Earnings Preview – Expectations Vary Widely, Valuations Equally

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Graham Copley / Nick Lipinski



October 11th, 2012

Earnings Preview – Expectations Vary Widely, Valuations Equally

  • The pundits are talking at length about how Q3 2012 estimates are on the whole lower than Q3 2011 actual earnings. This is not true across all of the Industrial Sectors and the correlation between expectations and valuation is good in general but has a couple of meaningful outliers.
  • Metals, Packaging and Paper are expected to show earnings declines year on year, but all others in our coverage group are expected to show growth. For Capital Goods, Electrical Equipment and E&C, expectations are for more than 30% year on year growth.
  • Some of the more positive groups are likely to be overly optimistic and we would expect some negative surprises. Valuations are most stretched, suggesting most downside risk, for Electrical Equipment, but have been stretched here for a while.
  • Several sectors are trading at significant relative premiums today versus October 2011; these look most pronounced relative to earnings expectations for Paper. On the flip side, Capital Goods and Transports have not seen a positive valuation move in the last 12 months that fully reflects expected earnings growth.
  • We sound like a broken record here on Paper, but low year on year earnings expectations yet higher valuation looks very out of place. A price rise for containerboard in Q4 2012 does not look like enough justification for this premium valuation.

Exhibit 1

Source: Capital IQ and SSR Analysis


Earnings estimates for 2012 fell further for many sectors in the Industrials and Basic material space during the course of September, as illustrated in Exhibit 2. However, as highlighted in the first Exhibit, the general expectation is for growth in Q3, year on year, in all but three sectors.

Exhibit 2

Source: Capital IQ and SSR Analysis

Where we saw estimate increases in September it was generally for the fourth quarter rather than the third, with Paper being the best example.

Estimate changes for Chemicals are partly a function of swings in natural gas pricing relative to oil. With the positive move in natural gas pricing in October, we would expect to see a small negative swing in estimates in October, absent any specific guidance in the earnings calls.

The most significant anomaly in the data in Exhibit 1 is best shown in the scatter plot in Exhibit 3. In this chart we plot the year-on-year expected earnings growth (decline) in Q3 earnings for each sector against the move in relative value from October 1 2011 to October 1 2012. For the most part the points sit on a fairly consistent line from top right to bottom left, which appears intuitively correct. The most obvious extreme outlier is the Paper sector where valuations are much higher today than they were a year ago despite an expectation that earnings will fall year on year in Q3 by as much as 24%. We highlighted in September that one of our concerns with Paper was a fall in gross margins over the last three quarters and that in past cycles these declines had lasted for an average of 7-8quarters and had driven valuations much lower. The quarter that is about to be discussed looks like it will be another of declining gross margins.

We use our “normalized valuation” framework to get to the X axis data for the chart in Exhibit 3 and there has been some debate as to whether we are understating the returns in the Paper industry in our more broad analysis. This issue is irrelevant in this instance as we are looking at a year on year change, and the factors in our analysis in 2011 are consistent with those in 2012.

Exhibit 3

Source: Capital IQ and SSR Analysis

On the other side of the chart, it looks like Capital Goods has seen no real valuation appreciation in the last 12 months despite much higher earnings. The same can be said of Transports. The possible explanation here is short term earnings revisions, which have been weak for both Capital goods and Transports and much better for Paper.

If we were to pay more attention to absolute earnings growth rather than incremental revisions, we would be buyers of Capital Goods and Transports today and sellers of Paper.

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