Will Quarterly Reports Raise Red Flags?

Results for January to March may deliver important clues on the state of the economy and where the market may be headed

The first-quarter earnings season is kicking into high gear at an uncertain time for investors.

The U.S. economy teeters close to recession. Consumers are slowing their spending, gasoline and crude oil prices hit new records, and home prices tumble ever lower. Meanwhile, the financial crisis drags into its ninth month with no end in sight.

How bad is it out there, and how bad will it get? The fog may lift soon: Companies' earnings reports from the first three months of the year began arriving on Apr. 7—with a disappointing update from Alcoa (AA)—and will continue for several weeks. By scrutinizing financial results and listening to executives' commentary, investors might get a better handle on where things stand.

BusinessWeek asked some experts—fund managers and analysts—which early earnings reports they will be watching closely in the next couple of weeks. These stocks might provide early clues on the direction of the economy and markets in the months ahead.

Merrill Lynch and Citigroup

Merrill (MER) and Citi (C), which both report on Apr. 18, were bruised and battered by the U.S. subprime mortgage crisis. The bleeding is expected to continue in this quarter, with multibillion-dollar writedowns of bad debt anticipated.

Ashwani Kaul, an analyst at earnings-tracker Reuters Estimates (RTRSY), says he's looking for Merrill and Citi to follow the lead of UBS (UBS), which "wrote off the kitchen sink" by announcing $19 billion in losses on Apr. 1 (BusinessWeek.com, 4/1/08).

Financial firms should take maximum losses now—by, for example, writing down bad debt to 10¢ on the dollar, not 40¢, Kaul says. It's the best way to put the financial crisis behind us, he says. "Stocks are going to be rewarded for just writing everything down and going forward."

By this logic, the larger the writedowns that Merrill and Citi can take on Apr. 18, the better for the long-term health of the financial system.

Caterpillar and United Technologies

Big industrial firms such as Caterpillar (CAT) and United Technologies (UTX) have seen strong sales overseas. Huge spending on infrastructure around the world has put their products in demand, while a weaker dollar has made their products even more attractive and widened international profit margins.

Gary Wolfer of Univest Wealth Management (UVSP) expects that trend to continue when United Technologies and Caterpillar report results on Apr. 17 and Apr. 18, respectively. Strength overseas should help those companies prosper despite a recession in the U.S., he says. "I think they're going to weather the storm very well."

Wolfer and many other investors, however, will get concerned if these firms' international sales start to deteriorate. That could be the first signs that the U.S. slowdown is spreading to Europe or other parts of the globe.

JB Hunt Transport

The outlook for the U.S. transportation industry is ominous. An economic slowdown means there are fewer goods to ship around the country, and higher fuel prices make moving freight more expensive.

Longbow Research recently surveyed many executives at trucking companies of all sizes, and 87% said they expect a recession this year. "We are in a recession now, and it's going to get worse before it gets better," said one respondent.

Adding to the worry, package-delivery giant United Parcel Service (UPS) recently cut its predictions for first-quarter profits by 10%.

The U.S.'s largest trucking firm, JB Hunt Transport Services (JBHT), is expected to report earnings in the week starting Apr. 14. Despite the industry worries, JB Hunt's stock is up 9% so far this year. Investors are betting perhaps on a second-half recovery, thanks to the federal government's fiscal stimulus package.

Lee Klaskow, an analyst at Longbow, says conditions for shipping firms are bad, and investors seem too optimistic about the transportation industry. "Things aren't that great, and it remains to be seen how that stimulus package [will] help the economy," he says. Weak earnings from JB Hunt could confirm Klaskow's gloomy diagnosis.

U.S. Bancorp

Compared with Merrill or Citigroup, U.S. Bancorp (USB) has been relatively unscathed by the credit crunch. That makes its Apr. 15 earnings report even more interesting to Dan Genter, chief executive of RNC Genter. The big subprime-related write-offs at other financial players don't bother Genter as much as what's happening to banks' core businesses—consumer and commercial lending. So, he will scrutinize the financial statements of U.S. Bancorp and other large, mainstream banks such as PNC Financial Services (PNC) on Apr. 17, Wachovia (WB) on Apr. 18, and JPMorgan Chase (JPM) on Apr. 16 for what's going on with their nonmortgage businesses.

How fast is credit quality deteriorating in other areas, and how much money are banks losing on bad loans? That could give important clues to the state of the economy. Also, investors will be wondering whether banks like U.S. Bancorp are lending out money. Are banks "going to open the spigot a little bit?" Genter asks. "If they're not loaning money, that's not good for anybody."

Financial Companies with Real Estate Exposure

Bank earnings can also offer insight into the state of the real estate market. Colonial Bancgroup (CNB) made a lot of loans in Florida, so it is heavily exposed to "ground zero" of the housing crisis, says James Schutz, an analyst at the Sterne Agee Group. Colonial reports on Apr. 21.

Schutz says First Horizon National (FHN) is another bank to watch. Reporting on Apr. 17, the bank has real estate exposure across the country—especially to home-equity loans and loans to real estate developers.

As banks have seen the housing market collapse, they have prepared for losses by setting aside large capital reserves, Schutz says. But will it be enough to protect them from the worst of the housing slowdown this year?

Another potential bellwether for the real estate industry is SL Green Realty (SLG), a real estate investment trust with heavy exposure to the New York office market. Its earnings report, on Apr. 22, could provide clues to what's happening in the country's largest commercial real estate market, says Matthew Ziehl, portfolio manager of the RS Small Cap Core Equity fund (GPSCX). Also, SL Green's report could help predict how many layoffs Wall Street firms are planning, Ziehl says. A sharp drop-off in leasing activity could mean New York financial firms are preparing to downsize significantly.

NetLogic Microsystems

It's obvious to all that consumer spending has slowed markedly, especially since December. But Ziehl says he is waiting for the earnings report of NetLogic Microsystems (NETL)—due on or after Apr. 21—for an idea of what's happening with corporate spending.

Many U.S. corporations—at least those outside the financial industry—still have strong balance sheets and are increasing earnings. So, Ziehl says, last quarter's earnings season showed little evidence that corporate information technology spending was slowing.

Cisco Systems (CSCO) is often seen as a good gauge of IT spending, but Cisco won't report earnings until May. Semiconductor firm NetLogic, however, sells about half its products to Cisco, making it a "good indirect read into what's happening," Ziehl says.

Last quarter, companies were reporting just as the economy appeared to be turning south. That caused many executives to sound confused when talking about the future—they really didn't know how fast conditions were deteriorating, so they found it hard to make optimistic forecasts.

Three months later, corporate executives in all industries have had more time to adjust to the slower economy. Kaul, of Reuters Estimates, expects "companies will start opening their mouths a little bit," and those forecasts will ease the market's fears.

However, if executives sound as befuddled this quarter as last, that will raise yet another red flag for the stock market.

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