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May 2021 | GSAM Connect

Credit Check-In: From Resilience to Recovery

“If “resilience” best described 4Q 2020, “recovery” is the word for 1Q 2021." 1

— Head of the Global Investment Grade Research team
GSAM Forum | 1Q 2021 Earnings Review
 

From resilience to recovery

First quarter earnings reflect a sharp rebound in economic activity – and suggest that the recovery is faster and more profitable than forecast. Around 86% of companies in the S&P 500 have beat expectations for 1Q 2021 earnings, while 72% beat sales expectations. Aggregate 1Q 2021 earnings growth for the S&P 500 was 50%, well ahead of the 20% forecast, and puts 2021 on track to exceed 2019 by 20%.

Many companies have bounced back rapidly. Winners in revenue generation last year continued to win in 1Q 2021 and more cyclical companies started to rebound, though commodity- and travel-related businesses have been slower to restart.

 

Strength across the credit spectrum

Looking closer, earnings releases show a continued healing of profitability, closing of the revenue and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) gap (when examining results for the four quarters ending 1Q 2021 versus full-year 2019 results) and increasing cashflow across the credit spectrum. On an EBITDA basis, margins for investment grade (IG) companies expanded about 70 bps relative to a year ago, reflecting several drivers. Many companies were able to offset higher input and transportation costs via higher prices, and issuers also benefited from operating leverage given the sharp increase in sales. For example, homebuilders are passing through significantly higher lumber costs because of strong housing demand and prices. From a regional perspective, profit margins in Europe were a little better than in the US, likely because of less inflation pressure.

IG balance sheets are surprisingly strong for this stage of the economic recovery, especially compared to predictions made at the onset of the pandemic. Net leverage for IG companies excluding financials is up only marginally since the onset of the pandemic as companies have retained cash flow and EBITDA has recovered. Many companies in the consumer, media and pharma industries have reduced leverage over the past year. During the first quarter, many companies in the investment grade market continued to retain cash flow. Interestingly, BBB-rated companies were more conservative pre-Covid and that trend has continued, making us constructive on this part of the market.

High yield (HY) earnings were equally strong and demonstrated impressive underlying momentum as economic activity ramped post-lockdown. For the fourth consecutive quarter, issuers reported better than expected results for both revenue and EBITDA (about 90% met or exceeded estimates in 1Q). In addition, the overwhelming majority of issuers – across a broad cohort of sectors – provided guidance that was in line with or above expectations, with only a small number of companies guiding to weaker operating performance. We maintain a heightened focus on commodity price inflation and potential implications. The early view is that the majority of management teams remain confident in their ability to pass through these increases. We currently see little impact on future operating margins and this provides some confidence that the large commodity price swings are more transitory in nature.

 

Where will the cash flow?

With corporate health recovering, the focus is now shifting to how companies will use their cash, balancing reinvesting in their businesses with paying dividends or, in some cases, balance sheet repair.

We expect that capital allocation could normalize, particularly among companies that had strong earnings and cash flow during 2020. Conversely, energy companies are resetting their operating model, which means targeting debt reduction and cutting back on capital expenditures (capex), some of which may not return to pre-virus levels. In the Metals & Mining sector, some companies are implementing variable dividends to help drive balance sheet repair.

We think Utilities are going to have to figure out how to fund their energy transition while meeting dividend obligations and capex needs which are currently outstripping cashflow.

In Financials, we think that eased regulatory requirements may prompt banks in the US and internationally to engage in shareholder-friendly activities including share buybacks and dividend payments.

We also expect to hear more merger and acquisition (M&A) announcements for a variety of reasons. Energy companies may use M&A to build scale and reorient their business models; large-cap technology companies that have already bought back a lot of stock may find deals to be a more attractive use of cash.

Overall, capex for non-financial US corporates is still lower versus a year ago and some normalization of capital allocation has yet to come through. Semiconductor capex is one area clearly rising due to the strength in the technology and auto supply chain.

 

1 Source: GS Asset Management. As of 18 May 2021.

 

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