The December half profit-reporting season was pretty lacklustre with essentially flat profits.
Profit growth is likely to pick-up in the year ahead but still lag consensus expectations for double-digit growth.
Australian shares are likely to rise over the year ahead as valuations are attractive and global shares are likely to rise, but are expected to remain a relative underperformer for a while yet.
There was plenty of nervousness going into the February profit-reporting season in Australia – and for good reason. Domestic demand has been weak, the strong Australian dollar is bearing down on trade exposed sectors and resources sector profits were coming off a high base with commodity prices falling in the second half last year. In the event the results were pretty much as expected – in a word lacklustre.
Reporting season wrap-up
The good news was most companies saw profit growth over the last year with 68 per cent of companies having reported a rise.
Against this, only 31 per cent of results beat expectations, down from 37 per cent for the June half 2011 results and well below the norm of 45 per cent.
This is the worst result since February 2009, in the midst of the GFC. Reflecting this, results were greeted cautiously with 52 per cent of companies seeing their share price underperform the market on the day results were released. While outlook statements have improved slightly from the last reporting season the net balance of positive statements remains relatively low.
Reflecting the generally lacklustre reporting season, analyst revisions to earnings expectations have generally been negative in Australia. The next chart shows that the number of Australian companies seeing their earnings forecasts being revised down by analysts has continued to outweigh the number of companies seeing upgrades. What’s more the pace of downgrades in Australia has been far more intense that has been the case globally for the last couple of years – which partly explains the relative underperformance of Australian shares. However, the good news is that the pace of downwards revisions is slowing, as is the case globally. In fact, based on weekly trends global earnings revisions are likely to turn into net upgrades soon.
2011-12 consensus earnings expectations have been revised down to three per cent, from seven per cent in late January and from 14 per cent a year ago. The downgrades have been concentrated in resources, insurers, other financials and media.
Several key themes are apparent. First, earnings growth was non-existent through 2011 - with aggregate earnings effectively flat to down slightly from the December half 2010.
Second, the weakness in earnings was broad based across all major sectors with resources profits down slightly, non-bank industrials flat and banks up slightly. A similar message is apparent in ABS measures of profits up just 2.7 per cent on a year ago and most sectors seeing falls in the December quarter including mining. This stands in contrast to a year ago when aggregate profits were up 20 per cent and a three-speed economy was evident with surging resources sector profit growth, solid bank profit growth and flat to slightly negative growth for industrials. Now they are all soft.
Third, the weakness in profits reflects a combination of factors with the main ones being weak domestic demand, the strong Australian dollar and commodity price softness during the second half of last year.
Non-bank industrials have been hit by a combination of weak domestic demand, sticky cost bases partly reflecting the 2010 surge in workforces and the strong Australian dollar bearing down on trade exposed sectors. Industrials profits have been doing it tough since before the GFC.
Banks have seen profit growth slow to a crawl on the back of soft credit growth, pressure on bank margins from higher funding costs and disappointing trading income.
Resources have seen profits stall partly reflecting the high base of 2010 but also a fall back in commodity prices during the second half of 2011 and increased costs associated with booming mining investment.
Of course, there have been some pockets of strength with mining services companies benefitting from the surge in mining related investment, and health care stocks with high quality franchises (such as CSL, Cochlear and Resmed). But the overall softness in profits is a confirmation of the broader weakness in much of the Australian economy.
Consensus earnings expectations are for 12.6 per cent earnings growth in 2012-13.
Profit growth is likely to pick up over the next financial year. The resources sector is likely to benefit from a continuing global recovery, modestly higher commodity prices and a rise in production. And industrials are likely to benefit from corporate restructuring, further falls in interest rates and an eventual pick-up in domestic demand, which should result in some margin expansion. Consensus expectations for margins are also more realistic than was the case six to 12 months ago. However, profit growth is still unlikely to meet current consensus expectations for 2012-13 with an outcome around seven per cent growth more likely – as domestic demand is likely to remain constrained and the Australian dollar is likely to remain strong.
A likely further downgrade in expected earnings growth for the year ahead should be largely factored in. The Australian share market is trading on a forward price to earnings multiple of 11.5 times. This is well down from 12.9 times a year ago. And even if year ahead earnings expectations are downgraded by another five per cent, this would still leave room for capital growth of around eight per cent if the market were to rise to say a 13 times forward PE. (A level which is below the market’s 15-year average of 14.5 times, but which may be appropriate for the more volatile environment we are now in.)
Another positive is that with corporate cash holdings at record levels and gearing low, there is plenty of scope for further increases in dividends, buybacks and M&A activity going forward, which are positive for the share market.
Notwithstanding the risk of a short term correction, further gains in global shares on the back of attractive valuations, continuing global recovery, easy monetary conditions and receding risks of a European melt down are likely to help drag up the local share market over the year ahead.
However, for the time being the Australian share market is likely to remain a relative underperformer. Since late 2009, Australian shares have underperformed global shares thanks to a combination of: the tougher domestic monetary environment which has both constrained domestic demand and limited the flow of funds into shares as Australian’s have preferred “cash in the bank”; the strong Australian dollar; and worries about a hard landing in China.
The fear of a Chinese hard landing is likely to recede further. However, there is unlikely to be much relief in terms of the Australian dollar (unless the world falls apart again, in which case it would actually be bad news) and monetary conditions in Australia are unlikely to ease much relative to the situation in the US and Europe. This suggests that Australian shares could rise further this year, but continue to lag global shares for a while yet.
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