Market reaction to full year or interim earnings releases is hardly predictable as is evident this reporting season. Stocks with fairly solid earnings have been aggressively sold off, while the market has rewarded other companies revealing eye-opening losses. Indeed, irrational price movements surrounding earnings season call into question the theory that share prices reflect company and market fundamentals. In theory, earnings that meet expectations should not cause share prices to change all that much. Again in theory, positive earnings surprises should move share prices upward and negative earnings surprises should see share prices tank. Surpassing, or failing to meet, consensus expectations is where the 'surprise' comes into play. But in reality there are myriad factors, many of them behavioral, that make reaction to an earnings report extremely difficult to predict. As examples, three of our most watched companies reported earnings earlier this week – Rio, Cochlear, and Telstra. Rio Tinto (RIO) is suffering from the reality of falling commodity prices and the perception that prices may continue to drop. The thunder cloud hovering above our big miners is the belief that the end is in sight for our mining boom. The reality is that the world is not going to stop making stuff from steel, nor is some kind of synthetic material about to replace iron ore. Although coal faces rising competition from natural gas, it is beyond the realm of possibility that coal, as an energy source for electrical generation and steel production, is going to disappear altogether. The world’s largest miner, Brazil’s Vale, recently reported its worst earnings in two years, initially causing investors to fear the worst for Rio. Analysts had already revised Rio's estimates downward and consensus profit estimates going into earnings season stood at US $4.9 billion with revenue at US$26.4 billion. The following 5 day price movement chart shows the share price moving higher preceding earnings with a sudden rise following the release on 08 August. Here is the chart:
Rio's actual earnings of US$5.15 billion beat consensus estimates but reported revenues of $25.3 billion missed estimates of US$26.4 billion. You can see the revenue miss was about $1 billion while the earnings beat was just $250 million. The other positive outcome was a 34% increase in Rio’s fully franked dividend. So in the face of mining bust scares, RIO's shares have performed rather well over the past month. Here is its one month share price performance chart:
Despite the revenue miss , investors were fairly satisfied with Rio’s earnings. Company management acknowledged challenging conditions but reiterated their belief in China’s 8% plus GDP; faith in the 'stimulating' powers of the Chinese government was also mentioned as a safeguard should China start to slow. That assumption is not necessarily universally shared. Earnings reports can become self-filling prophecies; we often accentuate results that support our biases about the company and ignore results not consistent with our pre-conceived views. While some analysts spotted no “skeletons” lurking beneath the most watched release numbers – earnings and revenue - others noted the US$1 billion deferred tax credit for the Mining and Resource Rent Tax (MRRT) that inflated the net earnings reported of $5.9 billion (although the number did not impact underlying earnings). In addition, investors should be wary of Rio’s present and future level of debt. Rio management is intent on forging ahead with costly expansion to boost production - but in the face of sagging demand, is this sensible?
In the aftermath of the recent release, Citi, BA Merrill Lynch, JP Morgan, UBS, Credit Suisse, and RBS Australia maintained BUY, OVERWEIGHT, or OUTPERFORM ratings on RIO. Anyone with a bearish outlook on Rio will focus on the 34% decline in earnings year over year coupled with a 12.8% decrease in revenues over the same period. Declining revenue and earnings in the face of tumbling commodity prices is also a cause of concern. Telstra (TLS) serves as another example of a less than rational reaction to an earnings report. The Telco giant has handily outperformed the ASX 200 over the last year, up almost 45%. Despite this, immediately prior to the earnings release, just one analyst in the market held a STRONG BUY rating on Telstra, according to Thompson/First Call. Four analysts had BUY ratings, twelve analysts had HOLD ratings, and one analyst maintained a SELL rating. In the opinion of many, Telstra is overpriced. Telstra's reported NPAT (Net Profit after Tax) of $3.4 billion missed consensus estimates of $3.56 billion, notwithstanding the fact that the $24.6 billion reported revenue represented a 1.1% increase year over year. In addition, the NPAT represented a 5.4% increase over the corresponding period a year ago. You may recall it seemed only a brief moment ago when investors were concerned about the future growth at Telstra in an NBN world. Here is a five-day chart showing price action going into earnings and immediately following the announcement:
Telstra has amassed an impressive pile of cash from asset sales and investors may have been anticipating positive announcements on special dividend payouts and ongoing expansion plans, neither of which was forthcoming. Even impressive growth figures on the number of mobile users was not enough to counter the perception that Telstra has run too far too fast. Although Telstra displayed the best earnings and growth outlook in years, analysts at RBS Australia, JP Morgan, and UBS, all maintained HOLD or NEUTRAL recommendations. Cochlear (COH) revealed a sudden 68% drop in NPAT to $56.8 million from $180.1 million a year ago. Total revenue dropped 4% to $779 million, down from $809.6 million a year earlier. You know the story here: the 2011 recall cost $100 million and ongoing concern about the rate of failures and loss of market share are the big risk factors. The immediate reaction to the profit drop is obvious by Cochlear's five day share price chart:
Stocks have a tendency to shoot first and ask questions later and the upward bounce following the initial 6% share price plunge may have been due to the realisation that if you take out the $101.3 million loss, the NPAT would have been $158.1 million, slightly less than the analyst consensus forecast of $160 million. However, none of this impressed analysts at the major firms. Deutsche Bank, Citi, and UBS maintained SELL ratings and JP Morgan downgraded the shares to UNDERWEIGHT. Cochlear’s CEO stated that the company “may have only lost 5% market share," which is positive news for the stock. The other positive outcome was a 4% increase in dividend. It's a little concerning that that COH shares are already trading above most analysts' target prices; prior to the earnings release, Thompson/First Call showed the average analyst price target at $61.39 (compared to Cochlear’s closing price at 09 August at $62.85). Note that immediately prior to the earnings release the shares were trading above $70. Next week, three major stocks from challenging sectors step into the earnings spotlight. Retailing, resources, and property have not been pummelled recently, so expectations for retailer JB HI FI (JBH), gold miner Newcrest (NCM), and property trust Goodman Group (GMG) are less than stellar. JB HI FI is the most shorted stock on the ASX and has been for some time. Year over year the share price has dropped 40%, only tempered by last month's rise. Here is its one month share price chart:
Retail sales have been up over the last five months. However, four interest rate cuts since November 2011 have hardly seen retail turn a corner. JBH share price was already scraping bottom when they lowered guidance earlier in the year; their lowest cost business model is putting tremendous pressure on margins in the face of increasing competition. Expectations for JBH are about as low as you can go, with anticipated drops in profit and margins, as well as same store sales comparisons. If they surprise and surprise big, a short squeeze is a real possibility but only a hardcore bull would take that chance and buy into JBH prior to earnings. Watch for management statements concerning growth prospects. Despite their troubles, it is interesting to note JBH still has BUY and OUTPERFORM ratings from RBS Australia and Macquarie. The price of gold has stabilised and is creeping up again; the long-awaited rise in share prices of gold mining stocks may be underway. Newcrest Mining (NCM) was down almost 50% heading into August, but a one-month share price chart indicates a change in sentiment towards the beleaguered miner:
Miners have been plagued by rising input costs, which favor companies with low cash costs per unit of production. Newcrest is a low cost producer so watch for any changes there. Production growth is another issue that troubles miners with small resource assets but again, Newcrest has a substantial producing and exploration asset base. Management outlook is crucial but the bigger issue for Newcrest is capital expenditures concerned with bringing some exploration assets into full production. Average analyst estimates from Thompson/First Call are - $4.44 billion in revenue with earnings of $1.39 per share. The Australian property market is certainly a risk factor here, but property trust Goodman Group (GMG) has hardely suffered from a downturn. Here is their one-year share price chart:
The company owns, manages, and develops industrial, warehouse, business park properties in Australia, New Zealand, Europe, the United States, and Asia. The move into the US market is recent and major brokers are impressed with the potential. Deutsche Bank, JP Morgan, UBS, and Macquarie have BUY, OVERWEIGHT, or OUTPERFORM ratings on the stock since the announcement. The Stockland Group (SGP) recently reported dismal earnings and an even drearier outlook. Their troubles centre around its residential and retail operations, rather than its commercial division. The big thing to watch is its European division. Goodman is moving into the Brazilian market as well, so management explanation of those plans and growth prospects may overshadow any negative news about Europe. Lastly, there's another factor impacting market reaction to earnings reports already in and those coming out in late August. That factor is a possible shift in sentiment. China released some numbers a few days ago that weren't good, but in a strange and bizarre twist, some experts are gleefully pronouncing these bad numbers as good for markets. A headline on CNBC International read “China’s Slowdown Is So Bad, the Market Is Cheering.” How can that possibly be? While industrial production fell to three year lows, so did inflation. As you know, the Chinese government has been taking steps to control the rate of inflation for over a year. Now some feel with inflation tamed, the government can move to stimulate growth in other ways. And while far from resolved, the European debt crisis appears to be under control and the employment picture in the United States has reversed its slide. All good signs for us here in Australia.
>> Click here to read other articles from this week's newsletter