Setbacks ahead, despite market's resurrection

Packaging company Amcor hit a record high on the ASX on Monday when it joined the queue of 50 or so companies to issue profit statements that inspired investors to keep driving the sharemarket higher.

Of the 20 per cent of listed companies that have posted their half-yearly profit results, most have performed in line or above market expectations. It is still early days but the emerging trend is an upgrade of earnings per share (EPS) for the first time in three years.

With the ASX already almost 10 per cent higher this year, this profit season had a lot riding on it. Goldman Sachs described it in a pre-reporting season note as a "reality check as to whether recent market optimism is suitably placed" and the extent to which prices have run ahead of fundamentals.

After several post-global financial crisis rallies in the past couple of years, which couldn't be sustained, investors have become wary of equities, particularly after a string of shock profit downgrades last year, coupled with falling commodity prices and ballooning costs.

But, this time around, companies including JB Hi-Fi, Leighton Holdings, Commonwealth Bank and Downer EDI have issued results that have surprised on the upside, with only a handful of smaller companies disappointing.

In Amcor's case, it managed to lift profit 5.7 per cent higher to $322 million, after taking into account the high Australian dollar, which wiped $20 million off profit when currency translation was taken into account. On a constant currency basis, profit was up 12.2 per cent.

The chief executive of Amcor, Ken MacKenzie, his executive team and the board should be applauded for returning the packaging giant to its former blue-chip stock glory. It is now perceived as a stock that reliably offers improved earnings, solid returns and focuses on shareholders.

Sometimes that involves making tough decisions. On Monday, the company announced it would shut down a 55-year-old mill at the end of the year, with more than 250 staff losing their jobs. As MacKenzie said: "We are playing a globally competitive game and we need to be low cost and competitive."

The mill became a victim of rising costs and the strong Australian dollar, which conspired to make the business unviable.

This is the new reality for most companies on the global stage, particularly as they battle a strong Australian dollar and high costs.

In the past few months, a series of other companies have signalled cost cutting as a way to improve profits. Rio Tinto, Boral, QBE, BlueScope Steel, Fortescue Metals and numerous others have joined the chorus of cost cutters. BHP Billiton will report its results on Thursday and the talk is that it will outline a cost cutting program.

After MacKenzie took the top job in July 2005, he sold $1.5 billion of non-core assets, cut costs, slashed debt and rebuilt the company's image after the news that it was involved in a price-fixing cartel with Visy. During that period, he made the company, transforming acquisitions of Alcan Packaging for $2.3 billion and Ball Plastics for $US280 million ($272 million).

Those acquisitions are almost integrated, allowing the company to focus on building strong cash flows to make acquisitions or return excess cash to shareholders through increased dividends or share buybacks.

Amcor is aiming to generate free cash flow of $400 million a year by next year, which - if it decided to spend on acquisitions over the next five years that delivered its targeted 20 per cent return on investment - would add $1.60 to its discounted cash flow valuation, based on Macquarie's numbers.

While Amcor's metamorphosis is all but complete, BlueScope Steel is undergoing a similar transformation after being forced to mothball its export business, slash staff and focus its energies on value-added services.

Investors rallied behind the stock, lifting it 16 per cent, after it posted a better than expected underlying profit of $10 million and continued to reduce debt. The company still has some way to go but, after losing billions of dollars in the past few years and racking up debts of more than $1.6 billion, it has managed to lift its shares from 42¢ in late 2011 to close on Monday at $4.35.

This year's profit season is a far cry from a year ago, when companies came out in droves to issue profit downgrades, to the point where analysts - and investors - were left with their pants down.

This time around, the companies that have so far reported - representing 25 per cent by market cap and 20 per cent of companies to report - have either met consensus or outperformed slightly.

Despite the upgrade to this year's EPS, investment houses are still projecting EPS to be down for the year but up for industrial stocks. Next year, EPS is forecast to grow about 12 per cent.

An analysis of profit results by Macquarie Equities highlights that profit margins are expanding, particularly in industrials stocks.

"While the December half industrial EBITDA [earnings before interest, tax, depreciation and amortisation] margin of 14.4 per cent exceeds Macquarie Equities' pre-reporting season forecast by 2 basis points, there is still plenty of scope for 'productivity improvements' to drive margins higher, given they remain well below pre-GFC levels," it said.

In the past quarter, the ASX 200 index has risen more than 13 per cent, in lockstep with global sharemarkets. In the US, Wall Street has gone gangbusters, up more than 6 per cent since the start of the year, while Britain's FTSE is up more than 7 per cent and Japan's Nikkei is up 8.4 per cent.

The drive to equities is part of a global "rotation" from bonds to equities. Price-to-earnings ratios have jumped from 10.6 a year ago to more than 13.7 and volumes through the market have almost doubled.

The Australian market might be going up but it is impossible to keep rising at the current rate. As Craig James of CommSec points out, that would mean the market rising 67 per cent over the course of the year.

"It is highly unlikely that gains of this magnitude will be realised," he says. "From here, the market will undoubtedly have some setbacks or face a period of consolidation. But, for now, it is the absence of bad news and shift of funds from cash to other asset classes like shares and property that is holding sway. Sharemarkets have bounced higher across the globe as bad news has evaporated and volatility has fallen." Indeed.