Impacts from Covid-19 – from business disruption to inflation – have dominated corporate earnings and behavior over the past few quarters. While companies have been adjusting to the inflationary environment and expecting supply chain disruptions to ease, the Russia-Ukraine conflict may exacerbate both of these trends while keeping the macro environment volatile. We look at how companies fared through the rapid rise in inflation in the second half of 2021 and how they might handle continued inflationary trends and volatility brought on by the Russia-Ukraine conflict.
Corporate earnings reports from Q4 2021 revealed inflation across the board, from wage increases to continued shortages from supply chains bottlenecks. Managements are doing what they can to offset inflation, noting that there may still be an impact on margins in the next quarter.
Overall, earnings before interest, taxes, depreciation and amortization (EBITDA) was up around 7% although cash from operations after working capital was not as strong. This may be partially due to some working capital builds in Q3 and Q4 2021. More cyclical companies appear to be doing a better job retaining cash from operations. We also noticed some front-loading of inventory due to supply chain concerns and will be watching to see if this normalizes in Q1 2022 and if it leads to lower payout ratios on dividends and/or constraints on capital expenditure (capex).
High yield issuers delivered a seventh consecutive quarter of “in line” or “better-than-expected” results for both revenue and EBITDA. However, similar to Q3 2021, the percentage of issuers missing expectations (22%) was slightly higher than the reported percentages in H1 2021 and H2 2020, and was largely attributed to supply chain and inflation issues. In addition, most companies providing forward guidance, suggested future earnings were likely to be in line with or above expectations. However, the percentage of high yield companies lowering guidance (23%) was also slightly elevated compared to previous quarters.
As we have been observing for the past several quarters, capital allocation remained disciplined, although some management teams are continuing to focus on shareholder returns. We continue to see many buyback announcements and dividends rising, while capex is slightly below 2019 levels, with more pronounced declines in energy spending.
The capex discipline from the energy sector particularly stands out given the rapid rise in energy prices. In contrast, utilities continue to face the challenge of balancing shareholder concerns around dividends with spending needed to achieve decarbonization goals.
Most companies were managing inflation in 2021 as a result of record economic stimulus combined with supply-chain bottlenecks, and expected it would start to fade; the Russia-Ukraine conflict may become a new driver of inflation, especially in energy and other commodities, notably food. The recent spike in energy prices is particularly challenging for transportation, especially airlines, which are having the biggest reductions in EBITDA forecasts due to fuel costs.
Consumers in the US and Europe are already feeling the impact of bans on Russian oil and gas, which may soon be combined with agriculture and food inflation. We are also seeing second order impacts resulting from the crisis that are rippling through the Automotive, Chemicals, Industrials, and Packaging sectors, among others. We are watching to see how rapidly this inflation is passed on to the consumer and if it translates to weaker discretionary consumption.
The Russia-Ukraine conflict also presents a new source of uncertainty and volatility – distinct from Covid – which may not yet be factored into corporate forecasts. This may also impact capex plans as companies tend to pull back in more volatile environments.
The good news is that corporate liquidity is better than when Covid began roughly two years ago. Companies have not wasted the low rate environment and net leverage is down across much of the market. While travel-related sectors still have higher leverage, energy balance sheets have come back strongly in 2021. We believe that despite new macroeconomic challenges, companies are generally in good health and should be able to weather the volatility.
Each month we feature quotes from our investment team, offering a glimpse into our investment views and what we are monitoring and analyzing.
“Notwithstanding high macro uncertainty, corporate fundamentals enter the commodity price shock from a position of strength, with good cash flows and strong operating margins. In fact, geopolitical uncertainty could uphold conservative corporate behaviors that tend to be credit friendly.”
Ben Johnson, Global Head of Corporate Credit
Goldman Sachs Asset Management | March 2022