• About 83% of companies in the S&P 500 index exceeded their earnings estimates in the second quarter
  • The worst sectors for revenue performance in the second quarter of 2020 were energy (down 52%), industrials (down 25%)
  • Retailers, energy firms and banks have incurred huge losses and are under pressure

The majority of publicly traded U.S. companies beat earnings expectations in the second quarter, but sales growth did not keep up the pace.

Mark Saylor, portfolio manager at Penn Mutual Asset Management in Horsham, Pennsylvania, said that about 83% of companies in the S&P 500 index exceeded their earnings estimates in the second quarter – the highest level in more than a decade. On average, they beat such estimates by 23%.

In the current environment, Saylor proposes that many companies are beating earnings’ estimates by cutting costs, that is, reducing headcount.

“Many companies were able to cut expenses to combat revenue declines,” Saylor told International Business Times.

This cannot continue – in order to maintain price momentum, companies will have to find ways to gin up sales and create growth organically.

Indeed, some corporations beat earnings expectations for artificial reasons.

Looking back at the second quarter, Saylor said it seems analyst estimates for the S&P 500 Index were cut too much.

“During the second quarter, analysts reduced their estimated earnings for the index by 37%,” he cited. “By the end of July, that number was adjusted even lower, with estimated earnings reduced by 44%. The previous record -- for as long as FactSet has tracked data -- for negative earnings revisions was 34% for the fourth quarter of 2008. Considering the historical precedent for the degree of downward revisions, [the second quarter of 2020] was very extreme.”

Saylor noted that while revenue growth was actually a little better than anticipated in the second quarter, they were still down by 10% compared to the prior year.

Interestingly, Saylor noted, through the first two months of the third quarter of 2020, analysts are increasing S&P 500 Index earnings estimates for the first time since the second quarter of 2018. “This is an expectation change from extreme negativity and time will tell if this outlook is too rosy, too soon,” he commented.

James R. Barth and Jitka Hilliard, finance professors at Auburn University in Auburn, Alabama, told IBT by email that analysts’ expectations are just forecasts, not concrete figures that should be taken too seriously.

“In recent months forecasts have been made under conditions of considerable uncertainty,” they said. “This includes substantial uncertainty about the future spread of COVID-19, the development of a vaccine, the speed of the economic recovery, and the outcome of the presidential election. Depending on the weights attached to such factors, it is easy for the earnings expectations of analysts to go off the mark for companies.”

According to S&P Global data, the worst sectors for revenue performance in the second quarter of 2020 were energy (down 52%), industrials (down 25%), materials (down 16%) and consumer discretionary (down 15%).

“Intuitively, this makes sense with the precipitous drop in oil and other commodity prices by early March, global economic shutdowns and furloughs and layoffs hitting consumer spending,” Saylor explained.

Companies that rely most heavily on foot-traffic are seeing the slowest sales growth, Barth and Hilliard said. “This includes airlines, cruise lines, hotels, restaurants, movie theaters, fitness centers, concerts, taxis, and other ride-sharing firms,” they stated.

Retailers, energy firms, and banks have incurred huge losses and are under pressure.

“For banks, they are currently experiencing net interest margin compression that has not been seen since the early 1980s,” Saylor observed. “On the lending side, the low [interest] rate environment makes pricing loans competitive. On the expense side, many banks did not have a high enough loan loss provision heading into [the second quarter] earnings and experienced above expected loan losses. “

Within retail, while e-commerce has performed well throughout the pandemic, retailers with a heavy brick-and-mortar presence have greatly underperformed.

“The combination of physical closures of storefronts due to the economic shutdown and a curtailment of consumer spending was too much for many retailers to handle,” Saylor said. “This year, [at least] 27 retailers have filed for bankruptcy. That is on top of 17 retailer bankruptcies in 2019.”

Barth-Hilliard stated that retailers, energy firms, and bankers have to hope there is a substantial and sustainable recovery.

“Also, they will have to make changes that embrace newer consumer preferences and incorporate newer technologies that facilitate greater use of the internet for work, education, financial transactions, shopping and entertainment,” they suggested.

The sectors delivering the strongest revenue growth during the second quarter were information technology (up 5%), health care (up 1%), financials (flat) and consumer staples (flat).

Of course, the market rally this year has been paced by large-cap tech names – some of which have doubled or tripled in value. Many people are working from home during the pandemic – and tech has benefitted immensely.

“Many families have children that are currently attending school in a virtual or hybrid format,” Saylor said. “Streaming entertainment, social media and gaming are increasing in popularity and adding users. No-contact takeout and grocery delivery services are in high demand. Technology companies provide the infrastructure, hardware and software to allow these experiences to happen.”

*Barth and Hilliard explained that due to COVID-19, people have been asked to change their behavior and most have done so by relying far more heavily on the internet for work, education, shopping, and entertainment.

“The tech companies that have been facilitating such behavioral changes have seen their sales surge,” they said. “When there are an acceptable treatment and safe vaccine for the coronavirus, things should return to a more normal state of affairs. This should slow the growth in sales, but there has most likely been a longer-term positive change in the reliance on tech companies.”

Indeed, the information technology sector is the best performing area of the S&P 500 Index this year, up nearly 29% through last Friday.

Speculation has also arisen that some companies, particularly oil and utility firms, may have to reduce or eliminate dividends to cut costs.

Many companies cut dividends in response to crises – this enables them to preserve cash for necessary expenses as revenues decline, thereby helping avoid defaults, Barth-Hilliard stated.

“Companies are still reducing and eliminating dividends,” Saylor said. “There was a flood of dividend cuts and suspensions early in the pandemic environment. They could be seen as proactive -- to protect balance sheets, ensure adequate cash flow to address operating needs – or reactive – companies operating on a thin margin, paying out most of their earnings as dividends.”

With respect to energy and utilities, Saylor noted both sectors are generally comprised of companies with significant annual capital expenditure and financing needs and minimal free cash flow to address them.

“For regulated utilities, which tend to have predictable, recurring revenue and earnings, a fixed dividend makes sense,” he said. “However, for companies with a more volatile revenue and net income profile year-to-year, a variable dividend based on a percentage of current year earnings or a trailing average of yearly earnings may be a more prudent approach. [But] we do not see many companies employing this dividend payout structure.”

But how can companies increase sales growth in this difficult environment?

Saylor suggested that one option to generate sales would be to reduce prices.

In hard-hit industries such as travel, a company like Carnival (CCL), the cruise operator, generally has two levers to pull to increase revenue, he suggested.

“These are occupancy and rate,” he said. “Given that occupancy is currently so low, the company will likely need to reduce rate (or offer onboard credits; anything to lower prices) to bring travelers back. It can be a difficult decision for management teams to sacrifice margin for growth. Hotel operators and other related travel companies face similar choices.”

Another option would be to quickly pivot or adapt to the new COVID-19 operating environment.

“A traditional furniture manufacturer like Herman Miller (MLHR) had lower total revenue year-over-year, but their retail business was up 40% from last year and their home office category was up 300% from last year,” Saylor noted. “To that point, they are creating ‘new concept’ stores focused on home office. They seem to be adapting and embracing this new growth channel without hesitation.”

According to data from Refinitiv, the companies in the S&P 500 index are expected to see their earnings drop by 21.9% in the third quarter on a year-over-year basis. For the fourth quarter, earnings are slated to decline by 13.6%.