Earnings: Beyond That Big Fourth-Quarter Spike

Although corporate profits in the fourth quarter will likely be dramatically better than a year ago, CEOs aren't pounding their chests yet.

Most chief executives acknowledge that the fourth quarter brought higher sales but remain reluctant to provide guidance that looks much into the future, says Hank Herrmann, chief executive of Waddell & Reed Financial (WDR), an Overland Park, Kan., fund company that manages $70 billion.

"A few [companies) are building backlogs, but not a lot. A few people are talking about their book of business improving some, but not a lot," he says. "Part of it is most CEOs still doubt the strength of final demand. The first quarter will be the first time where they start to feel confident about the demand they see. The fourth quarter still has too much of a seasonal element and [they worry that] the inventory rebound could be ephemeral."

Once companies see evidence of new job creation and decide they need to have capacity in place to meet an eventual rise in consumer demand, Herrmann believes CEOs will be more willing to take a chance on offering more constructive guidance for the future. Peter Cardillo, chief market economist at Avalon Partners, senses more enthusiasm among CEOs, based on signs of stronger economic activity ahead. Cardillo expects companies to start providing slightly longer-term earnings estimates, but with guarded outlooks.

Just how strong will earnings be? The weekly outlook published by Thomson Reuters (TRI) on Jan. 8 estimated a 184% increase in profits for the companies in the Standard & Poor's 500-stock index. The highest year-over-year growth rates are expected in financials [up to $2.4 billion, from -$81 billion a year ago], materials [up 163% to $3.0 billion] and consumer discretionary [up 114% to $15.5 billion], while the lowest anticipated growth is in energy [down 24% to $18.5 billion] and industrials [down 13% to $154.8 billion].

The easy comparisons with the fourth quarter of 2008 -- the worst in index history -- make for growth forecasts that border on being ridiculous, says Howard Silverblatt, head of index services at Standard & Poor's (MHP). "Earnings [for the S&P 500] usually tend to be in the $22 [per share] range. They fell all the way to negative 9% [a year ago], the only negative ever."

better comparison: Q3 2009?

The difference between -9% and the $16.09 that S&P estimates for the latest quarter equates to a growth rate above 17,000%, says Silverblatt. For a more practical comparison, he points to S&P 500 earnings of $15.22 in the fourth quarter of 2007, and $21.99 for the last three months of 2006 -- before the economy began to teeter.

Jeffrey Kleintop, chief market strategist for research at LPL Financial in Boston, wrote in an e-mail message that he expects profits for the S&P 500 to come in slightly above the mean estimate of $16.05. If the financial sector were eliminated from the year-over-year comparison, he said, earnings would be up by only 8%. Kleintop is one of a handful of professionals who believe comparisons with the 2009 third-quarter -- instead of the year-ago quarter -- make more sense on this occasion. He expects an annualized 5% revenue growth rate during the fourth quarter, plus an 0.4% increase to margins, to boost earnings 8% above third-quarter levels.

Year over year, the technology sector turned in the best performance in 2009 with a fourth-quarter increase of 59% and should draw the most scrutiny this earnings season, says Silverblatt at S&P. Investors expect higher earnings from pent-up demand for upgraded computer models. Capital expenditures on technology fell 22% in 2008 and are expected to increase 28% in 2010 -- returning to 2008 levels, he says.

S&P analysts forecast that profits for the energy sector should rebound 50% from a year ago, while industrials are expected to report a drop of 21% from the fourth quarter of 2008. Health-care earnings are expected to be up 18.7%; the bulk of spending anticipated to result from Congressional legislation won't be factored into profits until 2011 and 2012, Silverblatt says. Results for the financials are projected to swing from a net loss of $13.93 a year ago to a profit of $1.72 in the latest quarter.

It's hard to gauge how strong energy profits were in the fourth quarter, given how depressed refining margins and oilfield service earnings remain, David Bianco, chief U.S. equity strategist for BofA Merrill Lynch Global Research (BAC) told Bloomberg BusinessWeek in an interview. In a Jan. 5 research report, Bianco said he was more confident that oil prices are trading higher on the fundamental outlook for supply vs. demand, instead of merely on U.S. dollar weakness, as they did during the October 2009 rally. Higher oil prices on a stronger dollar should drive expansion of price-to-earnings multiples in energy stocks, he said in the report.

The financials' earnings won't tell you that much by themselves, says Bianco, who suggests they be considered in relation to the level of loss reserves that companies are taking. A bank could have lower earnings because it took a bigger loss reserve, "so it's not so much what is their bottom line, but how do they get to it?" he asks. If a bank says it built a loss reserve in 2009 large enough that it doesn't need to add to it this year, there should be tremendous earnings growth in 2010, he says. BofA Merrill Lynch is forecasting 50% earnings growth for the financials as a group in 2010.

S&P 500 sales plunged $1.54 trillion

This will be the first quarter since the recession started in 2007 in which the market looks for evidence of substantial revenue growth. Investors will no longer be satisfied to see profits climb only on sharp cost reductions, as they've done in the two previous periods.

The intensity of the focus on higher revenues makes sense when you consider that sales for the companies in the S&P 500 index plunged $1.54 trillion between October 2008 and the end of September 2009, according to Silverblatt. "That's bigger than the stimulus [package) and the health-care bill," he says.

Whatever revenue companies were able to preserve or increase in the latest quarter will more readily turn up as profit, thanks to increased operating leverage that resulted from cost-slashing, he says.

"That's why everyone's going nuts over sales," says Silverblatt. "That's why [mergers and acquisitions) are getting so much attention. It's one way to increase sales. You increase marketing and advertising, or you go out and buy [sales growth]," whether through whole companies or separate divisions.

Bianco at BofA Merrill Lynch will listen to earnings conference calls for signs of how sustainable companies believe their profit pickup has been, based on whether they see better prospects for higher revenue in 2010. Given the extent of budget cuts, it's a matter of how much cost companies need to restore as the economy starts growing again, he says.

Consumer discretionary companies probably had the strongest growth in revenue, even though holiday sales, up 3% from 2008, don't look "rip-roaring strong," says Bianco. Revenue growth will be more impressive for some nonretailers in the sector, such as McDonald's (MCD), Disney (DIS), Nike (NKE), and Coach (COH), because it won't result only from depressed year-ago numbers, he says. Their gains derive partly from positive currency translation effects from foreign sales because the dollar strengthened in the latest quarter.

a secular boom in cloud computing?

Herrmann at Waddell & Reed also wants to see which companies are confident they can sustain revenue growth in the year ahead. Companies that should be able to keep increasing revenues look relatively cheap compared with historic valuation levels because the market is recognizing only cyclical strength. He expects heightened appreciation for the secular growth potential of segments of the retail, technology, and health-care industries in the months ahead.

"Technology has been labeled a cyclical story, mostly due to the difficult decade just ending," Herrmann says, "Now we're going into a realization that there's strong secular story. We're in the early stages of a transition to cloud computing. It may be a slow start, but there will be quite a number of years where that will be a strong tailwind,"

What do earnings prospects suggest for the longevity of the stock market rally, now entering its 11th month? Equity investors remain skeptical of a sustained economic recovery, according to BofA Merrill's Jan. 5 report. Its earnings estimate of $17.30 for the S&P 500 suggests an annualized rate of $70. On that basis, investors are still demanding an equity risk premium above 450 basis points, higher than the average of 360 basis points between 1960 and 2008.

As quarterly earnings continues to improve, the S&P 500 should grind higher as investors gain confidence in BofA Merrill's normalized earnings forecast of $79 for 2010, the report said. Bianco and his team are emphasizing stakes in energy and industrials, on Asia-led global growth, as well as in financials, on a U.S. recovery that lacks inflation and keeps interest rates low.

While some Wall Street pros are eager for companies to return to providing longer-term earnings outlooks as the economy improves, not everyone believes that would be helpful so early in the recovery process.

"Given the state of the economy, I'm not willing to look more than a year out, especially in [the technology) sector," says Ryan Jacob, portfolio manager of the $38.8 million Jacob Internet Fund (JAMFX). "You can get into trouble because things can change so quickly."