Cost-cutting alone cannot sustain growth in earnings

As US earnings season begins, analysts are reining in estimates amid revenue concerns

ALUMINIUM GIANT Alcoa kicked off US earnings season last Thursday, beating estimates and cheering analysts. A mere handful of companies have reported thus far, however, with earnings season about to get properly under way in the following weeks.

Forty-three companies report this week. Another 385 report the following week, with 757 results expected during the last week of October.

Heady growth is expected, especially for technology companies, which are expected to contribute approximately 30 per cent of SP 500 earnings. Analysts predict technology earnings of $37.5 billion (€26.8 billion), the second-highest amount ever earned by the sector. Revenue growth is estimated to be a whopping 2.5 times that of the overall market. Global growth, especially in Asia, where technology companies have a firmer footprint, is driving these revenues.

Indeed, given the dollar’s relentless slide of late, US companies with significant international exposure should deliver the goods this quarter. The market certainly expects them to. Companies that derive more than 50 per cent of their revenues from outside the US have appreciated by almost 14 per cent since the dollar began its descent in early June whereas companies that generate all of their revenues in the US have risen by 8 per cent.

Overall earnings growth has been extremely strong this year. Second-quarter earnings were 38 per cent higher than the previous year while the coming quarter is expected to see a rise of 24 per cent compared to a year ago. Almost 80 per cent of SP 500 companies exceeded analyst expectations in the last quarter, way above the historical average (slightly less than two-thirds of companies typically beat estimates).

However, it’s not all sunshine. The US market as a whole, as opposed to the large-cap SP 500 index, enjoyed a beat rate of 66 per cent. That’s lower than the figure recorded in three of the previous four quarters.

Analysts, too, have been reining in estimates of late. Combined EPS estimates for SP 500 companies in 2011 fell to $95.17 last month, according to Bloomberg data that examined over 8,500 forecasts. That’s only slightly below August’s estimate ($96.16) but it does mark the first quarterly fall since June 2009. Bloomberg also notes that analysts have cut profit estimates in 20 of the world’s 24 developed markets last month, reflecting increased economic anxieties.

Negative earnings pre-announcements by companies are also on the increase and are 2.3 times higher than positive pre-announcements. That ratio is not too much higher than the historical norm but it is a noticeable increase on previous quarters.

Despite the increased caution, record earnings are still predicted for 2011, with a 15 per cent rise being forecast. Far from hitting $95, Gluskin Sheff’s David Rosenberg reckons that combined SP 500 EPS will be closer to $75 next year. The famously bearish Rosenberg has long been one of the most pessimistic of analysts but he’s not alone in seeing the $95 target as unrealistic. Strategists that focus on macroeconomic trends, as opposed to “bottoms-up” analysts that focus on individual companies, have an average 2011 estimate of just $87.

The main concern is revenues. While earnings growth of 24 per cent is expected this quarter, that’s almost entirely due to cost-cutting – revenues are expected to rise by just 7 per cent. Profit margins are just 1 per cent off their 2006 high but revenues, having risen by just 6.5 per cent from last year’s bottom, are more than 15 per cent off 2006 levels. Cost-cutting alone cannot sustain continued double-digit earnings growth.

Companies, meanwhile, continue to be cautious and hoard cash. Dividend payout ratios average 30 per cent, way off the historical average of 50 per cent.

The other primary concern is that markets are vulnerable to sell-off. Bespoke Investment Group notes that 70 per cent of SP 500 stocks are technically overbought – that is, they are trading more than one standard deviation above their 50-day moving average. Eighty-eight per cent of stocks are trading above their 50-day average while last month’s 9 per cent jump was the index’s largest September rise since 1939. This strong advance marks the seventh successive quarter that stocks have charged higher ahead of earnings season, with temporary sell-offs typically ensuing – the classic “buy the rumour, sell the news” reaction.

Bulls counter that valuations remain reasonable. Forward estimates indicate that equities trade at a lower valuation multiple than at any time since 1988, excluding the post-Lehman collapse. Bears cite the unreliability of these estimates, arguing that valuations are stretched if one examines long-term valuation measures that smooth out yearly earnings fluctuations over time.

As for the coming quarter, a relatively high beat rate is presumed. Will it be accompanied by continued lacklustre revenues? Will weak guidance or poor visibility lead to further cuts in analyst estimates or can companies deliver for the bulls? They’re the questions likely to be focused on by investors.