Brian Gaynor: Top firms need to lift earnings performance

Photo / Sarah Ivey

The June 30 year was another positive 12 months for the NZX as the benchmark NZX50 Gross Index appreciated by 15.8 per cent compared with 30.6 per cent for the previous June year.

The New Zealand sharemarket, as measured by the benchmark index, is now 113 per cent above its March 2009 global financial crisis low.

The NZX MidCap Index appreciated 17.9 per cent in the latest June 2014 year, the NZX10 Index - which contains 10 of our largest listed companies - was up 13.1 per cent and the NZX SmallCap Index 10.2 per cent.

The performance of the large, medium and smaller companies has been remarkably similar since the GFC with the small caps up 127 per cent since March 2009, the mid caps 122 per cent and the top 10 110 per cent.

The three best performing top 10 companies since March 2009 have been Xero with a positive 3614 per cent return, Ryman Healthcare 684 per cent and Auckland International Airport 174 per cent.

The top performing mid cap companies have been Diligent with plus 2467 per cent, A2 Milk 1050 per cent and Pacific Edge 625 per cent while the best small caps have been Hellaby Holdings with a 884 per cent return, Promisia Integrative, 880 per cent, and Turners Auctions, 675 per cent.

Can investors realistically expect the NZX's fantastic performance to continue?

Company earnings are the sharemarket's most important driver even though a small number of companies may be an exception to this rule. Xero and the other loss-making technology companies - both here and overseas - are obvious examples of these exceptions.

Thus, the future direction of the NZX will be determined by the earnings performance of our largest companies, particularly the most heavily weighted NZX50 Index companies.

The accompanying table shows the actual and forecast net earnings for the 20 largest NZX50 Gross Index companies. As these 20 entities represent 72.8 per cent of the index their performance will effectively determine the future direction of the NZX.

The figures are compiled from reported earnings and consensus broker forecasts. This methodology raises some anomalies, particularly in relation to Ryman Healthcare. The company reported net earnings of $195 million for the March 2014 year but analysts base their forecasts on underlying earnings, which are lower.

Thus Ryman looks as if it will report a decline in earnings for the 2014/15 year, according to the accompanying data, whereas it is expected to report an increase in earnings on a similar accounting basis.

Although the data has a number of anomalies it is a fairly accurate measurement of the profit performance of our largest listed companies.

The first point to note is that New Zealand may have a rock star economy but it certainly doesn't have a rock star listed corporate sector. In other words most of our largest listed companies haven't managed to hitch a ride on the booming economy as total earnings are forecast to be flat over the next two years.

These forecasts are a concern because brokers usually have a positive bias and there are more profit downgrades than upgrades at present.

A number of comments can be made about these top 20 companies and their earnings performance:

Our listed company sector is extremely small with the 20 largest listed companies reporting total net earnings of only $2.7 billion, or just 1.2 per cent of GDP, for the 2013 fiscal year. By comparison, the four major Australian owned banks reported total New Zealand earnings of $3.8 billion for the same 12-month period.

The electricity generators (Contact Energy, Meridian Energy and Mighty River Power) and property groups (Kiwi Income Property Trust, Goodman Property Trust and Precinct Properties) are all relatively stable with limited profit growth opportunities, at least in the short run.

Auckland International Airport, Infratil and Port of Tauranga are infrastructure companies with steady, but relatively subdued, profit growth prospects.

SkyCity and Trade Me seem to have run out of steam while Telecom, Sky TV and Z Energy also have relatively subdued growth prospects even though they are well managed.

This leaves only Fletcher Building, Ryman Healthcare, Fisher & Paykel Healthcare, Xero, Mainfreight and Air New Zealand with significant profit upside potential among the 20 largest listed companies. However, Xero should also be excluded because it will continue to report large losses for the next few years.

Fletcher Building is arguably the most disappointing top 20 company as it hasn't been able to hitch a ride on our rock star economy even though building and construction are major drivers of the economic upturn.

Chief executive Mark Adamson and his management team are increasingly looking like bemused surfers watching wave after perfect wave pass them by.

The domestic building sector started gaining strong momentum around 12 months ago and Fletcher's earnings for the six months ended June 30, 2014 and December 31, 2014 should benefit from this massive upturn yet there are rumours of imminent broker profit downgrades for the June 2015 year.

What is wrong with the company?

Has it made ill conceived overseas acquisitions as did its predecessor Fletcher Challenge in the 1980s?

There is a strong argument that shareholders should be advocating a break-up of Fletcher Building into two separate companies, New Zealand and overseas. This would allow investors to choose whether they wanted exposure to the domestic or overseas economy as Fletcher Building seems to be adversely affected by a weak NZ economy when Australia is doing well and by a downturn in Australia when New Zealand is picking up.

Ryman Healthcare has excellent long-term growth prospects but it only has targeted earnings growth of between 15 per cent and 20 per cent per annum because of land constraints and the unwillingness to take on too much risk.

Nevertheless Ryman had average sharemarket returns of 44.4 per cent per annum over the past five years meaning that its price/earnings multiple is getting higher and higher.

Fisher & Paykel Healthcare has gained huge momentum in recent years even though the high New Zealand dollar has created huge headwinds for the company.

Mainfreight, which has a great sense of history and has recently released another excellent annual report, has genuine growth prospects with operations spread throughout the world. Finally, Air New Zealand has performed extremely well in recent years.

The direction of the domestic sharemarket is probably more dependent on the profit performance of Fletcher Building, Ryman Healthcare, Fisher & Paykel Healthcare, Mainfreight and Air New Zealand than anything else. Fletcher Building and Air New Zealand will report June 30 year earnings next month while Ryman Healthcare will hold its annual meeting on July 30, F&P Healthcare on August 20 and Mainfreight on June 30.

These announcements and meetings will have a big influence on investor sentiment.

Meanwhile, the US Dow Jones Industrial Average (DJIA) closed at over 17,000 on Thursday while the NZX50 Gross Index, which includes dividends, finished at 5167, and the NZX50 Index, which excludes dividends, closed at 2759.

In the early 1980s the NZX50 Index was actually higher than the DJIA, which also excludes dividends, in numerical terms.

Wall Street has performed far better than the NZX over the past 30 years because the earnings performance of the country's largest listed companies has been far superior.

Our large listed companies need to perform much better if the current sharemarket momentum is to be maintained.

• Brian Gaynor is an executive director of Milford Asset Management which holds shares in all of the companies mentioned on behalf of clients.