EARNINGS UPDATE – WHAT TO EXPECT FOR Q2 AND BEYOND

Earnings season is about the pick-up momentum and will certainly dominate the market direction over the coming 6 weeks.  Preliminary results have been much better than expected.  Analysts have backloaded their 2009 earnings estimates due to their expectations for a second half recovery.  This pits us at an odd juncture in the market.  The current quarter’s estimates appear to be relatively low, but the second half estimates appear a bit optimistic.  Analysts currently expect a 14% decline in EPS versus Q2 of 2008.   Third quarter is expected to decline 22% and full year results are expected to be down 14%.   Full year expectations are for $59 in EPS while 2010 estimates are calling for $75.  Both appear a bit optimistic.  Thus far, there have been 6 positive surprises for every negative in Q2 earnings.  Although there haven’t been many reports this quarter this likely bodes well for more of what we saw last quarter when the overwhelming majority of companies beat expectations.

My proprietary expectation ratio continues to show near-term deterioration.  The data of late has been relatively light, but the change in trend is a certain sign that analysts are getting more aggressive with their earnings expectations.  It’s important to note that the ER is an intuitive forward looking indicator.

So, what do I expect to see in Q2?  Expect a huge amount of bottom line beats and in-line or worse than expected revenue figures.  The economy is still incredibly weak so the top line growth has been about in-line with analyst’s expectations, however, companies are cutting costs much more efficiently than expected.  This has created a huge divergence between the analysts revenue estimates and their top-line estimates. Our recent analysis of ths situation highlighted this phenomenon:

Cost cuts are no recipe for organic growth.  That can only be achieved through top line growth.  The implications here are that we are likely to see another quarter of “better than expected” bottom line earnings as analysts have adjusted their EPS estimates very little over the prior quarter.  This could further juice the stock market.  The more important factor to keep in mind, however, is that this is no recipe for long-term growth.  We will need to see a sharp expansion in the economy before revenue growth returns to the earnings picture.  For now, the positive results are nothing more than defensive posturing by corporations.  If the economy doesn’t turn up sharply heading into Q3 and Q4 it’s likely that investors will turn fearful of this false bottom line growth.

So we’re likely to see better than expected earnings, but a look under the hood will show much less earnings power than the EPS figures display.  The weak revenue trend should overshadow the EPS beats as the earnings season progresses.  Guidance will be equally important.  Q3 and Q4 expectations look far too optimistic to me and are pricing in a relatively strong economic rebound.  As recent economic data has shown, that’s an unlikely scenario, however, we could get more of what we saw last quarter due to bank earnings.  We’re almost certain to see a number of better than expected earnings results and tepid guidance due to analysts high expectations, but it’s very important to note that banks don’t give guidance.  Banks are also front loaded in the earnings season so they could set the tone early.  If they report better than expected numbers and don’t provide the outlooks that other big sectors will provide we could just be off to the races in the early weeks of earnings season.  The true profit picture will be much more apparent when energy, materials, and retailers report later in the earnings season and expect the quality of their earnings to be very poor.