Nelson: I Have Been Wrong About the Prospect of Near-Term Inflationary-Driven Earnings Tailwinds

publication date: Jul 4, 2022
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author/source: Valuentum Analysts
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Transcript

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.

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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.

Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.  

6 Comments Posted Leave a comment

Jeanne Roffee
Your humility is admirable. Comments about the Intelligent Investor doing well in recessions and bear markets due to reinvestment at a lower price are understood. Do you have some strategy to share to those subject to RMD who need the income distributed and cannot reinvest? Thank you for a great newsletter.
Ben Pedersen (New York)
Hi Brian,

In many of the reports (including the Exclusive publication) you guys write something along the lines of "We caution that company X is heavily dependent upon access to additional capital and/or capital markets." What does this mean in an environment where interest rates are rising so rapidly? Does this put some companies in risk of actual default for being over-leveraged or is this only talking about the ability to expand? (i.e. future earnings increases.) Also, in times like these, do most companies secure capital as quickly as possible (at the lowest rates possible) or are they subject to higher costs due to variable rising rates? Thank you.
Brian Nelson (Woodstock, IL)
Hi all -- thank you so much for all your comments and memberships. We appreciate them very much.

As many of you are aware, we are a fundamental, discounted cash-flow based research publishing organization, not a quantitative price-observed trading firm. The processes between these two different types of organizations are vast. Please sign up to our financial statement analysis and valuation webinar for more information on the work that goes into analyzing a company's intrinsic value, for example: Register for This Educational Webinar Series!

The weekly stock screener is updated periodically, generally each weekend. It can be downloaded at the following link -- login required -- please click 'Periodic Stock Screener' --> Periodic Stock Screener

The weekly screener can always be found in the 'Stock Screens' section on the left column of the home page.

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As it relates to the stock and dividend reports, the latest few industries that have been refreshed are as follows.

Mining & Chemicals industry (July 1): Mining & Chemicals Industry

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We've made substantial changes to our coverage in 2019 and early 2020, publishing many 'optimizing coverage' notes where available, per CFA best practices. Here is another announcement regarding changes in our report coverage, Improving Our Coverage

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There are several of these types of articles on our website as we've looked to optimize the value contribution to members: Ongoing Optimization To Maximize The Value.

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That said, we always emphasize transparency and include when we make any changes to the stock report coverage, when feasible. Our target stock and dividend report coverage going forward is roughly 200-300 reports at the moment, but this may increase or decrease depending on member interest and market conditions. We hope this answers your questions, and if we can be of any further assistance or if you have any additional questions, please just let us know.

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Brian Nelson (Woodstock, IL)
Hi all -- Thank you for your question regarding capital-market dependency risks. It is a great one because it hits at the heart of the MLP (master limited partnership) and REIT (real estate investment trust) business models.

Capital market dependency is typically a condition that occurs when a company's traditional free cash flow, as measured by cash flow from operations less all capital spending, is less than cash dividends paid. This means that the company is dependent on external capital, to some degree, to fund both growth and maintenance capital spending and its dividend or distribution.

The Dividend Cushion ratio helps assess a firm's capital market dependency. First, the raw, unadjusted Dividend Cushion ratio adds a firm's net cash position to the sum of its future free cash flows (cash flow from operations less all capital spending) over the next five years and takes that sum and divides it by the sum of the company's expected cash dividends paid and growth in them over the next five years.

The Dividend Cushion ratio is essentially a coverage ratio -- the higher the ratio above 1, the better able the company will be able to cover dividend payments in the future, in our view. For most of our coverage and for most corporates, the qualitative ratings for safety and growth are a function of the raw, unadjusted Dividend Cushion ratio, as shown below.

For MLPs, REITs, and some utilities, however, we may make modifications to the raw, unadjusted Dividend Cushion ratio in deriving the adjusted Dividend Cushion ratio. For example, with MLPs, we add back future equity issuance to the numerator and mitigate the company's debt load to a degree on account of assuming ongoing refinancing capacity for such entities.

These adjustments result in a sharp upward revision to the raw, unadjusted Dividend Cushion ratio. For MLPs, REITs, and some utilities, we base the qualitative rating on this enhanced adjusted Dividend Cushion ratio, but we also disclose the raw, unadjusted Dividend Cushion ratio in each case.

In short, we believe both the raw, unadjusted Dividend Cushion ratio and the adjusted Dividend Cushion ratio offer insights. The former reveals the capital-market-dependency risks inherent to MLPs (if the raw, unadjusted ratio is well below 1 or negative), for example, while the latter acknowledges that under benign market conditions, continued funding of the distribution/dividend would ensue.

In most cases, when assessing risks to the payout, we place greater emphasis on highlighting the raw, unadjusted Dividend Cushion ratio because it is more of a pure risk measure than the adjusted one, which considers a variety of incremental funding sources, which cannot be guaranteed during difficult credit conditions.

Though we may make qualitative adjustments to the ratings themselves on account of other factors, the assigned breakpoints are as follows for both measures (they can be found on the definitions page in the Dividend report in the back):

"Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion™. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR."

MLPs and REITs are risky entities that may face tremendous pressure during tightening credit market conditions or disruptions in the capital markets. The two measures of the Dividend Cushion help members assess those risks. Please let us know if we can elaborate further.

Kind regards,

The Valuentum Team
www.valuentum.com
Detlev Tiszauer (Fort Pierce)
As I understand it Valuentum attempts to predict future stock performance from a discounted cash flow analysis of the future expected earnings and looks at the momentum of the market in pricing that stock. Now while the financial analysis is future-focused, momentum is not. To be truly future anticipating, stock price momentum should also be future-focused. Of course estimating future momentum is significantly more difficult than estimating future earnings. There are no projections as there are for corporate earnings and no formulae for discounting expected future momentum to the present time. Although, with the advent of social sentiment scores, the predictions of political leaders and their actions that have predictable consequent future resultants, the momentum analysis in Valuentum could also be brought into a future-focus. Such a future-focus on momentum may help in market conditions as we find ourselves to be at present.
Ben Pedersen (New York)
Thank you for the response about capital-market dependency risks. I re-read it several times. I am learning a lot from you guys- as always. Keep up the great work.
 

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