US Corporate Profits at an Interesting Juncture
Earlier this week, I alluded that the third successive mid-year global economic slowdown could be more serious than the prior two episodes.China’s predicament of slowing growth is a formidable addition to the headwinds that are already in place. The implications for US corporate profits could be meaningful if overseas economic activity gets much worse: foreign-sourced profits have been a major factor helping to produce elevated levels ofUScorporate profitability.
S&P500 Q1 operating EPS was the third-highest of all time. Operating margins were also very high (9.1% versus the 7.2% historic average). While expectations for Q2 operating EPS and margins have been coming down, they should still remain very impressive. S&P500 operating EPS is expected to be $25.13 in Q2, while operating margins will still supposedly register 9.1%. At the end of December 2011, the projected S&P500 EPS growth rate for Q2 was +8.7%. This projection now stands at just +3%. What is critical for equity prices is how companies guide expectations about 2012 H2, but more importantly 2013.
Negative EPS Guidance Already More Prevalent in Q2
Although companies are usually loathed to issue negative guidance, Q2 was the most active for the current profits cycle. The ratio of S&P500 companies issuing negative EPS guidance to positive was 2.4 for Q2 compared to 1.5 in Q1. Small wonder why risky asset prices had a far tougher time in Q2. Although Q2 is expected to be an all-time high for S&P500 operating EPS, the year-over-year growth rate will fall to its lowest level since the end of the Great Recession in 2009 Q2. What baffles observers, including myself, is that a recovery in the yearly EPS growth rate is then expected in 2012 H2 and 2013. The prospective state of the global economy presents considerable challenges about how these growth rates will be achieved.
S&P500 Q2 EPS Growth: Strongly Influenced by Bank of America?
Financials (+48% yoy) are likely to register the healthiest EPS growth during Q2, while energy (-18% yoy) and materials (-12% yoy) will be the weakest sectors. The strong gains in financials are made possible by very weak comparisons twelve months ago. It is expected that Bank of America will be the strongest contributor amongst the financials. If Bank of America is excluded, EPS growth for financials will register just +4.7% yoy. The strong influence of Bank of America does not stop there: it will supposedly be the single largest contributor to S&P500 operating EPS for the quarter. If Bank of America is excluded, then S&P500 Q2 EPS growth goes from +3% to -1.7%.
Industrials are expected to register solid EPS growth (+6.8% yoy), driven by machinery and industrial conglomerates. Finally, information technology EPS in Q2 is expected to grow +3.3% yoy. The gain in EPS will be solely attributable to Apple. If Apple is excluded, then information technology EPS growth would fall to -2.4%.
Revenue versus Earnings Growth
Revenue growth for the S&P500 in Q2 is expected to be +1.4% yoy. This has been revised down from +3.4% at the end of March due to a strong influence from the energy sector. Nine out of the ten S&P500 sectors are expected register growth in revenue for Q2. Energy is the exception: Q2 revenues are expected to fall -14% yoy, largely due to the -20% decline in Brent Crude oil prices during the quarter.
Seven of the ten S&P500 sectors in Q2 will supposedly register sales growth higher than EPS growth, thereby conveying difficulties transferring higher sales growth into EPS growth. This dichotomy can seemingly be explained by rising cost pressures.
S&P500 revenue growth ex-financials is now expected to be +4.9% and +4.0% for 2012 and 2013, respectively. These new numbers for 2012 and 2013 were shaved from +6.7% and +6.3% in late-April. For the sake of comparisons, the growth of S&P500 revenue ex-financials was +8.2% in 2011.
S&500 Operating EPS growth ex-financials is basically expected to match sales growth in 2012 and 2013 by rising +5% and 4%, respectively.
Thoughts for 2012 H2 Profits
The two biggest headwinds facing theUScorporate sector for 2012 H2 are: 1) continued slowing economic activity outside of theUS, and 2) further appreciation of the US dollar versus the euro. Foreign-sourced profits contributed to elevated levels of US corporate profitability over the last ten years. This component is now clearly under pressure, the intensity of which may only get worse.
S&P500 operating EPS estimates remain stubbornly high for 2012 H2. Anticipated EPS growth for Q3 and Q4 are +2% and +14%, respectively. As far as Q4 S&P500 operating EPS is concerned, the biggest contributions to the +14% growth will supposedly come from materials (+32% yoy) and financials (+27% yoy).
Quick Thought on Valuation
The current 12-month forward P/E ratio for the S&P500 is 12.3. This is below the 14.4 average for the past 10-years. P/E multiple expansion is tough to justify in the current environment, particularly against a backdrop of elevated profitability. Equities look cheap for a simple reason: profits are very high. We cannot expect much help from lower discount rates. P/E multiple expansion needs to come via an upward revision to the normalised growth rate of US corporate profits. Markets appear to be reluctant to do this, mainly, I suspect, because nobody really knows the magnitude of degradation to US potential GDP growth in the post-Great Recession environment.
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