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By Jason Stipp and Robert Johnson, CFA | 10-24-2012 11:00 AM

Diagnosing the Earnings Malaise

Earnings disappointments so far have largely been tied to overseas--not U.S.--weakness, as well as sector-specific issues, says Morningstar's Bob Johnson.

Jason Stipp: I'm Jason Stipp for Morningstar.

Perceived disappointing earnings reports have given the market fits this week, but digging below the surface reveals some interesting trends.

Here to talk about what he sees when he looks at earnings reports is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: Very few people expected this to be a gangbusters earnings season. In fact the expectation was that it would be a poor earnings season, comparatively speaking. What were the expectations going into this season and what have we seen so far?

Johnson: The general consensus was 2% to 3% decline in S&P earnings, basically flat revenues, and then as we looked ahead, people thought this might be a little bit temporary and were looking for 9% to 10% growth into the fourth quarter.

Stipp: So we're just getting into earnings season now with a week and a half or so and a good number of reports. What are the trends so far, what have we seen and how has it compared to those expectations?

Johnson: In the 25% or so of the companies that have reported, it's very much in line. The earnings per share are down about 2.9%, and that's in that range of 2% to 3% that we talked about. It's probably a little bit more the mix of companies than anything else that have reported so far, but revenues are up about a 1%, and we said they would be flattish.

But on the front-end of the cycle, you usually see companies with more earnings growth. And one of the things that we've noted so far in the numbers--this is extremely interesting and very different than what we've seen in the past--is that almost two-thirds of all companies have missed the revenue estimate, but 55% have beaten when you get all the way down to the bottom EPS line.

Stipp: A lot of folks will look at those revenue misses and really become concerned, because revenue is revenue--earnings you can play around with and maybe make them look a little better in the short term.

What do you make of those revenue disappointments? Do you think that's a really bad sign for corporate health right now?

Johnson: I think a lot of people are reading it that way, but I think that's probably a mistake. I think a lot of what's happened on the revenue line deals with a lot of the foreign currency translation, with the dollar being stronger, and I think that has created a situation where an IBM is saying, well our revenues would have been $1 billion higher if it hadn't been for this. I think it is hard for everybody to guess exactly how those roll into a company's earnings; it makes it pretty difficult to do the forecast. They get pretty good in local currency, but once you start having to think about what's the mix in the [currency] translations, it becomes a little bit more difficult.

I think the reason earnings have been more along the lines of target is that as some of those sales are overseas, so are some of the costs. So those have come down, too, so you've really lessened some of that impact. And, of course, corporations have been extremely cautious as well. So you combine that all together, that's why I think you get this situation where earnings are beating and you're not doing quite as well on sales.

Stipp: Let's dig into the sector level, because we're seeing some interesting trends on sectors that are doing poorly compared to sectors that are doing a little bit better.

Tech seems to be one of the bigger disappointments. Now we're getting some more tech earnings this week from some of the big names. From what we've seen so far from last week, tech hasn't done so well.

Johnson: No. That's a group where maybe we've seen 10% declines in earnings year-over-year, and so that's a pretty dramatic set of numbers. It's IBM, it's Microsoft, a couple of the companies that reported last week were disappointing.

This week we're going to get Apple, and we've already got some of the other numbers like Facebook coming in that look a little bit above expectations, but going in through last Friday, we were down 10% on tech.

I think there are a lot of things happening there. We've talked many times about the new Microsoft Windows 8 coming out, and people not buying any laptops until that came out, and then we had expectations of a new iPad, and we've now finally gotten that, and the new iPhone, which impacted some of the quarterly numbers, but now they will look a little better again going forward.

So there were a lot of secular things that were happening there. Of course, when you have more use of iPads, too, on top of that, you're going to naturally hurt some of the suppliers of the plain PC market, and we've had bad numbers out of Intel, we've had bad numbers out of AMD, Marvell. So we've had a few bad numbers related to that whole syndrome of what's happening in that ecosystem. Some of it will clearly reverse here as those [product cycles] shift and uncertainties go away, but maybe not all of them.

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