Corporate confessions season
Corporate confessions can require multiple rounds of penance from the market.
As we near the end of another financial year end, the market is likely to go through the annual corporate confessions season ahead of reporting full year results in August. When assessing the impact of any change in earnings expectations, it is important to isolate the performance of the business in the period since the last update, as this will provide a better indication of the current earnings run rate as the company enters the new financial year.
A case in point is the announcement from Woolworths (ASX: WOW) last Wednesday. The company revised its net profit guidance from a 1.8 per cent increase in net profit as stated in February, to flat year over year. While a 1.8 per cent reduction in earnings does not appear too significant, it must be realised that all of the deterioration in full year profit expectations has occurred in the June quarter. For the fourth quarter to reduce full year profit by 1.8 per cent, earnings in the period must be down high single digits relative to management’s expectations in February.
The fall in expectations is due to the weak sales results in the June quarter for the Australian Food & Liquor division as well as the General Merchandise division. Fixed cost leverage in retail businesses means the impact of a sales shortfall is significantly larger at the profit level.
Given first half net profit before significant items was up 4.7 per cent, the guidance in February implied second half net profit would be down 1.6 per cent on the prior year. The revised guidance for flat net profit implies second half net profit is now expected to be down 5.5 per cent on the prior year. However, all of the deterioration in second half expectations, from down 1.6 per cent to down 5.5 per cent, has occurred in the June quarter. This implies that the June quarter net profit is likely to be down low double digits on the prior year, and it is this momentum that the company will be carrying into financial year 2016.
Bloomberg figures indicate that consensus financial year 2016 net profit expectations for the broking analyst community reduced by around 3.6 per cent on average post the announcement on Wednesday. However, the average forecast is now down just 4.3 per cent on financial year 2015 net guidance. Given the weak profit momentum being carried into financial year 2016, with fourth quarter net profit likely to be down in the low double digits, consensus forecasts are implying not just a stabilisation of earnings at this lower level, but a considerable recovery in momentum in financial year 2016. While this could happen, this appears to be an optimistic assumption at the present time, particularly with the potential for a new CEO to reset the market’s expectations of the sustainable earnings base for the company.
This highlights the risk that earnings expectations do not adjust for the full extent of the deterioration in current underlying profit momentum implied by a downgrade to earnings expectations late in the financial year. This quite often leads to further downgrades to earnings expectations at a later date.
Stuart Jackson is a Senior Analyst with Montgomery Investment Management. To invest with Montgomery, find out more.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Tony C
:
Add Flight Center to the naughty list and a savage price decline to what looked to me to be a very modest profit downgrade.
Two in two days has hurt what was shaping up to be a good year
Stuart Jackson
:
Flight Center is slightly different to WOW in that the changes to WOW guidance indicate a significant deterioration in earnings performance in the fourth quarter, with NPAT likely to be down double digits after growing in the first half. Flight Center’s guidance has effectively removed the expectations that second half growth would rebound as it cycled weak consumer sentiment in Australia. In August last year, Flight Center was guiding to flat first half PBT and a rebound in second half PBT growth of 8-12% relative to the prior year. The second half rebound was downgraded to between a 3% fall and a 10% increase in December. Now the company is expecting a second half fall in underlying PBT of between 3% and 8% on the prior year. Effectively the recovery has disappeared. Hence it’s not necessarily a significantly weaker fourth quarter relative to the first 9 months of the year that has brought the full year average growth rate down that would indicate deteriorating momentum. Rather it is just that the recovery didn’t occur. The effect on forward earnings forecasts is similar (ie a downgrading of the earnings growth curve), but the underlying run rate of the performance at Flight Center is likely to be more clearly apparent than for WOW. That’s not to say Fight Center doesn’t face ongoing headwinds. This disappointment comes despite resilient outbound tourist numbers due to the booking lag, which could be still to impact earnings, and the flipside benefit of the lower AUD on earnings translation from the US and UK businesses. Increased competition in the domestic market from bookings.com and AirBnB potentially indicate a more structural story operating in conjunction with a potential cyclical headwind.
Scott T
:
Welcome to the team Stuart. Looks like your timing is just as good as the rest of Montgomery staff. You open the week with a note about confession season, 3 hours later Seek hits the fan. I look forward to a Montgomery interpretation of Seek’s announcement today.
All the best
Scott T
Patrick Poke
:
Not entirely surprising Stuart, thankfully WOW has been on my ‘avoid’ list for some time now!
Curious to hear your thoughts on SEK’s ‘confession’ this morning (though I’m guessing we’ll have to wait until the fund has taken it’s chosen course of action). To me it seems like a large overreaction by the market; Seek Learning has only made up an average of about 10.4% of revenue and about 11.4% of EBITDA over the past 5 reporting period. It does have high margins at about 46.3% (1H15), but so does the employment business (57% for Au, 33% for O/S). It’s ROA is significantly lower than the domestic employment business, but significantly higher than it’s overseas employment business – reflective of the different stages of development of the 2 sectors.
Management’s comments were that it was largely caused by TAFE NSW’s system issues, which is definitely not concerning. Increased competition in the space is concerning, but due to the relatively small portion of earnings that Learning contributes, I’m not too worried.
One interesting point that came out of my sector-analysis was the ROA that the domestic employment business achieved in the 2014 FY was an impressive 89.91%. With the overseas assets being 13 times the book value of the domestic employment assets, it would not take a big increase in that 4.73% ROA for the overseas employment assets to see a huge increase in the company’s overall earnings.
All in all it didn’t have any major effects on my long-term view of the company, and given it was already a holding in my portfolio it seemed a good opportunity to pick up some more shares at a cheaper price.