Q3 earnings preview; small caps are shining; Rolls-Royce roars back

We remain quite bullish on the Q3 earnings season. Many recent earnings releases (those ending 31 August) from companies not following the calendar year have been much better than estimated with positive reactions in the stock price. Yesterday’s record August retail sales in Europe and better than expected ISM Service Index for September in the US are bolstering our view that most companies are well ahead of expectations and that earnings estimates are mostly too conservative.

Small caps are feeling the love

The reflation we have covered today on the back of yesterday’s cross market price action has also been reflected in small caps. Expectations of more stimulus in both the US and Europe will naturally lift the part of the equity market that suffered the most during the severe lockdowns earlier this year and that was certainly smaller companies. The stronger than expected macro figures lately are also underpinning a growth surprise and investors seem to be betting on this theme through small cap stocks. As the chart below shows small caps in Europe started outperforming last week and has accelerated this week. The same pattern shows up in US equities.

Rolls-Royce starts tapping bond market

Rolls Royce shares are up 10% again today extending the gains to 35% from the lows on Friday. The jet-engine maker is starting its senior unsecured noted in USD which is part of its $6.5bn rescue plan to get the company through its demand shock due to Covid-19. Analysts expect revenue to decline 34% in 2020 and delivering negative free cash flow of £4bn which is quite significant since the company’s enterprise value is only £7.2bn. The current net debt is around £4.5bn and expected to rise another £1bn under the new financing plan. To not lose grip of the situation Rolls-Royce has to keep its net-debt-to-EBITDA at no more than 3x which implies that EBITDA should quickly get back to £1.8bn which is where the company was in 2016 before things came apart. Rolls-Royce is a very high risk opportunity for investors, also reflected in its 9.2% 1-year default probability (Bloomberg’s default risk model), but carries an attractive risk-reward ratio if the economy heals faster than expected and commercial aviation can come back. But that is a very big unknown.