Second-Quarter Earnings Rebound No Fast Break

With the economy picking up steam, more companies are successfully meeting their performance targets, and S&P 500 earnings are finally expected to reverse their long decline in the second quarter.

Even so, many observers worry that expectations for a second-half earnings recovery remain overblown, and that investor concerns about the longer term could override optimism about the second quarter when it comes to putting money into the stock market.

"Estimates are far too aggressive for the second half. That's what is going to drive the market," said Joe Cooper, research manager for Thomson Financial. "Everyone realizes that the earnings turn is here, that they're going to be fairly strong and better than expected, but that's a given. We're waiting for the skeletons to come out of the closet and say things are still really soft," he said.

The second-quarter preannouncement season is gaining momentum, and it has so far been kinder to investors than any in the past year. To date, 822 companies have preannounced, with 287 raising their earnings guidance, 196 saying they will meet targets and 339 lowering their estimates. That puts the guidance ratio (negative announcements divided by positive announcements) for the second quarter at 1.2. By comparison, at this time in the first quarter it was 1.7, and a year ago it was at 3.6.

In the last week, several major companies have raised their second-quarter or 2002 earnings guidance, including global hamburger chain McDonald's(MCD Quote), consumer products giant Procter & Gamble(PG Quote), manufacturing behemoth TRW(TRW Quote), Internet security outfit Symantec(SYMC Quote) and health insurance products firm WellPoint Health(WLP Quote), among others.

But there have been plenty of doomsayers too. Among them was Intel(INTC Quote), which lowered its second-quarter numbers and said any second-half improvement in its business would only be seasonal. Hewlett-Packard(HWP Quote) also warned in early June that it doesn't expect any revenue growth in the second half, and once the evergreen optimist, Cisco(CSCO Quote), said it doesn't expect any upturn until 2003.

Growing Again

On average, analysts are now expecting S&P 500 earnings growth of 6.5% for the second quarter, compared with an 11.5% decline in the first quarter. At the start of this quarter, analysts were expecting 8.8% growth.

The estimate could come down further. The peak preannouncement weeks are yet to come, as most companies are still wrapping up their bookkeeping and tallying last-minute orders. The very last week of June and first week of July should see the bulk of companies preannouncing for the second quarter.

Meanwhile, investors need to be aware of the padding provided by new the accounting rule for acquisitions. Cooper says that the standard is expected to contribute 6 percentage points to S&P 500 earnings growth for the second quarter, leaving the adjusted estimate for growth at just 0.5%.

Sectors expected to post the biggest declines in year-over-year earnings are transportation and energy. S&P 500 transport companies are expected to post a 42% drop in earnings, while the S&P 500 energy sector is forecast to record a 39% slide vs. last year.

The cyclicals sector, which usually performs well in economic recoveries, is seen posting the greatest earnings growth, at 39%. Surprisingly, the technology sector, which is suffering from a glut of overcapacity and a dearth of capital spending, is expected to follow behind, at 28%. That's mostly because the sector is benefiting from a rebuilding of inventories, and sector profits were so dismal last year, analysts say, that comparisons are relatively easy.

"Technology earnings should come in a little bit above expectations," said Chuck Hill, director of research for Thomson Financial. "When you put everything together, you might say, things really look great. But that picture only tells you what's going on in the very short term here. There will be more focus on final demand in the third and fourth quarters," he said.

Out There

Ultimately, it's second-half estimates that investors should be wary of, analysts said. Some think there's no way U.S. companies can meet current consensus estimates for fourth quarter earnings, which put them above earnings reported in the fourth quarter of 2000, the boom era's earnings peak.

"I'm skeptical about second-half earnings estimates because the rebound is simply much too high," said Thomas McManus, equity portfolio strategist for Banc of America Securities. "You have to look at this in context from where we've come from. Consensus would have you believe that after five consecutive quarters of negative comparisons, second quarter is a transition quarter, and that the third and fourth quarters bring you back up to peak levels of profitability. Margins have held up better than some people had thought, but we just don't see nearly the revenue growth that's going to get you there."

Others think it's too early to tell for sure. "Logic says the slope of the upturn in capital spending should be more gradual than it has been in recent recoveries. What little credible information we're finally starting to get is not very encouraging, but it's still to early to be definitive about it," he said. "What we learn over the next month, as we go through the peak of preannouncement and earnings seasons, should give us a meaningful amount of information."

In the meantime, valuations remain high but have at least come down some. McManus, who says valuations have begun to look "interesting," raised his equity weighting just a week ago by 5% to 55%, still an underweight weighting, he says. Even so, the strategist thinks the price to earnings ratio on the S&P 500 should come down to around 15 from its current 20, based on 2002 earnings estimates.