Earnings Acceleration?

Key Points:

• Almost done with earning season: 99.0% of reports in, a very strong season. Earnings Surprise Ratio (#beat/#miss) at 4.57, slightly below 3Q level. Median Earnings Surprise 5.54%, a very strong reading

• Earnings of reported firms up 105.5% year over year, but just 14.5% excluding Financials

• Sales Surprise ratio at 2.30, median surprise 1.69%, 65.5% of all firms do better than expected on top line. More firms report growing than shrinking revenues, ratio 1.27

• S&P 500 Revenues up 6.07% year over year in 4Q, a vast improvement over 10.82% revenue decline the same firms showed in the 3Q. Revenue growth driven by Financials, some of which had negative revenues (accounting games) a year ago. Excluding financials revenues up 2.2% year over year
• Total S&P 500 Net Income in 2009 expected to be 10.1% below 2008 levels, following 23.0% plunge in 2008. Total earnings for the S&P 500 expected to jump 31.1% in 2010, 20.0% further in 2011

• Autos and Conglomerates perfect with no disappointments, Tech has only a single disappointment

• Total S&P 500 Revenue in 2009 expected to be 7.3% below 2008 levels. Total revenues for the S&P 500 expected to rise 3.31% in 2010, 6.59% in 2011

• Rebounding earnings for Finance, Materials and Energy to lead 2010 charge

• Huge margin expansion in 4Q expected to continue in 2010 and 2011

• Total revenues fell 7.4% in 2009, expected to rise 3.5% in 2010, up 7.5% in 2011

• Revisions ratios fall to 1.69 for 2010, and to 1.66 for 2011, both still very strong readings,  total activity past seasonal peak and plunging

• Transport, Retail and Tech  revisions strong

• Firms up/firms down ratio at 1.42 for 2010, 1.35 for 2011

• S&P500 expected to earn $548.1 billion in 2009, $718.6 billion in 2010, $862.1 billion in 2011

• Bottom Up estimates:  $58.99 for 2009, $77.20 for 2010, $92.76 for 2011

• Top Down estimates: $57.45 for 2009, $76.05 for 2010, $87.52 for 2011

Welcome to Earnings Trends. We have decided to start focusing our analysis of the S&P 500 based on Zacks' own sector groupings rather than the S&P GICS sectors. There are 16 Zacks sectors and only 10 GICS sectors, so the new groupings will result in better granularity of the data. The old way simply grouped too many very different companies together. In addition, we for the first time are presenting top line as well as bottom line expectations and surprise information.

We use the convention of referring to the next full fiscal year to be completed as 2010, although not all firms are on December fiscal years. This can cause discontinuities in the data, particularly around this time of year. The data is based on FY1, not based on 2010, even though I may call it 2010 in the report.

Earnings Season Nearly Finished

With 99.0% (495) of the S&P 500 reports in, the year-over-year earnings growth has simply been fabulous at 105.5%. However, much of that growth is due to a single firm, AIG (AIG) and its massive year-ago losses. By any normal standard, its losses were enormous this year as well, but last year was not normal. It is not like the $7.2 billion it lost in this year’s fourth quarter is chicken feed, but it is a huge improvement on the $37.9 billion it lost a year ago.

AIG was, of course, not alone among the financials in reporting epic losses a year ago, but if losses are epic poems, then AIG last year was the Iliad and the Odyssey rolled into one. If just AIG is excluded, the growth rate drops to 45.2%, and if all the Financials are excluded, the growth rate is just 14.2%. Still, firms with positive EPS growth out number those with falling EPS by a ratio of 1.80:1, and 63.2% of all firms reported positive EPS growth.

Even set against the expectations coming into the earnings season it has been an extremely good one. For every two earnings disappointments there have been more than nine positive surprises. In all, 72.9% of all firms reporting have come in with better than expected earnings.  Half of all the surprises (including the disappointments) have been more than 5.54%.

Likewise, on the top line things are coming in both better than last year and better than expected. Total revenues are 6.07% higher than a year ago among the 495 firms that have already reported, and positive revenue surprises are beating revenue disappointments by a margin of 2.30:1. Put another way, 65.5% of all firms have reported better-than-expected revenues. Overall, 56.0% of all firms have reported higher revenues than a year ago. In the third quarter, that figure was below 30%.

Large Firms' Gains Not the Whole Story

While the dramatic growth in earnings is largely due to turnarounds in a handful of very large firms moving from big losses a year ago to profits this year (or a much smaller loss, especially in the case of AIG), that is not the full story. Most of those big turnarounds were in the Financial sector. The Financial companies that have reported so far have earned $11.6 billion this year, while those same firms lost a total of $55.4 billion a year ago.

The Financials have also been the key driver behind revenue growth for the quarter, as a year ago we had the unusual situation where some of them were reporting negative revenues. If the Financials are excluded, the year-over-year revenue growth falls to 2.12%.

With or without the Financials, Earnings growth is dramatically higher than revenue growth, which means we are seeing a huge increase in net margins. That margin expansion is expected to continue, not only in 2010, but into 2011 as well. Earlier in 2009, margins were plunging. For the year as a whole, the decline in revenues is almost identical to the decline in net income.

Turning our attention to the first quarter expectations, total earnings are expected to rise by 22.8%, which sounds like a big slowdown from the 105.5% rate in the 4Q. However, it the Financials are excluded, we actually see an acceleration in year-over-year earnings growth to 23.6%. The Financials are expected to be just a little below average at 21.3& growth.

Autos and Construction both lost money in last year’s first quarter and are expected to be profitable this year, which means the percentage growth rates are not meaningful. Replacing the outsized gains from Finance will be extremely strong year-over-year growth from Materials, Tech, Industrials and Energy, all of which are expected to post year-over-year growth in excess of 40%.

Looking at full-year earnings, total net income is expected to be lower than that of 2008, but just by 10.1%, a much smaller decline than the 23.0% plunge in 2008 (Financials are the big swing factor).  This year will be one of earnings recovery, with growth of 31.1% expected, but note that that will still leave earnings below 2007 levels. Further growth of 20.0% is expected for total earnings in 2011.

Analysts See Growth Picking Up in 2011

As for the top line, after a 7.4% plunge in 2009, revenues are expected to grow by 3.5% in 2010, followed by 7.4% growth in 2011. Implicitly then, the analysts are predicating an economic recovery that gains steam in 2011, rather than one that peters out or double dips. After all, the amount of revenue going through the combined hands of the 500 biggest (OK, with some exceptions) firms in the country would seem to correlate pretty well with overall economic activity.

True, there is economic activity outside of the S&P 500, and not all S&P 500 revenue comes from inside the U.S. But there is nothing to suggest those shares have shifted meaningfully over the last few years or will over the next two.

In 2010, the percentage growth numbers will be not really meaningful for the Auto sector. While the 2009 numbers will be positive, they are so close to break-even that big percentage gains in 2010 are not to really be taken seriously. Among the larger sectors, Materials and the Financials are expected to be the growth leaders for the year. Energy is also expected to see a large rebound in its total profits. Energy is also expected to be the leader in top ling growth. 

The revisions ratios for both 2010 and 2011 are strong, and should give us confidence that those growth rates will actually be achieved, if not exceeded. Every sector but Utilities, Aerospace and Construction has seen more estimates raised for 2010 than cut, and the revisions ratio for 2010 stands at an extremely strong 1.69.

For 2011, the revisions ratio is at 1.66. The ratio of firms with rising mean estimates is also well above one for both years, but at 1.42 and 1.35 quite a bit lower than the revisions ratios. In other words, the positive earnings revisions are concentrated among relatively few firms.

The earnings yields on the S&P 500 continue to look very attractive relative to the 10-year bond yield. A P/E ratio of 14.9x based on 2010 earnings translates into an earnings yield of 6.71% and based on 2011 earnings the S&P has a P/E ratio of 12.4x, or an earnings yield of 8.06%. That is comfortably above 2x the yield on the 10-year T-note of 3.73%. Stocks look very attractive, at least relative to bonds.

Scorecard & Earnings Surprise
•    Almost done with earning season: 99.0% of reports in, a very strong season
•    Earnings Surprise Ratio (#beat/#miss) at 4.57, very strong but slightly below 3Q level
•    Growth in scorecard is only for those firms that have reported
•    Growth very strong at 106.6% yr/yr, but 45.2% if AIG is excluded, 14.2% excluding all Financials
•    Median Earnings Surprise 5.54%, a very strong reading
•    Year-over-year Earnings Growth Ratio (# Positive Growth/# Negative Growth) at 1.80, big improvement over recent quarters. 63.2% report positive growth

In evaluating the data presented here, keep the percentage reported in mind. The move to the 16 Zacks sectors means that even when all reports are in, some of the sectors will still have relatively few firms in them. For firms with only a few reports in, the median surprise will be very volatile as new firms are added to the sample.

With 99% of the reports in, this has been a very strong earnings season. Yes, we had easy comps from a year ago, but 105.5% year-over-year growth is nothing to sneeze at. Most of that eye-popping growth is due to a handful of firms, mostly in the financials. However, even if the Financials are excluded, earnings growth is still 14.2%. The majority of firms are reporting higher earnings than a year ago. Earnings are coming in much better than expected, with 72.9% of all firms reporting coming in with better-than-expected earnings, only 16.4% disappointing.

While all sectors have seen more positive surprises than disappointments, Tech has put on an absolutely stunning performance. With all of its results in, there have been 63 positive surprises and just a single disappointment.

Autos have far fewer firms, but with all of its results in, it has a perfect record, and a stunning 82.15% median surprise. Conglomerates also have a perfect record of 8 and 0. Retail, Business Service and Discretionary have hugely positive surprise ratios (10 or more). Disappointments are concentrated in the Financials, as the sector is responsible for 29.1% of all firms falling short of expectations.

Sales Surprises
• Sales Surprise ratio at 2.30: median surprise 1.66%, 65.5% of all firms do better than expected on top line
• More firms report growing than shrinking revenues, a ratio of 1.27
• 14 sectors report more positive revenue surprises than disappointments. Sales disappointments concentrated in Utilities and Finance
• Nine sectors have majority of firms with positive revenue growth, seven have more with falling revenues
• Medical firms with growing revenues outnumber falling revenue firms by more than 10:1

Total revenues of the 483 S&P 500 firms that have reported are up a very strong 5.86%. This is mostly due to a handful of Financial firms that actually reported negative revenues last year. The year-ago situation was highly unusual.

Excluding Financials, total revenues are up just 2.12%. However, nine of the sectors have reported higher revenues than a year ago. In distinct contrast to the third quarter, when less than one third of all firms reported rising year-over-year sales, this quarter rising revenue firms outnumber decliners by 1.29:1. The fact that earnings have risen far more than have revenues means that we are seeing an explosion in net margins (or, more precisely, we are recovering from the collapse in net margins a year ago).

Reported Quarterly Growth: Total Net Income

Year-over-year earnings growth is expected to be much lower in the first quarter than in the fourth quarter, but that is a function mostly of the big rise in sequential earnings from the fourth quarter to the first quarter of last year. However, if one strips out the Financials, the growth rate actually shows a big acceleration to 23.6% from 14.5%.

Autos and Construction will be doing the negative-to-positive thing, so the percentage gains really are not meaningful for those sectors. Among the sectors that actually earned money in last year’s first quarter, growth will be led by the Materials sector where earnings are expected to more than double.

However the biggest impact on total earnings will come from the Tech sector (it is much bigger than Materials), where earnings are expected to soar 55.1% over year-ago levels. Industrials, Energy and Transport will also show very strong earnings gains.

• The bulk of the earnings growth for the S&P 500 as a whole has come from the Financial sector, which collectively lost $55.4 billion a year ago, but has earned $11.6 billion this year
• Year-over-year growth much faster in the 4Q than in the 3Q (21.78%), but that is more about just how awful 4Q 2008 was. Sequential growth just 0.92%
• Year-over-year growth of 22.8% expected in 1Q, but down 4.3% sequentially
• Five sectors have posted lower total earnings this year than last, most notably Energy and Industrials. Transports and Utilities also see double-digit declines
• Among sectors that made money last year, Materials and Tech show very impressive year-over-year growth.
• In 1Q, Autos, Materials and Construction expected to post year-over-year growth of over 100%. Six other sectors to post over 20% growth
• The numbers in the table (and Revenue growth table) below only refer to those firms which have already reported. This is a change from previous weeks when only the not-reported figures were shown.

Quarterly Growth: Total Revenues

With the fourth quarter just about wrapped up, the attention is now on the first quarter. Overall year-over-year revenue growth is expected to be slightly lower than in the fourth quarter, at 5.08% versus the 6.07% reported in the fourth quarter. While the overall level of revenue growth will be roughly comparable, the sources will be very different.

Financials, which were responsible for more than half the revenue growth in the fourth quarter, are actually expected to see revenues plunge by 15.25% year over year in the first quarter. In the first quarter, revenue growth will be led by the Energy sector at 33.8%. Very strong revenue showings are also expected for the Materials, Autos and Tech Sectors.

•    S&P 500 Revenues up 6.07% year over year in 4Q, a vast improvement over 10.82% revenue decline the same firms showed in the 3Q. Revenue growth driven by Financials, some of which had negative revenues (accounting games) a year ago. Excluding Financials, revenues up 2.2% year over year.
•    Sequential revenue growth of 7.52% for 4Q, down 7.62% expected in 1Q
•    Nine sectors show positive year over year revenue growth, lead by Financials and Autos, while Industrials, Materials and Construction show double digit declines.

Annual Total Net Income Growth
• Total S&P 500 Net Income in 2009 expected to be 10.1% below 2008 levels, following a 23.0% plunge in 2008
• Total earnings for the S&P 500 expected to jump 31.1% in 2010, 20.0% further in 2011
• Earnings recovery to happen by mid-2011, full year 2011 earnings to be 3.1% above 2007 levels. In other words, the recovery in earnings will occur far before the recovery in jobs as we are unlikely to return to 2007 job levels until 2013 at the earliest
• Four sectors to see positive growth for 2009. In addition, Finance and Autos move from a loss to a profit, while Construction sees much lower losses. Among the positive-to-positive growth rates, none is more than 3%
• Autos, Finance, Basic Materials and Energy expected to be earnings growth leaders in 2010. Construction expected to move from the red to the black. Conglomerates are the only sector expected to see earnings declines in 2010
• Despite strong growth in both 2010 and 2011, Energy earnings in 2011 expected to be 20.2% below 2008 levels
• All sectors are expected to see further growth in 2011; Autos, Finance and Construction to lead (low base). Seven sectors seeing 20%+ growth, all but three of those in double digits
• The annual growth numbers are for all 500 firms in the S&P 500, regardless if they have reported or not

Annual Total Revenue Growth
• Total S&P 500 revenue in 2009 expected to be 7.4% below 2008 levels
• Total revenues for the S&P 500 expected to rise 3.47% in 2010, 7.35% in 2011
• Only 4 sectors to post positive revenue growth in 09, all but Finance and Staples expected to be positive in 2010
• Energy and Tech to lead 2010 revenue race, Medical and Materials expected to battle for bronze
• Staples revenues expected to drop for third year in a row in 2010
• Looking out to 2011, energy is only sector expected to see double digit revenue growth, although six other sectors expected to have revenue growth over 8%

Revisions: Earnings
The Zacks Revisions Ratio: 2010
• Revisions ratio for full S&P 500 at 1.69, still strong and rising again
• Tiny Transport sector has massive revisions ratio, Retail and Tech lead among big sectors
• Earnings surprises for 4Q09 earnings leading to upward revisions for 2010
• Construction, Utilities and Aerospace weakest sectors for 2010
• Ratio of firms with rising to falling mean estimates at 1.42 up from 1.34 last week
• Total number of revisions (4-week total) down to 2,622 from 3,294 last week (-20.4%)
• Increases down to 1,646 from 2,015 (-18.3%), cuts down to 976 from 1,279 (-23.7%)
• Total Revisions activity past seasonal peak, changes in revisions ratios to be more affected by old estimates rolling off than by new revisions coming on until next earnings season starts. Look for total revisions to fall below 2000 in next few weeks

Revisions: Earnings
The Zacks Revisions Ratio: 2011
• Revisions ratio for full S&P 500 at 1.66, down from 1.70, still very strong
• Transports in the lead. Tech and Retail also strong
• Ratio of firms with rising estimate to falling mean estimates at 1.35, up from 1.24 last week
• Utilities and Construction the weakest sectors
• Total number of revisions (4-week total) at 1,718, down from 2,039 (-16.0%)
•  Increases down to 1,069 from 1,272 (-15.9%) cuts fall to 643 from 767 (-16.2%)

Total Income and Share
• S&P500 expected to earn $548.1 billion in 2009, $718.6 billion in 2010, $862.1 billion in 2011
• Finance share of total earnings moves from 6.0% in 2009 to 14.3% in 2010, 17.5% in 2011
• Medical share of total earnings far exceeds market cap share (index weight), but earnings share expected to shrink from 17.4% in 2009 to 13.1% in 2011
• Energy market cap share also well below earnings share, and energy earnings share is growing
• Two sectors, Financial and Energy, to account for 51.8% of all incremental earnings between 2009 and 2011. Together they account for just 24.5% of total market cap

P/E Ratios
• S&P 500 trading at 19.6x 2009 earnings, or an earnings yield of 5.10%
• Trading at 14.9x 2010, 12.4x 2011 earnings, or earnings yields of 6.71% and 8.06%, respectively
• Earnings Yields extremely attractive relative to 10-year T-Note rate of 3.73%
• Medical has lowest P/E based on 2009 and 2010 earnings, but Energy and Finance appear cheapest looking out to 2011. Construction has highest P/E for 2010 and 2011
• Auto and Finance high 2009 P/Es to fall dramatically in 2010 and 2011
• S&P 500 expected to earn $58.99 in 2009, $77.20 in 2010 and $92.76 in 2011

The table below shows the S&P 500 firms with the biggest increases in their FY1 (mostly 2010) mean estimate over the last 4 weeks. To qualify, the current mean estimate has to be greater than $0.50 and there must be more than 3 estimates for FY1. In addition to the change in the mean estimate, the net percentage of estimates being raised is shown for both FY1 and FY2, as well as the P/E ratios based on each year’s earnings is shown.

Note that estimate momentum and value are not mutually exclusive, and that seven of the firms with the biggest positive estimate momentum have single digit P/Es based on FY2 earnings. The most interesting of these firms will be where the net revisions percentage (#up-#dn/Tot) is more than 0.50 but less than 1.00.

Big mean estimate changes based on a handful of individual revisions are suspect, but could prove to be the most interesting if other analysts follow suit. On the other hand, if all the analysts have raised their estimates already, the mean estimate is less likely to rise again over the next month.

Data in this report, unless stated otherwise, is through the close on Thursday 3/11/2010.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

More about Zacks Strategic Investor >>

Read the full analyst report on AIG