Q2 Earnings Review – One for the Record Books
Earnings season can be one of the most exciting times of the year in the financial world. Suddenly corporate America thrusts open its doors for all to see. Under normal conditions, this insight helps to set growth expectations and grade past performance. But 2020 is far from normal. Under the best of circumstances, forecasting earnings is a difficult task. This year, COVID-19-induced uncertainty turned it into a herculean one. The economy shut down, companies cut corporate guidance, fiscal and monetary stimulus dictated sector winners and losers, and increased financial stress forced industries to change their cash distribution policies. So, with all that to work through, the better-than-expected second-quarter performance was one for the record books, in more ways than one.
Earnings Leap Over a Low Bar
As of this writing1, 89% of companies have reported Q2 results and 83% of them have beat earnings per share (EPS) expectations. If that number holds, it would be the highest percentage of positive surprises ever, according to FactSet, which began tracking such data in 2008. On average, companies reported earnings 22.4% above forecasts thus far. Fifty-nine percent of companies beat on EPS and revenue metrics, including roughly 80% of the companies in the Technology, Healthcare, Industrials, and Consumer Staples sectors.2
But here’s the catch: Large positive surprises mean little when the bar is barely above the floor. As Q2 earnings season neared, analysts across Wall Street expected the S&P 500 to report a 44.6% drop in quarterly earnings compared to last year, the sharpest decline since Q4 2008.3 Now with the majority of data reported, the S&P 500’s actual EPS decline for Q2 looks to be about 33.8%, the largest improvement since the tech bubble in 2000.4
Analyst consensus forecasts EPS to decline 22.9% y/y in Q3 and 12.8% in Q4 before growth resumes in Q1 2021.5 For 2020, analysts expect S&P 500 EPS to fall 20.4% y/y to $129.70, before rising 28.0% to $166.02 in 2021.6 However, elevated uncertainty means investors should expect revisions. Numbers for Q2 2020 are already above their pre-season EPS estimates of $126.86 and have been revised higher with each week of reporting.7
Without Guidance, the Blind Leads the Blind
A signature COVID effect on earnings is the mass suspension of corporate guidance. In Q1, 185 S&P 500 companies withdrew or suspended their EPS guidance for FY 2020 or FY 2021. The Consumer Discretionary and Industrial sectors accounted for nearly half of dropped guidance.8 Corporations struggling to predict performance makes sense in a world where the government failed to implement a coordinated national response for a pandemic that forced the economy to close and consumer habits to evolve.
Suspending guidance was the responsible choice given the lack of visibility. However, the shortage of information has knock-on effects. Wall Street analysts commonly use annual corporate guidance in forecasts, so stripping away this starting point complicates the valuation process. The resulting information gap reduces market efficiency, facilitating larger separations between intrinsic and market value, and potentially increasing volatility as the gap closes. Guidance reductions contributed to Q2’s overly pessimistic earnings expectations, helping to set up surprises as firms began to print.
However, the lack of visibility isn’t permanent. Corporations now have months of experience operating in the COVID environment and the public response to the virus is gradually solidifying. Resuming guidance was only a matter of time, and a handful of names have restarted. Still, guidance remains scant overall. Eighty-nine companies issued in July, compared to the typical 160. As of this writing, 30 more issued in August, well below the nearly 100 companies that issued guidance in August 2019.
The ratio of above to below-consensus guidance for July and August remains at a record 4x, well above the long-term average of 0.7x. To date, Healthcare and Technology companies have issued the most positive guidance, and Utilities the weakest.9
Tech delivered when the economy needed it most. The sector facilitated the shift to work from home, connected people in a world of social distancing, and provided a host of entertainment options. Tech’s pre-positioning and quick adaptation facilitated some of the best reports this earnings season, making it a significant contributor to the market’s rebound.
When the crisis struck, the economy moved further online, whether business meetings, medical appointments, or grocery and restaurant deliveries. The pandemic supercharged adoption of existing, and increasingly enhanced, network technology solutions that gave consumers and businesses alternative access to the economy. As a result, the Tech sector benefited as it became necessary to conduct commerce through digital storefronts.
Out of the 11 S&P 500 GICS sectors, just Technology and Healthcare reported year-over-year revenue growth in Q2. Tech reported the largest percentage of positive EPS surprises, with 93% of companies out-earning their estimates.10 While not a pure-play tech screen, the FAANG stocks—Facebook, Amazon, Apple, Netflix, and Google—reported average earnings beats of 50% and contributed 25% of the S&P 500’s overall earnings beat.11
Technology continues to keep the economy afloat as the pandemic lingers on, but nowhere else have the sacrifices made during the crisis been as personal as in Healthcare. Early in the crisis, hospitals overflowing with patients and personal protective equipment shortages put the industry in distress. Since then, healthcare systems have adapted to and prepared for COVID, as have consumers. Spending on all but the most critical non-COVID related care declined significantly as patients delayed elective and nonessential procedures, even visits to doctor’s offices, that are important revenue generators for the industry.
Healthcare made progress on the elective front in Q2, though. According to Tenet Healthcare, volumes of certain elective procedures returned to a healthier 65–95% of pre-pandemic levels in May and the first half of June. But most hospital system CFOs don’t expect procedure volume to normalize until Q1 2021. The American Hospital Association projects that U.S. hospitals will lose at least $323 billion in revenue in 2020, primarily due to these volume declines.12
In the biotech and life science segments, work continues to eliminate the virus altogether. Funding for the vaccine effort is massive, with over $3 billion of federal money supporting research in addition to billions more from charitable institutions.13, 14 Revenue growth for the biotech segment is pegged at 11% y/y for Q2 2020, while EPS saw 5% y/y growth for the same period.15
So far, of all sectors, Healthcare has the third-largest positive difference between actual and estimated earnings for Q2, beating expectations by 22.3% on average.16 Ninety-two percent of Healthcare names reporting to date beat their EPS estimates. The sector as a whole reported the second-highest year-over-year EPS growth at 5.7% in Q2, fueled by a 3.2% increase in sales.17
Banks and the Financials sector overall remain in the crosshairs of the economic fallout from the virus. Luckily for the market at large, U.S. banks were generally prepared for the harsh economic conditions that the virus brought. Updated regulations following the 2008 Global Financial Crisis, including the Federal Reserve stress tests and sensitivity analysis, helped ensure this resilience through increased capital requirements and shored-up balance sheets. When reviewing the lessons learned from the current calamity, a strong banking system will be a bright spot.
However, consumer and corporate debt held by banks is a looming risk. To prepare for a potential onslaught of bankruptcies and nonperforming loans, banks increased loan loss provisions this year. In Q1, the six largest U.S. banks increased previsions by more than 200% y/y. These banks increased provisions by another 39.5% q/q in Q2 to bring the total up to roughly $35 billion.18, 19 These massive provisions were a drag on results, but don’t tell the whole story.
Financial sector earnings declined by 52.5% in Q2, the fourth-largest drop of the 11 sectors. Performance varied by segment. Capital markets reported 10% y/y earnings growth due to strong trading and investment banking performances, while consumer finance, banks, and insurance names reported substantial year-over-year losses. To date, all sectors except Energy and Financials reported earnings growth relative to their original quarterly expectations.20
Despite the rising number of bankruptcies this year, Federal Reserve and fiscal stimulus support have kept many defunct companies afloat. Perhaps the Financial sector’s true test will be once bankruptcies come to a head, as stimulus measures wane.
Dividends and Buybacks: Good News and Bad News
In times of economic strife, returning capital to shareholders can stress balance sheets and even public opinion. The banking industry highlights this complicated issue. After the 2008 crisis, banks had to cut their dividend distributions to cents on the dollar. Normally, dividend cuts are considered an act of last resort. They are seldom received well and typically draw the ire of the investing public, who see reduced payouts as a symptom of weakening corporate health.
Fortunately, the mistakes of 2008 resulted in regulation that increased the resilience of depository institutions. Banks came into the COVID crisis ready to handle “even the harshest shocks,” according to the Federal Reserve.21 Despite this assertion, the conclusion of the annual stress test resulted in the Fed requiring large banks to preserve capital by suspending share repurchases and capping dividend payments.
The Financial sector’s eight largest banks collectively represent about $9 billion of quarterly dividends, while the financial industry at large contributed nearly 15% of the S&P 500’s total distributions for 2019.22 Payout cuts could substantially decrease these numbers. On the positive side, of the largest institutions, only Wells Fargo had to reduce payments in Q2; the bank cut its $0.51 dividend by about 80% to just $0.10. In total, only 5% of S&P 500 dividend cuts since March came from Financials.23
Financials did not fare as well when considering buyback activity. The sector accounts for 23% of all S&P 500 buyback suspensions this year. While Fed restrictions prevented some activity, many companies were proactive; the eight CEOs of the largest and most diversified financial institutions headquartered in the U.S., known as the Financial Services Forum, suspended buybacks in March.
Other areas of the capital markets were not as lucky. Consumer Discretionary is responsible for nearly 40% of dividend cuts and 30% of buyback suspension since March.24 But this makes sense. In an economy where almost half of consumer spending is considered discretionary, we would expect non-essential goods to suffer during a quarter when personal consumption declined 34.6%.25 Retaining capital to shore up balance sheets and prepare for a possible resumption of consumer purchasing activity is necessary under these conditions. Consumer spending rebounded slightly in recent months, rising 8.5% in May, 6.2 % in June, and 1.9% in July.26 Despite this improvement, few Consumer Discretionary names have indicated when they plan to resume buyback activity. Most plan to take a more conservative wait-and-see approach.
In Summary: Better than Expected
Better-than-expected earnings combined with some hints of economic optimism are driving markets to new all-time highs. However, insightful guidance remains scant due to continued uncertainty. On the positive side, for those companies that did release guidance, the numbers were generally encouraging. This was especially true for the Information Technology and Health Care sectors. Limited visibility can create wide gaps between expectations and reality and, as we found, led to the highest percentage of earnings surprises in history. It can also create a distorted sense of the recovery from this economic crisis. If anything is clear right now, it’s this: 2020 is unique, and this year has gone out of its way to highlight the challenges of forecasting when the only certainty is uncertainty.