Financials: Fourth Quarter's Unlikely Hero? - TheStreet

Fourth-quarter earnings reports will start flowing in after the holiday season ends, and investors are hoping to see a break in the current streak of five straight quarters of negative year-over-year profit growth. What's most surprising about this latest round of quarterly releases, though, is that financial companies are expected to be a major contributor to earnings growth.

Yes, you read that correctly. Based on current estimates, the financial sector should see earnings

growth

in the current quarter, even as forecasts continue to be pared down. The sector should see profits totaling $12.4 billion in the fourth quarter, compared with a loss of about $15 billion in the year-ago quarter, according to Thomson Reuters.

Currently,

S&P 500

companies are expected to record a 7.3% growth rate from a year ago, although that number has dropped sharply from 46.7% back on Oct. 1. Fourth-quarter estimates continue to be revised lower for the financial and consumer discretionary sectors, as many expected because of the credit market and automaker woes.

John Butters, research analyst with Thomson Reuters, says that several other industries have seen the same pullbacks. According to his data, both the consumer discretionary and the materials sector should see negative 43% profit growth in the quarter on a year-over-year basis. Energy, industrials, information technology and telecom are expected to show declines in the low teens.

Steven Wieting, market analyst with Citigroup, agrees that the fourth quarter of 2008 will be the first to show significant profit declines away from financials, while reported financial sector profits might be stable or higher.

"For the first time since

the first half of 2007, the fourth quarter 2008 might see financial profitability at higher absolute levels than the year-earlier period as financial sector asset write-downs reduced overall S&P 500

earnings per share by roughly one-third in

the fourth quarter of 2007," Wieting recently wrote in a market analysis piece.

That means that positive earnings growth from the financial sector becomes even more important. "If financials are taken out of the mix, that overall growth of 7.3% would drop to a decline of 10.6%," said Butters, adding that health care, consumer staples and utilities are the remaining sectors that should see slight profit growth when compared to the fourth quarter of 2007.

Another quarter of negative year-over-year earnings growth would push the streak to six, which is one more than what Wall Street experienced when the tech bubble burst. With this backdrop, it may hard to believe that financials would see gains compared to a year ago, considering the credit crisis that has persisted through the current quarter. But there are a few explanations for what could be growth from a year ago.

Low Bar to Clear

For one, Butters points out that the fourth quarter of 2007 was one of the worst on record as year-over-year profit growth for all S&P 500 companies fell a whopping 25.1%. Observers are skeptical about how meaningful profit growth in fourth-quarter earnings will actually be. Even the slightest improvement will appear strong when compared to those results.

"It's not that financials are expected to do that well," Butters said. "The easy comparisons are helping the financial sector this quarter."

Looking back at the performance some of the financial components of the S&P 500 in the fourth quarter of 2007, it's hard not to expect that some of these companies will perform better than they did a year ago.

  • AIG (AIG) - Get Report was expected to post a fourth-quarter profit of 60 cents a share in 2007 but instead reported a loss of $1.25 a share due largely to a raft of writedowns on mortgage-related investments. On average, the troubled company is expected to report a loss of only 4 cents a share this quarter.
  • E*Trade Financial (ETFC) - Get Report saw a quarterly loss of $3.98 a share, greater than expectations for a loss of $2.90 a share. E*Trade should report a loss of 23 cents a share in the fourth quarter, according to a poll of analysts by Thomson Reuters.
  • SLM (SLM) - Get Report recorded an adjusted loss of 36 cents a share compared with expectations of a profit of 55 cents a share. Sallie Mae is expected to report a profit of 27 cents a share when it next reports quarterly results.
  • Merrill Lynch (MER) saw a fourth-quarter loss of $12.57 a share in 2007, with analysts expecting the company to lose $4.93 a share. That loss should shrink dramatically to 5 cents a share in the fourth quarter, according to a poll of analysts by Thomson Reuters.
  • Citigroup (C) - Get Report surprised analysts a year ago when it notched a loss of $1.99 a share, nearly doubling the average analyst estimate for a loss. Citigroup should post a fourth-quarter loss of 64 cents a share.
  • Morgan Stanley (MS) - Get Report was expected to report a loss of 39 cents a share but ended up losing $3.61 a share in the quarter. This quarter, Morgan should report a loss of 37 cents a share, according to Thomson Reuters.

Another source of hope that financials will show an overall profit is that the Thomson Reuters growth rates are based on the current constituents of the S&P 500 and do not bring into account companies that have been removed from the index over the past year. In other words, a more favorable apples-to-apples model is computed by Thomson Reuters, which makes the year-over-year comparisons more meaningful.

The S&P 500 no longer includes

Lehman Brothers

,

Washington Mutual

,

Countrywide Financial

,

Freddie Mac

(FRE)

,

Fannie Mae

(FNM)

,

Ambac Financial

(ABK)

,

Bear Stearns

and

Commerce Bancorp

, all of which were purged from the index in the last year. As these companies were included in data from the fourth quarter of 2007, an analysis comparing their performance against how current constituents performed this quarter would undoubtedly look much different.

"We use current constituents and rebuild year-ago earnings to build growth rates," Butters said. "That 7.3% number represents the growth of the current 500 constituents with what those same 500 companies earned a year ago. The same is true with the $12.4 billion growth for financials versus the loss of $15 billion a year ago."

Too Hard to Handicap?

Not all market watchers are buying into those analyst estimates, and some still insist that forecasts need to be torn down. Robert Pavlik, chief investment officer with Oaktree Asset Management, argues that it's far too optimistic to expect financials to lead the way in the fourth quarter.

"You have to think back to what happened to the financial sector in the fourth quarter," Pavlik said. "Since Oct. 1, very few banks have been making loans and there is very little underwriting going on. I'm wondering where the revenue is being generated from."

Paul Nolte, director of investments with Hinsdale Associates, argues that from an earnings perspective, it's extremely hard to handicap the value of the financials due to limited visibility and too many variables.

"It's as hard to handicap the financials as it was to handicap the technology stocks in 2002," Nolte said. "Companies are so damaged that if one has positive earnings, you don't know what it means. How was it generated? How much is owed to the government? From that perspective, it's hard to make an apples-to-apples perspective. Honestly, I have to throw up my hands because it's not going to have a good comparison to anything else."