Half-year company results highlights – UK companies bouncing back?

Lockdowns in the UK and abroad were at their peak between April and June 2020. The same three months this year saw restrictions gradually reduced. Consumers and companies upping their spending was therefore no surprise.

The recent batch of company half year results were among the most universally positive I can remember – at least in terms of the scale of year-on-year revenue and profit growth. The UK stock market is up 2.8% in three months as a result. (17 May 2021 to 16 August 2021)

But we think that good news was inevitable.

The question really is what the future holds, and there the answer varies considerably.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Banks – a temporary boost, but long-term challenges unchanged

12 months ago, the five large banks in the FTSE 100 reported profits after tax totalling £4.0bn. The first half of this year saw those same financial giants report a collective £17.6bn profit.

A lot of that improvement can be put down to a £19.2bn swing in the value of money put aside to cover bad loans. 12 months ago banks were expecting lockdowns to result in significant unemployment, with defaults on both personal and commercial loans expected to rise as a result.

In reality, massive government support programmes around the world, including furlough schemes in the UK, have kept the financial damage to a minimum. Businesses have kept their heads above water and consumers have been able to pay down debt. The money set aside for bad loans turned out to be overcautious, and is now being released, providing a huge boost to bank results.

The chart below shows the swing in impairments at the largest UK listed banks. These need to be looked at in the context of the bank’s overall loan book – so beware direct comparisons. However, the swing from large impairments last year to small write backs more recently is clear across the entire sector.

Source: Company half year reports 2021, accessed 16/08/21

However, you’ll notice that the £19.2bn boost to bank results from the improved economic environment only translated into a £13.6bn rise in profits. That tells us ‘underlying’ profits have struggled.

The problem is the fundamental outlook for banks hasn’t really changed from before the pandemic, when conditions were already tough.

At its simplest, banks make money by gathering deposits and then lending that money back out at a higher rate of interest than they pay to depositors. However, that model has become less profitable as central bank interest rates have fallen.

The cost of funding is already at rock bottom and can’t be pushed much further, but the money banks make on lending continues to fall. The gap between the two, known as the net interest margin, is squeezed as a result and loans become less profitable.

It’s a problem that’s been made worse by consumers using spare cash built up during the pandemic to pay down expensive debt like credit cards and overdrafts. Lower credit card debt is good for financial resilience among consumers. But it means banks have, relatively speaking, become more exposed to less profitable lending like mortgages.

While we’d expect consumer lending to grow again now the economy is back up and running, the fundamental challenges posed by low interest rates don’t seem to be going anywhere. While some banks can offset the interest rate headwind with fee-based income – like Barclays’ and HSBC’s investment banks and Lloyds’ Wealth and Insurance business – borrowing and lending is central to industry profits.

We think as long as interest rates remain at rock bottom, banks will struggle to grow. That might not be the end of the world given the relatively attractive dividends on offer – with prospective yields in the sector ranging from 3.6% to 5.3%. But we think that reflects a lack of attractive lending opportunities, together with the cancellation of dividends in 2020, which have left the sector awash with capital.

Companies which can’t find ways to use their capital productively are never going to shoot the lights out when it comes to future returns.

Remember, yields are variable and not a reliable indication of future income.

Read our latest Barclays research

Read our latest HSBC Holdings research

Read our latest NatWest Group research

Read our latest Lloyds Banking Group research

Read our latest Standard Chartered research

Commodities – back to the boom

Rarely has the boom and bust nature of commodities been better illustrated than in the last 12 months. In April 2020 the oil price turned negative for the first time in history. It’s now trading at over $60 a barrel. It’s a similar story in other commodities, with copper and iron ore prices doubling in a little over 12 months.

Commodity groups, whether they’re miners or oil & gas giants, are incredibly sensitive to the market price of what they produce. Whether iron is priced at $60 a tonne or $120 a tonne, the cost of scratching it out of the ground and shipping it to the world’s blast furnaces is much the same. The extra $60 all feeds through to profit.

It’s no surprise then that, year-on-year, the sector enjoyed some spectacular results.

While we generally prefer higher quality names in commodities – whose low cost of production typically keep them profitable in almost all price environments – booms like this actually tend to favour the weaker players. Consider the example below.

Miner 2 might be more profitable than Miner 1, but the percentage increase in profits is far smaller. Moving from a commodity price of $60 to $100 a tonne sees an 9-fold increase in profits at Miner 1, but profits at Miner 2 don’t even double. This is known as operating leverage.

Assuming the Price to Earnings (PE) ratios and number of shares in issue for both miners remains unchanged, then the share price growth in Miner 1 has the potential to be a lot higher than Miner 2.

However, this process works in reverse too. Commodity producers with higher operating costs tend to suffer more when prices fall.

The higher commodity prices have left the entire sector in a far better position now than 12 months ago. But the question investors need to ask themselves going forward is whether recent commodity price gains can continue. If not then companies with a very low cost of production like Rio Tinto, BHP or Shell might be better placed than others in their sectors.

Read our recent article on the pros and cons of operating leverage

One final note on commodities. The energy transition has taken up a lot of column inches in recent months – particularly in relation to the movement by oil majors to invest in new green energy technologies or face oblivion.

Green energy will absorb billions in capital spending over the coming years at both Shell and BP. However, both remain oil companies first and foremost, and between them reported free cash flow in the second quarter of $12.7bn. Neither oil & gas, nor these companies are going anywhere anytime soon, and they will remain a key part of the UK stock market.

Read our latest Rio Tinto research

Read our latest BHP research

Read our latest Shell research

Read our latest BP research

Tech – the transition’s only begun

Billions of consumers stuck at home over lockdown turned to technology to make the days easier. With lockdowns coming to an end in some key markets this half, you might expect the tech groups to suffer.

Growth has indeed slowed, but results at the big tech groups have still been stellar. Amazon reported 24% year-on-year revenue growth in the second quarter, while Facebook came in at 56%, Google owner Alphabet at 57% and Microsoft at 21%.

We think this reflects a step change in how the world works following the pandemic. During lockdowns, tech groups benefited as digital services replaced offline alternatives. However as the economy re-opens, those digital alternatives are holding on to a lot of the new business.

In fact, as the recovery in the economy gathers pace, and company and consumer spending increases, tech groups seem to be grabbing a good slice of that extra spending too.

Advertising is a good example of this in action. Facebook advertising revenue rose 56% in the second quarter, while Alphabet ad revenues rose 69%. That’s far faster than the 14% growth in global advertising spend forecast for this year as a whole. Global advertising spending might be bouncing back fast, but the distribution of that spend seems to have changed for good.

It was anticipation of this trend that led us to pick Facebook as one of our five shares to watch this year. However, increasing dominance hasn’t gone unnoticed and not all attention is good attention. Regulators in the US and China are increasingly scrutinising the industry – and the seemingly unstoppable growth of the last year will only increase calls for regulators to act.

Read our latest Facebook research

Read our latest Amazon research

Read our latest Alphabet research

Read our latest Microsoft research

Construction – builders under pressure, but foundations stronger elsewhere

While house price growth over the pandemic has been front page news, we think input inflation is the more striking feature of recent results.

Given the movements in commodity prices we mentioned in the section on miners above, some increase in the price of construction materials was inevitable. However, a spike in the price of goods like concrete tiles and timber joists is notable. Especially given building activity was actually down on pre-pandemic levels as late as June.

In July one of the UK’s largest housebuilders, Barratt Developments, reported cost inflation of 3-4%. For now that’s been offset by house price inflation, and the costs are being passed on to homebuyers with even higher house price growth. However, that can’t continue unless wage growth kicks in. Without it, margins will be squeezed.

Looking at the other side of the coin, the housebuilders’ pain is construction suppliers’ gain.

Builders merchant Travis Perkins reported 44.1% year-on-year growth at the half year, up 15% on what it achieved in 2019. That reflects good gross margins – the difference between what it costs to buy, make and sell its products compared to the price it gets from buyers. Cost savings achieved during the dark days of the pandemic also helped the numbers.

It’s a similar story at brick maker Ibstock – also one of our five shares to watch – where revenue recovered to 2019 levels, despite lower brick volumes thanks to rising prices.

We think this trend has scope to continue. While supply chains will adjust, resolving the temporary shortages that are driving price increases, housing price growth will probably steady in the near term. If that happens then housebuilder margins are likely to come under pressure, encouraging builders to get more houses finished if they’re to maintain profits. More houses at lower margins would suit construction materials groups down to the ground.

Read our latest Barratt Developments research

Read our latest Ibstock research

The author holds shares in Lloyds Banking Group.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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