U.S. EQUITY RESEARCH Sector Watch Q4 EPS OUTLOOK. January 9, Will Actual Results Continue to Beat Estimates by 3.6 Percentage Points?

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1 U.S. EQUITY RESEARCH Sector Watch January 9, 2017 Sam Stovall Chief Investment Strategist CFRA Author of The Seven Rules of Wall Street 1 New York Plaza 34 th Floor New York, NY (646) sam.stovall@cfraresearch.com Q4 EPS OUTLOOK Will Actual Results Continue to Beat Estimates by 3.6 Percentage Points? The fourth-quarter earnings reporting season is upon us. As of January 6, S&P Capital IQ s aggregate Q S&P 500 operating EPS estimate was $30.59, up 4.4% on a year-over-year basis (versus the $29.29 in Q4 2015). This advance represents the second consecutive time that the S&P 500 posted year-on-year EPS increases, after enduring four successive declines. Seven of 11 S&P sectors are expected to post positive earnings growth for Q4, with financials, materials, information technology and utilities leading the way. The energy sector continues to weigh on the Index, but less than in prior quarters. The other sectors projected to show declines are industrials, real estate, and telecommunications services. What will be the driving forces behind Q4 s results? The following are comments by CFRA Research s equity analysts as to the factors that likely affected EPS growth, including a 2% rise in the U.S. Dollar Index (Q average vs. Q average) and a 16% year-over-year jump in average quarterly WTI oil prices. Consumer Discretionary We have a relatively subdued outlook for Q4 EPS growth for the consumer discretionary sector, in part due to difficult comparisons across some of the major subindustry groups. Also, our outlook reflects expected margin pressures at traditional brick-and-mortar retail chains (versus online-based retailers) following another highly promotional selling season, despite seemingly healthy sales growth over the period. Some lingering impact on health concerns and labor cost inflation could also weigh on some restaurants and/or hospitality companies, along with international expansion costs. Also, we think the potential upside to a strong political advertising cycle may have been somewhat constrained by a Trump factor, with the media space also vulnerable to persisting concerns with TV ratings declines and pay TV subscriber losses (amid online video competition). Conversely, we think the automotive space benefited from a favorable U.S. mix shift and higher confidence post-election, partly restricted by higher S&P 500 Y/Y Growth in Operating EPS Estimates 2016 EPS % Changes S&P 500 Sector Q1A Q2A Q3A Q4E Year 2017e Consumer Discretionary Consumer Staples 0.8 (0.8) Energy (106.6) (86.1) (67.5) (8.4) (77.0) Financials (1.0) Health Care Industrials (3.8) (4.9) Information Technology (3.9) Materials (11.3) (4.2) (0.3) 15.7 Real Estate* (8.3) (14.5) (4.9) 8.0 Telecom. Services 9.1 (2.6) (2.6) (0.8) Utilities (2.5) (1.5) S&P 500 (6.7) (1.7) Source: S&P Capital IQ. Data as of 1/6/17. This report is for information purposes and should not be considered a solicitation to buy or sell any security. Neither CFRA nor any other party guarantees its accuracy or makes warranties regarding results from its usage. CFRA, the CFRA inverted pyramid logo, and STARS are registered trademarks of CFRA. S&P GLOBAL is used under license. The owner of this trademarks is S&P Global Inc. or its affiliate, which are not affiliated with CFRA Research or the author of this content. Copyright 2017 CFRA. Redistribution, reproduction and/or photocopying in whole or in part is prohibited without written permission. All rights reserved. 1

2 incentives spending. Also, while gasoline prices became less of a tailwind for overall consumer spending, a rallying stock market and higher consumer and business confidence were positives. Finally, we think share buybacks and incremental synergies from recent acquisitions also provided some likely (but relatively moderate) Q4 EPS support for certain constituents. The fourth-quarter represents the beginning of the slower part of the year for homeowners as winter looms. So, we see flat-to-lower total revenue compared with the seasonally strong earlier quarters. Gross margins should continue to trend lower as a result of higher land costs and labor shortages that push construction costs higher. New orders and backlog values are expected to be positive, but we expect Q4 results to be lower than Q3 results. Consumer Staples The Consumer Staples sector is expected to post a 5.9% rise in Q EPS, as compared to the 4.4% increase estimated for the S&P 500 and the 7.4% sector growth experienced in the third quarter. We believe key factors that drove the increase in Q4 EPS for the sector are increased cost savings generated from efficiency and productivity improvement projects, as well as improved customer demand and pricing power in a more favorable U.S. economic environment. We also believe the sector benefited from recent mergers, acquisitions and divestitures, which led to improved exposure to wider margin products and faster growing categories, along with an expansion in distribution, supplementing greater scale advantages. Strong free cash flow generation remains supportive of active share repurchase programs, in our view, providing additional EPS growth support. We see EPS benefits during the quarter partially offset by persistent deflationary pressures in certain food categories, increased drug reimbursement pressure, softness in demand from emerging and developing markets and unfavorable foreign currency exchange rates. Energy The energy sector no longer looks to be the laggard of the S&P 500 with an estimated 8.4% drop in year over year operating EPS in the 4th quarter, it now ranks as just the 2nd worst of the 11 sectors, instead of its (recently) habitual last-place ranking. Crude oil prices improved in Q4, rising about 16% year over year, while natural gas spot prices gained around 43% versus the year-ago comparison (using Bentek estimates). So why the decline in projected operating EPS? We think it could be a handful of factors, including hedges in place that locked in Q4 pricing below recently elevated spot prices; possible return to oil service cost inflation, albeit modest; and more conservative upstream spending in Q4 (based on decisions made earlier in the year) that could hamper production growth. Financials Investment Banking is expected to see positive earnings growth with double-digit gains in equity, fixed income and currency trading year over year, as well as sequential gains. Since the Trump election, institutional customers have been the most active. In Q4, investment banking should realize high single-digit growth with M&A and other advisory fees leading underwriting. Net interest income is another earnings driver with certain firms benefiting from rising rates. Capital Markets will likely see earnings strength driven by low- to mid-teen growth in trading volumes for products tied to cash equities, interest rate products, foreign currency and commodities. The recent trend of rising oil prices is boosting trading volumes in several of the energy derivative products. Any evidence that premium growth trends appear to be improving -- either through exposure or rate growth -- would be a significant positive for the property & casualty insurance group. Unfortunately, that may not happen given the excess underwriting capital (capacity) that we SECTOR WATCH 2

3 estimate to be in excess of $200B, and written premium growth in the aggregate may not top 3%- 3.5%. The recent rise in interest rates will not have a material positive impact on investment income, but will negatively impact the market value of bond holdings, slowing the growth (or even causing a decline) in book value. The Hartford just announced plans to mitigate their asbestos/environment exposure via a large and very expensive reinsurance transaction. This raises the bar for others who have not adequately dealt with this issue and will likely be a focus this quarter. The post-election rise in interest rates and expected decline in regulatory burdens have provided the stocks in the life insurance group with a significant catalyst. The focus this quarter will be the degree to which life insurers are able to fulfill investors expectations. There may be a pullback in the group as Q4 earnings remain pressured by low rates and lagging expectations. The regulatory environment remains uncertain, which may be more of a negative than the historical regulatory burden. Health Care In spite of the dismal performance for most health care stocks in 2016, the sector s earnings performance was likely better than anticipated. For the first three quarters of the year, actual earnings came in comfortably above estimates. We anticipate this trend will continue in Q as the 4.9% forecasted earnings growth would be the lowest rate of growth since Q when earning grew 3.3%. Amid the political rhetoric and subsequent volatility following the election of Donald Trump and the Republicans retaining control of Congress we note that any potential change to the Affordable Care Act should not have any impact on health care earnings until 2018, at the earliest. Whatever changes Republicans put forward would require a transition period of about months. For Q we see a similar environment to the prior three quarters. The continued focus on high drug prices likely tempered sales and earnings growth for the biotech and pharmaceutical industries. Pricing pressure within the generic space likely limited sales growth as well. We see health insurers earnings declining sequentially as health care utilization typically increases at year-end, driving up costs. Conversely, we see improving earnings for hospitals and other service providers, driven by increased utilization. Industrials We think accelerating GDP growth in Q4 likely contributed to strong momentum for several subindustries, including commercial transportation, construction & engineering, and industrial machinery. We think these companies are likely to have seen organic revenues improvements, while tight cost controls should allow for operating margin expansion. Aerospace and defense is likely to have seen strong commercial aerospace demand, while cost cutting and share buybacks should help defense names grow EPS despite a tepid revenue environment. Industrial machinery and tools and construction & engineering companies should benefit from increased industrial demand and construction activity throughout the U.S. We think the rising oil prices in Q4 should have helped those industrial names involved in the energy sector, including conglomerates and engineering companies. We see weakness in railroads driven by weak commodities and lower oil shipments, and think that while demand for air travel likely remains robust, rising oil prices might hurt EPS results for airlines. Agricultural equipment companies are likely to continue to have been constrained by lower commodity prices. Even though prices have risen recently, we do not think enough to drive markedly stronger agriculture equipment demand. Information Technology According to S&P Capital IQ aggregate estimates, fourth-quarter EPS for the S&P 500 Technology Sector is expected to increase 6.7%, compared with the prior-year period. S&P 500 SECTOR WATCH 3

4 EPS is projected to rise 4.4%. We see the October-to-December period as critical for most technology companies, as it includes consumers making purchases during the holiday shopping season and corporations spending what s left within technology budgets. The U.S. dollar influences the financial results of S&P 500 IT sector companies, given their substantial exposure to foreign sales. Increases in the dollar versus international currencies make U.S. products and services relatively more expensive for purchase in other currencies. For 2015, the technology sector generated 58% of revenues from international sources, according to S&P Dow Jones Indices, the second highest of the 11 economic sectors, and well above the 44% for the S&P 500. The profits on non-u.s. revenues also tend to be relatively high, given generally lower tax obligations abroad. Notably in the fourth quarter, especially following the U.S. elections, the dollar appreciated significantly against most global currencies, in particular rising 6% against the Euro and 16% against the Japanese Yen. We also think the elections, particularly the surprising result in the presidential contest, could have initially contributed notably to more cautious technology buying. However, we think confidence in the economy quickly recovered and increased since November 9, the day after the elections, perhaps actually aiding purchases in the fourth quarter. Materials Earnings per share for the S&P 500 materials are projected to climb 7.7%. Headwinds from the stronger dollar and from lower oil prices have dissipated and now we see volume gains starting to drive earnings growth, particularly for the chemical companies, which represent the largest component of the group. Fertilizer prices have risen since July and the Green Markets Weekly US Fertilizer Price Index (Source:Green Markets, Kennedy Information, LLC) stood at over 309 on December 23, 2016, after having fallen to 247 in July However, year over year, fertilizer pricing remains a headwind. Specialty chemical companies are likely to continue with volume gains, but are likely to pass on lower costs to customers. Q4 earnings for metals & mining companies should benefit from higher volumes, higher prices, and cost cutting efforts. While Q4 16 steel prices averaged about 29% above Q4 15, utilization rates in Q4 for steel mills have also been trending at about 5% higher than last year. The benefits from fixed cost leveraging is clear with significant improvements expected in EBITDA margins. A similar story is playing out in construction aggregates, where incremental margins have been above 75%. Gold Prices averaged 12.3% higher in Q4 16 vs. last year, while copper was 4.1% higher. Cost cutting (both operating costs and overhead costs) and debt reductions (resulting in lower interest expenses) is also helping most companies in the sector. Real Estate Fourth-quarter 2016 funds from operations (FFO) results and growth are expected to be positive for industrial, hotel & leisure and office categories. We expect some slippage in growth for multifamily and self-storage REITs that face oversupply in select markets, increased discounts or incentives, and affordability issues with rising rents for luxury apartments. Self-storage REITs face similar risks to rental rate growth along with seasonality pressure in some parts of the country. Rising rates associated with higher cost of capital should not be a factor in Q4. The rise in interest rates and the continued, slow demise of a number of department store chains has pressured the retail REITs space. Yield spreads -- or the difference in yields between shopping center REIT stocks and the US Treasury 10 year bond -- were 1.42% as of November 30, 2016, and have continued to widen. This compares with a historical average yield spread of 1.28%. This widening of yield spreads indicates the group may be oversold. At current levels we are neutral on the group, but think there may be an opportunity for those REITs that are able to counter negative interest rate trends with healthy demand for space and a relatively low cost of capital. SECTOR WATCH 4

5 Telecommunication Services The S&P 500 Telecommunications Services sector, according to Capital IQ consensus estimates, is expected to generate a Q4 EPS decline of 0.8%. We expect revenue pressure to remain, given fierce competition from carriers. However, we think broadband growth and cost savings will preserve free cash flow generation and support dividends. Although we anticipate subscriber growth and revenue benefits from the September launch of the iphone 7, wireless growth continues to be partly constrained as the industry moves to installment programs. Separately, aggressive promotional efforts by carriers related to the iphone 7 launch and holiday season seen during the quarter could have negative implications on the bottom line. We see a consumer sentiment shift towards value service providers given their lower cost, unlimited data options, improving networks, and availability of leasing options. We note that these carriers once again likely outstripped their larger peers in terms of postpaid phone subscriber gains. We believe competition between the largest wireless providers will remain intense. We see a greater focus to expand offerings in areas like the connected car and over-the-top space. In wireline, we expect continued access line weakness, but stable broadband subscriber gains. Competitive threats from cable and satellite providers should weigh on pricing and subscriber growth. However, we see continued cost cutting, merger synergies, and business market improvements supporting free cash flow. We see the telecommunications services sector being impacted by modest U.S. economic growth and still favorable rising interest rates. For the S&P 500 telecom space, we think free cash flow generation and potential synergies from pending acquisitions will be enough to support an attractive dividend yield (over 4.4%) for the sector. Utilities Despite still warmer than normal weather, higher heating-degree-days, particularly in the south and east, but also in the northern central and northeast regions, are likely to help drive both electric and gas volume growth for the fourth quarter. While higher heating-degree-days typically helps gas utilities more, higher heating-degree-days in the south leads to higher electric space heating requirements. Higher customer counts should also help to drive additional volume growth. Rate increases at various utilities are also likely to play a role in driving revenues higher for the quarter. We see cost reduction efforts helping to keep expense growth under control, but see higher depreciation expense from high levels of capital spending. Conclusion So there you have it. This week, the Q earnings reporting season begins in earnest. S&P Capital IQ aggregates point to a 4.4% year-over-year rise in operating results that is sequentially stronger than Q3 s 4% rise, and well above the near 7% decline experienced in Q1. In addition, investors may be expecting Q4 s improvement to approximate 8.0%. That's because actual EPS growth has exceeded estimated results in each of the past 19 quarters by an average of more than 3.5 percentage points. Granted, headwinds include a mid-teens percentage increase in this quarter's average price of WTI oil, as well as a 2% rise in the value of the dollar, but tailwinds include the near evaporation of the drag from energy EPS, combined with the easier comparisons with very weak Q S&P 500 results that signaled the start of a multi-quarter earnings recession. Finally, seven of the 11 sectors in the "500" should post EPS improvements, led by financials, materials, and utilities. SECTOR WATCH 5

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