The Fog of First-Quarter Profits


By Amey Stone First-quarter corporate earnings certainly aren't the primary focus of investors, who drove the stock market up 215 points on Apr. 2 on news that the U.S.-led military advance on Baghdad was going better than expected. Of course, these are the same fickle folks that in the 10 days prior had driven stocks down 500 points on worries the war would take longer than anticipated.

Still, the all-consuming nature of war isn't the only reason why investors don't seem to be worrying too much about first-quarter corporate earnings. And they aren't likely to get concerned soon, even with the start of the normally intense "preannouncement" season, when companies warn investors if they won't meet earlier earnings guidance.

MUTED EFFECT. Investors' new equanimity about earnings partly results from first-quarter results that are likely to be neither great nor horrible. And that's not too bad, considering the quarter wrapped up while war was under way, a potential epidemic was emerging in Asia, and most economic indicators were heading south. At the same time, investors likely will shrug off earnings news in the sectors that are likely to turn in the worst results. Those businesses can chalk up poor performance to factors that'll have little impact on results going forward.

With any luck, if the positive news from the front lines in Iraq continues, the difficult -- if not impossible -- task of sorting out the war's impact on consumer and business spending and on corporate earnings could be rendered moot. Although the war started with just two weeks left in the first quarter, many analysts have noted that so far, it doesn't appear to have had a major impact on business or consumer spending -- "certainly nothing like we saw after September 11," says Chuck Hill, earnings tracker First Call's research director.

It's already clear that this year's energy price spike will have the most impact in the first quarter and is likely not to be repeated in the second quarter, barring unexpected negative developments in the war. Crude-oil prices that leapt to a 12-year high of nearly $40 a barrel by late February were already down to $28 a barrel by Apr. 2. "Forget [first-quarter 2003] earnings," Hill wrote boldly in his Apr. 1 market commentary. "They're all about oil."

FEW REAL SURPRISES. The quarter's higher energy prices will drag down the results of transportation, utility, and materials sectors. Thanks in part to preannouncements from many outfits in those areas already, these warnings are running at a higher rate than they have at any time since the recession, says Hill. But in most of these cases, the "surprises" are hardly surprising.

On the positive side, the energy sector has higher prices to thank for an expected 171% surge in year-over-year first-quarter earnings. Energy's pop will be big enough to lift overall profits for the benchmark Standard & Poor's 500-stock index by 10.5% in the first quarter year-over-year (a bit better even than the fourth-quarter's 10.1% rise), says Hill. But when you factor out the energy sector, the jump in overall earnings will be only 4%. The earnings distortions created by oil-price volatility makes analyzing how first-quarter earnings come out "not worth the effort," Hill wrote.

An additional distortion muddying first-quarter results is the weaker U.S. dollar. This gives many corporations a significant revenue boost -- but not one that's that meaningful for investors. A Mar. 31 Merrill Lynch report on hardware companies figures that IBM (IBM), EMC (EMC), and Lexmark (LXK) could each see revenue gains of 7 percentage points from currency translations alone. Sun Microsystems (SUNW) could get 6 additional points. "We caution investors not to confuse the currency boost with a change in fundamentals," analyst Steven Milunovich notes in the report.

A BAR SET LOW. Earnings in the technology sector are likely to be a mixed bag in their own right. Some positive trends are bolstering profit growth in e-commerce, personal computers, and consumer electronics, notes Pacific Crest Securities in an April report titled An Encouraging Finish to a Difficult Quarter. And so far, the tech sector as a whole hasn't been beset with as many first-quarter earnings warnings as other sectors. "Information technology spending is not particularly good," wrote SoundView Technology Group analyst Arnie Berman in an Apr. 1 note. "Nonetheless, most tech companies appear to have set the bar low enough."

Tech concerns that rely on big-ticket purchases from large corporations are the most likely to disappoint badly in the first quarter (enterprise-software outfits are the most vulnerable). But an increasing number of analysts, including Berman, believe stocks will get a "free pass" as the disappointments are "chalked up to the war."

The idea of a free pass may be a little bit of a stretch. Stocks that have truly surprised investors with weak results, like Intuit (INTU) and Oracle (ORCL), have been beaten up. Yet their bad news had less of what Hill calls a "spillover effect" on other stocks in their sectors. "It gets buried in the war news," he says.

"PRETTY TOUGH." The confluence of factors that's making many investors shrug off current earnings information won't last long. Hill believes investors should pay close attention in late April and May when businesses will start commenting on second-quarter profits, and analysts may begin scaling back their hopes for a second-half earnings rebound if the war is dragging on and the economy still looks weak.

"We think this first quarter is going to be a pretty tough one," says Art Bonnel, portfolio manager of the Bonnel Growth Fund (ACBGX) in a conference call with financial advisers on Apr. 1. "After that, it depends on how long this war lasts."

Analysts expect 6.8% earnings growth in the second quarter, followed by a sharp 13.1% third-quarter jump, and an even sharper 22% fourth-quarter spike. If those projections start to come down en masse, stocks that now seem fairly priced will suddenly look quite expensive relative to earnings growth, and another wave of selling will begin, warns Bonnel. "In a bear market, there are three things investors need to focus on: Valuations, valuations, valuations," he says.

Given all the unknowns of war, trying to predict how the economy and corporate earnings will perform is a challenge. Hill says he has "no idea" how the second half of this quarter could turn out and says, "Our crystal ball is foggier than I've ever seen it." That alone makes a good case for taking the coming earnings news with a grain of salt -- if only temporarily. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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