Q4 Earnings: First Look Provokes Caution, Underscores Opportunity

by: Stephen Biggar


With about 64% of S&P 500 companies having reported, individual company earnings are down about 4.5% on average.

We note a stark contrast between average earnings and market-cap-weighted earnings.

Strong U.S. dollar continues to be a headwind.

Compared with the other three reporting periods, fourth-quarter earnings season has its own cadence. More than 65% of U.S. publicly-traded companies align their fiscal year with the calendar year; in some sectors, that alignment percentage is much higher. Companies thus take longer to report 4Q earnings as they gather full-year results and use that data as they prepare operations for the year ahead. This 4Q earnings season, companies are not just reporting challenging results, but they are girding their loins for what looks to be a persistently turbulent operating environment.

With about 64% of S&P 500 companies having reported, individual company earnings are down about 4.5% on average compared with calendar 4Q14. Calendar 4Q15 EPS for companies outside the Energy sector, on the other hand, is up about 2.3% year over year. These earnings growth measures are based on a simple average of all reporting companies. By contrast, earnings measured on a market-cap-weighted basis are up 4.3% (including Energy) and up 9.6% (excluding Energy) year over year. The market-cap-based outperformance indicates that the mega-cap companies are doing better at preserving modest earnings growth than smaller companies, which appear to be bearing the brunt of the earnings decline.

Energy sector earnings are down 40% year over year - better than the 60-70% declines from the middle quarters of 2015, but still a heavy drag on overall earnings. Many Energy sector companies are now issuing warnings of steep CapEx cuts and limited prospects for improved pricing before 2017. Until WTI oil shows an ability to stabilize above $30 per barrel, earnings for this group will be very difficult to predict with any accuracy.

In contrast to Energy, earnings are growing in a few sectors. In a world awash in cheap oil, beset by sinking commodity prices, and with a strong dollar making it harder for emerging economy consumers to afford things like iPhones, the U.S. consumer has been a bastion of strength. For 4Q15 at least, U.S. consumer strength prevailed. Among the major sectors, the best 4Q15 EPS growth to date has been in Consumer Discretionary, up over 20%. Consumer Staples is also positive, although its 3% Y/Y gain has been undercut by global exposure to weak currency nations.

Looking at other sector performances, Telecom stands out with a 28% gain. Two main events are driving the earnings surge in what is historically a slow-growth sector. Consumers are now paying full price for mobile data, as "all you can eat" plans fade away; and carriers are no longer subsidizing mobile phone purchases, at least for popular models such as Samsung (OTC:SSNLF) Galaxy and Apple (NASDAQ:AAPL) iPhone.

Most other sectors are either up a percentage point or two (Healthcare, Utilities) or down a percentage point or two (Technology, Financial Services). The surprise performer in 4Q earnings is Industrial, up 2%. Materials' 4Q15 earnings are down sharply, declining 18% year over year. For this sector, as for Energy, year-ahead warnings are equally weighing on share prices.

There is a disconnect in calendar 4Q earnings between companies whose earnings grew and those whose earnings declined. On average, companies that grew earnings increased EPS by 14% year over year. Companies with earnings that declined experienced twice that level of pain: on average, EPS declined 28% annually at companies reporting negative EPS trends. Intuitively, the list of lower earners is heavily populated by Energy and Materials companies. But several other industries are on the lower earnings list, including semiconductors, media and food & beverage.

How much did the strong dollar and weak foreign currencies (particularly the yen and euro) impact calendar 4Q15 revenue? Most companies with meaningful overseas exposure have reported repatriation-related currency headwind of 5-15%, with a median of about 8%. For calendar 4Q15 to date, revenue on average has declined 4.8% year over year. That suggests that the bulk of the top-line decline for 4Q15 can be explained by unfavorable currency repatriation.

As expected, Energy earnings are dragging down an otherwise slightly positive earnings environment. The surprise is not that bad Energy earnings have been joined by bad Materials earnings, but that any company at all can grow EPS in this fraught environment.

By the end of 3Q15, we sensed we had seen the bottom in commodities and currencies and the top in the dollar versus both mature- and emerging-economy currencies. While commodities and energy have worked lower and the dollar has worked higher in recent months, these moves have been much less severe than the large swings seen in 1H15. Even as we adjust expectations for coalescing realities, we regard the market as forming a tradable bottom. The wild card, however, would be a break in WTI to the mid-$20s.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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