Profit Boom Could Be a Bit Muffled

Times Staff Writer

The nation's biggest companies will report a sharp slowdown in earnings growth for the second quarter, according to Wall Street estimates, perhaps ending a long string of double-digit gains.

The overall year-over-year profit increase for companies in the Standard & Poor's 500 index is projected to be 9.1% in the quarter ended Friday, according to Standard & Poor's in New York. That compares with the 15.3% rise that S&P; companies booked in the first quarter.

But analysts' profit estimates generally have been too conservative in recent years, raising the prospect that shareholders will be pleasantly surprised as earnings reports roll in during the next few weeks.

The stock market, battered by a spring sell-off driven by interest rate worries, could use any help that better-than-expected financial results provide.

If S&P;'s number is on target, it would mark the first time in at least three years that blue-chip companies' overall profit grew at less than a double-digit percentage rate.

"This is a dip in growth," said Howard Silverblatt, senior index analyst at S&P.; "The major reason is consumer spending."

The economy is expected to have slowed significantly in the second quarter from the first because consumers spent less freely on homes, cars and other goods and services. In June, passenger vehicle sales fell 10.5% from a year earlier, for example.

Analysts with Wall Street brokerages have a more optimistic view of corporate earnings in the second quarter than their counterparts at S&P;, according to Thomson Financial in Boston. On average, the analysts polled by Thomson peg S&P; 500 profit growth at 12.3% for the second quarter -- which would still be a slowdown from the first period.

Both S&P; and Thomson estimates are for operating earnings, which exclude one-time gains or losses.

Some experts say earnings estimates are following a familiar pattern. Analysts have consistently been too pessimistic about profit growth in recent years, and big-name companies on average have easily beaten estimates each quarter.

Dirk Van Dijk, research director at Zacks Investment Research in Chicago, thinks analysts again are playing catch-up: In the last month, there have been 648 increases in 2006 earnings estimates for S&P; 500 companies, compared with 520 cuts.

If profit growth were headed for a steep falloff, he said, "the cracks in the ice would first show up in the estimate revisions."

Earnings provide the basic underpinning for stock prices, because long-term investors buy stocks for their growth potential. When earnings growth began to soar in 2003, so did Wall Street's current bull market.

The profit boom has been powered by the global economic expansion, continued gains in worker productivity and penny-pinching by corporate managers.

Over the last year, two other factors have been helping the bottom line, S&P;'s Silverblatt said. One is a surge in stock buybacks. Laden with cash, many blue-chip companies have been using some of their stash to purchase their own shares in the market. By reducing the number of shares outstanding, companies can boost per-share earnings growth (because whatever they earn is spread over fewer shares).

S&P; 500 companies spent $100 billion on stock buybacks in the first quarter, up from $82 billion in the first quarter of 2005, Silverblatt estimated. And more than half of S&P; 500 companies reduced their shares outstanding in the January-through-March period, he said.

Many companies also are earning more interest on their cash, the result of the Federal Reserve boosting short-term interest rates over the last two years, Silverblatt said. He estimates that interest income for nonfinancial companies in the S&P; 500 will jump more than 60% this year, after a 38% increase last year.

The problem with earnings growth that stems from share buybacks or interest income is that neither reflects how a company's underlying business is faring, analysts note.

Some industries don't need help from buybacks or interest earnings.

Energy companies, for example, continue to roll out spectacular results as crude oil prices hover around $70 a barrel, defying expectations of a decline. Oil and natural gas companies in the S&P; 500 are expected to post a 26% increase in second-quarter operating earnings, S&P; says.

Many producers of industrial goods also are expected to shine in the second quarter, buoyed by continued strong capital spending by businesses worldwide.

S&P; 500 industrial companies should record an overall earnings gain of 10.6% in the quarter, S&P; estimates. Among the firms in that sector is Rockwell Automation Inc., which produces factory equipment. The Milwaukee-based company is expected to earn 81 cents a share in the second period, up 19% from a year earlier.

By contrast, growth is expected to be lackluster in many consumer-related industries, as rising interest rates and high energy prices curb spending.

Operating earnings in the so-called consumer-discretionary sector, which includes carmakers, home builders and many large retailers, are estimated to have risen 5.6% overall last quarter, S&P; said.

For the home builders, analysts continue to slash earnings estimates for 2006 and 2007, Van Dijk said. "The estimate revisions there have been horrendous," he said, as rising mortgage rates damp expectations for home sales.

Many healthcare companies also are struggling to substantially boost profits, analysts say. "There is too much competition, too much government and too many lawyers in the sector," said Edward Yardeni, investment strategist with Oak Associates in Akron, Ohio.

Drug giant Merck & Co. is expected to earn 65 cents a share from operations in the second quarter, up 5% from a year earlier, according to Zacks Investment Research.

The technology sector has been a particular disappointment to many investors. Median earnings growth for tech companies in the S&P; 500 is expected to be 6.2% in the second quarter, Van Dijk said. That would sharply trail results for the industrial sector, basic-materials providers (such as mining firms and steelmakers) and other groups whose fortunes are tied to the economy's swings.

Although some tech companies are beneficiaries of strong capital spending, the group's image has been hurt by the growing probe into the companies' stock-option practices. One focus of investigators is whether companies manipulated option grants to their executives in the hope of securing bigger capital gains for the recipients, for example, by backdating grants to days when the company's stock price was at a near-term low.

As a group, tech stocks in the S&P; 500 are the worst-performing sector year to date, down 5% on average.

Overall, the performances turned in by S&P; 500 stock sectors this year are tracking earnings expectations. Energy stocks in the S&P; are on top, up 14% year to date. Consumer stocks trail industrial and basic-materials issues.

The S&P; 500 index itself is up 2.6% this year. Whether that performance improves may depend on whether companies can continue their streak of topping Wall Street's earnings expectations -- and on what their second-quarter reports say about the rest of the year.



2006 stock performance, by sector

Of the 10 major industry sectors within the Standard & Poor's 500 stock index, eight are positive so far this year, led by energy. Technology is the worst performer, down 5%.

S&P; 500 stock sector: Year-to-date change

Energy: +14.2%

Telecom: +12.1%

Basic materials: +7.2%

Industrials: +6.6%

Consumer staples: +3.8%

Utilities: +3.6%

Financial services: +3.0%

Consumer discretionary: +2.0%

Healthcare: -4.3%

Technology: -5.0%

S&P; 500: +2.6%

Source: Bloomberg News

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