Takeaways: Knowing when the game’s up might be the theme of the week. The Greek saga rumbles on with both sides not able to agree now on how close they are to a deal. Eurozone markets remain sanguine. UK markets are even buoyant, with rising earnings expectations providing support. But will the recent lack of profit warnings continue? challenges to UK profits go beyond oil and sterling. Meanwhile, cash remains high up the agenda. Some companies struggle with a lack, others are ‘burdened’ with a surfeit. A nice problem to have? Not if shareholder pressure is on and there isn’t an easy way to invest or return it.
Greece: deal or no deal
The Greek government think a deal is close; the view from Brussels is much more guarded. The clock is ticking a bit louder. Greece doesn’t appear to have the readies to make its June commitments without the next tranche of its bailout. But this saga has been all about the fudge. Even if default comes, it could take many forms, not necessarily with ‘GREXIT’ or even a suspension of ECB financing, so long as a new deal looks close enough.
Of course, even if this bailout cash is released, Greece will need more support and this will undoubtedly come at a price. Trust issues are big in two ECB’s at the moment. What’s also interesting is how the Greek example appears to have emboldened other anti-austerity parties in the ‘periphery’ – see Spain – whilst perhaps hardening the politics of the ‘core’- see Finland. Plenty of acts left in this saga.
Eurozone markets are mostly taking each act in their stride. True, there are good reasons to be positive beyond Greece. Eurozone earnings expectations have crossed into the black after what’s been termed the ‘best earnings season in four years’. Analyst upgrades beat downgrades for the first time since 2011. The biggest improvement came from companies targeting the domestic market – which underlines recent improving Eurozone data. How much would it take to upset this rebound? We might found out next month. Because saying ‘beyond Greece’ ignores the real threat of Greece not paying its debts – now or another time. Debts are more contained than previous crises, but other Eurozone nations are still ‘on the hook’ – to the tune of almost 3% of GDP in the case of Italy and Spain, who can ill afford it still. If Greece gets a deal this time, markets will rally again…until the next time…
Wot! No profit warnings?
There have been a few UK profit warnings in May, but the near silence is deafening after a run of ‘most since 2008’ months and quarters – including April. This could be one of the ‘quietest’ months since we started recording profit warnings in 1999.
Why the sudden halt? A lack of shocks and an unexpectedly decisive election result appears to set the ball rolling on contracts and investment decisions, whilst also removing uncertainty for some sectors, like house building & gambling. A continuing recovery in the Eurozone, along with the pickup in oil prices has also helped. The oil price rise appears to be just enough to take the immediate pressure off the sector, whilst being still low enough to boost major users coming off hedging contracts. This has all helped companies meet forecasts and feel more confident about the future.
UK earnings expectations are still falling slightly against three months ago, but much less than they were in February. The danger – as ever – is that expectations rebound too far. The outlook is improving, but from a low base with perhaps more fragility than recent record FTSE highs would suggest. The Share Centre reports that FTSE 350 companies with their financial year end in December (about half of them) have reported the lowest net profits since 2008. Of course, given the make-up of the index, the oil price dip was always going to have a strong negative impact and results should pick up if the rally holds – albeit with prices still well down YoY. The Share Centre also estimates a £50bn dent in 2014 sterling revenues for the FTSE 350 due to the strong pound. Again a slightly weaker pound should help boost earnings, along with stronger global growth.
But nothing is nailed on. Sterling could strengthen again in 2015 if a Greek default hits the Euro or the US recovery continues to falter. Higher oil prices have stalled rig closures, with the unexpected nimbleness of US shale producers adding to oil price volatility . But even with helpful commodity and currency winds, there are obviously deeper, more enduring issues dragging on profits. We’ve been tracking increasing price pressure across many sectors for some time. These are most obvious in retail, but also in business service and industrial sectors. Rising competition due to new (disruptive) entrants, and overcapacity along with ‘noflation’ are all potential drivers for the increasing price push back, cited in almost a quarter of profit warnings in the last year. Many companies have also consistently struggled to forecast accurately and show resilience in these tougher markets.
The previous exceptional profit warning cycle might be over, but this new low level might not last for long.
Cash – some companies have too little, others too much. Complaining about a surfeit of cash seems akin to grumbling about the blisters from diamond shoes. However, having a large amount of cash on the balance sheet can be troublesome. Activists have long petitioned US companies and increasingly European shareholders have expressed their expectation that companies will be fully invested. Holding cash becomes especially difficult to justify holding when European banks offer negative interest rates. It begs the question whether companies will be reluctant to make large divestments if it leaves them with significant cash holdings.
Pension schemes provide an obvious outlet to meet the challenge of ultra-low bond yields that have raised pension deficits to record levels. Daimler has topped up recently. But companies with liabilities aren’t always those with spare cash. Dividends and buybacks offer more shareholder pleasing options and European companies are closing in on their 2007 peak, according to Standard & Poor’s. This still leaves Europe well behind the US, where companies returned 52% of cash flows to shareholders during 2014 – split roughly equally between buybacks and dividends. In contrast, European companies returned 33% – 4% on buybacks and 29% on dividends. There is room to expand, however, there may be political barriers to significantly increasing shareholder rewards in Europe– especially in areas where unemployment remains high and investment levels remain low.
There will be many more articles written on why investment has remained low in this cycle. The (simplistic) answer might be that companies don’t feel they’ll receive enough of a return or that they can grow in other ways. There is certainly a strong M&A rebound in progress, although there are signs that enthusiasm may be waning Our CFO Capital Confidence Barometer reveals a more guarded M&A outlook, despite a rise in confidence overall. CFO deal appetite has fallen by half compared to six months ago. May be good deals are getting harder to find at the right price? Cheap cash and QE-fuelled market have rocketed valuations. Transformative acquisitions are high up the agenda and these don’t come easily or cheap. Our respondents are less confident in the likelihood that they will be able to close deals and in the quality of acquisition opportunities. Will we see M&A discipline in this cycle? We believe M&A activity could wane into 2016.