09 June 2023 Equities | US

Equity View: Latest Earnings Solid, But Outlooks Show Rising Caution

Summary

Q2 earnings have been solid, with S&P companies beating projections by an average of 7%. Most of this was due to low expectations. What matters more is outlooks.
In the tech sector, software and network hardware vendors are reporting that many companies are slower to order new equipment – a sign that they are becoming more cautious about how they spend their IT dollars. H2 may be more challenging for companies not directly in the AI business flow.
In the retail sector a large gap exists between companies catering to higher income and lower income people. Higher income people are still spending, but the lower income segment is hurting badly.
Consumer staples companies face more scepticism about whether they can maintain the price increases of recent quarters, due to stretched consumers and competition.

Market Implications

The equity rally will run out of steam as earnings growth becomes more about controlling costs than boosting revenue.

Introduction

An impressive Q2 earnings season is all but over – earnings beats are 7% for the S&P 500 (SPX) and Russell 1000 (RIY) and 5.3% for the NASDAQ 100 (NDX). That compares to beats of 2% or less in recent previous quarters. Clearly, companies set low expectations and analysts swallowed them hook, line and sinker.

Most recent earnings are no exception. But interesting insights are appearing in the outlooks and comments.

Technology

Corporate CAPEX Slows – Recent reports from Cisco (CSCO), Salesforce (CRM), Ciena (CIEN), Smartsheet (SMAR) all show solid beats, but generally disappointed on outlooks. Their client companies appear to be slowing down their purchases of software and networking equipment. For CIEN, the explanation was that companies over-ordered when supply chains were disrupted, and now could not deploy their purchases of new equipment fast enough. Bottom line, companies seem to be increasingly choosy about how they spend their IT dollars.

PC Drought Near an End? – Both Hewlett Packard (HPQ) and Dell Technologies (DELL) reported better than expected results, saying they see signs of a pickup in demand for PCs from companies. Consumer demand remains in the doldrums.

Retail

There is a clear divide between high-end retailers and those that serve lower income people.

Winners – High-end retailers such as Nordstrom (JWN), Lululemon Athletica (LULU) and Five Below (FIVE) reported solid beats and good outlooks. People are not spending like there is no tomorrow, but they are buying good stuff.

Losers – Retailers such as Dollar General (DG), Macy’s (M) and Casey’s General Stores (CASY) offered disappointing outlooks. DG said its customers are focused on food and related items and passing on higher margin discretionary merchandise. DG stock plummeted 28%. M also said discretionary purchases are weak, with 50% of its clientele on incomes below $75,000. CASY said sales of higher margin prepared foods at its convenience stores were down.

One exception was Ollie’s Bargain Outlet (OLLI), which sells brand name products at a discount. It attributed its results to increased numbers of higher income and young shoppers. In previous quarters, dollar stores and Walmart (WMT) got a similar boost, but there was little mention of it this time. Apparently, that boost was a one-off.

Other high-end apparel retailers such as Capri Holdings (CPRI) and PVH Corp (PVH) were more middle of the road, with beats but ambivalent outlooks.

Yellow Flag Waving – We think that people in the lower half (or perhaps two-thirds) of the income spectrum are under severe economic stress. Normally, companies like DG benefit when its customers are stressed. It’s not just DG – Walmart (WMT), Target (TGT) and Dollar Tree (DLTR) all offered similar warnings. This must be a big yellow flag for the broader economy. It may have little market impact for now – but it could be a continuous factor in the presidential primaries and election next year.

We are also cautious on spending by higher income people.

Consumer Staples

Hormel Foods Corp (HRL), Campbell Soups (CPB), and JM Smucker Co (SJM) followed most consumer staples companies with solid beats on revenue and earnings. But CPB stock dropped nearly 10% on concerns about whether it will turn to discounting to increase soup volumes. HRL said it plans to increase prices further this year to cover higher costs; SJM offered an outlook in line with expectations; both stocks were little changed.

Show Me Time – After successfully pushing through significant price increases over recent quarters, consumer staples companies will be increasingly scrutinised to see if they can sustain those gains and even build on them if inflation remains robust.

Consumer Discretionary

RV manufacturer Thor Industries delivered much better than feared results, and its stock jumped 17%. On closer inspection, it managed to clear out much of its 2022 inventory through discounting. It is focused on rightsizing and aligning 2024 production with demand. Demand for luxury travel by RV is there at the right price, but demand going forward may be soft.

Vail Resorts (MTN) missed modestly on earnings and revenue. The ski season in some Western US states was disrupted by too much snow, while mid-west and eastern resorts closed early due to lack of snow.

The problem here is not soft demand but more climate-related snafus.

Consumers may be open to spending on experiences and trips, but natural forces bigger than humanity could be disruptive.