Earnings Outlook May Be Cautious
Wall Street analysts have been underestimating profit growth for U.S. companies for two years, and the stock market’s bulls are hoping that streak isn’t about to end.
As second-quarter earnings season kicks off, companies in the blue-chip Standard & Poor’s 500 index are expected to post only modest year-over-year gains -- about 7.5% on average, according to Thomson First Call, which tracks analysts’ estimates.
But those same analysts also were projecting single-digit growth for the first quarter. The final number turned out to be nearly 14%, the seventh consecutive quarter of double-digit earnings gains.
“If history repeats, estimates for the S&P; 500 are way low again,” said Art Hogan, chief market analyst at brokerage Jefferies & Co. in Boston.
That could mean more pleasant surprises as companies roll out their results for the quarter ended June 30, which in turn could keep stock prices advancing, Hogan said.
On Monday, amid a broad market rally, the S&P; 500 index rose 7.58 points, or 0.6%, to 1,219.44 -- just under the 3 1/2 -year closing high it reached March 7.
The quarterly earnings derby always produces some bombs, and two already have gone off in Hollywood. On Monday, DreamWorks Animation SKG surprised investors by saying it would lose money in the second quarter. About two weeks ago, Pixar Animation Studios cut its second-quarter profit estimate, citing slow DVD sales.
Overall, however, the number of companies that have given advance warning about a shortfall in their results is down from the first quarter, according to Thomson.
As of Friday, 549 companies had said second-quarter earnings would be below expectations. At this point last quarter, 578 companies had warned about first-quarter results.
By contrast, 378 companies have said their results would meet or beat expectations this quarter, up slightly from the 374 that had said the same about first-quarter profit at this point in the last reporting season.
One reason for optimism about second-quarter profit growth is that consumer spending has remained strong in recent months despite record oil prices, said Tobias Levkovich, equity strategist at Citigroup Global Markets in New York.
“Retail sales data continue to show resiliency, which bodes well for corporate earnings” as consumer demand filters through the economy, he said.
In theory, analysts should be picking up on the economy’s strength and adjusting their earnings estimates accordingly. But as a group they’ve done a relatively poor job over the last two years of predicting profit growth.
At the start of the first quarter, for example, analysts expected S&P; 500 companies to post year-over-year growth of 7.6% in that period. When the results were all in, the actual increase was 13.9%, according to Thomson data. Those numbers reflect operating earnings, meaning results before what companies say are one-time gains or losses.
Among industry sectors in the S&P; 500, financial services companies’ earnings were expected to decline 1% in the first quarter from a year earlier. The actual change was a gain of 10%.
Profit in the healthcare sector was expected to be up 6% in the first quarter. It rose 12%.
Many experts say analysts purposely set their estimates low so that companies in effect have an easier time beating the numbers, thereby boosting the chances that their stocks will get a pop when results are announced.
But that wasn’t true in 2001 and 2002, when analysts were consistently too optimistic about earnings growth, Thomson data show.
Sam Stovall, chief investment strategist at Standard & Poor’s in New York, says many firms have become reluctant to provide the kind of earnings guidance they used to give analysts and investors. That stems in part from worries about running afoul of Regulation Fair Disclosure, a Securities and Exchange Commission rule that took effect in 2000 and requires companies to provide the same financial information to all investors at the same time, Stovall said.
“Companies figure, why give any guidance when you could be hit for not giving it to a wider group,” he said.
In the aftermath of the deep bear market of 2000-02, many executives also may be afraid of sounding too optimistic about their business, only to be proved wrong later, Stovall said.
Even if a large number of companies beat second-quarter estimates, there is no question that profit growth overall is slowing from the 20%-plus year-over-year gains in the first half of 2004.
What’s more, the energy sector is providing the biggest boost to earnings this year.
Second-quarter results for oil and gas companies in the S&P; 500 index are projected to rise 33% from a year ago, buoyed by record oil prices, Thomson data show.
Among other sectors, heavy-industry companies are expected to post 14% growth in the quarter. The average growth estimate for technology companies is 11%.
At the other end of the spectrum, financial services companies in the S&P; 500 are expected to show no growth from a year ago, but that in part reflects depressed results from mortgage finance giant Freddie Mac, said John Butters, an analyst at Thomson in Boston.
Companies in the so-called consumer discretionary industry sector, which includes auto makers, are expected to show a 3% average decline in earnings from a year ago.
Hogan, at brokerage Jefferies, said that even if overall S&P; earnings growth turned out to be 9% or 10% in the second quarter -- which would be the weakest gain since the second quarter of 2003 -- the important issue for investors was that many companies’ bottom lines still were improving instead of deteriorating.
Even modest growth in earnings should underpin stock prices at a time when long-term interest rates remain near historic lows and investors are finding a dearth of alternatives for their money, Hogan contends.
