Reporting season may reset profit expectations

The August reporting season looms as a key test of Australian corporate earnings expectations.

The local sharemarket has held up better than most this year, mainly due to the commodity boom. Picture: Getty Images

The August reporting season looms as a key test of Australian corporate earnings expectations.

The local sharemarket has held up better than most this year, mainly due to the commodity boom triggered by the Ukraine war and Western sanctions on Russia.

However, Goldman Sachs warns that consensus estimates are vulnerable to downward pressure on profit margins from rising costs in a more challenging demand environment. Similarly, Morgan Stanley has called for a “reset” of earnings estimates for domestic-facing companies.

Against a backdrop of rising rates and a slowdown in many global leading indicators, Australian firms are set to cycle one of the strongest periods of profit growth in over two decades, says Goldman Sachs Australia equity strategist Matthew Ross.

He notes strong demand when reopening after Covid-19 lockdowns in 2021 combined with a high level of stimulus to support record earnings growth this time last year.

In other words, the hurdle for growth in corporate sales and profitability this financial year is unusually high this reporting season. The risk is that some companies will fall short of expectations.

Industrial companies deli­vered average growth in sales and earnings before interest, tax, depreciation and amortisation of 12 and 19 per cent, respectively, in the second half of 2021.

That was well above 15-year averages of 6 and 7 per cent, respectively.

“Cycling such high growth rates in the previous corresponding period, and with global recession fears rising, many investors are increasingly concerned that the upcoming earnings season will see a spike in earnings misses, given consensus forecasts still imply a very strong half,” Ross says.

But the bigger risk may be for earnings estimates for the current financial year.

“We see margin pressure from rising costs in a more challenging demand environment as the bigger risk to earnings expectations into fiscal 2023,” Ross says.

“Coming out of the pandemic many firms have seen margins expand, given the combination of strong demand and short supply, but as disposable income comes under more pressure and supply returns, we expect margins will start to normalise.”

While the speed and magnitude of the tightening cycle has made many investors concerned about how quickly the domestic economy will slow, there’s been little in the way of “hard” data (as opposed to sentiment measures) to point to a broad slowdown in activity yet.

That may explain why consensus earnings estimates have held up better than usual.

Whereas estimates are normally downgraded by about 3 per cent on average in the first half of the financial year, this year they have risen 2 per cent.

That said, the past few weeks have seen a deterioration in the revision ratio (net upgrades divided by the number of revisions) as analysts have started fine-tuning their forecasts ahead of the August results season, pushing the revision ratio to its lowest level since the onset of the ­pandemic.

Despite concerns around margins, Ross expects companies to mostly report solid second-half revenues given domestic activity has generally held up well after Australia’s delayed reopening.

“The majority of leading indicators, despite having slowed relative to the previous corresponding period, are still above trend, while higher inflation will support the revenue line, with retail sales remaining elevated across most categories,” he says.

“Housing-exposed firms are likely to see the first signs of slowing activity given the large fall in building approvals, while we expect outlook commentary will turn more cautious given the large tightening in financial conditions and the associated fall in consumer confidence in recent months.”

Moreover, margin pressure from rising costs in a more challenging demand environment may be “the bigger risk” to earnings expectations into fiscal 2023.

Ross lists Megaport, City Chic Collective, GUD, Pro Medicus, Clinuvel Pharmaceuticals, NextDC, Wisetech, Breville, Reliance Worldwide, Qube, REA, IDP Education, carsales.com.au and Altium among companies cycling very strong revenue comparisons.

Consensus forecasts assume they will report 2HFY22 revenue growth over 20 per cent above pre-pandemic levels, despite having well-above average growth-rates last year.

“While acquisitions and other restructuring will skew this simple analysis it should provide a useful starting point to highlight where hitting earnings forecasts might be the most challenging as demand starts to slow,” Ross says.

Morgan Stanley equity strategists see five themes for the reporting season.

“August result season looms and we look to five key themes that will drive sentiment and risk appetite: consumer spending trends, cost of debt sensitivity, Australian dollar tailwinds, bank sector sentiment and corporate narrative around inflationary pressures,” say Morgan Stanley strategists led by Chris Nicol.

They note that while valuations have adjusted materially in anticipation of weaker earnings resulting from an increasingly aggressive monetary tightening cycle, earnings estimates are “relatively stale” in light of the rapidly changing macroeconomic environment.

“The fluid and still uncertain nature of the macro backdrop means that explicit guidance will remain as a cameo rather than a feature in the back pages of any company result presentation – but the significant change in conditions thanks to what is an increasingly aggressive tightening cycle will require commentary and insight into the sustainability of assumptions that drive margins and operating performance,” they say.