A Second-Half Earnings Reprieve?

First Call's Chuck Hill says despite some uncertainty, analysts aren't cutting their second-half estimates -- a favorable development

Though uncertainty reigns when it comes to forecasting earnings growth, many analysts didn't slash estimates for the remaining quarters of this year. This, says earnings tracker Chuck Hill, research director for Thomson Financial's First Call, is a positive development that hasn't been seen for some time. He says the key measure to watch in the coming months is the strength of consumer spending, which he hopes will be robust enough to soak up the excess capacity lingering in manufacturing and other sectors.

These were a few of the points Hill made in an investing chat presented May 15 by BusinessWeek Online on America Online, in response to questions from Karyn McCormack of BW Online. Following are edited excerpts from this chat. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: With the corporate profit trend all-important to a significant market climb, what's the current outlook?


Well, unfortunately, the second quarter will be softer than the first. Currently, industry analysts are expecting the S&P 500 year-over-year earnings growth to be around 5.9%. We think the final numbers will be between 6% and 9%.

Part of the message about the earnings outlook is that the crystal ball is as clouded as we've seen it, and we've felt that way for the last six months. Normally at this state of the quarter, with it being half over, we would have a single-number estimate for earnings growth that we would have confidence in.

The analysts are, on the other hand, expecting an upturn in the third and fourth quarters. The expected growth for the third quarter is 12.4%, and it's 21% for the fourth quarter. Normally, we'd be able to make a single-number estimate for the third quarter where we think things are going to end up, but we can't even put out a range that we have any confidence in at this stage.

Probably the most relevant question with regards to the earnings outlook was: "Is the anomaly the strength of Q1 or the weakness of Q2?" -- and we don't know the answer yet. The most favorable development during the first-quarter reporting season was the fact that the analysts didn't slash the estimates for the remaining quarters of this year. That's very different from the slashing that took place a year ago on the upcoming quarters and again six months ago on the upcoming quarters. However, that's no guarantee that the third-quarter expectations are going to materialize.

From a macro point of view, we think the most important thing to watch is any information that tells us something about consumer spending. Because this recession was so different from anything in our lifetime, because it was caused by a capital-spending binge rather than overspending by consumers, we need the consumers to keep increasing spending to soak up some of the excess capacity that remains in many industries. Hopefully, before too long, capacity utilization will be high enough in enough industries for business in the aggregate to open the capital-spending spigot more than the trickle of the last two years.

Q: Haven't earnings improvements for the most part this quarter been the result of cost-cutting?


Yes and no. If we look at the sector data, energy was clearly the star -- but due to the high energy prices, which were transitory. Energy earnings for the first quarter were up 180%, driven by a 46% gain in revenues. Overall, for the S&P 500, earnings will be up about 11.6% or so, while revenues will be up 9.9%. But all of that difference and more is due to the energy sector.

If we take out the energy sector, earnings are up 4.7%, while revenues are up 6.8%, indicating that at least for some of the other sectors, it wasn't all cost-cutting. The sectors where cost-cutting was responsible for much of the growth included the two key sectors of technology and consumer cyclicals. Earnings for tech were up 16% on revenue growth of only 2%. Earnings for consumer cyclicals were up 18% on revenue [growth] of 7%.

Q: Homebuilder Ryland Group (RYL ) beat first-quarter projections. Do you feel the housing market is still strong?


All the indications from the homebuilders are that it is. Analysts continue to raise earnings estimates for them, and they continue to beat estimates. It's been the mystery of this recovery why it's remained as strong as it has. Clearly, low interest rates are driving it, but nevertheless it continues to surprise the analysts.

Q: How big a part of this continued consumer spending has been from consumers gaining savings by refinancing their mortgages?


We don't have a number for that, but clearly it has been a factor for homebuilding, autos, and home furnishings and appliances, which consumers tend to buy on credit. But even with record incentive levels from the autos, home furnishings, and appliance companies, we're seeing a significant slowing in earnings from these companies, which indicates that consumers are getting more cautious. That could change if interest rates drop further, which after the deflationary news today on the producer price index would indicate that it's a growing concern.

Q: What are your thoughts on energy and natural-gas companies?


For the exploration-and-production oil and natural-gas companies, earnings last year were down 52%. This year they're expected to be up 94% -- obviously, at diminishing growth rates during the year. By fourth-quarter growth will be 15%, and next year, earnings are expected to be down 20% for the full year. So clearly, you're bucking the tide in that earnings growth is clearly going to be declining for a while.

Q: How do retailers like Home Depot (HD ) look?


Well, the retailers as a group are certainly a question mark. The numbers for April didn't look too bad, but when you remember that Easter last year was in March and this year in late April, it's pretty clear that the retail sales numbers for April were disappointing. The big concern whether consumers are going to continue to spend lies primarily with the employment data, where the layoffs just keep coming.

Home Depot is expected to report earnings next Tuesday. Earnings [per share] are expected to be 37 cents, up only a penny from last year's 36 cents. Growth is expected to improve as the year progresses but still be relatively modest. Back on Feb. 25, guidance was given that the earnings for this year would be from $1.70 to $1.78, but the analysts are predicting them at $1.69. The consensus on Home Depot for our analysts is about average.

Q: What about JDS Uniphase (JDSU ) and other fiber-optics outfits?


Well, the problem remains that we built far too many fiber-optic lines to nowhere, and it looks like it's going to be quite a while before capacity utilization reaches a level that could spark capital spending by the telcos. Analysts are looking for JDSU to narrow its losses as we go forward but won't look for profitability until around June, 2005. Only one analyst has a strong buy, none have a buy, 11 have a hold, 9 have a sell, and 2 have a strong sell.

Q: We've seen many earnings surprises in tech -- like from Computer Associates (CA ) and Intuit (INTU ) today. Do you get a sense that the tech outlook is improving?


Well, the analysts seem to think so, since they haven't really cut their estimates for this quarter and the second half very much. On Jan. 1, the expected earnings growth for the tech sector in the second quarter was 25%. It dropped to 23% by Apr. 1, and it's now at 21%. In the first quarter, the numbers went from 50 to 54 to 53, so clearly this is less than the normal trimming, but whether these expectations will be realized is a big question mark.

Cost-cutting seems to be where most of the growth is coming from, and there seems to be little upturn in the top line. One exception is the tech canaries that we watch. The two largest semiconductor foundries, Taiwan Semiconductor (TSM ) and United Microelectronics (UMC ), have seen a significant upturn in the last month or so.

Q: Since airline stocks are way down, do you think there are some bargains to be had for the future?


With the exception of Southwest and a few of the small new ones, you're really rolling the dice, because it may depend on what Washington does more than anything. The average consensus recommendation over the group is about, well, average. But as far as earnings go, the industry is expected to show bigger losses this year than last -- but to show smaller losses next year. Still, a good part of those estimates is not much more than guesswork.

Q: Do you think fixing the nation's infrastructure would give the market a faster shot in the arm than the Bush tax plan?


Probably, but even better would be to get more money directly into consumers' hands. Since overcapacity is the big problem, businesses aren't going to spend until there's better capacity utilization, no matter how the Fed lowers interest rates or how many tax breaks the Administration or Congress signs off on.

The infrastructure idea would at least indirectly get more money in the consumer's pockets, and that would be a help. But even more important is to provide some meaningful federal aid to the state and local governments, which may prove to be the biggest drag on consumer spending before the year is over [if they don't get some relief].

Q: Are telecom companies coming back?


Well, the telecom-service companies will experience revenue growth as a result of greater wireless and Internet usage, but it may be a while before the earnings come back, considering their tremendous excess capacity and huge amounts of debt. Given the regulatory issues on the table, there's a lot of risk [over] which companies are going to benefit the most, let alone how long it will take.

For the telecom-hardware companies, it's more a matter of time, but it may be a long time before most of the industry sees a meaningful pickup. Depending on the success of the new wireless technologies, there might be opportunities for those hardware companies focused on that area.

Q: Chuck, are companies providing more information when it comes to earnings guidance without the use of so-called pro forma techniques?


Well, the use of bad pro forma is declining and will decline further as a result of the Security & Exchange Commissions's implementation of regulation G on Mar. 28, which prevents companies going forward from excluding the same items repeatedly from the reporting earnings. There's nothing wrong with investors or companies excluding bona fide nonrecurring and nonoperating earnings from the reported earnings, but in addition to the serial offenders, there certainly were the occasional violators. Some of that still remains, but we think over the next year it will improve.

We're generally bullish on companies and sell-side analysts behaving better down the road (see BW Online, 5/07/03, "Still the Street's 'Fundamental Problem'".) Some meaningful changes in regulations are producing better results. Certainly in the recommendations area, there's a major policy change going on, and we go through this to some degree every business cycle. It's just that this time the excesses were much greater, because the bubble leading up to the correction was much bigger and longer.

One of the aspects of the capitalist system is that in every correction at the end of each business cycle, in addition to companies purging their operations to become more efficient, companies and the investment communities purge their ethical lapses and get back to better behavior. So it's just going to take a little more time and a little more work in this correction. But we're confident things will get back on track eventually.

Edited by Karyn McCormack

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