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Caution Signs in Third-Quarter Earnings

Earnings season pointed to a growing economy, but a few red flags were raised. 

Jeremy Glaser, 11/16/2011

Third-quarter earnings season has come and gone with a whimper and not a bang. Earnings reports were almost universally overshadowed by the seemingly endless stream of bad news coming out of Europe. And it didn't help that, overall, earnings were not that terribly exciting in the third quarter. Most firms reported results that were within spitting distance of analyst estimates, and there were only a handful of big surprises.

Before earnings season started, I outlined the key factors I was going to keep an eye on to determine if the economy is still in recovery mode or if there are signs of sputtering. In general, results were consistent with a slow but real recovery. However, there were more than a few signs that management teams are being cautious as global uncertainty mounts. Here's what I saw in the seven categories I focused on.

Europe Woes
The market's focus was clearly across the pond, so it was interesting to get an on-the-ground take of how the European economy is doing outside of the sovereign debt crisis. The consensus seems to be that there is an abundance of caution among Europeans at the moment. For example, General Motors GM said in their quarterly report that they are seeing "deteriorating economic conditions" on the continent and that their Europe unit won't meet profitability targets. At the moment, consumers just aren't willing to plunk down the big bucks for a large purchase like a car. There is just too much uncertainty about the future of the eurozone, and the possibility of a severe recession in Europe is holding back the so-called real economy.

U.S. Consumer
The U.S. consumer looked strong through the quarter. Some of the nicest economic news we've had recently is that consumers in America are out there spending money despite high unemployment and stagnating wage growth, and that trend continued in the third quarter. Big discounters such as Target TGT and Costco COST posted decent same-store sales growth and did not have to resort to huge markdowns and promotions to drive traffic. However, it appears that lower-end consumers are still running into trouble. Wal-Mart WMT saw same-store sales rise, but only because they began slowly raising prices, hardly a sustainable strategy for the low-cost leader. The drop in traffic to its U.S. stores also points to the struggles lower-end consumers are having.

On the other hand, the higher-end consumer looks much more robust. Companies like Coach COH saw strong results not only due to emerging-markets strength but also due to U.S. consumers. Sales were up 9% year-over-year in America as those consumers who are more secure in their jobs splurged on pricey handbags. Clearly one of the big consumer themes of the quarter was that the high-end is doing swimmingly while the low-end is still struggling.

Emerging Markets
Going into earnings season, there was some fear that emerging-markets growth was slowing down. This would have been very bad news, because emerging markets have in many ways been powering the global economy. These economies have very little debt, growing populations, and plenty of catch-up growth left. But there were some clouds on the horizon, too. Investors have been growing increasingly worried about a Chinese property bubble, and the law of large numbers means it is harder and harder to post eye-popping growth.

The quarter showed that emerging markets are still growing quickly, but that there is concern that the growth rate will in fact slow in the coming months. Consumers in particular are still holding up fairly well. Both Unilever UL and KFC owner Yum Brands YUM said that consumers are looking very strong and that they expect the strength to persist. Caterpillar CAT, which supplies a lot of heavy equipment to China and other markets, also saw demand rise at a solid clip. But Cat management did say they expect China to slow somewhat from current growth rates as the government takes its foot off the infrastructure pedal.

Outlook
This is really the big story of the quarter. Across many different firms and industries there was a real sense of caution and concern about the end of 2011. Management teams said that their corporate customers and consumers alike in the developed world were taking a wait-and-see approach and are being generally cautious when it comes to making big decisions.

Jeremy Glaser is the Markets Editor for Morningstar.com.
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