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About 70% of US corporates have reported their financial results for the 1st quarter of 2015. What have we learned?
Using figures from FactSet, EPS growth in 1Q is tracking minus 0.4% (year over year) versus an expected growth rate of 4.2% on December 31st when the quarter began; sales growth is tracking minus 2.6% versus an expected rate of 1.6%.
These are horrible results, right? Actually, companies are doing much better than these figures show.
It should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was roughly $100 in the 1Q of 2014; it fell 50% to an average of roughly $50 in 1Q of 2015. As a result, EPS for the energy sector fell by 60% and sales by 33% (data from FactSet).
The energy sector is clearly an outlier, driven by the rapid fall in the price of a single commodity. The sector had an operating profit weighting of 14.4% a year ago, making it the largest sector in the S&P 500. With the fall in the price of oil, that weighting fell to 10.4% in 1Q of 2015.
So what happens when the energy sector is excluded? 1Q15 EPS growth for the remaining 90% of the S&P jumps to 7.5%. Sales growth rises to 2.6%.
(Side note: the point of excluding energy is not to imply that it is unimportant or that actual S&P results are better than they are. Think of this as being like core-CPI: excluding energy gives a more reliable view of the underlying trend in inflation. This is why we are excluding energy companies' financial results: to see whether the underlying trend has changed for the rest of the S&P).
The 2.6% sales growth in 1Q, excluding energy, is a significant drop from the trend: throughout 2014, the trailing 12-month average sales growth was about 4%. In fact, although energy was the largest drag on 1Q sales growth, other sectors (discretionary, utilities and materials) were also weak. Healthcare was an outlier, growing sales at 10.5%.
Earnings growth of 7.5%, excluding energy, is very close to the trend: throughout 2014, the trailing 12-month average was about 8%.
When EPS growth exceeds sales growth, it means that profit margins are continuing to expand. In fact, that is the case: only energy has seen a meaningful drop in margins since 1Q of 2014. Among the other large weighted sectors, margins were either close to flat or higher (data from S&P).
The margins for the energy sector will continue to drop in 2Q of 2015: the average price of oil a year earlier was over $100 versus $60 today. But the drop will be less than it was in 1Q if the price of oil, which averaged less than $50 in 1Q, remains at current prices or rises further.
FactSet expects average margins, including energy, to rise to 10.3% in 2Q from 10.2% in 1Q. This is quite important. A 10 basis point increase in margins adds about 100 basis points to EPS growth. So, if sales, excluding energy, can continue to grow at 2.5-3%, non-energy EPS will grow 3.5-4%.
If oil prices can rise to $70 by the end of the 2015, the year over year impact of falling energy profit margins on total S&P EPS will become negligible.
Today, the consensus expects total S&P EPS for the full year 2015 to grow 1.8%. A year ago, the consensus had expected more than 10% growth in EPS this year, so expectations have fallen hard. Of note, therefore, is that EPS for 1Q was expected to be minus 4.1% just 3 weeks ago and now it has increased to minus 0.4%. Assuming the consensus will be too high for the full year may well prove wrong.
In the meantime, reflecting low and uncertain earnings growth, the S&P index is marking time. In the first 4 months of the year, the index gained just 1%. The trailing 12-month P/E ratio is 17.5x, which is high relative to the past 10 years (the pop in P/E in 2009 is due to EPS falling). If the market continues to trade at this multiple and, importantly, if it anchors its EPS growth expectations at close to 2%, this low rate of appreciation may continue for several more months.
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