Companies face ‘litmus test’ as earnings season heats up

Investors could be in for a shock this earnings season as markets further underestimate the financial blow delt by omicron in the first half of financial 2022, and the persistence of cost pressures, Morgan Stanley has warned.

With 19 per cent of the local bourse by market capitalisation reporting this week, the broker is expecting to see growing evidence of COVID-19-inflicted disruptions, supply chain friction and labour shortages.

While these issues present clear obstacles to growth, Morgan Stanley cautioned that their duration and severity have not been fully priced into forecast earnings, which could see some companies disproportionately punished.

“What keeps us from accepting that all is in the price is the relative staleness of earnings estimates and the fact that bottom-up margin assumptions appear to factor little of this impact in expectations with outer-year forecasts showing elevated margin outcomes [versus] pre-COVID history,” said Chris Nicol, Morgan Stanley’s head of Australian strategy.

“In our experience, earnings downgrades driven by margin resets carry share price reactions often deeper and more sustained. Litmus test ahead.”

The broker is anticipating that the effect of COVID-19 on mobility, consumption and disruption over the key Christmas trading period and start of 2022 will feature heavily in interim results commentary.

Inventory levels have been “left short” and the shift from “just in time” to “just in case” is already happening, Mr Nicol said.

The broker added that the La Niña effect on weather has compounded supply chain issues, while the ability for bricks and mortar to not only open for comparable hours, as pre-COVID-19, but at a similar cost per head, is proving to be problematic.

“The lead and lag effects will be well on display and at the very least some profit margin stress testing should be the order of the day,” Mr Nicol said.

Meanwhile, broker UBS argued that fears of an impending collapse in corporate profit margins are overblown, but at a stock level, the risks appear meaningful.

“For much of the last six months, the outlook for profits had been strong with upward revisions outnumbering downward revisions up until the end of December,” said Richard Schellbach, equity strategist at UBS.

“Since then, momentum has faded, and with this profit season capturing the omicron lockdown months of December and January, we expect the skew towards downgrades to continue throughout February.”