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Sam Stovall's Sector Watch

By Sam Stovall

Behind Earnings' Surprising Strength

S&P's sector-by-sector second-quarter review credits gains, in general, to global economic growth and improved pricing and cost controls

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From Standard & Poor's Equity Research
Question: When is "better than expected" a synonym for "normal"? Answer: When someone is discussing corporate earnings. The second-quarter 2006 reporting season is almost over, with only stocks in the retail sector yet to check out. And it appears as if we have our 17th straight quarter of double-digit earnings-per-share (EPS) gains for the S&P 500.

Prior to the release of first-quarter 2006 results, S&P equity analysts expected second-quarter operating earnings for the S&P 500 to advance 7%. Once the first-quarter reporting period had ended, and analysts were given updated guidance on second-quarter prospects, our second-quarter forecast rose to 8%. On June 28, that estimate had climbed to 9.4%. Now, however, it appears as if companies in the "500" will post a 13.5% rise for the quarter, pushing up the full-year forecast to 13.2% from 12.2%. So what went right?

Plenty, it seems. Better-than-expected second-quarter results were recorded by six of 10 sectors—Consumer Discretionary, Consumer Staples, Energy, Financials, Industrials, and Materials. Moreover, full-year estimates were raised for five groups: Consumer Staples, Energy, Financials, Industrials, and Materials.

What do S&P's sector heads see in the results reported this season—and what do they expect in the months ahead? Here, they offer their thoughts:

Consumer Discretionary: We would characterize EPS results thus far, as well as future guidance, as generally more negative than in recent times. For homebuilders, results were weak, with operating margins falling widely despite prices on settled homes that continue to rise steadily. Moreover, guidance and second-quarter demand—as measured by new unit orders that go into backlog—were extremely weak, suggesting margin diminution could accelerate when and if these orders become closings. However, weakening fundamentals going into the calendar second-quarter earnings season were pretty well telegraphed.

Autos and auto-parts companies' reports were a mixed bag, but one common theme was pain from higher raw materials costs such as steel and oil. From hotel companies, while we saw mixed results relative to expectations, we still got the impression that the U.S. industry remains in an uptrend, helped by higher room rates. With casino companies, we saw more EPS shortfalls vs. estimates than normal. For newspapers, general themes include strong Internet growth for all publishers, stock buybacks, dividend increases, strong outlook for broadcast advertising this fall, continued declines in circulation, weakness in traditional print advertising, hurt by a continued drop in auto advertising.

Fewer than 40% of retailers have reported, but their overall results were in line or slightly better than expectations, but with increased caution going into the second half.

Consumer Staples: It is shaping up to be a very good quarter for this sector. Whether we are talking about food packagers, household products, personal care, soft drinks, or tobacco companies, the two themes used to describe the improvement in earnings are strong pricing trends and cost-saving initiatives. For the rest of the year, even though input costs are expected to remain high (but the year-over-year rate of input-cost inflation is declining), companies have said that they are seeing benefits from pricing actions, cost savings and positive foreign exchange.

Energy: Results were generally better than expected. Integrated oil companies generally beat, more than missed, estimates. Exploration and production (E&P) outfits, land drillers, and oil service companies also mostly beat earnings, whereas oil drillers' results were a mixed bag. In general, there was some discussion of operators shifting over to oil activity from natural gas activity during the second quarter. Land drillers commented that customers were using rigs in oil developments instead of natural gas. Even though U.S. natural gas activity is up, production is flat. Producers are running harder just to stay in place, so earnings changes may be more hinged on pricing than before. Concern over a natural gas slowdown is not a new story, but drillers and services companies frequently tried to temper expectations by saying that the potential for a slowdown is still there.

Financials: Many outfits in this sector reported second-quarter earnings that were ahead of our estimates and consensus forecasts. Much of the outperformance reflected the impact of cost cuts or special items on margins. In banking, net interest margins held up well considering Fed tightening; credit quality continued to be better than expected. Investment banking also had a good quarter, and the deal pipeline looks relatively strong. And while commercial banking business remained healthy, mortgage banking earnings continued to decline but didn't have a significant falloff.

Many property and casualty insurers reported results that were ahead of expectations, driven by a benign claims environment, the impact of some cost controls, double-digit growth in investment income, and a stable premium pricing environment. Life and health insurers benefited from increased net investment income and expense discipline, while insurance brokers reported strong earnings on solid organic growth and firming rates in coastal areas.

Results for real estate investment trusts (REITs) were generally in line with estimates. Fundamentals remain strong for retail REITs and are improving for industrial REITs, while office REITs were generally meeting expectations with gradually improving occupancy and rental rates.

Health Care: Pharmaceuticals generally posted modestly superior results, helped by cost cutting, share buybacks, and the top-line benefits from Medicare, part D. Facilities, following two tough years as a result of bad debt and weak patient volumes, met the already low analyst expectations. Medical equipment companies recorded worse-than-expected results, on average, while managed care and services companies saw mixed results.

Industrials: We have been mostly seeing ongoing, but decelerating EPS growth taking place in the industrial machinery, electrical components & equipment, and railroads subindustries. Most companies in these groups have been meeting to slightly exceeding forecasts and are leaving guidance largely intact. The most positive performances took place in aerospace & defense (mostly in the aerospace part), where almost all beat estimates and slightly more than half raised guidance. It was also noted by many international conglomerates that global economic strength was healthy.

Materials: We have been seeing a somewhat mixed, but mostly positive second-quarter operating performance. The strongest results have been taking place in metals, with especially positive results in steel, where most beat forecasts, many by large amounts. The most disappointing performance that we saw was in the coal subindustry, which is followed by S&P's materials analysts but found in the Energy sector. Although overall earnings in coal were up strongly in second quarter, they still fell below forecast, and the outlook is growing less promising for the commodity. Price increases for coal slowed because of mild late winter, early spring weather, which allowed utilities to restock. Plummeting natural gas prices also pressured coal pricing.

Technology: It appears to us that consumer-oriented names fared better than enterprise-focused companies, as many enterprise companies referenced have longer sales cycles. Results for semiconductor and semi-equipment companies were pretty negative. Both hardware and software results were mixed, and EPS for services were not encouraging. The Internet area saw largely in-line reports and guidance, neither of which bodes well for these high-multiple companies. Share prices for these stocks have been among the weakest in the sector.

Telecommunications Services: In general, earnings performances were better than expected for the larger integrated telecom service providers. Earnings exceeded our expectations with strong broadband growth helping revenues and workforce reductions and other operating cost savings driving earnings before interest, taxes, depreciation, and amortization (EBITDA). Companies that choose to give guidance have raised their forecasts, but most outfits in the sector do not give guidance.

Utilities: Companies that came in below expectations typically did so for two reasons: abnormally mild weather or the loss of synfuel-related tax credits. Those that came in above expectations did so for a variety of reasons: warmer-than-normal weather, higher wholesale margins, higher transmission revenues, or the deferral of fuel and purchased power costs. For the most part, guidance has remained within the prior range, with the biggest adjustments made due to the loss of synfuel-related tax credits.

So there you have it. In general, earnings gained from healthy global economic growth and improved pricing and cost controls. But in the months to come, input costs will likely continue to be a drag.

Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry	Company	S&P STARS	Price (8/4/06)
Agricultural Products	Archer Daniels Midland (ADM)	4	$41
Coal & Consumable Fuels	Massey Energy (MEE)	4	$26
Construction & Engineering	Jacobs Engineering (JEC)	5	$84
Diversified Metals & Mining	Phelps Dodge (PD)	4	$86
Fertilizers & Agricultural Chemicals	Monsanto (MON)	2	$45
Gold	Newmont Mining (NEM)	4	$52
Ind. Power Producers & Energy Traders	AES Corp. (AES)	5	$18
Investment Banking & Brokerage	Merrill Lynch (MER)	5	$73
Oil & Gas Equipment & Services	Baker Hughes (BHI)	4	$78
Oil & Gas Refining & Marketing	Valero Energy (VLO)	5	$66
Railroads	Burlington Northern Santa Fe (BNI)	4	$69
Steel	Carpenter Technology (CRS)	4	$98

Stovall is chief investment strategist for Standard & Poor's Equity Research Services

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