Results season wrap
29 Sep 2016
By Shadforth Financial Group
Given that the first six months of the year saw concerns of a credit crisis, a hard landing in China, uncertain timing of US interest rates increases, a very tight Government election and Brexit, it is hardly surprising that the earnings season was volatile. When combined with stocks trading at lofty valuations and companies delivering mixed results, share price reaction was even more volatile.
As a whole we saw far less positive surprises from the earnings season than usual. Revenue growth in the second half was lower than in the first half, but, pleasingly, negative surprises were in line with previous years. The number of companies reporting in line earning increased, while analysts lowered earnings outlooks in general for FY17. We are expecting five per cent earnings per share growth for the year ahead. Earnings growth will be driven by the resource sector. We expect banks to be flat, while industrials should deliver earnings growth of eight per cent or better but are at risk of lower margins.
A few major themes from this reporting season included:
- the highly rated stocks disappointing to an unsurprising degree given the valuations and expectations built in
- defensive stocks remaining relatively expensive
- price earnings ratio expansion of the small-to-mid-cap sector both relative to their historic levels and relative to the top 20 stocks.
The sectors seeing positive upgrades include miners, materials and REITs as they benefited from ongoing lower rates, higher commodity prices and solid construction demand. Meanwhile healthcare and financials were downgraded due to lower interest rates, market volatility and slower earnings growth.
Resources have turned the corner with commodity prices having bottomed in December 2015. While Chinese demand remains a risk, companies have delivered strong cash flow generation, lower net debt levels and the beginnings of profit growth. The stock price movements have been aggressive as the market gives the miners the benefit of de-risked balance sheets and factors in future positive earnings.
Banks have faced multiple headwinds, including increased bad and doubtful debts, deteriorating assets, increased regulations and capital requirements, decreasing credit ratings (S&P directly or as a result of a rating change to the Australian Government rating) and finally increased funding costs.
Margins will be under pressure as a result, yet the banks have been able to negate the pressure and earnings downgrades were minimal. Furthermore, the banks appear relatively well capitalised and should deliver flat earnings growth. Interestingly, from a historical valuation perspective the banks are trading relatively cheaply both on a price to book and price to earnings perspective. See charts 1 and 2.
Source: IOOF Research
Source: IOOF Research
It should have been a fantastic period for the consumer given low interest rates, the wealth effect of higher housing values and low oil prices, but results were mixed due to the lack of wage growth and the lack of confidence in the Government.
The year ahead
The key call for the year ahead is likely to be around interest rates and the outlook for bond yields. Rates appear to have limited downsides. Where they move going forward will have an impact on equity valuations and, more importantly, the sectors that have benefitted from low rates, the hunt for yield and their defensive characteristics, namely property, utilities and infrastructure.
These sectors remain expensive from a historic, absolute and relative basis, but will be supported to a degree by the low interest rate environment. Property saw earnings expectations up slightly but at a decreasing rate. The infrastructure sector probably remains slightly more defensive in that it should continue to deliver earnings and distribution growth (see chart 3).
Source: IOOF Research
Traditional media had very poor results with earnings downgrade from 7Media despite their Olympics and election coverage. The long term fundamentals of the sector are really at risk as people increasingly use multimedia advertising, internet and digital as their marketing tools. There is growth, however, in the online and outdoor media spaces.
Gaming was relatively positive with defensive earnings and low mid-single digit earnings going forward. The gaming companies (Star in Sydney, Crown (CWN) in Barrangaroo and Las Vegas, Sky in Adelaide) all face capital expenditure as they look to reinvent, rejuvenate and attract players.
The consumer staple sector is split between the food suppliers to Australia and staple products to China. Woolworths (WOW), Metcash (MTS) and Wesfarmers (WES) face trends similar to those we’ve seen over the past years like food price deflation and international competition hurting margins, though pleasingly we have seen rational competition from WOW and WES. The Chinese suppliers like Treasury Wine, Bellamy and Blackmores are highly rated from a valuation perspective and were unsurprisingly not able to match expectations.
Healthcare delivered a volatile set of results for a traditionally defensive space. This was a result of both high valuations and expectations. Ansell was up 20 per cent, Sonic Healthcare up seven per cent, Ramsay Healthcare up six per cent and CSL down 10 per cent. Investors continue to think about healthcare from a yield and growth perspective with earnings a secondary factor.
Aged care should have positive tailwinds as a sector but it is a sector to avoid as we see limited growth for the next few years as the Government changes the way they reimburse companies and questions are raised about the charge outs by aged care facilities.
As companies struggle to generate revenue growth, valuations remain lofty in the defensives and small-to-mid-cap stocks, earnings and global growth remain low, stock selection will be paramount for the period ahead.