Diagnosing the Earnings Malaise

Jason Stipp: I'm Jason Stipp for Morningstar.

Perceived disappointing earnings reports have given the market fits this week, but digging below the surface reveals some interesting trends.

Here to talk about what he sees when he looks at earnings reports is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: Very few people expected this to be a gangbusters earnings season. In fact the expectation was that it would be a poor earnings season, comparatively speaking. What were the expectations going into this season and what have we seen so far?

Johnson: The general consensus was 2% to 3% decline in S&P earnings, basically flat revenues, and then as we looked ahead, people thought this might be a little bit temporary and were looking for 9% to 10% growth into the fourth quarter.

Stipp: So we're just getting into earnings season now with a week and a half or so and a good number of reports. What are the trends so far, what have we seen and how has it compared to those expectations?

Johnson: In the 25% or so of the companies that have reported, it's very much in line. The earnings per share are down about 2.9%, and that's in that range of 2% to 3% that we talked about. It's probably a little bit more the mix of companies than anything else that have reported so far, but revenues are up about a 1%, and we said they would be flattish.

But on the front-end of the cycle, you usually see companies with more earnings growth. And one of the things that we've noted so far in the numbers--this is extremely interesting and very different than what we've seen in the past--is that almost two-thirds of all companies have missed the revenue estimate, but 55% have beaten when you get all the way down to the bottom EPS line.

Stipp: A lot of folks will look at those revenue misses and really become concerned, because revenue is revenue--earnings you can play around with and maybe make them look a little better in the short term.

What do you make of those revenue disappointments? Do you think that's a really bad sign for corporate health right now?

Johnson: I think a lot of people are reading it that way, but I think that's probably a mistake. I think a lot of what's happened on the revenue line deals with a lot of the foreign currency translation, with the dollar being stronger, and I think that has created a situation where an IBM is saying, well our revenues would have been $1 billion higher if it hadn't been for this. I think it is hard for everybody to guess exactly how those roll into a company's earnings; it makes it pretty difficult to do the forecast. They get pretty good in local currency, but once you start having to think about what's the mix in the [currency] translations, it becomes a little bit more difficult.

I think the reason earnings have been more along the lines of target is that as some of those sales are overseas, so are some of the costs. So those have come down, too, so you've really lessened some of that impact. And, of course, corporations have been extremely cautious as well. So you combine that all together, that's why I think you get this situation where earnings are beating and you're not doing quite as well on sales.

Stipp: Let's dig into the sector level, because we're seeing some interesting trends on sectors that are doing poorly compared to sectors that are doing a little bit better.

Tech seems to be one of the bigger disappointments. Now we're getting some more tech earnings this week from some of the big names. From what we've seen so far from last week, tech hasn't done so well.

Johnson: No. That's a group where maybe we've seen 10% declines in earnings year-over-year, and so that's a pretty dramatic set of numbers. It's IBM, it's Microsoft, a couple of the companies that reported last week were disappointing.

This week we're going to get Apple, and we've already got some of the other numbers like Facebook coming in that look a little bit above expectations, but going in through last Friday, we were down 10% on tech.

I think there are a lot of things happening there. We've talked many times about the new Microsoft Windows 8 coming out, and people not buying any laptops until that came out, and then we had expectations of a new iPad, and we've now finally gotten that, and the new iPhone, which impacted some of the quarterly numbers, but now they will look a little better again going forward.

So there were a lot of secular things that were happening there. Of course, when you have more use of iPads, too, on top of that, you're going to naturally hurt some of the suppliers of the plain PC market, and we've had bad numbers out of Intel, we've had bad numbers out of AMD, Marvell. So we've had a few bad numbers related to that whole syndrome of what's happening in that ecosystem. Some of it will clearly reverse here as those [product cycles] shift and uncertainties go away, but maybe not all of them.

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Stipp: So a lot of tech-specific issues there.

Another one that looks really bad is basic materials--a lot of those numbers are just falling out of bed. What's the story there?

Johnson: We've said that a falling or slowing world economy would probably impact commodities more than anything else, and that the prices of commodities and the commodity bubble would probably be broken. We've got copper now at a six-week low, and we've had less demand in China, and so a broad range of commodities is cheaper now than it's been in a long time, the most recent of which is oil. West Texas is down to about $86 a barrel.

So we've brought in a bunch of commodities [prices], and that's hurting a bunch of their earnings. I think energy stocks were probably a little stronger a year ago in terms of earnings, and now this time they will be a little weaker. So you go across the board, a lot of materials--with a possible exception of lumber, which goes into our housing industry--I think we've seen a general weakening in commodities. Coal is another one where we've seen a lot of issues, and anybody that helps mine those things is also being affected.

Stipp: Or transport those things as well.

Johnson: Exactly.

Stipp: On the defense side, we're seeing some headwinds as well. How bad has defense been?

Johnson: It's been pretty bad. I love Boeing, and I want to talk about how successful they've been on the commercial side, but their defense business year-over-year is down 4%.

United Technologies said the U.S. [business] is OK, rest of world not so good, but the one part of the U.S. that's weak is defense. And I think as we go through and wind down our various wars and approach sequestration, those things are clearly hurting a wide range of companies. iRobot is another one that's reported really pretty dismal numbers based on slowing defense spending.

So one can argue whether defense spending is very productive, that it helps the economy or really hurts it. I'm going to stay out of that argument, but for now and in terms reported earnings numbers, defense has hurt us.

Stipp: And banks seem to do OK so far. What are some of the trends that are helping banks maybe perform a little bit better than some of the other sectors?

Johnson: I want to stress that things aren't necessarily wonderful at banks, but at least they're in many ways U.S. focused. And we've seen a pickup in the U.S. housing market, and we've seen the need for less reserves. On the other hand, the margin spreads aren't so good. But in general, the trend in the financials has been pretty good. They've been one of the better performers in terms of earnings and in terms of stocks recently.

Stipp: So you mentioned a couple of times "U.S. focused" and "overseas exposure." "Overseas exposure" usually in a negative light; "U.S. focused" in a more positive light.

When you start to look at some of the individual companies as well, you see this theme carrying through. What are some of the companies that have done well and how has U.S. helped them?

Johnson: The ones that have done well, let me just name a few, I just picked a couple off the tape from yesterday: Whirlpool was up almost 9% yesterday, Harley-Davidson was up in the 7% to 8% range, and UPS was up 3% or so.

Well you start to go through those--let's start at the bottom. UPS, the overall numbers weren't so hot, but they said they had great package volumes in the United States. So things here are clearly doing well, and that helped aid their overall stock performance.

Harley-Davidson, although they participate in world markets, it's a strong U.S. market for them, and they've done very well.

And Whirlpool, the whole housing market being up 30%-40% from a year ago and beginning to finally move into that sector, and again, [Whirlpool] is also a little bit U.S. centric.

Stipp: On the flipside we saw some real weakness in companies that seem like U.S. companies but have a lot of European exposure. What were some of the disappointments there?

Johnson: Well, 3M and DuPont would probably be the two I'd cite there, but I could go on with a long list. And I hadn't even realized, and I'm an economist, but they get two-thirds of their revenues outside of the United States. So the fact that those are the weakest of the bunch is very consistent with our whole thesis that the U.S. is decoupled from Europe and the rest of the world.

Stipp: One area where we thought we might see some strength was restaurants, because those do tend to be … some of them are global … but a lot of them tend to be more locally focused. But restaurants seem to be under some pressure in some of the earnings reports. How does that play or not play into your U.S. versus the rest of the world thesis?

Johnson: Well, you'd think a little bit more of that would be U.S.-centric, though McDonald's has a lot of their revenues overseas. But clearly one of the things that's happened in the U.S. that we've talked about is a real specific thing, kind of like the [factors] we talked about in tech with PCs. [Restaurants are facing] some industry idiosyncratic things, and that is, as more building space in malls became available--Borders went out of business and several others--there is now a lot more empty space in malls, or there was, and a lot of that's being filled by restaurants.

We talked about it, [our employment sector equity analyst] Vishnu [Lekraj] cited it when we talked about the employment report a couple of months ago even, that this is kind of weird. Restaurant employees are way up, and restaurants aren't doing that great.

Well, what's happening is that a lot of chains are expanding, and so they are splitting the same pie more ways, and restaurant stocks are not performing nearly as well as they had been. It's not across the board. Panera had some great numbers this morning, but we had McDonald's who didn't do so well and Chipotle has been a huge disappointment, but everybody had high-high expectations for that company.

Stipp: So definitely seeing some competitive issues there in restaurants.

So let's talk about looking forward the prognosis for this big trend that you're citing about U.S. relative strength and the rest of the world's relative weakness. Is this going to continue for us and how long do we have to put up with Europe really being a laggard and pushing earnings down?

Johnson: I think we still have to be very carefully with investments with a lot of overseas exposure, and the more [exposure] to Europe, the worst. I've cited all the faults with the various purchasing managers surveys, but to put them in line, we got them this morning, U.S. is 51, up from the prior month; China is at 49.7, also up very nicely from the previous month; and Europe is at 45, pulling up the bottom, below what it was the previous month. So they are still falling apart over there.

We had Spanish GDP yesterday, and it was down 0.4%. Given all the problems we've heard from there, 0.4% [doesn't seem] that bad. But I think if you look behind the numbers, there is more to come. Thinking about the government austerity and all the cutbacks there, I think that's just going to be the beginning of some of their numbers and how bad they look. And certainly within the European market, Germany was nothing to particularly write home about. So I continue to be worried. I think this indicates the decoupling again a little bit.

I think China is showing some … I think what's going on there is maybe we're seeing some bottoming in their construction market.

Stipp: But the U.S. construction market could potential be a bright spot for those U.S.-focused companies. Do you expect that, looking forward, we're going to see some more strength out of homebuilding and construction type of companies?

Johnson: Absolutely, and people that furnish homes, your Bed Bath & Beyond, your Home Depot, your Lowe's, your homebuilders. I think there are still positive things to happen there. The new home sales number this morning was up 5% or 6% month-to-month, almost 30% year-on-year. So we've had some really sharp improvements there in our U.S. housing related sectors, and I mentioned lumber also is one of the rare commodities that's up as we're beginning to really put that market in gear again.

Stipp: So if we're seeing some decoupling on the corporate side with companies that are more U.S. focused having better results than those that have exposure, especially to Europe, what about on the economic side? We're going to get a big piece of economic news in the third-quarter GDP, which is due to come out on Friday. What are your expectations for that number, and what are going to be some of the drivers? And are we going to see that decoupling continue into that GDP economic report?

Johnson: I think we will, and there are a few things that I've got to be cautious about, but in the last few days, even the consensus has come up. I forecast 2% for third quarter GDP last week, the consensus had been more like 1.6%. I noticed this morning before I came down here that it was at 1.8%, so the consensus has begun to move up. So unfortunately, the room for upside surprise is a little bit less, but that's up from 1.3% in the June quarter.

So we've got an improving trend here in the U.S. GDP number, and again I mentioned that Spain was negative, China had slowed to something like 7% and change, so we've seen slowing in several others, and [the U.S. is] kind of on the accelerating side of that curve.

Stipp: So [what are] some of the drivers behind that? What could be potentially on the upside? Are we going to see homebuilding and construction help out here? Are there going to be some other factors? And what's going to look weaker in that report?

Johnson: Well, the biggest upside is probably going to be consumer spending overall, which I expect to be over 2%. And again, I think that drives everything, so the rest of the numbers--what they do with inventory and how everybody kind of maneuvers the numbers around--that's a number that I focus on. And I think that will look pretty darn good.

Things to worry about: I think business spending. We saw the IBM, Microsoft, the corporate spending on software [was weak], which is a big part of that component. We've seen Cat and so forth have some disappointing numbers. Some of that's overseas, but again not big growth there. And so I think the corporate numbers could actually slip into the negative category.

Inventories will probably hurt. There was a big pull-down in inventories in the auto industry as they brought production way back down the last couple months. That may be the surprise negative in the report.

I think housing will do well on the report as it has for the last couple [of reports], and normally I'd say that we'll see a big acceleration, but we're going to get the construction number that really aids the GDP calculation the day after, so it will show up in the next revision, I think. So [housing] may be an OK number, not a great number, but I think it will get revised upward.

Stipp: Bob, some interesting trends that we're seeing carry through the earnings reports that we got so far and potentially through those economic reports we're going to get this week and also in the future. Thanks for joining me and for those insights.

Johnson: Thank you.

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