Nearly 90% of the S&P 500 has reported fourth-quarter numbers and the results remain bullish. Since there are more than a handful of firms that will report late due to options related restatements, we are very close to the end of the reporting season. Median growth going in was expected at around 10%, but companies have been able to post nearly 13% instead, compared to the same quarter a year ago. Positive analyst surprises continue to outnumber negatives by over 3:1 and six out of 10 sectors are showing double-digit growth.
The Materials sector has the growth lead this quarter and is head and shoulders above Healthcare, the sector with the next highest year over year growth. In Materials, as with many sectors, the current growth rate is expected to drop sharply in the first-quarter. For Materials, growth in the first quarter is expected to be less than half what it was in the fourth, but that is still higher than any other sector. Large expected comparable decliners are Alcoa (NYSE:AA), International Paper (NYSE:IP), and Phelps Dodge (PD). Note that these companies all reported triple-digit growth last quarter and only IP is expected to achieve that same feat in the first.
Lagging firms this quarter are centered in the Utility and Telecom sectors. The median utility has posted flat fourth-quarter comps and is expected to recover slightly in the first quarter, to a 4% growth rate. Telecom is the only sector in the red this quarter, with negative comps of just over 3%. Energy, which was the leader in the first three quarters of 2006 is showing only barely positive year over year growth, but then again it has some very difficult comparisons it is working against.
Overall, the S&P 500 is expected to post first-quarter median growth of 8.2%. With a similar surprise ratio to that of the last couple of quarters, the growth could again make it into double-digits.
To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our “revisions ratio.” This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.
For fiscal 2007, the ratio has finally broken above equality and has stayed above the 1.0 level for a second week now. Over the last four weeks, there were 1,679 upward revisions and 1,446 downward, yielding a total revisions ratio of 1.16. This is a slight improvement from last week when the ratio stood at 1.04. For comparison however, the third quarter ratio was much higher, at approximately 1.5 with a similar number of S&P 500 companies reported.
Comparisons with prior quarters are not as telling however, since the years have rolled over and our FY1 revisions are now for 2007. In past quarters, a positive surprise translated directly into a current year (2006) upward revision. Currently however, a fourth-quarter report only effects 2007 revisions through forward guidance or other forward looking indicators—not directly through higher reported EPS numbers. Thus, the 2007 revisions we are seeing represent an analyst’s viewpoint on the true full-year estimates.
Given the collapse in oil prices so far this year, it is not surprising that the Energy sector is leading the revisions decline, with over three cuts for every increase. In fact, if the sector is stripped out, the overall ratio improves to 1.35. The ratio of firms up to firms down stands at 1.04, but excluding Energy it is at 1.16. Even in Energy, however, the revisions ratio has improved substantially over the last three weeks, up from an abysmal 0.12.
With the recent rebound in oil prices we would not be surprised to see the Energy sector improve in coming weeks. Four sectors currently enjoying more than twice as many upward revisions as estimate cuts. Interestingly they include both Cyclical sectors (Materials and Industrials) and defensive sectors (Health Care and Staples).
Looking ahead to 2008, the ratio looks a bit more positive at 1.32. As more and more 2008 initial estimates and revisions come in, this ratio becomes more telling. The total number of FY2 revisions over the last month was just over 1,500, up from approximately 1,000 recorded three weeks ago.
The pattern of sectors with positive (above 1.0) and negative (below 1.0) revisions ratios is quite similar for both 2007 and 2008. Health Care and Materials are near the top while Energy and Utilities lag behind.
On a full-year1 basis, median earnings growth for the S&P 500 is expected to remain healthy. On a total basis however, growth is expected to slump into the high single digits for 2007 and then rebound in 2008. Median growth for the current (2007) and next (2008) fiscal years is expected to be 11.8% and 12.3%, respectively, actually a slight acceleration from the 11.7% expected/posted for 2006. On a total earnings basis, the growth rates are expected to show a sharp deceleration from 15.0% in 2006 to 7.9% in 2007. A rebound is then expected to 10.6% in 2008. It is still very much in the early days with respect to 2008 expectations. Those growth rates are interesting to look at, but don’t rely on them too much at this point.
We would point to a couple of technical points which are affecting the expected growth rates. The rates are based on the forecasts of EPS and then multiplied by current shares outstanding to get total earnings. Recently firms have been pumping enormous, and unprecedented, sums into share repurchase. In the first half of 2006, over $216 billion was spent by S&P 500 firms to buy back their own stock. This shrinks the number of shares outstanding and boosts the EPS growth rate. Add in dividends paid out and over 80% of earnings were returned to shareholders rather than reinvested by the companies. In 2006, growth was restrained in many cases by companies starting to expense stock options.
While expensing of options provides a level of earnings that is much closer to economic reality than not expensing them, doing so in the numerator (2006) and not in the denominator (2005) depresses the growth rate. For 2007, all firms should be on an apples-to-apples basis.
Unlike the growth rates in our Earnings Scorecard, the numbers in the table below represent the expected growth for all of a sector’s firms. Below, we now give a glimpse of 2008 expectations. On a median basis, earnings growth is expected to slow for Materials and improve slightly for Energy as both sectors enter 2008. On a total earnings basis, 2008 growth for these commodity based sectors is expected to be in the low single digits.
On a median basis, Telecom is expected to have a slight acceleration in earnings growth for 2007, but a significant deceleration on a total earnings basis. Mergers played a very significant role in the high total earnings growth for the sector in 2006. Consumer Discretionary is expected to have the highest acceleration in 2008 on a total earnings basis. Tech is expected to be the fastest grower in 2008 on both a median and total earnings basis.
Dirk van Dijk is Director of Research for Zacks Equity Research.