Third quarter earnings season is almost over. Total net income growth has been far higher than expected, although the median surprise and the ratio of positive surprises to disappointments is slightly below normal. Thus, I would characterize the season as good, but not great.
We have had 456, or 91.2%, of the S&P 500 firms reporting so far. The year-over-year growth rate for the S&P 500 (so far) is 16.17%. That is actually well above the 12.33% growth that those same 456 firms posted in the second quarter. However, the second quarter was distorted by some big hits to the financial sector, most notably Bank of America (BAC). This time it reported better than expected earnings and did not have the big write off it did in the second quarter. That resulted in a $12 billion swing in total net income between the second and third quarters.
If we exclude the financials, the year-over-year growth rate is just a bit higher at 19.61%, but it represents a slowdown from the second quarter, when growth was 20.74%. The final growth tally for the quarter is likely to be slightly lower than that. The remaining 44 stocks are expected to actually post earnings 5.44% lower than last year, down from positive 7.35% growth in the second quarter. At the beginning of earnings season, growth of 9.7% was expected; 12.2% ex-Financials.
If we combine the already reported results with the expectations, it now looks like the final growth will come in at 14.6%. If the remaining firms surprise to the upside the way the ones that have already reported do, it is not hard to see the final growth coming in at around 15%. The bar for the remaining firms does seem to be set pretty low.
Relative to expectations, both earnings and revenues are doing better than expected. Then again having far more companies report positive surprises than disappointments is entirely normal. The current ratio of 2.65 (for the 456) is worse than the average experience of the last five years or so. The median surprise is 2.78%, slightly below normal. Still, it is far more positive surprises than disappointments. Top line surprises started off extremely strong, but have faded.
The surprise ratio is now 1.44 for revenues with a 0.64% median surprise. Not bad, but not terrific either. Top-line growth so far has been 12.11%, and 12.57% ex-financials, on both counts actually a slight acceleration from the second quarter. The remaining 44 firms are collectively expected see their top lines rise by 4.17%, below the second quarter pace of 5.53%. All the reports from financial companies are in.
Expanding net margins have been one of the keys to earnings growth. That is still the case, with reported net margins of 10.01% so far, up from 9.66% a year ago, and 9.69% in the second quarter (for those 456 firms). However, the mix of firms that have reported so far is skewed towards higher margin firms, and the BAC effect is very big as far as the increase relative to the second quarter is concerned.
Excluding financials, net margins have come in at 9.04% up from 8.54% a year ago, and up from 8.99% in the second quarter. The remaining 44 firms are skewed towards much lower margin businesses such as Retail. They are expected to post net margins of 5.16%, up from 5.07% a year ago but down 5.57% in the second quarter.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.32% in 2009. They hit 8.58% in 2010 and are expected to continue climbing to 9.30% in 2011 and 9.74% in 2012. The pattern is a bit different, particularly during the recession, if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.98% in 2009, but have started a robust recovery and rose to 8.19% in 2010. They are expected to rise to 8.81% in 2011 and 9.01% in 2012.
Full-Year Expectations
The expectations for the full year are very healthy, with total net income for 2010 rising to $794.5 billion in 2010, up from $542.5 billion in 2009. In 2011, the total net income for the S&P 500 should be $910.1 billion, or increases of 46.5% and 14.6%, respectively. The expectation is for 2012 to have total net income passing the $1 trillion mark to $1.003 trillion, for growth of 10.2%.
That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $105.15. That is up from $56.87 for 2009, $83.31 for 2010, and $95.43 for 2011. In an environment where the 10-year T-note is yielding 2.03%, a P/E of 14.9x based on 2010 and 13.0x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.8x.
Estimate Revisions Peaking
Estimate revisions activity is nearing its seasonal peak. We have seen a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year. There are now more increases than cuts, with a 1.16 ratio, but by a margin that is still what I consider neutral.
To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by say a nickel, and the analysts don’t increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter.
With almost three positive surprises for every disappointment, one should expect more upwards revisions than cuts. That suggests that, on balance, the guidance given in the earnings conference calls was negative.
There is no mechanical effect when it comes to the revisions for next year, and those remain deep in negative territory at just 0.69. Still, that is better than last week, and last week was better than the week before. For this year, ten of 16 sectors are seeing more positive than negative revisions. Slightly more firms (ratio of 1.09) have higher mean estimates than a month ago.
For next year, only four sectors have more cuts than increases. As the principal argument in the bulls favor is the high level of corporate earnings, and the low valuations relative to them, this trend needs to reverse, and soon. The very low revisions ratio for 2012 is very troubling and is confirmed by the ratio of firms with rising mean estimates to falling mean estimates being just 0.60, but up from 0.48 lat week.
At times it seems like some sort of parallel universe version of “Annie,” where the rain will fall tomorrow, but tomorrow is always a quarter away. However, there are good macroeconomic reasons to think that earnings growth has to slow. Still, it seems to me that the bar is being set very low for the fourth quarter.
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