Reporting season Snakes & Ladders

Minimal Growth

Last August, it was the miners and energy sectors dragging down aggregate earnings, but this was offset by earnings growth from financials sector and the free kick that offshore earners received from a falling AUD. In August 2016, the aggregate net underlying profit1 growth for the ASX 200 was a paltry +0.2% with banks (0%) and industrials (-3%) being offset by growth from cyclicals (+2%) and most surprisingly resources (+7%) which were not as bad as had been feared led by the Big Australian BHP (share price +5% in August).

In calculating underlying profit one-off events and non-cash items such as asset write-downs are removed from the statutory profit in the attempt to gain a picture of how a company’s core business is performing.

The overall ASX 200 return for the month of August is only slightly below the overall aggregate profit growth reported. While this suggests a benign and boring reporting season for investors, the overall ASX200 return masks the dispersion in results, with the defensive sectors of utilities, telecoms and healthcare down 3-6% and energy, miners and the previously unloved consumer staples retailers up by a similar amount.

Give me my Money Back!

Capital management was again a prevalent in the recent reporting season and was understandably popular with investors, though it was less of a feature this reporting season than it has been in the past. Telstra, Qantas, IAG and CSL announced new share buy-back plans. Across the industrial companies, the dividend payout ratio has remained very high and is now approaching 80%. While rising dividends plays to the “search for yield” investment theme and currently boosts share prices, in the longer term companies do need to retain cash to reinvest in their operations to grow earnings in the future without adding to debt.

Gearing and the cost of debt declines

The de-gearing we have seen amongst corporate Australia sets the scene for this excess capital to be used in either a spate of acquisitions or returned to shareholders at the next reporting season. From meetings with management teams over the past few weeks, capital management appears to be the preferred course of action, though global and domestic political instability has made many management teams quite cautious to open their chequebooks.

Additionally, companies are paying much less for the debt they have, primarily by accessing the offshore debt markets. Falling debt costs have delivered profit growth in an environment where revenue growth has been hard to achieve. A range of portfolio companies such as Investa Office Trust has reported that the margin cost of their debt is in the 3.5-3.8% range.

One of the questions we have posed to management teams that we have met with over the last four weeks is “Given the current low cost of debt and the long tenor of debt available, does it not make sense to look at increasing gearing rather than paying down debt?” The responses from CEOs have been either a) “if I were running a private company I would increase our gearing from 30% to 50%, but fund managers like you won’t let me” or b) “the assets that I wanted to buy two to three years ago are no longer available at reasonable prices”.

Cost cutting

In the absence of revenue growth, Australian companies are clearly holding onto their wallets and delaying or halting significant investment spending. The large diversified miners were again very vocal about their focus on shareholder returns and their reductions in capital expenditure. In the cost cutting department, BHP was a highlight for me, with a 16% reduction in unit costs delivering a higher than expected profit. This outweighed in the minds of investors the 76% cut in the dividend and the prospects of falling commodity prices especially iron ore over the second half of 2016.

Best and worst results

Over the month the best results were from the domestic housing-exposed cyclicals and companies that were expected to deliver disappointing results but surprised on the upside. Results from housing-related companies Mirvac, Stockland and Lend Lease showcased the continuing strength of the Australian housing cycle and JB Hi-Fi and Harvey Norman both showed +12% profit growth and margin expansion despite heavy discounting from Dick Smith’s receivers trying to shift stock. In the better than feared category is Ansell which came in ahead of the market’s low expectations after a poor first half result in February. Similarly, Computershare and Woolworths performed well after bettering low expectations.

On the negative side of the ledger, the bottom performers were companies that did not deliver bad results per se, but rather high price to earnings companies that had results below lofty market expectations. CSL’s guidance of 11% net profit growth for FY17 and a $500 million buy-back disappointed the lofty expectations of sell-side analysts, though we note that over the last few years CSL has tended to fall around results and then recover over the next month. Medibank Private delivered 46% growth in earnings and expanded margins, but the stock price fell on concerns about slowing growth due to publicity issues and poor customer service. The market darling of 2015, Blackmores continues to have a tough 2016 despite reporting a 14th consecutive year of sales growth after management warned that sales in 2017 are likely to be lower as Australian retailers, and pharmacy chains had been de-stocking vitamins after buying extra stocks in 2016 to cater for entrepreneurs who had been cleaning out their shelves and on-selling their products online in China.

Another theme amongst the poor performers this August has been companies in the 2014 IPO vintage, significantly missing guidance in their second year as listed companies. Market commenters far more cynical and jaded than I have pointed that this has occurred after the end of the escrow period had ended for the shares held by their former private equity owners. Aged care provider Estia Health, Spotless and personal care and tissue manufacturer Asaleo all had a rough reporting season.

Article contributed by Aurora Funds Management:  (VIEW LINK)