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How to ride the earnings recovery

Earnings have been smashed, but companies are valued as though it’s plain sailing from here, sending PE ratios up and up
September 3, 2020

The V-shaped equity recovery indicates that the market mostly sees a return to normal programming within a year or so. But most companies will be entering 2021 in a very different situation to how they came into 2020. Debt is higher across the board in relation to cash profits, most industries are still constrained in some way by Covid-19 measures, and looking at the FTSE 100, capital expenditure is set to climb in 2021 after plunging this year, while sales will take longer to recover. These factors, plus possible changes to wage expectations, taxes and further rolling lockdowns mean even the lowered earnings estimates for next year and 2021 could be overly optimistic. 

Gross domestic product (GDP) is recovering at a much slower rate than company valuations in the UK and Europe, and especially in the US, where GDP fell 34 per cent in the June quarter while the S&P 500 climbed a quarter in the same period. The tech-focused Nasdaq 100’s performance was even more extreme, climbing 37 per cent from 1 April to 30 June. Berenberg’s model shows a tick-shaped recovery, where the US and eurozone hit early-2020 GDP levels around 2022-23 and the UK takes even longer. 

In the UK, government stimulus has so far protected jobs and balance sheets to some extent through the worst of Covid-19, but the furlough scheme is coming to an end and chancellor Rishi Sunak has floated higher taxes in future to pay down the now-£2-trillion-plus government debt level. “Today’s figures are a stark reminder that we must return our public finances to a sustainable footing over time, which will require taking difficult decisions,” he said. So far, the Treasury has pumped £190bn into getting Britain through Covid-19, plus over £300bn in debt guarantees. 

There are also expectations that the Bank of England will continue with asset purchases. This is the same across the pond after US Federal Reserve chair Jerome Powell said he was keen to keep interest rates low for some time even at the risk of pushing inflation beyond the previous 2 per cent general ceiling. 

So while equities were being boosted by central bank buying, and will seemingly continue to be, analysts have cut earnings on the basis of a Covid-19 recovery taking years. Consensus earnings per share (EPS) forecasts for the FTSE 100 in 2020 and 2021 have come down significantly since the Covid-19 crash in March, unsurprisingly, as the economy slowly finds its feet again.  

Between the end of February and end of March, the average consensus EPS figure for 2020 fell 17 per cent and by this month had fallen by 43 per cent, to 306p. While the 2021 EPS forecast changes have not been so precipitous, analysts have not got more optimistic as the year has gone on, shifting the 2021 FTSE 100 EPS forecast from 583p at the end of February to 523p at the end of March and 429p at the end of August. This 26 per cent drop between February and August represents billions of lost earnings that would have flowed into dividends, debt repayments and acquisitions.

 

Yield sign

In real terms for investors, the FTSE 100 average dividend yield has fallen from 5.2 per cent last year to 3.4 per cent this year, although consensus estimates show dividend cover going from 1.5 times this year to 1.75 times in 2021, a healthier multiple. This is the highest level of cover since 2014, perhaps because of the extent of the cuts earlier this year. The most prolific dividends payers in London, BP (BP.) and Royal Dutch Shell (RDSB), both slashed their base payouts to cope with lower oil prices and increase their ability to spend on new projects. 

There are some positive signs for near-term growth, to be clear. UBS economist Anna Titareva said in an August note that there were “clear indications” there would be a UK GDP rebound in the September quarter, and forecast a jump of 16 per cent on the previous quarter. 

This is still 10 per cent below a year ago, but a major improvement on earlier in the year. GDP tumbled 20 per cent in the June quarter, according to the Office for National Statistics (ONS). While the UK has done worse in GDP terms than many other countries, it is useful as a midpoint between the US and Germany, where harsher initial lockdowns and the broader reopening as a result saw GDP take less of a hit than in the UK and US. 

While the oil and gas players were among the worst hit by conditions this year, there are FTSE 100 companies trading at or higher than their February valuation. Certain retailers are already seeing gains from the recent return of consumers to physical shops. JD Sports (JD) is trading near its pre-crash level of 740p, although its 2021 EPS forecast (for the 12 months to 1 February) has dropped from 37p at the end of February to 12p most recently. This kind of price/earnings (PE) ratio jump has been common in the sector, pricing in a further rebound in 2021 and 2022. 

Even as a standout through its share price recovery and expected sales in recent months, JD’s profitability will come down. It is set to increase capital spending next year and will see its return on equity (ROE) plunge from over 20 per cent in 2019 to 9 per cent. Its five-year average is 31 per cent. The company’s sales are split geographically between the UK, Europe and the US, like many FTSE 100 constituents. 

British Land's (BLND) and Land Securities’ (LAND ) struggles to get rent off their retail tenants so far this year shows this success is not sector-wide, however. Others propping up average future earnings in the London blue-chip list are Bunzl (BNZL ) and gold-exposed miners such as Fresnillo (FRES). Selling personal protective equipment – as Bunzl does – was not enough to escape the EPS forecast knife, although analysts have since restored the 2021 EPS estimate to where it was in February, at 125p. 

 

Furlover 

Despite the market positivity, there is a pinch point coming in the UK that could challenge equity bullishness, even without a further lockdown. Unemployment figures have remained stable compared with before the pandemic, at 3.9 per cent. This is because of the furlough scheme, which peaked at almost 9m subsidy claims in May. Berenberg estimates that they fell back to around 4m in August as pubs and retailers opened their doors again. 

But that is still millions of people who could be out of work in November, cutting consumer spending and confidence. Berenberg senior economist Kallum Pickering told us unemployment is likely to jump in the coming months. 

“You will suddenly get a spike in the unemployment rate because when the scheme ends there will be a wave of redundancies,” he said, forecasting a 9 per cent unemployment rate in November. Germany and France will extend their jobkeeper schemes to avoid the shock to workers, but Mr Pickering said an extension from Number 10 was “highly unlikely” given the government’s preference to avoid supporting workers in ‘zombie’ jobs that would not exist after lockdown has finished. 

Major companies such as Boots, John Lewis and British Airways owner IAG (IAG) have already announced lay-offs despite the support on offer. This indicates a more structural change in their businesses: a shift to online retail for the former and a sharp shock hitting an already-struggling business in the latter. 

Given the hit to airline demand, IAG has not been swept up in the share price improvement since March, and is only forecast to move slightly back into positive earnings territory next year, albeit at 93 per cent below the 2019 EPS figure. IAG has been slower than others to raise cash, and is asking shareholders to back a €2.75bn rights issue at the 8 September annual general meeting. 

If passed, it will go to paying off debt – net debt climbed 38 per cent to €10.5bn in the six months to 30 June – and give it a liquidity buffer for the three years it expects the airline downturn to last. 

Chief executive Willie Walsh’s pessimism over the recovery was reflected by the analyst response: the 2021 EPS forecast dropped from 16c to 8c. Even after March and April, when global air traffic almost came to a standstill, the forecast was still for EPS of 86c. While hindsight certainly helps, it was clear air travel was about to face significant long-term challenges, and analysts were still only guiding for a moderate drop for 2021. 

 

 

Optimism 

The confusion over prospects is not just for those whose prospects keep getting worse. A company that has barely felt the impact of Covid-19 is Experian (EXPN), which gives consumers and businesses credit scores. It flagged a 5-10 per cent drop in sales in the June quarter and analysts duly slashed forecasts, but these turned around in the second half. The free cash flow consensus forecast is back to the initial $1bn estimate for its 2021 financial year, which ends on 31 March.  

The EPS forecasts have also turned around since May, but not the 47 per cent shift in free cash flow between the lowest point in May and the end of August. This clearly shows confidence in the company making it through the pandemic unscathed, but prompts questions about why the initial downgrade was so strong or why the ramp-up in free cash flow expectations was so much greater than EPS. Despite the downturn, Experian is trading at a forward PE of 36 times, well above its five-year average of 23 times. Buyers could be betting on credit scores becoming more critical if unemployment jumps in the UK or jumps again in the US, which is a major market for the company, as people turn to debt to make ends meet. 

Analysts have a history of getting the company's free cash flow wrong, with consensus 19 per cent too high in 2020 and 8 per cent too low in 2019. 

 

 

The eternal question is whether these valuations are reasonable. In UBS’s language, the Fed’s assets are surging to “unseen levels” and forecasts that they will rise from the $5-trillion-or-so level now to over $8 trillion next year. In that case, valuing companies based on future earnings does become a mug’s game. PE ratios in the US are already reflecting huge injections of cash. 

Looking outside of the Faang companies (Facebook, Amazon, Apple, Netflix and Alphabet), tech players with any connection to home-working have soared. The longevity of these gains is not clear. A lockdown standout is Zoom Video Communications (US:ZM), which has a five-year average NTM PE ratio of 1,795, making its current ratio of 200 times seem less outrageous. This is a case of near-term earnings growing alongside expectations, as its price has also surged over 300 per cent since the start of the year, to $295. Analysts don’t see PE going below 50 times before 2025, with the assumption that sales will have risen from an estimated $1.8bn this year to $5.5bn in 2025, while the cost of sales only climbs from $517m to $992m in the same period. 

Because Zoom is the posterchild of the working-from-home shares, looking at the S&P 500 index gives a fairer picture of US company valuations. The index’s PE ratio of 27 is well above the 18 of last year when there was not a global pandemic. 

 

 

What next?

The equity-GDP mismatch is less of a square peg in a round hole than a market banking on a recovery within a few years. Investors are still paying for future earnings, but they’re further out. There are clearly companies that won’t come out of the current crisis, however, and pushing earnings further out adds risk. 

Even in London, where valuations are not as supercharged as the US, companies are trading at the same level as pre-Covid-19 despite earnings being hit. Mr Pickering from Berenberg said the rebound didn’t “leave much scope for downside risks”, such as a major new Covid-19 outbreak or a “surprise bout of inflation”. There is also the US election to contend with. 

But he also sees much less of an arduous path back to economic health than the last recession. “This has been a historic economic shock in terms of the size,” he said. “But unlike, say, the financial crisis, which damaged the underlying growth potential of economies I don't see much risk that the underlying growth potential is badly damaged.” 

Given Jerome Powell told the world at the end of August that he was happy to keep injecting money into stock markets, a loss of any link between earnings and price could be the outcome rather than a quick shift to a bear market.