Improving business margins bolstered equities

The year 2017 was marked by the operating recovery of listed companies in Brazil. Businesses not only benefited from a weaker comparison base in 2016 but scored gains after successive rounds of cost-cutting. Given that, the economic recovery over the last year allowed for more significant profit margins and a higher number of companies swinging back to profits and reporting better operating performance than in 2016.

Investors didn't miss the chance. Through the course of 2017 companies enjoyed widespread stock gains, showing the market was trading ahead of the recovery and betting on stocks – a trend likely to continue in 2018 thanks to lower inflation and interest rates, in addition to the continuing recovery.

The market capitalization of companies in the market bellwether Ibovespa rose 23.6% to R$2.6 trillion on December 27 from R$2.1 trillion on December 29 of 2016, according to B3 data. All listed companies saw an average 27.5% gain in market value to R$3.2 billion on December 27 (344 stocks) from R$2.5 trillion in late 2016 (349 stocks). 

According to experts, the data indicate there was significant investor demand for Brazil, with an eye on corporate gains in 2017 – fourth-quarter earnings are set for disclosure starting this month. A Valor survey based on third-quarter earnings of 48 non-financial companies listed on Ibovespa saw only eight still posting negative margins.

The other 40 companies were able to stay profitable, with 17 of them reporting better-operating margins from already positive levels in the third quarter of 2016. Seventeen others saw worsening margins in the same period but still remained in the black, while six were able to reverse the negative margins a year ago, including giants like Petrobras, Vale, Usiminas, Embraer, Pão de Açúcar, and JBS. 

The operating margin of Usiminas, for example, rose to 7.10% in the third quarter from a negative 30.6% in the same period of 2016 – pushing its preferred shares (PNA) to rise 121.9% in 2017. Pão de Açúcar went to a margin of 4.6% in the period from a negative operating margin of 0.7%, while its stock rose 44.7% in 2017.

Luiz Cherman, a Brazil equity strategist with Itaú BBA, says 2017 was marked by a significant improvement in the business environment, whether because the comparison base in 2016 was too affected by the economic crisis, or because cost-cutting efforts in previous years only started boosting earnings in 2017 as sales accelerated. Companies had already invested before operating margins began improving, and Ibovespa had already been accumulating gains, leaving the market well balanced to bet on the recovery. “And we expect it to repeat in 2018 with GDP growing 3% from this year's 1%,” Mr. Cherman estimated in an interview late last year.

According to Itaú BBA calculations, out of 109 companies covered by the bank, 41% saw EBITDA margins rising in 2016 from the previous year. But in 2017, the percentage of firms reporting such gains rose to 65%. This year is expected to see an even bigger percentage at 79%.

A Valor survey shows that out of 276 companies studied there were 115 (41.7%) reporting operating improvements in 2016. But in 2017, out of a sample of 282 companies, 143 (50.7%) reported improvements. “Companies are doing their homework and working for operating improvements. Leaner companies will start the year with the Selic [benchmark rate] and inflation lower, and with growing GDP and demand. Despite the electoral volatility, the market is likely to keep trading ahead of a better 2018,” says Obede Rodrigues, equity manager at Fator Administração de Recursos, the asset management arm of Banco Fator.

Itaú is betting on that and expects Ibovespa to hit 87,900 points by late 2018, which would represent an  upside potential of 15% backed by accelerating economic activity and rising corporate profits, as well as by expectations that the next president will not squander the critical progress obtained so far and will continue upholding the reform agenda in 2019. “Our multiples are still attractive, the P/E [price-to-earnings] ratio is at 12 times, meaning we are cheap compared with other countries. It makes entire sense for investors to look into Brazil,” Mr. Rodrigues says.

When earnings are broken down by sector, construction companies showed the worst performance since the recovery tends to encourage sales of apparel and appliances but still has not led consumers to start buying homes. Itaú BBA, however, says their operating results could benefit in 2018, especially such companies as BR Properties and other shopping-mall operators, in addition to MRV Engenharia and Cyrela. “We also see opportunities in the pulp and paper sector, with higher prices, and in retail, both for groceries and discretionary spending due to improving job prospects,” Mr. Charman, with Itaú BBA, says.

But the widespread improvement can't hide differences between each sector's execution. CSN is one example, having swung to a loss, while Usiminas reversed negative margins into third-quarter profits. “Part of the market distanced itself from CSN with last year's delayed balance sheets and the stock mirrored that worse execution,” says Marco Saravalle, an equity strategist with XP Investimentos. While Usiminas rose 122% on the year, CSN has fallen 22.8%. “But steelmakers started [price increase] negotiations with carmakers so that the next earnings could show a consistent improvement,” he says.

The retail and consumer sectors are other examples, with Lojas Americanas and Renner standing out. While the former saw the performance deteriorate and return to negative margins, Lojas Renner is among the best performers after building on already good results. The difference became clear in their stocks: Americanas rose only 1.5% while Renner leaped 70.6%.

Bruna Pezzin, a sector analyst with XP, says the disparate performance is explained by Renner's higher average ticket from sales of appliances and textiles, while Americanas has a lower one and less available credit in stores, and saw revenues worsen in the third quarter. “But we continue believing in the company's execution as lower inflation holds back costs and allows for a bigger upward potential than Renner, which already harvested improvements in the third quarter.”

 Retail remains the market's darling, with high hopes for 2018. Mauá Capital partner Renato Ometto says the company's portfolio had “one of its best years” in 2017 with around 35% allocation into retailers and consumer-goods companies like Magazine Luiza and Via Varejo – which joined Ibovespa in 2018 after their stocks became more liquid. “We are optimistic. We see an upside potential of 40% in our picks,” he says.

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