With second quarter earnings season now essentially in the books, the first half of 2010 is in the rearview mirror and investors’ attention can now turn to the remainder of the year. Before we focus on what lies ahead for the second half, though, it helps to first review and analyze the recent earnings results and guidance. There are a few conclusions or observations that can be drawn. First, most companies once again had little trouble exceeding the Street’s earnings expectations. Take a look at the degree of these beats from some of the world’s largest corporations: Intel (Nasdaq: INTC) beat by $0.08, its largest beat since 1Q09; Apple (Nasdaq: AAPL) beat by $0.40 (not unusual for AAPL); JP Morgan (NYSE: JPM) beat by $0.39, its largest beat in more than two years; Caterpillar (NYSE: CAT) beat by $0.24; Exxon Mobil (NYSE: XOM) beat by $0.14, its largest beat since 3Q08; and Pfizer (NYSE: PFE) beat by $0.10, its largest beat in more than two years. In other words, the beats were unusually wide, and they were across all sectors. Guidance was nearly as upbeat, as the only piece of downside guidance was Apple’s below consensus Q3 EPS expectation, but that company is known to “sandbag” its guidance – meaning, it sets the bar very low for it to hurdle. So, what does this tell us? On the surface, this certainly looks bullish going forward. However, this is an incomplete picture. Ultimately, stock appreciation comes down to earnings growth, not whether a company can beat analysts’ projections. And, as we discuss below, the outlook isn’t quite as rosy using this measuring stick.
Mixed Sales Suggesting Softening Demand
By now, it’s widely understood that companies have leveraged their profitability through restructuring programs and workforce reductions. Operational efficiency has been taken to a new level, which of course, is shareholder friendly. But, this can only take a company so far. At some point, demand for products or services has to be the fuel that drives the bottom line. Unfortunately, there were some major top line hiccups in second quarter results that raise further doubts about the sustainability of earnings growth. Most notably, IBM’s (NYSE: IBM) revenue only grew 2% and came up short of expectations. More alarming was the fact that signed service contracts dipped 12%, which is an indication of softening demand. Other widely followed, influential companies to disappoint on sales include Texas Instruments (NYSE: TXN), Yahoo (Nasdaq: YHOO), Research in Motion (Nasdaq: RIMM), and Johnson and Johnson (NYSE:JNJ). An interesting point here is that in the prior two or three quarters, beating the revenue estimates was not a problem for a vast majority of companies.
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Comparisons Getting Tougher; Stimulus Running Dry
In the bulls versus bears battle, one of the bulls primary arguments for higher stock prices is that “earnings growth has been phenomenal.” By and large, this is true. But, the bears’ counter to this point is, “so what.” It’s not too difficult to show strong growth when a company is coming out of recessionary low levels. Furthermore, the economy has been pumped up with stimulus money, and exceeding low interest rates. There is no appetite in Washington to bring more stimulus packages to the table. With these factors in mind, will companies’ growth rates take a dip in the second half? Well, Microsoft (Nasdaq: MSFT), for instance, saw its December quarter EPS grow 57% this past year, but is expected to decline 7% this year. Another example is Wal-Mart (NYSE: WMT), which saw its October quarter EPS grow 10% in 2009, but is expected to grow at 8% for this year’s October quarter.
Slower Growth May Not Be A Bad Thing
Given that the earnings growth achieved over the past year has mostly been a function of cost-cutting measures and, perhaps some “artificial demand” from stimulus programs, maybe it’s not such a bad thing that earnings growth will cool. The economy doesn’t need more layoffs, and many feel that growing the federal balance sheet even more is a disastrous idea. Investors shouldn’t be taken off-guard by slower growth rates in the second half, and this may already be largely priced into stock valuations. So, our advice is, temper your growth expectations, and use our free trading reports to make strategic moves that will optimize your returns.
Contributing to this article was Dennis Hobein.
Disclosure: no conflicts to report.