Plenty of Speed Bumps for 2003 Earnings

The growth momentum profits gained for three straight quarters in 2002 isn't likely to keep growing in the first part of this year

By Amey Stone

With some exceptions, corporate earnings announcements for the fourth quarter -- thankfully -- have been generally benign. The first full week of trading every year is also the peak week for companies to preannounce whether they'll beat or miss earlier guidance. And in 2003 investors have learned that such companies as electronics retailer Best Buy (BBY ), software maker SAP (SAP ), and router maker Foundry Networks (FDRY ) would exceed forecasts. That news follows on the heels of better-than-expected reports from storage king EMC (EMC ), maternity retailer Mothers Work (MWRK ), medical device maker Guidant (GDT ), and software integration company WebMethods (WEBM ).

A smaller percentage of companies have given negative preannouncements than at the same point in the previous few quarters. About 43% of companies have made negative fourth-quarter announcements compared to 53% this far after the third quarter, according to earnings tracker First Call. In a Jan. 6 report, Soundview Technology Group strategist Arnie Berman dubbed this "the most mild confession season on record since the bubble burst."


  For the fourth quarter of 2002, analysts predict earnings will be up 11.2% over the year before, marking the sharpest year-over-year growth since the earnings recovery began in 2002's second quarter. "It's much less than people were expecting, but at least it's heading in the right direction," says Chuck Hill, First Call's director of research. But a solid fourth-quarter earnings period -- however welcome -- is far from a green light to jump back into stocks. In fact, early signs are that the last quarter's earnings growth rate won't be sustained in 2003's first quarter.

Even as First Call's fourth-quarter earnings estimates for companies in the Standard & Poor's 500-stock index actually nudged up last week, analysts were slashing estimates for the first and second quarters. They now predict earnings growth of 11.3% for the first quarter year-over-year and 10.4% for the second, and the actual numbers are likely to be lower. Hill says the slide won't be just the normal phenomenon of most companies reporting their strongest results in the fourth quarter and weakest in the first.

Final seasonal adjustments for 2002 have yet to be made, but First Call's rough estimates show that earnings in the second quarter were 2% ahead of the prior, in the third quarter they were up 4%, and it looks like fourth-quarter results will beat the third's by 7%. Hill expects that first-quarter results won't beat the fourth quarter's by a wider margin and may even be down sequentially. "We certainly are not going to see a continuation of each quarter beating the one proceeding it by a slightly wider margin," he cautions.


  There's little mystery as to why earnings growth is hitting a soft spot. Earnings tend to shadow gross domestic product, and economic growth slowed in the fourth quarter, prompting the Federal Reserve to slash interest rates in early November. Geopolitical risks continue to loom, holding back corporate spending. Companies face rising costs from insurance, pension liabilities, energy, and restructuring charges. A meaningful jump in capital spending, which would propel tech and industrial earnings, isn't expected until the second half of 2003.

The big question again is whether consumers will hang tough and keep the economy afloat until capital spending picks up. And many companies have done all the cost-cutting that they can do. "Some of the easy earnings gains you get at the beginning of the recovery are behind us, unfortunately," says Hill. "Now it is top-line growth that has to keep this thing going, but that's very iffy at this point." First Call forecasts 4% revenue growth in the fourth quarter, about the same as the third quarter. "It's a really fuzzy crystal ball right now," says Hill.

Many strategists are reserving judgment until companies comment on the first quarter when they report fourth-quarter results. After the bulk of fourth-quarter announcements are in -- usually by the third full week in January -- investors will have a pretty good sense of how the first half of the year will fare, says Hill.


  "Fourth-quarter earnings don't mean nearly as much as first-quarter guidance," says Trip Jones, a senior vice-president at investment firm Fulcrum Global Partners. If an increasingly probable war with Iraq goes well and oil prices come down, he thinks the market will rally regardless of the lack of improvement in first-quarter earnings.

However, if geopolitical risks remain, investors likely will remain skittish, and the market could stall, especially as it becomes clear that earnings growth is slowing. Given all the lingering risks, "investors will require nearly continual monthly confirmation of fundamental improvement to keep their fear of another ugly retest at bay," predicts Soundview's Berman.

He urges investors to "take comfort" that the worries weighing on the market -- and corporate earnings -- are widely shared and have been around for some time. That means they're mostly already reflected in stock prices, and any lessening of global political risk could prompt a strong rally. But until that happens, investors would be wise not to mistake solid fourth-quarter earnings as a sign of clear sailing ahead. The wary should at least wait to get through January before making a bold bet on the rest of 2003.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Beth Belton

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