Revision Ratios Still Rising

Growth

• Second-quarter total net income down 31.0% year-over-year
• Third quarter expected to be down 27.5% year-over-year
• Staples and Health Care only sectors to post positive growth in second quarter
• Only 30.9% of companies posted earnings growth; 23.7% posted sales growth year-over-year

Surprise

• Results much stronger than feared with median surprise of 6.7%
• Positive surprises lead disappointments by 3.4:1 margin (surprise ratio)
• Surprise ratio above 8:1 for Health Care and above 4:1 for Tech, Staples and Discretionary
• Margins the cause, not revenue growth
• 71.2% of firms beat on earnings: 45.9% beat sales estimates

Levels

• Bottom-up estimate for S&P 500 now $60.60 in 2009 versus $60.41 last week.
• S&P 500 now expected to earn $74.90 in 2010 versus $74.74 last week
• Top down estimates $53.84 and $67.44, respectively

Revisions

• Total estimate increases outnumber cuts by more than 5:3 for 2009
• Upward revisions outnumber cuts by more than 4:3 for 2010
• Revisions ratios for both years have risen consistently through earnings season
• For 2009, Staples and Health Care lead; Utilities and Telecom lag
• Tech and Materials also look good for both years

Valuation

• S&P 500 P/E at 16.6x based on 2009 earnings; an earnings yield of 6.02%
• P/E of 13.45x based on 2010 earnings; an earnings yield of 7.43%
• Earnings yields attractive relative to Treasury and corporate bond yields
• Health Care has lowest P/Es of any sector

Total Net Income Growth

• Results are absolutely bad, but better than expected (486 reports)
• Total net income reported $134.0 billion versus $194.3 billion last year, down 31.0%
• Only 30.9% of all reports show positive year-over-year EPS growth; 23.7% sales growth
• Only Staples and Health Care show positive growth
• Materials and Energy see massive year-over-year declines

The second-quarter earnings season is almost over. It was very ugly in an absolute sense. Fewer than 1/3rd of all companies managed to report higher earnings than they did a year ago.

This was due to very weak sales, with only 24% of all firms reporting higher revenues than a year ago. Obviously this means that there were some firms that were able to report higher earnings even in the face of lower revenues. Given the operating leverage that is inherent to most businesses that is a pretty impressive feat. However, just how sustainable is growth based on cost cutting? Certainly not as much as growth that comes from growing revenues.

There is sort of a paradox here. For an individual company, cutting costs almost always helps the bottom line. However, those costs are either someone else's revenues or paycheck. This lowers their revenues and incomes. If everyone is cost cutting, then the revenues will be lower across the board, negating the cost cutting the individual company did. Of course no single company can really buck the trend since then they would just have lower revenues without the lower expenses.

The total earnings reported so far of the 486 firms that had reported by the 8/20 close were $134.0 billion, a decline of 31.0% from a year ago. However, on a quarterly sequential basis, earnings are up 11.6%. Actual earnings growth has been a pretty rare commodity with only 150 of the 486 (30.9%) reporting firms actually posting higher net income than a year ago.

Perhaps even ore surprising is that only 115 or 23.7% have seen an increase in revenues. Total revenues for the 465 firms are 15.7% below last year. The median EPS growth rate is -16.1%.

One thing to keep in mind at this time of year is that we use a convention where the last full fiscal year completed is referred to as 2008, and the next one to be completed is called 2009. However, there are 23 S&P 500 firms which have June fiscal year ends, so as they report, their "2009" is becoming "2008", which can cause some of the "historical" numbers to change.

Keep in mind that medians are inherently equally weighted with the growth rate of a relatively small firm counting as much as that of an Exxon Mobil (XOM - Analyst Report) or a Wal-Mart (WMT - Snapshot Report). Also changes in share count can affect EPS growth, but not total net income growth. The median growth rate gives you a good idea of what the "typical firm" in a sector produced.

Surprises Scorecard:

• Positive surprises leading disappointments by a 3.4:1 margin
• The median surprise is a very strong 6.74%
• All sectors but Telecom have more positive surprises than disappointments
• Materials and Consumer Discretionary the leaders on the surprise front
• Tech, Health Care and Energy also doing better than expected
• Financials responsible for more than 1 in 4 disappointments

The Zacks Revisions Ratio: 2009

• Revisions ratio for full S&P 500 up to 1.68, from 1.57
• Revisions ratio up throughout earnings season
• Five sectors in positive territory; Staples and Health Care lead
• Industrials, Utilities and Telecom continue to see estimates cut
• Ratio of firms with rising to falling mean estimates up to 1.55 from 1.51
• Total number of revisions (4-week total) down to 4,371 from 4,587 (-4.7%)
• Increases up to 2,740 from 2,799 (-2.1%); cuts up to 1,631 from 1,788 (-8.8%)
• Total revisions activity passing seasonal peak

The sectors with the strongest surprise profiles are seeing the analysts raise their sights for 2009. This is to be expected since the second quarter is part of the full year, and the failure to raise estimates for the full year by the amount of the second quarter surprise amounts to a de facto cutting of estimates for the third or fourth quarters.

The consistent rise we have seen in the revisions ratio assuages the fear that I had earlier in the earnings season, when the revisions ration had turned positive, but not high enough given the level of positive surprises. Six sectors are now solidly into positive territory (above 1.25, I consider 0.80 to 1.25 to be neutral). Staples has been particularly impressive, with a ratio above 4, but Health Care and Tech also deserve positive notice as well.

The size of the increases in Tech is particularly noteworthy. Even after scrubbing out those with increases of greater than 100% or less than -100%, there were 13 Tech firms with increases in their mean estimates of over 20% out of 45 total in the whole S&P 500.

Some of the particularly strong Tech firms include (based on both size of the change in the mean estimate and the number of estimates raised), Applied Materials (AMAT - Snapshot Report), Motorola (MOT - Analyst Report), Sandisk (SNDK - Analyst Report), Teradyne (TER - Snapshot Report) and Western Digital (WDC - Snapshot Report).

The Zacks Revisions Ratio: 2010

• Revisions weaker for 2010 than 2009, but still net positive
• Revisions ratio rises to 1.38 from 1.31
• Tech and Staples showing best estimate momentum for 2010
• Telecom and Utilities getting cut.
• Ratio of rising to falling mean estimates unchanged rises to 1.43 from 1.28
• Total revisions activity passing highs for the quarter
• Total number of revisions rises to 3,674 from 3,888 (-5.5%)
• Estimate increases up to 2,133 from 2,205 (-3.3%), cuts up to 1,541 from 1,683 (-8.4%)

Valuation - Earnings Shares and P/Es

• Earnings shares, including historical, based on current make up of S&P 500
• Health Care to take earnings crown from Energy in 2009 and yield to Tech in 2010
• Energy's earnings share expected to plunge to 10.9% from 22.9%
• Financials' 2009 earnings share expected to rise to 11.6% from -0.8% in 2008.
• 12-month forward S&P P/E of 14.50 equates to earnings yield of 6.90%, which is very attractive relative to 10-year T-note yield of 3.57%, and somewhat attractive relative to 5.32% A rated 10-year corporate.
• Health Care has the lowest P/E sector for both 2009 and 2010, its market cap share (index weight) well below its earnings share

With more than 25 years of experience as an analyst and portfolio manager, Dirk van Dijk is Zacks’ Chief Equity Strategist. He also manages the new long-term investing service, Strategic Investor.

Data in this report, unless stated otherwise, is through the close on Thursday 8/20/2009