Stronger Earnings, but Still Weak - Analyst Blog


Third quarter earnings season was a good one, unfortunately we may not be able to say the same about the fourth quarter.  We got off to a very weak start, and while the last week was better, it just pushed the season from being very poor to mediocre at best.  So far 183, or 36.6% of the S&P 500 firms have reported.  However, assuming that all the remaining firms report exactly in line with expectations, then 50.2% of all earnings are in. 

Normally, when all is said and done, the median surprise runs about 3.00% and the ratio about 3.0.  So far, the median is at 1.87% and the ratio is 1.81.  While we don't have the drama of multi-billion dollar bank losses, this is the weakest start to an earnings season since the depths of the Great Recession.   In most recent quarters we have started out of the gate much faster than this, only to fade towards these levels. 

Total net income for the 183 that have reported is 7.08% above a year ago.  That is a big improvement over the negative 3.79% a week ago when just 70 firms had reported.  It is still less than half the 14.82% growth rate that the same 183 firms reported in the third quarter. The picture is just a little bit better if we take the Financials out of the picture.   Without them, the year-over-year rise in net income is 11.84%, down from 16.1% growth in the third quarter.

The bar is also set low for the remaining 317 firms, and significantly lower than the results we have seen so far.  They are expected to see year-over-year growth of just 1.93%.  If we exclude the Financial sector, earnings are expected to be 2.02% below last year's.  That is far below the 15.99% total and 19.16% ex-Financial growth those 317 reported in the third quarter.  In other words, we have started out weak, and it is expected to get worse.

Revenue growth has held up better, with the 183 reporting 6.05% growth.  Most of the revenue weakness though has come from the financials.  If we exclude the Financials that have reported, revenue is up 9.05% year over year.  The 317 are expected to see revenue growth to slow to 3.08% in total and 7.56% excluding the Financials.  In the third quarter, the 317 reported revenue growth of 13.16% in total and 14.18% excluding the financials. 

Net Margin Expansion Ending

With revenue growth slowing but holding up better than net income growth, it means that the net margin expansion game is coming to an end.  It has been a very big part of the spectacular earnings growth that we have seen coming out of the Great Recession.  For the 183, net margins have come in at 11.32%, up from 11.21% a year ago,  but down from 11.82% in the third quarter.  For the 317, margins are expected to be much lower, but they are lower margin businesses to begin with.  They, however, are also expected to fall, dropping to 7.42% from 7.51% last year, and well below the 7.78% in the third quarter. 

Excluding Financials the picture is even worse, with net margins of just 6.90% expected, down from 7.57% a year ago and 7.96% in the third quarter.  While in an absolute sense, those are still very healthy net margins -- much higher than the average of the last 50 years or so -- they are no longer expanding.  Then again, it was unrealistic to expect that they would always rise.  It does mean that earnings growth is going to be harder to come by going forward.

On an annual basis, net margins continue to march northward, but we are beginning to see cracks there as well.  In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009.  They hit 8.51% in 2010 and are expected to continue climbing to 9.04% in 2011 and 9.26% in 2012.  The pattern is a bit different, particularly during the recession, if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.93% in 2009, but have started a robust recovery and rose to 8.12% in 2010.  They are expected to rise to 8.67% in 2011.  However, they are expected to drop to and 8.62% in 2012.

Full-Year Expectations Healthy

Total net income in 2010 rose to $789.0 billion in 2010, up from $538.6 billion in 2009.  The expectations for the full year are very healthy.  In 2011, the total net income for the S&P 500 should be $894.6 billion, or increases of 46.5% and 13.4%, respectively.  The expectation is for 2012 to have total net income come close to $1 Trillion mark to $983.0 Billion, for growth of 10.1%.  Consider those earnings relative to nominal GDP.  If we use the middle of the year GDP level, S&P 500 net income has climbed from 3.89% in 2009 to 5.45% in 2010, and assuming that the 2011 expectations are on target, 6.01% in 2011. 

Of course, the S&P 500 earns a lot of its income abroad, and there are a lot more than 500 companies in the U.S. so to some extent that is an apples-to-oranges comparison.  It is somewhat ironic that the growth in earnings was robust when the economy was anemic, but now that the economy seems to be picking up, earnings growth is slowing down dramatically.  Europe, however, is falling back into recession, and even if the Euro does not totally fall apart, it is likely to be a deep and nasty one.  The BRICs have also all shown signs of slower -- but still robust by developed country standards -- growth.

A much broader measure of (domestic only) corporate profits tracked by the government rose to 9.92% of GDP in the third quarter.  Since 1959 (when the data starts), that measure has averaged 5.99% of GDP.  It is still not a record, though; that was set in the third quarter of 2006 at 10.29% of GDP.  Meanwhile, wages fell to a record low of just 43.75% of GDP, while the average since 1959 is 48.42% of GDP. 

Higher profits are great for the stock market, but ultimately companies need customers, and their customers need to have income (or borrowing capacity).  Thus there has to be a very real question about the sustainability of these great earnings.  I don't think it is wise to assume that corporate profits will continue to take an ever larger share of the economic pie.

The "EPS" for the S&P 500 is expected to be over the $100 "per share" level for the first time at $103.73 in 2012.   That is up from $56.83 for 2009, $83.23 for 2010, and $94.38 for 2011.  In an environment where the 10-year T-note is yielding 1.90%, a P/E of 15.8x based on 2010 and 14.0x based on 2011 earnings looks attractive.  The P/E based on 2012 earnings is just 12.7x.

Estimate Revisions Picking Up

Estimate revisions activity is past its seasonal low, and rising very fast.   In previous earnings seasons, we have generally seen a bounce in the revisions ratio, as the analysts have reacted to better than expected earnings and the outlooks on the conference calls.  So far there is no evidence of that happening.  The revisions ratio for FY1, which is mostly 2011 earnings now, stands at 0.50, or two cuts for every increase. 

The cuts are very widespread, with only a single sector, Transports, seeing more increases than cuts.  Eight of the sectors, including big ones like Energy, Health Care, and Utilities are seeing more than twice as many cuts as increases.  The picture for FY2 ( mostly 2012) is only slightly better, with a revisions ratio of just 0.61. Only three sectors, Transports,  Construction and Business Service are seeing more increases than cuts.  The widespread cuts are also confirmed by the ratio of firms with rising mean estimates to falling mean estimates, which now stand at 0.52 and 0.59, respectively.

Relative to recent quarters, we are off to an exceptionally weak start, but we are still seeing more positive than negative surprises.  We did get some very big and significant positive surprises in the last week, most notably Apple ( AAPL ) and Caterpillar ( CAT ).  As the earnings season has progressed, things have been getting a bit better, but only moved the season from being very poor, to Mediocre at best.   This is happening when the bar is set at its lowest point in a very long time.  For the remaining firms, the bar is also set low, however given the results so far, that really does not provide any assurance that they will be able to clear it. 

The market has been off to a very strong start of the year, despite the weak early results.  Valuations are still compelling, if somewhat less so than a few months ago.  However, if the results do not improve, it strikes me as likely that we will at least pause for a while.

The upcoming week will be a busy one, with 99 S&P 500 firms scheduled to report.  Thus by next week, we will be well past the halfway point in terms of the number of reports.  We are already past it based on the total earnings for the quarter.

APPLE INC ( AAPL ): Free Stock Analysis Report
CATERPILLAR INC ( CAT ): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Business , Stocks

Referenced Stocks: AAPL , CAT

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