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The big surprises - good and bad

This article appeared in the September 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Values much the same, but forecasts for many stocks trimmed after reporting season.

Photo of Andrew Doherty By Andrew Doherty, Morningstar

Investors were overwhelmed by the typical avalanche of company information during the reporting season. Our analyst team has concluded that results have generally been as expected but, as always, there were some significant surprises.

Fair values for stocks we research are little changed overall, largely because of our long-term focus. We still see the sharemarket as modestly undervalued, although less so since the start of the season because of the market rally in July and August.

The average price/fair value estimate for all companies covered is 93 per cent, up from 89 per cent in the middle of July. [That suggests the sharemarket is trading at a slight discount to Morningstar's aggregate valuation].

Earnings growth for companies that have reported, barely kept pace with inflation, with 3 per cent median growth for the year highlighting the slow-growth environment.

Resources investment activity is a key source of economic growth, as shown by strong results from mining services and mining-related capital goods suppliers. Telecom grew through increased mobile revenues. Gaming and wagering companies benefited from ongoing spending despite the decline in other discretionary expenditure.

Healthcare continued on its growth path through increasing demands from a growing and ageing population. Results were dragged lower by falls in earnings from companies in the materials sector because of lower commodity prices, production shortfalls and cost increases.

Discretionary retailers posted weak results linked to high savings rates and increased costs, and wealth managers suffered from weak asset prices and fund outflows.

Profit margins were pressured across a number of sectors hurt by soft revenues and higher wage, energy and other input costs. Balance sheets are in decent shape as managements remain cautious in an uncertain environment.

With more than 60 per cent of the S&P/ASX 200 companies we cover having published their full-year results to June 2012, slightly more had missed our forecasts (13 per cent) than exceeded them (10 per cent).

[Editor's note: Do not read the analysis below as recommendations. Do further research of your own or talk to your stockbroker or financial adviser before acting on themes in this article].

Negative surprises

Some of the biggest earnings misses were from companies in the materials industry, caused by lower commodity prices, increased costs and lower domestic demand.

BHP Billiton was one of the bigger disappointments. The 21 per cent fall in its US-dollar earnings was in line with consensus analyst forecasts, but below our forecasts. Petroleum prices were lower than expected, while metallurgical coal costs were higher and production was lower. We expect a solid lift in BHP earnings this year from higher US gas prices and improved copper production, despite our reduced forecasts, and retain our positive recommendation.

China remains the key growth source, although stimulus is needed to support near-term demand and prices. The no-go decision on Olympic Dam expansion in South Australia was probably the announcement of the season. Sharply increased capital costs and commodity price weakness have dramatically altered project economics.

Gold miner Newcrest (NCM) was also among the disappointments. Earnings slipped despite the contribution from Lihir and the robust gold price, because of higher-than-expected costs. We trimmed our forecasts and fair value but the recommendation remains positive.

Boral's (BLD) result was one of the worst of the season and below our forecasts. Building Products was the weakest division as reduced housing activity caused demand for bricks and roofing to slump. Losses in the US were reduced as the housing recovery continued. We cut our 2013 financial year forecasts but expect strong earnings growth in the next couple of years through modest improvements in Australian housing and infrastructure activity as well as improvement in the US.

Bread, milk and margarine producer Goodman Fielder (GFF) had another very poor result, well below our forecasts. We retain a negative view. The worst performer was baking, which is suffering from higher input costs, subdued consumer spending and pressure on margins from a weak competitive position relative to the powerful supermarkets. Business divestments and debt reduction are the key to improved earnings in the next couple of years.

Positive surprises

Some of the strongest results were from mining services companies enjoying the fruits of the resources investment boom. Monadelphous (MND) posted a better-than-expected 21 per cent rise in earnings with strong demand across all markets, helped by increased scope on a number of large projects. While we are impressed with the company's strong record of project delivery, we do not expect growth at this pace to continue now the cycle peak is not far away.

Downer (DOW) beat our low expectations, with strong returns in mining and infrastructure businesses offsetting a weak result in rail. Mining equipment rental business Emeco Holdings (EHL) grew earnings 28 per cent on revenue growth of 12 per cent, with an expanded fleet, strong demand and margin expansion.

Macmahon Holdings (MAH) lifted earnings 44 per cent on record revenue from mining services, strong construction activity and improved project delivery.

The resources investment boom will remain a key driver of Australian economic activity for some time, but slowing Chinese growth, the European financial crisis and lower commodity prices provide a more subdued outlook with increased likelihood of project delays or deferrals.

Insurance Australia Group (IAG) benefited from higher premiums, better margins and increased investment returns thanks to the rally in bonds during the year.

Casino operator Echo Entertainment (EGP) was ahead of forecasts thanks to lower-than-expected taxes. And casino operator Crown (CWN) grew earnings by 26 per cent driven by improved Burswood revenue and favourable VIP win rates at Burswood and Melbourne, which offset weaker Macau results.

Tatts Group (TTS) earnings grew 16 per cent from solid wagering, lotteries and gaming revenue - which was little affected by the weak discretionary spending environment - and cost savings through installation of proprietary IT systems into NSW lotteries.

carsales.com (CRZ), which aggregates online classifieds for cars, boats and motorbikes, delivered 25 per cent earnings growth. Revenue rose 23 per cent, helped by increased car dealer fees and revenues from display ads and private classifieds.

In healthcare, sleep apnoea products supplier Resmed (RMD) lifted earnings 18 per cent, supported by increased sales penetration internationally and the rollout of new products. Private hospital operator Ramsay Health Care (RHC) grew earnings by 15 per cent, driven by increased private hospital capacity and utilisation.

Retailing was not a surprise

Discretionary retailing was, not surprisingly, a weak spot because of adverse cyclical and structural forces. The 15 per cent fall in earnings by JB Hi-Fi (JBH) reflected the difficult times. Like-for-like sales fell 3 per cent for the year while award wages increased by the same amount.

In a similar vein, lower spending caused a 9 per cent fall in consumer products supplier GUD's earnings, despite the contribution from an acquired business in the industrial segment. A weak competitive position was exposed by the loss of market share to cheaper house-brand consumer products.

Financial services companies were hit by the downturn in asset prices and financial markets activity. Global share registrar Computershare (CPU) posted a 17 per cent fall in earnings, dragged lower by weak financial market activity, especially in mergers and acquisitions, Initial Public Offerings and capital raisings, and adverse currency moves.

Earnings declined 16 per cent for fund manager Platinum Asset Management (PTM) from lower asset-based fees because of net fund outflows and lower performance fees. IOOF (IFL) suffered a 14 per cent decline in earnings from outflows of higher-margin funds and higher costs due to acquisitions.

Qantas (QAN) earnings slumped 83 per cent as flagged in June, because of industrial action, higher fuel costs and the strong dollar. Debt-funded new aircraft purchases added to interest expense. International business losses almost doubled, offset by good results from Qantas domestic, Jetstar and Qantas Frequent Flyer.

This year's forecasts have been trimmed

The results season has prompted a trimming of our forecasts for the year to June 2013 by 4 per cent overall. There were more reductions than increases, given the subdued outlook for most sectors.

Some of the biggest cuts are to building materials suppliers Fletcher Building (FBU) (-21 per cent), Boral (-18 per cent) and housing products supplier GWA (GWA) (-13 per cent) because of reduced expectations for housing and commercial construction activity.

Reduced volume expectations and higher costs were behind cuts to earnings growth forecasts for BHP (-16 per cent) and Newcrest (-20 per cent). Emeco's (-11 per cent) earnings growth forecast is now more moderate because of the increased likelihood of delays in redeploying equipment, given the weakness in the coal sector.

The biggest boosts to 2013 earnings forecasts were in competitively advantaged healthcare companies Primary (+12 per cent), Ramsay (+7 per cent) and ResMed (+10 per cent). The above-expectations carsales.com result prompted an 8 per cent boost to forecasts mainly through increased expectations for dealership fees.

Our AGL Energy (AGK) forecast rose 12 per cent following the surprise 5.5 per cent retail customer growth in 2011-12. The 9 per cent rise in Challenger's (CGF) forecast was because of higher expectations for annuity sales, given their greater popularity in more uncertain investment climates.

About the author

Andrew Doherty is head of equities, Morningstar. Access a free trial of the popular Huntleys' Your Money Weekly newsletter.

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