The US earnings season: Margin squeeze

• As expected, the majority of US companies reporting third quarter 2022 results in recent weeks have talked about slowing consumer spending, foreign currency exchange headwinds, global economic weakness, elevated inflation and higher interest rates.
• Overall, 88 per cent of the companies in the S&P 500 index have reported actual results for the third quarter to-date. Of these companies, 70 per cent have reported actual Earnings Per Share (EPS) above estimates, which is below the 5-year average of 77 per cent and below the 10-year average of 73 per cent, according to FactSet data.
• And according to Bloomberg, about 24 per cent of the companies in the S&P 500 index have reported earnings that have fallen short of market expectations, the most since the onset of the pandemic in the first quarter of 2020.
• In aggregate in the third quarter of 2022, companies are reporting blended earnings that are 2.2 per cent above estimates, well below the 5-year average of 8.7 per cent and below the 10-year average of 6.5 per cent. It could potentially be the second-lowest ‘surprise’ percentage reporting by  S&P 500 companies in the past nine years.
• Earnings have been stronger than expected in the Energy, Health Care, and Information Technology sectors, while weaker than expected in Capital Goods (Industrials) and Media & Entertainment (Communication Services).
• According to FactSet, four of the eleven sectors are reporting year-over-year earnings growth, led by the Energy (+139.0 per cent), Real Estate (+18.4 per cent), and the Industrials (+15.9 per cent) sectors. But seven sectors are reporting year-over-year declines in earnings, led by Communication Services (-22.2 per cent), followed by the Financials (-20.2 per cent), Materials (-15.7 per cent), Utilities (-4.9 per cent), Information Technology (-2.1 per cent), Health Care (-1.9 per cent) and Consumer Staples (-1.7 per cent) sectors.
• The Energy sector has been a standout performer during the latest earnings season, lifted by surging fuel prices amid tight global energy markets and supply disruptions following Russia’s invasion of Ukraine. Chevron reported its second highest profit of US$11.2 billion on record, but warned that rising costs could weigh on investment.
• Banking giants Goldman Sachs and Bank of America posted better-than-expected profits. But US financials have turned from releasing reserves in 2021 to provisioning for loan losses in 2022, weighing on aggregate S&P 500 year-on-year earnings growth. And insurers have taken a hit from Hurricane Ian, also detracting from headline earnings growth.
• US megacap and growth-orientated technology companies have had a particularly difficult earnings season after heavyweights, such as Alphabet, Microsoft, Meta Platforms and Amazon all issued downbeat sales outlooks as they contended with rising concerns over a potential economic slowdown, rapid inflation and soaring borrowing costs. Notably, the under-pressure S&P 500 Communication Services sector is home to the parents of Facebook and Google.
• Microsoft posted its smallest rise in sales in five years and Google parent Alphabet grew just 6 per cent last quarter, its slowest pace since September 2013 (barring a small quarterly decline in 2020), according to Refinitiv. Amazon issued a disappointing fourth quarter forecast and missed on revenue estimates. Rising investment costs weighed on Disney’s revenue, but streaming services giant Netflix published positive results.
• Conglomerate GE (formerly known as General Electric), which is in the process of breaking up into three companies, said it will reduce global headcount by a fifth at its onshore wind unit, which has been battling higher raw material costs due to inflation and supply-chain pressures. And Boeing’s cash flow was better than expected but concerns about production concerned investors.
• And while the majority of large retailers are still to release results, Mattel, which is very susceptible to discretionary spending cuts, lowered its profit forecast for the year. The toymaker said that it would ramp-up promotions heading into the Thanksgiving-Christmas holiday season to encourage inflation-hit shoppers to buy its Barbie dolls.
• Nike shares came under pressure after a glut of unwanted merchandise eroded the sportswear giant’s profitability.
• But Coca-Cola joined rival PepsiCo in lifting its annual forecasts, as customers bought more soft drinks despite multiple rounds of price hikes.

Sales scorecard 

• As mentioned above, US company sales growth has slowed, but is still above pre-pandemic levels, supported by higher inflation. Blended sales growth is up 9.3 per cent in the third quarter of 2022 when compared with a year ago, according to the latest Bloomberg data. Median blended sales growth is at 8.3 per cent in the past quarter on a year ago.
• The proportion of companies beating sales estimates in the third quarter is sitting around 68 per cent according to Bloomberg figures, above the historical average of 59 per cent. The aggregate sales ‘beat’ has fallen slightly from 2.6 per cent in the second quarter to 1.3 per cent in the third quarter, but is well above the 0.5 per cent average historically. The median company is beating by 1 per cent, slightly above the average 0.6 per cent historically.

Margins scorecard

• But it’s operating margins – a key gauge of company profitability that has a track record of signalling where shares could be headed – that are raising alarm bells for investors. Excluding the buoyant Energy sector, which has benefited from a lift in crude and gas prices, Bloomberg analysts now estimate a 15.1 per cent operating margin for the third quarter, the lowest since the fourth quarter of 2020.
• The overall operating margin of 15.7 per cent also reflects that difficulty that most businesses are encountering trying to pass on higher costs to their customers. According to Bloomberg, firms in the Communications Services, Materials and Consumer Staples sectors have seen the biggest decline in operating margins from a year ago, weighing on profits.
• Margins of ‘big box’ retailers, such as Walmart and Target, remain under pressure from inventory overhangs, supply chain bottlenecks and soaring costs. And consumer staples companies Clorox, Walgreens Boots Alliance and Tyson Foods could see record annual margin contractions.
• But it’s the Energy sector, boosted by large oil and gas supermajors Exxon Mobil and Chevron, that are holding up overall margins when compared with a year ago at 21.2 per cent in the third quarter of 2022.

US earnings outlook 

Earnings beats and misses

• A key feature of the third quarter earnings season has been weakness in megacap technology companies’ top-line results and softer outlooks for advertisers and chipmakers. The mixed consumer outlook has seen increased management mentions of cost cutting with the potential for layoffs and inventory build-up.
• While US sharemarket indexes have broadly lifted during the third quarter earnings season, worries about the earnings outlook have resulted in shares of companies that have missed both earnings and sales expectations being hit hardest on the day of their releases.
• In fact, based on Bank of America figures, shares of companies that missed on both earnings and sales expectations fell by 6.7 per cent on the day of their results release relative to the S&P 500 index. The average decline was 2.4 per cent. And the median one-day performance of companies missing earnings per share (EPS) estimates was 2.5 per cent lower in the third quarter according to numbers crunched so far by JPMorgan.
• On the flipside, Bank of America figures also show that shares of companies that beat on both earnings and sales expectations rose by 1.3 per cent on the day of their results release relative to the S&P 500 index, with an average increase of 1.5 per cent.
• And the median one-day performance of companies missing earnings per share (EPS) estimates was 0.3 per cent higher in the third quarter of 2022 according to numbers crunched so far by JPMorgan. Overall, stocks beating estimates are still outperforming the market, but by modestly less than the historical average.

Earnings estimates

• As mentioned earlier, the third quarter earnings season has been notable for the poor sales guidance of big technology companies, advertising budget weakness, slowing demand for consumer devices, cost cutting by chipmakers, weaker consumer demand, rising job layoffs and hiring freezes, inventory overhangs and pricing power for consumables.
• Given the challenging economic backdrop, consensus market expectations for earnings growth for the fourth quarter of 2022 have been falling over the past few months, according to FactSet.
• On June 30, 2022 the estimated earnings growth rate for the fourth quarter was 9.1 per cent. By September 30, 2022 the estimated earnings growth rate had fallen to 3.9 per cent. And today, the estimated earnings decline is 1.0 per cent, suggesting most analysts now expect an earnings contraction. Even the Energy sector (down 1.3 per cent) is seeing cuts in forecasts, but estimates for travel companies have moved higher due to robust consumer demand.
• Bloomberg data shows that market consensus for the fourth quarter 2022 EPS is currently at $56.32 per share. For calendar year 2022, EPS of US$223 is expected, down 4 per cent from the most recent peak. And 2023 consensus estimates suggest a ‘soft landing’ for the US economy, despite elevated inflation and rate hikes. In 2023, EPS is currently at US$232, down 8 per cent from the most recent peak. Cuts in estimates are most aggressive for the Information Technology (down 3.1 per cent), Financials (down 1.8 per cent) and Energy (down 1.5 per cent) sectors.
• Many analysts expect a sharper earnings contraction in 2023, incorporating a US recession into their forecasts. For example, Citi analysts think that a US recession could see global EPS contract by approximately 20 per cent. The previous seven EPS recessions have lasted two years and saw earnings fall by 31 per cent. And BCA analysis suggests that trailing four quarter S&P 500 earnings tend to fall between 20 per cent and 25 per cent from peak-to-trough during downturns.
• Goldman Sachs strategists have published a recent note detailing their 2023 S&P 500 EPS growth forecasts, which have been cut from +3 per cent to 0 per cent. Analysts cited weak margins and now expect EPS to remain steady around US$224. They also retained their S&P 500 index targets for 2022 and 2023 at 3,600 and 4,000, respectively.
• In our view, should a US recession eventuate next year as expected, the combined weakening of the economy and easing in price pressures could trigger a lift in longer-dated US government bond prices (yields lower), boosting share prices and their multiples. But a potential rebound in equity market returns could be capped by an earnings contraction. The decline in earnings may not end until the second half of 2023 with the size of margin compression likely to increase due to still-solid wage growth. That said, should consumer spending continue to hold up in the face of cost of living pressures and rising borrowing costs, earnings could yet be supported in the near-term.