Friday, April 17, 2009
Playing the 2nd Derivative
By Richard Berner & Jason Todd, CFA New York The recent improvement in selected US and global data suggests that the worst of the global recession is likely over and that a bottoming process is underway. The equity market has fully embraced the improving second derivative trade and remains in the midst of its strongest rally since the bear market began in October 2007. We think investors can play the rally, but we remain cautious and look for opportunities to sell. There’s a fair amount of good news in the price, and financial markets are already moving to price in the next step of the recovery phase – that of reflation and economic stabilization. In contrast, we think the global recession has further to run and that the coming recovery will be modest. The breadth, depth and duration of this downturn also raise the potential for head fakes and false dawns on the path to a sustainable upturn that will, in turn, drive bouts of investor optimism and pessimism (see Depth and Breadth Matter, April 6, 2009). In particular, we remain bearish on earnings. We think that a number of top-line (revenue) and bottom-line (margin) pressures will continue to undermine corporate results, potentially capping near-term upside for the equity market. Revenue growth will remain under pressure from ongoing financial headwinds, inventory levels that are still top-heavy, and a further decline in pricing power. At the other end of the income statement, declining operating and financial leverage and a reversal of low-quality tailwinds, such as inventory revaluation, USD translation gains, pension gains and share count reduction, are squeezing profit margins – a double threat to corporate earnings. That the equity market has reacted to an improving ‘second derivative’ is not a concern. However, with the market up 28% from the low, it has already moved a long way towards pricing in a better 2H09 growth trajectory (or, thought of differently, pricing out the premium for downside tail risk) and is now at risk of taking for granted the timing, speed and magnitude of any recovery. Deep output recessions often signal that inventory liquidation will turn to accumulation, promoting snapbacks in output and eventually hiring. We do not believe that this will be the case in the current cycle. Corporate America has not cut production excessively in relation to the actual level of demand, and we think that the ongoing credit crunch will delay a recovery in both sales (pent-up demand) and thus hiring. Ultimately, the sustainability of equity gains will be determined by how much end-user demand (especially real consumer spending) recovers, and we think this rebound will be modest. (see Perfect Consumer Storm Not Over, March 31, 2009). Top-Line Revenue Growth – A Volume and Price Collapse We see three factors limiting the potential for upside surprise to revenue growth estimates through 2009. First, the ‘adverse feedback loop’ from a weak economy to credit quality and back is limiting the net benefits from policy efforts to restart securitization markets and ease the credit crunch. That headwind will cap consumer spending growth, as well as the benefits from lower mortgage rates on housing demand. And it will depress capital spending and limit the ability of stressed state and local governments to finance current services. Second, a contracting global economy will hobble US exports, which so often in the past have provided a cushion of support for US growth when the US business cycle and those abroad were out of sync. It’s worth noting that, with 38% of US earnings coming from overseas affiliates, the global recession is also hammering overseas bottom-line results. Third, with operating rates at record lows and slack in the economy continuing to grow, disinflationary forces will contain nominal revenues long after the economy begins to turn up. Corporate Profit Margins – Pressures Prevalent Equity investors may already be prepared to pay for the next earnings upswing, but we think that profit margins will continue to come under pressure from a combination of forces that are unlikely to dissipate quickly. Global recession together with high leverage (operating and financial) are creating a one-two punch for margins, which are in decline but remain elevated on a historical basis. We doubt that the full effect of declining operating leverage and plunging rates of capacity utilization – which are reducing pricing power – has completely worked its way through to the bottom line, especially as margins for a number of sectors (Energy, Industrials and Technology) were still close to peak only six months ago. We see additional headwinds for margins coming from a variety of sources: 1) A reversal of inventory revaluation gains, where plunging prices are depressing the book value of inventories acquired around the peak of the global boom, which we estimate will subtract 150bp from profits in 2009; 2) a stronger USD (up 21% 4Q over 4Q), reducing translation gains for foreign generated earnings, which stood at an all-time peak of 38% in 4Q08; 3) reversal of share count reduction, which added 250bp to earnings in 2006, 300bp in 2007 and 87bp in 2008, as both the cost and ease of financial leverage (issuing debt and buying back stock) reverse; and 4) rising pension costs as a deterioration in the funded status of pension plans draws greater cash contributions and as falling plan assets provide a smaller expected return boost to the income statement (we estimate this at 300bp in 2009) . Although margins are receiving some relief from falling input costs (particularly for raw materials – commodities and energy), lower imported goods prices, and a steeper yield curve, these are only minor offsets in comparison to the combination of headwinds discussed above. Where Are Earnings Most at Risk? Sectors we believe are most vulnerable to earnings disappointment and lower guidance include: 1. Technology (Hardware and Semis) – Semi stocks have risen more than 30% from trough in the recent rally. Inventories in the supply chain remain elevated, valuations rich, and we are wary of underestimating the scope of demand improvement necessary to take these stocks from an inventory rebuild rally to one supported by broadening fundamentals. We think the market is now discounting a best-case scenario of inventory replenishment starting in 2H09. This appears unlikely, given that Semis’ forward inventory days are at the highest level ever. A similar situation occurred in 2001 when the SOX rallied 71% and analysts revised estimates upwards as they mistook orders to restock as real demand. We are equally concerned about the rally in many Hardware names, where utilization rates remain weak and pricing and demand visibility poor (we have always bought Tech when utilization rates are rising, and sold Tech when utilization is falling). Historically, corporate earnings have led capex, and despite the limited capacity growth and broad underinvestment heading into the current recession, we think the risk of demand surprising on the upside (either corporate or consumer) is low. 2. Industrials (Cap Goods, Selected Transport, Distributors) – Declines in commercial construction and capex-related spending have been more severe than anticipated, and earnings will not rebound as quickly here as they do for shorter-duration cyclicals. We see the potential for significant earnings disappointment in coming quarters as margins come under significant volume and pricing pressure (as of 3Q09, the sector was still close to all-time peak margins and earnings). In addition, many industrial names have rallied strongly on the potential for inventory rebuild. However, recent company commentary indicates that inventory destocking in the channel shows no signs of abating. Moreover, inventory destocking is occurring in both industrial verticals and non-residential construction verticals. Typical re-stocking ahead of spring/summer construction seasons is not occurring. Further, at the manufacturer level we expect that widespread capacity reductions and an aggressive focus on working capital will also lead to reduced inventory levels. 3. Materials (Metals & Mining) – Materials rallied almost 38% in March, even though earnings visibility remains poor. We see continued pressures on commodity prices as demand remains weak and stock relatively high. Capex has broadly halved, and while these cuts have been earlier than in past downturns, inventory build may weigh on base metal prices in the near term. We do not think real demand recovery in excess of a re-stocking boost will challenge industry capacity over coming quarters. If demand recovery proves stronger than expected, copper is the most likely to replicate the price strength prior to the downturn. Steel and aluminum prices will likely respond in this scenario, but are less likely to benefit from excess pricing power due to more significant capacity overhang. Steel is in a relatively stronger position than aluminum due to low systemic inventory.