Solid Earnings Don't Convince the Bears

Results have been much better than expected, yet some analysts remain skeptical about the profit recovery.
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Earnings have been much better than expected in the second quarter, and estimates for the second half of the year have actually been revised higher. So why are some analysts still skeptical about the profit recovery?

It's largely because they don't believe the numbers.

For starters, earnings projections were shaved "aggressively" heading into the reporting season, said Francois Trahan, chief investment strategist at Bear Stearns. "The drop in interest rates and the dollar during the quarter are also lending a helping hand," he added.

Indeed, Thomson First Call said that favorable currency translations probably added about 2 percentage points to earnings in the second quarter.

On first glance, the earnings season certainly looks impressive. Results from the 303

S&P 500

companies that had reported earnings as of Thursday afternoon had smashed through analysts' estimates, with profit growth of 8.8% over last year on a 5.4% jump in sales. The blended results, which include those firms that have reported and those yet to release results, show an 8% jump in earnings, according to Thomson First Call. That's far better than the 5.3% rise analysts had predicted at the start of July.

What's more, estimates for the second half of the year have increased. Third-quarter profits are now slated to show growth of 13.6%, up from 12.7% on July 1. And fourth-quarter earnings are seen rising 21.7%, up from 21.3%.

Nevertheless, Trahan cautioned that it is "fairly typical for earnings momentum to lose steam 18 months or so into an economic recovery" because the post-recession productivity boom often fades at this point. Meanwhile, he said macro pressures on pricing -- and therefore margins -- have so far failed to abate.

"The bearers of bad news tend to delay reporting as long as possible," he said. "Earnings estimates will have to come down for the third and fourth quarters, with the latter being most at risk. The key question is whether the market will be able to look to the future as second-half 2003 downward revision activity picks up."

Jeffrey Saut, chief investment strategist at Raymond James, said he has been very disappointed with the quality of corporate earnings in the second quarter, noting that firms have used a variety of accounting techniques to bolster their numbers.

"I'm finding the way they're making their numbers is through line-item shifts in the income statement, changes in taxes and changes in depreciation schedules, so they're still playing the old abracadabra accounting card," he said. "It's legal, but it's disingenuous."

Saut also questioned whether firms will meet analysts' projections for the second half. "Estimates are going up because

stock prices are going up," he said. "When share prices get better, analysts raise their estimates. I've seen this go on for years."

One of the main reasons Saut is so skeptical is because he believes the economy is recovering at "crawl speed." As evidence of this, he pointed to an announcement from


(IBM) - Get Report

Thursday. The company said it would allow qualified customers to choose between making lower payments with reduced financing rates or deferring all payments at no charge until 2004. "IBM is effectively offering 0% financing. Are they doing that because business is good?" Saut asked.

Also, other analysts note, the dollar has recently started to gain ground and interest rates have moved higher over the past few weeks, so if this trend continues, it could hurt earnings going forward. The direction of interest rates is considered particularly important because financial companies, which have been some of the biggest beneficiaries of low rates, represent about 43% of S&P 500 profit growth in the second half.

Of course, higher interest rates and a stronger dollar would also imply a stronger economy, which could soften the impact to earnings.

Optimists think the bears are simply reaching for excuses right now. In fact, they feel the profit recovery will continue as corporate America responds to easier fiscal and monetary policy.

"There is more to the earnings story than just cost reductions and foreign-exchange gains," said Tobias Levkovich, chief market analyst at Smith Barney. "We contend that earnings skeptics have been proven wrong, as they were in April."

Still, even Levkovich conceded that earnings estimates, at least in the fourth quarter, are currently overstated. He pointed out that the financial sector is expected to post a 41% profit jump during the final three months of the year, but most of that is due to easier comparisons to last year, when firms were forced to take large insurance reserves. Absent the financial sector, he said, fourth-quarter earnings overall would be "something closer to the low teens."