Back on September 30, Q1 2015 earnings were expected to grow by 10% from a year earlier. A few short months later, Q1 EPS (non-GAAP of course) growth was revised to 4%. It currently stands at -2.8%, a number which as we reported a month ago, is the biggest annual drop since 2012 [8]. What is the reason for this collapse in EPS?
There are two.
First, plunging crude prices, which after rebounding from the low $40s, have since posted a modest dead cat bounce to the upper-$40s, but are nowhere near enough to allow quarterly EPS growth to resume its historic pattern of growing in the high single, low double digits. The devastation that has resulted in the Capex of the shale sector including the already ramping up layoffs of energy workers [9], extensively documented here, needs no further commentary.
Second, the surging dollar has led to a drubbing for corporate profitability, and one needs merely to glance at some of the earnings call transcripts of the multinationals to realize just how much of an impact the strong USD has become.
- “Finally, we do see currency as a continued headwind. We factored into our guidance the headwind of approximately $0.15 to $0.20, which was roughly the same rate of devaluation we experienced in FY 2014.” –Monsanto (Jan. 7)
- “Before I share with you some of the highlights from the quarter, let me provide some background on the impact to our business from the volatile foreign exchange rates. Nearly every currency we do business in weakened against the U.S. dollar when compared against Q3 last year, last quarter or against guidance…These rate changes negatively impacted both the income statement, where we use an average rate for the quarter and the balance sheet, which is translated using spot rates at the end of the quarter. For instance, total revenue would have been $13 million higher using Q3 rates from last year, a $11 million higher using rates from last quarter, and $3 million higher using the rates given in September for guidance.” –Red Hat (Dec. 18)
- “Turning now to revenues, net revenues for the quarter were $7.9 billion, an increase of 7% in U.S. dollars and 10% in local currency, reflecting a negative 3% FX impact compared to the negative 2% impact provided in our business outlook last quarter.” –Accenture (Dec. 18)
- “Our Consumer Foods segment operating profit, adjusted for items impacting comparability, was $310 million or up about 7% from the year-ago period…Foreign exchange had a negative impact of $8 million on net sales and about $6 million on operating profit for this segment this fiscal quarter.” –ConAgra Foods (Dec. 18)
- “And as I mentioned, foreign exchange lowered reported sales by 2 percentage points.” –General Mills (Dec. 17)
- “The as reported numbers were heavily impacted by the strengthening of the U.S. dollar in comparison to other currencies. Total revenue saw a 4% currency headwind which would double what it was at the time of my guidance.” –Oracle (Dec. 17)
The problem is that, as noted above, the bounce in WTI has since peaked and after hitting the low $50s, is once again on the way down, suggesting even more pain for the energy complex. Furthermore, with the Fed widely expected to hike in the summer even as 20 central banks around the globe have eased in just the past two months, the dollar is hardly expected to weaken materially at least until the Fed reverses course on its tightening intentions, which may take a significant period of time.
So what does all that mean for EPS, forward multiples and the market? In one word: hockeystick. In two words: epic hockeystick.
The chart below is from the latest factset earnings insight, and it shows that after sliding 2.8% in Q1, earnings are expected to soar dramatically, posting unprecented Q/Q growth, and return to growing at 7% clip in the fourth quarter.
[10]
There are three problems with the above chart.
- First: as mentioned earlier, it assumes that both crude oil prices, and the USD return to a trendline normal level. For now, neither of these appears to be even remotely feasible.
- Second, the assumes a return to trendline growth even as sales growth for all of 2015, a topic we discussed previously, is now set to post its first annual decline [11]since Lehman.
- Third, the only way declining sales can be transormed into EPS growth is through a new round of profit margin growth. There is one problem with that. This:
Net S&P500 Margins, as tracked by Factset, just posted their biggest decline since... Lehman.
So what happens if one adjusts the Wall Street consensus forecast, something which will happen anyway sooner or later once the "priced to perfection" forecast fails to materialize? We have shown one model forecasting what happens to Y/Y EPS growth if one assumes the same annual decline for the rest of 2015 as took place in Q1.
This is the visual result:
[12]
Adding up the forecast quarter, means that non-GAAP EPS in 2015 will be 115 instead of 120, suggesting the forward P/E multiple is not 17.6x where it ended at close of trading today, but 18.4x, by far the highest since Lehman, and also it would imply a GAAP EPS of 20.2x: in other words, the market is, using real earnings, already trading above the magical "David Tepper" bogey of 20x!
But let's assume the Wall Street consensus is right, and instead of dropping by nearly 3% every quarter, earnings regain their stride even as sales decline for the full year - something which even Wall Street now admits will happen.
What needs to happen? Well, net margins have to go from merely ridiculous levels, hugging the 10% number - something they have never managed to achieved in the past - and rise to an absolutely mindblowing 11% by the end of the year.
Visually, this would look as follows:
[13]
And with all variable costs already trimmed out of existence in the past 5 years, this can mean only one thing - millions more in layoffs, especially if the companies that comprise the above sample are also eager to maintain their record pace of corporate buybacks: something they would be unable to do with the residual cashflow that lower sales generate.
In other words, yes: the S&P may well be "fairly priced" here, if one assumes an 18x (rounded up) forward P/E multiple to be fair - a number which is above the prior 5-year average forward 12-month P/E ratio of 13.6, and above the prior 10-year average forward 12-month P/E ratio of 14.1. It is also above the forward 12-month P/E ratio of 16.2 recorded at the start of the first quarter (December 31).
And in order to achieve that, not much has to happen: instead of hiring millions, America's corporations just need to fire about 2-3 million people in order to extract the kinds of net margin efficiencies that are already priced in!
Which can only mean one thing: the BLS is going to be very, very busy coming up with seasonal adjustments, scapegoats, and pro forma justifications over the next 9 months to mask the fact that as the S&P continues to rise to record levels, and as the underlying corporations fire in droves, and present a picture of a stable and growing US economy, one which is, at least in C:\BLS\models\labor\payrolls\goalseek.xls adding some 230,000 seasonally-adjusted "workers" every month.
Source: Factset [14] [14]
