In our July 9 post, Second Quarter Earnings – How Bad Will they Be?, we answered: Bad enough to compel strategists to eventually cut their 2012 S&P 500 EPS estimates from $103-$105 to $100. While $100 still seems reasonable, the tone of Q2 profits is even worse than we expected.
No Signs of Imminent U.S. Recession . . .
EPS results do highlight several pillars of strength that are sustaining U.S. economic growth despite weak employment and counterproductive fiscal and regulatory policy:
- The major regional banks (WFC, BBT, USB, PNC, etc.) are reporting decent loan growth.
- U.S. auto sales are healthy. Ford’s North American business was solid, as were Eaton’s and Alcoa’s auto business. This is not so much evidence of strong consumer confidence as the advanced age of the American auto fleet–it’s cheaper to replace than repair that gas-guzzling old jalopy.
- The housing sector is growing again, which boosts activity in related areas of finance, retailing, law, advertising, etc.
- Aerospace is healthy, judging from Boeing’s results and Alcoa’s commentary.
. . . but Some Ominous Signs of a Consumer Slowdown
Quite a few large, high-quality consumer companies have reported weakening demand, especially late in Q2, including McDonalds, Starbucks, Chipotle, and (earlier) Nike. This weakness was not across-the board—VF Corp. and Six Flags were strong – but it is still worrying, particularly because it occurred while consumers were getting a small “tax cut” from lower gasoline and nat gas prices.
Here Come the Guidance Cuts
The strong dollar is a modest negative for U.S. firms, but the key driver of cuts is is slowing global growth, led by Europe. The U.S. is not particularly strong; Europe is in a severe and worsening recession; China is slowing; and other BRICs such as Brazil and India are sluggish. The situation in China is opaque and could improve, but Europe (which accounts for well over 40% of the foreign sales of the S&P 500) is in dire straits. Consider that Spain, with 25% unemployment, just announced a new fiscal tightening package; soon France will follow suit. The UK is in recession, and Germany is slowing along with its export markets. European banks, whose balance sheets are loaded with dodgy sovereign bonds, are deleveraging by curbing lending. European companies will embark on another round of layoffs over the next few months. A weaker Euro eventually will improve competitiveness, but this takes a long time—several quarters, not a couple of months. And political unrest creates downside risk; even fairly innocuous street protests and strikes are enough to damage a key industry, tourism. (Despite Europe’s problems, the continent has many fine firms serving global markets, which could be good investments.)
Here are some of the major firms that cut guidance. (Zacks confirms that many more firms are cutting guidance in Q2 earnings season than Q1.) Keep in mind that companies like to raise guidance during the course of a year, which has been the norm since mid-2009. So this raft of cuts by big companies is extremely significant.
- Cummins Engine, a high quality company with significant emerging market exposure, slashed 2012 revenue guidance about 12%.
- Chip makers Intel and AMD both cut revenue guidance, and AMD had a big earnings miss.
- Coca-Cola‘s unit growth was weak due to slowing demand in Japan, China and Brazil.
- Johnson Controls (auto parts and building controls) had a big miss.
- Dow Chemical, which has broad global exposure, missed estimates and slashed guidance. (DuPont, by contrast, largely maintained guidance while warning about soft demand.)
- Texas Instruments issued weak guidance because “the global economic environment is causing both [customers and distributors] to become increasingly cautious in placing new orders.”
- Yum Brands, one of the most leveraged U.S. plays on Chinese consumers (they love the Colonel’s chicken), reported weak results.
- UPS cut guidance as international business was flat-to-down on a unit basis, before currency.
- ITW and Eaton, diversified industrial firms cut guidance, partly on weak foreign demand.
- Ford cut guidance on weakness in South America, Europe and Asia. The company said it needs to slash capacity in Europe.
- Flextronics, a contract manufacturer that assembles electronic devices for other companies, said demand is soft and weakened late in the quarter.
- Mettler Toledo, which makes scales and other instruments, cut guidance and thinks local currency revenue growth will be about 4% not 6.5%.
- 3M, widely considered a global industrial bellwether, maintained earnings guidance but cut unit growth guidance.
- Auto parts maker Borg Warner, with high exposure to Europe and Asia, cut guidance significantly.
- United Technologies cut revenue guidance about 5%.
- Starbucks cut guidance on weaker trends in the U.S. and overseas.
- Las Vegas Sands, which operates gigantic casinos in Macau and Singapore, cut guidance.
The Cuts Will Keep on Coming
In our experience when macro conditions deteriorate companies usually don’t cut guidance enough the first time. (Financial psychologists call this “anchoring” – people tend to be “anchored” to their old estimates and change them slowly.) So I expect estimates to keep coming down for the next couple of months. Because much of the global economy takes August off, September comprises far more than 33% of Q3 business activity. Therefore we expect many negative preannouncements in the second half of September and early October. If this occurs, investors will start to worry about profits in 2013, the year of the fiscal cliff – will they be $110 or $100 or $90?
Weaker Profits Means Fewer Jobs
Companies will respond to “weak macro” by restraining capital spending, hiring fewer people, and trimming payrolls. Europe, in particular, is in for a major round of layoffs. The fiscal cliff is an extra reason for caution, particularly for defense contractors and their many suppliers in the industrial and technology sectors.