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| Writedowns and raisings plague reporting season | The Intelligent Investor, 2/16/2009
The stockmarket has already predicted a slump in company profits. With reporting season now under way, we're seeing the first real signs of bad news - and there's quite a bit more to come.
The United States economist Paul Samuelson famously quipped that 'the stockmarket has forecast nine of the last four recessions'. There's no argument the market is a fickle beast, but it did a masterful job of predicting the current one. And if the size of the fall in the All Ordinaries Index is anything to go by - 53% from the peak in November 2007 to the low in November 2008 - this recession will be a doozy.
As the market is an anticipatory mechanism, it's only now that companies - with the exception of early casualties like Centro, Allco and ABC Learning - are beginning to confess their bad news. There's plenty of it around in the current profit reporting season, so let's consider some of the key themes.
Demand takes a tumble
First up, with the long boom well and truly petering out, revenues for many companies have slowed. Most retailers - with a few important exceptions - experienced negative same-store sales in calendar 2008 as the effect of earlier interest rate rises and petrol prices began to bite. To stimulate sales as the economy has deteriorated they've had to cut prices, eating into profit margins, as Harvey Norman has noted. While few retailers have reported thus far, profits are set to fall sharply when they do.
But the news for retailers hasn't been universally negative. JB Hi-Fi, with its value positioning in the 'sweet spot' of consumer electronics, reported an astoundingly good interim profit, up 41%. And online retailers with reputations for value, such as Webjet and Wotif, have also escaped the downturn - so far, at least.
Building materials companies, though, are at the coal face of weaker demand. In Australia, Boral's revenues have been hit by declining construction activity, but the US is the real problem, with housing starts there down 65% from the peak. Fibre cement manufacturer James Hardie, which generates more than 75% of sales from the US, has just announced third-quarter profit down 56%. And diversity hasn't saved Fletcher Building either, which is also suffering across the Pacific.
The currency's good for some
For companies with US operations, there is one bright spot - and that's on currency translation. The Aussie dollar has slumped more than 30% against the US dollar from its peak last July, and more than 15% against the euro, making overseas profits more valuable to Australian shareholders. So it's a shame that, in most cases, their overseas operations are deteriorating faster than their domestic ones.
For domestically focused companies, though, the volatility in the Aussie dollar is bad news for profits. Currency hedging prevented appliance manufacturer GUD Holdings from suffering during the half to 31 December, but Alesco and McPherson's weren't so fortunate. The lower dollar also means overseas travel has become more expensive, which is affecting the profits of Qantas and Flight Centre. Retailers, which typically import much of their merchandise, are trying to push through price rises - a tough ask in this climate.
For other companies, rising costs are as much a problem as slumping revenues. Road safety company Saferoads recently complained that higher steel prices - and the lower Australian dollar - were largely responsible for a 63% slump in first-half profit. Hills Industries, noting similar cost problems, reported a 10% fall in first-half profit and a profit downgrade for the second.
One of the few bright spots this reporting season has been the mining services sector. Albeit assisted by acquisitions, Bradken reported profit up 51%, and Emeco up 28%. But, with their resource company clients cutting back, it's almost certainly a last hurrah, and high debt levels won't make life easy for them.
Writedowns ramp up
With margins and cash flows for most companies under pressure, and asset prices slumping, writedowns are also looming as a significant issue. Auditors are exerting pressure on companies to write down goodwill and other assets. Last week, Australian Wealth Management was forced to make goodwill writedowns of $146m by its auditors, while Leighton Holdings wrote off $239m on its holdings in various listed construction and infrastructure investments.
Most companies, determined to look on the bright side, trumpet that writedowns are 'non-cash'. But that doesn't quite tell the full story. Companies can only legally pay dividends from profits, and large writedowns often wipe out any retained earnings on the balance sheet. Australian Wealth Management, for instance, had to cancel its interim dividend for exactly this reason. We believe other companies with significant intangibles on their balance sheets - Wesfarmers has $21bn, for example - are also at risk of large writedowns this year. More dividend cancellations are expected.
Writedowns, by reducing the 'equity' part of the balance sheet, can have other economic consequences too. Lenders usually require companies to maintain certain banking covenants, such as a specified net debt-to-equity ratio, for example. Reduced shareholders' equity makes for nervous lenders and, occasionally, for breaches of banking covenants.
Gearing's not great
While on the topic of debt, lower asset values and sagging cash flows are having another effect. Companies - and their bankers - are realising that boom-time debt levels are no longer appropriate. Debt, in short, is as popular as a python at a picnic. It's why we're seeing a significant number of capital raisings, with more than $9bn already raised this year (see table). Many more are expected, with companies such as PaperlinX, OneSteel and Boral still too highly geared for comfort.
Capital raisings in 2009
| Company | Minimum raised ($m) |
| BlueScope Steel | 113 |
| Bank of Q'land | 108 |
| Lend Lease | 303 |
| Macquarie Office | 508 |
| Newcrest Mining | 750 |
| Qantas | 500 |
| Suncorp Metway | 855 |
| Tabcorp | 300 |
| Wesfarmers | 2,900 |
| Westfield | 2,900 |
| Westpac | 442 |
| | 9,679 |
Most capital raisings, though, have been by relatively large companies. Highly geared small companies, such as Alesco, are trying to avoid a 'dilutive and expensive equity raising', as it recently reported. But shareholders are paying for the group's debt levels in another way, with the company recently suspending its interim dividend.
Even relatively conservatively geared smaller companies, such as WHK Group, have made surprise cuts to their dividends this reporting season. Once cash-rich companies, such as West Australian Newspapers, have recently established dividend reinvestment plans to cut debt.
Larger companies have also reduced payouts. Wesfarmers recently announced its dividends for the 2009 financial year would not exceed $1.00 a share, down from previous expectations of $2.00 a share. AMP has just cut its final dividend from 24 cents to 16 cents. And while Commonwealth Bank maintained its interim dividend, management warned that the final dividend was at risk.
Banks begin to stumble
Few industries are more intimately connected with the economy than the banks. Here, too, evidence from reporting season shows things will worsen. Most of the much higher bad debt expense in Commonwealth's interim result was from exposure to large corporate failures such as ABC Learning Centres. The deterioration in the small business and consumer portfolio is yet to fully flow through but, as unemployment rises, it's bound to come.
In Suncorp Metway's case, exposure to failed property developers and 'major weather events', combined with buying Promina for a nosebleed price, has necessitated one of those 'dilutive and expensive capital raisings', to use Alesco's words. With smaller banks under pressure, the big four are increasing their market shares in both loans and deposits.
Well aware that conditions are worsening, and that there might be an opportunity to pick off weaker competitors, Commonwealth and Westpac have recently raised more capital. ANZ has recently denied the need for an equity raising, but it's the quick or the debt-ridden at the moment. Companies that delay their capital raisings - or try to muddle through - are tending to come off second best.
Guidance goes west
With the economic environment as uncertain as it is, it's no surprise that few companies are providing profit guidance. Retailers began saying 'no comment' last year, and even sector standout JB Hi-Fi warned recently that the 'retail outlook is less certain than previous reporting dates'. Leighton was one of the few to give a reasonably upbeat statement on both its short- and long-term outlook, probably a function of its size and diversity.
And yet, for all the profit pain we've had this reporting season, there's certainly more to come. Many companies now reporting results noted that conditions were fine until about November, when demand fell off a cliff. With the pundits tipping unemployment to rise from 4.8% to more than 7% this year, 2009 is set to be a much tougher year for company profits. But, while the worst of the profit downturn might not be seen for another six months or more, share prices are already anticipating a lot of pain. Bad news doesn't make for poor investing conditions - quite the opposite in fact.
With dividends under pressure, and capital raisings aplenty, there will be demands on your cash flow this year. But now isn't the time to panic. Rather, with share prices having halved, it's time to make your own 'wonderful watchlist'. Because one thing's for sure - smart investors are already positioning themselves for the upturn.
Disclosure: The author, James Greenhalgh, and other staff members, own many of the stocks mentioned. See the staff portfolio on the website for a full listing. Published online on 16 Feb 2009.
About the Intelligent Investor
Independent, jargon free advice written especially for the private investor who wants to learn more about the secrets of successful investing. Printed each fortnight, The Intelligent Investor is advertising free and crammed with independent advice on over 25 stocks. More info / FREE newsletter. |  |
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