Earnings: A Clearer Picture Emerges

S&P equity analysts expect results to recover in the second half of 2008, with the Consumer Discretionary and Financials groups leading the way

by Sam Stovall From Standard & Poor's Equity Research

Approximately 90% of the companies in the Standard & Poor's 500-stock index have reported December-quarter earnings, and company managements have delivered whatever guidance for the year ahead that they are comfortable offering. S&P equity analysts now have a better handle on just how bad things were in the second half of 2007 and whether 2008 will look any better.

At the end of 2006, S&P equity analysts expected operating earnings per share (EPS) for the S&P Composite 1500 (comprised of the S&P 500, MidCap 400 and SmallCap 600 indexes) to advance 10% in 2007, a healthy follow-up to the 15% gain seen in 2006. Yet with 2007's results nearly final, we now find that EPS for the S&P 1500 actually sank by almost 4% on a worse-than-expected fallout from the housing, subprime, and credit crises.

Within the S&P 1500, the S&P 500 index, which represents 88.5% of the market value of the 1500, likely registered a 4.2% year-over-year decline, while the S&P MidCap 400 (7.8% of the 1500) eked out a 0.1% gain, and the S&P SmallCap 600 (3.7% of the 1500) fell 5.6%.

The 1500's negative earnings results for the year were the result of deteriorating profit growth for the Consumer Discretionary and Financials sectors in particular, as these sectors posted declines of 17.8% and 33.3%, respectively, as of Feb. 19, 2008. The second half of last year was the toughest for the overall market, as it suffered through EPS declines of 9% in the third quarter and 22% in the fourth, a quarter that many dubbed the "kitchen-sink quarter" as companies wrote down everything—including the proverbial fixture.

While some would say that it was about time that earnings fell—since the 1500 had posted double-digit annual advances since 2002—others look to last year's declines as a launching point for easier comparisons in 2008. Below the surface, the worst performers in 2007 are expected to be the best performers in 2008, as we see the Consumer Discretionary group posting a 21% earnings advance, while Financials should record a near 30% increase.

Other potential sector standouts include Information Technology with an expected 19.7% increase, and Telecommunications Services with a jump of more than 36%. No sector is expected to see declines, but six of the 10 are projected to post increases that are below the overall market's. The weakest earnings performances are likely to be registered by the Materials, Industrials and Consumer Staples sectors, with gains of 7.3%, 8.3%, and 9.4%, respectively.

Sector Summaries

Within Consumer Discretionary, S&P analysts see the greatest EPS upside coming from companies in the Tire & Rubber (+74%), Internet Retail (+53%), Home Furnishings (+24%), Leisure Facilities (+24%) and Education Services (+20%) subindustries. In fact, 26 of the 33 subindustries are expected to post EPS advances in 2008. Only Automobile Manufacturers (–74%), Photographic Products (–17%), Homebuilding (–17%), Leisure Products (–6%), Home Improvement Retail (–4%), Household Appliances (–2%), and Department Stores (–0.2%) should see EPS declines this year. We are forecasting 15.7 million new light vehicle sales in the U.S. in 2008, down 2.4% vs. 2007. Heavy-duty truck demand should also decline for the year, but we expect year-over-year gains beginning in the fourth quarter. International growth remains a theme among most companies in this sector.

S&P's Consumer Staples analysts see the most important themes for sector members as being the effects of high commodity costs, price increases, restructuring efforts, and strong international exposure. Analysts have reported that many companies are passing along price increases to offset higher commodity costs without meaningful push-backs by retailers or consumers. While marketing spending continues to be robust, in our opinion, many of the companies are restructuring or conducting cost-containment programs that, along with price increases, have at least maintained operating margins.