August 2023: Winners & Losers

Below is Part Two in a three series follow-up on the recent August results season in Australia. Part One was re-published by The Australian newspaper on the weekend of 9-10 September.

The proverbial cavalry storming over the hill this August reporting season in Australia were the discretionary retailers led by Harvey Norman (HVN), JB Hi-Fi (JBH), Premier Investments (PMV), Super Retail (SUL), The Reject Shop (TRS) and a number of others.

It wasn't so much an expression of undiluted strength, more a result of analysts downgrading forecasts too deeply while consumer spending did weaken, but remained resilient overall.

This, however, hasn't changed analysts cautious stance, and the jury remains out whether resilience remains the key word for the six months ahead, or whether this process of slowing spending on the back of RBA tightening remains poised for the next leg lower.

Those who keep a close eye on the finer details point out there have been plenty of signals and indications of weakening market conditions in the early weeks of the new financial year, and not only for consumer spending locally.

Witness also the implicit profit warning issued on Monday morning by scrap collector Sims (SGM), good for a punishment in excess of -10% on the day.

Viewed from a different angle, the not-as-bad-as-feared August results season was effectively 'saved' by small-cap companies.

Small Caps Commanding The Limelight

Out of the 390 corporate results covered in total, the FNArena Monitor put down 112 (28.7%) as a 'beat' versus 109 (27.9%) as a 'miss', with the remaining 169 (43.3%) in line with analysts expectations.

But if we limit ourselves to smaller samples, the numbers turn markedly worse.

For the 44 companies inside the ASX50, total beats number 14; higher than the 12 results in line, but below the 18 results we labeled as a 'miss'. For the ASX200, 160 companies reported and here too, total 'misses' (55) outnumbered total 'beats' (49).

Smaller companies proved better performers in the face of multiple economic challenges. This is not so much an indictment on Australia's blue chips as it is more evidence of a multilayered, bifurcated world in which one sector is finally recovering from covid doldrums while another is feeling the squeeze from higher interest rates and changing spending patterns.

It just so happens that some of the segments facing more tailwinds than headwinds in Australia are populated by smaller sized companies.

One such sector are the contractors and engineering companies servicing mining projects and the energy transition. The largest two representatives on the ASX are Seven Group Holdings (SVW) and Worley (WOR) with market caps of respectively $10.3bn and $8.9bn, but the numbers shrink pretty quickly thereafter (Seven Group is not a pure-play either).

Pure-plays Monadelphous (MND) and NRW Holdings (NWH) only have market caps of $1.3bn and $1.1bn respectively and they are seen by many as leaders in a sector that comprises of a few dozen smaller peers. Downer EDI (DOW) is larger, but diversified, and reducing its specific exposure to this segment that can be extremely cyclical over time. Mineral Resources (MIN) provides services for third party miners as well.

The August season just ended has provided analysts and investors with plenty of clues and indications of better times ahead for this sector, at least in FY24 and potentially FY25 too. A post-August sector update by UBS highlights the strong positive EPS growth profile that seems on offer compared with the overall dismal looking -6.6% for the ASX200 in general.

The sector generally is still battling higher costs and difficulties with finding skilled personnel, but an uptick in capex by miners and energy companies should outweigh the risks and negatives, so the narrative goes. UBS's top picks for the year ahead are Worley, Seven Group, and Imdex (IMD).

Plenty of others received positive responses and commentary in August, including Austin Engineering (ANG), Chrysos Corp (C79), Emeco Holdings (EHL), Macmahon Holdings (MAH), Monadelphous, and Mitchell Services (MSV).

Another market segment that stood out prominently in August was the automotive sector, with companies like Infomedia (IFM), GUD Holdings (GUD), PWR Holdings (PWH), and Supply Network (SNL) all commanding the spotlight in a positive fashion. Super Retail is equally part of this industry.

Analysts were most surprised by ongoing favourable conditions for vehicle dealerships, which includes Autosports Group (ASG), Eagers Automotive (APE), Motorcycle Holdings (MTO), and Peter Warren Automotive (PWR), as well as novated leasing and vehicle financing through Fleetpartners (FPR), McMillan Shakespeare (MMS), SG Fleet (SGF) and Smartgroup Corp (SIQ) as electric vehicles increasingly become a positive feature for the industry.

Small cap analysts at Goldman Sachs also highlighted the better-than-forecast performances, on balance, from smaller cap companies, with the added observation the likes of Dicker Data (DDR), IDP Education (IEL), Inghams Group (ING), IPH Ltd (IPH), Maas Group (MGH), and ReadyTech Holdings (RDY) were given a lot of opportunity to 'beat' because forecasts had been significantly downgraded in advance.

Redirecting the focus to the FY24 outlook, Goldman Sachs' top picks are now Macquarie Technology Group (MAQ) -lauded for its strong growth outlook for the next five years- alongside Lifestyle Communities (LIC), an all time favourite at the broker, ReadyTech Holdings, which genuinely surprised last month, IDP Education, Life360 (360), and TechnologyOne (TNE).

The latter company did not report in August but the analysts at Goldman Sachs argue TechOne is currently enjoying its strongest earnings growth outlook in multiple years.

Small cap specialists at UBS have their own preferences, of course, and their Key Picks post August are Autosports Group, Breville Group (BRG), Corporate Travel Management (CTD), IDP Education, Imdex, Kelsian Group (KLS), NextDC (NXT), Ridley Corp (RIC), and Webjet (WEB).

UBS is specifically cautious on Eagers Automotive and G8 Education (GEM).

Zooming in on local REITs, Macquarie's small cap favourites are Qualitas (QAL), Centuria Industrial REIT (CIP), and Arena REIT (ARF) alongside large cap favourites Goodman Group (GMG), Mirvac Group (MGR) and Dexus (DXS).

Insurers Enjoying Positive Momentum

One sector outside of the small caps segment that showed its positive features in August was insurance, even though industry laggard Insurance Australia Group (IAG) still managed to disappoint following notable price increases communicated in June. Its share price has been further hit by news ASIC is taking the insurer to court for misleading its customers.

Expectations are QBE Insurance (QBE) is now shaking off its long history of operational disappointments while Suncorp Group (SUN) is everyone's favourite on a solid, growing dividend in combination with a cheap looking valuation, awaiting further progress on the intended sale of the banking business to ANZ Bank (ANZ).

Insurers as a group have been one of the stand outs in August in terms of positive revisions for earnings per share (EPS) estimates. Sector analysts don't expect any interruptions to the positive momentum any time soon. The sector also includes Medibank Private (MPL) and nib Holdings (NHF) for which views generally are more neutral.

Equally, the operational momentum for ASX-listed insurance brokers remains strong into FY24. The best performer both in and post August is AUB Group (AUB), but analysts remain equally positive about Steadfast Group (SDF) and PSC Insurance (PSI).

Market dynamics might not be quite as favourable for the likes of Tower (TWR) and NobleOak Life (NOL).

In a post-August update, sector analysts at Morgan Stanley suggested the return of an El Nino period could see the insurers temporarily over-earning on drier-than-usual weather, with share prices re-rating in response.

Quality On Top

Investors are trained to look out for cheaply priced bargains, which presents its own set of challenges as stocks often prove cheap for good reason. Less attention tends to be given to Superior Quality that shows itself in multiple ways, including in August.

The first example that comes to mind is the notable difference in operational strength, and the lack thereof, between REA Group (REA) and the smaller Domain Holdings Australia (DHG). There's no second-guessing as to who's the superior player in the industry; the share price divergence tells the story.

A second example would be the direct comparison between Coles Group (COL) and supermarket competitor Woolworths Group (WOW). Sector analysts have long been pointing out the latter has built an advantage through investing in technology that will require Coles years to catch up.

That difference showed itself through the lack of protection against an increase in customer theft, whereas Woolworths proved a lot less vulnerable, though its supermarkets are operating in the same market, under similar conditions.

Normally I would also include CSL (CSL), and even ResMed (RMD), but the healthcare sector in 2023 is very much revealing to investors it is not immune to post-covid pressures and headwinds. Staff costs, wage inflation, a slower recovery in patient visits, balance sheet gearing and rising interest costs; these factors all featured in February and August, and they continue to impact for the year(s) ahead.

Sector analysts at Jarden have labelled it "the great margin reset". It might yet take a while before the investment community gets its head around what the future exactly looks like for a sector that has been loved by many over the past two decades. Jarden's sector favourite remains CSL, "one of the higher quality stocks with multi-year improvements in top line, margin and cashflow".

The analysts would also recommend ResMed, but for the GLP-1 uncertainties. "[...] it remains impossible to quantify the GLP-1 effect, other than it appears overdone. Sleep apnea will not be cured but the role to be played by GLP-1 drugs when considering side effects and cost is difficult to quantify so early into their launch."

Ord Minnett's contribution: "[...] we think the global market is untapped and big enough for CPAP to remain a meaningful solution in addressing sleep apnoea".

Jarden's favourite small cap healthcare stock is Aroa Biosurgery (ARX).

On my observation, August did highlight the lower quality companies in healthcare on the ASX, with yet more disappointment from Healius (HLS) and with Ramsay Health Care (RHC) essentially proving why its share price has been unable to post any sustainable gains post 2016.

Many have been highlighting the private hospitals operator as a post-covid "must have", and many an investor has bought into the "still Quality" narrative, but I have long ago come to the conclusion the Quality tag no longer applies, as is the case with the likes of Iress (IRE), Lendlease (LLC), Orica (ORI), and AMP (AMP).

It's probably fair to conclude these Quality tags remain in use long after they no longer apply, and in each example hoodwinked shareholders end up paying the price.

Other companies that showed their Quality characteristics in August include Wesfarmers (WES), Carsales (CAR), CommBank (CBA), Cochlear (COH) and Goodman Group among large caps, and Audinate Group (AD8), Altium (ALU), Breville Group, Dicker Data, Hub24 (HUB), IDP Education, Netwealth Group (NWL), and Pro Medicus (PME) among the smaller caps.

Within this context, I note the cheapest among the large-cap banks, Westpac (WBC), was seen as releasing yet again the weakest of the large-cap trading updates in the sector, while Bank of Queensland (BOQ) is considered too risky to comfortably recommend by most sector analysts (even though the shares are looking "cheap").

It remains one of my long-standing observations that Quality businesses tend to outperform their cheaper priced alternatives in the long run, a feature that usually applies even more when market conditions worsen.

Consumer Stocks Not Out Of The Woods

Retailers and other consumer-oriented companies experienced the return of investor interest in June, having sold off a number of times previously on general angst of what exactly the impact from RBA tightening and cost inflation could well be.

At first sight, that pre-August rally proved prescient with most companies at least meeting forecasts, leading to share prices re-rating. But most analysts have remained undeterred and are unwilling to now assume the only way forward includes a general upturn for this sector in broad terms.

Instead, most economists and analysts are suggesting the next six months or so will likely prove the most challenging for companies dependent on household spending in Australia.

Combining the two contrasting factors, sector analysts post-August are trying to identify which ASX-listed companies can be given the benefit of the doubt. It goes without saying, there's no general consensus, except maybe for which companies not to own just yet.

On Jarden's approach, which spans the whole gamut of being exposed to consumer spending, the most attractive-looking companies are Woolworths, Flight Centre (FLT), Corporate Travel Management, The Reject Shop, and Accent Group (AX1).

Currently the least attractive, according to Jarden, are Lynch Group (LGL), Coles, Adairs (ADH), Costa Group (CGC), and JB Hi-Fi.

Among defensive plays, Jarden's preference is biased towards Woolworths and Metcash (MTS) over Endeavour Group (EDV) and Coles.

In contrast, analysts at Morgan Stanley cannot get exited about local companies -at all!- and prefer to be overweighted offshore earners. This broker's most preferred exposures are (again on a broad consumer spending theme) Aristocrat Leisure (ALL), Treasury Wine Estates (TWE) and IDP Education.

Morgan Stanley's fear is the emergence of a FY24 downgrade cycle for the sector. Among retailers, those carrying an Overweight rating from the broker include Lovisa Holdings (LOV) and Breville Group -offshore earners- as well as Premier Investments (offering "strategic value").

Analysts at UBS are more focused on threats such as the rising cost of doing business (CODB) generally and inflation in wages specifically. They are equally cautious about the outlook for discretionary spending. UBS's preference lays with Lovisa Holdings, Metcash, Treasury Wine Estates, and Wesfarmers.

Companies to not own, according to UBS, include Accent Group, Domino's Pizza Enterprises (DMP), Harvey Norman, Premier Investments, and Super Retail.

Are Tech Companies Hiding The Truth?

One trend in August that stood out for Macquarie's TMT (Telecom, Media & Technology) sector watchers is the shift towards increased capex spending that previously might have been categorised as opex.

Not that any of this has a direct influence on a company's valuation, but Macquarie suspects technology companies are trying to "protect" their EBITDA numbers, effectively giving investors an impression of better operational momentum by directing some of the operational costs elsewhere in the financial accounts.

Companies that have guided to higher capex in August include Telstra (TLS), Seek (SEK), Carsales, Domain Holdings Australia, Nine Entertainment (NEC), Seven West Media (SWM), Altium, Appen (APX), NextDC, and Wisetech Global (WTC).

Companies that increased capex guidance in combination with lower opex include REA Group, TPG Telecom (TPG), News Corp (NWS), IDP Education, and Audinate Group.

It is also Macquarie's observation investors were all too willing to reward strong top line growth momentum, as well as the structural growers in the sector.

Macquarie's key picks are Telstra, Carsales, Seek, and NextDC, while the two key no-nos are Domain Holdings and Appen.

August Not The Worst

In thirteen years of closely monitoring corporate results in Australia, only two seasons registered more 'misses' than 'beats'; it happened the first time in August 2019, when the outlook for the Australian economy was deteriorating quickly, and a second time in February this year.

August 2023 saw total beats slightly outnumber total misses; by 3 results exactly (112 versus 109). While this is far from fantastic, in direct comparison with the February outcome earlier in the year it is an improvement, though maybe not to the extent we're all ordering champagne for the post-season analysis.

What equally counts is the average EPS forecast has now sunk to -6.6% for the ASX200, while dividends are also expected to drop in aggregate (possibly by -8%). If correct in twelve months' time, this will mark one of the weakest performances for corporate Australia in a long while, outside of covid-impacted 2020 and the GFC.

Five sectors are forecast to see average EPS retreat in the year ahead: consumer staples, energy, financials, materials and real estate. These sectors represent circa two-thirds of the ASX's total market capitalisation. On Ord Minnett's observation, only healthcare, industrials and utilities are showing profit stability.

Morgan Stanley, on the other hand, warns there's major risk in current forecasts for industrials, which represents a rather broad basket ranging from Transurban (TCL) to Dalrymple Bay Infrastructure (DBI), also including A2B Australia (A2B), Kelly Partners (KPG), Freelancer (FLN), and lots more.

In contrast, the valuation of equities, on average, both against bonds and versus long-term references, is above average. Locally, the PE ratio for the ASX200 sits around 15.5x, some 100bp above the long-term average. It is precisely the valuation that has many a market analyst uncomfortable, in particular when taking into account the possibility of more rate hikes and deteriorating economic momentum.

One explanation is that markets are looking forward to when the economic upturn and the commensurate recovery in earnings announces itself. It also means there's the always lingering risk that in case of disappointment, the subsequent sell-offs can be larger than otherwise might have been the case.

This possibly explains the rather mediocre share price responses that have been observed both in Australia as well as in overseas markets in response to corporate results recently. On the one hand markets showed no hesitation to punish at times even the slightest form of disappointment, while the appetite for outsized rewards in case of an earnings beat often proved temporary or not present at all.

While total dividends are expected to shrink further in FY24, it's worth pointing out dividend announcements in general actually surprised for the season. This marks yet another difference with February when the balance had tilted to net disappointment. Regardless, Ord Minnett has singled out consumer staples, real estate and communication services as sectors disappointing on dividend payouts.

Ord Minnett believes standout results were delivered by AUB Group, Brambles (BXB), Breville Group, Carsales, Cochlear, Goodman Group, GUD Holdings, Hub24, Inghams Group, Megaport (MP1), REA Group, and Wesfarmers.

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