings growth is done for now.
Now is the season for spilling the bad news, conceding big asset writedowns, mass job cuts and generally hosing down expectations with the language like ”significant challenges lie ahead”.
A few trends should be mentioned. Tax rates have been surprisingly low which suggests “profit-smoothing” and unrealistic profit margins in many stocks.
Macquarie Equities found, on analysing the first 114 companies to report – making up roughly half of the major companies in this earnings season – that large cap industrials produced earnings 4% below forecasts. Banks were 1.4% below and resources 1.7% above pre-season estimates.
Many of the stocks had already handed down earnings confessions in the weeks preceding so much of the bad news had already been factored in. Still, disappointing earnings tend to subdue stock price performance over the ensuing few months.
The broker also found that negative surprises outweighed positive surprises by 15 to 9 and, stripping out resources, whose growth reflected the commodities boom, the ”slip-sliding” of earnings per share (EPS) growth was a ”stand-out feature”.
Only JB Hi-Fi and Bradken sallied forth with upgrades for this financial year without suffering substantial downgrades in financial year 2008.
Bear in mind that as companies have struggled to recapitalise and, in many cases, refinance in the face of high leverage, there have been a few rights issues and a raft of underwritten DRPs (dividend reinvestment plans). These have diluted earnings so when looking at the big picture it is best to forget about the likes of EBITDA and other metrics and look at earnings per share.
It’s a sombre picture. In light of the likelihood of a lot more nasty surprises and the spectre of recession in the US and perhaps Australia, EPS estimates still look on the high-side.
On Macquarie’s numbers, taking out resources numbers for 2009, the prediction is for 2.2% growth in EPS this year, or almost one-third of the 6% forecast before the earnings season kicked off.
Further to trends, June half-year earnings were hit by further pressure on margins. The trend would appear to be down.
The biggest deterioration in any sector was banks whose September-half year estimates for EPS growth started at 3.4% and are now -10.1%. The Australian market is overweight with financial stocks, with the big banks comprising a large chunk of the index, and therefore affecting the performance of almost all super funds.
Every week a new bout of bad news shakes the banks. This week it was Centro.
Having failed to find a cornerstone equity investor, Centro now has to battle on servicing the interests on the $2.3 billion in loans it owes to Australian banks alone, before putting a dent in its other debts.
ABC Learning, which is suspended and scheduled to restate its accounts in the coming days faces a shareholder lawsuit and a large pile of debt – some $600 million rumoured in exposure by CBA including $250 million in bank loans plus around $360 million in convertible notes issued last year for ABC Learning in an underwriting shortfall.
Then there is Babcock & Brown and its spin-offs of which all the major banks are exposed, Allco, MFS, Commander, City Pacific, and the list goes on.
These Bad Boys will prove a drag on the market and on bank profits for years to come. Meanwhile, listed property trusts have been a disaster and will need to be recapitalise en masse, diluting earnings in the process.
Qantas with its aging fleet may need to revisit the equity market at some point now it has a new CEO and a good excuse.
Wesfarmers, which bought Coles with lashings of debt at the peak of the market, will have an uphill battle now keeping a premium in its stock price given the paltry return on equity from its $19 billion acquisition. It seems the enormity of the task may have dawned on the market after the Wesfarmers profit result, given yesterday’s share price shellacking.
Looking at a few of the other bellwethers, Telstra’s EPS growth is tipped to slow from 13% to 3%, Seven from 19% to 4%, Crown from 8% to zero and Lend Lease from 10% to -33%.
Among the financial engineers the leverage will remain at risky levels for some time. The Macquarie satellites Macquarie Airports (MAP), Macquarie Infrastructure (MIG) and Macquarie Communications (MCG) have begun pulling back their asset valuations and in the case of MAP and MCG have disposed of assets into Macquarie wholesale funds.
The potential for blow-ups here cannot be discounted. Meanwhile, their growth for growth’s sake is not an option for now.
This downturn is characterised by a slew of, for want of a better phrase, changing paradigms.
The US consumer is, for the first time in years, failing to prop up the world’s biggest economy. The housing market has yet to hit bottom there and the US dollar is in terminal decline – although marauding hedge funds appear to have whipped it up in recent weeks while jerking around other markets too during the northern summer’s thin trading days.
The oil price is now in an entirely different trading band, as is gold.
China will run its own oil reserves down in six years. The advent of climate change politics is forcing radical economic transformation. The credit crisis is yet to work through the global banking system. The challenges are daunting.
For Australia, in particular, the fate of the economy hinges on Asia. Should Asia and especially China come off the boil so will commodity prices. Should Asia hold up the Australian market is not bad value at the moment.
For the bulls there is the comfort of knowing that the market has come off 20% already. It is far cheaper than it was and interest rates are set to fall. Generally, equities rise when interest rates fall – though this seems no ordinary cycle. Shares had risen when rates had risen for two years until late last year.
For the bears, there is the logic that earnings are shaping up to be flat at best while, recession is on the cards and we are little over half a year into a bear market.
In a serious bear market – and we haven’t had one of these since the early 1990s – investor faith in a recovery increasingly dissipates until the point of capitulation when disillusion sets in and people give up buying for the bounce.