Monday, October 23, 2006

So Far, So Good for Earnings

News Analysis
October 23, 2006

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So Far, So Good for Earnings

Despite slowdown worries, analysts expect S&P 500 companies to post their 18th straight quarter of double-digit earnings growth

Wall Street is enjoying another solid batch of corporate profits as the third-quarter earnings season nears its midpoint. As of Oct. 20 the Standard & Poor's 500 index was on track to post its 18th consecutive quarter of double-digit earnings growth. Companies in the index are projected to post an average year-over-year earnings gain of 13.4%, and that figure could go even higher, according to S&P.

A little more than a third of the S&P 500 companies have reported results so far, and 73% of them show quarterly earnings that topped analyst estimates. Financial and energy companies should account for 43% of earnings, S&P projects, though the sectors represent just 31% of the market. Consumer discretionary companies are posting solid gains over last year's soft second half, while information technology lags despite positive surprises from Wall Street darlings Apple (AAPL) and Google (GOOG).

It's no coincidence that stocks have continued climbing in recent weeks amid the upbeat earnings picture. On Oct. 19 the Dow Jones industrial average topped 12,000 and closed at an all-time high of 12,011.81, then retreated the next day (see, 10/19/06, "Dow Marks First Close Above 12,000"). The broader S&P 500 also touched multiyear highs during the week before finishing at 1,368.6 on Oct. 20.

Bears Kept at Bay

Investors will be watching in the week ahead for earnings reports from energy giants Exxon Mobil (XOM) and Chevron (CVX), among others. Meanwhile, profit growth is widely expected to decline in the fourth quarter and into 2007 alongside a cooling U.S. economy. For the current quarter, though, analysts expect investors to keep dodging profit slowdown worries.

"There've been a lot of dire forecasts about declining earnings growth, but it just hasn't happened," says Brian Gendreau, investment strategist at ING Investment Management. "Maybe people are finally realizing this is for real."

Financial companies were on track for a 13.1% year-over-year gain in earnings, according to S&P, despite worries about interest rates and the slowing housing market. Shares of Merrill Lynch (MER) reached a 52-week high on Oct. 17 as the brokerage said its third-quarter profit more than doubled. Bank of America (BAC), JPMorgan (JPM), and Morgan Stanley (MS) also beat expectations, offsetting a shortfall by Goldman Sachs (GS). Citigroup's (C) better-than-expected earnings came on disappointing revenues.

Some of the earnings growth for consumer discretionary stocks follows weakness in 2005 in the aftermath of Hurricane Katrina. Motorcycle maker Harley Davidson (HOG) and fast-food chain giant Yum! Brands (YUM) were among companies impressing the Street this earnings season (see, 10/13/06, "Yum! Growth with Global Flavor"). McDonald's (MCD) posted a 15% earnings increase on Oct. 19 but declined on the session as the results were in line with a pre-announcement a week earlier.

Housing Effects

Despite recent declines in oil prices, the energy sector's upcoming earnings reports could be solid as well. Oil prices fell from $73.94 to $62.91 during the quarter, but in between they reached an all-time peak of $74.80. "While the net may not be a record, it's feasible that the sales will be," says Howard Silverblatt, S&P's senior index analyst.

The basic materials sector may not be able to dodge the fallout from falling commodity prices. Aluminum producer Alcoa (AA) kicked off earnings season with softer-than-expected results, attributed to weak demand from automakers and homebuilders.

The softening housing market could continue to loom large in the quarters ahead as well. On Oct. 20 shares of Caterpillar (CAT) tumbled after the heavy-equipment maker and Dow component reported lackluster earnings and lowered its forecasts through 2008 (see, 10/20/06, "Slower Housing Puts a Dent in Caterpillar").

"Anything that seems to touch housing has been disappointing," says David Chalupnik, head of equities at U.S. Bancorp Asset Management and First American Funds. "That's been the weak spot. Everything else seems to be pretty much on target or better."

Will Tech's Time Come Again?

Information technology is the one sector expected to post lower year-over-year earnings, according to S&P. True, the likes of Apple, IBM (IBM), and Intel (INTC) trumped estimates, but Advanced Micro Devices (AMD), EMC (EMC), and Yahoo! (YHOO) all disappointed the Street (see, 10/19/06, "Apple's Big Mac"). The sector's earnings are expected to recover next year, which will send its 2007 price-to-earnings ratio below 19, notes S&P's Silverblatt. "Is it value or the realization that high-cap technology is no longer a growth industry?" he asks.

Earnings leadership will continue to rotate away from basic materials and energy in coming quarters, others say. "If commodities continue to stay at these prices or lower, the comparisons for the first and second quarter are going to be murderous for these companies," says Ashwani Kaul, chief market strategist at Reuters Estimates. "Look for financials to really step up."

In the meantime, investors still have plenty of third-quarter results to assess. Among companies set to report this week are Ford (F), AT&T (T), General Motors (GM), and Microsoft (MSFT), along with the previously mentioned energy heavyweights. While the current quarter is unlikely to mark the end of the recent profit parade, earnings season may still give the Street a few surprises.

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