The Factory Daily Letter
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Another strong season - but beneath the surface there is now some weakness and inconsistency
We expect the season's 'Triple winners' to prove most robust in the current environment
At first glance, results again far exceeded expectations
Over recent earnings seasons most corporates have continued to report above-average results, both top and bottom line, still beating expectations as the strong demand for goods and services by US consumers has supported the bouyant economic growth evident through 2021 - allowing many US corporates to report historical results. However, while most economists expect US GDP growth to remain robust this year, signs of normalisation have been creeping into the reports as evidenced by the rising challenge of reporting better-than-expected numbers.
The picture in the US
The chart below shows the current beat rates for sales and EPS for the S&P500. As we write nearly 78% and 73% of those that have reported have beaten EPS and sales estimates respectively: both remain above their long-term averages, but they have both also clearly peaked:
Moreover, the extent to which companies have managed to outperform analysts’ estimates (surprise), is also now rapidly normalising. The EPS surprise rate (5.3% in Q1 2022 - which is below the long-term average of 5.89% and down from 10.28% in Q4 2021) is losing traction as the positive base effect passes through and rising costs start to put margins under pressure. Sales surprise has also started to come down, but remains above average (2.9% vs 1.2%).
The picture in Europe
In Europe, the economic cycle seems to be lagging that of the US, and while the ‘normalisation’ process has begun, European companies have nonetheless managed to deliver a much stronger quarter than their US peers (see our recent letter European earnings: persistent resilience).
In terms of beat ratios, both sales and EPS numbers have enjoyed a somewhat surprising rebound off the last quarter. Respectively, 67.7% and 77.8% of those that have reported have beaten Q1 estimates – on both counts some of the highest levels of the past several decades:
EPS surprise is running at 13% and sales at 2.5% on average: both measures remain far above the historical trend:
Peak earnings growth is behind us
Fewer companies are however reporting positive EPS growth. The chart below illustrates how S&P500 EPS growth has evolved since 2019. It clearly tanked in 2020 due to the first wave of global pandemic lockdowns, but then went on to peak in Q3 21 at around 91%. Since then, it has been normalizing and is expected to be less than 10% this quarter:
While such normalization is to be expected, more worrying is that the percentage of companies generating positive growth this quarter is expected to fall back below 60%, a level which, if we exclude the post-Covid period, is a little below the longer-term historical average:
Digging deeper into the detail
Broadly speaking, US top line looks solid (with communication services bucking the trend)
In terms of sales, growth is running slightly below 14% with energy and health care contributing the most (3.8% and 2.7% respectively). Surprise is running broadly above consensus expectations with nearly 74% of companies beating estimates. Only the communication services sector bucks this trend the percentage membership reporting positive surprise below 35%.
The blended earnings growth rate for the first quarter is running at 9.1%, with just over 78% of those reporting having beaten EPS estimates (which while below the latest four-quarter average of 84%, is still slightly better than the five-year average). Surprise is running at 4.9% above expectations, which is also well below the average surprise over the previous four quarters of 15.7%.
Sector-wise, utilities companies have enjoyed the best surprise (14.8%) but only 59% of stocks in the sector beat expectations. Energy remains by far the largest contributor to overall growth (6%): excluding the sector the growth rate would be around 3%.
In Europe results have been much better than expected, but mainly thanks to the energy sector.
The table below shows the revenue growth and contribution by sector for the Stoxx Europe 600 index. While all sectors reported solid positive revenue growth, dependence on the energy sector remains high, the sector posting a positive contribution of almost 18%. That said, if we exclude the energy sector, revenue growth is nonetheless still solid at around 16%. In terms of cyclicals versus defensive names the contribution of cyclicals is slightly higher at 9% versus 6%.
The table below shows the net income results of the Euro stoxx 600 companies by sector. That over 65% have reported above-consensus results with an average surprise of 16.6% illustrates the unexpected ability of European companies to cope with the challenging environment so far, particularly in terms of managing costs in light of inflation. However, in terms of EPS growth (42.3%), it should be noted that the energy and materials sectors were the contributors (31.3 and 7.9, respectively). Excluding these sectors, average EPS growth would be around 3%.
Compared to their American counterparts, European companies have been benefitting from a series of favourable tailwinds that have masked weaknesses beneath the surface
The Stoxx 600's greater exposure to the classic “reflation” sectors (such as energy and materials and in a lesser extent banks) has been a key contributor to the strong Q1 results in Europe (these three sectors represent 30.2% of the Stoxx Europe 600 vs 18.3% for the S&P 500). The Euro’s recent depreciation against the US dollar has also been a key tailwind: as illustrated below, the differential in terms of positive surprise between the US and the Europe tends to follow the EURUSD pair, with European equities tending to capture more upgrades than the US when the euro is weaker. So it is that the weakening Euro we have witnessed over the past six months could help support it into the next quarter:
However, the relative strength of European EPS is concentrated in two sectors, raising questions about the sustainability of the future earnings trajectory
This year’s disappointing equity price action has been driven mainly by rising yields and geopolitical tensions which have been at odds with the globally positive EPS revisions in both Europe and the US. 2022 EPS has been revised up 9.4% since the beginning of the year (while S&P500 EPS has seen only a +2.6% increase).
But these positive revisions have been entirely driven by energy (+50%) and materials (+10) - and moreover overshadowing serious negative revisions elsewhere. Also worth a mention is that (recent underperformance nothwithstanding), the technology sector is the only other sector to benefit from positive revisions:
In the US, the energy sector continues to contribute most to overall EPS growth
The graph below compare the sectors contribution to overall EPS growth for the S&P500. While technology continues to remains a driver for overall EPS growth as referred to above, the major contributor is the energy sector, which is benefiting from the recent rise in energy prices. On the other hand, financials and discretionary have a negative contribution, showing that the current environment remains challenging for a large part of the economy.
The graph below shows how energy sector contribution has evolved since 2019. It shows how the sector has long been a drag on overall EPS growth and that since Q2 2021 and the reopening of the post-pandemic economies, the rise in the price of oil has helped it regain a dominant position in terms of contribution to growth:
On the flip side, retailers are now suffering from the current backdrop
US consumption remains the key driver of the US economy and Q1 2022 earnings reports from retailers have been mixed so far. Indeed, while analysts’ sales estimates have been beaten by 80% of companies listed on the S&P 500 retailing index - and 100% of those listed on the S&P 500 Food and Staples Retailing index - EPS results show signs of deceleration compared to last year and Q4 2021. Concerns over how corporates can maintain high margins amid rising inflationary pressures sparked a significant sell-off across US retailers Wednesday (and more broadly across all sectors) as Target (down c.25% on this single day) reported lower-than-expected margins and provided weak Q2 guidance, echoing Wallmart (-11% in Tuesday) Other stocks such as Dollar Tree (-14.4%) and Costco (-12.45%) also significantly suffered from a contagion effect.
The table below summarizes the reported results across the retailers for the first quarter of 2022. Sales growth averaged 4.88% compared to last year for the S&P 500 Retailing index (but down from 9.25% compared to Q4 2021) and nearly 7% for the S&P 500 Food and Staples retailing index (higher than Q4 2021’s growth rate of 4.2%). Averages surprise remained positive (and slightly higher than in Q4 2021). We note some names have suffered significant drops in sales growth, such as Bath & Body Works (-45% YoY) and Ebay (-17.8% YoY); while Lowe’s, O’Reilly Automotive and TJX missed sales estimates:
From an EPS perspective, results have been even weaker: while 73% of the companies listed on the S&P 500 Retailing and 75% of those listed on the S&P 500 Food & Staples Retailing have beaten estimates, many of them have seen a sharp negative growth in earnings. Overall, the net income growth of the S&P 500 Retailing index is down 57% compared to last year, and down 3.5% for the S&P 500 Food and Staples Retailing index.
While online retailers such as Amazon, Etsy and eBay have suffered from lower net income, brick-and-mortar retailers have also suffered, such as Target – (EPS $2.19 vs $3.07 expected) – which reported higher freight costs, supply chain issues and general cost as headwinds for its profitability.
Bath & Body Works (EPS $0.64 vs $0.53 expected) topped analysts’ estimates but cut its profit outlook amid inflationary pressures. Its net income was down 45% compared to Q1 2021. TJX’s reported profits were however sharply higher than last year, with EPS rising 51% and beating estimates. The stock was up 7% intraday but finally ended in negative territory as the sell off was broad-based.
On the staples side, Walmart surprisingly missed estimates by a wide range as well and reported a decline of nearly 25% of its net income compared to a year ago. The company cited higher general costs as well as higher levels of inventory as key factors that weighed on profitability. The sharp rise of foods also put pressure on Walmart’s margins, which tends to sell already-low margin food products. Nonetheless, it raised its outlook for sales for the remaining of the year but expects its bottom line to shrink as well.
What are the retail managers saying?
Below, we provide on an anecdotal basis some of the more positive and negative comments from Retail CEO’s earnings calls for Q1 2022:
Pessimistic sentiment has been weighing on the post-reporting price action
Q122 has been one of the worst quarters in terms of post-reporting price action in the post Covid-crash era. Across companies beating estimates the price reaction has been flat, while companies missing estimates have been punished severely – suffering -1.6% in median performance in Europe and -3.1% in the US.
Focus on the best-in-class : “Triple winners”
The outlook for equities has clearly darkened since Q4 2021 as investors grapple with the change in rhetoric from the central bankers - notably regarding terminal rates and the inflation regime; and they are now speculating around the risk and timing of stagflation / recession. The US equity market (S&P500) is currently on track to record its fourth-worst annual performance since inception as valuations have started to unwind and rising input costs have started to affect margins (as highlighted recently by the retailers).
Nevertheless, some companies are still showing a strong degree of resilience, and have managed to raise their forward guidance for 2022 - on top of beating sales and EPS estimates: “triple winners”. In a slowing economic environment, with heightened geopolitical tensions and reduced visibility, we expect investors to continue to reward those companies that continue to deliver on both profits and revenues, and that are sufficiently confident in their business to raise guidance.
Perhaps surprisingly, 52 companies of the S&P 500 meet this criteria this reporting quarter, which is high sample regarding history and particularly given the context:
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