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Will Earnings Reflect a Recovery?

Pat Dorsey, CFA

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. Well, second-quarter earnings season is under way, and although much of the attention over the past couple of months has been on macroeconomic indicators such as the unemployment rate and the new orders rate and various types of information coming out of Washington, D.C., we'll soon get bottom-up information on hundreds of companies across the economic landscape--which of course we'll be watching very closely to see whether the "green shoots" spoken of by Chairman Bernanke and others are really all that green, or whether perhaps the recovery might be slower than some are anticipating.

We'll be looking at earnings from the major sectors in the market, in tech, consumer, industrials, health care, and financials. I polled our 90-person analyst team to see what are the key issues they will be looking at over the coming few weeks as the earnings roll in. I wanted to go sector-by-sector with some of the key themes we'll be watching for in earnings as they come in.

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In technology, we've seen chip industry benefiting from a pickup in demand in inventory restocking. The question is, how sustainable is that restocking? Is it really just end-user demand, or is it just that inventories got too low as pretty much the world shut down late last year and early this year, and then inventories got rebuilt, and then demand will peter out. We think that's the case, but we'll be waiting to see.

A similar story in hardware. A lot of big enterprise consumers have been putting off discretionary purchases for as long as possible. Many big tech companies are looking for a second-half rebound. Again, we're a little skeptical that's going to materialize. We'll be looking for guidance and any signs whether that will come to pass or not.

Finally, on the software side, one of the big questions is what kind of pricing software companies are getting on their very lucrative maintenance contracts. Usually a big software company like Oracle or SAP makes some very high margin revenue off of the maintenance and service contracts. Typically they've had pretty good pricing power on those. We'll have to see if that persists.

Moving on to the consumer, we'll be looking for signs of continued trading down. Has the trading down trend plateaued or does it continue? And any signs of life in discretionary spending. We'd like to see them, not sure we will. But we'll be looking for any signs that consumers are returning to the kinds of purchases that really aren't necessities.

And then finally, on pricing trends, we need to see how much discounting is going on. If discounting kind of abates or flattens out, that may indicate that retailers have gotten down to an inventory level that better reflects more modest consumer demand.

Moving on to industrials, we'll be looking on the shipping side, which is sort of the life blood of the economy and gives you a good read on how much goods and services are moving around the country in terms of rail volumes and trucking volumes. What is that telling us about the level of economic activity in the country?

FedEx recently indicated that they think they may have hit bottom in terms of package volumes. We'll be waiting to see if that's the case.

Unfortunately from the rail side--well, rail car loadings and car volumes are still declining at a pretty fast clip. That is a data point we'll be watching very closely. Warren Buffett recently said it's one of his favorite economic indicators, and the negative data coming out of car loadings and rail volumes stands in stark contrast to some of the more positive data coming out of things like the ISM new orders index. So we'll be trying to reconcile those two as we look for data in the upcoming earnings season.

Some of the CFOs at large industrial companies such as 3M and Tyco indicated they thought their business has bottomed in the second quarter. We'll be looking for any confirmation of that from other companies going forward.

Again, we're trying for this inventory stocking and restocking question. The big question is to what extent this pop in demand we've had recently is just inventories getting back to a normal level, or how much of it is actual demand from end users requiring increased production.

That's a huge theme you're going to see rolling throughout this earnings season, and it's especially important for industrial companies.