Weak Start to Earnings Season

Third quarter earnings season was a good one, unfortunately we may not be able to say the same about the fourth quarter. While it is still too early to draw any firm conclusions, only 70 firms (14.0%) have reported, the median surprise is 1.80% and the surprise ratio is just 1.86. However, assuming that all the remaining firms report exactly in like with expectations, then 22.7% of all earnings are in. Normally, when all is said and done, the median runs about 3% and the ratio about 3.0. While we don’t have the drama of multi billion dollar bank losses, this is the weakest start to an earnings season since the depths of the Great Recession.

In most recent quarters, we have started out of the gate much faster than that only to fade towards those levels. If we are going to have a “normal season” we will have to see the later reporting firms come in stronger than the early reporters. Total net income for the 70 that have reported is actually 3.79% below what those same 70 firms earned a year ago, and is 9.39% below what they earned in the third quarter. They reported year over year growth of 10.02% in the third quarter. The picture is just a little bit better if we take the Financials out of the picture. In the early going, they are a big part of the picture, representing 31.4% of the firms, and 37.3% of the total earnings reported. Without them, the year over year decline in net income is just 0.90%, and earnings are up sequentially by 2.15%.

The bar is also set low for the remaining 430 firms, but still better than the results we have seen so far. They are expected to see year over year growth of just 3.87%, or 2.00% if we exclude the Financial sector. That is far below the 16.89% total and 19.60% ex Financial growth those 430 reported in the third quarter. In other words, we have started out very weak, and it is not expected to get much better.

Revenue growth has held up better, with the 70 reporting 1.98% growth. Most of the revenue weakness though has come from the financials. If we exclude the Financials that have reported, revenue is up 7.42% year over year. The 430 are expected to see revenue growth to slow to 4.65% in total and 8.20% excluding the Financials. In the third quarter, the 430 reported revenue growth of 12.53% in total and 13.41% excluding the financials. With revenue growth slowing, but holding up better than net income growth, it means that the net margin expansion game is coming to an end. It has been a very big part of the spectacular earnings growth that we have seen coming out of the Great Recession. For the 70, net margins have come in at 12.05%, down from 12.78% a year ago, and 13.13% in the third quarter.

For the 430, margins are expected to be much lower, but they are lower margin businesses to begin with. They however are also expected to fall, dropping to 8.12% from 8.18% last year, and well below the 8.61% in the third quarter. Excluding Financials the picture is even worse, with net margins of just 7.77% expected, down from 8.24% a year ago and 8.78% in the third quarter. While in an absolute sense, those are still very healthy net margins, much higher than the average of the last 50 years or so, but they are no longer expanding. Then again, it was unrealistic to expect that they would always rise. It does mean that earnings growth is going to be harder to come by going forward.

Estimate revisions activity is past its seasonal low, and should at least triple from here by early to mid February. In previous earnings seasons we have generally seen a bounce in the revisions ratio, as the analysts have reacted to better than expected earnings and the outlooks on the conference calls. So far there is no evidence of that happening. The revisions ratio for FY1, which is mostly 2011 earnings now stands at 0.49, or more than two cuts for every increase.

The cuts are very widespread, with only a single sector, Transports, seeing more increases than cuts. Eight of the sectors, including big ones like Energy and Tech are seeing more than twice as many cuts as increases. The picture for FY2, or mostly 2012 is only slightly better, with a revisions ratio of just 0.59. Only three sectors, Transports, Industrials and Construction are seeing more increases than cuts. The widespread cuts are also confirmed by the ratio of firms with rising mean estimates to falling mean estimates, which now stand at 0.57 and 0.60, respectively...

Relative to recent quarters, we are off to an exceptionally weak start, but we are still seeing more positive than negative surprises. This is happening when the bar is set at its lowest point in a very long time. For the remaining firms, the bar is also set low, however given the results so far, that really does not provide any assurance that they will be able to clear it. The market has been off to a very strong start of the year, despite the weak early results. Valuations are still compelling, if somewhat less so than a few months ago.

However, if the results do not improve, it strikes me as likely that we will at least pause for a while. The upcoming week will be a busy one, with 117 S&P 500 firms scheduled to report. Thus by next week, we will be almost at the halfway point, and will be in a better position to “Call the Election”.

Source: Zacks

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