With over 95% of the S&P 500 reported, fourth-quarter earnings season is effectively complete. Over the next several weeks many of the remaining companies should report, a portion of which have been held up due to options related restatements. Going in this season, median fourth-quarter growth was expected at around 10%. Companies, however, were able to post nearly 13% instead, compared to the same quarter a year ago. Positive analyst surprises have outnumbered negatives by nearly 3:1 and six out of 10 sectors were able to post double digit growth.
The Materials sector was the growth leader during the fourth quarter and remains head and shoulders above the Industrial sector, which posted 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 during the fourth quarter were 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 5.5% growth rate. Telecom is the only sector in the red this quarter, with negative comps of over 10%. Energy, which was the leader in the first three quarters of 2006 is showing only slight year-over-year growth, but then again it has some very difficult post-hurricane comparables.
Looking ahead, the S&P 500 is expected to post first-quarter median growth of 8.3%. With a similar surprise ratio to that of the last couple of quarters, the growth could again make it into double digits.
The Zacks “Revisions Ratio”
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 recently broken above equality, 1.0, and has stayed above this level for a third week now. Over the last four weeks, there were 1,244 upward revisions and 1,135 downward, yielding a total revisions ratio of 1.10. This is down slightly from last weeks 1.16. For comparison, the third-quarter ratio was much higher, at approximately 1.4 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 earlier this year, it is not surprising that the Energy sector is leading the revisions decline, with over two cuts for every increase. In fact, if the sector is stripped out, the overall ratio improves to 1.25. The ratio of firms up to firms down stands at 1.1, but excluding Energy it is at 1.19. Even in Energy, however, the revisions ratio has improved substantially over the last month, 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. Three sectors currently enjoy more than twice as many upward revisions as estimate cuts: Industrials, Health Care and Consumer Staples.
Looking ahead to 2008, the ratio looks a bit more positive at 1.26. 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 1,200, up from approximately 1,000 recorded four 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. Industrials and Consumer Staples are near the top while Energy and Utilities lag behind.
On a full-year* 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 11.4% and 12.3%, respectively. On a total earnings basis, the growth rates are expected to show a sharp deceleration from 14.7% in 2006 to 7.7% in 2007. A rebound is then expected to 10.8% 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 be flat for Materials and improve significantly 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 show a slight drop in earnings growth for 2007, but a significant downturn in growth 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.
Market Cap versus Total Earnings
When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.
The chart below shows the share of total earnings for 2006, 2007 and 2008, as well as the share of total market capitalization for each sector (the final bar shown). Since the S&P 500 is a market cap weighted index, this is the same as its index weight. On the chart below, the difference between the sizes of the first three bars shows if a sector is gaining or losing “earnings share”. The difference between the final bar and the first three bars shows if the sector is selling for an above or below market P/E. If the final bar is smaller than the other bars, the sector is selling for a below market P/E. However, as opposed to just showing the sector P/Es, it also shows the relative importance of the sectors to the overall index.
Clearly the Financials are the biggest influence on the market, with a weight of 21.1%. However, that sector is also relatively cheap on an earnings basis, and thus serves to hold the overall P/E of the index down. In other words, Financials deserve to be the biggest influence on the market, since they contribute 26.5% of the total expected earnings for 2007.
Energy looks to be under represented in its influence on the market since it is expected to provide 13.5% of the total earnings for 2007, but represents only 9.4% of the total market capitalization of the index. While its earnings share is currently expected to decline to 12.5% in 2008, even on this basis it is still much cheaper than the overall market.
In more conventional terms, the Energy sector is trading for 10.6x 2007 and 10.3x 2008 earnings. The S&P is trading for 15.2x and 13.7x, respectively. The second chart below shows the sector P/Es ranked from lowest to highest based on estimated 2007 P/E ratios.
* We follow the convention of referring to the most recently completed full fiscal year as “2006”, and the next full fiscal year to be reported as “2007”.
Dirk van Dijk is Director of Research for Zacks Equity Research. Matt Thurmond contributed significantly to this report.