With summer on its way, coronavirus-driven lockdowns have begun to subside. Hopefully, the worst of the pandemic has passed. However, Wall Street analysts seem to be blind to the real impact to earnings we’ll see in the second quarter.
2020’s first quarter earnings were brutal. Yet, analysts of the biggest investment banks in the world think that the second quarter is due for a significant rebound. This is not just a case of traditional Wall Street optimism. This time, the analysts are not only directionally wrong in their earnings forecasts, but also wrong in orders of magnitude.
Moreover, the Street doesn’t see the big bath coming at all. The “Big Bath” is when a collapse in actual cash earnings is compounded by a financial reporting anomaly that rears its ugly head every ten years or so. That time is now.
As companies start to pre-announce and eventually report “Big Bath” earnings, how will the market react to hearing an almost daily barrage of the worst quarter of earnings in ten or twenty years?
The Numbers
So far, over 90% of the S&P 500 index companies have reported on their first quarter. Earnings per share (“EPS”) dropped nearly 65% from the first quarter a year earlier, from $35.02 down to about $12.55.
In what can only boggle a reasonable mind, Wall Street currently forecasts operating earnings and net earnings to recover significantly from the first quarter of this year to the second. Consensus analyst estimates show EPS popping from $12.55 up to $21.18. Analyst forecasts of “operating” earnings also rebound by 20% in the second quarter.
Wall Street analysts project both operating and reported earnings to recover dramatically next ... [+]
The coronavirus lockdown began around March 15. The big drop in first quarter earnings stemmed from just two weeks of economic lockdown.
With the lockdown only beginning to lift around Memorial Day, most companies will be reporting a minimum of 8 weeks of economic malaise in their second quarter. Depending on their industry or geographic footprint, some firms will see damage to the full 13 weeks.
While many management teams have stopped providing guidance, that doesn’t eliminate analysts’ responsibility to provide their best possible forecasts.
Analysts, and the market, may be in for a very rude awakening as we approach second quarter earnings season in mid-July, and even see pre-releases from companies beforehand.
It appears highly likely that companies will report numbers far below analyst estimates and significantly below the stock market’s expectations, given current valuation levels.
Not only would one expect the second quarter to look much worse than the first on a pure cash earnings basis, the “Big Bath” of accounting write-offs has barely begun.
Under Generally Accepted Accounting Principles (GAAP), CFOs and the auditors are required to examine their businesses for potential write-downs and restructurings. The overly complex and confusing GAAP accounting rules provide for a wide berth of judgment and perfectly legal and allowable non-cash write-offs and write-downs.
The financial reporting rules allow CFOs to basically take a bad quarter and make it look much worse.
In the minds of CFOs, if the results are bad and likely to disappoint investors anyway, why not make things look as bad as possible, in order to make the business look better in the future?
Mistakes made in years past, such as goodwill from acquisitions, can be written down now if the auditors agree its value is impaired, to make the balance sheets look more efficient.
Another, more insidious item is restructuring charges. These can actually make future earnings look better than reality, too.
Management’s future plans for actions like down-sizing, right-sizing, offshoring, and switching workforces to telecommuting can be recognized in this coming quarter. In other words, the expenses for all these actions are recorded now even if the cash expenditure for these items occurs over the next few quarters and even years.
Financial reporting under GAAP - and International Financial Reporting Standards for that matter too - allow companies and their auditors to make a bad quarter look really bad, and future quarters look better than cash earnings would suggest.
So, as-reported earnings are likely to not only look worse than expected, but also look far worse than reality, as bad as it might be. That’s a recipe for a massively discomforting revelation that Wall Street and most investors are unlikely prepared for.
And it’s happened before.
Lehman Brothers And The Pandemic
One of the seminal moments of the Great Recession was the Lehman bankruptcy. It was an announcement that fateful Monday morning, September 15th, 2008, that helped send the global economy and equity and credit markets into a deep downward spiral.
Much like the beginning of the coronavirus lockdown this time around, that announcement occurred just fifteen days before the quarter end. With only eleven business days remaining in the quarter, inertia alone carried much of the real economy forward for the next two weeks.
Few executives found the time to act on that Lehman announcement. Considering how little time there was to understand and analyze the problems of September 2008, management teams simply hadn’t digested just how bad things would get.
The following weeks, in the fourth quarter of 2008, allowed management teams and financial executives to see and react. Through much of October and even into November of 2008, credit markets were in turmoil and the economy was in tatters.
Operating EPS for the S&P 500 was $15.96 in Q3 2008. By Q4 2008, operating earnings fell to -$0.09.
Accountants also had no time in the third quarter to react to the Lehman announcement. But in the fourth quarter their actions were shell-shocking.
One of the key factors for auditors in assessing going concerns of businesses and write-downs is a reasonable outlook of future conditions. This is important to determine what assets a company should impair or how much a company can and should build in restructuring charges.
In September 2008, in the heat of the moment, companies were scrambling to close earnings and figure out liquidity issues. Companies weren’t sure if the crisis was going to be a more focused issue in a few select industries or if disruptions were going to hit the entire economy.
So, while some unusual one-time write-offs were taken in the third quarter of 2008, key items like restructuring charges didn’t budge.
However, in the fourth quarter of 2008, companies really had a grasp on the implications of the Great Recession. That’s when a giant wave of corporate restructuring plans and charges were taken.
Use of unusual items rose dramatically in the fourth quarter of 2008, before leveling off thereafter
That was the “Big Bath” quarter of 2008. Companies took over $200 billion in non-operating unusual items charges in Q4. As bad as cash earnings were, the big bath made the as-reported official earnings number look far, far worse.
A Repeat Big Bath In 2020?
One of the defining moments of this pandemic was San Francisco’s “shelter in place” order on March 17th, with two full weeks left in the quarter. It’s eerily similar relative to the timing in the quarter of Lehman’s announcement in 2008.
And similarly, the bulk of the global impact of the economic shutdown has come in April and May. Obviously, forecasts for earnings to rebound in the second quarter of 2020 aren’t capturing that.
Flash forward to the end of May, and most of the US economy has been shut down, with just a few locations starting to open up in the last few weeks. With June fast-approaching, widespread reopenings are hopeful, but not certain.
Right now, management teams are looking at a disaster of a second quarter. The first quarter was a relative cakewalk. Clearly, companies did not have time to recognize the issues. The accounting and earnings of the first quarter show little in the way of special charges.
Management teams took relatively few unusual item charges in the first quarter of 2020
Without any visibility on how long the shutdown would last, and how it would impact companies, management teams were not thinking of restructuring charges in the first quarter. In fact, announced and booked restructuring charges were actually lower in the first quarter as compared to the last quarter of 2019!
Merger & restructuring charges have been flat the past four quarters
Clearly, the “Big Bath” has been saved for the second quarter.
Between the longer shutdown in the second quarter, and the more time management teams have had to evaluate their accounting options, major one-time write-offs and write-downs of all kinds are on their way.
Without a doubt, Wall Street estimates are wholly oblivious to the coming earnings mess. Most investors don’t realize the nuanced yet super-material impact of the accounting anomalies.
Special, unusual charges can be made by companies at any given time for many company-specific reasons. However, this kind of en masse pile-on of charges only happens once a decade or so.
While most of corporate America is due for a “Big Bath”, there are certain industries where mounting charges have been coming due for some time. We’re bound to see them now.
Five companies provide examples of firms and industries that will undoubtedly require giant write-offs, and yet we haven’t seen much of any yet. Some of them are about to have a repeat of their own experience in 2008. These include Delta, 3M, Yum Brands, Citigroup, and Schlumberger.
These companies took material restructuring charges in the fourth quarter of 2008, after taking next ... [+]
It’s Always Darkest Before The Dawn
When this surge of write-offs and weaker-than-expected earnings hits the headlines, it is going to be scary for investors. Market sentiment will suffer a massive blow. There will be an obvious jump to wonder whether earnings are going to take much longer than expected to recover.
However, the “Big Bath” allows CFOs to put prior issues behind them. It’s a capitulation of fundamental results of a company. Firms are getting a reset on their books, essentially. After taking that “bath”, financial statements are set-up from a low base to rise higher. The restructuring reserves that will have been built on balance sheets will help that even more.
And as importantly, after a terrible second quarter where the world was shut down for upwards of two months, it's going to be almost impossible for the third or fourth quarter to be as bad as the numbers that companies will be reporting in July and August.
This won’t just be a fundamental base in earnings, it's likely to lead to a basing of stock markets too.
It is no surprise that in early 2009, as corporations were wrapping up a tough Q4 2008 earnings season, the S&P 500 hit its lowest point during the Great Recession. It’s been all uphill from there.
Be prepared for bad news from corporations and a market sell-off in the coming months. But also be prepared to not panic in the midst of that sell-off, because this is a healthy process of corporate earnings bottoming, before the move higher.
...and the market will likely follow them.
