Earnings Season Gets Off To A Mixed Start

While still in the early innings, second-quarter earnings season is in full swing.

We have enough results to form a reasonable picture of what the quarter looked like. So far, 89 firms, or 17.8% of the S&P 500, have reported. It is not a representative sample, as some sectors historically report sooner than others. Nonetheless, this very limited sample is somewhat encouraging.

Positive surprises are leading disappointments by a 2.9:1 ratio, in-line with recent historical norms. The median surprise is also in-line with recent history, and perhaps a bit better than normal at 3.70%. Expect both the surprise ratio and the median surprise to jump around quite a bit in the early going of the earnings season.

The median year-over-year EPS growth rate of 9.93% would be wonderful news for the market, if it holds as the season progresses. Given the expectations for those that have yet to report, that seems possible. The median expected EPS growth rate for the 82.2% of firms that are yet to report is 9.64%. Given the propensity for positive surprises to outnumber disappointments on a median EPS basis, the second quarter earnings season could be far better than the mood of the market would seem to indicate.

Based on the early actual returns, Tech is winning the growth derby with median EPS growth of 28.6%. This is based on the results of 15 companies, or 21.1% of the total Tech firms in the index. Positive surprises are leading disappointments by a 3.66:1 ratio. Materials are in second place with a very strong 24.0% showing, based on the four firms that have reported so far. Each and every one of which has been a positive surprise.

The Financials have been the weakest sector by far with the median EPS dropping by 24.2% from a year ago. The sector is responsible for almost half of all the earnings disappointments to this point. Even so, there have been more positive surprises than disappointments in the sector.

At this point though, expectations for those that have yet to report are more important than the few that have actually reported. Energy is currently expected to win the growth derby, not exactly a shocking idea with oil currently hovering in the $135 a barrel area. Perhaps the bigger question is: Why isn’t the expected growth rate much higher than it is? After all, the price of crude has just about doubled since this time last year. Since it costs them something to get the oil out of the ground last year, one would expect that gross profits would more than double as a result. The 30.0% year-over-year growth in EPS for the sector looks very conservative to me.

Tech and Industrials are currently expected to win Silver and Bronze in the second quarter, with growth of 18.4% and 18.2%, respectively. The strong showing by Materials so far is expected to fade, as the median expectation for the firms yet to report is only 2.6%.

Once again, the biggest loser in the quarter is expected to be the Financials, with half the firms remaining expected to see a drop in their EPS of over 5.9%. That however, would be a big improvement over the results to date.

Consumer Durables follows with an expected drop of 1.3%. Given that the bulk of the stimulus checks are being mailed out in May and June, it would not surprise me if the retailers in the sector do a little bit better than expected for the quarter. However, even if that is the case, the effect would be short lived. The expected rebound to 3.4% growth in the third quarter seems to reflect slower assumptions about the pace of stimulus check disbursements than has actually happened.

Some of the factors that should help median EPS growth are share repurchases, which - though having slowed in recent months - will still reflect what happened last year. Oddly, increased share counts will also help boost EPS among the Financials. Since the ones that have increased their share counts the most (by going hat in hand to the sovereign wealth funds looking for new capital) are also the ones that are likely to report losses, so the loss per share will be less.

In addition, to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. The weak dollar has also boosted those companies that export a substantial portion of their sales.

Keep in mind that median growth rates are inherently equally weighted, so the growth rate for Cabot Oil and Gas [[cog]] is just as significant to the results for the Energy sector as the growth rate for Exxon [[xom]].

Total Net Income Growth

While on a median EPS growth basis, things might look ok, the same is not true on a total net income basis. This is shaping up to be yet another very ugly quarter.

The blame for net income decline once again goes to the Financials (with best supporting actor nomination for the Consumer Discretionary). Overall, the second quarter is now expected to be even weaker than the first quarter, but not quite as ugly as the fourth quarter was.

Overall, total net income for the S&P 500 is expected to be 17.3% below the second quarter of 2007. This number is deteriorating rapidly, last week the decline was only expected to be 14.7%. In the Financial sector, total net income is expected to be 73.8% lower (was 62.9% last week).

Things are also falling apart for the Discretionary firms, even despite the massive forced lending program known as the stimulus checks. Total net income for the sector is expected to be down 32.5% from a year ago, and even worse showing than the 18.8% year-over-year decline posted in the first quarter.

Looking at the reports in so far, things look very bleak indeed for the Financials with the total net income of the five firms that have actually reported so far down 83.0% from a year ago. The 25 firms reported a total of $3.16 billion in profits this year versus $18.6 billion last year. There will be more massive write-offs this quarter, but hopefully not quite as massive as we have seen in the previous two quarters. The key flavor of the quarter this time around should be write-offs related to counterparty risk with the monocline insurance firms like Ambac [[abk]] and MBIA [[mbi]] which have finally lost their AAA designations.

Total net income for all the S&P 500 firms that have reported so far is 21.8% below last year.

Energy is expected to be the strongest sector, with total net income climbing 19.0%. However, that is significantly slower growth than the 25.8% posted in the first quarter. Next quarter, the analysts are expecting Energy to really hit a gusher with 52.3% growth expected. With oil at $135 or so, and Natural Gas over $13, the 10% rise in total net income for the sector is seems very conservative, and points to the amount of escalation on the cost side of the equation for the Energy firms. Yes, the price of oil is going up, but so too is the price of the steel pipe they put in the ground when they drill a well. While overall, there is a significant tendency for analysts to be too conservative in their earnings estimates, I suspect that Energy will be the place with the most potential for large positive surprises.

Tech looks like a strong runner up in an otherwise weak field, with growth of 12.2% expected.

Beyond that, growth does not look very inspiring. Staples looks like it will capture the bronze with growth of only 7.0%. Five sectors are expected to post lower total net income in this years’ second quarter than they did a year ago.

The Zacks Revisions Ratio

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our “revisions ratio.” This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

The revisions ratio for 2008 fell yet again. It has now fallen in seven of the last eight weeks. It is now at 0.63, a reading that is negative, down from 0.65 last week, and 0.80 two weeks ago. The overall pace of estimate revisions is starting its seasonal rise. Over the last four weeks there have been 1,776 changes in estimates: 686 up and 1,090 down, up 21.1% from 1,467: 576 up and 891 down last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.74, slightly stronger than the revisions ratio, but also in negative territory. Two sectors are in positive territory, three in neutral and five in negative territory.

Energy was far and away the strongest with over five increases for every two cuts. While estimate increases were widespread in the sector, firms worth highlighting would include Noble Energy [[nbl]], Occidental Petroleum [[oxy]] and Hess [[hes]]. From a total economic impact point of view, significant increases were also seen for all of the big three, Exxon [[xom]], Chevron [[cvx]] and Conoco [[cop]].

Tech was the only other sector in positive territory, but it is well below where it has been in recent weeks. Telecom was very weak this week, but that was on a very small number of total revisions.

The Financials were once again very weak, with over six cuts per increase. Some of the largest and most significant Financial companies had some of the largest cuts, including American International Group [[aig]], Citigroup [[c]] and Merrill Lynch [[mer]].

The 2009 revisions story is similar to the 2008 story, just slightly weaker. The revisions ratio also continued its decline, and is now solidly in negative territory. It fell to, 0.56, from 0.61 last week, and 0.76 two weeks ago. We still consider that to be in neutral territory.

Virtually all the strength is in the Energy sector, with a revisions ratio of 3.19. Utilities also put in a decent showing at 1.54. The Energy sector accounted for almost one third off all estimate increases over the last four weeks, and just over five percent of the estimate cuts.

If Energy were excluded, the revisions ratio would fall to 0.41. 16 of the 37 firms in the Energy sector have seen their 2009 earnings estimate increase by double digits over the last four weeks alone, including all of the big three (XOM, CVX and COP).

The revisions picture for the Financial sector is even worse for 2009 than it is for 2008, coming in at 0.09, or over eleven cuts for every increase. Revisions like these will eat away at the robust earnings rebound seen for 2009 (unless 2008 gets cut faster). If the Financials were excluded, the revisions index would pop to 0.87.

We do not seem to be getting out of the woods on the Financial sector front. While there is weakness throughout the sector, some of the biggest banks were the weakest, including Bank of America (BAC), Citigroup (C), and Wachovia (WB).

The total number of revisions for the whole S&P 500 for 2009 is also well past its seasonal low point, and starting up out of the valley. There were a total of 1,515 revisions: 543 up and 972 down. This is up 18.4% from 1,280 (487 up and 793 down) last week. As second quarter earnings start rolling in, expect the pace of revisions activity to pick up significantly. The ratio of firms with rising mean estimates to falling mean estimates is 0.62, a little bit better than the revisions ratio, but also in negative territory.

Market Cap versus Total Earnings

When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.

For years, the Financials were the dominate force in the market, both in terms of market cap, and even more so in terms of total earnings. They have now been decisively dethroned on both counts. On the Market cap front it just recaptured second place from Energy. However, it slipped into third place behind Tech based on 2008 earnings. Still, despite their current problems, the Financials are still a very significant influence on the market.

Even with all the disasters in the sector, for 2007, the Financials accounted for 22.1% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 13.0% before rebounding to 18.3% in 2009. However, in recent years the sector has accounted for well over a quarter of all earnings.

Energy has usurped the crown this year, with its earnings share climbing to 21.1% from 15.6% in 2007. This week Energy surpassed Financials for the 2009 earnings crown as well, and is now expected to get 19.4% of all S&P 500 earnings in 2009.

On the market cap (and index weight) front, Tech overtook the Financials a two months ago and currently stands at 16.9%. The Financials have plunged to 14.5% of the index. As recently as the end of February, Financials had a 17.2% index weighting versus 15.7% for Tech and just 13.0% for Energy. Most analysts are using very conservative pricing assumptions in their forecasts for the Energy sector (relative to that implied in the futures market), so earnings estimates still have lots of room to rise.

Keep in mind that these numbers are snapshots, when you should be thinking about a movie. At the end of February (the first time we had a complete read on 2009), the Financials were expected to gather 22.1% of all earnings for 2008, and Energy was expected to only get 16.0%. For 2009, the expected earnings shares were 15.0% for Energy and 22.4% for Financials. A year ago before the credit crunch hit, Financials were expected to gather 26.3% of 2008 earnings and held a 19.4% weighting in the index. Energy represented just 10.9% of the total market capitalization and was expected to get 12.9% of the total earnings in 2008.

In general it seems as if the Energy sector is consistently gaining 0.2% of share for each year every week, with a similar decline for the Financials. If those trends continue, then Energy could be as dominate on the earnings front in 2008 as the Financials were in 2007.

For many years Financials were clearly the dominate factor in the overall market, despite generally selling for below market P/Es. Based on 2008 earnings, the Financials have a P/E of 15.7x and based on 2009, only 9.2x. However given the pace of estimate cuts in the sector, the true P/E is probably higher since the actual earnings will be significantly lower. The P/E based on 2008 earnings is now above that of the market as a whole. That is the first time I can recall that happening.

Energy has just taken the throne as the cheapest based on 2008 earnings trading at 9.2x, and 8.2x based on 2009 expectations. There is no question in my mind that Energy is the cheapest sector of the market, and every portfolio should be overweight in it. The Tech sector is far and away the most expensive in the market, trading for 17.4x 2008 and 14.8x 2009 expectations.

Keep your eyes on the revisions. Unless the spreading of economic weakness to the rest of the world causes oil prices to plunge (and the recent trends are very much in the other direction), you can have much more confidence in Energy earnings forecasts actually being achieved (or exceeded) than is true with the Financials.

The S&P 500 as a whole is trading for 14.1x and 11.7x, 2008 and 2009 earnings, respectively. Based on a blend of 50% 2008 earnings and 50% 2009 earnings; that translates to a 7.58% earnings yield, which looks extremely cheap relative to a 4.08% ten year T-note. Even against the A rated corporate bond yield of 6.40% it looks attractive. However, the current level of expectations for corporate earnings still implies that profits will stay well above their historical averages as a share of GDP. That would be an exceedingly rare occurrence during a recession. The comparison between the earnings yield on the S&P and the 10 year T-note is in my opinion more a reflection of the extreme unattractiveness of long term T-notes at this point than stocks looking particularly cheap in general, however there are attractive stocks out there.

It appears that the flight to quality has caused a massive bubble in the price of T-notes. This is far and away, in my opinion, the most significant bubble in the market today, not the price of oil. The prices are hard to justify given the risk that the massive injections of liquidity by the Fed to ameliorate the credit crunch will end up fueling the fires of inflation.

Neil Malkin contributed significantly to this report.
Data in this report, unless stated otherwise, is through the close on Thursday 7/17/2008

Posted in Categories: Contributor, External Research, Stocks, USA.

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