Sunday, January 25, 2015

2015 EPS Growth May Be Half What Analysts Are Expecting

US corporates have started reporting their financial results for the 4th quarter of 2014. So far, it looks horrible.

Bearing in mind that just 18% of the S&P has reported, this is how the quarter is tracking: EPS growth of 0.3% versus an expected growth rate of 8.5% on September 30 when the quarter began; sales growth of 0.6% versus an expected rate of 3.7%.

The question is whether these results indicate that the trend in earnings and sales growth is changing. The answer is no for sales but yes for earnings.

It should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was roughly $95 in 3Q; it fell 30% to an average of roughly $65 in 4Q.  The year-over-year fall is about the same. As a result, EPS for the energy sector fell by 24% and sales by 17% (data from FactSet).

The energy sector is clearly an outlier, driven by the rapid fall in the price of a single commodity. The sector has a weighting of approximately 15-20% (based on last year's sales and EPS as a percentage of total sales and EPS, according to S&P). Excluding energy, 4Q EPS and sales growth would both be roughly 4%.

(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).

4% sales growth is close to the trailing four quarter average at the end of 3Q for the S&P. This is also consistent with the 2.5%-3% real growth seen in most of our main macro indicators (post). So sales seems to be continuing its trend. There is no smoking gun here.

However, 4% EPS growth is less than half of the 9% trailing four quarter average at the end of 3Q. That's a big drop. What accounts for that difference?

Recall that the higher growth rate in EPS relative to sales is a product of expanding margins. A 10 basis point increase in margins adds about 100 basis points to EPS growth. Over the past year, trailing 4 quarter margins have expanded by about 40 basis points. This has turbo-charge EPS growth in recent years.

So the upshot is this: excluding energy, margins for the rest of the S&P may have reached a plateau. This is quite a change. Why might this be?

Energy is not the only sector being hit at the EPS level. Consumer staples EPS contracted by 2.5% in 4Q and financials contracted by 4.7%. Staples have probably been hit by the rise in the dollar; their foreign currency earnings repatriated to dollars will be impacted. This is true for all companies, in any sector, with large ex-US earnings. The flattening yield curve is probably the main culprit impacting financials.

Again, the 4Q financial reporting period is only just beginning. It is too early to say how this quarter will end and how 2015 will unfold. There are a lot of moving parts impacting both sales and earnings: currencies, commodity prices, interest rates, to name just a few. Some or all of these might reverse in the months ahead. Or not.

But the early read is that the trend in sales growth is fine but the period of margin expansion, and hence EPS outperformance, may be ending. If that's the case, EPS growth in 2015 may be half the 8% that analysts are expecting.

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