The Transcript Q4 2021 Letter
What we learned from Q4 2021 earnings calls
Note to our esteemed readers: Two quarters ago, we began writing a quarterly letter to our subscribers to review the key trends that we saw in the latest earnings season. This week we are publishing our letter for the Q4 2021 earnings season. Enjoy it!
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Macro
Coming into 2022 the world was facing a surge of COVID caused by the Omicron variant. Cases of Omicron were widespread, but luckily less severe than previous strains of the virus. Although Omicron did cause some economic disruption, it appears to have marked the end of the COVID era as a dominant force in the public mindset.
"Despite the tougher January, we're happy to see COVID cases again on the downswing across the broader U.S. Cancellations are declining and group lead volumes are normalizing. Forward hotel book has been stable over the past few weeks and are once again starting to outpace 2019 levels." - MGM Resorts International CEO William Hornbuckle
The start of 2022 has been rocky for capital markets. The S&P 500 has fallen in value by 8.5%. The NASDAQ has seen a more severe 13.6% decline. The declines have primarily been driven by concerns over tightening monetary policy. The Fed has signaled that it intends to raise interest rates and reduce asset purchases to address surging inflation. CPI rose by 7.1% in 2021.
Partially driven by inflation and stimulus, earnings surged in 2021. S&P 500 index earnings were $195.18 in 2021, compared to $94.13 in 2020. 2020 earnings were depressed by the pandemic, but 2021’s earnings were still an impressive 39% higher than in 2019 when they were $139.47. Thanks to this earnings growth, the S&P 500 now is priced at 28.5x forward earnings. Still historically high, but not necessarily extreme compared to interest rates. Earnings growth is expected to slow in 2022 and this is also likely weighing on equity markets.
Still, underlying demand remains robust in the economy. Comments from some key banks suggest that consumer spending on debit and credit cards is very strong. Consumers are still flush with cash from the stimulus, although there may be some bifurcation starting between high-income and low-income consumers.
We’ve seen weakness around spending in our lower-income cohorts…we’re seeing the effects of inflationary pricing around that where there is a more elastic demand curve around that. Certainly, with higher income cohorts, you’ve got a more inelastic demand curve, and that’s a lower percentage of our base." - PayPal (PYPL) CFO John Rainey
This strong demand means that supply chains are still pressured. Labor markets are especially tight. Companies continue to talk about a “war for talent” and the inability to stay fully staffed. The Fed is under pressure to act more quickly.
"...here we are on the fourth-quarter call and the Fed has finally woken up to the problem that they should have foreseen a year ago. The problem now is that the Fed is taking its sweet time putting in place their action plan to deal with the skyrocketing inflation and the overheating economy….While I don't think that inflation will stay at the 7% level, I do believe that without quicker and more decisive action by the Fed, it will be seen that they are fighting a forest fire with a water pistol. As long as interest rates are below the inflation rate, the proverbial punch bowl is still there for all market participants to grab a drink” - Loews (L) CEO James Tisch
International
Geopolitical concerns have recently become more noticeable in earnings calls. Capital markets and corporate leaders are tracking the Russian invasion of Ukraine closely. The largest direct impact appears to be on energy markets, especially in Europe.
"The geopolitical clouds that we have over Europe, if they were to materialize would certainly have an impact on energy prices and through energy prices and increased cost throughout the whole structure of prices. But it would also impact growth as a result of reduced income and possibly as a result of reduced consumption and deferred investment." - ECB President Christine Lagarde
Financials
Traditional banks are expected to be beneficiaries of rising interest rates. However, volatile capital markets are impacting several business lines in the financial sector. IPO activity is tracking down significantly. Mortgage lending is also likely to have slowed. We read that private capital markets have slowed some but they have not come to a halt. Private Equity firms have raised so much money that needs to be invested. Their scale is changing the structure of M&A markets.
"The pipeline and the activity level is extremely high, but the pace of closures is according out a little bit, it's just taking longer. So everything that you're working on is just a little harder, a little longer, a little tougher…We don't see a lot dropping out of the pipeline, we just see it, you know, the thing you thought we closed next week is going to close in three weeks, or four weeks. And we're seeing that pretty. We're seeing that in the first quarter. So although our pipeline remains extremely high, and every banker I talked to, seems to be almost busier than they were last year. We're definitely seeing the pace of closings slow in the first quarter as a result of the volatility." - Moelis & Company (MC) CEO Ken Moelis
Consumer
The consumer is not showing any signs of slowing demand despite rising inflation. Most companies that we listen to have noticed surprisingly low price elasticity of demand, which means that they continue to raise prices without seeing significant impacts. At the margin, consumer spending does appear to be shifting some from Pandemic Era patterns. Peloton, for instance, stands out as a company that got caught in a rapidly shifting demand environment. Interestingly, the housing sector does not yet appear to be softening despite growing headwinds in interest rates and the downshift in pandemic era demand.
“…we also acknowledge that we have made missteps along the way. To meet market demand we scaled our operations too rapidly and we overinvested in certain areas of our business. We own this. I own this and we are holding ourselves accountable. That starts today.” - Peloton Interactive (PTON) CEO John Foley
Another important catalyst that we’re watching is the changing nature of digital advertising markets. Apple’s changes to iOS/IDFA privacy settings have impacted many social media companies, especially Facebook. This is leading to potentially large shifts in digital advertising budgets. Additionally, we’re seeing increasing mentions of “subscription fatigue,” which may create opportunities for more ad-supported content among streaming media companies.
“…It takes more work to figure out where to watch what you want to watch. It is. And for the average American household to be paying for 15 subscriptions instead of 2 or 3 that they were a few years ago, the cost is prohibitive. So insert AVOD. And now all of those companies are graded on subscribers. How many subscribers do they get? And just some pretty impressive numbers across the board. And just from many of them, as we watch how they reported on their last year. But in order for them to keep those subscribers, they have to make it affordable. So we expect to see more and more of them adopting advertising. They need that to be relevant so that they show fewer ads that are more relevant to the user so that they keep an amazing experience for the consumer, but then the consumer can also afford it." - Trade Desk (TTD) CEO Jeffrey Green
Technology
The NASDAQ’s 13.5% decline to start the year is arguably the most important thing happening in technology right now. Technology (especially FAANG) has dominated capital markets for over a decade. Underperformance from tech is not something that most of us are used to seeing.
With some company-specific exceptions, we don’t see any signs that fundamental growth dynamics are shifting. However, low-interest rates, which prioritize growth, can not be extracted from tech valuation performance. So any structural change in the interest rate environment could have a longer-term impact on investment returns from technology companies.
"In the immortal words of Bill and Ted, we had a most excellent quarter” - Cloudflare (NET) CEO Matthew Prince
Industrials
Supply chains are still very disrupted and there are few signs that things are getting better. We do see sprinklings of optimism from time to time, but most companies seem to project that they will be facing challenges throughout 2022. We see a ~2:1 ratio of negative to positive comments on supply chains.
“...what we're seeing right now is better flow through all across the supply chain…as far as the supply chain, we talked about it in Q3” - Walmart (WMT) President & CEO of Walmart US John Furner
“The supply of semiconductors is improving, but auto production remains well below consumer demand.” - The Goodyear Tire & Rubber Company (GT) CEO Rich Kramer
"We expect supply chain impacts to remain as challenging in the first half of the year as they were in the third and fourth quarter" - Honeywell International (HON) CFO Gregory Lewis
Recent geopolitical turmoil has reinforced a trend towards industrial nationalism. This may be an emerging trend to follow.
"...over the last 30 years, we saw that we went from 80% of semiconductor manufacturing in the West in U.S. and Europe to 80% in Asia…My moonshot is that by the end of this decade, the U.S. would have gone from 12% to 30%, Europe from 9% to 20%….we've seen extraordinary tailwinds to help to reestablish this geographically balanced, more resilient supply chains for the future." - Intel (INTC) Pat Gelsinger
Energy & Materials
Surprisingly, energy was the best performing investment sector in 2021. We wrote about some of the dynamics at play early last year. The sentiment was very negative due to a global push to transition to electric vehicles and renewable energy. ESG mandates also contributed to depressed valuations. These trends will likely still dominate in the long term. However, the world still relies on fossil fuels and a rebound in travel led to a bounceback for oil companies. Russia’s recent actions have added additional supply pressures to energy markets.
“ You've got the invasion on Ukraine and what is playing out there has shocked the markets dramatically and the concern now is that inflation will be much, much higher than expected towards noting that Ukraine is a major food producer. They are the Fourth largest producer of potatoes in the world things you learn when you start ratings on them. There is going to be pressure not just on oil and gas, which is coming from Russia and a massive issue for Europe in particular, but also on foodstuff things like sunflower oil which has the world's largest producer” - ASX Ltd
Wisdom
We appear to have exited the Pandemic Era, and this means that stimulus is being removed from economies around the world. Geopolitics has also now become a factor in capital markets. Because of these dynamics, 2022 is likely to be a more difficult year for earnings and valuation growth than 2021. This forecast will likely change throughout the year, but The Transcript will continue to track these dynamics as they evolve.
“Well, I always say the same thing, realistic expectations which is low expectations. If you have unreasonable demands on life, you're almost -- you're like a bird that's trying to destroy himself by batching his wings on the edge of the cage and you really can't get out of the cage. It's stupid. You want to have reasonable expectations and take life's results good and bad as they happen with a certain amount of stoicism. There'll never be any shortage of good people in the world. All you got to do is seek them out and get as many of them as possible into your life and keep the rest the hell out” - Berkshire Hathaway (BRK.B) Vice Chairman Charlie Munger