2009's Absurd Earnings Expectations

by: R. J. Rhodes

Some people think that earnings have become irrelevant. And looking at individual companies irrelevant as well. To be sure, while I don't believe that is true, for the time being it is de facto the case. Investors are not going to care about earnings or capitalize companies appropriately until the macro problems are well in hand. And every day that goes by offers new evidence that Governments, for now at least, still have little control over the debt crisis. Even those in Government that implicitly realize this and understand the magnitude of the global meltdown do not have the means to stop the destruction. Thus, the markets are doing what Governments cannot do - systematically wiping out debt by forcing debtors to sell assets or if unable to do so, walk away.

So, before we can declare the beginning of the end...not the end, but the beginning of the end - of this bear market, several things have to happen:

  1. Debt needs to be reduced for all segments of the economy until it is in line with incomes and asset values. We are a long way from that happening.
  2. Housing inventory needs to be run off so that natural demographic demand forces come into play
  3. A risk taking mentality and trust of the capitalistic system must be restored. Right now, risk cannot be assumed b/c investors have no idea what the rules of the game are going to be.

These are things which we can understand at some depth (in my case, a pretty superficial understanding). The complexities are intimidating. Indeed, if it were simple, Geithner & Bernanke would have pushed the magic button by now.

So back to something at the kindergarten level I can understand: earnings. Investors still pay a lot of attention to earnings per share, and talk about P/E ratios, even though the concept of earnings has been tarnished by various dubious concepts, the most obvious of which is "pro forma" earnings, used predominately in Silicon Valley. That said, I still track "operating earnings" despite some hypocrisy inherent in the numbers. Primarily this is because it is difficult without making a lot of arbitrary assumptions to assign the write offs that reduce operating earnings to an appropriate accounting period.

If a company writes off a bad investment, ideally that ought to be spread out over all the accounting periods in which the investment was held, since it may have been bad for its entire life. On the other hand, maybe it was a good investment for a while, but a sudden event made its continued cash production suspect, so that is recognized in the current period. In the first instance, we do not have the information at hand to apportion the bad investment over its unuseful life. In the second, it is sudden, but the write off arguably has nothing to do with the core operating results of the rest of the company. So "operating earnings" is an imperfect device, but has merit in gauging underlying progress. I would balance it out by looking at production of cash over a full cycle, growth of book value, return on capital vs. cost of capital and other checks of true value creation.

With that intro, let's take a look at the continued shocking failure of the sell side to even make an attempt at recognizing erosion of current earning power even when bombarded daily with brutal evidence. With earnings season about 7/8 over, the gap between bottoms up and top down estimates for 2009 stands at an astonishing 29%, well above the typical spread at this time in the calendar. [Note: data per Standard & Poor's Corp.] Therefore, lots of estimates still have to come down significantly. Whether stocks react is another question: Surely investors must have great suspicion, if not total derision, toward Street earnings numbers, so maybe it is a non-event. If so, then we ought to stop even discussing P/E multiples for either individual companies or the index on a forward basis, because the data is totally meaningless. Here is my checklist of why earnings estimates are still in Dreamland.

12 Reasons why Street earnings forecasts for 2009 are grossly inflated:

1. The math of comps: Many companies actually had pretty good results for the first 3 quarters of 2008. In the quarterly spreadsheets I track, earnings quality was eroding, margin pressures were starting to creep in, and operating leverage was declining markedly, but at the earnings per share line, a majority of firms were still doing OK in terms of growth. The inflection point for non-financial firms was Q4, when the wheels came off (except for select healthcare and consumer names). But here in 2009, we will have not just one weak quarter, but at least 3 and maybe all four. In 2008, the H-1 quarterly run rate for the S&P 500 was 17, dipping to 16 in Q3 which is only slightly less than normal seasonality. In 2009, I could envision a sequence like 9, 10, 11, 15 adding to 46 for the year. To think we are going to lift off the Q4-08 level and get back to more "normal" earnings is fantasy. Yet the bottoms up sequence the Street has for this year is ~ 14, 16, 18, 18.5 for a total of 67.55 as of last week.

And this is wrong because:

2. FX. The strain of currency translation was modest until Q4-08, when it became a big number for multinationals. Some who have given guidance for '09 are dialing in a big drag - e. g. like 8 percentage points on the earnings per share line. The long term concept on the U. S. dollar is for major weakness. But that does not seem to be in the cards any time soon. Foreign economies are imploding fast and their currencies are falling faster than the dollar. There is even speculation the Euro may not survive.

3. Pricing is getting worse and there is massive over capacity everywhere. Couple this with the need to liquidate debt and pricing power is going to continue to be non existent. Margins generally just started to weaken in H-2 of last year...this is not a 2 or 3 quarter process, it will take a lot longer to reverse.

4. Oil is down and likely to stay down all year. Ditto natural gas. This is backing up into most aspects of oil service leading to excess capacity after a period of very tight markets. Yet energy sector profits did not really hit the wall until Q4-08, so again, the issue of 3 tough comps immediately ahead. Oil looks like it continues to make a stand at the ~ $35/bbl level, repeatedly, so perhaps this is where all the forces of supply/demand and marginal costs of production are coming together. We know that many oil projects need $40 or even 60 or 70 dollar oil to be economic, so seeing a floor in the mid 30's kind of makes intuitive sense. And CAPX is being slashed on nat gas drilling which will eventually lead to lower production and price recovery in gas.

5. Banks. Credit has not bottomed. Losses will possibly match 2008 or even worse. And the news out of European banks (not in the S&P 500, but will spill over to our markets) is even more dire.

6. Employment is not going to improve in 2009, and that drives consumer spending.

7. Deleveraging will occupy many companies, not growth. Bankruptcies will hit gigantic levels. It is impossible to grow when you are downsizing.

8. For consumers, the mentality is going to be saving/hoarding, not spending.

9. Housing still has downside in terms of price and inventory liquidation.

10. Foreign economies as noted are sick and going to get sicker. Overseas earnings are ~ 40% of total S&P 500 profits.

11. The stimulus bill is going to prove to be minimal in its impact on revenue and jobs in 2009.

12. There is a replacement cycle out there for a lot of "stuff". But not yet. Not even close. Critical items will be replaced, but everything else is going to be repaired or deferred.

I close with the following table of data showing end of Nov. expectations and current. Note that even with overwhelming real time evidence of demand falling off a cliff, the Street with one month to go printed numbers for Q4 that are going to be off the mark by almost 70%! Talk about letting the blind lead........truthfully, a blind analyst who had a working brain could produce better estimates than this!

As discussed above, I think the right number for '09 is one beginning with "4". So the top down guys are in the ballpark. I am going to stick w/ my wild guess of 46 for now. At the company level, I would advise being very wary of any back end loaded forecast, unless you have solid evidence that specific events will happen. For example, maybe the company has a military contract that is going to start shipping in high volume at a certain date, or some such activity that you are really sure of and can corroborate with management.

Disclosure: no positions