How the US earnings season shot the lights out

'Astounding' is the word that Bob Desmond, Head of Claremont Global used to describe the recent US earnings season. Wrapping up this week, all major US companies revealed their 2nd quarter numbers including revenue, growth and forecasts. To say it was a strong earnings season would be an understatement. 

For the first time since Q1 2008, 86% of companies beat expectations on the revenue line. These strong numbers didn't discriminate against certain sectors either. Across the board, companies managed to deliver strong growth. Desmond drew on examples like Microsoft to Nike and even Visa, to demonstrate how his expectations were exceeded. 

"To be honest, we went in with high expectations and they have been well surpassed." 

Earnings are high, the consumer is strong and the recovery is well and truly here. But while companies managed to deliver record-breaking numbers, it wasn't enough for the market. Take Facebook for example, which managed to smash expectations on revenue, earnings and average revenue per user, yet the share price tumbled, down 5% in one day. The reason is a mystery to Desmond but reminds investors about thinking long-term. 

"Businesses are not linear things, there will be disappointments along the way. So for us, it's really about what is the long term trajectory." 

To reflect on all things US reporting season, I sat down (virtually) with Bob to discuss the earnings season that exceeded expectations. We chatted about why the market isn't responding well to cracking results, the common themes CEOs are discussing and why we're well and truly into the recovery phase. 

Key points: 

• 0:20 - Bob's overarching reflection on US earnings season 
• 2:51 -  Expectations going into US earnings season and Alphabet's killer results 
• 4:13 - Other companies managing to smash expectations 
• 5:55 - Why big tech earnings were so impressive, but the market didn't react well 
• 8:24 - One stock that delivered great earnings but flew under the radar 
• 9:29 - Common themes amongst the CEOs 

Edited Transcript 

Bella Kidman: Bob, thanks so much for joining me on the back of US earnings season. How would you sum up US earnings season in one sentence?

Bob Desmond: Thanks for having me on Bella. In one sentence, astounding, incredibly strong. If you actually look at the revenue base (I was looking before this interview), it's not something we spend our time thinking about, to be honest. We think more about our businesses if you like, rather than the markets.

But I saw actually Bernstein put a piece up that 86% of companies beat on the revenue line. And that's actually the strongest quarter since Q1 2008. So it is an incredibly strong earnings season. And we went in with high expectations and to be honest, they've been surpassed, well surpassed.

Well, valuations have been incredibly high in the last year. The S&P 500 is up over 38%. Did that worry you a little bit going into earnings season - that companies couldn't meet the expectations that were being forecasted for them?

I guess I understand what you're saying from a short-term or a market perspective. In the way we look at our portfolios, we're looking at what they're going to be earning in five years. So we know over that sort of that timeframe, there's going to be hiccups along the way. 

We tend to look at them over a three to five-year period but yeah, expectations were high going in. And if I look at our companies, nearly all of them were in line or well ahead of expectations, and we've taken our numbers up and taken our valuations up. So what we've seen is even though the prices have been moving up, those earnings are more than growing into the prices that you're seeing in the market.

Bella Kidman: I'd be interested to know, obviously if you look at companies on a three to five year view, how important is earnings season? Do you pay close attention, obviously to the companies that you hold, but is it something that you materially consider when you're looking at a company?

Bob Desmond: It's hugely important for sure. Yeah, it's kind of a health check on how the companies are going. I guess what's not important, or less important I should say, is that if they miss or there's a slight disappointment. Businesses are not linear things, there will be disappointments along the way. But for us, it's really around, what is the longterm trajectory? How are they talking about competition, market share, competitive advantage? How they're allocating capital? What's happening with their margins? It's a health check. We don't think about ‘did they meet expectations’? It's more, did they meet our expectations in terms of all of those things I mentioned.

Bella Kidman: You mentioned also that you had quite high expectations going into this earnings season and they've been met, and if not, they've exceeded your expectations. I'd be interested to know, could you walk us through that? What your expectations were going in, how they were exceeded, and maybe you can draw on some examples of some companies that exceeded your expectations.

Bob Desmond: Sure. If you actually look across our portfolio, we really have five divisions, if I think about it, I kind of think about it as an industrial holding company with five divisions. And if I look in the tech bucket where we’ve got Alphabet and Microsoft. Alphabet's result was astounding, they had 57% revenue growth. And even obviously up against a really easy stack or easy comp I should say last year with COVID. But on a two year basis, they grew 26% per annum which is astounding for a company that's nearly 2 trillion in market cap. So that was a blow up number for us. On the back of that, we took up our earnings and our estimates 5 or 6%. So that was a blow out number. Microsoft, now they had 17% constant currency revenue growth. Again, astounding for such a big business to be growing at that sort of rate. There, we took up our earnings and our estimates by around 8%. So those were in that bucket, just really, really strong. And as you say, went in with high expectations and more than delivered.

If I think in our business services division, we’ve got Aon there. We were kind of expecting for the year sort of mid single digit plus organic revenue growth. They came in basically for the half year at 8% organic revenue growth. We think they'll probably do eight or 9% for the year. So that was a really, really, really strong result.

If I think of areas in the consumer space as well, something like Nike. Over a two year stack they had 21% revenue growth. There we took up our earnings and our valuation in high single digits. So, we've seen really, really strong numbers across the board. If I look in the consumer payments space and consumer, if you look at something like Visa now, their two year stack on payments volume was up 21%. So they're back to kind of domestic and ahead of where they were pre-COVID. I mean, obviously their cross-border business, especially travel is down over 50%. So the consumer has been really strong, tech's being really strong, business services has being really strong. And our companies are reporting fantastic results.

Bella Kidman: So you obviously had high expectations. Did that backfire a little bit where there were a few companies that you thought would do well and then they missed out and your expectations weren't met?

Bob Desmond: No, no, everything was in line or ahead. If I look at something like CME, which is something I own in the portfolio, that was pretty much in line. Something like Diageo, they had a very strong results but that was kind of in line with what we're expecting. Yeah. I suppose the real beats were in were in tech, business services, consumer. Healthcare was really strong in parts of our portfolio as well. So no, there were no disappointments at all.

Bella Kidman: So let's talk a little bit about tech. Last week, we saw the earnings come out for a lot of the big tech names particularly the Faang stocks. And there were certain stocks like Microsoft and Alphabet that did very well and managed to get an increase in their share price after that. But there were stocks like Facebook, Netflix who really suffered after their results, even though they delivered quite good numbers. So did you anticipate that perhaps the market would react badly to some of that information and the forecasting that they put out or was that quite a surprise to you?

Bob Desmond: Netflix, we don't follow at all to be honest. It's not really on our watch list, that's not something that's on our radar. In terms of Facebook, we obviously follow it very closely, it's a direct competitor to Alphabet. We thought their result was very, very strong. We think it's a really strong business that's delivering to our expectations. I'm not quite sure why the market was disappointed to be honest. At the end of the day, we just look at the results, how they've delivered. And I think it was a very, very strong result. I can't remember the revenue number, would have been well over 50%. And we see over the medium term, that's a 15 to 20% grower easily and pretty much a market multiple. So I'm not sure why the market was disappointed. We don't really try and think too much, what's the market thinking about this? We're more interested in what do we think about it?

Bella Kidman: I totally understand that it's more of a what did the company deliver but when the result is so good and the market reacts so poorly, does that worry you? Do you think that that's perhaps an indication of a volatile market and you need to step back a little bit or how do you view that?

Bob Desmond: In those types of situations, what we try and do is actually try and think of the reason why there was the disappointment, if we could put our finger on it and obviously that's not always so easy to do. And then we try and think, is that a short-term or a long-term problem? And more often than not, if you want to buy a great business, you do want a short-term problem. The market doesn't give you many opportunities. And so if there's something that's short term, maybe their revenue guidance was disappointing or something like that, we don't get too worried about that. What we get more worried about is there's a sign of loss of competitive advantage, there's competitive encroachment, something like that, poor capital allocation, gone and done a dumb acquisition. That's something that worries us much more than guidance that's one or two or 3% for the next quarter less than the market was expecting.

Bella Kidman: Well, big tech has obviously gotten a lot of attention from the market, but I'd be interested to know what one stock is that you think kind of flew under the radar in terms of their earnings but delivered very well that isn't necessarily in that big tech bubble.

Bob Desmond: Well, I guess the one that is one I've already touched on which is Aon. It's kind of seen as a bit of a boring business, it’s probably over time a mid single digit organic grower, but it's got terrific financial metrics. It's a 28% margin business, pretty much spending less than 2% of sales on CapEx. It's got hardly any working capital. They allocate capital really well, they buy back four to 5% of their stock every year. And so the guidance last quarter, we look at their main competitor, Marsh McLennan, both sort of businesses we're talking mid single digit organic growth. Marsh basically came up with 13% organic growth and Aon with 11 for the quarter. So that was really, really strong and shows you the recovery that's taking place. Those businesses, really the key drivers are employment, capital expenditure, obviously cyber-risk is becoming a big thing as well and really, really strong results.

Talking about the health of the US economy, rumours of inflation, did you notice any kind of common denominator with those things?

Bob Desmond: Yeah. There are a couple. I'd say, and we kind of forget this, in Australia we're still in lockdown and especially in Sydney. The US consumer's really, really opening up really quickly. 

So - some of the things that I found interesting. For example, there will be more US tourists in Greece this year than they were in 2019. Things are really opening up. If you look at some of the payment company volumes in the US in terms of eating out, entertainment, et cetera, they're supporting 2019 levels now. It really is opening up really quickly and I think speaking to companies there, you kind of had this confluence of events where spring came along, everyone felt a bit better, summer's along and everyone was vaccinated and so the kind of the combination of the two. And then the US consumer is sitting on two and a half trillion dollars of excess cash. So there's a lot of money that needs to be spent. So I think that is a really key theme and we saw it through the numbers.

But what's really interesting is that is something that's been well known by the market, and actually in terms of share price, our consumer stock has actually been lagging. So sometimes you try and pick a theme, but the market's already worked it out. But I think that was something that was really obvious. We don't follow banks, it's not something we want to own. We don't like the capacity and we don't like the leverage. But it's clear, looking at something like AmEx, the huge reserve releases that are there, the ability for banks. Something like AmEx is running with a common equity ratio of 14% when the target's 10. So there's a lot of capacity for banks to lend more money. They can't lend because of consumer's in such strong state, they're struggling to actually lend, but there's a lot of capacity for them to lend and or for the consumer to gear up as well. It's kind of a weird recession where consumers have come out of the recession with much stronger balance sheets than they went in. So that was kind of different.

And then on the inflation front, I guess, there's a lot of raw material inflation obviously with really, really easy or tough comps if you like. So a company like Sherwin-Williams, they were running basically the raw material inflation running in the high teens for this year. And they are putting through some really hefty price increases, took 3% in Q2 and in the next quarter they're putting through 7% price increases. Now in the short term, those raw material increases are actually slightly negative so you are going to get gross margin slippage. But actually for the businesses that have pricing power, that's actually, long-term really positive. Because what ends up happening is that all material inflation bates but the companies hold onto the price increases. And so in the long-term, that's actually accretive to margins. So that's kind of what we saw across the board. There's obviously a shortage of labour, there's problems in freight, there's problems in logistics, and then there's just the straight raw material inflation.

Bella Kidman: So have you made any material changes to the portfolio on the back of this earnings season? And perhaps you could walk us through maybe an addition or disposal that you've had to think about or that you're considering at the moment?

Bob Desmond: I hate to be boring Bella. We haven't changed anything through this earnings season to be honest. In fact, yesterday we did our first trade in three months. We don't trade that much. So no, no, pretty much the same as what we had going in.

Bella Kidman: Fantastic. Well, that's all the questions that I have but thank you very much for your time. We really appreciate it. And it was really interesting to get your thoughts on the US earnings season that's just passed.

Bob Desmond: Great Bella. Thanks for having me on.

This transcript was edited for clarity and length

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Bob Desmond

Head of Claremont Global, Portfolio Manager

Claremont Global

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