Reporting season preview: Confess or impress this reporting season

Having endured a trying six months to the end of 2011, Australian equity investors breathe a sigh of relief as the start of the year has been far more positive. As the 2012 February reporting season approaches everyone is now asking what will this season reveal? Research house and fund manager Lincoln Indicators believe that this reporting season is likely to see a continuation of Australia's two-speed economy, and may reveal challenging circumstances in Australia generally. That said the opportunity for real wealth creation purchasing deeply discounted companies is enough to get every investor excited.

Lincoln CEO Elio D'Amato explains, "In recent weeks we have witnessed the markets ruthless reaction to disappointing company announcements and, despite low equity prices, some of these reactions have been justified. The stakes are high and disappointing earnings results will be treated accordingly. However, as always, tough times can provide investors with huge opportunities to get their portfolio rebalanced and ready for better times. The reporting season provides us with up to date information that investors can utilise to get set for the future."

This reporting season will reveal generally weaker results than in recent post GFC memory, but quality businesses will still report well. "Investors should be wary that poor results will be punished harshly by the market. However, despite the volatile market conditions, there are some real gems out there if you do your research" says D'Amato. "And this is no doubt reflected in the announcements that have been feeding through from companies at the coalface over the last six months."

Looking forward, conditions will improve in Australia through a possible relaxation in monetary policy and a global shift from global central banks towards fiscal loosening in order to stimulate growth. Undoubtedly, macroeconomic conditions remain turbulent as the European region battles a suffocating debt burden and the US attempts to spend its way to growth. However, Australia's newly crowned largest trading partner, China, may have some tricks up its sleeve in the form of looser monetary policy. Such action has already given the country the ability to produce a better than expected GDP growth rate in the December 2011 quarter.

With the scene set, this February reporting season is likely to be one of hits and misses. Investors should take the opportunity to ensure they are comfortable with the levels of risk their portfolio represents before the news starts to flow. Ultimately it will be the healthy companies with strong balance sheets and cash flows that will rebound strongest and reward the bold and brave investor savvy enough to pick up a bargain.

The macroeconomic drivers

Australia's futures market is factoring in two interest rate cuts over the next 12 months, suggesting that easing monetary policy may begin to provide relief to the growing number of sectors experiencing the squeeze. "Although the futures market is factoring these cuts in 12 months, we expect two interest rate cuts to come sooner rather than later, as retailers and the traditional economy continues to struggle. However, the attitudes of fiscal and monetary policy makers may be more influenced by the global macro environment than has been the case in the past." Despite the broad factors driving the case for easing, Australia is fast becoming one of the last bullish havens with growth being driven by continuing strength in commodity prices.

This is where policy makers in Australia are facing inherent difficulties. Whilst the traditional economy continues to struggle, moves to ease policy only serve to increase the magnitude of inequity in our two speed economy by facilitating faster growth in the resources and energy sector. So whilst we are expecting an easing in monetary policy, there may be some reservations held by the Reserve Bank of Australia before the scales are tipped.

Likely misses this reporting season

Unfortunately for many Australians, the recent economic weakness has hit hard, and nowhere has this been higher profile than the retail sector. An epidemic of earnings warnings - David Jones Limited (DJS), Billabong International Limited (BBG), JB Hi-Fi Limited (JBH), Kathmandu Holdings Limited (KMD) - have set market expectations low as we approach the confessions season. Mr D'Amato elaborates "Despite low expectations for the retail sector this reporting season, we are still of the view that the risk of further disappointments does exist in weaker companies. That said there are some better placed to weather the storm." He continues, "Super Retail Group Limited (SUL) and Thorn Group Limited (TGA) are our preferred retail exposure, and the fact they are producing solid returns in this environment is a testament to the strength of these businesses. Unfortunately outperformers in this sector are expected to be few and far between."

Outside retail, building products and manufacturing businesses have been responsible for a number of downgrades to market expectations such as OneSteel Limited (OST), BlueScope Steel Limited (BSL), GWA Group Limited (GWA). "Traditional manufacturing is a sector that is under pressure. Unfortunately construction has been weak, and with lending a bit patchy we don't see building products reporting well in general."

Despite the enticing dividends being offered by Australia's financial institutions, "Banks are unlikely to produce inspiring earnings growth when reporting this February. Traditional earnings growth spurred on by lending and expansive credit markets will be difficult to produce." That said, at current prices the investment case for many of our major financial institutions does remain strong if you are an income seeking investor. So whilst a parallel can hardly be made in the expectations for the financial sector and the expectations for the retail sector this reporting season, the catalysts for growth that investors may look for in a financial report are likely to be absent.

In a similar and perhaps more sinister vein than banks, insurance businesses are also set to report disappointing results this reporting season. "It is the nature of many insurance companies that their risks, from an earnings point of view, are tied into claims activity. This in turn is tied to the insurable event, and as we have seen in 2011 natural disasters can really hurt an insurance company's bottom line." We have seen from recent announcements by QBE Insurance Group limited (QBE) and Suncorp Group Limited (SUN) that the insurance sector is struggling, and we believe this will continue.

Likely hits this reporting season

We believe businesses that service the mining and energy sectors represent deep value at current market prices and are our pick for sectors that will outperform in 2012. With capital expenditure expectations remaining strong, and major mining businesses making significant reinvestment into the development of their Australian assets, these mining services businesses are likely to report promising earnings numbers generally.

Whilst the market is jittery, many investors will continue to look towards defensive stocks to provide solace in their portfolio. This is an effective strategy for capital protection, however stock selection remains of significant importance. "Investors should look to the telecommunications, IT and healthcare sectors with some optimism, as these areas of the economy have an established defensiveness to their earnings and are generally less discretionary than the sectors we are expecting to struggle," says D'Amato.

In addition to mining and energy based services, there are some businesses that are likely to outperform in the discretionary services sector, when reporting financial results this term. "Businesses at the forefront of technological innovation, or possessing some key competitive advantage are more likely to report well. Examples of such companies would include REA Group Limited (REA), Fleetwood Corporation Limited (FWD), Corporate Travel Management Limited (CTD), Carsales.com Limited (CRZ), and Mermaid Marine Australia Limited (MRM). "Stock specific research has never been more important than now under fast moving and volatile market conditions. Any weakness is punished, so selections should be based upon an examination of a company's Financial Health position, growth prospects, and outlook."

Commodities in focus

Given expectations that commodity based businesses will continue to drive growth in the Australian economy, it is important for investors to understand the underlying commodity price drivers for the coming period.

"Of late commodity prices have not experienced the unyielding strength of years gone by, but the fundamental supply demand drivers for the resources and energy leveraged sectors of the Australian economy remain solid," explains D'Amato. "The last few months have seen some uncertain and nervous times for commodity exporters which is best highlighted by the dip in realised iron ore prices at Fortescue Metals Group Limited (FMG). However, we remain positive on most bulk commodities as the competitive advantage of exporters (as compared to Chinese producers) remains intact." Certainly that rings true for iron ore, however coal export prices have suffered slightly after supply has clawed back from the floods in Queensland late last year.

One notable performer over recent years includes Lincoln Star Stock Iluka Resources Limited (ILU), which is one of the world's foremost producers and exporters of mineral sands. And despite the positive longer term share price run that the company has seen, Mr. D'Amato believes that the outlook for mineral sands remains positive: "Whilst many may be doubting ILU given a plateau in zircon production being reached in the recent times, the company is actually exhibiting its agility by shifting the focus to rutile (titanium dioxide) production in order to take advantage of recent price strength."

Of course, niche commodities aside, all things shiny have been nearer the front of investor's minds, as gold and precious metal producers continue to dazzle the market. However, in recent times gold prices have wavered (most market prices have seen extreme volatility). We maintain our view that gold is reasonably priced at current levels, and whilst strong gains are unlikely, stability in the gold price at such inflated levels would be beneficial to our gold producers. Of note in the sector, is a junior producer and Star Stock, Silver Lake Resources Limited (SLR). "The company is one of many gold producers making hay whilst the sun shines, and we are expecting a decent report from many of this ambitious gold company's operations despite a bit of volatility creeping into pricing."

Finally on the commodity outlook, D'Amato explains Lincoln's thoughts on energy prices, "There is good stability under the oil price at US$100 per barrel in our view. And certainly with the situation in Iran and other globally material oil producing nations there is the potential for upside shocks to that price in the coming six months." LNG is fast becoming an important part of the Australian landscape, and high hopes are held out for Papua New Guinea (PNG) LNG participant Oil Search Limited (OSH).

Dividends in focus

As mentioned earlier, many investments are appealing solely by virtue of their income potential, let alone any capital appreciation. However, with the shock of QBE's dividend cut still searing into many income investors' minds, it is important to exercise discretion when investing with income objectives in focus. Elio D'Amato explains, "QBE is a perfect example of a dividend trap. Dividends can represent fantastic value, especially with the benefit of imputation credits, but the dividend must be sustainable. Investors should be wary of businesses in sectors that are struggling, or are in a situation that may see difficulty in earnings growth". Certainly with the tough times in retail, manufacturing and some financials (largely insurance), considering the certainty of a dividend yield is arguably as important as examining the company's historical dividend yield itself. "Remember high yields are often based on historical payouts, and can be caused by either good payout ratios, or in many cases, a declining share price. And in some cases the low share price should be a warning flag."

Whatever your investment objective, there will be plenty to consider this February. Certainly the market is likely to be led by commodity based businesses, with some potential dividend plays offering investors a shield from the tough times. Discerning investors who select financially healthy stocks which have a proven track record of generating increasing returns offer shareholders strong opportunities to outperform.

Lincolns top ten stocks to watch this reporting season

Fortescue Metals Group Limited (FMG)
Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $6.92

FMG is an emerging large scale iron ore producer operating in the Pilbara. The company is currently producing roughly 55 mtpa, but has ambitious aspirations to achieve production of 155 mtpa in financial year 2014. These plans should cost the company around $10 billion in capital expenditure inclusive of its mining fleet. Despite its high profit margins, FMG's leverage and aggressive growth plan results in a risky but high growth exposure to iron ore.

OilSearch Limited (OSH)
Stock Doctor Recommendation: Accumulate
Financial Health: Strong
Lincoln Valuation: $7.83

OSH continues to make solid progress on its flagship PNG LNG project with development on schedule and only slightly above budget. The company's producing assets in Papua New Guinea continue to provide the company with a good stream of cash flow. There is the scope for further upside in 2012 as OSH embarks on an ambitious exploration program which aims to locate additional resources for the development of further LNG trains.

Iluka Resources Limited (ILU)
Stock Doctor Recommendation: Accumulate
Financial Health: Strong
Lincoln Valuation: $21.18

ILU is a major mineral sand producer operating in Australia and the USA. Whilst ILU has focused on the market for zircon in recent times, the advantageous pricing environment for titanium dioxide (rutile) has enabled the company to show an extra dimension. ILU is uniquely equipped to activate marginal rutile production as prices trend upwards, and similarly switch off such production in times of price deflation. Positively for investors, titanium dioxide pricing has been strong of late, and this is forecast to continue.

Mineral Resources Limited (MIN)
Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $14.24

Mineral Resources is traditionally a mining services business, specialising in crushing services provided to iron ore producers. However, in recent times the company has shifted to production of its own and has successfully shipped first ore from its Carina iron ore deposit in Western Australia. With expansion plans on the horizon, and port capacity to ramp up to 4.4mtpa for export, the company presents strong growth fundamentals for investors to consider.

McMillan Shakespeare Limited (MMS) Stock Doctor Recommendation: Buy
Financial Health: Satisfactory
Lincoln Valuation: $11.06

Salary packaging and fleet management provider McMillan Shakespeare is expected to report strong results this half. We expect the benefits gained by complementary growth opportunities from the acquisition of Interleasing to contribute to performance this period. Furthermore, employment in Australia remains resilient, which is a key sensitivity for MMS.

Decmil Group Limited (DCG) Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $2.79

Having announced the acquisition of an interest in an accommodation camp in Gladstone QLD, Decmil Group presents investors with a more diversified risk exposure than in the past. We expect some margin expansion to be reported, as the civil EPC contractor looks to take advantage of the resources and energy boom time.

TPG Telecom Limited (TPM) Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $1.95

Shares in low cost internet service provider TPG Telecom has underperformed over the last six months. However, this share price movement has been based largely upon TPM's increased holding in listed competitor iiNet Limited, and the ensuing market speculation of possible merger and acquisition activity. In our view this is a transaction that remains unlikely to occur given the clear differences between the two businesses. As such, and with an established brand and reputation for low cost quality internet service provision, TPM has been underestimated by the market in the lead up to this reporting season, and offers investors a healthy discount to our Lincoln Valuation.

Hansen Technologies Limited (HSN) Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $1.15

HSN represents a reliable stream of earnings as it provides integrated billing systems which are intrinsically embedded into their customers' businesses. The company's contract in Spain, signed six months ago with telecommunications company Tuenti, provides an avenue for further geographical growth. We are expecting a modest uplift in earnings in financial year 2012 with the company offering investors a solid dividend yield.

Silver Lake Resources Limited (SLR) Stock Doctor Recommendation: Accumulate
Financial Health: Strong
Lincoln Valuation: $4.09

SLR is an emerging gold producer focused on its brownfield Mount Monger mine and Murchison prospect. The company has been frugal in implementing its expansion plans, which has worked to its benefit in implementing stepped multi-mine projects. Production levels should continue to improve over the course of the next few years, with upgrades to its Lakewood ore processing facility at Mount Monger and subsequent refurbishment and relocation of its Leonora processing facility to Murchison.

Forge Group Limited (FGE) Stock Doctor Recommendation: Buy
Financial Health: Strong
Lincoln Valuation: $6.15

FGE is growing in status to be a serious player in the engineering, construction, management and maintenance space. A financially strong company with an exceptional order book and strong prospects, the company recently invested further into the burgeoning energy and utilities management sector through the acquisition of CTEC Pty Ltd. With capital expenditure on mining projects expected to remain strong for some time, FGE is diversifying its operations to broaden its revenue stream in the long term while leveraging of its current reputation as a quality provider of services.