Q1 Earnings: 2 Ways To Spin

• Reported Q1 total net income down 32.4% from year ago, but up 103.1% from Q4
• Ex-Financials total earnings down 36.6% from a year ago, and down 14.7% from Q4
• Total net income down in all sectors but Financials and Health Care
• Health Care, Tech and Discretionary all showing lots of positive surprises
• Full S&P 500 (SPX) total net income expected to be 32.2% lower than Q1 2008
• Decline expected to continue in Q2, with a year-over-year decline of 36.2%
• Total net income expected to fall 16.0% for all of 2009, after 18.9% fall in 2008
• Revisions Ratios improve into Neutral Territory
• Bottom up estimate for S&P 500 now $57.21 in 2009 versus $57.43 last week.
• S&P 500 now expected to earn $72.61 in 2010 versus $72.59 last week

Total Net Income Growth

The book are just about closed on first-quarter earnings season. It was a book open to many interpretations, depending on which sort of spin you want to bring to it.

If you were inclined to be looking for green shoots, there was ammo for your argument in that the total net income reported was far higher (more than double) in the first quarter than in the fourth quarter of 2008. A bull would also be able to point to the fact that more than twice as many firms reported earnings above expectations than those which disappointed. The median surprise was a very healthy 4.22%.

A bull could also point to the huge increase in the number of upward estimate revisions for 2009 in response to the better than expected earnings. While estimate revisions activity always picks up at this point in earnings season, the rise in the number of estimate increases absolutely swamped the rise in the number of cuts. Relative to a month ago, estimate increases are up 264%, while the number of estimate cuts has only increased 61%. This has brought the revisions ratio from a deeply negative 0.41 to a neutral 0.92.

However, a bear would have ample ammo as well. He would start by pointing out that total net income was 32.2% below year ago levels, and that the improvement relative to the fourth quarter was entirely due to one sector, the Financials. Furthermore the quality of earnings in that sector was abysmal, with billions of dollars of "profits" booked because the bond market had serious questions about the solvency of the firms. Also a very large portion of the increase came from one company, American International Group (AIG - Snapshot Report) losing only $1.6 billion instead of losing $37.9 billion (both excluding one-time items).

If we look at the 394 non-financial companies, rather than all 464 firms that have reported, total net income is actually 14.7% lower than in the fourth quarter.

A bear would also argue that companies long ago learned that it is better to under promise and over report, and that we went for years with a ratio of positive surprises to disappointments of over 3:1, so the first quarter surprise ratio of 2.1:1 is not really all that great. The bear would also point out that there have still been more estimate cuts over the last 4 weeks than estimate increases, even if the ratio is no longer lopsided in favor of cuts.

All things considered, I would have to say the bears have a better argument, but it is not a slam dunk in their favor.

Looking ahead to the second quarter, things don't look too great, with total net income expected to be 36.2% below year ago levels. The only sector that is expected to squeak out a gain over year-ago levels in the second quarter is Staples, and that is just 3.5%. Eight sectors are expected to see total net income at least 25% below year ago levels. (Five of those sectors could see a drop of greater than 40%.)

For all of 2009, total net income is expected to drop 15.9% on the heels of a 20.3% decline in 2008. However, if the first quarter was down by 32.4%, and the second quarter is expected to be down by 36.2%, then there has to be positive year-over-year growth in the second half. Given the comps, expect that to happen in the fourth quarter.

Scorecard and Median EPS Growth Rates

• The surprise ratio is at 2.09 (below normal) and the median surprise at 4.22% (above normal)
• Reported median EPS is running -17.3%
• Every sector but Telecom and Health Care is down
• Materials, Energy and Financials post biggest declines in median EPS growth
• Only Staples and Discretionary have large numbers of firms yet to report
• Positive surprises concentrated in the Discretionary, Health Care and Tech Sectors
• Full year 2008 EPS expected to be down 10.0% among reported firms

Median EPS year-over-year growth paints a somewhat different picture than does total net income growth. The overall quarterly declines reported are significantly smaller, at 17.1%. The rankings of the sectors are also different, most notably in the case of the Financials. Instead of leading, financials are near the back of the pack with a 34.6% decline.

Overall we are seeing more than twice as many positive surprises as disappointments, but surprises leading disappointments is normal. However, the size of the median surprise is bigger than normal at 4.22%. That does seem to be a legitimate green shoot.

Overall, Tech has the best looking surprise profile, with a ratio of positive surprises to disappointments of 3.9:1 and a median surprise of 6.9%. Consumer Discretionary also looks good with a surprise ratio of 2.6:1 and a huge median surprise of 9.73%. The Financials are the only sector with more disappointments than positive surprises. Five sectors have all their reports in, the stragglers are concentrated in the 2 consumer sectors.

The Zacks Revisions Ratio: 2009

• The revisions ratio for the full S&P 500 is up to 0.92, from 0.85 last week
• One month ago, the ratio was 0.41; the improvement has been steady and strong
• Five sectors are in positive territory; Telecom, Staples and Tech lead
• Now into Neutral territory for the S&P 500 as a whole
• Financials continue to see estimates cut
• Ratio of firms with rising to falling mean estimates rises to 0.76 from 0.72
• Total number of revisions (4-week total) up to 4,416 from 4,046 last week (9.1%)
• Increases up to 2,119 from 1,858 (14.0%), cuts up to 2,297 from 2,198 (4.5%)

While we are still seeing more estimate cuts than increases, the ratio has improved dramatically over the past month. This has been happening on a far larger total number of revisions. A month ago, there were only 582 increases (four week moving total) and 1,423 cuts for a ratio of 0.41. Since then the number of estimate increases as almost quadrupled to 2,119, while the number of cuts has risen by only 61%, resulting in a ratio of 0.92.

I see this as a very significant "glimmer of hope". Half of the sectors are now, not just above 1.0, but into true positive territory. Telecom is extremely strong, with almost three increases for every cut. It however is a very small sector. Staples is showing an impressive 1.92 revisions ratio and Tech is not to shabby at 1.70.

Better than expected first quarter earnings are leading to positive estimate revisions. This is not only true for the S&P 500 as a whole but at the sector level as well. Just compare the positive surprises versus disappointments in the table above with where the sectors are on the Revisions ratio rankings.

The Telecom Charge is being lead by Sprint (S - Analyst Report), which has seen 17 estimate increases versus no cuts over the last 4 weeks, resulting in a 53.2% increase in its mean estimate. Qwest (Q - Analyst Report) was also impressive with a 15.8% increase it its mean estimate due to 15 increases and only one cut. Within the Tech sector, the increases were concentrated among the chip companies with especially strong performances from firms like Broadcom (BRCM - Analyst Report), Intel (INTC - Analyst Report) and Texas Instruments (TXN - Analyst Report).

The Zacks Revisions Ratio: 2010

• The revisions ratio is up to 0.82 from 0.71
• Telecom and Tech the strongest; Financials the weakest
• Positive surprises leading to more upward revisions
• Ratio of rising to falling mean estimates rises to 0.65 from 0.54
• Total revisions activity should peak in a few weeks
• Total number of revisions rises to 3,332 from 2,996 (11.2%)
• Estimate increases rise to 1,481 from 1,243 (19.1%), cuts rise to 1,851 from 1,753 (5.6%)

The overall picture for 2010, is similar in outline to that of 2009, but not quite as good, with the revisions ratio rising to 0.71 from 0.59 last week and 0,30 a month ago. Telecom and Tech also lead for 2010, while Financials and Industrials are continuing to get cut. The Utilities are much weaker for 2010 than they are for 2009. The rise in the total number of estimates has been even more dramatic for 2010 than for 2009.

• P/Es are too low since earnings estimates are too high
• Health Care expected to take earnings crown from Energy in 2009, keep it in 2010
• Energy Earnings Share expected to plunge to 11.8% from 23.6%
• Financials 2009 earnings share expected to rise to 10.2% from -1.7% in 2008.
• Consumer Discretionary market cap share far above earnings shares (overvalued?)
• Health Care market cap share well below earnings shares (undervalued?)
• 12-month forward S&P P/E of 14.29 equates to earnings yield of 7.09%, very attractive relative to 10 year T-note yield of 3.13%, only mediocre relative to 5.43% A rated 10 year corporate.
• T-note rates are rising and more realistic earnings yields of near 6.16% based on lower earnings ($55) means the spread, while still attractive, is not overwhelming.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 5/14/2009