Nelson: I Have Been Wrong About the Prospect of Near-Term Inflationary-Driven Earnings Tailwinds
publication date: Jul 4, 2022
author/source: Valuentum Analysts
During the past several weeks, we've grown increasingly concerned about the health of consumer-tied entities across not only the consumer staples but also the consumer discretionary spaces.
Many consumer staples entities, while raising prices, aren't raising them fast enough to drive operating-income and bottom-line expansion, while many consumer-discretionary companies are facing higher freight and logistics costs and weaker performance in China, perhaps best revealed by Nike's most recently-reported quarter, where inventory advanced 23% compared to the prior-year period.
The tell-tale sign about the health of the consumer may be Amazon (AMZN) Prime Day, which is coming up on July 12-13, but based on many of the reports we've monitored this past earnings season, even if sales are strong on Amazon Prime Day, several businesses may still have a difficult time leveraging consumer demand and price increases into operating income and earnings-per-share expansion this year.
Perhaps we were somewhat late to the view that pressure on S&P 500 earnings growth might very well materialize after evidence of Walmart’s (WMT) and Target’s (TGT) disappointing quarterly earnings and outlooks a number of weeks ago, but it wasn’t until the Nike (NKE) earnings report, released June 27, that all but sealed the deal, in our view, that the probability of a recession in the U.S. is increasing.
When we looked at Walmart’s and Target’s fundamental trajectory, the story was similar, though Target is clearly doing worse. Top-line growth ensued for both during their most recently-reported quarters but consolidated gross margins faced pressure, and operating income tumbled tremendously.
Their outlooks weren’t great either. For Target, in particular, the company originally guided its second-quarter operating income margin rate well below consensus estimates at the time, to 5.3%, due to gross-margin pressure from higher freight and transportation costs and measures to reduce inventory. However, just a few weeks later, Target reduced that second-quarter operating margin target again to just 2% as it works through excess inventory with aggressive markdowns.
Clearly, consumer-tied businesses, whether consumer staples or discretionary, are facing tremendous cost pressures. Though some of those cost pressures are freight and logistics expenses, which might play into the hands of FedEx (FDX) and rival UPS (UPS), FedEx still noted that it also experienced "lower shipment demand due to slower economic growth and supply chain disruptions."
The tech sector is being weighed down by concerns over business advertising revenue, and while Meta Platforms (META) and Alphabet (GOOG) trade at very attractive price-to-fair value estimate ratios, things could still be worse than we’re expecting given news over hiring slowdowns for engineers at Meta and a greater focus on cost efficiency at the firm, even while it spends heavily on security, privacy and the metaverse. In light of the crypto bust and tech hiring slowdown, Silicon Valley may be in a world of hurt at the moment, and this may only be starting to show up in the numbers.
At the end of last year, I was excited by the prospect for companies to layer on pricing power to drive nominal earnings higher in the coming inflationary environment. With equity prices based on nominal earnings, I was therefore expecting nominally higher equity prices, too. Let’s say a company generates $100 million in revenue and has $50 million in expenses. Inflation rises 10%, where revenue is now $110 million and expenses are $55 million, both advancing 10%. In this scenario, earnings have also advanced 10%, to $55 million from $50 million. Higher expected earnings to some degree based on the ability to price higher, higher expected stock prices and therefore returns.
I expect such a simplified scenario to happen to some degree over the longer run, that is for stock prices to reflect higher nominal earnings expectations in the longer run, but right now, operating-income and earnings at several consumer-tied bellwethers are getting pummeled because of inflationary pressures. In light of the operating-income declines during the first half of this year at some of the stronger companies out there, I believe it’s now going to take some time for my thesis for inflation-driven nominal earnings expansion and therefore higher long-term equity prices to play out. I still think it will happen, but the near-term earnings performance at several big names has been nothing short of disappointing.
Here are some numbers, for example: Income before income taxes at Nike fell 26% on a year over year basis for the three months ended May 31 on roughly flat revenue. Consolidated operating income at Walmart fell 23% during its first quarter ended April 30, while revenue still increased 2-3%. For the three months ended April 30, Target’s operating income dropped more than 43%, while sales still advanced 4%. These are some huge operating income declines, despite revenue resilience, at some of the biggest consumer-related names.
I simply was not expecting the magnitude of such operating-income drops across consumer-tied companies, and while I think long-term inflation will eventually help drive higher nominal earnings in the longer run when conditions reach “normalization” again, the lag will be much longer than I originally thought. The numbers out of Walmart, Target, and Nike, for example, speak not only to tremendous earnings weakness, but also to the prospect of economic recession in the U.S. That may be no reason to panic now, however.
For starters, the worst in terms of equity price declines may already be behind us and the markets seem to be looking to carve out a bottom as they near technical support levels. From where we stand, equities have already been punished quite a bit so far in 2022, where companies such as Meta are trading at 10-12 times 2023 expected earnings. Furthermore, the hardest part of having sold stocks at the top is knowing when to get back in, and in my view, once the U.S. economy turns for the better, I would expect violent moves to the upside on some of the most beaten down names.
Though I have been clearly wrong on my near-term thesis for inflation-driven earnings expansion, we still did great sorting through investment idea considerations. Through late June, for example, the simulated Best Ideas Newsletter portfolio has generated 4-5 percentage points of alpha relative to the S&P 500, as measured by the SPY. The simulated Dividend Growth Newsletter portfolio is down only modestly this year, also performing better than traditional benchmarks. The simulated High Yield Dividend Newsletter is generating “alpha” against comparable benchmarks, and the Exclusive publication continues to deliver, with both capital appreciation ideas and short idea considerations generating fantastic success rates. ESG and options-idea generation have also been great.
With all this being said, in the long run, I believe nominal earnings will expand rapidly from 2021 levels, which is why I remain bullish on stocks. I believe markets tend to overestimate earnings in the near term and underestimate them in the long run. The intelligent investor knows, too, that the most money is made during recessions and bear markets, where steady reinvestment and dollar cost averaging help to better position portfolios for higher returns over the longer run. The newsletter portfolios are well-positioned for continued “outperformance,” in our view, and while we may make a few tweaks to them, we’re not making any material changes at this time.
The start to 2022 has been rough on an absolute basis, but I believe better times are ahead, and now is certainly not the time to panic. Happy investing. Thank you for listening, and we’re available for any questions.
Tickerized for holdings in the SPY.
Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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