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Highlights of the reporting season

March 2017

By Antares Equities

Aggregate profit growth rebounds, thanks largely to resources

Aggregate market profits rose 18% year-on-year in the six months to end-December 2016, rebounding strongly from the 5% fall experienced in the previous half year. This was generally stronger than analysts’ expectations, with half yearly net profit growth now at its highest level since 2011 (Chart 1). Earnings surprises were also positive.

Chart 1: Half yearly underlying net profit growth – aggregate market

Source: Company data, Deutsche Bank, March 2017

Industrials, banks and resources all contributed to the earnings recovery but as Chart 2 shows, the resource sector was the standout. Resource half yearly net profit growth soared to 165% year-on-year, driven by mining companies that benefited from strength in key commodity prices, particularly iron ore and coal.

Chart 2: Half yearly underlying net profit growth - resources

Source: Company data, Deutsche Bank, March 2017

Some of the key themes in the sector were strong earnings, capital management and higher than expected dividends.

Industrials – defensive earnings growth exceeds cyclicals

As Chart 3 shows, net profit growth for industrials (companies other than resources and banks) rebounded solidly and the previous weakness in bank profits was reversed, largely due to lower than expected bad and doubtful debts.

Chart 3: Profit growth – industrials and banks

Source: Company data, Deutsche Bank, March 2017

Within the industrial sector, defensive company earnings rose 8.3% in the half year, recovering more than cyclical company earnings that rose 4.3% (Chart 4). This outperformance by defensive industrials was partly driven by improved earnings results from companies like Woolworths, Wesfarmers (which includes Kmart and Bunnings) and Healthcare stocks, such as CSL and Cochlear.

Chart 4: Half yearly underlying net profit growth – cyclical industrials versus defensive industrials

Note: Cyclical industrials comprise stocks in steel, building materials, transport, commercial services and consumer discretionary. Defensive industrials comprise consumer staples, healthcare, telecoms, utilities, general insurance and property. Source: Company data, Deutsche Bank. March 2017

Banks: majors and regionals diverge on bad debts

The only major bank to report in February was Commonwealth Bank (CBA), while National Australia Bank (NAB), ANZ Banking Group (ANZ) and Westpac Banking Corporation (WBC) delivered quarterly trading updates. The main themes across the sector include continued success in cost control and the beneficial impact of mortgage re-pricing, which is contributing strongly to revenue growth.

In recent quarters, investors have focused on the very low level of bad debts among the banks, which has contributed significantly to profitability, but there is a lot of debate about when the bad debt cycle will start to deteriorate. This issue is a major factor differentiating the major banks from the regionals during this reporting season. Amazingly, bad debt charges actually fell for CBA and ANZ and remained very low for NAB. Among the regional banks, however, bad debt charges are starting to rise (eg Bendigo Bank, Mystate) and this is likely to be a constraint on future performance.

The other risk to the bank sector is the residential housing cycle, given house prices are at such high levels. But this appears unlikely to impact share prices in the near term while extremely low inflation is keeping domestic interest rates at such low levels and unemployment remains benign.

Cost control continuing but new announcements more scarce

Given the subdued growth environment over the past few years, cost cutting has been a major driver of earnings growth across most sectors of the market. Looking forward, the question remains as to whether this can continue – earnings growth based on cost cutting alone is not sustainable over the longer term.

The reporting season seems to confirm this view, as the number of newly announced cost out initiatives has dwindled over the past year and the size of programs is generally getting smaller.

Infrastructure and capital spending exposed stocks coming back into play

Although domestic capital expenditure (capex) trends remain weak, the reporting season did suggest some improvement in the earnings of companies with capex exposure and those tied to infrastructure projects that have finally commenced. Examples include Cimic Group (CIM) and Downer EDI (DOW). The surprise in the DOW report was the 54% rise in earnings within its Technology and Communications Services division. This was attributed to the NBN rollout and work for Telstra, both of which are likely to continue in coming quarters. So diversifying away from mining capex is working for some companies. A list of CIM’s contract wins in 2016 – Canberra Light Rail Stage One, level crossing removal in Victoria, metro rail network operations and maintenance (NSW & VIC), freight rain and naval ship maintenance, construction of a tunnel in Hong Kong – reinforces how crucial infrastructure projects are for these companies given the prevailing lack of private investment.

The US non-residential construction cycle is also strengthening, generating stronger earnings for US-exposed Australian companies such as Boral.

Dividends and capital management……again!

Two of the biggest recurring themes in reporting seasons over the past few years have been high dividends and capital management initiatives. They were prominent again in February but perhaps with some signs of change. Chart 5 is a long-term chart of the S&P/ASX 200 dividend pay-out ratio. Yes, it’s come off its highs in recent quarters but it is still way above the long term average of 67% (dotted line).

Chart 5: S&P/ASX 200 dividend payout ratio

Source: Datastream, Deutsche Bank, March 2017   

Within sectors, the pay-out ratio for resource companies is significantly above historical levels as these companies are paying out dividends rather than investing for growth. This may prove to be a cyclical trend. Examples of resource companies that announced higher than expected dividend payments include Rio Tinto, BHP and Fortescue Metals Group. Other large cap companies that positively surprised on dividends included AGL Energy, Amcor, Crown Resorts, Insurance Australia Group, JB Hi-Fi, Perpetual, Seek, Tatts Group, Treasury Wine Estates and Westfarmers1.

On the capital management front, a number of companies announced share buy-backs (AMP, BlueScope Steel, Coca-Cola Amatil, Rio Tinto, QBE Insurance Group, Crown Resorts), while RIO and FMG hinted at further capital management initiatives in the future.

Earnings outlook – upgrades or downgrades?

Earnings downgrades have been the norm in recent years but not this time - the first half reporting season resulted in upgrades to consensus earnings per share (EPS) expectations. Goldman Sachs data suggests this is being driven by a 7.5% upgrade to FY17 resource sector EPS growth to 117% year-on-year and a 0.9% upgrade to FY17 bank sector EPS growth to 2.9%. Disappointingly, FY17 EPS growth expectations for industrial stocks was marginally lower (-0.6% to 7.2%) but this is a relatively good result given the past six first half reporting seasons have been associated with average downgrades of around 1.5%.

1Morana Hunter, “Equity Strategy – Hidden Figures”, 3 March 2017, p.22.

Important information

The above information is of a general nature and has been prepared without taking account of your individual investment objectives, financial situation or particular investment needs. It is not intended as financial advice to retail clients. Before making an investment decision, you should consider the appropriateness of the information, having regard to your objectives, financial situation and needs. We recommend you consult with your financial adviser, who can help you determine how best to achieve your financial goals and whether investing in a fund is appropriate for you.

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