With so many clouds over the global economy and the stock market, investors might have expected that the “confession season” preceding the February-March reporting season would be a very busy one.
In “confession season,” companies alert the market to changes in their profit guidance, or downturns in their business (usually both). What we saw over the recent season was further proof of how painful earnings downgrades can be, with some typically disastrous reactions in terms of share price.
Cooling global economic growth (in particular, from the main engine of global growth, China), a slumping domestic housing market, fears over Australian consumer spending and the fall-out from the financial services Royal Commission are just some of the cocktail of fears that are weighing on the stock market. The market is in no mood for unexpected (or repeat) profit downgrades: but companies’ continuous disclosure requirements make them necessary. It is a dire conundrum for companies whose business outlook is deteriorating.
The reaction of the market to a profit downgrade can be horrendous. Discount retailer The Reject Shop had 39% stripped from its value, after its trading update of 17 November contained a downgrade to profit expectations. A shock downgrade from the highly-rated fruit and vegetable grower Costa Group last month produced the exact same response from investors. Such a market response can, at a stroke, negate months (even years) of patient capital growth: The Reject Shop’s slump took the share price back to where it was in 2004 (it had been on a long slide from $18 in 2010), while the more recently listed (2015) Costa Group had its price stripped back to where it was in April 2017.
Given the troubled economic backdrop, it might have been expected that there would be more downgrades around the market. But there have been relatively few.
The dilemma for investors is, if a company is made much cheaper by a stock market pounding following a downgrade, is that a buying opportunity – even with the fact of the weaker outlook that was the cause of the downgrade?
It hasn’t all been gloom – for example, Treasury Wine Estates brought out a surprise upgrade in January, and earlier upgrades also came from insurer NIB Holdings (NHF), software group WiseTech (WTC) and travel group Corporate Travel Management (CTD). Computershare (CPU), Seven West Media (SWM) and Medibank Private (MPL) and plumbing supplier maker Reliance Worldwide (RWC) have all reaffirmed existing guidance.
Now it is over to the reporting season – half-year earnings for most companies, but full-year results for those with a December balance date – and after a quiet confession season, investors can only hope that there are few negative surprises. If so, the market vengeance will be brutal.
Earnings downgrades so far
The Reject Shop (TRS) got in early, in October, blaming stagnant wage growth and rising household costs for an alarming drop in sales that will savage its December-half profits. TRS received a takeover bid in November (from the private investment company of Raphael Geminder, the executive chairman of packaging company Pact Group), which helped rejuvenate the share price, but on consensus target price, analysts see the stock, at $2.76, as heading much lower, to $2.23.
Also in October, travel agency group Flight Centre (FLT) brought out new earnings guidance for the half and full year that were below consensus, and the share price fell 10%, to $46.08. Full year pre-tax profit is now expected to come in at $390 million–$420 million, or 1.4%–9.2% ahead of FY18. Since the downgrade, Flight Centre has retraced to $42.02. Before its FY18 full-year result, FLT was trading at a prospective FY19 price/earnings (P/E) ratio of 25 times earnings: the new P/E is 14.4 times expected earnings. FLT appears to be a situation where a downgrade, and the subsequent market reaction, has clearly opened up value: the analysts’ consensus target price is now $53, which implies upside of 26% upside from current levels. Moreover, FLT offers at this price an attractive FY20 estimated of 4.6% fully franked.
Construction, property and infrastructure company Lendlease (LLC) disappointed the market in November by announcing a provision of about $350 million after tax in its under-performing engineering and services business. The shares fell 18%, to $12.72, and LLC has subsequently fallen to $12.14. Analysts’ consensus target price is now $15.35, which if achieved would represent upside of 26.4%. The FY20 expected yield on LLC is 5.97%, unfranked.
Also in November, packaging firm Pact Group (PGH) downgraded its earnings forecast for 2019 from a range of $270 million–$285 million, to $237 million. The downgrade came after a disappointing FY18 result: the stock fell 10%. PGH shares fell to $3.25, but have since recovered to $3.88: that is well above the analysts’ consensus target price of $3.66.
In December, building materials producer Adelaide Brighton (ABC) recast its expectations for underlying profit in the year ending December 31 2018 to a range of $188 million–$195 million: the new figure was less than the underlying net profit of $190.3 million earned in 2017, and a downgrade on the full-year guidance that ABC gave when it released its half year results in August. A double downgrade is a no-no: on analysts’ consensus target price of $3.66, ABC is heading lower.
Also in December, weaker-than-expected profit guidance from fuel supplier and convenience retailer Caltex Australia (CTX) disappointed the market. The shares fell by 16% to a four-and-a-half year low after the company indicated that its profit could fall as much as 16%. At $27.18, CTX is quite a bit lower than the analysts’ consensus target price of $29.79: there is also an attractive FY19 (December year-end) estimated yield of 4.6% fully franked
Outdoor clothing and equipment retailer Kathmandu Holdings (KMD) kicked off January with a surprisingly weak trading update: after previously reporting strong same-store sales growth for the first quarter, and saying that it expected first-half profit to be “strongly above last year,” KMD admitted in the first week of the year that trading results in Australia and New Zealand over the Christmas and Boxing Day period had been “disappointing” and below expectations. KMD shares fell 18% to $2.15, but have moved back to $2.34. At these levels, KMD appears – based on an analysts’ consensus target price of $2.84 – to be good buying, but investors would have to be comfortable that the retail outlook is not as dire as many predictions have it. A 6.9% fully franked expected FY20 yield is also attractive, if the forecast full-year dividend of 16.2 cents is achieved.
Scrap metal processor and trader Sims Metal Management (SGM) also downgraded in January, hit by tariff and trade war concerns. Having already told the market in September that its underlying earnings before tax and interest (EBIT) for the September quarter was weaker than expected, Sims warned in January that EBIT in the December half of the 2019 financial year is likely to be more than 12% lower than the year before, at about $109.8 million. The stock slumped 16% to $9.19, and although it has recovered to $10.36, the analysts’ consensus target price sees scope only for a move to $10.48. An FY20 estimated yield of 4.4% fully franked is not enough to make Sims a buy.
Costa Group’s January update, which told the stock market to expect “largely flat growth” in net profit for the June 2019 year, after sales of tomatoes, berries and avocados for December and January came in lower than expected, was a shock to investors – given that the company had previously told investors to expect low double-digit profit growth. Costa is another example of a company that was priced for growth, meaning that the fall was always going to be big: CGC fell from $7.37 to $4.51, and analysts took the knife to expectations. The revised guidance looks achievable, but Costa Group is not getting back to $7.37 anytime soon. That pruning is bad news for holders of the stock, but CGC has recovered to $5.42 – a 20% recovery – and analysts see it reaching $5.58, if there are no more sudden demand slides. Costa Group has lost its star growth stock status, and the estimated FY19 (December year-end) yield of 2.59% fully franked is not enough to cover that.
Fertiliser and explosives maker Incitec Pivot (IPL) warned late last month that unplanned outages at its Louisiana (USA) ammonia plant and Phosphate Hill (north-west Queensland) ammonia phosphate plant would between them cut $45 million off its EBIT for the financial year ending September 30, 2019: that is equivalent to about 8% of last year’s EBIT of $557 million. IPL shares fell 8%, to $3.28, but have moved back to $3.34. Analysts like the stock, with a consensus target price of $3.80, although the FY20 estimated yield of 4.1%, 11.6% franked, is not overly exciting.
Air New Zealand (AIZ) slashed its earnings outlook in January, after bookings were hit by a softening tourist market, amid ongoing issues with the Rolls-Royce Trent 1000 engines used in the Boeing 787-9 fleet. The airline told the Australian and New Zealand stock exchanges (the company is listed on both sides of the Tasman) that it now expected pre-tax earnings of NZ$340 million–400 million (A$324 million–A$381 million) in the year to June 30 2019. That represents a cut of as much as 37%. On the ASX, AIZ shares fell 45 cents to $2.70 – down 14.3% – and have subsequently traded down to $2.57. Having absorbed the downgrade, analysts now have a target range of between NZ$2.55–NZ$3.00 (A$2.43–A$2.86). The expected dividend yield is now about 8.4% for FY19 and 8.9% for FY20.
(The problem for Australian investors is that the imputation credits from fully franked New Zealand dividends are not available to Australian residents: the New Zealand government refunds the imputation amount to foreigners, minus 15% withholding tax. This refund is paid as a supplementary dividend, increasing total dividends received by foreigners by about 18%. This makes New Zealand dividends not as tax-effective for Australian investors as local stocks paying fully franked dividends.)
AMP (AMP) was another to downgrade expectations in January, with last year’s net profit poised to be almost vaporised in the wake of the company’s horror year of damaging revelations. AMP cut its already weak profit guidance further, saying that net profit for the 2018 calendar year would be “approximately $30 million” — 96% lower than the $841 million profit reaped the previous year. Underlying profit — which removes the effect of one-off profits and losses — will also be drastically weaker, falling from $1 billion in 2017 to $680 million last year. The final dividend will slump from 14.5 cents to 4 cents. AMP looks to offer value on its financial metrics – but it could not be bought with any confidence.
Also in the financial sector, Australia’s largest annuities provider, Challenger (CGF), downgraded earnings expectations in January, saying it expected its June 2019 earnings to be in the range of $545 million–$565 million, down from a previous guidance range of $591 million–$613 million. Challenger blamed “increased market volatility” during the first half of 2019, including lower cash distributions in its life division, with earnings also hit by lower funds-management performance fees. CGF shares crashed 17%, to $7.40, and have subsequently slipped lower, to $7.21. On the basis of the newly adjusted analysts’ consensus target price of $9.20, CGF appears to offer substantial upside, and the FY20 estimated yield of 5% fully franked is also attractive.
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