The economic backdrop and lead-in revisions heading into Australia’s August reporting season have been extremely strong, both continuing their positive path since the vaccine announcements last November.
Despite the temporary setbacks of lockdowns in Melbourne and Sydney, we see Australian companies are in a strong position for above expectation earnings and dividend results and to announce the return of capital to investors. We do however expect that companies will temper their enthusiasm in outlook comments.
Conditions continue to be supportive of earnings across industries
In recent months, the World Purchasing Manager Index (PMI), a good indication of actual conditions for companies, appears to have reached a kind of peak. Despite a recent resurgence in COVID-19 cases, we expect conditions to remain at high levels, with just the rate of improvement slowing.
Australian consumer confidence and business conditions have also showed good indications of the earnings environment for companies through the 6-month period since last reporting season.
Other indicators such as wage growth, house price growth, building approvals, iron ore and copper prices are very supportive for earnings in consumer, construction and resources industries. In the energy space, the oil price has recovered strongly from COVID-19 lows as the demand returns with activity, however earnings conditions have been more subdued due to increased pessimism around energy transition and a reluctance to drill new wells.
Lead-in sales, earnings, and profit margin expectations upgrades at highs
As we do each reporting season, we have been monitoring the trend of consensus brokers revisions leading into actual reporting to gauge the pulse of the market.
The period since the February reporting season has had the strongest earnings per share (EPS) upgrades that we have seen in the 10 years since the GFC, with upgrades to EPS forecasts of 4.6% in July alone1.
We have also seen strong expectations for profit margins, up significantly from the subdued position in 2020. This is really being driven by the acceleration of digital transformation, cost outs and a shift away from physical delivery. We do however see some risk to the longevity of profit margin expansion given lockdowns and that they are now already above pre-COVID-19 levels.
The period since the February reporting season has seen the strongest earnings per share (EPS) upgrades that we have seen in the 10 years since GFC.
Dividends to be better than earnings
The level of lead-in EPS upgrades indicates a strong set of results going in and that conditions have been good for companies to deliver strong results for last 6-month period.
Importantly, these lead in indicators have made us optimistic on dividends per share (DPS) and dividend payout ratios. We actually think that better DPS results will be better than EPS upgrades.
Companies had been continuing to reduce their payout ratios to conserve cash during the COVID-19 uncertainty, with ratios falling from an average of 65% to 58% over last 12 months. We are now beginning to see companies talking about and raising their ratios again.
So far, we have already seen Rio Tinto shift to the top of their payout range from much more conservative levels to reflect their strong cash flows.
Expect to see other forms of capital management
As my colleague Will Baylis discussed in a recent blog, we also expect to see a spike in the announcement of capital management activities, in particular from the banks.
Given that the banks were last year providing for recession type scenarios, much reduced risk weighted assets and ongoing loan loss write backs have now pushed capital positions to a point where capital returns will be required. The capital ratios of the big 4 banks are now too strong with Tier 1 capital ratios at around 14%, when they should be more like 11.5%2.
We have already seen on-market buy backs from ANZ Banking Group and National Australia Bank, and we expect that Commonwealth Bank could do a significant off market buy back with a large, franked dividend component.
We will also see special dividends from companies where they don’t have the size to do an off market buy back. While there have been low market expectations for dividends from consumer stocks due to impacts of COVID-19, we expect we will see strong returns from consumer companies.
We believe that JB Hi-Fi, Super Retail Group and Harvey Norman are likely to increase capital returns given their ongoing super profitability in recent times and low debt situation.
Impact of recent lockdowns to temper outlook
Prior to the recent Melbourne and ongoing Sydney lockdowns, we would have expected to hear both strong results and positive outlooks from management. With the ongoing uncertainty around lockdowns, we think that there are no reasons why results would not be good, but management will again be tempering that confidence in their forward guidance.
While lockdowns are bad for sentiment, and for the lives of the people who must endure them, we now have a good understanding of what the downside scenario for earnings and dividends is from last years’ experience and scenario analysis.
We do not think that we are going to see the need for crisis level dividend reductions again from this lockdown. Debt levels for typical industrial companies are down 20% on pre-COVID-19 levels3, and while this debt reduction has resulted in some dilution, today’s companies are in a much better position. We also expect that as the vaccine rolls out more broadly, the prospect of further lockdowns will be greatly reduced.
Furthermore, not all companies have been impacted in the same way. The lockdowns impact companies that manage shopping centres or offices, or are dependent on physical premises for sales, but companies that have managed to adapt quickly to the environment and shift in demand from consumers, have continued to be very strong.
Companies like Wesfarmers, JB Hi-Fi, Super Retail Group and Harvey Norman are really benefitting from the fact that consumers are not travelling overseas and will be spending that A$50-60 billion4 which normally gets spent offshore, locally for some time to come.
CBD-based retail continues to be weak due to reduced foot traffic, but suburban shopping and everyday needs retail are a lockdown winner for the likes of SCA Property Group, Charter Hall Retail.
Inflation is not always bad
We would also note that there is a significant transitory inflation pressure given shortages in supply chains, and we see there is a chance that it will be more persistent than is being expected.
However, inflation is not bad news for all assets, and for many Australian equities it is actually supportive of their earnings growth given company revenues and profits are earnt in nominal terms. If inflation rises, this can be often be passed through to consumers in the price of goods sold. Many Real Assets also have built-in stabilisers to manage the risk of rising inflation.
The yield on Australian equities continues to be strong compared to alternative income assets, and this should be supportive for equity share prices going forward, especially with the inflationary pressures on defensive assets.
As the reporting season continues to unfold, our analysts will conduct over 100 meetings with management teams. We look forward to seeing further upgrades to forecasts, return of capital to investors and a pathway out of lockdown.
In late September, we will publish our semi-annual Reporting Season Wrap, which will bring together our full statistical framework, and key fundamental views and insights from company engagement.
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