by As the second-quarter earnings season draws to a close in the United States, with 89 percent of companies in the S&P 500 having announced quarterly results, there’s both good and bad news to report. Sugar first: Seventy-four percent of companies beat consensus estimates, slightly better than the 10-year average of 70 percent. The outlook for the future is getting rosier, too. The consensus forecast for 12-month forward earnings growth is now 7.2 percent, up from 5.2 percent at the beginning of this year. Now for the medicine: The earnings surprise ratio (the ratio of total earnings to expected earnings) was 4.1 percent, below the long-term average of 4.5 percent. Revenues also disappointed – only 49 percent of companies beat consensus expectations compared to a long-term average of 58 percent. As the second consecutive quarter in which a majority of companies failed to beat revenue expectations – In the first quarter, only 47 percent did — we’ve officially entered what’s known as a revenue recession. There are several explanations for the disappointing sales figures, with weak commodity prices and a strong dollar chief among them. Revenues across all sectors were down 3.8 percent year over year, but the energy and basic materials sectors were the worst performers, down 35 percent and 11 percent, respectively.
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As the second-quarter earnings season draws to a close in the United States, with 89 percent of companies in the S&P 500 having announced quarterly results, there’s both good and bad news to report. Sugar first: Seventy-four percent of companies beat consensus estimates, slightly better than the 10-year average of 70 percent. The outlook for the future is getting rosier, too. The consensus forecast for 12-month forward earnings growth is now 7.2 percent, up from 5.2 percent at the beginning of this year.
Now for the medicine: The earnings surprise ratio (the ratio of total earnings to expected earnings) was 4.1 percent, below the long-term average of 4.5 percent. Revenues also disappointed – only 49 percent of companies beat consensus expectations compared to a long-term average of 58 percent. As the second consecutive quarter in which a majority of companies failed to beat revenue expectations – In the first quarter, only 47 percent did — we’ve officially entered what’s known as a revenue recession.
There are several explanations for the disappointing sales figures, with weak commodity prices and a strong dollar chief among them. Revenues across all sectors were down 3.8 percent year over year, but the energy and basic materials sectors were the worst performers, down 35 percent and 11 percent, respectively. Low oil prices are an obvious headwind for energy companies, but the slowdown in China also hurt the basic materials sector, which includes companies that refine and process industrial metals.
In addition to their heavy exposure to commodities, energy and basic materials companies are also the sectors that a strong dollar hits the hardest. Currency woes were widespread, however. Analysts in Credit Suisse’s Private Banking & Wealth Management division note that the performance of the 50 S&P 500 companies that rely most heavily on exports to Europe has deteriorated steadily compared to the rest of the index since the dollar started strengthening relative to the euro in mid-2014.
What does it all add up to? A likely increase in M&A. “If this earnings season is showing us anything, it’s that there is less ‘pie’ to go around in terms of revenues – but the same number of companies are chasing those revenues,” Credit Suisse’s Michael O’Sullivan, Robert Cronin, Marc Häfliger, and Ankit Agrawal write in the report. “The natural conclusion is that we will see more consolidation as companies group together to improve scale.” In fact, that consolidation is already happening. Companies are on track to ink $2.6 trillion in M&A deals in 2015, up from $2.1 trillion in 2014.
Conditions are ripe for further merger activity, as corporations have relatively little leverage, confident CEOs, and lots of cash. Despite several years of very low interest rates, companies are only carrying net debt of 1.6 times EBITDA, in line with the 25-year average. At previous cycle peaks, that ratio has hit 2.2. Meanwhile, a recent CEO confidence survey shows that 85 percent of CEOs are at least somewhat confident about their prospects for revenue growth over the coming year. Bullish CEOs are more apt to make deals, Credit Suisse believes.
The bank’s analysts expect U.S. companies to have a particular eye on international deals, given the $2 trillion offshore cash pile that firms cannot bring home without handing 35 percent to Uncle Sam. European deals look particularly attractive, given the cheapness of the euro. Credit Suisse created a list of 15 global companies that it believes are prime takeover targets, and three of them are European.
There are four materials companies on Credit Suisse’s takeover list, making it the best-represented sector. There are also three biotech and pharmaceutical companies, two software and services companies, and one technology company. These sectors have enjoyed rapid technological innovation over the last decade, which is itself a natural driver for M&A activity.
Buybacks also continue to be a popular use of corporate cash, as the same factors that create a promising environment for M&A – low interest rates, light debt burdens, and CEO confidence –also favor share repurchase programs. More than 50 percent of the companies in the Russell 1000 index are repurchasing their own shares, and Credit Suisse believes the trend has room to run. Firms are using only 34 percent of their aggregate free cash flow for buybacks, compared to 51 percent at the height of the last business cycle in 2007.