Equity Strategy
29 November 2023
Earnings Watch: Downgrades the New Normal
Downgrade Cycle Still Reasonably "Normal"

Earnings revisions have slipped back into negative territory again, although the proportion of downgrades to upgrades remains reasonably normal by Australia's historical standards. 

The number of downgrades continues to outweigh the number of upgrades; however, this was typical of the decade pre-COVID.

With a depressed forward price-to earnings (PE) multiple, the market appears to be concerned about whether Australia's recent trend of negative earnings revisions is gaining momentum, with equity investor concerns around the economic outlook still lingering as they have for over a year. However, for now, there is no real evidence of a significant worsening in the downgrade cycle. 

While the market remains in a downgrade cycle, there have been pockets of positive earnings revisions.

Figure 1: ASX 200 "size weighted" earnings revision trend has slipped back into negative territory but remains “normal” by historical standards
Figure 2: The number of downgrades continues to outweigh the number of upgrades

Cyclicals Performing, Defensives Downgraded

Cyclical sectors such as banks, materials, and retail have outperformed, even in cases where certain sectors notably banks, experienced downgrades. The economy has proven more resilient than most expected, and a pronounced downgrade cycle has not materialised. This has driven a rerate in these sectors as earnings have been ‘better than feared’ overall. 

There have been minimal earnings revisions in the consumer goods (retail) and services sectors, although we have witness a divergence in the performance of the two sub-sectors over the last 3 months. The sector tilt towards defensive stocks in consumer services, which the market shifted away from due to the economy's unexpected resilience and rising bond yields, has negatively impacted the sub-sector’s performance.

Healthcare, consumer staples, and telcos have seen uncharacteristic downgrades.

These sectors are typically resilient and ‘downgrade-free’ over the cycle, and, therefore, they trade on higher earnings multiples. Consequently, companies in these sectors were sold off in the face of uncharacteristic downgrades. 

As cyclical earnings soften over the next year, a shift back to defensives is anticipated. When earnings growth is becoming increasingly scarce in a slowing economy, defensives should outperform. 


Defensives Hit by Cost Pressures

While some cost pressures are easing, a number of traditionally defensive companies have been hit by persistent cost inflation which has weighed on margins. Ramsay Health Care's (RHC) margin recovery has disappointed investors. The private hospital owner/operator has been plagued by elevated costs and weaker margins since the pandemic, largely due to a poor staff availability and elevated labour costs, as well as higher interest expenses.

Similarly, Sonic Healthcare (SHL) has received earnings downgrades from the street as it continues to face persistent labour cost pressures, which have pushed out the timeline for the company’s margin recovery.

Figure 3: Market rotating into cyclicals, even if upgrades have been minimal
Figure 4: Earnings revisions versus performance by sector

Insurance: Premium Growth

The insurance sector has maintained positive earnings momentum for the past 3 months, delivering above-market returns accompanied by positive earnings per share (EPS) revisions. The hardening premium cycle, coupled with an El Niño summer (which could result in lower perils costs), has prompted earnings upgrades in the sector, driven by improved margin expectations. Anticipating the insurance cycle to remain robust over the next 12-24 months, we have recently increased our weighting to the insurance sector and provide a detailed discussion of our perspective on insurance in our note Insurance > Banks.


Banks: Heightened Competition Driving Downgrades

While bad debts are not a material concern in our view, banks are experiencing earnings downgrades. In the latest reporting season, the big four banks and AMP Ltd (AMP)/ Bank of Queensland (BOQ) addressed net interest margin (NIM) compression. Persistent competition in mortgage lending and deposits is impacting bank earnings. Cost inflation exceeded expectations and remains a challenge for most banks. 

There is a higher likelihood of earnings downgrades than upgrades in the next 6-12 months in our view, given sustained competition and pressure on NIMs. Our portfolio maintains an underweight position in banks.

Standout Industrials

Figure 5: ASX100 (excluding resources) performance versus earnings revisions

Wisetech (WTC)/Xero (XRO): High Multiple, High Expectations

WTC is the key downgrade offender in the tech sector. Before the result, WTC was trading on a 12-month forward PE of ~85x, but the stock got punished for a downgrade to FY24 earnings. WTC’s premium valuation naturally allows little margin for error or missteps when it comes to earnings. 

This is similar to Xero (XRO), where an earnings miss due to gross margins and softer subscription growth in the UK got unduly punished at the recent result. Interestingly, XRO has seen net upgrades over the past 3 months as profitability comes more into focus.

Both these stocks look oversold, in our view.

James Hardie (JHX): Cost Disinflation Strikes Again

JHX’s positive earnings momentum has been sustained after the most recent 2Q24 result, which was another strong update from JHX, with Q2 earnings in line with expectations. More importantly, both Q3 earnings guidance, which was well above consensus estimates (27% mid-point), and an announced buyback were supportive of earnings upgrades. 

JHX has continued to demonstrate its resilience with a stronger-than-expected recovery in margins, driven by price/mix, and the disinflation of major cost items like pulp and freight. We expect further upgrades; the question is to what degree this has been ‘priced in’. At a 12-month forward PE of ~18.5x (relative to a 10-year average of ~20x), it still appears as if upgrades are not fully priced in for JHX over the next 6-12 months. 

ResMed (RMD): De-rate not Coupled with Downgrades

RMD has undergone a seldom-witnessed de-rating over the past 6 months, as the company has been being heavily impacted by 'weight loss drug mania' focused on the potential hypothetical long-term impacts that increased adoption of GLP-1 drugs could have on the size of the company's addressable sleep apnea therapy market. 

RMD posted a solid set of results and saw earnings upgrades over the past 3 months, and yet the stock has significantly underperformed. If RMD continues to upgrade and the weight loss drug mania cools, this stock will likely outperform over the course of the next 12 months, and we continue to see this pullback as a great buying opportunity.

Macquarie Group (MQG): Earnings Normalising

Macquarie Group (MQG) typically underpromises and over-delivers. However, the recent result unexpectedly fell short with a -20% profit miss. The commodity division normalised from elevated earnings in FY23, while Asset Management faced a -71% year-on-year (YoY) profit drop due to lower green energy investment income and higher interest rates. 

It is worth noting that the downgrade was attributable to non-cash earnings (accounting adjustments). Operating income was actually in line with expectations, and this is presumably why the share price has not fallen substantially.

Despite the cyclical challenges, our constructive outlook for the business remains intact, with MQG being a top-tier asset manager and investment bank with a first mover advantage in the green infrastructure space, while the retail bank continues to strengthen its position in the domestic mortgage market, bolstering the group’s ‘annuity style’ earnings. 

The current share price provides an attractive entry point, trading on a PE of 15x, with 14% annual earnings growth expected over FY24-FY26.


Divergence in Commodity Prices

There have been a number of upgrades and downgrades in the resources sector due to the underlying commodities.

Iron ore miners have seen upgrades as the iron ore price remains elevated, as China continues to provide support for the property sector (although stimulus remains measured).

The sharp decline in lithium chemical prices since late 2022, amid a slowdown in EV growth, has led to downgrades for the sector as a whole. While the lithium sector continues to exhibit significant volatility, the structural outlook remains positive. Therefore, the current weakness in the lithium sector should be seen as an attractive buying opportunity for investors.


Energy – Rally Short-lived

Factors such as uncertainty surrounding OPEC's cuts and reduced tensions in the Middle East have contributed to a decline in oil prices. This challenges energy stocks like Santos (STO) and Woodside (WDS).

Given the underinvestment in new projects (supply) over the last decade and the ongoing resilience in demand, we maintain a structural bullish outlook on oil and gas for the medium term. The recent pullback presents a favourable opportunity to capitalise on the weakness of energy stocks. Our preference is Woodside (WDS).

Figure 6: Major earnings upgrades and downgrades
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Written by

Rob Crookston, Equity Strategist

Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.

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