Expect Further Earnings Upside as the Recovery Unfolds

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 |  Includes: CAT, INTC, SPY
by: Elliott Gue

Second quarter earnings season is winding to a close. After listening to dozens of conference calls and reading scores of press releases, it’s time to reflect.

By and large, earnings releases were better than most analysts expected heading into July. Roughly 77 percent of S&P 500 companies beat consensus earnings forecasts for the second quarter by an average margin of 11 percent.

This suggests that the earnings revisions cycle has finally bottomed for most sectors. The revision cycle is straightforward: In the early stages of an economic (and profit) recession, analysts tend to hold their estimates too high; companies routinely disappoint as they simply can’t meet still-lofty expectations in the face of economic headwinds.

Because big companies try to manage expectations so they’re able to beat estimates, the majority of S&P 500 firms still show positive surprises in any given quarter. But looking back to the second quarter of 2008, only around 68 percent of S&P 500 firms exceeded estimates, and the average beat was just under 1.9 percent. These are historically low numbers, certainly a far cry from the results I just noted for this quarter.

Analysts still hadn’t lowered their estimates enough to reflect deteriorating conditions a year ago. Recall that last summer there were still a good number of economists on the Street projecting the US would skirt a recession, despite the fact we know (in hindsight) the country entered recession at the end of 2007. Analysts just weren’t yet in tune with reality.

At some point in every cycle, however, analysts finally react to economic conditions and slash estimates aggressively. In this cycle, the big downward push in estimates kicked off last fall.

This brings us to the final part of the revision cycle. Just as analysts tend to hold estimates too high at the beginning of a profit down-cycle, they tend overshoot to the downside near the end of the contraction. That inflection point occurred this quarter; this is why an unusually large number of S&P 500 firms beat estimates by a historically wide margins.

Check out the chart below of earnings estimates for Caterpillar (NYSE:CAT) for a closer look at how the revision cycle looks on paper.

Source: Bloomberg

This chart depicts Caterpillar’s projected 2009 earnings from late January through the middle of August. As you can see, Caterpillar’s earnings estimates were slashed from around $2.50 per share at the end of January to as low as $1.15 per share just before the current earnings season.

But after the company reported it became clear that analysts were too bearish on its prospects; Caterpillar’s estimates have soared lately.

For an even more pronounced example, check out the history of earnings estimates for Intel (NASDAQ:INTC) over a similar time period.

Source: Bloomberg

Earnings estimates for chipmaker Intel also plummeted early in 2009 and scraped along a bottom for a few months early in the year. But since late April expectations have been rising.

In other words, Intel’s revision cycle appears to have bottomed out sooner than for Caterpillar, and the recovery has been quicker. This has been a common phenomenon with a number of technology stocks I follow in Personal Finance.

This revision cycle is certainly one reason that technology has been a leadership group this year, holding up better than the broader market early in the year and rallying faster after the March low.

At this point you might be wondering why this all matters. The simple answer is that rising earnings estimates tend to drive stock prices higher. The bottoming of the revision cycle will be a key upside catalyst for the broader averages through the end of the year.

Two additional points have been widely discussed in the financial media concerning second quarter earning season.

First, although most stocks beat estimates, only one sector showed positive year-over-year earnings growth, health care. Some with a bearish bent have used this as an indicator that the current rally is doomed to fail.

But that argument doesn’t hold water. It’s obvious that at the bottom of a profit recession earnings are going to be lower for most sectors on a year-over-year basis; this is the definition of a profit recession. The real issue is what’s changing on the margin; this is where a positive earnings revision cycle fits in.

A second point you’ll hear is that although companies beat earnings estimates, these beats were primarily due to aggressive cost-cutting rather than actual revenue (sales) growth. In other words, companies are boosting their profit margins by cutting costs, and there is, as of yet, no sign that final demand is picking up.

It’s clear that if the recovery is to be sustainable we need to see actual revenue growth, not just further cost-cutting. In fact, many companies have probably already picked the low-hanging fruit when it comes to cutting costs; it would be difficult for most firms to continue generating big earnings upside from falling costs alone.

I suspect we’ll begin to see signs of final demand improving over the next two quarters as the economy exits recession. And it’s not at all unusual to see companies cutting costs at the bottom of a profit cycle.

Better still, there’s an extremely important bright side to this cost cutting: US corporations are looking very lean right now. As actual final demand and sales growth emerge, much of that growth will drop straight to the bottom line.

US corporations have a great deal of earnings leverage to any recovery in final demand and should be able to post some truly impressive year-over-year growth numbers as we head into the latter months of 2009.

Because cost structures are so lean, US companies will likely see significant earnings upside as an economic recovery unfolds. Even if I’m correct and the coming recovery is rather insipid by historical perspective, there could be significant upside to corporate profitability.