The good news about the third-quarter earnings season is that it will very likely show growth, particularly among technology companies. The bad news is estimates of the pace of that growth keep shrinking.

Consensus estimates for the third and fourth quarters have been coming down rapidly over the last month, with every positive preannouncement being met by two negative warnings even as second-quarter earnings eked out their first gain in five months. But some pundits believe the numbers for the second half are still overly optimistic.

"We've been in a free fall," said Chuck Hill, director of research at Thomson Financial/First Call. "I usually have some credible estimates by now, but there's too much fog in my crystal ball."

Since July 1, third-quarter growth estimates for the S&P 500 have been slashed by 3.7 percentage points while fourth-quarter estimates have been cut by 3 percentage points, putting projected growth figures for the third and fourth quarters at 12.8% and 24.7%, respectively.

"There'll be more cuts, but how much more, I just don't know," Hill said.

The Coming Tidal Wave

Hill expects August to be a relatively quiet period for earnings warnings but said he expects the third phase of the preannouncement period in September to be disappointing.

Tom McManus, equity strategist at Banc of America, said he is looking for around 7% growth in the third quarter and around 15% in the fourth quarter. Although the economy is still perhaps the biggest concern for corporate America right now, the pressure to clean up balance sheets is also likely to dampen the results, he said. "I think every CEO is going to encourage his whole team to take a more cautious approach to booking revenues and profits," he said.

One change that could potentially impact numbers is the expensing of stock options. So far, only a handful of companies have said they would adopt the accounting change, and companies like Computer Associates ( CA)and ( AMZN) have said the change won't go into effect until 2003. But for others, like Coca-Cola ( KO) and Bank One ( ONE), the expensing of options will begin this year. Some analysts' estimate that earnings would be 10% lower this year if companies treated options as expenses.

The Aug. 14 deadline for CEOs to sign off on their financial statements could also take a bite out of third-quarter expectations, according to some experts. Meanwhile, increasing pressure to remove pension gain assumptions from net income could hurt profits even more.

Pension Shortfalls

When companies are generating more money from current employees than they need to pay their retirees, they often invest that cash to generate a profit. But accounting rules mean that firms can book income based on projected rates of growth, which overstates profits, according to some critics. Morgan Stanley said pension income boosted earnings by 5% last year. "Given that plan return expectations are too high, future years will likely lead to reversals," said Morgan analyst Steven Galbraith.

Galbraith actually believes that the cash funding of pension shortfalls is likely to be a more significant problem than any reported income effect. Still, he also noted that the weak dollar and low interest rates should help to counter headwinds from options as expenses and potential changes to pension gain assumptions. "For all the wind that has been at the back of earnings from pensions and options in the last two years, many companies faced equally serious headwinds from an overvalued dollar," he said.

Dollar Woes

With 30% of earnings derived from abroad, a weaker dollar could boost S&P earnings by as much as 6%, or $4 a share, over the next few years, he said. Several companies have already cited more favorable currency translations for better-than-expected results in the second quarter.

Galbraith said the recent collapse in interest rates should also be beneficial to earnings, adding about $20 billion, or $2 to $3 a share, in the year ahead.

In addition, he argued that, in one sense, earnings are understated because of the massive shift towards companies deploying intellectual capital. If R&D were to be amortized like capital expenses are depreciated, S&P 500 earnings would get a one-time $8-a-share lift, he said.

A more immediate lift to earnings this year could come from share buybacks, which have risen sharply in the last few weeks.

The Tech Juggernaut

Still, several analysts agree that profit estimates are simply too high, particularly in the technology sector. Despite sharp revisions recently, analysts are still expecting to see 65% growth in the third quarter year-over-year.

Hill said the group is vulnerable to further cuts, particularly after Taiwan Semiconductor ( TSM) reduced its capital spending plans. He also expressed concern about the financials, which he believes may have to take additional writedowns as a result of their exposure to WorldCom. The beleaguered telecom concern, which filed for bankruptcy this month, has about $4.5 billion in bank loans. Financial stocks are expected to see growth of 36% in the third quarter.

"I would say that the vulnerable places are tech, industrials and financials: that's where I'd expect to see further cuts," Hill said, adding that projections for the industrial sector stand at -1%.

Estimates for the consumer cyclical stocks, on the other hand, haven't been trimmed since the beginning of the month and have actually risen 5 percentage points since April 1. That sector is expected to see growth of 22% year-over-year.

"The consumer could conceivably begin cutting back in the fourth quarter but right now I don't see anything that suggests that's under way," Hill noted.

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