The O'Brien Column: Performance reflects flexibility of small firms over large entities

By Peter V O'Brien

Friday 18th February 2000

Investors in the New Zealand sharemarket are expecting some significant profit increases this year, judging by the historic price/earnings multiples attached to several stocks.

Historic multiples have to be treated cautiously because they are exactly that: historic. They relate to what has happened but the market operates on what is likely to happen in future.

Variations between high and low multiples can also be misleading, whether historic or analysts' prospective projections, because a low figure can reflect the market's view that the outlook for a particular company is weak and, conversely, a high multiple can be related to very low earnings but relatively high share prices.

The matter of a "particular company" is also relevant to the debate about the sharemarket's overall performance, discussed in the O'Brien column on the next page.

There can be a problem in assessing historic multiples, due to variations between a company's reported earnings a share, which might take account of unusual items (if they are gains), and analysts' adjusted earnings a share, which usually take out one-off items.

Meat company Affco was an example of the problem. The company reported an after-tax profit of $6.52 million for the year ended September 30, but that included $6.42 million of net gains on sale of assets.

The company said its diluted earnings a share were 3.41c, which would give a historic p/e of 11.7 at the current share price of 40c.

Deduction of the $6.42 million gain on sale of assets would have reduced the net operating profit after tax (actually a tax credit last year) to a figure which The National Business Review's share table put at 0.1c a share, to produce a massive p/e.

There can be variations in calculating such adjusted earnings per share (eps), so the Affco example should not be taken as the last word on the subject.

High-flier stock Baycorp Holdings is a better example of a high historic p/e. There was general agreement the consumer and business credit information and debt collection company earned 17.6c a share in the year ended June 30 from net profit of $13.45 million.

That gave a historic multiple of 51.7 at a share price of $9.10 but the market expected a significant improvement in earnings in the current term, a guide to which would be available in the interim report due yesterday.

Baycorp's annual meeting in November was told the company's opportunities for increased profitability would emerge mainly from three key strategies.

The first would be to obtain further leverage in the New Zealand market. Raising market awareness of Baycorp's core services, new business solutions and "expertise as a provider of outsourcing services" would help to attract potential customers and to ensure future business from customers it already had.

The second strategy was the expectation that the Australian joint venture Alliance Group Holdings would offer considerable future earnings potential and the opportunity to draw on the group's advanced technology.

Building more alliances, using the company's technological strength in the domestic and international marketplace, was Baycorp's third key strategy.

The market perceived Baycorp had entered a growth path, both locally and overseas, and rerated the company's share price considerably over the past year.

That historic price/earnings multiple should fall substantially, assuming appropriate earnings a share growth is realised.

Evergreen Forests was another example of a company with a relatively high p/e multiple. It reported last week on the six months ended December 31. The forestry group earned 2.4c a share in the year ended June 30, 1999, which produced an historic multiple of 20.8 at a share price of 50c.

Evergreen's latest interim report showed eps as 1.1c on a diluted basis, after treating convertible notes as converted, compared with 0.68c a share in the corresponding period of the previous year.

Assuming the company earned the same amount in the second six months as in the first (a theoretical approach), full-year eps would be 2.2c on a diluted basis and the projected p/e to June 30 this year would be 22.7. But on an undiluted basis - comparable to last year - the eps would be 3.26 and the undiluted p/e multiple would drop to 15.6.

That was admittedly theoretical, particularly the exercise involving undiluted eps, but it showed how improved earnings, or expectations thereof, can have a significant effect on a company's share price relative to its historic p/e.

A glance at historic price/earnings multiples of more than 20 in most share tables showed investors' expectations of improved profitability were probably justified.

The list included Auckland International Airport, Independent Newspapers, Metropolitan Lifecare, Nobilo, Port of Tauranga, South Port, Trustpower, The Warehouse Group and Waste Management.

That list could be a useful portfolio in anyone's hands but also showed the market looks ahead, rather than back.

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