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The fourth-quarter earnings season's effect on the stock market is generally delayed. For the last 10 days of the year, the usual preannouncements are subsumed by the holidays. Perhaps that's why the market tends to rally early in January, when visions of sugar plums still dance in investors' heads.
It's now time for more clear-eyed appraisals. The analysts' consensus is that earnings for the Standard & Poor's 500 will rise by about 16% in 2002 vs. 2001. That's a pretty good forecast when you consider it compared to a 28% earnings decline the previous year. The outlook is starting to reflect the fact that companies across most industries have been cutting costs to the bone. Even a slight pickup in demand should sweeten earnings as the year progresses.
Over the next week or so, however, corporate managers will have mostly disappointing news for investors. Not only will fourth-quarter earnings continue on a shrinking trend, they'll probably be worse than analysts expect, as managers use the rotten business environment as an excuse to clean house of all the things they should have written off ages ago.
THINKING POSITIVE. As dismal as the fourth-quarter profits picture is likely to be, though, some signs indicate that earnings losses may be hitting bottom. For one thing, price-to-earnings multiples are creeping up -- as they should when earnings hit a trough. For another, the number of positive preannouncements this earnings season appears to be rising slightly.
The second week of January is generally the peak week for earnings preannouncements -- and that's looking better. "We're only half way through it, but the trend is clear," says Hill. "There have only been 576 negative preannouncements so far. That's 3% below the number at the equivalent time a year ago."
As negative guidance dwindles, optimistic news is on the rise. For the first few quarters of 2001, positive preannouncements accounted for only about 13% of the total, well below the 25% average that occurs when earnings bottom. That fourth-quarter positive preannouncements have crept up to about 26% of the total suggests earnings have stopped falling. During peak earnings periods, about 50% of preannouncements are positive.
FORGETTING THE FOURTH. Another hopeful sign: Multiples are starting to rise again. The S&P 500 trades at about 27 times trailing operating earnings, when its trend rate is arguably 15 to 20 times. The higher multiple shows the market's belief that earnings will rise. As these earnings are realized, p-e multiples will come back down.
In the meantime, "the market has correctly decided that the numbers for the fourth quarter are indicative of nothing," says Milton Ezrati, senior economist and strategist at Jersey City fund manager, Lord, Abbett & Co. "The write-offs for the fourth quarter of 2001 should be huge, as they have been all year."
That's largely because managers will use investor expectations of bad earnings news to pile extraordinary charges onto the income statement and clean up their balance sheets. In an average year, one-time hits to earnings, such as the cost of layoffs, writing off obsolete inventory, or restructuring amount to between 10% and 15% of operating earnings, Ezrati estimates. In 2001, these write-offs soaked up about 45% of operating earnings.
ON THE COMEBACK TRAIL. That should be good news for profits down the road. "Business has done everything it can to stem the flow of red ink," says Ezrati. "So any activity will go straight to the bottom line" in the future. Current stock prices reflect that outlook. "Earnings for the fourth quarter will be worse than for the third, and the first quarter will be slightly worse than the fourth, but that's already [priced into] the market," says Chuck Hill, director of research at Thomson Financial's First Call. "We'll see an upturn in the second quarter."
One sector that could be poised to benefit from its 2001 cost-cutting is auto parts. While it's true car companies used significant discounting to borrow significant sales from 2001, they've been so aggressive about chopping inventories that they'll have to increase production to fulfill even the reduced demand for cars.
Some of 2001's worst-hit sectors may stabilize in 2002. Companies that manufacture materials -- such as paper, chemicals, and metals -- saw their earnings drop by 51% in 2001, according to S&P's estimates. As other sectors start to respond to the economic recovery, they'll ramp up production and require more of these materials. As a result, S&P estimates the materials sector's earnings could rise by 54% in 2002.
TELECOM TURNAROUND? Sectors that performed the best in 2001 may show steady but unimpressive growth in 2002. Patent expirations are threatening the earnings of drug companies. Eli Lilly (LLY
) will lose the patent on Prozac. Bristol Myers (BMY
) will lose its signature diabetes drug Glucophage. And Merck (MRK
) will lose Pepcid and Prilosec. "The sector will have high single- or low double-digit growth in 2002, vs. low- to mid-double-digit growth a year ago," says Herman Saftlas, pharmaceuticals analyst at S&P. Consumer staples and financial services may have earnings growth of 8% or so, according to S&P estimates.
Even the very dark telecom tunnel may have some light at its end. "On a year-over-year basis, things may not look that strong, but on a sequential basis, things may start to look a little better," says Craig Shere, telecommunications analyst at S&P. Fourth-quarter earnings will reflect some equipment write-offs in the wake of September 11. But the 2001 layoffs at the Baby Bells have significantly improved their cost structures.
In addition, the adoption of a new accounting standard that eliminates goodwill write-offs could add as much as 15% to the sector's earnings, according to Steven Wieting, senior economist at Salomon Smith Barney. In telecom's fastest growth area, wireless companies like Nextel (NXTL
) and Sprint PCS (PCS
) will continue to inch their way toward profitability in 2002.
BIG CUTBACKS. Nevertheless, don't expect a sudden spate of capital spending among telecoms to rescue the economy. "Everybody has announced big cutbacks to their capital spending programs," observes Shere. SBC Communications (SBC
) announced it would cut back on its Pronto project, the plan to extend high-speed digital subscriber line service to its network. AT&T Wireless eliminated its fixed-wireless program. And Sprint stopped its rollout of ION, a bundling service for local long-distance and high-speed data. "These are just three examples of multibillion dollar projects being eliminated," says Shere.
That's unfortunate for the likes of Cisco (CSCO
) and other telecom equipment providers that likely will be the tech sector's last to turn it around (see BW Cover Story, "Cisco: Behind the Hype"). "The things that pulled tech out of the prior recession won't happen this time," observes First Call's Hill. "This recession we had too much capacity going in, so even with lower interest rates there's no point in adding capacity," says Hill.
The importance of interest rates shouldn't be underestimated in the profit picture. "From 1989 to 2000 the S&P Industrials -- which includes everything except financial companies, utilities, and transportation companies -- saw their earnings go up 114%," says Wieting. "If you exclude the decline in net interest costs, they would only have risen by 64%."
A REWARD? Of course, interest rates have most likely bottomed out, so companies can't count on much more help from that area this year. But that doesn't preclude the beginnings of an earnings recovery later in 2002. It would be the reward for aggressive cost-cutting and a mild uptick in consumer demand as confidence rebounds.
"A 15% to 20% operating earnings gain is modest for a cyclical recovery," points out Lord Abbett's Ezrati. After the earnings devastation in 2001, modest gains may look downright stellar.
Popper is an associate economics editor for BusinessWeek Edited by Beth Belton
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Copyright 2002 , by The McGraw-Hill Companies Inc. All rights reserved.
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