Once again, earnings season highlights corporate America’s resilience. Investors were braced for an earnings decline in the second quarter of 2015 but will almost certainly end up with another quarterly earnings gain despite the significant drags from the oil downturn and strong U.S. dollar. This gain is largely thanks to effective cost controls that have propped up companies' profit margins. With more than two-thirds of S&P 500 companies having reported second quarter 2015 results, we provide an earnings update.
Solid Performance (Ex-Energy)
With 70% of S&P 500 companies having reported as of July 31, 2015, the index is on track to produce another year-over-year earnings gain. The average upside surprise of 5% thus far positions the S&P 500 to deliver a 2% increase when all results are in (the same as the first quarter result), a good number compared with recent trends. The earnings “beat rate” of 72% is five points above that of the first quarter of 2015 and six points above the three-year average. Revenue results have been more mixed, with the revenue beat rate at 50%, six points above that of last quarter but five points below the three-year average.
The second quarter’s earnings performance is particularly impressive when you remove the energy sector’s expected nearly 60% year-over-year decline. Excluding energy, S&P 500 earnings growth is tracking 8 percent to 9 percent (see Figure 1), an excellent growth rate, especially considering that the strong U.S. dollar is also dragging down S&P 500 earnings, though not by quite as much (it's estimated to be by 3 percent to 4 percent). Company results (outside of the energy sector) have been supported by improved global growth, lower energy costs and effective cost controls.
The upside to earnings estimates is coming primarily from these sectors:
Health care. The health-care sector has produced the biggest upside to prior estimates among all sectors thus far (tracking to 10.9% whereas the previous estimate was 4.1%) aided by pharmaceuticals, biotech and medical technology. The sector, which remains one of our favorites, continues to benefit from strong drug development trends and the increasing number of insured patients under the Affordable Care Act.
Financials. The financial sector has been helped by solid loan growth (particularly business loans), a steeper yield curve (which helps net interest margins, a key source of bank profits), low default rates, healthy merger and equity trading activity and companies' progress at resolving legacy regulatory costs. All these factors have helped drive solid earnings growth (of 20%).
Consumer discretionary. Second-quarter earnings in this sector were aided by prices at the gas pump, which have fallen since last year. Also, the housing market gained steam during the second quarter, and there has been rapid growth in the Internet retail sector.
Energy. Sharply lower oil prices have driven energy sector earnings down significantly. However, oil prices rose from the first quarter of 2015 to the second quarter, helping the sector thus far produce solid revenue upside, which has led to better-than-expected earnings. The refining business continues to be a relative bright spot.
Limited Overseas Disruption
As we wrote in our earnings season preview on July 13, 2015, we did not expect Greece-related weakness in Europe or severe stock market volatility in China to have a meaningful impact on earnings. That has largely been the case, although several industrial companies with larger exposure to China have cited some demand weakness there, and that has contributed to the lack of earnings upside. Industrials have also been hurt by commodity sensitivity and by companies' global reach, leading to a disproportionate impact from the strong dollar.
A few companies have cited weakness in Europe, but they have been few and far between. One retailer cited currency volatility as an issue, while a cruise line mentioned macroeconomic challenges in Europe. Most large-cap companies have cited healthy activity in Europe that has generally been in line with or better than previous expectations. The limited reduction in forward 12-month estimates for the S&P 500 (negative 0.6% versus the long-term average of negative 2%) since earnings season began and the favorable trend in global economic data provide evidence that the environment overseas has not deteriorated meaningfully since the end of the first quarter.
Margins Are The Story
With earnings on pace for a modest gain and revenue tracking toward an approximate 3% year-over-year decline, the story this quarter is again strong profit margins. As shown in Figure 2, corporate profit margins (without the energy sector) are at more than 10-year highs and have ticked higher in recent quarters despite repeated calls from many market pundits for margin contraction. There are many things driving improved profitability (again, outside energy): low commodity prices, low borrowing costs, low wage inflation and more corporate efficiency (partly brought on through a broader deployment of technology). Share buybacks continue to provide a boost as well.
We thought that earnings estimates had a reasonable chance of increasing during this earnings season given previous estimates of reductions and the improving global macroeconomic environment. With 70% of companies having reported, we are very close, with only a 0.6% reduction in the forward-12-month estimates. This reduction in estimates is smaller than those observed in recent quarters (2 percent to 3 percent) and reflects corporate resilience in the face of significant headwinds. We continue to expect earnings to accelerate during the second half of the year, driven by potentially better U.S. and overseas economic growth, solid profit margins, benefits from lower energy costs and smaller drags from the U.S. dollar and energy.
Burt White is a managing director and chief investment officer at LPL Financial.