Capital Markets

Earnings Bubble Loses Air

Analysts slash earnings estimates for the fourth quarter.
Jennifer CaplanNovember 21, 2000

The corporate earnings bubble, whose capacity to expand once seemed infinite, is losing air as more companies fall short of Wall Street’s expectations. In the midst of electoral turmoil and a jittery stock market, analysts have slashed earnings estimates for the fourth quarter.

Despite a solid 18 percent earnings growth rate in the third quarter, analysts acknowledge a general downward trend in earnings this year and expect the decline to accelerate in the fourth quarter and into 2001. Most analysts are predicting that earnings at S&P 500 companies will rise about 11.4 percent in the fourth quarter–a paltry growth rate when compared to the 21.6 percent average posted in the past five quarters.

“We’re seeing far more than the normal downward revisions in earnings estimates for the fourth quarter in just the first five weeks of this quarter,” says Charles Hill, director of research at First Call/Thompson Financial. “The expectations for the fourth quarter for S&P earnings growth on October 1 were 15.6 percent. They are now around 11.4 percent. That’s more than the normal trimming we get in the entire quarter.”

“Analysts have also taken the estimates for the first quarter of 2001 down from 14.2 percent to 11.2 percent. Clearly we are experiencing a free fall in earnings estimates,” adds Hill.

The first quarter of 2000 saw earnings skyrocket to 23.6 percent, followed by a 21.6 percent growth rate in the second. Although these dizzying rates inflated consumer confidence and boosted the stock market, they set off alarms in more prudent quarters. Skeptical analysts warned that these levels were unsustainable.

Hill tells “When we did 23.6 percent in the first quarter, we pointed out that it was the highest growth rate since the fourth quarter of 1993. Coming out of a recession, we expected those numbers back then. When we got similar levels in the first quarter of 2000, we said it was not a sustainable level of growth, and that they would have to taper off even if the economy held up.”

Despite a decline of 3 percent in earnings growth from the second to third quarters, and warnings from nervous analysts, however, there hasn’t been a corporate profit recession—or a significant correction, for that matter. According to First Call, the distribution of those beating, matching and falling short of expectations in the third quarter—60 percent, 29 percent, and 12 percent, respectively– continues to be favorable. That is significantly better than the seven-year averages of 56 percent, 19 percent, and 26 percent, respectively.

First Call analysts warn, however, that solid third quarter earnings numbers should not be a reason for too much optimism. They contend that the real test as to how much fourth quarter earnings growth is likely to slow, will come in January, as the pre-announcement and reporting season for the quarter heats up.

Most analysts caution that the reasons for the most of the negative pre-announcements, including the slowing U.S. economy, high energy prices, and the weak Euro will likely have a greater impact on fourth quarter results.

The Culprits of Depressed Earnings

A number of factors are contributing to the free fall in corporate earnings estimates for the fourth quarter.

Mitch Zacks of Zacks Investment Research says the fact that it is primarily large cap companies that are getting thrashed by decreased earnings is of particular relevance. He believes that there are diminishing returns to corporate growth. There comes a point beyond which profit margins can’t grow and companies are forced to increase boost through growing revenue.

Zacks points out that throughout the 1990s bull market, when Wall Street forced companies to increase their earnings per share, companies responded by making managerial decisions that increased their profit margins: They cut costs, restructured, and made acquisitions that increased earnings per share.

Zacks stresses that high levels of EPS growth can only be accomplished for so long before companies have to increase revenue. “Once a company cuts all the fat,” says Zacks, “there is nothing left to allow them to grow EPS.” Large corporations eventually run out of the ability to squeeze costs, and must start growing their revenue numbers, he adds.

“Take IBM, for instance. Analysts are projecting an 11 to 15 percent EPS growth rate per year over the next five years. IBM’s sales have hovered at around $21 to $22 billion per quarter for the past few years. In order to meet Wall Street expectations, IBM must grow sales by approximately $2 billion per quarter. The company must, therefore, add $500 million worth of sales per quarter if its cost structure remains the same. You don’t just obtain $2 billion worth of sales per quarter out of nowhere,” Zacks asserts.

Joseph Kalinowski, Equity Strategist at IBES, says a series of Federal Reserve interest-rate hikes intended to cool an overheated economy have had a real impact on corporate earnings. “Those rate hikes have taken some time to filter through the economy,” he says, “and it is our feeling that they are starting to have an effect.” Kalinowski also points to a slowdown in consumer spending to explain depressed corporate earnings, particularly in the retail sector.

Consumer Cyclicals Are among the Losers

First Call’s Charles Hill says the big losers in the fourth quarter will be consumer cyclicals, basic materials, and communications services. Hill believes that a slowing U.S. economy, higher energy costs, and a weak Euro will all have a significant impact on these sectors in the fourth quarter.

Consumer cyclicals like retail, housing, home furnishings, and autos will be particularly hard hit in the fourth quarter, says Hill. “The numbers have been lowered in this sector from 10 percent to 3 percent,” he says. “We are actually going to come in at negative 6 percent in the third quarter instead of the 12 percent original estimate. Consumer cyclicals were up 12 percent in the first quarter, and 7 percent in the second,” adds Hill.

Analysts claimed this was a transitory decrease in consumer cyclicals, blaming it on bad weather patterns in parts of the country, and higher gas prices. “They were looking for 12 percent growth in the third quarter and 15 percent in the fourth quarter,” says Hill. “We knew something was wrong. Either the analysts were going to have to slash estimates, or the Fed would have to keep raising interest rates, but you couldn’t have it both ways. Midway through the third quarter analysts started slashing estimates for consumer cyclicals.”

Hit hard by high energy costs, basic materials- -papers, metals and chemicals–will be another underperforming sector in the fourth quarter, says Hill. Analysts have had to revise fourth quarter earnings estimates in this sector from 7 percent to negative 4 percent.

“Steel, in particular, is having problems already. All three industries, however, use oil to drive their operations,” says Hill, who also blames the weak Euro for depressed earnings at big multinationals.

Analysts at Salomon Smith Barney, however, are more optimistic on the outlook for this sector and expect earnings to grow in the low to mid- single digits in 2001.

Hill believes that communication-services companies like AT&T and WorldCom will be hit hardest in the fourth quarter. He predicts that stiff long distance service competition, overcapacity from fiber optic line expansion, and costs associated with merger adjustments will batter the sector in the fourth quarter. The communications services sector posted a 3 percent earnings loss in the third quarter. Analysts have recently cut fourth quarter estimates for the sector from a 7 percent loss predicted only one month ago down to a 26 percent loss.

Transportation companies, particularly airlines and trucking companies, will also be adversely affected in the fourth quarter, due mainly to higher energy costs, but also to a weaker Euro and a slowing economy. “We have seen big cuts in the transportation sector as fuel costs have soared,” says Hill. “Analysts have slashed earnings estimates in this sector from 30 percent to 14 percent for the fourth quarter of this year.”

Hill says that although decreases in earnings growth in communication and transportation were anticipated, most people believed technology would hold up at least through the fourth quarter. This has not been the case, however, as analysts have been forced to cut fourth quarter technology earnings estimates from 29 percent to 17 percent. Consensus expectations for the S&P tech sector for 2001, however, show a 22 percent increase.

Other shaky sectors that may be hard hit in the fourth quarter include wireless services, personal computers, telecommunications, and broadcasting.

Wins Seen for Energy, Utilities

Hill thinks the winning sectors in the fourth quarter will be energy and utilities.

Services and equipment companies in the energy sector, like Baker Hughes, will do particularly well in the fourth quarter, he predicts, noting that these companies have tended to lag two to three quarters but will catch up and exceed estimates in the fourth.

“Service and equipment companies in the energy sector were having down earnings in the first two quarters, while producers were having huge year over year gains. In the third quarter they started catching up, and will have explosive earnings in the fourth quarter,” says Hill. First Call analysts also predict that oil refining and marketing companies like Sunoco will fare particularly well in the fourth quarter.

“We also expect that utilities, mainly electric utilities, and a few gas and water utilities, may also turn out on the upside in the fourth quarter,” adds Hill. Companies in this sector have been crushing estimates in the first two quarters and somewhat in the third, he says. But it is hard to predict exactly what will happen in the fourth quarter because there is so much deregulatory activity occurring in the sector.

Analysts at Salomon Smith Barney say that utility-sector earnings per share have surged in an environment of deregulation, with EPS up nearly 22 percent in the first half of 2000. Because demand growth has exceeded supply growth, prices have risen after the market was allowed to operate without intervention.

“It’s a whole new ballgame for the analysts in the utilities area,” says Hill. “These guys used to worry about weather companies had enough cash flow to be able to raise dividends. Now it’s a brand new world.”

Kalinowski of IBES says that some of the “defensive industries”–those not susceptible to fluctuations in the Euro or changing interest rates, like domestic health care, drugs, electric utilities, and gas and oil–will outperform estimates. “Those consensus numbers are not being slashed as dramatically as some of the basic industries like transportation,” says Kalinowski.

Salomon Smith Barney analysts claim that financial market pain and adjustment already suffered in 2000 make a solid gain in financial-sector EPS very possible in 2001. Salomon analysts remains bullish on the health care sector, predicting that even if the economy slows more than expected, earnings in this sector are likely to show the largest EPS gain in 2001.

Reasons to Panic?

What if there is, in fact, an earnings free- fall that will only accelerate? Are there reasons to panic? If history is a worthy yardstick, the answer is no. Earnings have gained just 7.5 percent on average each year since the post World War II era.

Some analysts believe a correction in earnings growth in the fourth quarter is actually a healthy sign. Kalinowsky remains bullish on corporate earnings and is confident that a slowdown in the fourth quarter will merely check a dangerously bloated growth rate.

“Everything was just running a little too hot,” he says. “Now we are just starting to come down to normal levels. Hopefully by [the middle of] next year everything will be down from that super-accelerated pace.”

“Even if we see 9-10 percent earnings growth for next year, that is still fantastic,” he says.

Analysts at Salomon Smith Barney believe that the macro-oriented problems facing the U.S. economy are temporary, rather than structural. “We remain very optimistic about the longer-term prospects for continued U.S. earnings expansion, even as the economy carries a heavy ‘cyclical burden’ in the near term,” the company said in its report on earnings.

Investors shouldn’t throw in the towel quite yet, it appears.