Third quarter earnings results are pouring in. Total net income growth has been far higher than expected, although the median surprise and the ratio of positive surprises to disappointments has been about normal. Thus I would characterize the season as good, but not great.
We have 324, or 64.8%, of the S&P 500 firms reporting so far. That sort of understates things a bit, since those 64.8% of firms represent 75.7% of all expected earnings for the quarter. That is provided that the remaining 176 firms all report exactly in line with expectations.
The year-over-year growth rate for the S&P 500 (so far) is 17.58%. That is actually well above the 11.48% growth that those same 324 firms posted in the second quarter. However, the second quarter was distorted by some big hits to the financial sector, most notably Bank of America (BAC). This time BofA reported better-than-expected earnings and did not have the big “write off” it did in the second quarter. That resulted in a $12 billion swing in total net income between the second and third quarters.
With and Without the Financials
If we exclude the financials, the year-over-year growth rate is just a bit higher at 19.14%, but it represents a slowdown from the second quarter, when growth was 21.25%. The final growth tally for the quarter is likely to be lower than that.
The remaining 176 stocks are expected to growth their earnings 6.65% over last year, down from 13.28% growth in the second quarter. If we exclude the financials, the remaining growth in the third quarter is expected to slow to 7.36% year over year from 15.04%. Then again, at the beginning of earnings second quarter season, growth of 9.7% was expected; 12.2% ex-financials.
We will need another season where positive earnings surprises far outpace disappointments if we are going to match the second quarter growth rate. If we combine the already reported results with the expectations, it now looks like the final growth will come in at 14.73%. If the remaining firms surprise to the upside the way the ones that have already reported do, it is not hard to see the final growth coming in at around 16%.
Positive Surprises No Real Surprise
Relative to expectations, both earnings and revenues are doing better than expected. Then again, having far more companies report positive surprises than disappointments is entirely normal. The current ratio of 3.10 (for the 324) is in line with the average experience of the last five years or so. The median surprise is 2.82%, slightly below “normal.” Still, it is far more positive surprises than disappointments.
Top-line surprises started off extremely strong, but have faded. The surprise ratio is now 1.55 for revenues with a 0.68% median surprise. Not bad, but not terrific either. Top-line growth so far has been 11.94% and 12.25% ex-financials — on both counts actually a slight acceleration from the second quarter. The remaining 176 firms are collectively expected to grow their top lines by 2.75%, or by 8.91% if we exclude the financials, both well below the second-quarter pace.
Expanding net margins have been one of the keys to earnings growth. That is still the case, with reported net margins of 10.74% so far, up from 10.23% a year ago, and 10.18% in the second quarter (for those 324 firms). However, the mix of firms that have reported so far is skewed towards higher-margin firms, and the BofA effect is very big as far as the increase relative to the second quarter is concerned.
Expectations for the Rest of the S&P 500
Excluding financials, net margins have come in at 9.37% up from 8.86% a year ago, but down from 9.42% in the second quarter. The remaining 176 firms are skewed towards much lower margin businesses such as Retail. The remaining 176 are expected to post net margins of 7.12%, up from 6.86% a year ago and 7.09% in the second quarter.
Excluding the financials, though, it looks like the expanding net margin party might be coming to an end, with 6.77% expected, down from both the 7.03% level of the second quarter and 6.87% a year ago.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.32% in 2009. They hit 8.58% in 2010 and are expected to continue climbing to 9.31% in 2011 and 9.80% in 2012. The pattern is a bit different, particularly during the recession, if the financials are excluded, as margins fell from 7.78% in 2008 to 6.98% in 2009, but have started a robust recovery and rose to 8.20% in 2010. They are expected to rise to 8.83% in 2011 and 9.07% in 2012.
Focus on the Full Year
The expectations for the full year are very healthy, with total net income for 2010 rising to $796.0 billion in 2010, up from $543.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $908.2 billion, or increases of 46.5% and 14.1%, respectively.
The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.009 Trillion, for growth of 11.1%. That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $105.99. That is up from $57.09 for 2009, $83.63 for 2010 and $95.44 for 2011.
In an environment where the 10-year T-note is yielding 2.39%, a P/E of 15.4x based on 2010 and 13.5x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 12.1x.
Heavy Estimate Revisions
Estimate revisions activity is rising rapidly, as is seasonally normal. We have seen a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year, but it is still far from turning positive. To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by, say, a nickel, and the analysts don’t increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter.
With more than three positive surprises for every disappointment, one should expect more upward revisions than cuts. Even so, the ratio is still deep in negative territory at just 0.77, although that figure still includes some estimate changes that were made before the earnings reports came in (we track a four week moving total). There is no mechanical effect when it comes to the revisions for next year, and those remain even further in negative territory at just 0.42, or more than two cuts for every increase.
The net cuts are very widespread. For this year, only six of 16 sectors are seeing more positive than negative revisions. For next year, every sector but Business Service has more cuts than increases, and cuts outnumber increases by more than two to one in 12 sectors.
As the principal argument in the bulls favor is the high level of corporate earnings, and the low valuations relative to them, this trend needs to reverse, and soon. The very low revisions ratio for 2012 is very troubling and is confirmed by the ratio of firms with rising mean estimates to falling mean estimates being just 0.38.
