The Earnings Rebound May Be Misleading

On the surface, the flood of better-than-expected second-quarter earnings reported in July might suggest that a rebound for U.S. business is in full swing. More than three-quarters of companies that had announced results by July 27 topped Wall Street profit predictions. Operating margins—a much watched measure of profitability—were running at an average of 11.6 percent, compared with a more typical 7 percent. Big corporations such as Honeywell (HON), UPS (UPS), and FedEx (FDX) are also forecasting more black ink in the months ahead.

There's plenty of sobering news, however, lurking within the upbeat pronouncements. Many executives are generating stronger profits by wringing costs out of their businesses rather than by expanding revenues. Most of the quarter's earnings pops at companies such as DuPont (DD) reflect overseas operations or exports, not business in the U.S., where consumers remain tightfisted. And for many companies, the quarter's gains were magnified when compared with results in recession-wracked 2009.

"Earnings are nicely up from the second quarter of 2009—no great feat," says Howard Silverblatt, an analyst at Standard & Poor's (MHP). But he notes that soaring margins are actually a function of less-than-robust sales growth, since a dollar of earnings is a bigger percentage of $9 in sales than of $10. A fifth of the companies that reported earnings by July 27 fell short of their second-quarter revenue estimates.

Consumers are spending 60 percent of what they normally do during a recovery, according to Bruce McCain, chief investment strategist at Key Private Bank (KEY). Restrained consumer spending, along with uncertainty about health costs after the enactment of reform legislation, are contributing to business cautiousness about investing and hiring, he adds. "They're willing to give up some of their upside to retain their defensive position."

There is some good news about earnings. Exporters to developing markets—the "spark plug" in the recovery, McCain says—have posted profit and sales gains as they help India and Brazil build infrastructure. Almost 72 percent of industrial companies have posted sales that topped estimates, compared with 61 percent of all companies. Equipment maker Caterpillar (CAT), which generates 67 percent of its sales from outside the U.S., reported second-quarter sales that beat estimates and boosted its 2010 earnings outlook. Caterpillar cited higher demand for construction gear in developing countries.

A similarly upbeat vibe characterizes many foreign units of big American companies. Columbus (Ga.)-based Aflac (AFL), which gets most of its revenue from insurance sales in Japan, saw its second-quarter profits surge 85 percent, thanks to strong health and life policy sales there. And DuPont's sales in the Asia-Pacific region surged 47 percent, vs. an 18 percent rise in the U.S.

So far, though, it's unclear when the domestic U.S. business climate will improve markedly. Corporations that serve business customers seem to have the edge. Computer printer maker Lexmark (LXK), for example, reported that its second-quarter earnings more than doubled. "The reason Lexmark is growing is our enterprise [corporate] business is growing," says Chief Executive Officer Paul Curlander.

It's a different story for businesses focused on consumers. CVS Caremark (CVS), the largest U.S. provider of prescription drugs, on July 28 cut its 2010 forecast on worries that fewer consumers would seek medical care because of the still-weak economy. That caution is echoed by executives across U.S. industries.

"The business-to-business side is pretty good," explains Kurt Kuehn, chief financial officer of UPS, which saw second-quarter earnings jump 90 percent, in part because of a big boost in business shipments in Asia. "The consumer is another question. The more attached to consumers you are, the more risk."

The Bottom Line: U.S. companies are reporting strong second-quarter profits; there are reasons to question how promising the results are.

Before it's here, it's on the Bloomberg Terminal.