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Corporate Earnings: Now the Hard Part

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

Earnings season is coming to a close, and, for a change, it didn't exactly knock our socks off.

So, given the overall negative tenor potentially to earnings season, I'm checking in today with Morningstar markets editor Jeremy Glaser's alter ego, Bearemy, who tends to look at the glass half-empty side of things, to get his take on this earnings season and what it means for investors.

Thanks for joining me, Bearemy?

Jeremy Glaser: You're welcome, Jason.

Stipp: So, you have been looking at earnings, and the trends that we've been seeing, and you have noticed some differences in this most recent earnings season from what we've seen before. What's your broad takeaway about earnings?

Glaser: I certainly think that one of the big concerns that I've had for a while is that corporate earnings were going to begin to slow down. That doesn't mean that earnings are necessarily going to go negative, but that growth is really going to moderate, and a lot of that was just because growth had been so good over the last couple of years.

I think one of the big surprises coming out of the recovery was just how strong corporate profitability was. Even when the economy wasn't doing that well, even when we were kind of fretting about moving into that double-dip recession, corporate earnings kept coming back stronger than normal. I think that there were a couple things driving this, and most of it was cost-cutting.

We had companies just absolutely cutting to the bone, laying off workers wherever they could, getting more productivity out of the workers that were existing, shedding businesses that weren't really adding anything, maybe even doing some acquisitions that were priced pretty cheaply, but that were able to start producing earnings right away. Corporate America was able to turn its act around very quickly from the bottom of the recession, and start producing a lot of money and a lot of potential cash flow for shareholders.

I think this is something that isn't sustainable; it can't go on forever. You can only cut so many costs, and you can only improve margins so much before you run into an underinvestment problem, where you haven't put enough money into those growth initiatives to keep things going. And at one point you're going to catch up to the growth in the economy, where we did see good emerging-markets growth helped push a lot of earnings forward. Relatively better-than-expected consumer spending in United States certainly helped to push some of that going forward, but none of these are trends that just can go on forever.

I think this quarter we started to see the first inklings of the beginning of that slowdown, beginning to get back to more of a normalized earning growth environment. According to Bespoke Investments, about 60.4% of companies in the S&P 500 beat earnings expectations, beat what analysts thought they were going to make in the quarter. This is down from around 62%, which is the historical average, and down well below the 80%-type numbers we were seeing at the peak of those surprise quarters, where basically every single company was beating expectations, and not just by a little bit, but by a ton.

I think, this is an interesting ... inflection point: Are corporate earnings going to be able to go back on that upward trajectory; I think that's probably not likely due to some of those reasons that we talked about just a minute ago. I think it's showing that we're getting back to some of that normalized earnings growth, that in order to really get bigger, [companies are] going to have to focus on investments, focus on, "how do we improve those returns on invested capital?" Some of that low-hanging corporate fruit, low-hanging cost-cutting is certainly gone.

Stipp: On the flip side, on the stock market side, we've also seen that a lot of those easy gains, that bounce-back from the depths of the recession when people worried about Armageddon that didn't come to pass--those gains are probably gone as well, right?

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Glaser: Absolutely. Our equity analysts think that the stock market as a whole is basically fully valued--maybe a little bit undervalued depending on the sector you're looking at, but for the most part, stock are trading for about what they think they're worth, and about the expectations of future growth. So if we think about what stock returns are going to look like going out over the next couple of years, going out over the next decade, it really looks like a lot of what investors are going to get is that growth in earnings, is the cash that's going to get paid out in dividends. It's not going to be so much from a huge expansion in the multiples that investors are willing to pay for [stocks], or a huge expansion going from being incredibly undervalued to being fairly valued, which means somewhat muted returns. That doesn't mean [you should] completely stay away from equities. We've talked before about how returns in the bond market [will face] a lot of headwinds that could keep those returns even below stocks, but certainly the kind of returns that we've seen over the last couple of years probably aren't going to be replicated looking forward.

Stipp: You can say, "now the hard part."

So you have a few ideas here. You have a few analyses of companies that reported earnings that illustrate some of these trends. Let's start in the tech sector and talk about an area where we've seen certainly some disappointment in the results, and that's in personal computers, Dell and HP. What do those results tell you?

Glaser: A big driver of a lot of the big gains in earnings over the last couple of quarters has been inventory restocking, has been corporations making some of those investments they put off in the depths of the recession, because they just didn't want to spend any money; they didn't want to part with a single dollar. And I think that a lot of those low-hanging gains are gone.

HP and Dell this quarter had OK results, but nothing particularly spectacular. Now some of that was impacted by the flooding in Thailand and the lack of availability of hard drives, which make comparisons somewhat difficult, but our analyst Mike Holt, who looked at these companies, really sees that it's going to be a challenge for the big PC manufacturers to show that they're not just commodity makers, and that there really is a differentiation on the hardware side, and they're going [have] to differentiate themselves on the service side, and it's something that's not going to just happen overnight. It's really going to take a lot of work in order to get those businesses turned around. So, it's not that demand has completely evaporated for these products, but a lot of that catch-up demand is gone, and it's something that investors are really going to be focused on.

Stipp: In the retail space, Wal-Mart is certainly a bellwether of what's going on among the consumer, especially some of those lower- to mid-tier consumers. What did their earnings say?

Glaser: Consumer spending has certainly been an area that we've been laser focused on when trying to evaluate the economy. It's a huge part of GDP; it's what consumers are actually out there spending. It drives just a lot of different businesses, and we heard from Wal-Mart and Target this quarter that lower-end consumers are really having a lot of problems still, that even though they're maybe not quite as bad as it was ... at that absolute trough of the economy, they're not out there spending on a lot of discretionary items; they're still going paycheck to paycheck. They're buying just exactly what they need, and they are still looking for absolute low prices.

As gas prices start to tick up, this could become an even bigger problem. If inflation starts to tick up, this becomes an even bigger problem. So I think any companies that serve these customers are going to have a lot of trouble pushing earnings growth.

Stipp: We know that banks and financial services got some tailwinds when they were able to release some of their reserves as the economy started to look up, as some of the bad loans that they had started to roll off. But the fundamental business of the big banks, like Citigroup, are we going to see that they're going to be able to continue some of these trends, or has a lot of the low-hanging fruit been plucked there as well?

Glaser: This was not a good quarter for the big banks. We heard from Citi and from Bank of America and from some other banks that really it was not a good quarter for trading. The proprietary trading desks, which were using the bank's own money, just weren't doing anything special. Loan growth is pretty anemic; there aren't a lot of people out there who are creditworthy and want a lot of new debt right now. It really makes it difficult to grow those books, especially with the housing market still looking--maybe stabilized--but still somewhat in the basement.

It's certainly challenging, and I think as the regulatory regime for these banks becomes more complicated, if ideas like the Volker Rule split off that trading completely. If higher capital ratios and if other regulations make it difficult for these banks to be the huge earnings powerhouses they were before, they're going to have to fight against those potential headwinds in order to keep growing. I think that one bad quarter of trading doesn't mean that the banks are totally toast. Obviously, they're much stronger now and are much better capitalized than they were just a few years ago, but a lot of that easy money, like you were saying, coming from the reserves is certainly gone.

Stipp: Another stock that had a big splash with their IPO, Groupon, but their earnings result, was it closer to a belly-flop?

Glaser: Well, it's true I can't quite resist talking about Groupon, because it was just such an unbelievably hyped IPO to the point that it was almost getting a little bit batty that folks were so excited about the growth that was coming out of this company. But as investors took a little bit of a closer look at the financials and started to get a little bit of a look under the hood, a lot of people got a lot less excited about it. They had to restate their IPO offering statements a few times because the SEC was a little bit uncomfortable with some of the non-GAAP measures they were using to judge their performance, and in their first quarter as a publicly traded company, they didn’t really produce particularly great results.

They're still losing money. In sharp contrast to another potential tech IPO darling--or what will be a tech IPO darling, Facebook, when it comes to market later this year, Groupon is still losing a lot of money. They still have to spend a ton to market for every customer. It really looks that as they grow and have to hire more sales staff and have to go out there and find new businesses to offer deals with, it's expensive to do that, and they really have to put a lot of that money and invest a lot of that money.

So, it looks like what was hoping to be this great high-margin, recurring business model, is going to be more of a traditional heavy-investment, long-slog type of company, where they're going to really have to put those resources to work for a long time in order to really see the returns. It looks a lot more like a normal company than just a crazy high-flying tech name, and I think that Groupon really is going to have some struggles in the years ahead.

Stipp: Lastly, Jeremy, in the industrial and the manufacturing space, Boeing, certainly a company that Bob Johnson at least says has a pretty big impact on the economy at large. What did those results tell you, and do they have a lot of runway ahead of them?

Glaser: Bob is absolutely right that Boeing is incredibly important to the U.S. economy--not only just because of their own employees, but all the suppliers who are making all the little pieces and parts that go into, say, a 737, but certainly they've also benefitted from huge aircraft orders.

As a lot of emerging markets continue to grow richer, people are demanding more air travel, and they need planes to do that in, and I think certainly Boeing and its archrival Airbus have been trying to fill this demand by taking on huge orders. Their order books keep swelling and swelling and swelling, but both have had pretty bad execution problems in actually getting a lot of these new products to market.

Last quarter, Boeing shipped only two of its 787s, which is its new wide-body aircraft that has huge orders, but they're really having trouble getting the line ramped up, getting it fast enough, getting the production quality high enough so they can actually get these aircrafts and airframes out the door and to the clients. And if they can't really get these deliveries fast, if they can't do it in an efficient way, they're never going to make money on this program.

Right now, all of the investment is obviously upfront in the design and in the engineering and getting the first few off the line, and then you really make the payoff down the road, but if they can't get down the road, if it's always more engineering work, if it's always trying to get the line to be a little bit more efficient to get to those kind of numbers that they need to hit in order to reach all of their deliveries, I think that they're going to have a lot of problems. And they're going to see profitability decline as they have to keep investing just to fill this order book.

So, it's great that they have these great orders, but if they can't actually fulfill it profitably, and if they keep seeing new potential competitors, especially in the single-aisle space from Brazil and from China and from some other places, I think that earnings story might not be as sweet as that order book story.

Stipp: Well, I think, there are probably worse things than a fairly valued market in the middle of a recovery, but it does sound like the market is going to need a little bit more elbow grease to keep it going in the future. Thanks so much for your perspective on this.

Glaser: You're welcome, Jason.

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