Wed, 26 Sep 2012
Wall Street expects 3Q will be the first down quarter of earnings in the recovery, but the U.S. economy should pick up some global slack, says Morningstar's Bob Johnson.
Jason Stipp: I'm Jason Stipp for Morningstar.
Despite a generally sluggish economy, we've had a string of pretty good earnings seasons throughout the recovery, but analysts have more pessimistic assumptions for upcoming third-quarter earnings. What's behind that? I'm checking in today with Bob Johnson, our director of economic analysis, to get some insights.
Bob, thanks for joining me.
Bob Johnson: Great to be here.
Stipp: So, Morningstar analysts don't actually calculate earnings expectations quarter-by-quarter specifically, but you looked at several sources.
Stipp: … And it looks like that folks expect a more disappointing third-quarter earnings season. What are some of the numbers saying?
Johnson: The general view is now that S&P earnings will be down about 3% in the third quarter. That's compared to the same quarter a year ago and that stays with my framework of always wanting to look at things year-over-year to strip out the seasonality. So, we've got about a 3% decline expected by analysts right now. That represents the first decline of this recovery, which began in 2009. So, it's kind of a big deal. It's a psychological point where it looks like maybe we'll have down earnings.
Stipp: You found also that some of the Wall Street expectations are for generally flat revenues, but as you said, earnings to be down. How is that a change from what we've seen in the past?
Johnson: I think that in the past we've seen margin expansion coming from increased productivity, and falling commodity prices in some cases helped to aid the numbers as well. And so we had earnings going quite a bit faster than revenues. Now, we've got the reverse, where we've got some foreign exchange issues in particular hitting the numbers, and so I think that we'll actually have relatively flat revenues and down earnings.
Stipp: We do know that management teams can sometime sandbag the numbers, and they've got lots of room for cover with emerging markets seemingly slowing down, and the situation in Europe, although stabilized, is still out there. How much do you think management teams are trying to under-promise and hopefully over-deliver when the results come out?
Johnson: Well, that's been the pattern almost every quarter we go through, and usually the first couple of months of the quarter the earnings estimates come in, and management is kind of, "trim that down a little bit" or "you look a little high here," and then when they actually report the quarter, the numbers turn out to be, "A-ha! We beat the numbers," and miraculously every quarter 60% to 70% of the companies beat earnings expectations. So, that's a lot of what's behind it.
In fact, the range … between what people predict and what actually comes in, because of that sandbagging effect that you point out, we could possibly get the flat S&P earnings. If they're projecting minus 3%, 0% is certainly in the realm of possibilities.
Stipp: So with those short-term earnings estimates there is a bit of a game going on there, so that companies can beat the expectations, as you said.
So, what are behind some of these less-optimistic earnings outlooks? What are some of the key factors, as you see them, why we might see some actual decline in earnings versus when we had seen growth in the past?
Johnson: I think number one is probably emerging markets, and I could probably even throw Europe in there. As those have slowed, that has really begun to impact companies that get a substantial portion of their revenues and earnings overseas. It becomes a very difficult game of figuring out exactly how much does, but a large portion of it comes from overseas. And certainly most of the growth has come out of the emerging markets over the last two or three years. Now, looking at China, which was growing at 9.5% in the second quarter of 2011, now it's only going to be growing 7.5%. And then we've seen India slow down from that same 9%-ish range even further [down], and even Brazil has slowed almost to practically nothing.
So, as those emerging markets were an important part of the growth story, not a huge part of revenues, but growing at pretty astronomical rates, they really helped out corporate earnings, and now those same emerging markets are beginning to slow, and so that's certainly been an effect.
Certainly, Europe has less effect, but we are even seeing [an effect] there. Oracle in their earnings announcement, [reported] overall revenue growth of 2% to 3%, but Europe, Middle East, and Africa revenues [were] down 12%. So Europe, especially when you are selling to European governments, is beginning to bite.
Stipp: Also related to the overseas portion of earnings, foreign exchange rates you said could have a negative effect on earnings this time around.
Johnson: Right. If you sell the same number of euros worth of products right now, you are converting at a rate of 1.25 instead of 1.40, and that's a 12%-13% impact on earnings right there, just from the weakening euro, and there are other currencies that we've also gotten stronger against, and that affects the earnings numbers that we've seen. That's even excluding the fact that some goods [from] the U.S. might be priced out of [some foreign] markets, because we are now too high-priced [due to the strength of the dollar]. So, some of that foreign exchange is a big deal, and it's beginning to appear in almost every conference call.
Stipp: Those currency effects can reverse themselves, also. So it could be a shorter-term issue, but that's one of the wildcards.
Also you mentioned earlier that … we saw some commodity effects, and we saw some in the second quarter. Could commodities also be a negative factor for companies in their third quarter earnings reports?
Johnson: Absolutely. Steel, aluminum, oil, a lot of the basic materials [companies] are in the [S&P 500] Index. They make up not an insignificant portion of the index. Right now oil is relative flat, but almost everything else is down, and down big. So, when you put all the commodities together, we're down about 18% year-over-year.
Now, we may be up a little bit from the second quarter with all the QE3 stuff, but when we look year-over-year, which I like to do, commodities are down, and down a lot, and obviously that goes straight to the bottom line [for commodity-related companies], because you still have your mining cost and all your physical costs, and with prices down, the earnings impact on basic materials companies can be significant.
Stipp: There are a couple of positives for some sectors that Wall Street analysts are seeing, which might actually have growth in their earnings from the third quarter versus a year ago. Where are some of the bright spots?
Johnson: There aren't a lot of them, to be honest, in terms of earnings, but obviously one of the biggest is going to be construction related. We talked in last week's video http://www.morningstar.com/cover/videocenter.aspx?id=568200 and last week's column http://news.morningstar.com/articlenet/article.aspx?id=568485, a lot about the housing industry and how that has truly revived. But even though they are up a lot, they're a very small percentage of the index. So, that will be one sector where you'll see some very good news. We've already seen some very good news out of the homebuilders in the last week.
I think banks may be another sector that looks pretty good because of much less reserves than a year ago, and a couple of special situations in there as well where we're now going from losses to gains, which will particularly help, [given] the way the index is constructed.
Stipp: And going down to individual companies: Over the last few weeks, we've got some negative news, some warnings from some companies that their earnings were going to fall short of what previous expectations were.
What are some of those stories, and are some of those company specific or are they connected to some of the broader themes that you've addressed as headwinds right now?
Johnson: Roughly a hundred companies have pre-released or actually had August releases, and about 80% of those have been a miss, which is a much higher percentage than we usually get.
A few of the themes are very much tied to what we are seeing in individual companies. So, the falling basic materials situation, for example--we got a warning out of Norfolk Southern. Well, it's usually considered an [economic] bellwether--anything that ships affects the economy. Well, a lot of what's happening there is this whole move from burning coal to burning natural gas, and now we're moving to much less coal in this country, and even the coal for export isn't what it was because of slowing steel markets and auto markets in other parts of the world. So, clearly basic materials had a huge impact on Norfolk Southern, and is also impacting the earnings estimate.
And obviously another warning we got just yesterday was Caterpillar, and again, a significant portion--maybe as much as half of their operating income--comes from mining-related machinery. Significantly less of revenues, but a considerable portion of their profits come from mining machinery. And that all depends on that basic materials theme, which I've clearly said is getting a little bit weaker.
Stipp: What about on the tech sector side; we've had a few tech earnings warnings. What's the story there? Is that industry specific or is that broader economy issues trickling into tech?
Johnson: It's actually two of those things, and we've had three [warnings], and they are all a little bit different, have different nuances to them. We've had the Oracle [warning] that we talked about; … government sales in Europe are a big impact there.
Intel's warning is related to something kind of different, and we'll probably see a little bit of positive side, too, on that from Apple. But clearly as Apple takes over more of the world and more people buy tablets and less people buy PCs, that clearly has impacted Intel, and their results. And the iPhone, maybe to a lesser degree, also effects firms like Texas Instruments, two of the companies with negative surprises.
The one other thing I would add on the Intel side is that obviously, we've been [saying], there is no PC growth in the U.S. How the heck has Intel done as well as it has? And obviously the answer has been emerging markets. And now, as we talked about earlier, with slowing emerging markets, that's beginning to affect Intel as well. In addition to the whole Apple-related situation.
By the way, we will see the converse of that, too, especially in the economy, where Apple's new iPhone will actually be a meaningful addition, probably more than we'll see from auto sales, to GDP in the third quarter, which is kind of an amazing thing to say.
Stipp: So, we can talk about some of the company-specific issues and some of the economic issues that may affect the earnings reports from a lot of the names that we are going to hear in the coming weeks.
My question for you, though, is, we had a trend where even though the economy was sluggish, [corporate] earnings continued to come in really well, quarter-after-quarter throughout the recovery. And now it feels like the economy might--and as you estimate--pick up a little bit of steam in the second half, but now earnings are pulling back. What's the disconnect there, and is this a trend that's shifting, and it's going to be here to stay?
Johnson: Well, you know that's an absolutely fascinating question. We have had some remarkable growth in S&P earnings over the last three years in a very lackluster U.S. [economic] recovery, and that's because a lot of the growth is coming out of emerging markets. And not only is that where the sales are occurring, but the support even the manufacturing of goods sold in those markets are now often happening outside of the U.S.
So the profits are going up, but it's doing nothing to the U.S. economy, except maybe a few headquarters people. And now we are seeing just the reverse, where emerging markets are slowing, but because of the housing markets picking up here, the auto market remains very robust here, that things here in the U.S. in terms of employment and GDP growth are really quite good, but S&P earnings are starting to slide the wrong way.
Now the one thing I kind of miss … I've said all of this many times in many different ways, but the one thing that is out there is that, obviously, if somebody like a Caterpillar slows down outside of the United States, even though it might not have a direct impact on the U.S., as much as some people think, the headquarters people are affected. And you know, you don't add people, maybe even you contract or control, or something like that. So that's the type of thing that's out there that can slow the economy, and where we will see some blow-over effect from some of the slowing in the international markets. But so far, it's really played out, that the U.S. economy has remained relatively OK, and as much as we've been hurt by any slowing in Europe, we've helped by falling commodity prices.
Stipp: So, in your opinion, housing, [falling commodity prices], and the auto market here in the U.S., is that going to be able to offset the weakness that we're seeing internationally, and keep us on more of an upward trajectory, even if earnings aren't reflecting that immediately?
Johnson: It's a dangerous thing to say, but I'm going to stick with it: When I first started this, almost a year ago now, I was a little bit scared, saying that, if the rest of the world economy slows, it's not an all bad thing here, because of how badly commodities had been killing the U.S. consumer.
I'm going to hang in there. I think that the U.S. economy will continue to do well, and as I say, maybe even accelerate a little bit because of housing, despite some of the slowing in the rest of the world.
Stipp: All right, Bob--some very interesting insights on the upcoming earnings season and the effects of the economy wrapped up into those expectations. Thanks for joining me today.
Johnson: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.