Earnings Season is Here!

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The third quarter earnings season is upon us. So far earnings have been holding up well, with more positive surprises than disappointments. Most of the surprises are only by a penny or two. We suspect that many companies try to low ball expectations going into a reporting period so they can have a low hurdle to get over. Also, many of the firms which have reported so far had quarters which ended in August, and were thus unaffected by the storms. Estimate increases for firms in the Energy sector significantly offset declines elsewhere.

• Over the last week, the mean estimate for the current fiscal year (mostly 2005) has increased for 94 of the S&P 500 firms and declined for 116, a ratio of 0.81.
  
• Over the last month, 206 firms have seen estimate increases, while 216 have been cut for this year, a ratio of 0.95. The average estimate fell 0.32%.
  
• For 2006, the estimates rose for 207 and fell for 219, a ratio of 0.95. The average estimate fell 0.05%.
  
• A total of 735 current fiscal year estimates were increased over the last month for this year while 949 were cut (ratio of 0.77). Excluding Energy, the revisions ratio falls to 0.66, as there were only 597 estimates increased and 904 cut.
  
• For 2006, 698 estimates were increased and 718 were cut (ratio of 0.97). However, excluding Energy, 539 were increased and 707 were cut (ratio of 0.76).

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• The median growth rate for firms in the Energy sector is 65.3% for 2005¹. This does not represent the earnings peak. A further 18.2% growth is expected in 2006.
• The median firm in the S&P 500 is still expected to post double digit earnings growth for both 2005 (12.1%) and 2006 (12.5%).
• Telecommunications and Consumer Discretionary sectors expected to post the lowest growth in 2005.

¹We follow the convention of referring to the last completed fiscal year as 2004, and the current fiscal year as 2005 when discussing the aggregate data. All data is as of 10/12/05 close.

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• Total net income is expected to grow 12.5% in 2005 and 11.7% in 2006 for the S&P 500
• Four sectors, Energy (43.1%), Industrials (19.8%), Materials (16.4%), and Technology (11.7%) are expected to post double digit growth in 2005.
• The energy sector is expected to account for 37.3% of all incremental earnings (i.e. earnings growth) for 2005.
• Two sectors are expected to post lower total earnings in 2005 than they did in 2004. Earnings are expected to fall 11.9% for the consumer discretionary sector, largely due to lower earnings and losses in the Auto industry. Total earnings are expected to fall 5.4% in the Utilities sector.
• The Energy sector has a 9.5% weight in the S&P 500 index, but is expected to account for 13.5% of the total earnings in 2005

While the chart above looks at the median growth rate for firms in a sector, it does not make any difference if all the firms above the median are small, and all the ones below the median are huge. It gives a good look at the sort of growth the “average” firm in the sector will post, but not the overall growth of the sector’s earnings. For example, in the Energy sector, Exxon is only one out of 29 stocks, yet accounted for 38.4% of all the earnings in the sector in 2004, Chevron accounted for an additional 17.8% of earnings in 2004. Clearly the growth rates of these giants matter more to the total incremental earnings of the sector than the earnings of Rowan, which accounted for only 0.4% of 2004 earnings, even though Rowan is expected to post earnings growth of over 500% in 2005.

Since larger companies tend to be slower growing (it is harder to add an incremental billion in earnings than it is to add an incremental million in earnings), the general growth picture is of somewhat lower growth. The total net income of the S&P 500 is expected to be 12.5% higher in 2005 than it was in 2004, with a further 11.7% growth currently expected for 2006. Only four sectors, Energy (43.1%), Industrials (19.8%), Materials (16.4%), and Technology (11.7%) are expected to post double digit growth in 2005. The total earnings for the Utilities sector are projected to decline by 5.4% in 2005. Driven by losses and much lower earnings in the Auto industry, the Consumer Discretionary sector are expected to fall by 11.9% this year.

Some interesting insights can be gained by looking at the total earnings expected for a sector. For example, six sectors are remarkable close in their total share of 2004 earnings, ranging from 11.8% for Technology to 9.9% for the Industrials sector. The Financial sector, with 27.8% is far and away the largest total earner in the S&P 500. Three sectors, Utilities, Telecommunications and Materials are relatively insignificant to the total earnings picture. Exxon alone (4.1%) accounted for more of total 2004 earnings than any of those three sectors.

The Energy sector ported record earnings in 2004, so it can hardly be argued that 2004 represented depressed earnings for the sector. However, the energy sector is currently expected to account for 37.3% of all incremental earnings (i.e. earnings growth) for 2005. In the process, it is expected to grow to 13.5% of total 2005 earnings. Given current estimate revisions trends, we would expect that when all is said and done, it will represent an even higher share of incremental and total 2005 earnings. The Industrials sector is the only other sector which is currently expected to increase its share of total earnings by more than 0.2% in 2005, expanding from 9.8% to 10.5%.

While the energy sector is expected to account for 13.5% of the total 2005 earnings for the S&P 500, its share of the total market capitalization (and thus its’ weighting in the index) is only 9.5%. It is thus hard to argue, even after the great run it has had this year, the Energy sector is overvalued. This is particularly true after the pull back suffered by the sector over the past week. By comparison, the Consumer Discretionary sector has an 11.1% weighting in the index but will account for only 5.5% of the total earnings.

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• The average Energy firm in the S&P 500 saw its mean estimate for 2005 rise by 4.37% over the last month. Estimates rose for 24 firms and fell for only four.
• For next year, the average estimate rose by 8.96% for energy firms, with the mean estimate up for every stock but one.
• Every other sector but Telecommunications (up 0.12%) saw a decline in its average estimate for this year over the last month.
• The Consumer Discretionary sector suffered an average decline of 4.13% for this year and 2.37% for next year this month.
• For the Materials sector the average estimate fell 2.33% for 2005 and 1.06% for 2006.
• Almost three 2005 estimates were cut for each increase in the Consumer Staples sector.

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Over the last four weeks, the mean estimate for this year rose for 206 firms in the S&P 500, and fell for 216 firms, a ratio of 0.95. The average estimate for S&P 500 firms fell 0.32% over the last four weeks. A total of 735 individual estimates were increased while 949 were cut, a revisions ratio of 0.77.

The Energy sector again has had the strongest estimate revisions for 2005 over the last month. This is true regardless of which angle it is looked at. The average firm saw its mean estimate rise by almost 4.37% in the last four weeks. It has now been more than a month since Katrina hit, so some of those early estimate revisions are rolling off, yet still the estimates continue to rise. This rise was led by the E&P firms, particularly those which are weighted towards natural gas. However, the gains were extremely widespread, with 24 of the 29 firms in the sector posting gains. The four declines were small, and were concentrated among the drillers, where operations were disrupted by the hurricanes. Individual estimate increases were 3.07 times estimate decreases (the Revisions Ratio).

The Telecommunications sector was the only other to post an increase in its average estimate over the last four weeks, rising 0.12%. This is a very small sector, with only nine firms, four of which were up and four were down. Four estimates increased for every three which were cut. Technology sector was relatively strong. While the average estimate fell by 0.33%, 40 stocks enjoyed increases while only 24 suffered declines For the sector, rising estimates outpaced cuts by better than a four to three ratio. Within the Tech sector, we would highlight the Semiconductor industry, with the exception of Intel, as particularly strong.

The Consumer Discretionary sector was just plain ugly, with the average estimate falling 4.13% over the last four weeks. Firms with falling estimates outnumbered those with increases by more than two to one, as did individual estimate cuts versus estimate increases. The news was bad for the newspapers and the analysts hit the brakes for firms in the auto industry.

The Materials sector was also weak, falling 2.33% over the last month, with both the number of firms down, and the total number of estimates cut, outpacing increases by about than three to one. We would highlight the Paper, Aluminum and Chemical industries as particularly weak. The Copper industry is bucking the trend (no surprise with the red metal trading at record highs). Oil and Natural Gas are the primary raw materials for the Chemical industry, which is causing margin pressure. It also takes an extraordinary amount of energy to convert bauxite (Aluminum ore) into a beer can, so energy costs are the primary factor behind the weakness in that industry.

The Financial sector was also weak, with cuts outnumbering increases by a eight to five ratio. The average estimate fell 1.65%. The insurance industry was particularly weak.

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The overall picture looks a little bit better for 2006 than for 2005, although softer than it was just a few weeks ago. When looking at the sector level, the roster of winners and losers looks very similar to that of 2005.

Energy is still the winner in a walk. Over the last month the average firm saw its estimate rise by 8.96%. Every firm in the sector but one saw its estimates increase. There were more than 14 estimates increased for every one that was cut. The Energy sector accounts for only 5.8% of the firms in the S&P 500, but accounted for 22.8% of all estimate increases, and only 1.5% of all estimate cuts for 2006 in the last month. If estimate increases in the Energy sector are excluded, the revisions ratio for 2006 falls 0.76. While all areas of the sector were strong, the strongest of the strong were the Refiners and the E&P firms.

Technology again takes the silver medal, with an average estimate increase of 0.73%, a revisions ratio of 1.42 and 38 firms with increases versus 24 with falling estimates. We would highlight the Semiconductor industry as a significant area of strength in the sector.

The Consumer Discretionary sector was weak for 2006, with the mean estimate falling 2.37%, a revisions ratio of only 0.35 and more than twice as many firms with falling estimates than rising estimates. The auto industry was moving fast in reverse, and there was also substantial weakness among the retailers and the newspapers.

The Materials sector was also weak, with the mean estimate falling 1.06%, a revisions ratio of 0.62 and 17 firms with falling estimates versus only 11 with rising estimates. We would highlight the weakness in the Chemical and Paper industries. Copper bucked the trend. Both Consumer sectors also had a weak revisions picture for 2006. Retailers and Newspapers were notably weak.

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As we start the third quarter reporting season, a total of 47 S&P 500 firms have reported for the third quarter² . For the most part these are firms where the quarter ended in August, and thus reflect no impact from the storms. That being said, the results so far are encouraging, with 66.0% beating expectations, and only 14.9% disappointing. The Semiconductor industry enjoyed positive surprises in the Technology sector. However, revisions are the best indicator of if a firm will exceed expectations or disappoint, particularly large revisions. Given the estimate revisions trends we discussed above, we don’t expect the better than four to one ratio of positive to negative surprises to last. Also, we would expect to see positive earnings surprises concentrated in the Energy and Technology sectors. The Materials and Consumer Staples sectors are most likely to see a significant number of earnings disappointments.

²Defined as the fiscal quarter ending in August, September or October.

Note: EPS growth compares current quarterly results vs. prior year ago quarter

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Below is a list of key companies that should report this week. To view the entire list of companies reporting on a given day, check out the Zacks earnings calendar.