by Tajinder Dhillon.
Earnings season kicks off this week and will provide further insight to a myriad of questions – will a greater percentage of companies miss earnings expectations? Will there be continued pressure on profit margins? Will forward earnings expectations continue to reset?
Using data from the January 6th publication of the S&P 500 Earnings Scorecard, 22Q4 earnings are forecasted at $447.07 billion (-2.2% y/y, -3.6% q/q) while revenue is forecasted at $3,697.7 billion (+4.1% y/y, -0.7% q/q). This will mark the first negative earnings growth rate since 2020 Q3 while revenue growth will be the lowest since 2020 Q4. Analysts have also downgraded both earnings and revenue growth expectations aggressively heading into earnings season.
Earnings growth has come down by 3.2 percentage points (ppt) heading into earnings season. This is in-line with the long-term average decline of 3.2 ppt and a median decline of 2.2 ppt. The decline in growth expectations this quarter is a repeat of last quarter which also saw the earnings growth rate decline by the same amount.
22Q4 y/y earnings growth peaked in January 2022 (+14.3%, +16.2% ex-energy) which has since dramatically declined (-2.2% y/y, -6.7% ex-energy) as shown in Exhibit 1. This marks a ‘reset in growth expectations’.
Furthermore, ex-energy earnings growth is expected to be negative for the third consecutive quarter, something we have only seen in two prior periods (2008, 2020).
Exhibit 1: S&P 500 22Q4 Earnings Growth Rate
From an earnings contribution perspective, the energy sector is currently forecasted to contribute 4.1 ppt towards the index growth rate of -2.2%. Said differently, the energy sector has an earnings contribution greater than all the remaining sectors combined. Industrials (2.4 ppt) and Real Estate (0.1 ppt) are the next largest contributors while Communication Services (-2.2 ppt), Information Technology (-2.2 ppt), and Financials (-1.4 ppt) are the largest detractors to earnings growth this quarter (Exhibit 2).
While Energy is contributing the lion share of earnings growth from a year-over-year perspective, the sector is expected to post a quarter-over-quarter decline in earnings growth (-17.0%), which would mark the second consecutive quarterly decline and put further pressure on the breadth of earnings growth.
Exhibit 2: S&P 500 22Q4 Earnings Growth Contribution
To put Exhibit 2 into further perspective, we outline a range of outcomes in the 22Q4 earnings growth rate if we exclude the top and bottom individual earnings contributors. When doing this, we observe a potential earnings growth rate ranging from -5.0% to +1.7% (-1.2% when excluding both top and bottom contributors).
More specifically, when excluding the top three positive earnings contributors, the earnings growth rate declines from -2.2% to -5.0%. When excluding the top three negative contributors, the earnings growth rate improves from -2.2% to +1.7%. More details can be seen in the table below.
22Q4 Earnings growth rate: -2.2%, if we exclude the top three positive contributors, the growth rate changes to:
If we exclude the top three negative contributors, the growth rate changes to:
If we exclude both the top three positive and top three negative contributors, the growth rate changes from -2.2% to -1.2%.
Finally, exhibit 3 looks at the difference between ‘market-cap’ and ‘share-weighted’ weights for the S&P 500 sectors. The S&P 500 Earnings Scorecard utilizes a share-weighted methodology as opposed to a traditional market-cap weighting.
Energy has a 5.1% market cap weight in the S&P 500, yet its earnings weight this quarter is doubled at 10.7%, the largest positive gap of all sectors which highlights the reliance on Energy to deliver earnings this quarter. The Energy sector also has a 9.7% revenue share-weight, which is 4.5 percentage points higher than its market-cap weight.
Conversely, Consumer Discretionary has a market-cap weight of 9.9% compared to an earnings share-weight of 6.9%. One other noteworthy mention is Information Technology, which has a market-cap weight of 25.7%, but is only expected to deliver 11.7% of the aggregate revenue this quarter. This is the largest negative gap of all sectors and highlighting the premium assigned to this sector by the market.
Exhibit 3: Market Cap vs. Share-Weight for S&P 500 Sectors
2022 Q3 saw the lowest percentage of companies beat earnings expectations since 2020 Q2. 70.7% of constituents posted a earnings beat which is a nine-quarter low and below the prior-four quarter average beat rate of 75.5% (Exhibit 4).
Similarly, the aggregate earnings surprise factor last quarter was also at a nine-quarter low (3.4%) and below the prior-four quarter average surprise factor of 5.3% and below the long-term average of 4.1%.
Exhibit 4: S&P 500 Beat Rate and Surprise Factor History
Using the Screener app in Refinitiv Workspace, we can screen for yet-to-report constituents that have seen the largest upgrades and downgrades heading into earnings season.
Exhibit 5 highlights companies who have seen earnings downgrades of at least 20% as defined by the 60-day mean estimate change in ‘EQ1 Preferred Earnings’. Preferred Earnings is defined as EPS for most companies except for Real Estate where it can be either EPS or FFOPS depending on analyst coverage.
Wynn Resorts (WYNN.OQ) has seen the largest downgrade in EPS estimates over the last 60 days (-301.2%) followed by MGM Resorts International (MGM.N, -61.0%), Target Corp (TGT.N, -57.9%), Dentsply Sirona Inc (XRAY.OQ, -53.4%), and Wells Fargo & Co (WFC.N, -50.5%).
Exhibit 5: Largest Negative Revisions for 22Q4
Exhibit 5 also displays the Predicted Surprise (PS) for each constituent, which compares the SmartEstimate vs. Mean Estimate. A PS greater than 2% or less than -2% is deemed significant as our research shows that StarMine will accurately predict the direction of the earnings surprise 70% of the time.
The StarMine SmartEstimate is a quantitative analytic which is used as an input to many of the StarMine models. The SmartEstimate places a greater weight on higher ranked analysts who are more accurate and timelier.
We see a positive correlation between constituents who have seen a large downgrade and a corresponding negative PS. Furthermore, a positive correlation is shown between the mean estimate change vs. Analyst Revision Model (ARM) score (i.e., companies that have seen large downward earnings revision also have a low ARM score).
ARM is a percentile stock ranking model that is designed to predict future changes in analyst sentiment by looking at changes in estimates across EPS, EBITDA, Revenue, and Recommendations over multiple time periods. The last two columns display both the current ARM score and its 30-day change.
Looking at the Predicted Surprise and ARM columns can be very useful during earnings season to assess the likelihood of whether companies are expected to beat or miss earnings while at the same time gauging analyst sentiment.
Exhibit 6 displays the same data for constituents with the largest upgrades heading into earnings season.
Exhibit 6: Largest Positive Revisions for 22Q4
Using data from the S&P 500 Earnings Scorecard (subscribe here), we look at quarterly net profit margins for the S&P 500 using point-in-time data using actual reported data (Exhibit 7). Net profit margins peaked in 2021 Q2 (12.9%) and have declined for five consecutive quarters to 11.6% last quarter.
Based on analyst expectations, net margin is expected to decline again this quarter to 11.1%. The forward four-quarter (23Q1-23Q4) net margin is currently 11.7%.
Since 2021, the net margin for the overall index has declined by 90 basis points (0.9 percentage points (ppt)) with five sectors seeing an increase in net profit margins led by Energy (9.8 ppt to a current margin of 14.1%), followed by Industrials (2.6 ppt, current margin: 9.1%), and Utilities (0.2 ppt, current margin: 13.3%).
Conversely, six sectors have seen net profit margins decrease with Financials having the largest decline (-9.8 ppt, current margin: 15.2%), followed by Communication Services (-4.5 ppt, current margin: 9.2%), and Information Technology (-1.3 ppt, current margin: 23.0%).
Exhibit 7: S&P 500 Net Margin Expectations
If companies highlight margin pressure this quarter, we expect margin expectations to further decline and filter through into the bottom-up EPS estimate for the index. As per Refinitiv Datastream, forward 12-month EPS estimates peaked in June 2022 ($238.23 per share) and have since declined by 4.8% to a current value of $226.88 per share (Exhibit 8).
Earnings expectations have become out-of-sync with the stock market, leading to one of the largest gaps between ‘P’ vs. ‘E’ in recent years.
The S&P 500 forward 12-month P/E ratio is 16.7x, which ranks in the 70th percentile (since 1985) and a 3.4% discount to its 10-year average (17.3x). For reference, the trough forward P/E during the last four recessions were as followed: 10.1x (Oct 1990), 17.3x (Sept 2001), 8.9x (Nov 2008), and 13.0x (March 2020).
Exhibit 8: S&P 500 ‘P’ vs. ‘E’
Markets are looking to companies to provide commentary on several issues from the macro-outlook, health of the consumer, impact of inflation and higher input costs, hiring plans, and the strength of the U.S. dollar which will generate headwinds for companies with international revenue exposure. Supply chain pressures have eased when looking at Fed Surveys as indicated by faster deliveries to factories and a reduction in order backlogs.
Given the host of worries noted above, we may see an increase in companies either a) withdrawing forward guidance, or b) lowering forward guidance which will bring further downward revisions to earnings and revenue estimates.
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