Earnings: Not So Gloomy After All

Outside of big financial firms, most companies posted solid Q4 profits. Looking ahead, investors are bracing for bad news

Amid all the worries about a U.S. recession and multibillion-dollar credit losses for financial firms, it's easy to lose sight of one fact: Most corporations are still making a lot of money.

The current fourth-quarter earnings season, in which corporations report results for the final three months of the 2007 calendar year, is mostly over. At first glance, the results look terrible, fulfilling the expectations of a stock market that has tumbled 12% in two months.

With 369 of the companies in the Standard & Poor's 500-stock index already reporting, Reuters Estimates (RTRSY) projects fourth-quarter earnings for the index will fall by 20.4%. That's quite a turnaround from October, the start of the fourth quarter, when analysts were expecting S&P 500 earnings to rise 11.5%.

But unless you look more closely at the season's profit reports, you will miss a silver lining: The big culprit in the weak profits are financial outfits. Outside of that sector, earnings have held up well.

Adding Up Losses

Of course, it's not easy to simply wave aside the financial sector's woes. Huge losses continue to pour out of the sector. According to Reuters Estimates, S&P 500 financial companies' earnings are expected to plummet 94% from a year ago.

Subprime-related losses at big banks such as Citigroup (C) have caught even the most pessimistic analysts by surprise. The average S&P 500 financial company reported a loss almost 170% worse than its analysts were expecting. "The financials have ruined the party," says Ashwani Kaul, an analyst at Reuters Estimates.

Though the losses were worse than expected, Wall Street had been expecting big financial losses for months, ever since the credit crisis hit in the summer of 2007. So what about the rest of the economy?

Standard & Poor's, using a slightly different methodology from Reuters Estimates, expects the S&P 500 to post a 23.2% decline in earnings for the 2007 fourth quarter. But, excluding the financial sector, S&P projects a 13.7% gain in earnings.

Slowdown Looms, Investors Worried

Three sectors—energy, health care, and information technology—are projected to see profits rise more than 20%, S&P says. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

The big subprime-related hits have hurt the large banks and brokerage houses in the S&P 500, but they've avoided the many small and midsize firms that aren't included in that broad index.

Ryan Crane, a small- and mid-cap fund manager at Stephens Investment Management Group, says so far profits in his corner of the market have been "pretty good."

Not that that's helped stock prices. Crane and other market observers say Wall Street has ignored good earnings reports. Investors are already looking ahead, and they're worried. The fourth quarter of 2007 is "in the rearview mirror now," says Doug Peta, a strategist at J. & W. Seligman.

With an economic slowdown looming, the concern is over how companies will fare in the current and future quarters. The word on everyone's lips lately is "recession." Are we in a slowdown or a deeper downturn? How long will the bad times last? There's a great deal of uncertainty, not just among investors and the general public but also corporate CEOs.

A Promising Forecast

While reporting solid profits, management has been cautious about predicting 2008 results. "The management teams aren't willing to stick their necks out," Crane says.

Peta suspects some executives are accentuating the negative. With so much uncertainty, "they want to underpromise and overdeliver," he says. If they overpromise now, it's likely investors, obsessed with the threat of recession, won't believe them.

According to Reuters Estimates, analysts expect weak profits in the first two quarters of the year—anemic 1.9% growth this quarter, followed by a 3% rise in the second quarter. But then analysts expect earnings to jump higher by midyear, to end 2008 with a 15.4% rise in S&P 500 profits.

In theory, investors should be looking forward to these good times, when profits bounce back. Many expect the Federal Reserve interest rate cuts to start taking effect, pulling the economy out of its slowdown. But that's not how investors are acting so far.

Proceeding with Caution

Among the worries is that the credit crisis drags on longer than the market expects. The terrible financial sector profits in the fourth quarter reflect the rough credit market conditions at the end of the year. But since then, the credit markets have gotten even worse, notes Brian Reynolds, chief market strategist at M.S. Howells. "It's been a disastrous year," he says, and unless conditions improve, you can expect a "whole new round" of multibillion-dollar write-offs at financial firms. Many hoped the financial sector would finally stop bleeding in the early part of the year. That seems increasingly less likely.

Also, Crane of Stephens Investment Management worries about signs that the financial sector's weakness is spreading to the economy's strongest areas. Executives at technology firms that reported earlier in the earnings season sounded relatively upbeat. But as the season has dragged on, their 2008 predictions have become more cautious, Crane says.

So, though the fourth-quarter earnings season is nearly over, the results have settled almost nothing. In the coming quarters, investors are hoping for a rebound but anxious that economic weakness could spread throughout the economy. When it comes to corporate profits, Wall Street, executives, and investors are stuck peering into a very murky future.

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