November 12, 2012

Earnings Roundup: Time to Bid Farewell to Trough Earnings

by Greg Harrison

Analysts may be bearish, in response to equally downbeat forecasts from companies warning that their fourth-quarter results will fall short of expectations, but the bottom line is that the fourth quarter outlook is still for a return to a growth in profitability.

As earnings for companies in the S&P 500 continue along the path to what seems likely to be the quarter during which they will record the first year-over-year decline in three years, the question remains whether this really does mark a trough for corporate profits. As companies have reported their results for the third quarter, the blended earnings growth estimate has risen; more often than not, those companies are reporting stronger results than analysts had forecast, even though those forecasts themselves had been slashed in the weeks and months leading up to the end of the quarter. But it’s hard for investors to draw much comfort from the future earnings prospects: analysts have turned their attention to fourth-quarter estimates, slashing the forecast for S&P 500 earnings by four full percentage points since October 9, and cutting back their outlook for early 2013 as well.

Much of the rationale for these downward earnings revisions can be traced back to the negative guidance that companies are issuing as they have announced their third-quarter results. For every company making a bullish forecast involving beating future earnings estimates, no fewer than 3.8 companies have taken the opportunity to warn investors that their results will fall short of consensus estimates. Optimism is in short supply, it seems. Still, despite the negative outlook, analysts still expect that earnings growth will move back into positive territory in the fourth quarter and into the new year, as seen below in Exhibit 1. These estimates certainly will fluctuate along with the economic outlook and any changes to business conditions, but now that the third-quarter earnings reporting season is largely behind us, negative guidance – one of the major catalysts for the downward revisions – is largely behind us.

To be sure, serious question marks still surround major markets in which most of the companies in the S&P 500 do business. In the United States, the economy faces the fiscal cliff; Europe is battling recession and a long-running crisis; in China, growth is slowing to levels not seen in nearly two decades. Given these headwinds, how will the pace of S&P earnings growth get back on track, and for the third quarter to prove to be the trough in the current earnings cycle? One possibility is for current areas of strength, such as the Consumer Discretionary and Financial sectors, to remain strong, while companies in the weakest sectors, Materials and Energy, report improvement in their results. That is exactly what analysts expect to happen, as summarized in Exhibit 2, below.

The companies in the Consumer Discretionary group generated the highest earnings growth rate during the third quarter, and analysts expect this sector to extend its track record of double-digit profit growth throughout 2013. American consumers usually can be counted on to spend freely in the fourth-quarter holiday season, and this year appears to be no exception to that rule. Over the last several weeks, analysts have been increasing their same-store sales estimates. Analysts now predict several kinds of retailers – apparel, home furnishings and home improvements stores – to post particularly strong results. In the last week, the sector’s results were further buoyed as many cable and satellite broadcasting companies announced better-than-expected results.

Analysts expect the Financials group to lead all sectors in earnings growth during the fourth quarter, predicting that the rebound in the housing market and the active mortgage refinancing rate will send earnings of banks and other companies in this group 26.5% higher. Regional banks are a major beneficiary of this trend, and their relatively lower risk levels have helped them to post consistent earnings growth, even as the biggest banks have reported results that have fluctuated dramatically. Still, during the fourth quarter analysts expect the larger banks also will do well: they currently forecast that Citigroup Inc (C.N), Goldman Sachs Group Inc. (GS.N), JPMorgan Chase & Co (JPM.N), and Bank of America Corporation (BAC.N) will all see earnings growth topping 30% for the fourth quarter.

If analysts are correct, in spite of the pessimistic environment, the fourth quarter may well mark the beginning of a recovery in earnings growth. Although analysts currently predict that profits for S&P 500 companies will grow only at the relatively anemic pace of 5.6% over year-earlier levels, the combination of strong earnings from companies in the Consumer Discretionary and Financials sectors, and the improved outlook for those in the Materials and Energy groups suggest that the period of negative earnings growth will be short-lived.

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