Zacks Earning Trends

Transcription

1 October 2, 2014 Zacks Earning Trends Sheraz Mian Will Earnings Season Stop Market Bleeding? Global growth worries have started weighing on stock prices lately, prompting some to claim that the long-feared correction has finally arrived. Hard to tell at this stage how enduring the current pullback will prove to be as other recent episodes of market weakness have been short-lived and shallow. But we will know soon enough as the Q3 earnings season that ramps up in the coming days will give the market a clear directional push one way or the other. As you can see in the chart weekly earnings calendar below, we don t have that many reports coming out next week, with Alcoa (AA) and Pepsi (PEP) as the only major releases. But the cycle really ramps up in a big way the following week. The low levels to which estimates have fallen gives companies an easy-enough hurdle to jump through. But that will hardly be new as roughly two-thirds of the S&P 500 members beat earnings estimates in the typical earnings season anyway. What will be new however is if we see any improvement on the guidance front, which has persistently been negative for quite some time now. Even modest improvement on the guidance front will reassure investors that questions about the growth outlook for Europe, Japan, China and elsewhere are not having a bearing on corporate profitability. Hard to imagine how guidance could become even worse than it has been in recent quarters. But any guidance deterioration will likely accentuate current global growth worries and serve as a fresh headwind for stock prices.

2 Estimates for Q3 came down as the quarter has unfolded, with current expectations of +1.5% total earnings growth in the quarter down from +6.3% growth expected in late June. The chart below shows how estimates for the quarter have evolved over the past two and a half months. Estimates for most sectors came down, though revisions for the Consumer Retail/Wholesale, Finance, and Energy are the most pronounced. The Finance sector was relatively late to the negative revisions party, but Bank of America s (BAC) shift from estimates of positive 32 cents earnings two months back to a loss of 8 cents at present has been a big reason for the sector s weak aggregate growth numbers. The 40 cents negative swing in Bank of America estimates may not sound like much, but that s a actually a swing of a little over $4 billion in total earnings. The chart below shows the sectors with the major negative estimate revisions. 2

3 The last earnings season was a notable improvement over what we have been seeing in recent quarters, with growth and positive surprises, particularly on the revenue front, tracking above recent trend levels. The question is whether it was a one-off bounce from the anemic Q1 level or the start of something more enduring? We don t know yet, though the coming Q3 earnings season will give us a good sense of how to answer that question. 3

4 Q3 Earnings Season Gets Underway The 2014 Q3 earnings season has gotten underway, with results from 22 S&P 500 companies with fiscal quarters ending in August already out (Alcoa, which reports this coming Tuesday after the close, is the first S&P 500 member on calendar quarter to report results). We have less than a dozen companies reporting results next week, but the reporting cycle gets into high gear the following week (week of October 13 th ), with more than 60 S&P 500 members reporting results that week. Total earnings for the these 22 companies are up +13.1% from the same period last year, with 59.1% beating expectations. Total revenues for these companies are up +4.4%, with 65% beating revenue expectations. We don t have enough of a sample size to draw any conclusions at this early stage, but the earnings and revenue growth rates are broadly in-line with what we saw from the same group of companies in 2014 Q2 and modestly below the average for the preceding four quarters. The table below provides a Scorecard for the 22 companies that have reported results, as of Thursday, October 2 nd,

5 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. 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 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. Expectations for Q3 For the S&P 500 as a whole (combining the results from the 22 companies that have reported with estimates for the remaining 478), total earnings in Q3 are expected to be up +1.5% from the same period last year, on +1.8% higher revenues and modestly lower margins. 5

6 Estimates came down as the quarter unfolded, though it has to be acknowledged that the pace of negative estimate revisions for Q3 was tracking lower earlier on relative to other recent quarters. But the pace of negative revisions accelerated towards the end, with the magnitude of negative revisions for Q3 essentially no different from what we have been seeing in other recent periods. The current +1.5% growth expected in Q3 is down from close +6% growth expected at the start of the quarter in early July. Estimates for 14 of the 16 Zacks sectors came down, with the Medical and Transportation sectors as the only ones that experienced positive revisions. Negative revisions were particularly pronounced in the Finance, Energy, Retail, Autos, and Basic Materials sectors. We started seeing some improvement on the estimate revisions front towards the middle of the Q2 reporting cycle, with estimates for Q3 not falling as much as in prior periods. But our optimism on that count proved to be premature as the revisions trends eventually gathered pace, pushing Q3 earnings growth estimates to the current +1.5%. The table below provides a summary view of the expectations for 2014 Q3. 6

7 We know with a lot of certainty that actual results will be better than these pre-season expectations, a function of management teams excellent track record of anchoring Wall Street expectations CEO s know that it pays to under-promise and over-deliver. Roughly two-thirds of the S&P 500 members typically beat earnings expectations every quarter (small-cap stocks in the Russell 2000 and S&P 600 indexes beat at much lower levels). So, more results along those lines would be nothing new and wouldn t tell us much about the health of corporate earnings. What we haven t seen for a while instead is favorable comments from management teams about business outlook. Corporate guidance has been negative for almost two years now, causing estimates to keep coming down and the long hoped-for earnings growth turnaround getting pushed forward. In a way, this earnings season will be the first normal reporting season of 2014 Q1 was held down by weather-related issues and Q2 represented a rebound from that. With none of those issues at play now, this reporting season promises to give us a true lay of the land on the earnings front. Beyond actual guidance, it will be interesting to see management teams qualitative discussion of - a. The global growth worries that have dominated market discourse in recent days. The stabilization in the European economy over the past year had started showing up in management commentary on the earnings calls. We will see what effect the recent reversal of that favorable narrative will be on the outlook for the current and coming quarters. Questions about the outlook for Japan and China are similarly important. b. The strengthening U.S. dollar will likely be a factor as well. If we see no improvement on the guidance front on the Q3 earnings calls, we will start seeing estimates for Q4 and beyond start to come down in the coming weeks. At present, total earnings are expected to be up +7.6% in 2014 Q4 and an additional +10.8% in 2015 Q1. We will see to what extent those estimates will hold up as the Q3 reporting season ramps up. The Context for Growth Expectations Let s take a look at how consensus earnings expectations for 2014 Q3 compare to what companies earned in the last few quarters and what they are expected to earn in the following quarters. Table 2 below presents the year over year earnings growth rates - expectations for Q3 and the following three quarters. It also shows consensus earnings growth expectations for 2014 and Table 3 presents the same data for revenues. 7

8 Table 2 Earnings Growth Context 8

9 Table 3 Revenue Growth Context Note: Lack of consensus revenue estimates, particularly for a number of key Finance sector companies such as Berkshire Hathaway, makes consensus projections for the sector less precise. Data for all the other sectors is fairly reliable. As such, we suggest using the ex-finance growth rate as a proxy for the index as a whole. 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 total of aggregate earnings for all the companies in the S&P 500. For historical periods through 2014 Q2, we have taken the net income or total earnings (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, 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 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. 11

12 In plain language, what Table 4 tells us is that companies in the S&P 500 are expected to earn $266.8 billion in 2014 Q3, down from the 2014 Q2 total of billion. The overall level of total earnings has been very high in recent quarters. In fact, the 2014 Q2 tally was a new all-time quarterly record, surpassing the record reached in 2013 Q4. The Margins Picture Net margins (total earnings/total revenues) are expected to be essentially flat from the year-earlier period, but modestly down from the preceding quarter s level. The table below shows net margin expectations for Q3 in the context of where they have been and where they are expected to go in the coming quarters. Table 6: Quarterly Net Margins The table 7 below shows net margins on a trailing four-quarter basis. So, the 9.9% net margin for 2014 Q3 reflects estimates for Q3 and actuals for the preceding three quarters, and so on. 12

13 Margins follow a cyclical pattern. They expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. At that stage, margins start to contract again. We may not be at the contraction stage yet, but we do need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out. Market Cap vs. Total Earnings The charts below show the share of total earnings for 2014 as well as the share of total market capitalization for each of the 16 Zacks sectors. Since the S&P 500 is a marketcap weighted index, each sector s market cap share is also its index weight. Finance has regained its leadership position in the index in terms of earnings contribution, though it still remains significantly below its record 27% share of the index earnings in The sector lost its leadership position to Technology in the wake of the global financial crisis, but got it back in 2013 and remains on track to retain the position this year and next. 13

14 The Finance sector is an even bigger contributor to the S&P 600 index, expected to bring in 26.5% of the small-cap index s total earnings in And unlike the S&P 500 where the Technology sector has the larger market cap, Finance is the biggest market cap contributor to the S&P 600 index. % Share of Mkt Cap Consumer Discrt 4.9% Retail 8.3% Medical 13.0% Consumer Stapls 7.5% Auto/Tires/Trks 1.3% Basic Materials 2.9% Transportation 2.1% Utilities 5.1% Business Svcs 3.0% Industrial Prod 2.2% Construction 0.7% Conglomerates 3.2% Finance 16.1% Computer & Tech 19.2% Oils/Energy 9.2% Aerospace 1.5% 14

15 Share of 2014 Income Consumer Discrt 4.3% Retail 6.8% Medical 12.0% Auto/Tires/Trks 1.7% Consumer Stapls 6.7% Transportation 1.9% Business Svcs 2.5% Industrial Prod 2.4% Basic Materials 2.8% Construction 0.6% Conglomerates 3.2% Utilities 5.6% Computer & Tech 18.0% Finance 18.5% 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 Oils/Energy 11.2% Aerospace 1.7% 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. 15