The February 2023 reporting season was a ‘mixed bag’, with a relatively large dispersion of outcomes between different sectors and companies.

In aggregate, the ASX 200 experienced downgrades of ~2.3% to 12-month forward EPS expectations in February, as analysts factored further evidence of lingering cost pressures and a softening consumer into their forecasts.

Market expectations are now for the ASX 200 to grind out EPS growth of 5.0% and 0.7% in FY23 and FY24, respectively, representing a marked slowdown from the growth of 22.5% seen in FY22.

We think there is more downside for earnings in FY23 and FY24 as the economy is likely to soften further from here. However, we are seeing pockets of resilience that should hold up well through this downgrade cycle.

In this note, we explore how the Wilsons Australian Equity Focus Portfolio is positioned in relation to the key themes we are paying attention to from reporting season.

Reporting season provided further evidence that consumers are paring back their expenditure on discretionary goods and big-ticket items, as pulled-forward demand from COVID unwinds and cost of living pressures eat into household budgets.

Bellwether retailer Harvey Norman’s (HVN) trading update showed its Australian same-store sales fell ~10% in January compared to the year prior, while in the same period, JB HI-FI’s (JBH) like-for-like sales growth decelerated to 1.5% (vs FY20) from 26% (vs FY20) a year earlier.

The moderating consumer demand backdrop has driven a rise in inventory levels for some names. Not only is sitting on elevated inventories often a forward indicator of softening demand, it can also create additional costs (e.g. warehousing) while it weighs on free cash flows and increases the risk of product obsolescence, which can necessitate an increase in promotional activity to clear stock.

A number of businesses, including JBH, have signalled that discounting is ‘starting to build’, which has contributed to our cautious stance towards retail and consumer goods, as weaker top-line growth combined with increased discounting and fixed cost deleverage is ultimately a recipe for weaker operating margins.

There has also been increasing commentary that consumers are ‘trading down’, with Woolworths (WOW) CEO Brad Banducci saying consumers were eating more at home rather than dining out, for example.

That said, it hasn’t been all bad for consumer businesses.

Some consumer services companies produced strong results on the back of normalising spending patterns post-COVID with progressively more money being spent on services than goods. The Lottery Corporation (TLC) (Focus Portfolio 3%) had a stellar 1H23 result, which included EBITDA growth of +15.8% as lottery sales were resilient. At the same time, margins benefitted from an increasing penetration of the digital channel.

There were also pockets of resilience from retailers with well-capitalised core customers (i.e. with less mortgage debt) and store roll-out initiatives. In this vein, Universal Group (UNI) (Wilsons O/W) and Lovisa (Wilsons O/W) both released positive trading updates highlighting sales growth of +16.8% and 24.3%, respectively, in the first 7 weeks of CY23.

Cost pressures have been broad-based to date, impacting everything from cradle (Baby Bunting’s (BBN) infant goods stores) to grave (Invocare’s (IVC) funeral services).

The most widespread (and potentially persistent) hit to margins has been from higher employee costs stemming from the tight labour market. For instance, Cleanaway (CWY) (Focus Portfolio 3%) reported a heightened number of job vacancies caused employee costs to rise +16% due to the need to pay more overtime and use more expensive labour hire contractors.

However, there is growing evidence that supply bottlenecks and energy costs are starting to ease, providing some relief to margins. Wesfarmers (WES) pointed to a ‘normalisation’ of its supply chains, while Super Retail Group (SUL) (Wilsons M/W), highlighted shipping rates improved markedly in 1H23.

While we expect inflation to ease over the medium-term, the near-term threat to profitability is nevertheless meaningful and we see further downside to margins from here, particularly in more cyclical sectors with less pricing power (e.g. retail, discretionary goods).

While a number of services businesses performed admirably in 1H23, none have quite measured up to the strength of those leveraged to the rebound in travel, which reported exceptional results as the significant pent-up demand following years of restrictions continued to be unleashed by consumers.

We have been positive on the ‘re-opening thematic’ for some time on the view that the market has underestimated the significant amount of pent-up demand for travel, which has helped keep air passenger volumes elevated, even in the face of elevated prices and the broader consumer slowdown.

We think this trend still has further to run in 2H23 and FY24, with consumers continuing to prioritise their expenditure on travel over other items while international travel remains well below pre-pandemic levels. China’s recent re-opening from lockdown provides another tailwind for the sector.

Housing-exposed companies have been heavily impacted by softer global housing markets, including James Hardie (JHX) (Focus Portfolio 3%). Weaker US housing construction activity saw JHX downgrade its FY23 NPAT guidance for the third time by ~10% to a range of US$600m-US$620m, implying broadly flat growth over the year.

Despite the near-term cyclical challenges, the market’s reaction to these results was relatively sanguine.

In our view this reflects the fact that housing exposed shares had already de-rated considerably, pricing in cyclical weakness well before any EPS downgrades came through. As housing exposed companies are seemingly near ‘peak pain’ and approaching the end of their downgrade cycles, investors appear increasingly focussed on the attractive longer-term structural outlook for these companies and the valuation discount currently on offer for patient capital.