Businesses Opening Their Pocketbooks

Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar's Bob Johnson, of course, keeps track of all the broad economic data, but he also digs into corporate data and taps into Morningstar equity research to calibrate his economic forecast. Now that it's earnings season, we're getting even more data on that front. He's here to tell us what he is seeing now.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: So a quick question for you to start out with: What are some of the broad things that you're looking for in earnings this time around? So as we are gearing up, what trends were you hoping to see?

Johnson: Sure. A couple of trends--we expected good earnings growth. We're thinking maybe the S&P earnings would grow around 12%. Now it's been higher than that, but 12% is still a very satisfactory number.

What I was really looking forward to this time around was to see a little bit better revenue growth. We've had this great earnings growth, but a lot of that's been cost-cutting. Well, this time around, I think revenues may grow as much as 10% for the S&P, the first time in this recovery for that kind of double-digit rate, and now the rates between the sales and the profit growth are approaching each other, which is a good thing, I think.

Stipp: So, we just started to get some earnings. So, we're in the early stages, in the early innings, of the earnings season. But a few trends that you've noted so far in what we've seen.

The first one is an important one, I think, for around this time of the economic cycle: business spending, something that we ultimately want to see pick up, oftentimes will pick up a little bit later in a recovery. As we starting to see that happen?

Johnson: I think we are, and we saw a little bit of a slowing in the December quarter, and I'm hoping for better on the whole economy that business spending steps up a little bit here in the first quarter to offset a little bit of the consumer softening that we're seeing here in the first quarter.

We've seen it a couple of different reports. I think Intel was probably the prime example of some really good indicators for the spending on capital goods. They reported a 30-some percent increase in their server sales. Servers are used by corporations for their major computers, and so that was a really a great number to see, that 30% growth. It totally knocked the cover off the ball compared to what people were looking for. People were very worried about Intel; they had heard PC sales were softening and got really scared, and then they have this business spending offset some of the softer PC spending, and it was great to see.

Stipp: And Intel itself also is doing some spending for its own business?

Johnson: That's really interesting. Great that you mentioned that. They announced they would increase their capital spending to well over $10 [billion] for this year, and it was just over $9 billion the last estimate they made. So they've increased over 10%. So clearly they're investing back in themselves as well.

Stipp: Outside of the tech industry, did we see signs of business spending in any of the other reports that came out?

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Johnson: Well, we were seeing some good news out of the industrial sector. I think we've seen out of United Technology, we saw some good numbers, even some surprising numbers out of their air conditioning division, which goes into commercial buildings, which we think would be kind of soft, was looking better.

Eaton, who is involved in a lot of capital goods for manufacturing, showed a very nice quarter.

CSX Railroad, that ships a lot of goods, reported also a very nice quarter and improving margins as well.

So, we're seeing a broad range of things do well in the industrial sector, and businesses are indeed investing in themselves again a little bit.

Stipp: Early in earnings seasons, we hear from the financial companies; they are among the first to report. Finance is obviously a very important part of the economy. What are you pulling out with an economic perspective from the financials results we've seen so far?

Johnson: Well, with the financials, you need a good healthy system, and I think the system is strengthening. I think the low rates have helped the banks get their balance sheets better, and in fact we're seeing that their loan loss reserves are coming down, the delinquencies on loans are getting better, so they can reduce the reserves down, and that's really driven earnings, probably at a higher rate than what the S&P is growing.

But the bad news is that they're not loaning out a lot more money, and some of it's because there's no demand from people that could borrow, and then you've got the other part of the population that wants to borrow but can't because of bad credit. So the banks net, their lending is not looking so good.

Stipp: So kind of a glass half-full, half-empty situation with financials at least for right now.

Johnson: Yeah.

Stipp: So another thing that we've obviously had on our radar is inflation and commodity inflation. So can you tell us, have we seen any trends yet in any companies that reported that show inflation is really starting to impact their bottom line?

Johnson: Well all of the retailers and a lot of consumer companies tend to report at the back-end of the earnings cycle. So we haven't seen a lot yet, but I know Alcoa was certainly one where they benefited from higher aluminum prices, but they obviously use a lot of energy and a lot of other input cost, too. So their margins weren't quite as good as we had hoped, and they started off the earnings season as they always do--they're the first one--with results that were a little below expectations last week.

So that's the first thing we've seen with commodity kind of pressuring company's earnings, but as we get more consumer companies in here, we hope to hear more about that.

Stipp: We absolutely have to keep it on our radar.

Bob, you mentioned a little bit early on about some of the earnings trends and the revenue trends. One question I want to ask you about the trends we're seeing on the S&P 500 companies, it seems that we've seen more strength in earnings than we have in the economy. Can you talk a little bit about why we're seeing that disconnect? Why do we see that earnings are pretty robust and we've seen economic data that is okay, and it's on the right track, but it's not as seemingly robust as earnings.

Johnson: Absolutely, and to put that in perspective, for the overall GDP growth, we've had 3.1% in the fourth quarter and now we're down to thinking it's going to be between 1% and 2% [for the first quarter], and part of that [is due to] strange factors, but we will be down to 1% to 2% here probably in the first quarter. So, clearly the economy has slowed just a bit. But on the other hand, S&P earnings look like they have accelerated. The real reason behind that is because a lot of the S&P companies get their earnings and revenues from overseas as well as in the United States, and we're seeing increasingly that they are doing their capital spending overseas. When they're doing their hiring, they're hiring a few more overseas than in the United States. So that's partially why we've got the disconnect--some of that spending is happening overseas.

Stipp: Okay, when we look at the S&P value and also some of the earnings trends that we're seeing, does it look like we might be hitting a full valuation on those S&P 500 companies?

Johnson: Well it's very interesting. I think we've got some nice earnings numbers in front of us. Last year we earned maybe close to $84 a share or so on the S&P 500, and we're trading at about 1330 right now, and it looks like that $84 will probably increase something like 14%-15%. So we're getting pretty close to $100 a share in earnings on the S&P, which makes the math kind of easy, if we're at 1330 we're selling it at 13.3 price/earnings ratio--which doesn't strike me as being terribly expensive, but if you think this is peak earnings, well then maybe it is.

But I think there are a number of industries that can still get a lot better; homebuilding and so forth can get a lot better yet.

Stipp: All right, Bob, well thanks for the insights on the earnings that we've seen so far and the connection with the economy, and for joining me today.

Johnson: Great to be here.

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