The Daily Update - Earnings Season: CAT-Calling Peak Profits

Attractive from a distance, but disappointing close-up… It's such a let-down when – after catching a glimpse of some sparkling earnings – markets were hoping to see some ‘healthy assets’ and a confident outlook. But it wasn’t to be, and the market quickly lost interest in Caterpillar (CAT) yesterday after a flash of favourable earnings was followed by a slightly more muted earnings call. Notably, outgoing Group President and CFO Brad Halverson stated that, “The outlook assumes that first quarter adjusted profit per share will be the high-water mark for the year.”

This “high-water mark” soundbite clearly spooked investors sending their stock down more than -10% after a 4.5% gain on the back of the earlier earnings release. This puts the Caterpillar’s equity return down -7.5% YTD (after a stellar +75% last year!). Yet the reaction seems overstated when, along with beating forecast revenue and profits, the company raised their expected EPS to almost $1-2 higher than analyst’ median forecast citing “operational excellence”, “strong cost control” and higher demand for its products as economic growth continues.

With the company’s focus on providing machinery for capital intensive projects, Caterpillar is widely seen as a bellwether for global economic strength. And so yesterday’s melancholy market reaction to Caterpillar seems to have reverberated across US equities and bonds with the S&P 500 ending the day down -1.4% and US 10-year Treasury yields crossing 3%. It’s unsettling when markets not only require forecast beating earnings (and upward adjustments to future earnings) but unequivocally positive outlooks from the management in order to justify their current P/E multiples. Of course this also happened with Google taking a -5% hit earlier in the week: when strong earnings were all but forgotten after the company reported on rising payments to advertisers.

With many of these multiples at steep levels it’s understandable that any blemish in management outlook could be taken as a need to revise down valuations. As we progress through earnings season, it would certainly be concerning for equity investors if we continued to see further examples of downside on the back of broadly positive reporting; perhaps this would be even more of a warning sign than poor earnings themselves.

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