I just counted. I’ve been through 90 quarterly earnings seasons. What do half of these quarters have in common? The second half of the year will be stronger than the first half! I love this story — it never gets old. Tell it to me again. And again. And again. By now I know this story is usually fiction, but the sell-side analysts seem to play along year after year. I’m not sure why, but I have theories that range from analyst turnover to it’s easier to fill in an earnings model by simply cutting and pasting company guidance.
Very rarely does a company in the first half of the year say the second half will stink. They almost always say the future will be brighter. It encourages confidence and optimism – not to mention a higher stock price! What’s the downside? If management is wrong they’ll simply call their favorite sell side analysts and encourage them to gradually reduce their estimates. The company will then beat the “new and improved” lowered guidance and the stock will go up again. Do you see how this works? My favorite part comes after the company beats lowered guidance and the analyst who was played like a fiddle says on the call, “great quarter guys!” I’m sorry for making fun of the second half rebound story and everyone who plays along year after year, but it’s just too easy.
Given the popularity of the second half story, I was surprised by Graco’s (GGG) guidance today. Graco manufactures equipment that pumps and dispenses fluids. They have a very broad product line and have three divisions: Industrial, Process, and Contractor. When I think of them I usually think of paint sprayers, but they manufacture a lot more. As a business, I like Graco and consider them a high quality cyclical company. As many companies I follow with industrial exposure are reporting, Graco experienced a slow top-line quarter (3% organic sales growth). Graco also lowered its expectations slightly for the year. Management stated, “Modest first half organic growth has resulted in a reduction in our full-year outlook for 2016. We have revised our low-to-mid single-digit growth expectation down to a new outlook of low single-digit growth.”
I shouldn’t have been surprised by Graco’s quarter or outlook as it coincides with what I’m seeing in the sectors where they’re seeing softness. What surprised me is they didn’t provide second half guidance showing a rebound. This was Graco’s response to a question regarding their industrial business and their second half outlook (minute 32 on today’s call). Management stated, “I don’t want to make it sound like today we’re giving up hope, but I want to be realistic. And we don’t want to sit here and tell you everything is going to be rosy in the second half.” “…and we don’t know what’s going to happen globally and the geopolitical environment in the second half so we definitely as a group we haven’t given up on the second half, but what we’re trying to do is communicate that from a realistic viewpoint we ought to think about the second half on industrial more like the first half than on some hockey stick that is based upon a dream. [emphasis mine]”
Thank you Graco for your honesty. They don’t know so they’re not going to predict a “rosy hockey stick second half”. Instead, management is going to use a “realistic viewpoint” that isn’t based “upon a dream”. How refreshing and good for Graco! Their business is naturally cyclical and it’s ok not to know, especially in a challenging operating environment. This goes back to my belief that equity risk premiums are too low and should not be abolished by another crowded “this time is different” theme. Risks to companies’ cash flows have not diminished. They are alive and well, no matter how many times we’re told the second half is going to be better.