Strong Profit Growth Estimates Raise Questions
Company earnings have been so surprisingly strong over the last two years, they bring to mind the familiar caveat for anything financial: If it seems too good to be true, it probably is.
But in this case, profits in fact have been as rich as they’ve seemed, some veteran analysts and investors say. That should be heartening, because the stock market’s advance since 2002 has been rooted in earnings results.
Many companies now are rolling in cash, a direct result of their spectacular income gains.
What’s probably too good to be true, some Wall Street pros say, is the outlook. Expectations are widespread that profit growth will continue at a double-digit pace in the second half of this year.
That’s asking a lot from companies in the face of record energy prices, rising interest rates and other challenges, says Steven Wieting, economist at Citigroup Global Markets in New York. “There should be a slowing down of estimates,” he says, referring to the earnings predictions made by analysts at his brokerage and others.
Instead, growth estimates remain robust for the current quarter and the fourth quarter.
On April 1, tallying all of the estimates for companies in the blue-chip Standard & Poor’s 500 index, earnings tracker Thomson Financial in Boston calculated an expected year-over-year growth rate in third-quarter operating profit of 13.8%.
By July 1, that aggregate figure had risen to 15.1%. As of last week, it had reached 15.9%.
For the fourth quarter, the respective growth estimates as of April 1, July 1 and last week were 11.7%, 12.2% and 13.6%.
For the second quarter, with results already in from nearly all of the S&P; 500 firms, the actual earnings growth rate was about 12%, according to Thomson.
Now, the big reason for the increases in the third- and fourth-quarter S&P; 500 estimates is one industry sector: energy. With oil above $60 a barrel, it stands to reason that analysts would be betting that energy companies’ results would continue to be stellar.
What’s surprising is that analysts are largely holding to their optimistic third- and fourth-quarter estimates for many other companies. They’re still projecting double-digit growth for five of the 10 major industry sectors in the S&P; 500 in the third quarter and for six of the 10 sectors in the fourth quarter, according to Thomson data.
Maybe they’re calling the trend correctly. Despite soaring energy costs and higher interest rates, the U.S. economy has picked up since spring. Business inventories are low and should be rebuilt. There are signs of faster growth in Europe and Japan. And global stock markets certainly aren’t signaling an economic downturn on the horizon.
Still, after such a long period of vigorous profit gains, many experts believe a further slowdown would be natural.
“I’m concerned that the expectations are too high” for the second half, says Nick Raich, research chief at Zacks Investment Research, a Chicago-based earnings tracker.
If they are, it would be the first time in more than two years that analysts have overestimated companies’ results. For every quarter since the second period of 2003, analysts have guessed too low, and companies as a group have easily beaten those estimates.
That has reinforced the popular perception that analysts are in cahoots with the companies they follow. The game would be played like this: A company’s top executives low-ball analysts, suggesting, say, that earnings of 30 cents a share would be reasonable for the quarter, even though the executives actually figure the company should be able to earn 32 cents.
When the company reports results -- voila! -- it has earned 32 cents, thus beating the estimate. Investors are thrilled. The company’s stock goes up. Everybody’s happy.
Richard Bernstein, chief U.S. strategist for Merrill Lynch & Co. in New York, thinks that game has been rampant the last few years. A new variation, he says, is that some companies earn Wall Street kudos even though they report a year-over-year decline in earnings -- as long as results, while down, still beat estimates.
A case in point was Avaya Inc., which builds communications networks for businesses. It was expected to report operating earnings (that is, results before gains or losses considered to be one-time in nature) of 12 cents a share for the quarter, down from 16 cents a year earlier. Instead, the company earned 14 cents -- which constituted a “positive surprise” even though it still was a decline, Bernstein notes.
He asserts that there was enough of that going around in the second quarter to send up a warning flare, even though overall S&P; 500 profit data for the period show a gain.
“Things have stopped getting better” in terms of earnings growth, says Bernstein. Not surprisingly, he is one of Wall Street’s better-known pessimists and has been for a while.
One danger now, he says, is that analysts’ numbers for third- and fourth-quarter growth are so high, they will encourage company managers to turn to accounting sleight of hand to try to beat those estimates.
There is historical precedent for that, Bernstein says. Every company, after all, would like to believe it can be a perpetual growth business, not subject to cyclical swings in earnings. To admit that you’re cyclical is to condemn your stock to a low valuation. Who needs that?
“As growth slows, companies start to finagle to show that their earnings aren’t cyclical,” Bernstein says.
Yet one money manager who pays close attention to earnings trends thinks it’s too early to worry about an epidemic of accounting chicanery.
Robert Olstein, manager of the Olstein Financial Alert stock mutual fund in Purchase, N.Y., believes that companies have dramatically improved their financial reporting since the Enron Corp. scandal and its fallout in 2002, in part because of stricter accounting rules.
The result, he says, is a much higher “quality” of earnings; in other words, what’s there tends to be real, not illusory.
Olstein hunts specifically for companies that are generating a lot of cash flow. And in aggregate, business cash flow has been tremendous the last two years, he says, as sales have picked up while companies have held the line on costs.
“Free cash flow is at the highest levels in the 38 years I’ve been in this business,” he says.
That has translated into record cash balances for the 376 industrial companies in the S&P; 500, according to Standard & Poor’s data. The cash hoard for those firms stood at nearly $634 billion on June 30, up from $352 billion at the end of 2001, S&P; said.
Strong balance sheets mean companies have greater financial flexibility, including to raise dividend payments to shareholders or buy back stock. Large cash holdings also can provide an inherent advantage for businesses, and thus for their investors, when economic growth begins to slow.
Olstein views the cash-flow data as so favorable, he figures the stock market as a whole is 4% to 5% undervalued at the moment.
But will other investors see things that way if, instead of the double-digit earnings growth analysts are predicting for many companies this quarter and next, the gains come in much weaker -- say, in the mid-single-digits?
Investors ought to be satisfied even with significantly slower profit growth, because any increase would be atop an already huge earnings base, Citigroup’s Wieting says.
The risk is that analysts may have set up themselves, and the market, for disappointment with the growth estimates they’re maintaining for the second half, he says.
“Earnings are great,” Wieting says. “Let’s not push for ridiculous.”
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Earnings growth: Too rosy a view?
The consensus view of Wall Street analysts is that earnings will be growing at a double-digit pace in the fourth quarter in six of the 10 major industry sectors in the Standard & Poor’s 500 index -- a forecast some market veterans say is too optimistic.
Estimated year-over-year change in operating earnings:
*--* Industry sector Q2 ’05 Q3 ’05 Q4 ’05 Q1 ’06 Basic materials +26% +4% +4% 0% Consumer discretionary* --1 +4 +10 +22 Consumer staples +6 +7 +9 +11 Energy +42 +38 +18 +22 Financial services +3 +25 +15 +1 Healthcare +10 +5 +8 +8 Industrials +20 +20 +21 +14 Technology +14 +11 +16 +18 Telecom +17 +4 +3 +11 Utilities +11 +16 +14 +9 S&P; 500 +12 +16 +14 +11
*--*
*Includes such industries as autos and hotels.
Source: Thomson Financial
Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit latimes.com/petruno.
