Category Archives: Corporate Earnings

Don’t Be Fooled by Noise, Earnings Will Tell the Truth

• A look into next month’s earnings season and trends.
• 6 out of 10 S&P sectors have earnings declining.
• 72% of companies issued negative guidance.

Introduction

With all eyes focused on Brexit and the FED, it seems that no one really cares what is going on in the economy and, most importantly, with corporate earnings. Don’t forget that next month is earnings season and the earnings trend up until now has been a negative one. As corporate earnings are the main factor in stock returns, you should be focusing on how to prepare for that and not on Brexit as it will probably be forgotten by next week.

Many believe that predicting corporate earnings is not possible, but thanks to the multitude of data constantly published, it does not seem impossible. It just takes a lot of work and analysis.

This article is going to analyze sector-by-sector news in order to estimate the upcoming earnings season results.

Corporate Earnings

The main thesis behind bearish market views is that corporate earnings have been steadily declining for the past two years.

Figure 1: S&P 500 earnings. Source: Spindles.

The little uptick in Q1 2016 was mainly due to commodities prices rising and smaller losses in the energy sector, but is still below Q1 2015 which marks five consecutive quarters of year-over-year declines in earnings. The main influence in the above decline comes, of course, from energy and materials, but don’t be fooled by that as 6 out of 10 S&P 500 sectors had earnings declining for an average decline of 6.7%.

Figure 2: S&P 500 earnings growth by sector. Source: Factset.

Energy

Energy earnings are easy to predict as they are related to crude oil and gas prices. Stocks usually follow those prices, so it is difficult to get a significant prediction here.

Figure 3: S&P 500 energy earnings. Source: Spindles.

As crude oil and gas prices have been on average much higher than in Q1 2016, we should not expect negative surprises in the sector, but earnings will be again lower than Q2 2015.

Figure 4: Crude oil in last 12 months. Source: Bloomberg.

Materials

The story with materials is similar to the one for energy as prices have rebounded a bit but are still far below Q2 2015. The metal price index shows how the subdued commodity prices are not rebounding that fast and it will take a longer time for the lower margins to eliminate higher cost production.

Figure 5: Metal price index. Source: index mundi.

This slump in commodity prices is going to keep material earnings depressed and far below the averages of the last 5 years but as the below figure shows, the industry is cyclical both in the long and short term, so traders could grasp the opportunities given by the high volatility and long term investors can buy the excellent low cost commodity producers at low historical prices.

Figure 6: S&P 500 materials earnings. Source: Spindles.

Consumer Discretionary, Information Technology and Healthcare

Consumer discretionary, information technology and healthcare were the bright lights of Q1 2016 with earnings growth but this is about to change as the majority of companies issued negative guidance.

Figure 7: Number of S&P companies with positive and negative guidance by sector. Source: Factset.

Of the 113 S&P 500 companies giving guidance, 81 have issued negative guidance while only 32 have issued positive EPS guidance.

A good example of how earnings can be predicted is by looking at car sales. Automotive companies have low PE ratios as everyone expects a decline in sales but the decline is not coming. Car sales have fallen by 7.4% year-over-year but this has been covered by increases in minivan sales.

Figure 8: U.S. car sales. Source: Wall Street Journal.

For those interested in particular automotive companies and monthly sales, a site to watch is Motor Intelligence. For example, General Motors witnessed a 5% yearly decline in sales which is going to have a very negative effect on earnings while Ford managed to increase sales by 4% in the U.S. for the same period.

Longer Term Earnings Expectations

Analysts are always positive as they are mostly employed by investment banks and whose goal is to pump asset prices in order to gain more on commissions. Therefore, analysts will always see declines as just temporary and base their estimations on the rosiest scenarios. The current trend sees declining corporate margins but analysts expect this trend to turn around immediately.

A good way of debunking this assumption is to compare the current analysts’ estimations with the same from a year ago.

Figure 9: Current analysts’ S&P 500 corporate margins estimations. Source: Factset.

Analysts’ estimates from the same period last year were much rosier than what really happened and it is difficult to expect margins improving with full employment negative guidances.

Figure 10: Analysts’ S&P 500 corporate earnings estimations from last year. Source: Factset.

The current profit margin is 9.7% while last year analysts estimated a profit margin of 10.6% for this period.

Conclusion

Corporate earnings can be partly estimated for subsequent quarters as lots of data—like car sales or retail trends—are publicly available on a monthly basis. By tracking such indicators an investor can minimize the risks of being caught up in a stock amidst a negative earnings surprise. As in the longer term there are many factors that can lower or increase earnings like the strength of the dollar, Chinese demand or oil prices, no one can know what will happen but can assess the probabilities of something happening and the effect on a portfolio.

The current trend is a negative one showing no strong improvement signs as commodity prices are still subdued. The economy is reaching full employment which should increase operating costs, and buybacks are not that profitable for companies as they are paying high prices for their own shares.

There is a Huge GAP Between Reported and GAAP Earnings

• Real earnings are currently 25% lower than pro forma reported ones.
• The other consolidated income statement can also hide surprises.

Introduction

How would life look if things were as you saw them or exactly like someone presented them? Surreal for sure as it would require a non-human mind to objectively process information and accept a situation as it is. People usually fall in love with the wrong person or feel depressed over nothing important. The same is applicable in business, but it’s strongly biased toward falling in love with one’s business and refusing to see the flaws of it. Such a behavior results in a large gap between pro forma reported earnings and official Generally Accepted Accounting Principles (GAAP) results.

Investors have to be mindful about that when analyzing earnings, and must precisely determine what the real situation is compared to managements’ rosier view. Even Buffett touched on the subject in his last letter to shareholders warning that “it has become common for managers to tell their owners to ignore certain expense items that are all too real” and analysts are part of the culprit as they propagate misleading numbers that can deceive investors.

Gap Between GAAP and Pro Forma Earnings is Widening

Pro forma figures exclude certain items that are considered by management as non-recurring. Some of those expense items include the costs of laying off workers, legal costs, acquisition expenses, cost of stock-based compensation, expenses related to asset volatility, asset write-downs, effects of foreign-currency moves, omitting results from newly opened and recently closed stores and depreciations not related to current operations. By eliminating noise, management’s intention is to present earnings related to the core business as what is happening around it is of no importance. The best way to explain what is going on is to let you read yourself. Apache Corporation (NYSE: APA) reported the following in its annual report:

For the year ending 2015, Apache reported a net loss of $23.1 billion, or $61.20 per diluted common share. On an adjusted basis, Apache’s 2015 loss totaled $130 million, or $0.34 per share. Net cash provided by continuing operating activities was approximately $2.8 billion, and adjusted EBITDA was $3.9 billion in 2015. Total capital expenditures were $4.7 billion for the full year, or $3.6 billion when excluding leasehold acquisitions, capitalized interest, Egypt noncontrolling interest, and spending on divested LNG and associated assets. This was at the low end of the company’s full-year 2015 guidance range of $3.6 to $3.8 billion.

APA’s management managed to turn a loss of $23 billion into an adjusted loss of $130 million and even finish with positive adjusted EBITDA of $3.9 billion. It is practically impossible for an investor not specialized in accounting to understand what is real and what not in such an annual report. Unfortunately, APA is not an exemption in the corporate world but more of a new mainstream.

Figure 1: Gap between pro-forma and GAAP earnings widening. Source: The Wall Street Journal.

The official GAAP S&P 500 earnings in 2015 were $787 billion versus pro forma estimates of $1.04 billion which means that 25% of expenses are not treated by management as expenses but as mere non-recurring items. It is the widest difference since 2008 and a closer look shows that S&P 500 real GAAP earnings have not increased by 0.4% like pro forma earnings show, but instead declined by 12.7%. The issue is not only related to smaller companies like the above mentioned APA, but also to blue chips. 18 of the 30 Dow Jones Industrial Average (DJIA) members have reported higher pro forma than GAAP earnings.

Figure 2: DJIA average year-over-year change in EPS. Source: FACTSET.

Even blue chips report higher earnings than real earnings, and companies have had a history of treating the ordinary as extraordinary when business conditions worsen. In 2014, the difference between GAAP and pro forma earnings was 11.8% while in 2015 it jumped to 30.7% for the DJIA companies that report pro forma earnings.

Figure 3: Difference between (%) pro forma and GAAP earnings for DJIA stocks. Source: FACTSET.

The most notable example from the DJIA is Merck (NYSE: MRK), who reported 2015 GAAP EPS of $1.56 and pro forma EPS of $3.59. The difference, according to management, comes from acquisition and divestiture related costs, restructuring costs and legal fees. The funny part is that in 2014 they excluded the same costs to form pro forma earnings and also forecast 2016 GAAP EPS to be between $1.96 and $2.23 while pro forma reported earnings are expected to be between $3.6 and $3.75. It seems illogical to name costs that occur year after year non-recurring.

Other Comprehensive Income

Another accounting issue that is not so much discussed about in the media is other comprehensive income (OCI). OCI includes revenues, expenses, gains, and losses under both GAAP and International Financial Reporting Standards (IFRS) that are excluded from net income on the income statement and are therefore listed after the income statement. Those items are mostly items that have not yet been realized and might change in the future. For example, an investment in a foreign country and currency is affected by currency fluctuations when the value is translated into the home currency. One year it can have a positive effect while the other a negative effect, therefore those differences are kept in the other comprehensive income statement until realized.

Items included in OCI and excluded from the income statement usually are:

• Unrealized holding gains or losses on investments that are classified as available for sale.
• Foreign currency translation gains or losses.
• Pension plan gains or losses.

Before investing, it is good to take a look at accumulated OCI in order to see if the company has some huge unrealized future risks or benefits. Unfortunately the risks and unrealized losses are always wider than unrealized gains.

Conclusion

A good note for the average investor is that the SEC is looking at the issue and probably is going to regulate the way companies report earnings in order to limit the deceiving of investors. But, in the meantime, each investor should meticulously study the pro forma, GAAP and OCI earnings in order to estimate his investment. To conclude, Buffett applauds companies that report OCI income in the regular income statement and only real GAAP earnings.

An Analysis of the Latest Earnings Reports

• “Sell in May and go away” doesn’t sound so foolish anymore.
• The Dow Jones Industrial Index average revenue has declined by 4.1%.
• High liquidity and employment enables buybacks and pension funding that keep the market at high levels.

Introduction

Recently there have been some surprising earnings debacles. This article is going to elaborate on them and discuss possible reasons and consequences of the earnings misses.

Summary of Earnings

Apple (NASDAQ: AAPL) reported Q2 EPS at $1.9, missing analysts estimates by $0.1 and a revenue decline of 12.8%, also missing estimates. It guided to lower Q3 revenue of $41-$43 billion which is also below estimates of $47 billion.

In spite of declining revenue AAPL continues its buyback program and increased it from $140 billion to $175 billion. By buying its own shares, AAPL is investing in a company with declining revenue and earnings instead of focusing on growth and development. Only the future can tell if AAPL will manage to turn things around and increase revenue or the buyback strategy is the only plausible strategy for AAPL’s management in order to increase EPS. In the meantime, AAPL’s shares were down 9% after the release.

Alphabet Inc. (NASDAQ: GOOG) also missed expectations with revenue growth of “only” 17.4% y/y and EPS of $6.02. GOOG spent only $2 billion on buybacks in the last quarter. Not much when compared to AAPL’s $6.6 billion for buybacks and $2.9 billion for dividends. The above represent two different strategies and focuses. GOOG’s shares were also down 7.3% after earnings.

Another company in the digital world that has seen shares plunge soon after the earnings release is Netflix. Netflix (NASDAQ: NFLX) reported revenue growth of 24.8% y/y and positive earnings per share but the slower than expected growth in subscribers influenced a 15% stock price decline.

The same happened to Twitter (NYSE: TWTR), revenue grew by 36.4% but shares declined by 9.2%. Microsoft (NASDAQ: MSFT) was also down 10% after earnings.

Before moving away from the digital sector, I’ll mention that the S&P 500 was mostly flat while the above companies sustained large losses.

In the financial sector Bank of America (NYSE: BAC) has seen revenue decline by 8% and earnings in-line. American International Group (NYSE: AIG) posted a loss of $1.1 per share but nevertheless increased buybacks by $5 billion and increased its dividend by 14%. Goldman Sachs Group (NYSE: GS) reported a decline of 55% in earnings and a 40% decline in revenue.

The above earnings reports and management actions do not create a positive sentiment. The digital companies like NFLX or social platforms like TWTR are still growing but at a slower rate, the oldies like AAPL and MSFT are not growing anymore and the financial sector is also facing strong headwinds.

In order to see how the market is doing in general—and not to focus on the companies mostly analyzed in the news—a good representation of the market is the Dow Jones Industrial Average Index (DJIA). The below table shows quarterly revenue growth from the 30 companies that constitute the DJIA.

Table 1: DJIA revenue growth per company.

Of the 30 companies in the DJIA 5 companies still have to report earnings and 12 have reported declining revenues, while of the 13 reporting revenue growth only 6 of them have seen revenue grow at a rate above 2.2%. The average revenue decline was -4.1%. With such a strong decline in year on year revenues a similar decline in the Dow Jones index would not be surprising. But what is surprising is that the DJIA has risen 1.8% in the two weeks of the earnings season.

Figure 1: DJIA index in the last two weeks. Source: Yahoo Finance.

A reason for the DJIA rising could be that the IRA contributions deadline was on April 15. As the US employment rate is still high and the interest rates are low there was plenty of liquidity to fund pension contributions and consequently the stock market.

Figure 2: US unemployment rate. Source: Bureau of Labor Statistics.

But with declining corporate revenues, management might focus on cost efficiency by laying off employees. Up until now, corporate revenues have been constantly increasing and the consequence was increased hiring. The opposite should happen if the revenue growth trend reverses as the first indications show.

Figure 3: S&P 500 Revenue. Source: Multpl.

The previous decline in corporate revenues from the 2008-2009 period had a severe influence on the unemployment rate bringing it up to 10%. Also it was a sharper decline in revenues than the current one, accompanied by a stronger decline in earnings and without quantitative easing.

Conclusion

The high market liquidity influenced by low interest rates enables companies to finance themselves cheaply and reinvest that money into buying their own shares and thus skewing real ratios. A low unemployment rate means that contributions to pensions and financial institutions are high and those can keep the market up, even with revenues declining. But, the declining revenues make the following rule of thumb an interesting perspective:

Sell in May and go away.

FBN Securities researched on how the unwritten rule performed in the last 20 years and the results show that the above rule is surprisingly accurate.

Figure 4: S&P performance by month. Source: FBN Securities.

Returns on being long in May are negative while returns related to the colder months of the year are very positive. As it is very difficult to time the market and very easy to be wrong when selling in May, the above rule of thumb should be taken with a grain of salt. But, seeing that revenues are declining, and declining revenues will eventually have an impact on the economy, it might not be a bad idea to rethink portfolio allocations and risk exposures.