Commodities cast a long shadow over earnings season

9th February 2016

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As the fourth quarter earnings season gets underway, Steve Clayton, head of equities research, Hargreaves Lansdown takes a look at the impact of the commodities crisis and other themes…

2015 was the year when commodity markets crumbled, leaving producers’ share prices in tatters. Confidence in their ability to pay dividends collapsed too and by the end of the year, major oil and mining companies were standing on historic yields of 7% and more.

The weakening Chinese economy looks set to play a big role in 2016. So far, signs of recovery are elusive, at best and the Chinese stock market is down more than 20% so far this year. Reported growth is still almost 7%, but it doesn’t seem to feel like that to the companies trying to trade over there. Expect to see more and more businesses bemoaning weaker Chinese demand when they come to report their results.

Commodity calamities

So far, Royal Dutch Shell has reiterated its promise to pay $1.88 in dividends, for both 2015 and 2016; it first made the promise when it bid for BG Group in the spring of last year. But earnings have collapsed, with full-year earnings set to be sharply lower.

BP has announced a 90% fall in adjusted profits for the fourth quarter, but it held the dividend, only to see its shares slump anyway. At the reported level, the company delivered one of the worst losses in UK corporate history, after writing off billions against assets damaged by the low oil price.

BHP Billiton’s long-held policy of paying a dividend at least as much as the year before looks set to be abandoned; consensus earnings forecasts suggest a dividend at the historic $1.24 level could be as little as 25% covered and the double-digit yield says that the market has long given up hope of it being maintained.

Rio Tinto may feel it has to pay up; it fended off takeover approaches from Glencore and BHP Billiton in recent years. To deny shareholders the chance of a takeover premium, only to see the share price collapse, and then to cut the dividend would be unpalatable, to say the least. But damned if they do, damned if they don’t, could be the order of the day, unless earnings bounce back sharply, for no business can pay an uncovered dividend in the long run.

Suppliers to feel the pinch too…

The oil and mining industries invest hundreds of billions of dollars every year maintaining existing production and developing new resources. The slump in the value of their output has led to aggressive cuts in this expenditure, as companies seek to conserve cash.

Many UK industrial companies supply goods and services to these sectors. We have already seen warnings of developing weakness in demand and expect to see more as results come in. Names in the frame include Weir, whose frack pumps and mining equipment will surely be suffering sharp falls in demand.

AMEC Foster Wheeler will be regretting the debt it took on to buy Foster Wheeler; CEO Samir Brikho has already stepped down and the group is looking for a successor. Someone will need to relish a challenge, with demand for new oil and gas engineering projects looking precarious at best.

Other names feeling the effects will include IMI, Rotork, Elementis and Smiths Group. The market knows bad news is on its way, the impact on share prices will depend whether it is better or worse than expected.

Rain or shine, but not frost

Retailers saw pre-Xmas buying patterns disrupted by unseasonably warm weather and it hasn’t really got much colder since. If Jack Frost doesn’t show up soon then retailers are going to start worrying about how they will shift their Autumn/Winter ranges before summer arrives.

We know that Next went into the sale with a clean stockroom, whilst Debenhams seemed to have taken a view that winter could be mild, which paid off handsomely over Christmas. But Steve Rowe, the new man at the helm of M&S is unlikely to be having a cakewalk in his first few weeks in command. Still, M&S has a 31 March year end, so he has a while to try and trade the business out of the weather-related difficulty.

Food retailers’ generally saw sales a little better than feared over Christmas, but with no respite on margins. It seems too early for dividends to begin much of a bounce-back after the cuts of 2014 and 2015, so investors are likely to focus on their cash flows and intentions on pricing and new store openings. Sainsbury will be hoping to shift the debate from grocery price fights to what it can make out of Argos, assuming the takeover proceeds as planned.

Banking

The major US banks reported lacklustre income, with investment banking the weak point. Deutsche Bank followed up by reporting a jaw-dropping 30% fall in income at its investment banking division in Q4.

Barclays announced cuts to investment banking activities, whilst HSBC has announced a global pay and hiring freeze. RBS has announced additional PPI provisions, but says that should be the end of the matter. The market will be hoping that other banks, especially Lloyds, can give similar comfort that the fiasco, which has seen over £20bn of compensation paid out by UK banks, is coming to an end.

UK banks too, are likely to report fairly modest income growth, with profits supported by very low levels of bad debts.

The Lloyds share sale has been postponed by the chancellor, because of recent weakness in bank shares. The irony is that Lloyds now trades in the open market at around the price that investors would have paid, after discounts and loyalty bonuses. Under the reported terms of the offer, the loyalty bonus would only have been available on the first £2,000 of shares acquired.

There is of course no limit on the amount of shares an investor can purchase in the open market.

The drugs do/don’t work

GlaxoSmithKline reported a 15% decline in core earnings per share (constant exchange rates), which was marginally ahead of company guidance. While 2015 was a difficult year, investors are focusing more on the outlook, which is perceived as starting to look up. Sales of new pharmaceutical and vaccine products are growing strongly, and the company is undergoing a large scale restructuring to cut costs and boost margins. As a result, the group forecasts double-digit earnings growth in 2016, followed by mid-to-high single digit growth out to 2020.

AstraZeneca’s full-year results underwhelmed investors, with the shares down around 6% following the announcement. Core earnings per share (EPS) came in at $4.26, an increase of 7% on the prior year (at constant exchange rates) and in-line with company guidance. However, the outlook for 2016 was a little weaker than expected. The company is guiding for a low-to-mid single digit decline in sales and profits in 2016, as the group’s Crestor treatment loses US patent protection.

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