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Do Earnings Spell Recovery?

Jason Stipp

Jason Stipp: I'm Jason Stipp with Morningstar. With earnings season well under way, market watchers are picking apart the earnings reports for signs that the economic recovery is actually going to have some legs.

Here with me to talk about some of the surprises and some of the disappointments is Jeremy Glaser. He's morningstar.com's markets editor. Thanks for joining me, Jeremy.

Jeremy Glaser: You're welcome, Jason.

Stipp: We've had a good number of earnings reports now from a few different sectors. Let's start off with the banks. What's your big takeaway for the banks? Any surprises in there?

Glaser: Yes, I think the overall takeaway is that it seems that the credit crisis that's gripped the banking sector for so long seems to finally be coming to an end. I think the thing that was maybe a little surprising to me was the difference in how the banks are approaching this almost return to normalcy.

You see Goldman Sachs being very aggressive out there. They posted earnings that were very surprising on the upside, and you saw that they were doing a lot of proprietary trading--they were using their own balance sheet to make more money, taking more risks, issuing a lot of equity and debt for companies, and really doing a good job with that.

While other companies like Morgan Stanley, which is another strong bank that made it through the crisis, seemed to be a lot more conservative and was not as adventurous out there when they were doing their trading. We saw that their earnings disappointed a little bit.

I think seeing those banks take divergent paths is something that really struck me when I was taking a look at those earnings when they were coming out. I think it will be particularly interesting to see which of those strategies ends up paying off in the long run.

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Stipp: It seems like for the investment banks there was a certain degree of pent-up demand for their services that maybe we saw playing out in the second quarter. How sustainable do you think that might be? Is that yet to come?

Glaser: Yes, I think that's absolutely right, that there were just people who couldn't access the credit markets for so long, and once they opened up there was a rush to the gate to get any refinancing that they would need to get done off the table. I think that that's not a sustainable earnings stream. I don't think we're at any kind of normalized earnings level.

For Goldman you wouldn't expect that quarter to be able to continue to replicate over time. Just by the sheer fact that there just isn't that much equity to be issued. They are going to have to come down from where they are now.

Stipp: The second thing that seemed to potentially surprise investors, especially after the last few quarters prior to this, earnings actually seemed to be at least not horrible, and in some cases surprised on the upside. But there's a little bit more to the story behind earnings. What's your takeaway on the earnings picture?

Glaser: Yes, I think you have to look at those earnings numbers pretty closely, because a lot of companies reported decent growth, or at least a much smaller reduction in earnings than were originally thought. But a lot of that wasn't coming necessarily from better revenue growth or from better fundamentals. It was coming from aggressive cost-cutting measures or coming from a lack of charges over special items that had been in previous quarters.

I think a good example of this was the newspaper stocks which rose--big, big gains on their news. McClatchy and Gannett for example were up over 50% on their earnings news. It wasn't that all of a sudden the newspaper industry is a great one to be in, or that ad sales have started to skyrocket, or people have decided they don't want their news on the Internet; they want to get the paper delivered.

It's that these companies have cut beyond the bone really their cost structure. They fired a ton of reporters, they fired a lot of staff, they have closed printing presses, they're not delivering every day. Whatever they need to do to cut costs, they have done. This is helping their bottom line right now, but it's not a sustainable practice. These companies over time can't keep cutting and cutting and cutting. There's no company left.

I think that some of earnings that maybe surprised Wall Street and that maybe saw their stocks bump up might have been some premature excitement, given that a lot of those gains were not sustainable.

Stipp: If cost cuts are actually leading to the better bottom line that we've seen on a lot of these companies, I guess the other negative is that if that's not coming from growth, perhaps that casts a little bit of a darker picture about where we are in the recovery right now. Things actually haven't really begun to pick up to the point where sales have started to drive earnings as much as the cost-cutting side.

Glaser: Yes, I think you're right there. You've seen a couple companies such as Intel report that they're starting to see demand pick up, they think that we've seen a bottom. But I think a lot of that demand could be coming from inventory restocking.

We've just seen inventory levels depleted as companies decided not to place new orders and have just been fulfilling the few orders they have had from their stock on hand. You see that you have a company like Intel just has a couple of quarters of very low shipments, all of a sudden has to start pumping out a lot more to fill this inventory that was depleted.

If you look at Microsoft earnings, which were very disappointing, and showed their first full-year revenue decline in the history of the company, you see that demand for PCs, the actual end product, have not necessarily picked up very much, but that there is still demand for some of the underlying products as that inventory gets depleted.

I think that it's certainly important to watch that there's a difference between the economy having stabilized, which is a theme that we heard from a lot of management teams and we've heard from a lot of different companies, from things actually getting better.

I think another good example of this are some of the industrial companies, such as 3M and General Electric, reported quarters that were much better than first quarter and much better than some of the results that they have seen in the past, but weren't necessarily rosy. So things for them, they see things stabilizing, they don't think things are getting any worse, but there isn't signs that things are getting a lot better.

Stipp: Thanks for joining me, Jeremy.

Glaser: You're welcome.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.