Third-quarter earnings season doled out plenty of bad news to investors. While a big batch of companies reports earnings this week, so far companies on balance have posted fewer stronger-than-expected results and more big misses. At the same time, many companies have come out with negative profit outlooks and are setting expectations for slowing growth in the upcoming quarters.
Still, there are a handful of stocks that beat market expectations by a decent margin and are still considered undervalued by Morningstar analysts. To highlight opportunities for the long-term investor, we ran a screen for these stocks.
Five stocks made it through our screen, including GSK (GSK), formerly known as GlaxoSmithKline, for the second quarter in a row. Here’s a snapshot of the results. More details on our screen, along with comments on the stocks from Morningstar analysts, can be found later in this article.
How Do Third-Quarter Earnings Compare?
Third-quarter earnings are coming in at their weakest pace since the first quarter of 2020. A total of 671 out of 843 U.S.-listed stocks covered by Morningstar analysts have reported so far, and only 29% beat FactSet consensus estimates by 10% or more, 4 percentage points less than in the second quarter and 12 percentage points fewer than from a year ago.
Altogether, about 45% of companies beat earnings estimates by 5% or more, the fewest since the first quarter of 2020, when 47% of companies beat earnings estimates that much and when the COVID-19 pandemic started to disrupt business operations and left markets in a frenzy.
More companies disappointed by a higher margin as well in the third quarter, with 18% of the companies that have reported missing estimates by 10% or more, higher than the quarterly average of 14% in the previous year, and a level not seen since the second quarter of 2020.
While Morningstar stock analysts pay close attention to earnings, they focus on long-term results and valuations. One quarter usually doesn’t lead to a change in the long-term assumptions behind the assessment of a stock’s fair value, unless a company also comes out with new, material information that affects the assumptions that opinion is based on. For example, new data on a drug that raises the probability of approval, or pricing gains on a key product line could affect an analyst’s long-term thinking.
Still, looking at quarterly earnings against the valuation backdrop can help investors identify opportunities.
We screened for stocks that beat expectations, but remained undervalued, to help investors capitalize on new investment opportunities that arose during earnings season.
To help keep the focus on those that had truly strong results and did not beat on earnings through accounting gimmicks or one-time factors, companies were also screened for revenue beats of 5% or more. We then filtered for stocks with a Morningstar Star Rating of 4- or 5-stars. Those stocks were then screened for a Morningstar Economic Moat Rating of “wide,” which is designated if a Morningstar analyst believes a firm has a durable competitive advantage over its peers.
Only 5 stocks made the cut in our screen, here’s how Morningstar analysts reacted to their results.
GSK
- Earnings Per Share: US$1.08 versus consensus estimate of US$0.90
- Revenue: US$8.97 billion versus the consensus estimate of US$8.31 billion
- Star Rating: 5-Stars
- Discount: 37%
“GSK reported better-than-expected third-quarter results largely driven by strong sales of COVID-19 treatment Xevudy. However, given the likely decline in Xevudy sales over the next year due to the pandemic receding and strong competing oral COVID-19 treatments, we don’t expect any major changes to our GSK fair value estimate based on the solid results.”
“We continue to view the stock as undervalued, with too much investor concern on the Zantac litigation. With the majority of scientific data showing no consistent link between the drug and cancer, we view the risk of a settlement over $10 billion (implied by the August stock price reaction) as unlikely.”
— Damien Conover, director of equity strategy
Polaris
- Earnings Per Share: US$3.25 versus consensus estimate of US$2.78
- Revenue: US$2.34 billion versus consensus estimate of US$2.19 billion
- Star Rating: 4-Stars
- Discount: 33%
“We don’t plan any material change to our $175 fair value estimate for wide-moat Polaris after digesting its third-quarter financials and view share as undervalued. Third-quarter sales rose 32%, to $2.3 billion, modestly ahead of our $2.2 billion forecast, with off-road rising 33%, on road higher by 30%, and marine up 42%. Even better, Polaris was able to produce solid profitability, with gross margin in off road expanding 340 basis points and on road up 293 basis points (in line with our estimates), thanks to pricing and mix.”
“Also, marketing and selling expenses were controlled, at 5% of sales (down from 7% the past two years), with promotions limited by constrained volumes at retail. The ability to improve operating margin (to 10.4% ex financial services, up 240 basis points) in an uncertain consumer environment offers us confidence that Polaris should be able to capture further gross margin upside as transportation and input costs normalize over the next year, even if promotional cadence begins to rise.”
— Jaime M. Katz, senior analyst
Sanofi
- Earnings Per Share: $1.43 versus the consensus estimate of $1.31
- Revenue: $13.01 billion versus the consensus estimate of $12.02 billion
- Star Rating: 4-Stars
- Discount: 25%
“Sanofi reported strong third-quarter results ahead of our projections, but we don’t expect any major changes to our fair value estimate based on the outperformance, which was partly driven by earlier-than-expected flu vaccine sales. Nevertheless, we continue to view the stock as undervalued with the market not fully appreciating the long-term growth outlook for the firm supported by immunology drug Dupixent and new pipeline drugs that also support the firm’s wide moat. Additionally, we continue to view stock valuation loss earlier in the year surrounding concerns on potential Zantac litigation as excessive.”
— Damien Conover, director of equity strategy
Constellation Brands
- Earnings Per Share: US$3.17 versus the consensus estimate of US$2.82
- Revenue: US$2.66 billion versus the consensus estimate of US$2.51 billion
- Star Rating: 4-Stars
- Discount: 10%
“We’re adjusting our fair value estimate for Constellation Brands to US$274 from US$267 per share after incorporating second-quarter results that included sales growth of 15% for beer and 1% for wine and spirits, outperforming estimates. Despite capturing 40% beer operating margins in the first half, management guided to 38% margins in its full-year outlook, implying a second-half profit slump as Constellation faces inflationary pressures, predominantly from raw material inputs and packaging. Additionally, we have maintained higher levels of near-term capital expenditures to account for the buildout of the Veracruz brewery. In the longer term, we remain sanguine about its growth prospects, see room for solid margins to improve, and view cost headwinds as largely transitory.”
— Jaime M. Katz, senior analyst
Thermo Fisher Scientific
- Earnings Per Share: US$5.08 versus the consensus estimate of US$4.83
- Revenue: US$10.68 billion versus the consensus estimate of US$9.94 billion
- Star Rating: 4-Stars
- Discount: 9%
“Against the backdrop of declining coronavirus revenue, wide-moat Thermo Fisher Scientific’s third quarter was strong. The firm’s core operations, buoyed by biopharma demand, grew 14% in the quarter, implying ongoing market share gains for the company. The outperformance led Thermo Fisher to slightly raise its annual guidance. We’re maintaining our US$590 fair value estimate and view shares as modestly undervalued.”
“Across all segments, Thermo Fisher called out price increases to reflect the inflationary environment—the firm stated that it is nearly entirely offsetting inflation through price increases, which is impressive and supportive of the company’s dominant vendor position.”
— Alex Morozov, director of equity research, EMEA
