May 29, 2012

Earnings Roundup: Financials Hold the Key to Second Quarter Profits Forecast

by Greg Harrison

It’s a wrap: the first quarter earnings season is all but over, and looking ahead to the second quarter, it already seems clear that we’ll be in for more of the same. After eight straight quarters of double-digit increases in profits, we now seem to be facing a third quarter running of modest, single-digit gains of the kind that we saw in the first quarter. As we reported throughout the earnings season, while expectations were underwhelming – when the quarter wrapped up, analysts were calling for gains of only 3.2% in profitability for the S&P 500 – the number of positive earnings surprises helped push the actual gains to a far more impressive 8.1% increase in earnings for the first quarter.

With five weeks to go until the end of the second quarter, analysts currently expect S&P 500 profits to grow 7.4%. At first glance, that looks uncannily similar to the first quarter results – until we dig into the forecasts for individual sectors, and realize that growth projections for the financial services companies account for the vast majority of that increase in profitability. Indeed, analysts now forecast that the Financials sector will report earnings growth for the second quarter of an astonishing 62.9%. Without that contribution, overall forecast growth in profits for S&P companies tumbles to only 0.3%.

The aggregate number, and the outsize gain analysts expect companies in the Financials sector to report, mask several worrying indicators. For starters, that predicted performance by companies in the Financials isn’t all that it might appear to be. Analysts aren’t calling for these firms to demonstrate a sudden surge of earnings power; rather, the gains they will deliver will be measured against a very weak second quarter of 2011, making them look far more impressive than they actually are. Indeed, if compared to the first quarter of 2012 rather than the second quarter of 2011, analysts expect earnings growth by the companies in the Financials sector to decline 5.4%. The problems are more widespread, however. As seen in the chart below, analysts have been cutting estimates in other sectors of the S&P 500. The Materials group has been particularly hard hit; while analysts had been calling last summer for its second-quarter 2012 earnings to climb 18.4%, their current forecasts are for the group’s profits to fall by 11.6%, largely due to falling commodity prices.


It’s not all doom and gloom, however. In what seems to be becoming a pattern, analysts have taken to downplaying the upside potential for profits at the companies they cover, setting them up for positive surprises as those companies begin reporting their results. That’s what happened during the first quarter, when the actual increase in profitability ended up being more than double those initial forecasts. And it isn’t just the analysts who are trying to lower investor expectations: the companies themselves have been doing their best to ensure their shareholders aren’t anticipating any big gains in profits. Company-issued guidance is at its most negative level seen since the fourth quarter of 2008, when those managers were trying to steer their companies through the worst of the financial crisis. So far, 73 companies have issued negative preannouncements for second-quarter earnings, while only 23 have felt free to guide investor expectations higher: a negative to positive ratio of 3.2.  There is, however, a significant degree of variability between sectors when it comes to guidance, as reflected in the chart below. Companies in sectors such as energy, where earnings are highly dependent on commodity prices, avoid issuing guidance. On the other hand, a considerable number of companies in the Information Technology group share their internal earnings estimates with their investors and the market.


The Industrials sector has one of the most bullish N/P ratios – 1.5 – among the S&P 500 groups, in the wake of its successful first quarter, during which it generated the highest earnings growth rate within the index. Even though this ratio reflects the fact that more companies have offered negative guidance than positive guidance, it still paints a more upbeat picture of this group than for other sectors; it also is significantly better than its long-term average N/P ratio, of 2.3. After the Financials, Industrials are expected to lead the S&P 500 in earnings growth for in the second quarter; analysts currently expect companies in this group to generate earnings that are 10.6% higher than those reported in the second quarter of 2011.

Ironically, while the members of the Financials group may be about to post the strongest year-over-year gains in earnings, seven companies from within their ranks have warned they won’t report earnings that meet analyst expectations, while only one has declared that it expects to beat those estimates.  The outlook for companies in the Consumer Discretionary sector is even more negative; a dozen companies have issued negative preannouncements, while only one has said it believes it will beat analysts’ forecasts (and another four have issued guidance that is in line with analysts’ forecasts). Seven of those 12 negative preannouncements have come from retailers, a number of whom have struggled to boost sales in the first quarter. Their ranks include Kohl’s Corp (KSS.N), Ross Stores Inc. (ROST.O), and GameStop Corp (GME.N).

With second-quarter earnings expectations beaten down once more, investors will be looking closely for clues as to whether companies beat those forecasts, or whether the prophets of doom who argue that the worsening Eurozone debt crisis and slower growth in the emerging markets will put an end to a 10-quarter streak of gains in corporate profitability.


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