What Recession?

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by: Pinxter Analytics
Summary

Most of the Dow Jones Industrial Average companies have reported their full year 2018 earnings, and the raw data is interesting, to say the least.

After a robust tax-cut-fueled EPS surge through 2017, expectations for the year to come along with cooling revenues are prompting calls for a global growth slowdown.

I believe numbers are still conservative and that key companies from within the bunch, representing $6.5 trillion of market value, show a more optimistic picture than most are expecting.

I remain bullish in the near term.

Earnings for the major companies were flying high in Q1 and Q2 of 2018 as most major consumer spending indicators were surging and enterprise technology spending seemed to be on track to deliver meaningful growth throughout the year. But then in the 3rd quarter something happened.

The Dow Jones Industrial Average (DIA) is comprised of 30 companies with a combined market capitalization of around $6.5 trillion, if you average out the last year or so, and there are some interesting data points that come from studying those companies' earnings reports over the last several years and what they expect to report in the upcoming one.

The Raw Data

For 2018, these 30 companies reported EPS of $232.07, which rose 25.1% from 2017's EPS of $185.51. Most will attribute this to a combination of tax cuts and share repurchases as revenues only rose 9.12% from $2.85 trillion in 2017 to $3.11 trillion in 2018.

This was, however, an acceleration from the growth we saw in 2017 when EPS grew 13.9% from $162.86 and revenues grew 5.7% from $2.7 trillion. It's evident that there was indeed growth across most sectors, and although I believe there is an argument to be made that looking only at the top 30 companies versus a wider ranged market can be misleading, I do believe that it paints enough of a picture of the economy especially given similarities to the 500 companies in the S&P 500 index (SPY) and the Nasdaq 100 index (NDAQ), adjusted to the weight of Financials vs. Consumer vs. Technology of the aforementioned indexes.

(Source: Pinxter Analytics / Company Filings / Analyst Estimates)

The Drivers

EPS growth for the year appeared pretty consistent across all industries. The only companies which didn't grow EPS by double digits were Cisco Systems (CSCO), Coca-Cola (KO), IBM (IBM), Merck (MRK), Nike (NKE), Procter & Gamble (PG) and Walmart Stores (WMT) (although Walmart has yet to report Q4 earnings). On the other hand, Chevron (CVX) and Caterpillar (CAT) grew EPS by 118% and 64%, respectively, and taking that growth away reduces the entire index EPS growth to just 14%, in line with the previous year.

On the flip side, only 11 of the 30 companies reported revenue growth over 10% in which only American Express (AXP) and Caterpillar reported growth over 20%. Notably, both Coca-Cola and McDonald's (MCD) reported revenue declines of around 10%, driven by weaknesses in their core markets as the world gets more aware of health. Other companies like Walmart, Verizon (VZ), Procter & Gamble, Pfizer (PFE), IBM, Cisco, and 3M (MMM) reported revenue growth under 4% for 2018, in wide contrast with EPS growth.

When we look at what the companies reported in 2017, it's not surprising to see Chevron and Caterpillar at the top of the EPS growth table with 245% and 101%, respectively, as the Oil markets were the prime growth factor over 2016. Companies like Verizon, Travelers (TRV), DowDuPont (DWDP), Walt Disney (DIS) and Coca-Cola reported negative EPS growth and companies like American Express, Cisco, IBM, United Technologies (UTX) and Walmart reported growth of under 2%.

Revenues came in even worse. If you exclude DowDuPont's 65% revenue growth (due to the merger), the entire Index only grew revenues by 2.5% compared to 2017. Now it's not a surprise that EPS grew meaningfully as global markets recovered from their slump but revenues barely rising was a concern. Only DowDuPont, Caterpillar, Chevron, and Visa (V) reported revenue growth of over 10% and most reported near-0% growth for the year.

Guidance: Just Conservative, or a Recessionary Trend?

EPS for 2019, according to analyst estimates based on company guidance which were compiled by Zacks Investment Research, is expected to grow 8.4% to $251.56 and revenues are expected to grow 5.24% to $3.28 trillion. Notably, only Microsoft (MSFT), Exxon Mobil (XOM) and Visa have guided for 10% to 12% revenue growth even as almost half the companies project double digit EPS growth.

Companies like Intel (INTC) and Walmart are guiding for negative EPS growth and IBM, Procter & Gamble and McDonald's are guiding for negative revenue growth while Johnson & Johnson (JNJ), Verizon and Goldman Sachs (GS) are projecting revenue growth of under 1%.

Given the fact that EPS and revenue projections have seen large downwards revisions in the last few months, it's no surprise that companies have adjusted their views in accordance with the slowdown they see in China and the US as the trade war continues. However, if that's resolved, we'll likely see a slew of guidance upgrades in the first half of 2019 but even if not, upward revisions by analysts will likely come at any hint of enterprise spending upgrade cycles or consumer spending bumps, even if China headwinds persist.

Enterprise vs. Consumer Spending

A deeper dive into some of these companies' income statements show a match with what the entire industry is saying - the economy may be cooling, but that's not yet reflective in consumer spending figures.

Enterprise spending a.k.a. capital expenditure is cooling after H1 of 2018 as companies continue the practice of shareholder value over investments. I pointed out the broader implications and realities for Apple (AAPL) and Microsoft in my previous article Apple's And Microsoft's Cash: A Year Later, in which I present the facts about the capital expenditure environment after my initial assessment of the new tax law was imposed and I wrote the initial Apple's And Microsoft's Shareholder Repatriation Is Not A Sure Thing. This isn't just investing in themselves, which then drives a higher rate of product innovation, but also then requires upping purchases from other companies like Apple buying from chip manufacturers and Whole Foods (AMZN) buying raw materials from food processing companies. It's a cycle which is cooling and being exacerbated by the preference of cash hoarding and shareholder value programs.

Consumer spending remains strong. This is partly due to higher debt, both in the form of personal debt (credit card and bank loans) and other debts like student and automobile loans, but spending remains strong. People are shifting where they spend money from "stuff" to experiences so we are seeing traditional services companies like restaurants and travel companies doing better as traditional retailers keep inflation down, but it's there. I do believe we're in for a slowdown period which will coincide with softer capital expenditures by the major companies but as we see good signs from revenue growth estimates for giants like Nike and Coca-Cola, which are primarily consumer-driven, they are funded by a much higher growth rate for Visa and American Express (debt).

Conclusion

Even though a slowdown is evident as global growth headwinds persist, it's clear that an 8.4% EPS growth rate and 5.24% revenue growth rate projections when expectations are this low is not a bad sign historically and that it'll take more than a few bad guidance updates to dampen the prospects of the US economy.

Last month I wrote an article titled Bear Market? What I'm Buying when most of the major market indexes were close to a bear market, as characterized by a decline of 20% or more, and laid out a plan of what companies I was looking at buying, which were consumer-related rather than enterprise-related.

All in all, there's an inherent risk investing with global markets as higher interest rates put an end to easy debt-fueled growth and the tax cut short-lived boost loses its steam. The larger problem, for which I'll dedicate an entire article to later in the quarter, is how the US debt is being affected with no boost to investments and an insignificant rise in consumer spending and earnings.

For now, however, markets are stable enough and consumers are spending what they have (and then some) on a shifting brand segment of products and services and I believe it should continue for the time being. I remain bullish on a select number of companies, some of which are included in this article, and the rest can be found here.

Disclosure: I am/we are long VZ, NKE, AMZN, IBM, MSFT. SHORT SPY, AAPL, CVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.