PORTFOLIO POINT: Most companies are still making money, confirming that the equity market, as a whole, has been oversold.
From what I can gather, the consensus view is that the earnings season has been mixed so far. Not as bad as some had thought it was going to be, but not especially good either.
That’s all fine and well but these comments don’t really tell us anything. Nor, by the way, does the observation that ‘x’ number of companies beat expectations compared to last year and so forth. Especially in an environment when ‘now-casting’, as the RBA puts it, or the ability to determine what is happening now, in real time, is proving to be so difficult for market analysts. A key reason for this is that the market is beset with confusion and pessimism – volatility and the like.
For me, the question is basic. Are companies making money, from a macro perspective? Good money – and I make a distinction here from what they are doing with that money and their performance more generally – through cost control and capital management etc. When I look at that question and combine it with the very real macro-economic trends I have discussed in other issues, I find that corporate Australia is doing well and the outlook remains very positive.
Take a look at chart 1. It shows two measures of a company’s earnings – revenue and earnings before interest, tax, depreciation and amortisation (EBITDA). Most analysts tend to concentrate on earnings per share or EPS. EPS might be the better indicator of value, but that’s not my focus today.
We know companies are cheap already. P/Es are low and a lot of bad news has been priced in. So, with that in mind, and in a world where ‘now-casting’ is so difficult and there is so much negative news flow, the more basic question for investors is, as I mentioned, whether companies are making money? Because, to justify current valuations, you really need to see some evidence of a deterioration in the underlying earnings flow from commercial activity.
If underlying earnings are positive, if the trend for corporate activity is still good, then it confirms that the equity market, as a whole, has been oversold and that valuations are indeed very cheap.
Chart 1: Implied revenue growth through the earnings season to date
Now, we’ve got about a week or so to go before the reporting season ends, so the sample above is obviously not complete. It does, however, cover 65 or so companies that have reported full-year results to date, with these companies representing about 73% of the market.
Getting back to chart 1, the good news is that there really isn’t any evidence of a significant deterioration in earnings quality. By and large, companies are still making good money. Revenue growth for instance rose 6.4% over the year, with EBITDA above that, rising 8.4%. Cost controls to do with operations look to be OK then given that stronger growth.
Having said that, it doesn’t look like the cost cutting needs to go too far. For a start, EBITDA growth is above last year’s – that is, it looks to have accelerated on this sample, and revenue growth is down only slightly from last year’s 7.3% pace (same sample for consistency rather than the full spread of firms).
While this may be down from the heady double-digit revenue growth we saw in the few years prior to the GFC, we have to remember these years were not normal – there were some unusual circumstances driving that exceptional performance. Some was organic, some was driven by acquisition. The broader macro backdrop was that we were experiencing very strong credit growth, a rapid acceleration in commodity prices, strong investment and rapid advances in technology, to name just a few.
Recall the digital revolution really kicked in over those years, driving rapid growth in sales of consumer items – iPhones, LCD TVs and the like. Then there were the healthcare benefits, for example advances to Cochlear implants. Many of these influences are still with us, but the growth rates have tapered. And so too has revenue growth.
But this does not indicate a weak economy or poor corporate performance in general. A sectoral breakdown shows this in greater detail.
Chart 2: Revenue by broad sector
You can see from the above chart that there aren’t too many problems across the sectors as a general comment. Revenue is stronger in some cases than others – mining/energy/utilities. But that’s not to say it’s bad elsewhere.
Revenue growth in the consumer space, for instance, has picked up slightly to 4.3% from 4% last year and that’s with the significant price deflation hitting some sectors, not forgetting ongoing structural change affecting some companies. Indeed in the consumer, health, utilities/energy and the IT/telecoms sectors, revenue is accelerating as is economic growth more broadly. Again, growth rates are down from some of the extraordinary growth rates seen prior to the GFC – but that is not the benchmark for the reasons discussed.
Now it’s true to say that this earnings season hasn’t been all good news. There have been some high-profile underperformers like Billabong just today, Fairfax Media and, of course Qantas. Nevertheless, the above charts suggest that this relative underperformance reflects company-specific issues rather than a broader economic malaise. For instance in some cases, for example Fairfax and some of our clothing retailers, there was probably a reluctance to invest appropriately or adapt to technological change. In the case of Qantas, even the company’s pilots seem to suggest that company mismanagement was the issue driving a $244 million loss. Revenues were certainly stronger – up 5.5%, which is actually above the decade average of 4.1%. This suggests that cost or capital management issues may indeed be to blame. And it’s not an isolated story – Toll Holdings, for instance, reported profit fall of 77%. That got a lot of press. Revenues, however, were up about 6%. These indicate possible problems with management, not a lull in economic activity or sluggish conditions.
What we can take out of this is that the signals out of this earnings period have actually been quite good in so far as economic or commercial activity is concerned. Indeed, earnings data to date suggests that much of the pessimism weighing on the market and some of the underperforming results reflect a failure of company executives and board members to adapt to structural change. Or even more simply, the fact they have made bad decisions.
A key implication for investors is that we need to have a very hard look at the company management and their track record. Indeed, it appears to be more important now than ever. Otherwise I think the picture being painted more generally, in this perpetually bleak environment, is actually a good one. It complements other data from the Australian Bureau of Statistics (and elsewhere) showing the economy is travelling at a decent clip.