1q corporate results: 3% earnings growth expected in 2019 · pdf file 30.05.2019...

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  • 1Q Corporate Results: 3% Earnings Growth Expected In 2019

    May 30, 2019 by Urban Carmel of The Fat Pitch

    Summary: Overall, corporate results in the first quarter of 2019 were good, but not great. Sales and earnings growth were 6% and 8%, respectively. Margins rebounded from the end of 2018 but are still below the cycle high made in 3Q18.

    Looking ahead, analysts' expectations for 10% earnings growth in 2019 have been revised down to 3%. This estimate will be about right if margins can be maintained at the their 1Q19 level, but if the dollar continues to appreciate, earnings growth could be close to zero and another drop in oil prices could cause earnings to decline.

    Valuations are now back to their 25-year average. They are not cheap, but if investors once again become ebullient, there is room for valuations to expand. With earnings growth likely to be negligible, the key for share price appreciation in 2019 is likely to hinge almost entirely on valuations expanding.

    96% of the companies in the S&P 500 have released their first quarter (1Q19) financial reports. The headline numbers were good, but not great. Here are the details:

    Sales

    Quarterly sales grew 6% over the past year. On a trailing 12-month basis (TTM), sales were 8% higher yoy, a strong result (all financial data in this post is from S&P). Enlarge any image by clicking on it.

    The arrows in the chart above and those that follow indicate the period from 2Q14 to 1Q16 when oil prices fell 70%. The negative affect on overall S&P sales (above) and the energy sector alone (below) is easy to spot.

    Page 1, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://us.spindices.com/indices/equity/sp-500 https://1.bp.blogspot.com/-pmSJda3-mqU/XO7FNkPBMqI/AAAAAAAAumY/ETSfDUYfslE4CBtrcnDwybduKsAlhVwqQCLcBGAs/s1600/sales.png

  • The six sectors with the highest weighting in the S&P grew an average of 9% in the past year (box in middle column) and, since the peak in oil in 2Q14, their sales have grown an average of 36%. In contrast, energy sector sales have declined 37% (far right column).

    Excluding the volatile energy sector, sales for the remainder of the S&P have continued to trend higher at about the same rate over the past 8 years (blue line; from Yardeni).

    The dollar has become a headwind for sales growth: in the past year (thru 1Q19), the dollar appreciated by 8%; this accounts for about a 4 percentage point decline in growth in corporate sales growth. For the current quarter (2Q19), the dollar is pacing 6% yoy appreciation.

    How does the dollar impact sales growth? Companies in the S&P derive about half of their sales from outside of the US. When the dollar rises in value, the value of sales earned abroad (in foreign currency) falls. If foreign sales grow 5% but the dollar gains 5% against other currencies, then sales growth will be zero in dollar terms. The chart below compares

    Page 2, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-MTJ3fYNak7Y/XO7Fi29pAMI/AAAAAAAAumg/zZK_VUNIV9YKIpjnBgwsJ_Ot-aMz7rj8ACLcBGAs/s1600/energy%252Bsales.png https://1.bp.blogspot.com/-ELFqMNlfdpM/XO7HVPHmG4I/AAAAAAAAums/66LKeDqJoxc0tq2DrkmY-bq15qqFcgLAQCLcBGAs/s1600/sector%252Bsales.png https://1.bp.blogspot.com/-O-OawdGPpn8/XO7ACbkaFNI/AAAAAAAAul4/BUskXbd78IArmEvgt-HDKmZfxT9fTvbyQCLcBGAs/s1600/spx%252Brevs.png

  • changes in the dollar (blue line; inverted) with growth in S&P sales (red line): a higher dollar corresponds with lower sales (from Yardeni).

    Earnings and Margins

    Operating EPS grew 5% over the past year on a quarterly-basis and 16% on a trailing 12-month basis (TTM). GAAP EPS was better: 8% quarterly growth yoy and 17% growth TTM. More on these differences below.

    Importantly, EPS has fallen from its recent all-time high in 3Q18, the first substantial fall since the "profit recession" in 2015.

    The arrows in the next chart again indicate the period when oil prices fell 70% between 2014 and 2016. The improvement in total EPS since then comes with energy sector EPS at one-third of its level in mid-2014.

    Page 3, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-I-LROnVkveE/XO7Bpax7ZlI/AAAAAAAAumE/FUBKP4yAyvsygPusFZjvNqgAFioIkNlfwCLcBGAs/s1600/rev%252Band%252Busd.png https://1.bp.blogspot.com/-jlpqYLsoAZM/XO7IhWyeXMI/AAAAAAAAum0/1IbSu9x6HGYgYwOycTIUQM2K8K633ZumACLcBGAs/s1600/eps.png

  • Likewise, overall S&P profit margins peaked at 10.1% in early 2014, fell to 8% at the end of 2015 and have since rebounded to 11.3% in 1Q19, an improvement from 10.1% in 4Q18 but well below the high of 12.1% in 3Q18.

    Excluding the energy sector, margins rebounded to 11.9% in 1Q19, but may have peaked at 12.6% in 3Q18.

    Most of the largest sectors have increased their margins 1-2 percentage points in the past 2 years but their margin peak, so far, was last year.

    Page 4, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-rQf6y-XOknM/XO7ehuCbeeI/AAAAAAAAuo8/H6fiSMxBvsU_8ghT-m9mCUx63QUSPdBcACLcBGAs/s1600/energy%252Beps.png https://1.bp.blogspot.com/-SksC-7TC-ow/XO7JfyMsafI/AAAAAAAAunE/Nnn7RqFI_zI3c9vJyXBLmwdIKUy1-ejBQCLcBGAs/s1600/margins.png https://1.bp.blogspot.com/-uHSdqJE4BnE/XO7J43By2NI/AAAAAAAAunM/5fW8K6O5smcBP3UClsospTARawsLQ1KPQCLcBGAs/s1600/ex-energy%252Bmargins.png

  • The fall in margins is most apparent in the important technology sector, where margins shot up from 15% in 2016 to 23% in 2018 but have since fallen back to 20%. This is weighing on overall margins for the S&P

    Misconceptions and Bad Memes

    There are some popular misconceptions that are regularly cited with respect to corporate earnings.

    First, companies have been accused of inflating their financial reports through a net reduction in shares through, for example, corporate buybacks. In reality, however, 90% of the growth in earnings in the S&P over the past 9 years has come from better profits, not a net reduction in shares. Better profits have driven growth, not "financial engineering."

    Page 5, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-_fVNG62A2ac/XO7KfBpI0TI/AAAAAAAAunU/Hdr5zy2oVSQycch2lpjFf71B46hnEv4TQCLcBGAs/s1600/sector%252Bmargins.png https://1.bp.blogspot.com/-3URq2wkdYqQ/XO7LbsnrFrI/AAAAAAAAunc/oB0VEU2as6s9pVJXr6utGtWMV3rC1YKTgCLcBGAs/s1600/tech%252Bmargins.png

  • That has been true over the past 17 years, during which the net change in corporate shares has accounted for just 4% of EPS growth (from JPM).

    In fact, despite record buybacks, the difference between EPS and profits has been consistently narrow.

    Page 6, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-D9wzbYXnRJo/XO7LtX7Y_1I/AAAAAAAAunk/p4DHFCxhJvk5TYrC0AmzOEjZqCh3g6hhQCLcBGAs/s1600/source%252Bof%252Bgrowth.png https://1.bp.blogspot.com/-rxgkGL6ZuDc/XO6tKA8Rg9I/AAAAAAAAulU/pzE7YE3fQM8IEYLofBTrJPQPURgFuahBACLcBGAs/s1600/share%252Bcount.png

  • Second, equity prices are said to have far outpaced earnings during this bull market. In fact, better profits accounts for about 75% of the appreciation in the S&P over the past 9 years. Of course valuations have also risen - that is a feature of every bull market, as investors transition from pessimism to optimism - but this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from Barry Ritholtz).

    Over the past 2 years (since 1Q17), during which time the S&P has risen about 20%, earnings have risen 34%, i.e., faster than the S&P index itself thereby accounting for more than 100% of price appreciation. The same is true over the past 1 year (from JPM).

    Page 7, © 2020 Advisor Perspectives, Inc. All rights reserved.

    https://1.bp.blogspot.com/-fxZiRcJabtY/XO7MgrC8R7I/AAAAAAAAunw/HlhRID4UtaYPGLmcD2b9_kCjauNY6jCkgCLcBGAs/s1600/gaap%252Bvs%252Beps.png https://www.bloomberg.com/view/articles/2017-10-27/how-to-tell-the-bulls-from-the-bears https://1.bp.blogspot.com/-UpMUk_D-nsI/XO7NSTakC-I/AAAAAAAAun8/QEngdjdR_l45s3u2AJuS2t8s0QQSGFJZQCLcBGAs/s1600/source%252Bof%252Bchg%252Bin%252BSPX.png

  • Third, financial reports based on "operating earnings" are said to be fake. This complaint has been a feature of every bull market since at least the 1990s. In truth, the trend in GAAP earnings (red line) is the same as "operating earnings" (blue line).

    It's accurate to say that operating earnings somewhat overstate and smooth profits compared earnings based on GAAP, but that is not new. In fact, the difference between operating and GAAP earnings in the past 27 years has been a median of 10% and the recent history has been no different (it was 9% in the most recent quarter). Operating earnings overstated profits by much more in the 1990s and earlier in the current bull market. The biggest differences have always been during bear markets.

    Page 8, © 2020 Advisor Perspectives, Inc. All rights reserved.

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  • Outlook for 2019 Looking ahead, expectations for 10% earnings growth in 2019 have already been revised down to 3%. Sales growth is expected to be 5% in both 2019 and in 2020 (from FactSet).

    There are 5 considerations with a strong bearing on forward sales and

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