By David Aurelio
What should you do when in the middle of an earnings recession? Set your expectations low and tune into the beats - at least that seems to be the theme this earnings season. Analysts typically become more bearish heading into earnings season; however, this quarter it appears as though they may have been overly pessimistic. As a result, of the 166 S&P 500 companies to report Q1 2016 earnings so far, 75% beat the Street's expectations. If this continues, it will be the highest percentage of overperformance since Q1 2010, when 78% reported above estimates.
Exhibit 1. S&P 500: Q1 2016 Blended Earnings Growth Rate History
Source: Thomson Reuters I/B/E/S
Now for the bad-ish news
The bears came out of hibernation heading into the Q1 2016 earnings season. Analysts expect this quarter to be the third consecutive year-on-year (Y/Y) earnings decline. Expected Y/Y earnings growth rates for the first quarter of 2016 fell 9.4 percentage points (pp) to a decline of 7.1% on April 1 from January 1. This is the largest downward move in growth estimates over the three-month period leading into earnings season since Q1 2009, when expected growth fell 23.6 pp. This 9.4 pp drop is well below both the average (since Q1 2003) decline of 4.3 pp and median decline of 2.9 pp - and it didn't stop there. Y/Y earnings growth estimates continued to fall, hitting -7.8% on April 15. With over three-fourths of companies beating estimates and earnings coming in 4.1% above consensus, Y/Y earnings growth is starting to reverse, and expectations for Q1 2016 have improved to a 7.1% decline from the prior year.
One of the challenges of starting an earnings season with what appears to be overly bearish expectations is gauging where final earnings growth rates will land after companies report. The median improvement in earnings growth rates from the start of earnings season to the end is 3.5 pp and the average is 1.7 pp (since Q1 2003), but what happens when companies beat estimates at a much higher rate?
Over the past four quarters, S&P 500 companies reported earnings above estimates, at a median rate of 68%. Looking back to Q1 2003, in quarters where companies beat earnings at a rate of 68% or higher, final Y/Y earnings growth rates improved by a median of 4.9 pp and average of 6.8 pp from expectations at the start of earnings season. In periods where the beat rate was 70% or greater, growth improved by a median of 6.3 pp and average of 8.8 pp. Therefore, it is likely that Q1 2016's earnings growth rate will substantially improve by the end of this earnings season.
The week ending April 22nd, 97 S&P 500 companies reported Q1 2016 earnings, with 79% above analysts' consensus. In aggregate, these companies beat earnings by 4.4%. An impressive 25 posted double-digit or higher earnings surprises. One of these double-digit earnings surprises came from Intel Corp. (NASDAQ:INTC), which grew earnings by 31.7% from the prior year and revenue by 8.0%. Intel reported earnings of $0.54 per share versus a consensus of $0.48 per share, which was down 4% from the $0.50 per share expected on February 1. Revenue of $13.80 billion fell short of analysts' $13.83 billion estimate.
PC market trends
From 2013 to 2015, the PC total available market (TAM) declined by 10%. This is partially behind the announcement that trumped Intel's 12.5% earnings surprise. A major reorganization and shift in strategy is expected to cut 12,000 positions by mid-2017 and reassign CFO Stacy Smith to head sales, manufacturing, and operations. Intel CEO Brian Krzanich stated that the intent of this initiative is to "intensify our investments in the products and technologies that fuel the growth in the Data Center, IoT (Internet of Things), Memory, and FPGA businesses, and we expect it will result in an even more profitable Client business." In other words, focus on technologies that require heavy data processing.
Intel lowered its outlook on the PC market to a high-single digits decline from a mid-single digit decline at the start of the year. Smith went on to explain, "The linearity, so first you have to understand, the first half is impacted by the fact that as our customers view of the market came down, and if you recall we had a more cautious view of the market than they did when we started the year. They were bringing down inventory levels, and that impacted us in Q1 and I think you'll see the same impact as we forecast a roughly seasonal second quarter that we'll continue to see those customers burning off inventory. We think that doesn't repeat in the back half, so it's a little bit of a tailwind."
What's driving GM?
Another example of overly bearish expectations on an index heavyweight that resulted in a double-digit earnings beat was General Motors Co. (NYSE:GM). Earnings of $1.26 per share were up 46.5% from the prior year, and higher than the $1.00 per share consensus. Analysts dropped estimates by 11.5% from $1.13 per share on February 1st. GM set a Q1 record with adjusted EBIT of $2.3 billion and reported a gain of 4.4% on revenue of $37.3 billion versus an expectation of $35.7 billion. Looking ahead, GM sees currency and the Brexit as a risk, but stability in subprime activity.
With regard to Europe and currency, CEO Chuck Stevens said, "I'd say the biggest cloud or headwind out there is the currency environment and what's driving that is the weaker pound sterling, which obviously isn't being helped by the Brexit situation. And I'd say that's the biggest risk that we have amongst many, but that's the biggest risk that we have right now that we are working to manage through."
Stevens discussed subprime saying, "our subprime portfolio originations have been relatively constant over the last number of years, so we are not growing that. That's first. Two, AmeriCredit, now GMF, subject matter experts in subprime and managing the risk associated with subprime. Third, our delinquencies and credit losses associated with subprime have been very stable over the last number of years. We see no incremental risk associated with that. And then, finally, we are running today originations as we execute our captive strategy. 80% of originations are prime, near prime. So again very stable levels of subprime activity at GMF."
Spring earnings storm
This week is forecast to be the busiest of the Q1 2016 earnings season, with 186 S&P 500 companies expected to report earnings. The three companies with the largest drag on Q1 2016 earnings growth will report: Exxon Mobile Corporation (NYSE:XOM), Chevron Corporation (NYSE:CVX), and Apple Inc. (NASDAQ:AAPL). They are expected to post earnings declines of 73.5%, 114.0%, and 14.2%, respectively. The influence on Q1 2016 earnings growth expectations is so extensive that if all three are excluded from the calculation, the expected decline in earnings for the S&P 500 is nearly cut in half and improves to a drop of 4.3% from the prior year.
By the end of the week, over 60% of the S&P 500 will have reported Q1 2016 earnings, and we will find out if the bears came out of hibernation too early or if the bulls lead this week's stampede of earnings.