A Sober Look at Third-Quarter Earnings

They're good, but not as strong as they appear at first glance. And that accounts for the sour mood among lots of pros on the Street

By Eric Wahlgren

So far, third-quarter corporate earnings haven't looked too shabby. For the 353 companies -- 71% -- in the benchmark Standard & Poor's 500-stock index that had posted results by Oct. 24, profits were up 5.8% this quarter over the same period a year ago.

True, that's a far cry from the 16.6% increase Wall Street had forecast in early July, before profit warnings lowered the bar. Nevertheless, it represents the second quarter in a row of year-over-year increases after five straight quarters of earnings declines. Enthusiasm over earnings reports drove the S&P 500 up nearly 16% from Oct. 10 to Oct. 21.

Even though the market stumbled on Oct. 22 and Oct. 24, the bulls haven't gone into hiding. On the contrary, stocks were up again in the week ending Oct. 25. But with plenty of market experts wary about the advance for several reasons, smart investors may want to hold onto their hats for the next few weeks. The reason: Third-quarter numbers may look more bullish than they actually are (see BW, 11/4/02, "Graphic: An Early Look at Third-Quarter Profits").


  On the surface, it does seem like companies have been besting Wall Street's forecasts this quarter by a wider margin than usual. As of Oct. 25, released results topped estimates by an average of 3.5%, says Trip Jones, a senior vice-president at Fulcrum Global Partners in New York. That's higher than the 2.8% average "beat" that outfits in the S&P 500 score. (As a rule, estimates lower the bar, since Wall Street rewards pleasant surprises and punishes bad ones. See BW Online, 8/6/01, "A Penny Shaved Is a Penny Earned".)

Jones points out, however, that if software giant Microsoft (MSFT ) -- which blew past even analysts' most optimistic expectations -- is taken out of the mix, earnings exceeded estimates by 2.4%. If you don't count the Colossus of Redmond, notes Jones, results "are running below trend."

Another factor in some analysts' sour mood: It turns out much of the quarter's corporate-profit growth came from cost-cutting rather than any real increases in sales -- or demand. Consider Xerox (XRX ). The office-equipment maker on Oct. 23 posted a third-quarter profit, vs. a loss a year earlier. That was welcome news, of course. But Xerox revenues in the quarter fell 6%. The move back to profitability was chiefly the result of controlling expenses. That was the case at many other companies, too.


  "Cost-cutting is a short-term fix," says Peter Cohan, a financial consultant and executive in residence at Babson College in Babson Park, Mass. "What really gets investors excited is growth. Many companies have gone as far as they can on cost-cutting, and demand isn't growing."

And that leads to the third bugaboo troubling investors: Companies remain infuriatingly mum about their future outlooks. Typically, upbeat expectations can be as much a stock price booster as are positive profit reports. But this quarter, lips are zipped about the next quarter, let alone about next year.

"I haven't really heard anything from any company that really matters to suggest that the weakness that we've seen this year is getting any better," says Mark Sellers, editor of Morningstar StockInvestor, a financial newsletter published by the Chicago-based mutual-fund researcher.

In fact, companies that have opened up about what's to come have been mainly downbeat. When Intel (INTC ) posted profits that missed expectations on Oct. 16, the chipmaker also warned that the economy had not recovered enough for holiday sales to support much improvement in the fourth quarter.


  To some extent, the pessimism is understandable. Stocks were pummeled in 2001 because earnings projections remained so bullish even in the face of the bursting market bubble. "Companies are being a lot more cautious than they were a year ago," says Sellers. Indeed, last year many of them dared to predict that a turnaround would occur sometime in 2002's second half. Although business has stabilized in a number of sectors, few have shown any real vitality. Of the promised rebound, Sellers says it "really hasn't happened."

The question is: Are execs being too cautious? Actually, the fourth quarter's outlook is supposed to be better than the third. Earnings are now seen rising 17.2% year-over-year in the quarter, according to Thomson First Call. But that target is expected to come down over time, as companies continue to warn about trouble ahead.

The ratio of negative to positive earnings "preannouncements," as guidance is called, currently stands at 1.7 for the fourth quarter, according to Thomson First Call. That's an improvement from the 2.3 ratio for the third quarter, but the ratio in the second quarter of 2002 was 0.9. "Guidance is doing a little bit better, but it's still not great," says Jones.


  And after all the accounting scandals and bookkeeping questions that surfaced over the summer, investors also remain skeptical about the quality and clarity of earnings, says Fulcrum's Jones. "There are clearly some major earnings issues that have not been resolved," he says. Besides the lack of any real return to growth in revenues, companies may have to reduce their assumed rate of return from pension funds. That, of course, could hurt their income statements.

And don't forget insurance costs, which continue to rise and could also take a bite out of profits, Jones says. Moreover, debt ratings are falling, which is making it harder to get the capital needed to stay in business, let alone expand. As Jones notes: "That hurts everyone."

Despite all these factors for investors to weigh, Jones suspects that the market may have more near-term upside than the bears realize. "I think that we're getting some stimulation from earnings right now," he says, though he still thinks that Wall Street, overall, remains in a bear market. When the earnings season tails off near the end of October, investors may go back to focusing on things like the economy and profit guidance. Unless these improve, however, stocks may face a tougher climb.

Wahlgren covers the markets for BusinessWeek Online in New York

Edited by Douglas Harbrecht

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