Is The Earnings Picture Really Weak?

Note: The following is an excerpt from this week’s Earnings Trends report. You can access the full report that contains detailed historical actual and estimates for the current and following periods, please click here>>>

Here are the key points:

• Earnings growth in 2019 Q1 is expected to turn negative, the first earnings decline since 2016 Q2. Driving the Q1 earnings decline are margin pressures across all major sectors even as revenues continue to grow.

• Tough comparisons to last year when margins got a one-time boost from the tax legislation coupled with the rise in payroll, materials and transportation expenses are weighing on margins.

• Total S&P 500 earnings are expected to decline -4.0% from the same period last year on +4.6% higher revenues and 100 basis points of compression in net margins. Earnings growth is expected to be negative for 10 of the 16 Zacks sectors, with Technology and Energy as the biggest drags.

• Technology sector earnings are expected to decline -10% from the same period last year on +3% higher revenues, with the semiconductor space as the biggest drag. Excluding the Tech sector’s weak growth in Q1, total earnings for the rest of the index would be down by -2.1% from the year-earlier period.

• Estimates for Q1 as well as full-year 2019 steadily came down over the last few months, with the magnitude of negative revisions one of the highest in recent years.

• The earnings season has gotten underway, with results from 22 S&P 500 index members already out (fiscal quarters ending in February). Total earnings for these 22 companies are down -10.9% on +4.3% higher revenues, with 72.7% beating EPS estimates and 50.0% beating revenue estimates.

• For the small-cap S&P 600 index, total Q1 earnings are expected to be down -10.1% from the same period last year on +4.1% higher revenues.

• For full-year 2019, total earnings for the S&P 500 index are expected to be up +2.0% on +3.5% higher revenues, which would follow the +23.4% earnings growth on +9.2% higher revenues in 2018.

• Estimates for 2019 have been steadily coming down, with the current +2.0% growth rate down from +9.8% in early October 2018.

• The implied ‘EPS’ for the index, calculated using current 2019 P/E of 17.5X and index close, as of April 2nd, is $163.92. Using the same methodology, the index ‘EPS’ works out to $181.94 for 2020 (P/E of 15.8X). The multiples for 2019 and 2020 have been calculated using the index’s total market cap and aggregate bottom-up earnings for each year.

With earnings growth in the first two quarters of 2019 expected to be in negative territory, the ‘earnings recession’ term is liberally being thrown around. This is coming at a time when late-cycle worries have already made market participants overly sensitive to the shape of the Treasury yield curve and its cyclical implications.

The definition of ‘recession’ is two or more quarters of negative growth, typically GDP growth. The chart below of quarterly year-over-year earnings and revenue growth for the S&P 500 index shows estimates for the current and following three quarters and actual results for the preceding 5 quarters.

To be totally pedantic about it, the recession talk reflects ground reality, as you can see in the chart above. After all, earnings growth in the first two quarters of the year is on track to be negative, even though the 2019 Q2 growth pace is barely in negative territory at present.

We shouldn’t take this recession talk too seriously, however. The reason is that the negative growth in the first half of the year is solely because of very tough comparisons. In other words, the base period for 2019 Q1 growth is 2018 Q1, when earnings received a huge boost from the tax-cut legislation. You can see this in the expanded version of the above chart that shows all four quarters of 2017 as well.

The lower corporate tax rates that showed up in earnings for the first time in 2018 Q1, the base year for 2019 Q1, boosted profitability through margin expansion. As such, we are up against some tough comparisons in 2019.

The tax cut legislation didn’t have a direct bearing on revenues last year and we are not seeing that much drop off in estimates for this year either, as the earlier chart above shows (orange bars). Importantly, growth is expected to resume in the second half of the year and accelerate into next year.

The chart below puts earnings growth expectations for full-year 2019 in the context of where growth has been in recent years and what is expected next year.

So, if the earnings recession is only ‘technical’, is there nothing to worry about on the earnings front?

That’s not correct as there are legitimate reasons to be wary of the earnings picture. The earnings growth trajectory would be challenged and difficult even without the issue of the aforementioned tough comparisons as the global economic growth backdrop has become less favorable and cyclical rises in transportation, logistics, payroll and other expenses are squeezing margins. As a result, analysts steadily lowered their estimates for 2019 Q1 as well as full-year 2019, as you can see in the chart below.

The weak guidance from Nike (NYSE:NKE) (NKE), FedEx (FDX), Adobe (ADBE), Oracle (ORCL) and others in this reporting cycle suggests that we will likely see a replay of what we experienced the last earnings season that pushed estimates lower. We will be keeping a close eye on how estimates for 2018 Q2 evolve as companies report Q1 results and share their outlook for Q2 and beyond.

Recent revisions trend shows that these low growth expectations for the coming quarters still remain vulnerable to further downward revisions. In other words, it is reasonable for market participants to nurse some doubts about the current earnings backdrop.

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