Zacks Earning Trends

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1 October 4, 2016 Zacks Earning Trends Sheraz Mian Is Earnings Recession Coming to an End? Earnings growth is expected to be in negative territory in the Q3 earnings season, which will follow 5 back-to-back quarters of earnings declines for the S&P 500 index. But many in the market don t see the earnings picture in those grim colors. In fact, many see this earnings season as an inflection point, with earnings declines coming to an end and steady growth resuming from Q4 onwards. Driving this view are three key points. First, the magnitude of negative revisions that Q3 estimates suffered were lower compared to what we had seen in the preceding quarters. Estimates for Q3 came down as companies reported Q2 results and guided lower, with expectations of earnings growth for the S&P 500 index dropping from an essentially flat reading at the beginning of July to the current -2.9%. This is a lower drop than we became used to seeing in the comparable periods in the preceding quarters. Second, the -2.9% decline in Q3 earnings on +1% higher revenues will be the lowest decline rate expected at the start of the season. At the comparable stage in the Q2 earnings season, earnings growth for the S&P 500 index was expected to be -6.2%, which actually turned out to be -2.8%. We had similarly bigger decline rates expected at the start of earnings season in Q1 and the quarters prior to that, with actual earnings growth rates coming in better than pre-season expectations by about +2% to +3%. If Q3 results follow this trend, the finally growth tally will most likely be close to a flat finish. Third, the Energy sector still remains a big drag on the aggregate growth picture, with total earnings for the sector expected to be down -66.6% from the same period last year. Excluding the Energy sector, total earnings for the S&P 500 would be modestly in positive territory, up +0.3%. The Energy sector still has plenty of challenges, but the tyranny of tough comparisons is starting to fade. It is a smaller burden in Q3 than was the case in either of the preceding two quarters and comparisons are expected to turn positive in the following earnings season. Standout Sectors this Earnings season Earnings growth is expected to be negative for half of the 16 Zacks sectors, led by Energy (- 66.6%), Transportation (- 21.8%), and Autos (- 18%). The Transportation decline is primarily concentrated in the legacy air carriers, particularly American Airlines (AAL) and United Continental (UAL) that are experiencing higher costs following recent labor contract awards. The Auto sector s growth issue is primarily due to Ford (F), which guided lower the last earnings season. Growth is expected to be negative for the Technology sector as well, with total earnings for the sector expected to be down -1.9% from the same period last year on -1% lower

2 revenues. The Tech growth challenge is primarily concentrated in Apple (AAPL) whose September-quarter earnings are expected to be down -20.7% on -9.6% lower revenues. Excluding Apple, the sector s Q3 earnings would be up +2.9% on +0.5% higher revenues. On the positive side of the ledger, we have Construction (+7% earnings growth in Q3), Business Services (+6.7%), Retail (+4.5%), Utilities (+4.6%) and Finance (+3.7%). Estimates Beyond Q3 The chart below shows Q3 growth expectations contrasted with what was actually achieved in the preceding four quarters and estimates for the following three periods. Full-year 2016 earnings growth expectations are now negative, similar to what we saw last year. Beyond the current period (September quarter), meaningful growth is expected to resume from Q4, which is then expected to continue into Easier comparisons for the Energy sector arrive in Q4, when the sector s earnings growth turns positive. But the expected growth in Q4 and beyond isn t solely a function of easy comparisons for the Energy sector the expectation is for positive momentum from a broad cross section of sectors. Those expectations will most likely need to come down. But it will be interesting to see to what extent they will have to come down. 2

3 Q3 Earnings Season (Officially) Gets Underway Alcoa is typically the first S&P 500 member that uses calendar quarter for reporting purposes to come out with quarterly results each earnings season. But while the aluminum giant is the overall first to report results each quarter; the official earnings season actually gets underway weeks before its earnings report. For the Q3 earnings season, Oracle became the first to come out with results and 18 other index members have reported since then. All of these 19 index members reported results for their fiscal quarters ending in August, which gets counted as part of our Q3 tally. Total earnings for the 19 S&P 500 members that have reported results already are up +5.1% from the same period last year on +4.3% higher revenues, with 84.2% coming ahead of EPS estimates and 63.2% beating revenue expectations. 3

4 Note: Here are few key points to keep in mind while reading this report. a. All the earnings analysis in this report pertains to the S&P 500 index, a handy proxy for the entire business world. We use the index s current membership as the basis for all period comparisons, meaning that even historical periods reflect the index s current membership. b. We divide the corporate world into 16 sectors compared to the official S&P 10 GICS. We have standalone sectors like Autos, Construction, Conglomerates, Aerospace, Transportation and Business Services that provide for a better understanding of trends in these key areas of the economy. c. All references to earnings mean total earnings and not mean or median EPS. d. We make adjustments to reported GAAP earnings to account for non-recurring or one-time items, but we do consider employee stock options (ESOs) as a legitimate business expense. Unlike Zacks, Wall Street and all other data vendors don t treat ESO s as a recurring business expense. It is hard to draw any useful conclusions from this small sample of results, but the growth pace is tracking above what we have seen from the same group of 19 S&P 500 members in the recent past, as the comparison chart below shows. Positive surprises for EPS and revenues are similarly more numerous at this admittedly early stage, as the comparison chart below shows 4

5 For all practical purposes, however, the trends at this stage don t really mean much. The chart below shows the weekly reporting calendar for the S&P 500 index. 5

6 Q3 Expectations As a Whole For Q3 as a whole, total earnings are expected to be down -2.9% from the same period last year on +1% higher revenues. Estimates came down as the quarter unfolded, with the current expected -2.9% decline down from 0.0% growth in early July. But as referred to earlier, the magnitude of negative revisions that Q3 estimate suffered has been below what we have been seeing in other recent periods. The table below provides a summary view of the expectations for 2016 Q3 As you can see in the table above, the Energy sector continues to be a big drag on growth this quarter as well, with total earnings for the sector expected to decline -66.6% from the same period last year on -16.8% lower revenues. 6

7 Excluding the Energy sector, total earnings for the rest of the index would be up slightly (up +0.3% on +2.7% higher revenues). What this shows is that there is not much growth from other sectors that can offset the Energy sector drag, with 8 of the 16 sectors are expected to come out with earnings declines in the period. For the Technology sector, total earnings are expected to be down -1.9% on -1% lower revenues, which would follow the +1% growth in the sector s earnings in Q2 on +1.5% higher revenues. A big reason for the sector s negative growth is Apple, whose Q3 earnings are expected to be down -20.7% from the same period last year on -9.6% lower revenues. Excluding Apple, the rest of the Tech sector in the index will have positive earnings growth of +2.9%. Overall, growth is problematic for tech hardware makers and relatively more robust at software (and services) providers. For the Finance sector, total Q3 earnings are expected to be up +3.7% on +1.3% higher revenues, which would follow the -5.2% decline in the sector s earnings in Q2 on +1.8% higher revenues. In other major sectors, earnings growth is expected to be positive in the Retail (+4.5%), Construction (+7%), Medical (+2.8%) Utilities (+4.6%), and Industrial Products (+3.8%). The Context for Growth Expectations Let s take a look at how consensus earnings expectations for 2016 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the coming quarters. Table 2 below presents the year over year quarterly earnings growth rates actuals as well as estimates. Table 3 presents the same data for revenues. 7

8 Table 2 Earnings Growth Context 8

9 Table 3 Revenue Growth Context The next two tables present the same data in a different format instead of year-overyear growth rates, we have the dollar level of total earnings and revenues for each of these quarters. 9

10 Table 4 Total Quarterly earnings 10

11 Table 5 Total Quarterly Revenues It may be obvious, but it s still useful to explain what we mean by total earnings. This means the sum of net income for all companies in the S&P 500. For historical periods through 2016 Q2, we have taken the total earnings (net income, not EPS) for each company in the S&P 500 and added them up to arrive at the sector and index level totals (we do adjust reported GAAP earnings for non-recurring items, but consider employee stock options as a legitimate business expense). For the coming quarters, including the ongoing Q3 reports, we have taken the Zacks Consensus EPS for each company in the index, multiplied that by the corresponding share count (from the last reported quarter) to arrive at the total earnings for each company. And then we aggregated them to arrive at the totals for each sector and the 11

12 index as a whole. The lack of accuracy in real-time share count notwithstanding, this gives us a fairly accurate view of the total earnings picture. In plain language, what Table 4 tells us is that companies in the S&P 500 earned $267.2 billion in 2016 Q2 and are currently expected to earn $267.9 billion in 2016 Q3. Annual Earnings For full-year 2016, total earnings for the S&P 500 index are currently expected to be down -2.4% on basically flat, 0.1% revenues, which would follow the -1.1% decline in the index s total earnings last year. On an ex-energy basis, 2016 earnings would be up +0.5% vs. +6.0% in Table 6 below provides a summary view for 2016 contrasted with estimates for 2017 and the actual results for As you can see, consensus expectations reflect a notable improvement in earnings growth momentum next year, with total 2017 earnings for the index expected to be up +13.4% on +3.9% higher revenues and strong margin gains. Tables 7 & 8 on the following pages provide the summary annual earnings and revenue data for the 10-year period from 2008 through

13 Table 6 Summary Annual Earnings Picture 13

14 Table 7 Summary Annual Earnings 14

15 Table 8 Annual Revenues The charts below show current consensus earnings estimates for this year contrasted with what is expected for 2017 and 2018 and actual results for the preceding 8 years. 15

16 Chart 9 Total Annual S&P 500 Earnings Chart 10 Total Annual S&P 500 Earnings (Excluding Energy) 16

17 Chart 11 Total Annual Earnings Growth Chart 12 Total Annual Earnings Growth (ex-energy) 17

18 The three sectors expected to be big drivers of earnings growth in 2017 and 2018 include Technology, Finance and Energy. The charts below show current earnings expectations for these sectors Chart 13 Energy Expected to Stabilize Chart 14 Tech Growth Expected to Ramp Up 18

19 Chart 15 Finance Expected to Become the Biggest Contributor Index EPS and PEs The table below shows the PEs and EPS for the index. As you can see, the index is expected to earn $ in EPS in 2016 on a bottom-up basis and $ on a topdown basis. 19

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21 The Margins Picture The table below shows net margin expectations for Q1 in the context of where they have been and where they are expected to go in the coming quarters. Table 16: Quarterly Net Margins The charts below show current margins expectations in a historical context. The first chart shows margins on a quarterly basis since early 2011 while the second one shows annual margins since As you can see, margins are already past cyclical highs. 21

22 Market Cap vs. Total Earnings The charts below show the share of estimated total earnings for 2016 as well as the share of total market capitalization for each of the 16 Zacks sectors. Since the S&P 500 is a market-cap weighted index, each sector s market cap share is also its index weight. The Finance sector is about even with the Technology sector in terms of earnings contribution even though it carries a smaller weight in the index. 22

23 % Share of Mkt Cap Consumer Discrt 5.2% Retail 9.2% Medical 13.1% Consumer Stapls 8.2% Auto/Tires/Trks 1.0% Basic Materials 2.3% Transportation 2.1% Utilities 3.0% Business Svcs 3.4% Industrial Prod 2.0% Construction 0.7% Conglomerates 3.0% Finance 15.3% Computer & Tech 23.1% Oils/Energy 6.7% Aerospace 1.6% 23

24 Share of 2016 Income Consumer Discrt 5.4% Retail 7.7% Medical 15.4% Consumer Stapls 7.0% Auto/Tires/Trks 2.3% Transportation 2.9% Utilities 3.3% Business Svcs 2.9% Industrial Prod 2.0% Basic Materials 2.5% Construction 0.7% Conglomerates 2.9% Finance 20.7% Computer & Tech 21.5% Oils/Energy Aerospace 1.1% 1.6% Want more information about this report or about Zacks Investment Research? Contact Terry Ruffolo at or at Visit the Zacks Media Room at zacks.com/media-room Disclosure: This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. 24