- Bank of America shares likely to see an FICC earnings boost
- IBM outlook clouded by the need to change its business model
- Netflix overvalued, economies of scale unlikely to materialise
Netflix and chill? Not likely for NFLX investors... Photo: iStock
By Peter Garnry
As we wrote last Friday, this week is a major earnings release week with 246 large cap companies globally reporting Q2 earnings, giving us a glimpse into the health of the corporate sector.
Today sees three mastodons of the US equity market report their Q2 earnings – here's what to expect.
Bank of America: FICC to bolster result
Expectations were downbeat going into Q2 for US financials as analysts agreed that activity levels had been low, but the first seven financials results have all come ahead of revenue estimates by around 1.5 percentage points and around 3 points on EPS with only one miss on earnings.
The driver has been the FICC segment which jumped 35% year-over-year at JPMorgan due to strong activity in credit and securisations largely as a result of a strong June due to market volatility ahead of and following the UK referendum.
Deutsche Bank, Goldman Sachs, and Credit Suisse are the global investment banks that get the largest share of their revenue from FICC, so we foresee better-than-expected results from these banks.
Bank of America daily chart since July 2015:
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Source: Saxo Bank
Bank of America’s EPS estimates for Q2 have come down 18% the past six months as the global economy has slowed down and analysts expect Q2 EPS at $0.33 (down 25% y/y) and net revenue $20.4 billion (down 8% y/y). Given the earnings releases from Wells Fargo, Citigroup, JPMorgan and PNC Financial Services, however, we expect Bank of America (BAC:xnys) to beat estimates and also be upbeat about the US consumer as JPMorgan cited in its earnings presentation.
The Q2 earnings release is scheduled for 1045 GMT.
Valued at 0.59 on the price-to-book ratio, there is some attractive upside potential in the share price as Bank of America is now consistently delivering just above 10% return on equity when adjusted for long-term, non-recurring items.
We see fair value for this stock around the $17 level. The only negative issue with Bank of America is its relatively low Tier 1 Common Equity ratio at 10.3% in Q1. This low ratio will put a cap on dividend growth over the coming years as Basel III rules are required by banks globally.
IBM: desert walk
Warren Buffet’s first sizeable technology investment was in IBM and this turned out to be the perfect indicator that the stock had peaked (Berkshire Hathaway owns 8.46% of the firm's outstanding shares as of Q1).
As it turned out, Buffett did not understand the industry and the business. The cloud-computing disruption driven by Amazon’s EC2 offering is changing the industry, putting downward pressure on margins. IBM was not the stable growing “auditing” business that Buffett had concluded it was.
Instead, IBM is in a "desert walk" to change its business. While the company has successfully managed to do so multiple times since the 1930s (when IBM was the leading technology company in the world), this time might be different. The competitive landscape is tougher and switching costs are lower from previous technology shifts.
This forceful change in the industry has lowered IBM’s revenue 25% in five years and there are no signs exist that it will change any time soon.
IBM daily share price since July 2015:
Analysts are expecting EPS at $2.89 (down 25% y/y) and revenue at $20.1 billion (down 4% y/y). The release is scheduled to 2000 GMT.
IBM expects around 60% of its operating income to come in the second half which makes the stock fragile to adverse developments such as a slowdown in Europe’s IT spending post-Brexit.
The persistent slowdown in BRIC countries will also be a drag on IBM’s results in Q2 and outlook. Sentiment is downbeat on IBM as its Watson division is not growing as fast as expected (this represents the company’s big bet on predictive analytics).
Valued at EV/EBITDA 10.6, this stock is not cheap and is in fact clearly overvalued. With negative top line growth and margin pressure the EV/EBITDA should be closer to 7, translating into a forward P/E ratio of 8. As a result, we are negative on the stock.
Netflix: hoping for a profitable future
Regular readers of our trade ideas will know that put on a successful Netflix short position on January 26. Our main investment thesis was based on the fact that Netflix’s operating cash flow is growing much slower than cash spent on content assets. The logic, of course, is that that this cannot continue forever unless the company can tap into capital markets and fund this content-buying spree.
In addition, the US market for video content is saturating fast as multiple competitors have entered the market with the most notable competitor being Amazon. This means that Netflix has to tap into international markets to grow its business which at the same time spreads its resources over 130 new markets requiring massive content acquisition.
Netflix daily share price since July 2015:
Analysts are expecting Q2 EPS at $0.09 (up 18% y/y) and revenue $2.11 billion (up 28% y/y) driven by international growth in its subscriber base. However, at one point this growth has to translate into higher margins and profitability.
As competition has increased, Netflix has realised that the day when it controls the distribution channel of video content will never come and as a result its bargain power over content producers will never rise.
Therefore, the only way to meaningfully increase operating margins over time will have to be driven by in-house content production where Netflix controls the marginal cost of production. However, this strategy is capital intensive and increases the risk profile of Netflix.
The company’s own forecast includes economics of scale driving significantly higher profits in 2017. We doubt this will happen.
Valued at 12-month forward EV/EBITDA 81 the stock is among the most expensive in the US large cap equity market, perhaps only surpassed by Tesla Motors. We cannot justify the valuation given operating profit trajectory and rising competition with Amazon being a tough competitor in Netflix’s home market. We remain negative on the stock.
— Edited by Michael McKenna
Peter Garnry is head of equity strategy at Saxo Bank