THE BAR IS SET LOW FOR 1ST QUARTER EARNINGS

By Dirk Van Dijk, CFA, Zacks Investment Research

Key Points:

• The Fourth Quarter earnings season effectively over.  Started out very poor, but improved to mediocre as the season wore on.  Total reported earnings growth is 5.59% for the 495 firms (99.0%) that have reported so far, but those represent 99.8% of total expected earnings.  Ex-Financials growth is 6.09% year over year.  Total revenue growth 5.58%, 8.14% ex-Financials.  Median earnings surprise 2.27% and median sales surprise 0.18%.  Net margins reported at 8.91% unchanged from last year.
• Sharp slowdown from the 14.84% earnings, and 11.25% revenue growth those same 495 firms reported in the third quarter.
• Full year total earnings for the S&P 500 jumps 44.9% in 2010, expected to rise 15.2% further in 2011.  Growth to continue in 2012 with total net income expected to rise 9.3%.  Financials major earnings driver in 2010.  Excluding Financials growth was 28.2% in 2010, and expected to be 17.4% in 2011 and 6.5% in 2012.  Growth of 12.5%, 12.1% ex-Financials expected for 2013.
• Total revenues for the S&P 500 rise 8.04% in 2010, expected to be up 8.93% in 2011, and just 1.37% in 2012.  Excluding Financials, revenues up 9.34% in 2010, expected to rise 10.90% in 2011 and 3.42% in 2012.  For 2013, 4.91% growth expected, 4.94% ex financials.  
• Annual Net Margins marching higher, from 5.88% in 2008 to 6.27% in 2009 to 8.36% for 2010, 8.84% expected for 2011 and 9.53% in 2012.  Margin expansion major source of earnings growth.  Net margins ex-Financials 7.79% in 2008, 6.93% in 2009, 8.09% for 2010, 8.56% expected in 2011, 8.81% in 2012. For 2013 10.22% expected, 9.44% ex-Financials.
• Revisions ratio for full S&P 500 at 1.03 for 2012 (neutral), at 1.09 for 2013 (neutral). Ratio of firms with rising to falling mean estimates at 1.05 for 2012 (neutral), 1.14 (neutral) for 2013.  Total revisions activity past seasonal peak, and falling fast.  
• S&P 500 earned $788.8 billion in 2010, expected to climb to $893.4 billion in 2011.  In 2012 the 500 are collectively expected to earn $975.2 billion. For 2013, $1.098 Trillion expected.  
• S&P 500 earned $56.79 in 2009: $81.98 in 2010 and $94.53 in 2011 expected bottom up.  For 2012, $103.32 expected, $116.25 for 2013.  Puts P/E’s at 14.45 for 2011, and 13.22x for 2012 and 11.75x for 2013, very attractive relative to 10-year T-note rate of 2.04%.

The Earnings Picture

While we started out the fourth quarter earnings season on a very weak note, the picture has improved as the season has worn on.  I would not want to suggest that this has been a good earnings season, but it is not the ugly one it appeared to be just a few weeks ago. The season is effectively over now.

So far 495, or 99.0% of the firms have reported.  However, assuming that all the remaining firms report exactly in like with expectations, then 99.8% of all earnings are in.  Normally, when all is said and done, the median surprise runs about 3.00% and the ratio about 3.0.  So far, the median is at 2.27% and the ratio is 2.26.

While we don’t have the drama of multi-billion-dollar bank losses, this is still the weakest earnings season since the depths of the Great Recession.  In most recent quarters, we have started out of the gate much faster than that only to fade towards those levels; this time the reverse is true, but we are running out of real estate to catch up.

Total net income for the 495 that have reported is 5.59% above a year ago.  It is less than half the 14.84% growth rate that the same 495 firms reported in the third quarter. The picture is similar if we take the Financials out of the picture.  Without them, the year-over-year rise in net income is 6.09%, down from 17.70% growth in the third quarter.  Sequentially, total net income so far is 3.18% below the third quarter, or 3.58% lower ex-Financials.  The pressure on the growth rate is coming from both the numerator and the denominator (year-ago earnings growth was strong, and thus tougher comps).

The remaining seven firms are too small and few to have any significant impact on the overall results, thus we skip the expected income growth, sales growth and net margin tables this week.  Fourteen of the 16 sectors are done with earnings season.

Revenue growth has also slowed down, with the 495 reporting 5.58% growth.  If we exclude the Financials that have reported, revenue is up 8.14% year over year.  In the third quarter, revenue growth was 11.25, or 13.15% excluding Financials.

For the 495, net margins have come in at 8.91%, unchanged from a year ago, and down from 9.37% in the third quarter. Excluding the Financials, net margins are 8.01%, up ever so slightly from 7.98% a year ago and well off the 8.49% of the third quarter.  While in an absolute sense, those are still very healthy net margins, much higher than the average of the last 50 years or so, but they are no longer expanding significantly.  Then again, it was unrealistic to expect that they would always rise.  It does mean that earnings growth is going to be harder to come by going forward.

Net Margins Keep Growing

On an annual basis (all 500), net margins continue to march northward.  In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009.  They hit 8.36% in 2010 and are expected to continue climbing to 8.84% in 2011 and 9.53% in 2012.  The very preliminary expectation is that they will rise to 10.22% in 2013.

The pattern is a bit different if the Financials are excluded, as margins fell from 7.78% in 2008 to 6.93% in 2009, but have started a robust recovery and rose to 8.09% in 2010.  They are expected to rise to 8.56% in 2011.  They are expected to rise to 8.81% in 2012, and then up to 9.41% in 2013.  There should be some caution in using the 2013 numbers, as the analyst sample sizes are still well below those for 2012, especially when it comes to revenues.

However the rise in net margins for 2012 and 2013 seems to be more due to very low revenue growth than fast earnings growth.  After posting 8.73% growth in 2011, and 10.90% ex-Financials, revenue growth is expected to drop to just 1.37% for 2012 and rebound to only 4.91% in 2013.  Excluding Financials, growth is expected to be 3.42% for 2012 and 4.94% for 2013.

Quite frankly, given the recovering economy, the very low rate of revenue growth is surprising.  Weakness in Europe and a somewhat stronger dollar may be playing a role there.  However, I suspect that either the analysts are being overly cautious about their revenue estimates, or the economy might not do as well as people are now expecting.  I suspect it is more the former than the later.

Total net income in 2010 rose to $788.8 billion in 2010, up from $538.6 billion in 2009.  The expectations for the full year are very healthy.  In 2011, the total net income for the S&P 500 should be $893.4 billion, or increases of 44.9% and 15.2%, respectively.  The expectation is for 2012 to have total net income come close to $1 Trillion mark to $976.6 Billion, for growth of 9.3%, followed by growth of 12.5% in 2013.  Total net income is expected to finally pass the $1 Trillion mark in 2013 at $1.099 Trillion.

S&P’s “EPS” & Revisions Ratios

The “EPS” for the S&P 500 is expected to be over the $100 “per share” level for the first time at $103.32 in 2012.  That is up from $56.79 for 2009, $81.98 for 2010 and $94.53 for 2011.  For 2013, the S&P 500 is expected to earn $116.25.  In an environment where the 10-year T-note is yielding 2.04%, a P/E of 14.5x based on 2011 and 13.2x based on 2012 earnings looks attractive.  The P/E based on 2013 earnings is just 11.8x.

Estimate revisions activity is past its seasonal peak. And starting to decline rapidly.  In previous earnings seasons we have generally seen a bounce in the revisions ratio, as the analysts have reacted to better-than-expected earnings and the outlooks on the conference calls. We finally have some evidence of that, but not much and it comes more from old estimate cuts falling out of the moving four-week total than from new estimate increases being made.

The revisions ratio for FY1, which is mostly 2012 earnings now stands at 1.03.  The picture for FY2, or mostly 2013 is only slightly better, with a revisions ratio of just 1.09. The ratio of firms with rising mean estimates to falling mean estimates, which now stand at 1.05 and 1.14, respectively.

As the earnings season has progressed, things have been getting a bit better, but only moved the season from being very poor to mediocre.  This is happening when the bar is set at its lowest point in a very long time.  For the remaining firms, the bar is set even lower.

The market has been off to a very strong start of the year, despite the weak early results.  Valuations are still compelling, if somewhat less so than a few months ago.  While earnings growth is slowing, it is still positive.  The numbers for the first quarter look like they could be a little weak. With a decline of 2.15% year over year expected. For the full year, growth of 9.31% is not all that bad, especially with it expected to pick back up again to 12.52% in 2013.

With all the fourth quarter reports in, and virtually no first quarter results in, we omit the surprise and reported quarterly earnings, revenues and margin tables this week.  The focus is all on the expectations for the first quarter.

Expected Quarterly Growth: Total Net Income

• Total net income is expected to be 2.59% below what was reported in the first quarter of 2011, versus +5.88% growth in the third quarter.  Excluding Financials, negative growth of 3.01%, down from +46.30% reported in the fourth quarter.
• Relative to the fourth quarter total net income to fall 5.41%, ex-Financials to drop 8.34%.
• Nine sectors expected to post negative year-over-year growth, seven lower sequentially.  Autos and Materials particularly weak year over year.

Quarterly Growth: Total Revenues Expected

• Revenue growth expected to be just 0.06% year over year, up just 2.88% ex-Financials.  Sharp slowdown from 5.54% year over eyar growth in the fourth quarter, 8.17% ex-Financials.
• Sequentially revenues down 6.39% from the fourth quarter, down 5.51% ex-Financials.
• Financials continue to see very negative revenue growth.
• Thirteen sectors expected to see revenue growth decelerate from the fourth quarter.

Quarterly Net Margins Expected

• Sector and S&P net margins are calculated as total net income for the sector divided by total revenues for the sector.
• Net margins expected to fall to 9.05% from 9.32% a year ago, but up from 8.93% in the fourth quarter.  Net margins ex-Financials expected to fall to 8.31% from 8.82% a year ago and down from 8.57% in the fourth quarter.
• Margin expansion is the key driver behind earnings growth.  Due to seasonality, it is best to compare to a year ago, particularly at the individual company and sector levels.  Even with the expected dip, margins are at very high levels relative to history.
• Ten sectors expected to see year over year margin compression, ten to also see sequential compression.  Margins expected rebound sequentially in the second quarter for all sectors, but still be down year over year for ten sectors.

Annual Total Net Income Growth

• Following rise of just 2.4% in 2009, total earnings for the S&P 500 jumps 44.9% in 2010, 15.2% further in 2011.  Growth ex-Financials 28.2% in 2010, 17.4% in 2011.
• For 2012, 9.4% growth expected, 6.6% ex-Financials.  For 2013, 12.7% and 12.3% ex-Financials.
• Fourteen sectors see total net income rise in 2011 and all but Aerospace and Utilities in 2012. Utilities only (very small) decliner in 2010.  Nine sectors expected to post double-digit growth in 2012 and nine in 2012, 13 in 2013.  Energy, Materials, Staples and Health Care expected to grow less than 5% in 2012. Aerospace and Utilities only sectors to decline.  Slow growers in 2011 to be high growers in 2012.
• Sector dispersion of earnings growth narrows dramatically between 2010 and 2013.  Nine sectors expected to grow between 13 and 17% in 2013.  Only three in single digits and only Construction (still a low base) over 20%.

Annual Total Revenue Growth

• The number of revenue estimates is smaller than earnings estimates, especially for 2013.
• Total revenues for the S&P 500 rise 8.93% in 2011, but growth expected to slow to 1.87% in 2012, early expectation for 4.88% growth in 2013.
• Energy, Industrials, Materials and Autos lead revenue race in 2011.  Three other sectors (all cyclical) also expected to show double digit revenue growth in 2011. Construction leads for 2012 and 2013, Industrials, Transports and Tech also strong.
• All sectors but Staples, Finance and Aerospace show positive top line growth in 2011.  Financials and Staples expected to see negative growth again in 2012. All sectors expected to see 2013 growth.
• Revenue growth significantly different if Financials are excluded, down 10.56% in 2009 but growth of 9.34% in 2010, 10.92% in 2011, and 3.92% in 2012.  Early expectation for 4.98% growth in 2013.

Annual Net Margins

• Net Margins marching higher, from 5.88% in 2008 to 6.27% in 2009 to 8.38% for 2010, 8.86% for 2011.  Trend expected to continue into 2012 with net margins of 9.51% expected.  Rise to 10.22% expected for 2013.
• Financials significantly distort overall net margins. Net margins ex-Financials 7.78% in 2008, 6.93% in 2009, 8.10% for 2010, 8.58% expected in 2011.  Expected to rise to 8.80% in 2012, then to 9.41% in 2013.
• Financials net margins soar from -8.42% in 2008 to 15.33% expected for 2012, 17.08% for 2013.  As much from revenue weakness as earnings strength.
• Fourteen sectors saw higher net margins in 2011 than in 2010.  Thirteen sectors expected to post higher net margins in 2012 than in 2011.  Thirteen sectors expected to see margin expansion in 2012.  All sectors see expansion in 2013.
• Sector net margins are calculated as total net income for sector divided by total revenues.  However, there are generally fewer revenue estimates than earnings estimates for individual companies.

Earnings Estimate Revisions: Current Fiscal Year
The Zacks Revisions Ratio: 2012

• Revisions ratio for full S&P 500 at 0.96, down from 1.03, still neutral.  Total revisions activity past seasonal peak and falling.
• Industrials lead, Autos also strong, both with two increases per cut or more (but very small samples).  Utilities, Aerospace, Transports very weak.
• Ratio of firms with rising to falling mean estimates at 1.24, up from 1.05, still a neutral reading.
• Total number of revisions (4 week total) past seasonal peak at 1,912, down from 2,651 (-27.9%).  Increases at 934, down from 1,343 (-30.4%), cuts at 978 down from 1,343 (-27.2%).

Earnings Estimate Revisions: Next Fiscal Year
The Zacks Revisions Ratio: 2013

• Revisions ratio for full S&P 500 at 1.14 up from 1.09, still in neutral territory.
• Eight sectors have positive revisions ratios (at or above 1.0). Autos, Conglomerates and Industrials lead.  Utilities, Aerospace and Transports very weak, have two or more per increase. Very small samples, however.
• Ratio of firms with rising estimate to falling mean estimates at 1.39, up from 1.14.  Now in Bullish territory.
• Total number of revisions (4-week total) at 1,897, down from 1,897 (-20.0%).
• Increases at 808 down from 991 (-18.5%), cuts at 710, down from 1,160 (-38.8%).

Total Income and Share

• S&P 500 earned $538.6 billion in 2009, rising to earn $788.8 billion in 2010, $893.42 billion expected in 2011.  Earnings to approach the $1 Trillion mark in 2012 at $976.6 billion, pass in 2013 at $1.099 Trillion.
• Finance share of total earnings moves from 5.9% in 2009 to 17.3% in 2010, dip to 15.3% expected for 2011; rebound to 17.4% then rise to 17.8% in 2013.  Energy share also rising going from 11.9% in 2009 to 14.6% in 2011, dip to 13.4% in 2012, 13.3% in 2013.
• Medical share of total earnings exceeds market cap share (index weight), but earnings share expected to shrink from 17.3% in 2009 to 10.5% in 2013, down each year.
• Market Cap shares of Construction, Staples, Retail, Transportation, and Business Service sectors far exceed earnings shares of any of the years from 2010 through 2013.
• Earnings shares of Energy, Finance, Autos and Medical well above market-cap shares.
• As a general rule, one should try to overweight sectors with rising earnings shares, underweight falling earnings shares, but also over weight sectors where earnings shares exceed market-cap shares.

P/E Ratios

• Trading at 16.65 2010, 14.45 2011 earnings, or earnings yields of 6.02% and 6.92%, respectively.  P/E for 2012 at 13.22x or earnings yield of 7.56%.  Very Preliminary 2013 P/E of 11.75, or earnings yield of 8.51%
• Earnings Yields still attractive relative to 10-year T-Note rate of 2.04% and 30-year bond rate of 3.19.
• No single-digit P/E sectors for 2012; Autos, Oil and Finance cheapest for 2012 and 2013.
• Construction has highest P/E for all four years by wide margin.
• S&P 500 earned $56.79 in 2009 rising to $81.98 in 2010.  Currently expected to earn $94.53 in 2011 and $103.32 or 2012.  Preliminary 2013 estimate $116.25.

Data in this report, unless stated otherwise, is through the close on Thursday 3/22/2012.

We use the convention of referring to the next full fiscal year to be completed as 2011, not all firms are on December fiscal years, this can cause discontinuities in the data.  The data is based on FY1, not based on 2011, even though I may call it 2011 in the report. All numbers, including historical ones, reflect the current composition of the S&P 500, thus some historical numbers may differ from those reported by S&P which are based on the composition of the index at the time of the reports.

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