Earnings: Wait Till Next Year


The stock market is ultra-sensitive to corporate earnings, and it's likely to be the second half of next year before they turn up significantly. That's the prediction of Chuck Hill, director of research for First Call, an expert earnings analyst.

The September 11 attack probably cost 5 percentage points in earnings for the third quarter, Hill says -- they're likely to be down 22% from year-ago levels, vs. the 6.2% drop he forecast back in July, and his prediction of 17% decrease just before the attack. And he sees no sign of slowing in the rate of companies warning about poor earnings.

For the just-ended third quarter, Hill says only health care and utilities will show better earnings. The worst performance will be from the transportation sector, because of the disaster for airlines, and second worst will be technology. When recovery does come, he sees perhaps the best opportunities in consumer-related cyclical stocks.

These were among the comments Hill made in a chat presented Oct. 18 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts from the chat follow. A complete transcript is available on AOL at keyword: BW Talk.

Q: Chuck, there seems to be some fairly good earnings news, but is it helping the stock market? What's your macro market view right now?

A: The "fairly good earnings news" really only applies to the fact that more companies are making estimates than missing, but that's always the case. The real question you have to ask is: Are companies beating the estimates by more or less than they usually do? And the answer is they're doing it by less than normal this quarter.

Expectations for the S&P 500 earnings growth for the quarter were for a decline of 6.2% as of July 1, the beginning of the quarter. By 9/11, it had dropped to a 14.7% decline. After the attack, it dropped to a 22.8% decline by the start of the main part of the third-quarter reporting season. We're likely to end up down about 22%. Prior to the attack, we had felt that the final numbers would be down about 17%, so we lost about 5 percentage points as a result of the attack. The more important thing, I think, in terms of the earnings outlook is that there's no sign of deceleration in the rate of earnings warnings.

Our view is that the market is not likely to mount a sustained recovery in the near future. We recognize that the market will always turn up before the economy and earnings turn up, but there has to be a better sense of how deep and how long the earnings downturn is going to be. We think the earliest the earnings could turn up would be the second quarter of next year, but more likely it won't happen until the second half.

Q: Which sectors are expected to turn in the best and worst third-quarter earnings results?

A: Only 2 of the 11 S&P 500 sectors will have good earnings. Health care, where it's business as usual, as one would expect even in an economic downturn, is expected to show earnings growth of 13%. The utility sector is expected to have earnings growth of 10%.... One has to be selective in which [utilities] you buy, or you have to buy a large basket of them. The reason for the great divergence is the deregulation of the electric utilities now under way.

The other nine sectors are all expected to have down earnings, with the worst being the transports, due to the severe problems the airlines are having. The second-worst sector is technology, where earnings are expected to be down 74% from the year-ago quarter.

Q: What's your outlook for 2002 for telecommunications companies such as Global Crossing (GX)?

A: Well, the analyst who covers communications services is expecting earnings for the 2002 year to be up 18% -- that compares with expectations of a 22% decline for this year. For Global Crossing, the losses this year are expected to widen to $3.10 a share, vs. a $2.41 loss last year. And in 2002, the losses are expected to widen further to $3.27. Of the 13 analysts who cover it, 12 have a "hold" on it, and only one has a "buy".... Since we know that "hold" is usually a code word for "sell," it's pretty clear that analysts are fairly negative on this stock.

Q: What do you think of the financial sector?

A: Well, the financial sector's earnings for the third quarter are expected to be down 14% from a year ago, but that's mainly due to the hit the insurance companies are taking from the 9/11 attack. Most of the costs for that will fall in the third quarter. The expectations for the fourth quarter are that earnings will be up 14% from a year ago. But the worry in the financial sector in general...is that you have the crosscurrents of lower interest rates being a positive but customer credit problems being an increasing negative.

Q: How do the large money-center banks look during this period?

A: Well, since most of the big money-center banks these days are also in the investment banking business, we have an added risk of that business staying weak for a while. That's in addition to the earlier concerns about client creditworthiness and the increasing loan-loss reserves that banks are having to take. But, on the other hand, the prospect of further Fed interest rate cuts are a positive. In addition, some of the major money-center banks are still having digestion problems from recent acquisitions. Lastly, we have the worries about the venture-capital businesses that some of the money-center banks have gotten into in a big way.

The one entity that has stood out in recent quarters has been Citigroup (C). They did take a hit in the third quarter because of their insurance operations, but that's now behind them. It seems like management continues to do a good job in a tough environment, and the analysts are extremely positive on their recommendations of Citigroup.

Q: Is there still too much optimism in the market based upon future earnings? Perhaps there wouldn't be if the market listened to Chuck tonight!

A: Yes, first of all, the earnings for 2002 are highly suspect. Current expectations for S&P 500 earnings growth are for a gain of 17.5% next year, which is slightly higher than where the analysts started the year.... That might have made some sense earlier in the year, when many people were expecting an earnings recovery to start in the second or third quarter of this year, but now with no recovery before at least the second quarter of next year, that means earnings have been declining on a seasonally adjusted basis each quarter in 2001 and will probably do so in the first quarter of 2002.

Even if they were only flat with the fourth quarter, and the rest of the year recovered at the same rate that earnings declined this year, that would mean earnings growth for next year was flat with this year. So one has to seriously question the current expectations of 17.5% earnings growth.

When we look at market behavior in past business cycles, the pattern has been that the pendulum swings too much to the optimistic side in the late stages of the recovery, but then has to swing too far to the pessimistic side before a sustained market rally occurs. Clearly, we had what Mr. Greenspan may have prematurely called "irrational exuberance" on the upside two years ago, but we still have not seen that over-pessimism. So we would expect the market to at least test the recent lows -- and maybe even go below them -- before we get a sustained rally.

Q: What about defense stocks?

A: Well, there's no question they'll benefit. The defense budget will go up, but it probably won't have much impact on earnings until the latter part of 2002. The improved earnings outlook, however, is probably already in the stocks.

Q: A lot of analysts see bargains in the depressed stock sectors. Does your study of earnings point to any stocks that would be worth buying for the long term when they're down?

A: Well, First Call is not in the business of recommending stocks. We would offer the comment that it may not be technology stocks that lead us out of this downturn. That may have been the case in past recoveries, but this downturn has been different than most business cycle downturns in that it was too much capacity, particularly in tech, that was the problem, as opposed to the usual problem of too much demand and not enough capacity. So it may well be that the better opportunities will be in cyclical stocks, particularly the consumer-related cyclical ones.

Q: What about opportunities in consumer-related cyclical stocks? Any companies in this area that look strong on an earnings basis?

A: I think that there will be opportunities with top quality companies in areas like retailing and home furnishings and autos. I'd stay away from anything but the top quality ones, because the shakeout over the next few months could be painful.

Earnings? Within the retailers, discounters continue to do much better than the department stores and now are doing better than the upscale retailers, but it's too early to talk about how earnings are going to recover in retailing until we get some better idea of how consumer-spending patterns are going to adjust to the post-attack environment. The whole issue of personal safety and its impact on consumer spending are a whole new ball game for us.

Q: Could you comment on Enron's (ENE) earnings problems?

A: Enron has been a company that's been very aggressive in the business of trading assets, with the use of derivative instruments as part of their program. So it's always been a high-risk situation, but nevertheless one that attracted a lot of interest because they were plowing a lot of new ground, particularly relating to the deregulation of electricity. In addition, it now appears that there may be some conflict of interest problems involving the CFO. Whether those prove to be a problem remains to be seen.

I would put Enron in the category of a very risky stock, but one that analysts are exceptionally positive on. Of the 17 who have recommendations on the stock, 13 have a "strong buy" and four have a "buy." At least at the moment, the earnings expectations for Enron remain quite positive. Earnings are expected to be $1.81 this year, up from $1.47 last year, and are expected to grow to $2.14 next year.

Q: People have been asking this question for months -- when do you think monetary policy will have effect?

A: We said at the beginning of this year that we felt it wouldn't have much of an impact on earnings until first-quarter 2002.... Unfortunately, the attack prevented some of our turnaround predictions. Fed actions will not be enough to offset the downturn we're now in, and it's questionable if the earlier actions would be enough to turn things around in the second quarter of 2002. Clearly, the additional stimulus we're getting following the attack should ensure an upturn in second-half 2002 earnings. At this point, the Fed's clearly willing to err on the side of too much stimulus to be sure we get out of the current problems. That might mean that even if we exit 2002 with a lot of momentum in the economy in earnings, we may be faced with an inflation problem.

Q: Chuck, Microsoft (MSFT) beat earnings after the market closed [and the stock rallied]. [Does] anything stand out in its report?

A: Microsoft did warn slightly on the December quarter and for the June year, but given that they have a history of lowballing somewhat, it probably means that earnings are likely to come in where the current estimates are now. And in this environment, that's certainly bullish. Unlike many of the other techs, Microsoft has a strong product-cycle upturn going for it.

Q: Any final thoughts for us, Chuck, on the best investment strategy for now as you see it?

A: I think it still pays to be conservative until we get some better visibility on how deep and how long the recession's going to be and until there's hopefully some better resolution on the outcome of the current military operations. Keep in mind that with these heightened risk factors, valuations will be lower than normal.


Steve Ballmer, Power Forward
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