Are company analysts Pollyannas or are macro-minded strategists Chicken Littles?
That’s becoming one the most vociferous debates in market circles ahead of second quarter earnings in the US. Many observers, myself included, expect across-the-board revisions to reflect an extremely onerous operating environment characterized by margin headwinds, Fed tightening and a decelerating economy.
Despite retailer guidedowns, hiring freezes across industries and margin misses aplenty, bottom-up consensus hasn’t really budged. Expectations for profit growth have flattened out, but haven’t turned lower, a state of affairs that prompted one CIO to decry a “horrifying” lack of initiative on the part of analysts.
Read more: One CIO Is ‘Horrified’ At Analysts’ Profit Complacency
In a new note, Goldman’s Ben Snider recapped the recent history of US corporate earnings. Quite a bit of the surge in profits over the past two years was attributable to margin expansion, which “catapult[ed] earnings higher [and] surprised most analysts,” he remarked.
A re-acceleration of net profit margins to record highs midway through last year may help explain analysts’ collective reluctance to give up on calls for even higher profitability going forward. In aggregate, S&P companies are expected to enjoy 30bps of margin expansion next year, while the median stock is seen growing margins by twice that amount.
That, despite what Snider noted are “tightening financial conditions, persistent input cost pressures and slowing revenue growth.” That’s not a macro conjuncture conducive to enhanced profitability, and neither are recessions.
Since 1970, the median peak-to-trough contraction in margins around economic downturns was 130bps, with the shallowest episode coming in 1981 and the worst profit crunch two decades later, during the dot-com bust (figure on the right, above).
Goldman leveraged a macro-based model of EBIT margins to estimate operating profitability for 2022 and 2023. Not surprisingly, the bank’s estimates suggest the median stock will experience margin compression next year, not expansion, irrespective of whether the US economy succumbs to recession.
Specifically, Goldman’s model shows profitability could shrink by a little less than 70bps for the median S&P 500 company (ex. financials and energy) in a non-recessionary scenario (the bank’s base case) and almost double that in a recession. So, the difference between analysts’ current estimates, which reflect 60bps of margin expansion for the median company, and Goldman’s model-implied margin compression, is almost two full percentage points.
When you consider all of the above, do note that S&P 500 companies currently enjoy an average consensus rating of 4 on a scale of 1 to 5, where 1 is Sell and 5 Buy.
As the figure (above) shows, that represents the most optimistic take on share prices in two decades. Bloomberg’s Elena Popina called it a “new extreme” for bullishness even as notoriously bullish Wall Street analysts go.
Commenting further, Goldman’s Snider wrote that the rising cost of debt matters too. “Although S&P 500 companies generally have strong balance sheets and long-maturity, fixed-rate debt, rising interest rates will nonetheless put upward pressure on borrow costs,” he said, noting that excluding financials, “a 100bps increase in S&P 500 borrow costs would lower net profit margins by roughly 40bps and reduce earnings by about 3%.”
If the Chicken Littles are even a semblance of correct, US shares likely have further to fall unless you believe investors will be inclined to pay more for every dollar of diminishing earnings as the economy slows and the Fed hikes rates into restrictive territory.
To be slightly Pollyannaish, the 1981 recession was caused by excessive tightening to combat inflation, like the one coming up, so maybe margin compression will be less than the median.
A little detail about street company models. Almost all will model expenses (COGS, S&M, R&D, G&A, etc) as a percentage of revenue. That implies that expenses are all variable. Almost none build out the expense lines in detail from their variable and fixed parts. Often the fixed parts are the majority of the expense line. Therefore, street models typically underestimate operating leverage, on the way up and (more salient now) on the way down.
jyl
Sir, you have it on the nose! The media rarely figures out how much power operating leverage has in corporate performance. Healthcare, utilities, transportation, hospitality and cyclical manufacturing, among others, have high fixed costs and high operating leverage. Great when volume is rising and gross margins are at least steady, but terrible when volume is down and/or gross margins are compressed. The habitual error of treating all expenses as a percent of sales creates real performance surprises and frequent errors in management. Another place where errors are habitual is in retail and services like restaurants. Variable costs are only those which vary directly with sales. Clerks in stores, bank tellers, counter folks at MacDonalds are costs as soon as they are scheduled, whether or not they actually have work. This makes them fixed costs whenever they are on the floor. However, most analysts routinely treat them as variable costs, and this mispecification can lead to bad forecasts and poor management decisions.
One thing I learned a long time ago is to watch the incremental margins. E.g. incremental gross margin = (change in gross profit) / (change in revenue). These provide quick-n-dirty “reality checks” on much margins will go up (down) as revenues increase (decrease), even if one doesn’t separately model the fixed and variable components of expense.
In mid 2020, looking at incrementals led to margin and earnings forecasts for 2021/22 that were far above the then-consensus. Today, looking at incrementals will likely point to forecasts for 2023 that are far below consensus.