Ugly earnings by Monsanto today say sector selection will count during third quarter reporting season
The really ugly earnings report delivered today by Monsanto (MON) should go a long way toward clarifying the debate over calendar third quarter earnings. The company announced a loss of 19 cents a share for its fiscal fourth quarter that ended on August 31 and said that earnings would remain weak through 2016. Analysts had expected a loss of 3 cents a share. The company also reported that it cut 2,600 jobs or about 12% of its total workforce.
What’s that you say—you didn’t know there is a debate over earnings for the calendar third quarter? Earnings per share for the stocks in the Standard & Poor’s 500 are projected by Wall Street analysts to fall by 6.9% in the quarter.
End of debate, no?
Well, no. There’s a good possibility that the projected decline in S&P 500 earnings overstates the weakness in the quarter. The index, in comparison to the actual economy, over-weights the energy sector. Which raises the possibility that overall corporate profits—outside the energy sector–are better than projections for the S&P index indicate.
That side of the debate scores some points in the Federal Reserve’s report “Nonfinancial Corporate Business Profits.” In the calendar second quarter, corporate profits by the Fed’s measure climbed 11% year over year. That’s the most since the fourth quarter of 2012. In contrast the S&P 500 showed a decline in corporate profits of 2%, according to Bloomberg.
Goldman Sachs has an explanation for the disparity. The plunge in oil prices, revenue and earnings that is hammering energy company profits is one side of the positive effects of ultra low interest rates, low energy costs, and restrained wage growth has been good for company profits everywhere outside of the energy sector. Income in the third quarter is projected by S&P to grow by 10% or more in telecommunications, technology, consumer discretionary, and health care.
The big wild card for the overall earnings picture is the strong dollar. How will that affect profits for big U.S. exporters?
From the evidence in Monsanto’s report today, companies with big exposure to the negative effects of a strong dollar, with big exposure to commodities markets, and with big exposure to emerging economies are going to show disappointingly weak earnings. Monsanto took a hit as a strong dollar damped sales across Latin America and as the company continued to cut prices (although the worst of that seems to be over.) Monsanto continued to face pressure on its Roundup product from generic glyphosate with farmers looking to save money in the face of commodity price pressures. Brazil, where the economy is in recession, added to the decline in profits.
It would be a good strategy to focus on sectors experiencing solid profit growth and stay away from laggards—but if growth at the laggards is bad enough, it can, history says, take the entire market into a downturn.
Very careful and very selective buying would seem to be in order on dips in the stronger sectors of the market.
Glencore (GLNCY), the commodities and trading group that fell 28% yesterday, rebounded almost 17% today as Wall Street investment banks and their analysts declared that the sell off had been overdone.
Of course, you’re entitled to a bit of skepticism about that conclusion since many of these defenders have a bit of self-interest in the game. For example, Citigroup, one of the strongest defenders of Glencore today—“The market response is overdone. In the event that the equity market continues to express its unwillingness to value the business fairly, the company management should take the company private”—was part of the syndicate that took Glencore public in 2011—which resulted in $240 million in fees for investment bankers–and has worked on other Glencore deals since then, including the 2012 acquisition of coal miner Xstrata. That deal resulted in $140 million in fees for members of an investment banking syndicate that included JPMorgan Chase, Deutsche Bank, Goldman Sachs, Nomura Holdings, and, of course, Citigroup.
One of the reasons to take Wall Street with a grain of salt on Glencore now is that it’s the 2012 acquisition of Xstrata that is at the heart of Glencore’s current troubles. In that deal Glencore paid $29 billion (in Glencore shares) for Xstrata, then the world’s largest coal exporter. Glencore owns more than 30 coalmines in Australia, Colombia, and South Africa.
In retrospect Glencore bought Xstrata near the peak for thermal coal (coal for burning in power plants) at $150 a metric ton. Thermal coal sold on September 22, 2015 for $46.85 a metric ton.
That 70% drop in the price of coal presents two problems for Glencore now. First, it has slashed cash flow and earnings at Glencore. In the first half of 2015, Glencore saw adjusted net profits of $882 million, down from $2 billion in the first half of 2014. That’s a big deal for a company with a debt-to-equity ratio of 104%, roughly double the debt burden at Rio Tinto (RIO) and BHP Billiton. Second, with coal prices down and a recovery looming far down the road, if ever, as utilities move away from burning coal to generate electricity, Glencore has fewer attractive assets to sell in order to reduce debt. That leaves the company looking at selling shares in order to pay down debt. Any sale of shares would certainly reduce the stake that existing shareholders own in the company. And that would be especially painful if the financial markets decide that they don’t want to pay very much for Glencore’s commodity-sector assets, especially its coal assets.
Glencore (GLNCY in New York) had a bad day. A very bad day. The New York traded ADRs (American Depositary Receipts) of the commodities trading and mining company were down 28% for the day.
Commodities and mining stocks in general aren’t having a great day. The financial markets are again selling off these sectors on fears that growth in China is slowing and that demand for commodities will continue to fall. Giant Brazilian iron ore miner Vale (VALE) was down another 9.96%. Diversified BHP Billiton (BHP) was down 4.36%; Rio Tinto (RIO) tumbled 4.58%, and Freeport McMoRan Copper and Gold (FCX) plunged 9.08% on the day.
But there’s a huge difference between a 28% drop and a 4.4% or even a 10% decline. What’s so special about Glencore?
Three weeks ago Glencore CEO Ivan Glasenberg announced a debt-reduction plan that included selling part of its agricultural business and a $2.5 billion sale of new shares in an attempt to reduce Glencore’s debt to $20 billion from $30 billion. Goldman Sachs is out saying that if commodities fall another 5% Glencore would not be able to maintain its current credit rating. Both Moody’s Investors Service and Standard and Poor’s have negative outlooks on the company, which they rate Baa2 and BBB respectively. Investment bank Investec has said that in the absence of substantial restructuring, if commodity prices remain at current levels the company could see almost all of its equity value disappear.
The current down cycle in commodity demand and prices hasn’t yet resulted in much in the way of large production cuts. In copper, for example, Glencore and Freeport McMoRan have announced big production cuts for 2016 and those “big” cuts amount to just 500,000 metric tons or about 2% of total world annual supply. Bank of America Merrill Lynch calculates that the copper market needs another 500,000-ton reduction in supply before demand exceeds supply.
In this situation—with supply falling so slowly and for some commodities (such as iron ore) still not falling at all—the strength of a company’s balance sheet has become more important than the size of its reserves or the productivity of its mines. Without a strong enough balance sheet to get to a turnaround in commodity prices, whenever that might happen, an eventual recovery in commodity prices is irrelevant.
That’s why financial markets are focused on issues such as BHP Billiton’s promise to maintain its current dividend and where the cash flow to sustain that dividend might be come from. And whether Chesapeake Energy (CHK) has enough attractive assets to sell at a decent price to continue to reduce debt. And it’s why commodity producers continue to cut capital spending. The most spectacular example of that today is Royal Dutch Shell’s (RDS) decision to cease all drilling in the Arctic. (The fact that the company spent $7 billion on its first test well and found only indications of oil and gas might have something to do with the decision too.)
Bad news for the South African platinum sector, which produces about 80% of the world’s platinum. A sharp drop in capital investment beginning in 2008 (when it was an annual $3 billion) and stretching into 2015 (when it was an annual $1 billion) has hit platinum output hard. Projecting from capital spending, the World Platinum Investment Council calculates that South African output will be below 2015 levels in 2016 and 2017. That would produce ongoing deficits in global supply in those two years.
The forecast is for a deficit of 445,000 troy ounces in 2015—which is actually better than the deficit of 785,000 ounces in 2014.
The improvement in the supply/demand deficit from 2014 is a result of the end of strikes that decimated production in South African in 2014. Supply is forecast to rise by 9% in 2015 to 7.9 million ounces thanks to the end of the strikes. Demand is forecast to climb 4% to 8.4 million ounces in 2015.
But thanks to continued labor unrest in South Africa and the fall off in investment in South Africa’s aging deep shaft mines, the industry is unlikely to see a repeat of the big 2015 increase in supply
Eventually that will result in an increase in the price of platinum, which hit a six-year low in August after falling 17% in 2015. The low price for platinum has resulted in a pickup in investment demand from Japanese investors, who buy bar platinum, and from exchange traded funds.
My thesis since I added Stillwater Mining (SWC), the only North American miner of platinum/palladium metals, to my Jubak’s Picks portfolio is that South African’s pain would be Stillwater’s gain. That hasn’t worked out very well in 2015 as Stillwater—down 37.92% year to date—has tumbled to match the fall in a South African miner such as Impala Platinum Holdings (IMP:SJ)—down 37.95% for 2015 through September 9.
But I think that the continued drop in South African production means Stillwater is likely to turn the corner as platinum and palladium prices gradually recover on the supply/demand deficit. (Shares of Stillwater held steady in August even as commodities in general fell on China growth fears.) The company actually increased capital spending by 9.7% in the second quarter of 2015 from the second quarter of 2014 and managed to take $7 a ounce out of its all-in sustaining costs in that period.
Obviously any gain in Stillwater Mining shares depends on a recovery in platinum prices but with South African production continuing to lag, I think there’s a good chance of that happening in 2016. I’d call this stock a hold for patient investors with a target price of $12.50 a share, up from $9.15 on September 9, by September 2016. The shares are down 19.95% since I added them to my Jubak’s Picks portfolio on September 25, 2012.
Commodity prices continue to tumble and are now down to the lowest levels since dinosaurs walked the earth.
But both the gold futures and spot market broke below $1100 an ounce this morning before rebounding to slightly above that level. That puts gold near a five year low.
And gold isn’t alone.
Both West Texas Intermediate and Brent crude have ended the recovery that had taken oil from a six-year low. U.S. benchmark West Texas Intermediate is back below $50 a barrel with futures touching $49.92 this morning. That’s the lowest intraday price since April 6. Brent crude has continued a decline that began in June to drop well below $60 to $56.51 in London.
And copper, widely seen as the commodity most sensitive to growth rates in the global economy because it is used in so many sectors from construction to electrical goods, continued to fall, declining another 1.44% in London to $5480 a metric ton.
I can see three reasons for the drop across all these commodity sectors.
First, the continued strength in the U.S. dollar is depressing the dollar price of all commodities. The widely held belief that the Federal Reserve will raise interest rates in 2015, perhaps as early as its September 17 meeting, contributes to a belief that the dollar will continue to climb.
Second, forecasts continue to say that the global economy in general and the Chinese economy in particular continue to slow and that in the absence of faster growth, supply is in excess of supply. This is especially true for commodities such as oil and iron ore where increases in supply have overwhelmed demand. Iron ore, for example, has recovered from the panic selling that accompanied what looked like an uncontrolled plunge in the Shanghai stock market. That panic took iron ore down to $44 a metric ton, a 10-year low. But even today’s price above $50 a ton is shockingly low when you remember that iron ore traded at $120 a metric ton as recently as June 2014.
And third, traders and investors simply have no appetite for commodity positions in their portfolios and without a reason to buy, they are cutting back their allocation to commodities in general. Whereas not so long ago, I heard recommendations for a 5% to 10% allocation to gold, for instance, today I’m hearing recommendations for 2% to 3%. Even a price drop to $1100 hasn’t led to an uptick in demand from the world’s two swing markets in gold—India and China. In Mumbai, for instance, gold typically trades at a premium to London, since jewelry demand in India helps support gold prices in that market, but right now gold in Mumbai is trading at a discount to London. It looks like Indian and Chinese retail purchasers of gold, known for waiting until the price is low before buying, have concluded that prices are still headed lower.
That seems likely, not just for gold but also for commodities in general. Inflation, a key driver in past commodity rallies, is conspicuously absent this go round. The Federal Reserve will raise interest rates in late 2015 or early 2016 and that will push the dollar higher. While it looks like the Greek debt crisis has been postponed and that China’s bear market in Shanghai and Shenzhen has stabilized, temporarily I believe, there’s not much evidence of a recovery in economic growth in emerging world economies, especially China, that would push demand for commodities higher. And, finally, from oil to iron ore, supply in key commodities looks likely to growth over the next 12 months.
In other words it looks like it’s too early to buy crushed commodities or the even more savagely depressed shares of commodity producers. For some of these commodities—gold is a prime example—asset sales are ramping up as the most stressed companies look to raise cash. Oil production is still climbing as Saudi Arabia and Iran both position themselves for a fight for market share. The big iron ore producers have cut back on capital spending but the pipeline is still full of new projects scheduled to come on line next year and into 2018. The one commodity to keep a close eye on is copper, where some projections show a supply deficit as early as 2016.