Would you like fries with that?
A Review of Earnings Transcripts and the Resulting Economic Outlook for 2023

Earnings season is upon us, and within the earnings transcripts there is primary perspective from company executives on their views on the strength of the economy. These transcripts when examined, can provide investors with clues on the health of specific segments of the economy. In many calls, senior staff will hint at, and at times forecast, what they believe will occur in the short to medium term.

Companies often use specific metrics from their operations to gauge the strength of the economy and make these forecasts. A particularly memorable metric has become known as the Fry Attachment Rate. This term was originally coined by Tom Werner the CEO of Lamb Weston, which is the potato processing company that supplies frozen French fries to many restaurants, including McDonald's. Functionally, the Fry Attachment Rate is the rate at which consumers answer “yes” to the age-old question “would you like fries with that?” The reasoning behind this metric is that it can be used to gauge consumer sentiment, that is, if a consumer is less worried about their financial standing and is more willing to spend, they are more likely to add fries to their meal. Since Lamb Weston introduced this in 2022, McDonald’s has referenced it during earnings calls as well. Within McDonald's Earnings transcripts you often company executives discussing how many items were included per order, positing the same thing, that if consumers are willing to add fries, soda or another item, it indicates that the consumer is spending freely and less budget conscious. Throughout this insight we will discuss some lessons learned from earnings transcripts and consider what this can tell us about the economy as a whole.

Heading into this earnings season, many of the overall market themes were unchanged from the previous quarter. Is the Fed going to rate hike us into a recession? Will it be a hard landing or soft landing? Has the Fed finally gained control of inflation? Perhaps the only new themes introduced in the early part of 2023 were the layoffs that have occurred across many industries, but primarily tech, and the stress within the financial sector following the collapses of SVB, Signature, First Republic and the sale of distressed Credit Suisse.

These themes, primarily the recession discussion, were echoed when examining earnings transcripts. As of May 2, 41% of earnings calls of S&P 500 companies made reference to the terms “recession,” “downturn” and “slowdown” according to Refinitiv Transcripts. And while this is less than last quarter, it is still greater than the 5- and 10- year averages.4 It is also worth noting that while this may suggest that there are reasons to be concerned about, or at least risk aware of, the economy, not all mentions of these terms are negative for company fundamentals. For example, On Semiconductor said demand for chips remained healthy despite “a broad-based macroeconomic slowdown.”

Analyst consensus estimates suggested this earnings season we would likely see an earnings recession, that is a second quarter of decreased earnings, but many believed that this was already priced into markets after many analysts made aggressive downgrades to estimates. Rather analysts have advised that future guidance from companies could be part of earnings transcripts that power equity returns in the short term and give clues on the health of the economy. So far, the data suggests that the pendulum may have swung too far on estimate downgrades. As of 5/8/2023, roughly 420 of the companies that reported first quarter results are posting net 7.2% higher than expected (the long-term average is 4%) and top-line sales have been better-than-expected too, posting 2.5% higher than expected, compared to the long-run average of 1.3% positive surprise.5

Now that we have provided a backdrop for this earnings season and have considered expectations, we can dive into some earnings transcripts to consider what supports, and in some cases, contradicts the macro themes that appear to be defining the market in 2023.

When considering the overall strength of the economy, we believe the consumer is a natural place to start. The strength of the consumer has been a defining force behind market appreciation post Covid, and therefore, cracks in consumer strength or moves toward negative consumer sentiment could be a good reason to become more cautious for the market’s path forward. Unfortunately, some of the largest consumer cyclical and consumer staple companies suggested that those cracks may be materializing.

McDonald's, for example, explained they expect to see a mild recession within the US and Europe in the medium term and when they are forecasting company performance, they are doing so using assumptions that represent a recessionary environment. McDonald’s CEO, Chris Kempinski, had this quote within Q1’s earnings transcript:

While his wording is mild and measured, this is an indication from the head of McDonald’s that one of their gauges of consumer sentiment and health is trending negative.

There is a debate to be had about how to consider the consumer sentiment takeaways from McDonald's and Amazon; is this discretionary spending, and if they are seeing less consumer spending, does that just mean that folks are tightening their budgets rather than having their budgets stressed? It is eating out and online shopping after all, but considering the specific profiles of these companies, it is perhaps a bit more complicated. To either confirm or refute our findings from McDonald’s and Amazon, we turn to two companies that are consumer staples, Procter and Gamble and Nestle.

First, within the Q1 earnings transcript for Procter and Gamble, there are several references to how inflation is impacting their prices and customer behavior. The Chief Financial Officer, Andre Schulten, remarked that “commodities and supplier inflation are still a significant headwind” and that freight costs remain high. Due to these increases to bottom line cost, P&G increased prices on average 10%. While most consumers were able to stomach the price increases, sales volumes did decrease 3%, which suggests some went elsewhere to seek cheaper alternatives.10 Additionally, the executive team did indicate that P&G expects more volatility in consumer dynamics through the second half of the year.

Nestle told a similar story. They had an overall decrease in volume but were able to make up for it and more with average price increases of 9.8% across their product line.11

While none of the evidence laid out suggests that the consumer is severely strained, when considered together, four of the largest consumer-facing companies in the world are suggesting that there is marginal weakness in the consumer and the consensus suggests that it is prudent to be very risk aware within markets.

No conversation on this earnings season would be complete without touching on the huge layoffs we have seen and the focus on operational efficiencies. While layoffs have been broad based across sectors, they have been especially acute within Technology. Meta laid off approximately 21,000 employees, about one quarter of their total work force. Within the earnings transcript on its staff reductions, CFO Susan Li said “As we move forward, including out of the sort of layoffs that we’ve been implementing and the direct restructuring work, we’re going to continue focusing on efficiency work.”

Similarly, Amazon made similar changes to their staff size and made similar comments within their earnings transcript. Andy Jassey, Amazon’s CEO, said “We also made the very difficult decision to eliminate about 27,000 corporate roles,” further stating that “I think every business is working really hard and finding ways to be more efficient.” Amazon and Meta seem to be following the same playbook. As topline revenue growth slows, they are turning to the bottom line and trying to affect company results by decreasing costs. Another tech company, Lyft, followed suit, saying they made staff reductions for cost savings and didn’t even bother using the word “efficiency.”

When considering the layoffs we have seen and the focus on effecting results through cost reductions, it appears that some of the world’s largest tech companies are preparing for an environment in which growth may be hard to come by. These are the same companies that previously chased growth metrics at any cost necessary, and thus this represents a major turn in their philosophy. Within their earnings transcripts, there were many clues about the cautiousness that leadership has for the economy.

The last piece of any earnings transcript (before Q&A) is the company providing guidance on what they expect company performance to look like over the short term. As we stated in the introduction, many investors and analysts believed they had a good understanding of where earnings might come in, but felt guidance from companies would be very important for equity performance. The earnings transcript from Airbnb is a great example of how Q2 guidance was perhaps more of a market mover than Q1 results (perhaps unfortunately for investors in this case). The earnings transcript contained many positives from Q1: Airbnb had its most profitable Q1 on a GAAP basis, had a record high 120 million nights and experiences booked, and a 24% increase in revenue. Despite these results, following the earnings release the stock opened down 10% the next day. Analysts and members of the financial media are pointing to the fact that senior Airbnb staff provided guidance that EBITDA would likely be lower on a margin basis compared to Q2 2022. It seems counterintuitive, that a company hitting record highs would see such negative performance, but this follows what we posited above, that Q1 earnings were likely priced in, and that guidance would be a defining factor for the market in the short term.

Earnings transcripts from the first quarter painted a picture of companies uncertain about what the future holds in the short term. Despite overall strong results, companies made comments focusing on operational efficiencies and setting expectations for a weaker consumer and economy in 2023. While we don’t believe the takeaway should be that equity markets will experience huge drawdowns, it is easy to see a scenario in which equity markets remain data-dependent and trade sideways, at least until we have more clarity on the Fed’s path forward. We at Crystal Capital believe that these markets are environments in which experienced managers can add value.

Sources:

1. A fascinating anecdote about the 'fry attachment rate' (yahoo.com)
2. Recession talk tapers off on latest quarterly conference calls | Reuters
3. Premarket stocks: The earnings recession is here. There could be worse to come | CNN Business
4. S&P 500 2023 Q1 Earnings Preview: Entering an Earnings Recession | Lipper Alpha Insight | Refintiv (refinitiv.com)
5. Corporate earnings haven't been great, but they're still outperforming (axios.com)
6. Airbnb (ABNB) Q1 2023 Earnings Call Transcript | The Motley Fool
7. Airbnb_Q1-2023-Shareholder-Letter_Final.pdf (q4cdn.com)
8. Earnings: Corporate America Focuses on Layoffs and Cost Cuts, Not Growth - Bloomberg
9. Procter & Gamble (PG) Q3 2023 earnings (cnbc.com)
10. The Procter & Gamble Company (NYSE:PG) Q2 2023 Earnings Call Transcript - Insider Monkey
11. Nestle beats quarterly sales estimates with price hikes | Reuters