Earnings season officially gets started this week, with reports already released from Alcoa, Pepsi, JP Morgan and a few others. Tonight Google will be reporting after the close – a stock I continue to view favorably. Next week the reports will pour in and by the end of next week we’ll have a pretty good feel for the tenor of US Q3 earnings. It is an important quarter because the market started to price in an abrupt slowdown around the world which would naturally be expected to negatively impact earnings in subsequent quarters. It now appears the market got way ahead of itself with negativity and bearishness as the S&P 500 approached 1,100. Since the past couple weeks couldn’t produce evidence of a spiral into chaos in the Eurozone, a hard landing in China, and an imminent recession in the US, the market simply went back up. Asian markets which led on the way down have been up for 6-days in a row and the H-Shares in Hong Kong have bounced 21% in a 6-session stretch (be careful to not get bearish at the wrong time!). This is the set up into the Q3 earnings season. I’m going to be very focused on corporate results for the next month because we will really glean how companies were able to perform in an extremely tough environment. Here is what to scrutinize:
1) Europe – are US multinationals which have exposure to Europe experiencing a dramatic slowdown in sales growth? While the news and headlines have been horrible there has actually be some mixed data out of Europe. I’m encouraged by business confidence measures in Germany and recent industrial production data out of Italy.
2) Currency Impact – US multinationals have recently been experiencing about a 3-7% benefit to both sales and operating profits from favorable currency translation. This benefit will dissipate into next year at current levels of exchange rates. How well have non-US assets and liabilities been matched? Have there been hedges put in place for next year? How much of the expense structure is in local currency on an individual company basis? These answers will vary company by company but I’ll look for hidden risks related to currency movements.
3) Margin Improvement in 2012? – A potential positive offset from a somewhat stronger USD, has been commodity prices coming down in a number of areas. While lower input costs typically flow through corporate income statements with a lag, I’ll be looking for signals regarding the extent this could impact 2012 margins.
4) China Hard Landing – China has been the growth engine of the world as it ranks at the top (or close to the top) in terms of total population and real GDP growth. There have been a plethora of fears related to Chinese local debt, civil unrest, accounting fraud, and a hard economic landing. I constantly watch macro and local Hong Kong corporate data but I look to validate this with what the multinationals have to say about China. Recent commentary from Nike, Yum Brands, and Pepsi has been positive.
5) Capital Allocation – Most US multinationals have shifted to a lower growth gear. Conservative plans for new business projects, hiring and capital expenditures have led to a surge in corporate free cash flows. With depressed stock prices in Q3, I’ll look to see which companies allocated capital wisely and purchased their own stock at depressed levels. Many companies in the S&P 500 have the potential to grow EPS by 4-6% from allocation of free cash flow to share buyback alone. It doesn’t take much operating profit growth to get to high single digit or even double digit earnings growth if you are reducing the share count 4-6% each year. Analysts don’t tend to accurately model this impact and it hasn’t been priced in. I’ll point out that this is sustainable each year so long as profit margins and sales levels don’t decline dramatically.