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The Earnings Picture 12-12-11 - Analyst Blog

Third quarter earnings season was a good one. Total net income growth was far higher than expected, although the median surprise and the ratio of positive surprises to disappointments is slightly below normal.

This week we will change our focus to the expectations for the fourth quarter. The year-over-year growth rate for the S&P 500 is expected to slow dramatically, to just 4.62% from 13.44% in the third quarter. Excluding Financials, the growth slowdown is expected to be even more dramatic, dropping to just 3.97% from 17.7%.

Keep in mind, though, that at this point in the third quarter earnings season the expected level of earnings growth was just 12.04%, and 11.73% excluding the Financials. Thus, it is not inconceivable that we might squeak into double-digit growth again in the fourth quarter.

Earnings growth is slowing on both sides. Revenue growth is expected to slow to 3.40% from 10.37% year over year. Excluding Financials, revenue growth is expected to slow to 7.64% from 13.14% in the third quarter. Sequentially, revenues are expected to be down 0.80% overall, and up just 1.53%.

Net Margins Expansion Slowing

As revenue growth is slowing, so to is the rate of net margin expansion. Overall net margins are expected to climb to 9.11% from 8.94% a year ago, but excluding Financials, net margins are expected to actually fall to 8.45% from 8.74% last year. Sequentially net margins are expected to be down both in total and ex-Financials from 9.35% and 9.07%, respectively.

The net margin expansion game is getting long in the tooth, but it does not look like it is entirely over. It has played a key role in the remarkable earnings recovery we have seen since the depths of the Great Recession.

On an annual basis, net margins continue to march northward. 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 9.21% in 2011 and 9.62% 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 8.74% in 2011 and 8.91% in 2012.

Full-Year Expectations Still Good

Total net income in 2010 rose to $788.7 billion in 2010, up from $538.4 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 $904.5 billion, or increases of 46.5% and 14.7%, respectively. The expectation is for 2012 to have total net income come close to $1 Trillion mark to $994.0, for growth of 9.9%.

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, 6.02% this year. 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. Nevertheless, it does demonstrate that corporate profits are doing a heck of a lot better than the rest of the economy.

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 $104.87 in 2012. That is up from $56.80 for 2009, $83.18 for 2010, and $95.39 for 2011. In an environment where the 10-year T-note is yielding 2.05%, a P/E of 14.8x based on 2010 and 12.9x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.8x.

Estimate Revisions Drying Up

Estimate revisions activity is well past its' seasonal peak and is plunging (seasonally normal). We saw a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year, but now that bounce seems to be over. Once again, there are more estimate cuts than increases, with a 0.90 ratio. That is still in neutral territory.

However, the situation for 2012 is not as good. There the ratio never got above 1.0 during the earnings season, and has now also started dropping again, and currently stands at 0.77. That is a slightly bearish reading.

To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by, say, a nickel and the analysts don't increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter. With almost three positive surprises for every disappointment, one should expect more upwards revisions than cuts.

Many of those increases are now falling out of the four-week moving totals. That suggests that on balance the guidance given in the earnings conference calls was negative.

At the sector level, with the drop in overall revisions activity, the sample sizes are getting quite thin, which makes them somewhat less significant, but that does not mean that they should be ignored entirely. For 2012, the estimate cuts are very widespread. There are just two sectors -- Industrials and Retail -- that have seen more upwards than downwards revisions for 2012, and Retail just barely (1.08 ratio).

Meanwhile, five sectors have at least two cuts per increase. Autos, Aerospace and Business Service are faring the worst, but on very thin sample sizes. Financials still have a large number of total revisions, and there the ratio is 0.49.

The Industry Winners (& Losers)

As far as sectors are concerned, it looks like the clear winner in the third quarter was Energy. It won gold by a healthy margin for both earnings and revenue surprise, as well as for revenue growth. It took home silver for earnings growth, edged out by Construction, which was coming off a very low base a year ago. There was no clear-cut loser for the quarter, but Utilities, Aerospace and Financials were all candidates for that dubious distinction.

The third quarter was a good one. However, the expectations are very subdued for the fourth quarter, and the hurdle is getting lower. Looking ahead to the first quarter, that slowing is expected to continue, with just 1.04% total, and 2.62% ex-financial growth expected.

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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 Nasdaq, Inc.


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

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