No Profit Pollyannas Allowed

At this point, I’m not sure anyone is as optimistic about the outlook for US corporate profits as company analysts (still) are.

To be fair, they probably don’t deserve the starry-eyed Pollyanna label. Just because a given analyst is predisposed to optimism when it comes to his or her coverage universe, doesn’t necessarily mean that person everywhere and always dons rose-colored glasses. An analyst might be optimistic (unrealistically so, even) about the companies with which he or she is intimately familiar, but still be bearish on the overall macro outlook, although that juxtaposition will look suspiciously like cognitive dissonance in proportion to how cyclical that person’s coverage universe is.

That’s my (one and only) attempt to exonerate bottom-up consensus in the face of ongoing concerns that analysts are behind the curve in marking down profit expectations for corporate America. The criticism isn’t new, certainly not historically, but not in the context of this cycle either. Just before Q2 reporting season, the cacophony of derision grew loud indeed, but company analysts were vindicated when second quarter results cleared the (lowered) bar. Q3 was a different story, though. Results were spotty, at best, leading top-down strategists to cut forecasts further, leaving an even wider disparity with consensus.

Goldman’s David Kostin, for example, sees no index-level earnings growth in 2023. “We forecast 2023 S&P 500 EPS will equal $224, unchanged from 2022,” he wrote, in the bank’s year-ahead US equities outlook. “While revenue next year should increase by 4%, roughly in line with nominal GDP growth, net margins will contract by 58bps, from 12.2% to 11.6%, eliminating any EPS growth at the index level,” he added, noting that consensus still sees earnings growth of 4% next year and 10% in 2024. “Margin forecasts explain why our top-down EPS estimates register below bottom-up consensus estimates,” Kostin went on to say.

The table (above) is a snapshot of Goldman’s outlook and how it compared to consensus as things stood this week. For those interested, there’s a more detailed discussion of Goldman’s earnings outlook here.

If you ask Morgan Stanley’s Mike Wilson, bottom-up consensus isn’t even close. Wilson expects index-level EPS of just $195 in 2023 in his base case on margin compression of 150bps.

While detailing his profit outlook, Wilson cited the bank’s leading earnings indicators, both of which suggest outsized declines. The bank’s go-to indicator comprises ISM manufacturing, consumer confidence, housing starts and credit spreads. It adjusts automatically based on correlations, such that if any one factor becomes too detached, the model temporarily drops it. As you can see from the figure on the left (below), the indicator tips a substantial deceleration in earnings growth.

The figure on the right (above) is a new Morgan Stanley model which strips out ISM. “We systematically assessed ~10,000 monthly macro series during the process of constructing this indicator and wound up including the series listed in the footnote below Exhibit 14,” Wilson explained, after noting that it “possesses a similarly strong r-squared when run against actual S&P 500 EPS growth, and points to an even more severe decline in earnings growth over the next 12 months.”

Wilson emphasized that the bank’s top-down forecasts for profit growth deceleration are predicated mostly on margin compression. Top line growth is expected to slow, but it’s margins that “do the heavy lifting to the downside”, as he put it.

In the bank’s bear case, margins contract by more than 200bps. Consensus sees flat profitability at worst. Wilson was keen to note that even in the bear case, the contraction Morgan sees wouldn’t represent a singularly extreme deviation from trend, even if the decline is large in absolute terms (figure below).

“The combination of sticky wage costs and slowing end market/consumer pricing has been evident in recent macro data and loudly signals margin pressure,” Wilson warned, offering a simple illustration that compares the spread between nominal GDP growth and wage growth to EBITDA margins. “On a similar note, the spread between top line growth and PPI growth is another way to think about margins from a top-down standpoint and also points to cost pressure risk looking forward,” he said.

As for the contention that earnings (or nominal profits, at least) will hold up because inflation is likely to remain sticky, Wilson delivered a characteristically trenchant critique, the gist of which can be captured in just two sentences.

“Thinking about the areas of inflation that are likely to remain more resilient into next year (shelter, wages, certain services) and the areas that are likely to decelerate more acutely (goods) does not paint a constructive picture for S&P 500 margins, in our view,” he wrote. “The index is levered to wages, in particular, on the cost side and goods, in particular, on the end demand side.”


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6 thoughts on “No Profit Pollyannas Allowed

  1. Considering where we were March 2020 this seems pretty sedate. Good boring.
    Best wishes to the people of Ukraine and to the people throughout the world who are going hungry because of the invasion.

  2. I’d be willing to bet that wage pressure subsides 2023. Tech and housing related wages will lead the way. A lot of tech talent is flooding the market with the massive layoffs across major and minor players and that’ll create downward pressure on pay. The housing industry will be next as more people start to leave due to lack of work. Not sure if that’ll bleed into the services sector, but I wouldn’t be surprised if margins in tech hold up well next year.

    I have started to reassess my view of housing in the Bay Area due to the massive decrease in valuations across many tech companies. That equity ain’t looking nearly as good as it used to for a lot of folks in the industry and I imagine that’s where a lot of down payments were coming from.

  3. Company analysts tend to underestimate fixed costs and operating leverage at inflection points.

    I was taught to track incremental margins, e.g. (3Q22 gross profit – 3Q21 gross profit) / (3Q22 revenue – 3Q21 revenue), and make sure my forecast incremental margins were consistent with those delivered in prior downturns and upturns. I was also taught to build as much fixed cost detail as possible into models. The result tends to be earnings forecast below consensus at the start of downturns and above cons at upturns.

    For example, suppose company revenue is $100, COGS is 70% of revenue with 50% of COGS ($35) is fixed cost and 50% ($35) is variable (proportional to revenue), SGA is 25% of revenue with 80% of SGA ($20) is fixed and 20% ($5) is variable. Result is EBIT $5.00 (5.00% EBIT margin). Suppose revenue declines -5% to $95. Result is EBIT $2.75 (2.89% EBIT margin). Revenue declines only -5% but EBIT declines -45%.

    (This might describe a manufacturing company with high asset intensity hence sunstantial depreciation in COGS, plus all the manufacturing labor, factory, warehousing, distribution, etc costs in COGS, that generally have to be paid regardless of product volume or price.)

    Most company analysts will not slash EBIT forecast that much, until reality compels it. Why – various possible reasons, but most Street company models don’t actually have much fixed cost detail.

    You can do that for whole industries and sectors, as well as for companies. I don’t know how the top-down strategists do it, but I’ll bet the best ones, with substantial resources, are looking at incremental margins by industry.

    In my SP500 valuation model, I think (from memory) I have something like 2023 revenue -5% and EBIT -28% YOY.

    Now throw in inflation, which few current analysts (me included) are accustomed to modeling.

    1. jyl- thanks for posting the details of your analysis. As a retired CPA, I appreciate the detail.

      Which assumptions that you made or other factors that you did not even take into consideration are you most worried about not being accurate- besides the general “catch all” of inflation?

      1. I can’t really model for inflation with any detail. For each company, or industry, you’d have to know or estimate the input costs (COGS in raw materials, intermediate goods, transport, energy, hours worked, wages, etc) and inflation’s effect on each, as well as price and volume for the output (sales), and then similar for SGA. That is too detailed for anyone but a specialized company analyst, which I no longer am, and even they will have a hard time getting that level of detailed information. Add in the company’s hedging, and FIFO/LIFO effects (is the revenue recognized today from products/services that entered inventory last quarter or three quarters ago?), and all the other adjustments (write-offs, valuation allowances, etc) and it just isn’t possible for an external analyst to get it right or, sometimes, even sort of right. The further you get down the income statement the harder it is, and when trying to forecast cash flows or balance sheets, it is even harder.

        The other thing to consider is that the value of sellside analysts to their research customers (large institutional investors) is primarily management access, gauging investor sentiment, coming up with trade ideas, and gathering/disseminating company/industry information flow, secondarily in forecasting this quarter’s metrics (and there more directionally than exact point numbers), and only tertiarily – is that a word? – in forecasting earnings or cashflow several quarters or years out. They have to prioritize their resources. A publishing analyst with 15 or 20 companies under coverage may only have one or two junior analysts doing the modeling, and it is easy for a young analyst to sink an entire workday into updating and revising forecasts for a single company.

        When I was a buyside company analyst, I used to wonder why sellside models were not more sophisticated, eventually I understood.

        It doesn’t make it easier that I, like most current investors, was not in the business when we last had high inflation. I’ve been around longer than some (since the late 1990s) but high-single-digit or double-digit inflation is still something from the history books. The commonly available data sources (the standard Bloomberg, Factset, etc subscriptions) don’t even show much company financial data earlier than 1990 or so. Companies, industry structure, and data collection were so different in the 1970s-1980s. You can look at a strategist’s note saying that industry X outperforms in inflationary periods based on data from 1950-present, but is the industry the same today as it was then?

        We (investors) are feeling our way through unfamiliar waters with only moldy old charts of the “Here Be Sea Monsters” variety. Which makes things interesting and entertaining, and full of opportunity, but not easy.

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