Hot and cold profits

PORTFOLIO POINT: The latest reporting season has been one of sharp surprises on the upside and downside.

Each reporting season has its own peculiarities, and no matter how hard we try to prepare and to anticipate what the big themes will be there is always room for surprise. Reporting season in Australia for 2010-11 has not disappointed on this front.

With all but a few companies yet to report, we’ve heard announcements covering about 95% of market cap in Australia and about 85% of listed companies. So let’s look at some of the themes that have emerged over the past few weeks.

We’ll start with some general observations. There have been many more earnings misses than beats. That's an understatement: data from Bloomberg shows that more than half of all companies reporting in August fell short of market expectations.

This is not especially unusual: all reporting seasons in Australia since 2007 have seen more companies miss expectations then beating them, though seldom by such a wide gap.

Since share prices already had been sold down in the leadup – in some cases quite a bit – and since we were already expecting a wave of cuts and downgrades, it actually didn't seem too bad. This perception is further supported by the fact that, in a general sense, most earnings misses were quite benign and analysts have responded with a rather mild set of cuts and downgrades.

Sure, we had a few really negative experiences, such as with Billabong (BBG), Gunns (GNS), Goodman Fielder (GFF), Alesco (ALS) and Transfield Services (TSE). For all of these companies, the reverberations of this month's disappointment will weigh on the share price for many months, perhaps longer.

But there were, against expectations, many positive surprises: many companies had cash in surplus and decided to reinstate or raise dividends, add special distributions or launch share buyback programs.

Perpetual (PPT), Crown (CWN), Foster's (FGL), Amcor (AMC), CSL (CSL), Pacific Brands (PGB), Mount Gibson (MGX) and many others pampered shareholders with unexpected capital management initiatives, propping up returns at a time when the sharemarket was flirting with two-year lows.

Others, such as Rio Tinto (RIO) decided to buy out minority shareholders in Coal and Allied (CNA). BHP Billiton (BHP) disappointed by not announcing anything special, but it did raise its dividend by 22% to a fully franked US55¢ a share, which would indicate that shareholders should perhaps not be feeling too hardly done by.

Buybacks and dividends have been one of the real surprises this reporting season. This, stockbrokers say, bodes well for the Australian sharemarket because these initiatives put firm support under share prices.

As mentioned earlier, in the wake of this month's corporate releases, earnings forecasts by analysts have held up surprisingly well. This not only suggests expectations prior to August had become too negative, but also that earnings growth for the years ahead is not as dire as one might have feared.

So we're back into double-digit earnings growth then?

With economic growth in both the US and Europe looking shaky, China holding its own but still slowing down and with a sudden, sharp deterioration in the June quarter in Australia, it's probably wise to retain some degree of caution. That is why some observers question whether analysts have gone far enough, or whether we will see continued cuts and downgrades in the weeks and months ahead?

One observation stands regardless, that the weaker parts of the Australian economy are operating under circumstances that are akin to a prolonged recession. It would also appear these companies have now finally decided to bite the bullet. I cannot recollect a similar reporting season that saw so many job cuts as this month, with companies including Qantas (QAN), BlueScope (BSL), OneSteel (OST) and Westpac (WBC) each announcing up to more than 1000 job cuts, while analysts at BA-Merrill Lynch counted more than 7000 individual job cuts since early June.

One of the key questions for the Australian economy, and for the sharemarket, is how these thousands of job losses will impact on labour statistics, and thus on the Reserve Bank's policy considerations.

All this meant some overdue decisions have finally been made. Tabcorp (TAH) split its operations, as did Foster's (FGL), and Brambles (BXB) has put Recall up for sale; while Fairfax (FXJ) is going to brush a big broom through its operations and list one-third of the NZ-focused Trade Me website. Ten Network (TEN) is restructuring, too, as is APN News & Media (APN).

All in all, or so it would appear, "recession" is now day-to-day reality for retailers, manufacturers, property markets, media companies and tourism operators. For most companies in other sectors, however, life isn’t so bad.

Mind you, this has been the reporting season in which rising costs and a strong Australian dollar started biting for miners and energy companies, and most have disappointed with their results.

Highlight results

The stand-out observation, for me, was that BHP Billiton (BHP) achieved its record annual profit on a 4% increase in volume. Copper, iron ore and crude oil prices are not going to double in price in the year ahead, so investing in mining and energy companies will be all about meeting production targets and achieving production increases from here onwards.

In case anyone wondered: BHP's percentage EPS growth is now projected to be in the mid-teens for this year and with little left for 2012-13. BHP has a lot of cash in surplus to prop up these numbers; a lot of smaller peers do not.

History suggests companies that raise their dividends are more likely to outperform in the months after reporting season, while those that cut dividends usually underperform, but I remain sceptical whether this also applies to BHP Billiton and other miners. Mining companies generally surprised with their dividends this reporting season, but that won't change their volatile character and close links to global growth and general risk appetite.

Probably the biggest surprise this reporting season has been that when it comes to genuine profit surprises, those that force analysts to lift projections and maybe even raise valuations, targets and recommendations, have in the main been industrials.

At the top of that list have been the so-called “pick and shovel services providers” to the energy and mining sectors, with companies such as Bradken (BKN), RCR Tomlinson (RCR), Mineral Resource (MIN), Forge Group (FGE) and Campbell Brothers (CPB) all producing genuine surprises with upside potential for the years ahead.

This group of companies produced many more positive results, including from Fleetwood (FWD), GR Engineering (GNG), and Boart Longyear (BLY), but the five mentioned above are simply the true standouts as far as positive changes to analysts estimates and targets are concerned.

Surprises also came from Domino's Pizza (DMP), ARB Group (ARP), Envestra (ENV) and Lycopodium (LYL) but investors should be very cautious about these four because valuation limits seem to have already presented themselves.

Stocks that equally surprised, but with still plenty of valuation potential left, include (in no particular order) Sims Group (SGM), Austbrokers (AUB), Iluka (ILU), Macquarie Telecom (MAQ), Amcor (AMC), Challenger Financial (CGF), NIB Holdings (NIF), Super Retail Group (SUL), Santos (STO), Tox Free Solutions (TOX), Wesfarmers (WES), SAI Global (SAI), CFS Retail Trust (CFX), Carsales.com (CRZ), Flexigroup (FXL), Kathmandu (KMD) and Telstra (TLS).

Each reporting season delivers its own key sentiment reversals that have long-lasting consequences. For example, in February this year Ardent Leisure (AAD) rose from the dead, while the tide turned against CSL (CSL) and CSG Group (CSV). Today, share prices for both CSL and CSV are well below their levels earlier this calendar year.

In the same vein, I believe the current reporting season is likely to have brought a key reversal in underlying sentiment towards Telstra (in a positive sense), and negative reversals for Matrix Composites & Engineering (MCE) (click here), QBE Insurance (QBE) and for Woolworths (WOW).

The Woolworths result is further emphasised by the fact its main competitor Wesfarmers (WES) is among the genuine standout performers this month and my growing suspicion that various headwinds are contributing to a broader derating for Woolworths re-establishing it as a $25-something stock for the near term, instead of a $27 stock with upside potential to $30.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.