The 2015 third-quarter earnings season, now under way, is an important one that should provide investors with some insight into how companies fared financially during the volatile summer months. Emerging market turbulence, currency fluctuations and general uncertainty regarding markets and the economy were among the factors shaping the landscape during the quarter.
US “buyback” stocks have not outperformed so far this year
US company earnings forecast to decline
At a glance, the third-quarter earnings season looks like a typical season in which companies on average beat the estimates by a narrow margin. Among the companies in the S&P 500 index that had reported by the middle of last week, 74% beat profit expectations and 44% exceeded sales forecasts, according to data compiled by Bloomberg. More than 100 of the S&P 500 companies had reported as of the end of the week. Overall earnings for S&P 500 companies were expected to drop 6.1 percent in the third quarter, based on analysts’ estimates.
Earnings drop mainly due to emerging markets, commodities
But compared with the declines in 2001 and 2009, this quarter’s earnings decline is relatively mild, and is more like the one we witnessed in 1998. That is because we are not in an economic recession. The drop in earnings is due to a limited number of emerging market and commodity-related sectors. Domestic sectors are holding up better because they do not suffer from the stronger dollar and benefit from domestic strength. If the season develops like previous reporting periods, the earnings growth rate will gradually improve and probably end the quarter near -3% to -4%. This is already visible in the weekly earnings momentum data showing some improvement from the rock-bottom levels of the previous week. We maintain our full-year estimate of an earnings decline of 2% compared to 2014 in the US.
Share buybacks may become less popular
A big question is whether companies will continue to buy back shares as enthusiastically as before. The combination of higher credit spreads and higher equity prices makes the trade-off somewhat less compelling. The rise in the net debt-to-equity ratio and the decline in the interest rate cover may also limit buyback activity.
Buyback index not outperforming broader market
The most compelling argument against buybacks may be the observation that so far this year, companies that have bought back shares have not outperformed the broader market. At the end of last week, the S&P500 buyback index was down 2.4% this year whereas the broader market was up 0.8% (see graph). This may be a bigger incentive for companies to reduce their buyback plans. In this respect it is also noteworthy that the Bank of America/Merrill Lynch Fund Manager October Survey shows that for the first time since 2010, more investors think that companies should use cash to strengthen their balance sheets instead of distributing it to the shareholders.
Margin pressure in non-financial sectors
Non-financial companies are feeling some margin pressure from three sources. The first is an increase in non-cash costs, mainly depreciation, amortization and provisioning, from 5% in 2013 to 5.5% currently. This is linked to the increase in capital expenditure from 6% of sales in 2011 to 7.6% currently — an increase that sheds a different light on the view that companies are unwilling to invest. In relative terms, the telecom and utility sectors are the big spenders; in absolute numbers, the energy sector remains by far the biggest capital investor, accounting for 32% of the total expenditures in the non-financial sector. This figure will fall, given the drop in oil prices.
Higher financing charges and wages
Another source of drag on US profit margins is an increase in interest charges, which represent 2% of sales, 40 basis points more than a year ago. This increase is explained by higher debt levels and higher interest rates, especially in the lower-graded companies. The third source may be higher wages. This is not really visible yet, but anecdotal evidence is popping up in corporate guidance.
Stronger earnings growth in Eurozone
All in all we expect US earnings to rise by 5% in 2016, below the 8% we expect for the Eurozone, but much will depend on the movements in the USD and the strength of the global economy. The financial sector will be a big contributor to Eurozone earnings growth in view of the turn in the credit cycle and the provisioning cycle.