Five things to watch during Europe's 'terrible' earnings season

LONDON (BLOOMBERG) - First-quarter results from Europe's biggest companies start to come through this week and market participants are bracing for the worst numbers in years after the Covid-19 pandemic led the region's major economies into lockdown.

"Obviously, it's going to be a terrible earnings season," said Aaron Barnfather, the head of European equity portfolio management at Lazard Asset Management.

"Western economies haven't seen this kind of heart attack, economic growth stopping in the way that it has, pretty much ever in history, or at least since the war. So it's extremely difficult to be 100 per cent confident about what the environment will look like next."

Luxury-goods giant LVMH, chip gear-maker ASML and cosmetics group L'Oreal are among a handful of companies that kick off the results season in coming days, before reporting ramps up the following week.

Amid the gloom, investors will be paying close attention to who is likely to be the first to emerge from this crisis by looking at how companies manage their balance sheets and their outlook for the year ahead.

Here are five things investors and strategists will be watching for:

Analysts have been accelerating their downgrades of European earnings, with cuts outnumbering upgrades by a record number in March, according to Citigroup data.

Since the end of February, EPS estimates for European equities have been cut by a weighted average of 14 per cent, while early guidance from the likes of Adidas and Pernod Ricard imply an average decline in operating profit of 50 per cent for the early part of the year, according to Bloomberg Intelligence data.

UBS head of European equity Nick Nelson says that investor questions these days are focused on earnings and he expects profits to fall 33 per cent in Europe this year.

But it's not all doom and gloom as he forecasts an economic recovery in the second half, which will enable companies to be able to return to profit growth in 2021.

The good news is that European equities seem to have already priced in most of the bad corporate news, according to Bloomberg Intelligence analyst Laurent Douillet.

After the recent stock market rally, equity prices are implying an earnings rebound of 10-15 per cent in 2021 after falling 20 per cent in 2020, he said.

Alberto Tocchio of Colombo Wealth calls dividends the "critical point" of this earnings season and expects to see "huge pressure" on companies to reduce their payouts - both because some state aid, like that in France, will come with a caveat of suspending dividends and because companies won't want to risk laying off workers because they run out of cash.

He believes retailers, luxury-goods firms, automakers and consumer discretionary are at high risk of suspending dividends.

Unlike their American peers, European companies have been quick to slash or suspend dividends.

At least 141 of the benchmark Stoxx 600 index members have canceled or postponed payouts since mid-March.

UBS and Credit Suisse Group on Thursday (April 9) said they will split their payouts for 2019 into two instalments at the request of financial markets regulator Finma, withholding part of the money until the second half when the impact of the pandemic will be clearer.

However, the dividend gloom might be a temporary risk of this year and payouts can make a comeback in 2021 along with profits, Peter Oppenheimer, chief global equity strategist at Goldman Sachs, said in a Bloomberg TV interview on Wednesday.

During such uncertain times, investors will be paying much more attention to the strength of corporate balance sheets and companies' cash flow levels relative to their leverage.

"We tend to look much more at the quality of the balance sheet and how cash flow dynamics change in a more difficult environment," said Lazard Asset Management's Barnfather.

"We're trying to avoid companies that are going to need to raise capital."

Investors have been showing a clear preference for European companies with quality financial profiles this year, with the Morgan Stanley index of European strong balance-sheet companies down 12 per cent this year compared with a plunge of 28 per cent for its weak balance-sheet equivalent.

Encouraging signs have been appearing over the past three weeks in credit default swaps, which help assess risks in the overall equity market.

The Markit Itraxx Europe index tracking European corporate credit risk has been coming down after spiking on March 18 to its highest since 2012.

Although a much more limited trend in Europe than in the United States, buybacks will likely be axed this earnings season along with dividends.

Tocchio of Colombo Wealth expects a reduction of between 40 per cent and 50 per cent in European buybacks in 2020 and a significant slowdown in the coming years.

Distiller Diageo said on Thursday it will not initiate the next phase of its three-year buyback program during the remainder of fiscal 2020.

HSBC was one of the first in a string of British banks to suspend buybacks after the regulator pushed to contain such spending.

As some companies are forced to lay off employees or reduce their salaries, more executives will likely be giving up their bonuses and taking a pay cut.

Ryanair chief executive officer Michael O'Leary told the Financial Times that he and the rest of the airline's employees will take a 50 per cent pay cut and Fiat Chrysler Automobiles CEO Mike Manley said that he'll take a 50 per cent salary cut starting in April to avoid reducing staff.

Standard Chartered's top executives are giving up their cash bonuses for 2020 and making donations to efforts to help those affected by the Covid-19 pandemic.

Chris Bailey, a European equity strategist at Raymond James, said the way companies treat their workforces will matter to investors as it'll "say a lot about company culture, which is not unimportant going forward as a company tries to recover."