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Third quarter earnings season is effectively over, with 99.2% of the companies, and 99.8% of the expected total earnings in. Total net income growth has been far higher than expected, although the median surprise and the ratio of positive surprises to disappointments is slightly below normal. Thus, I would characterize the season as very good, but we have seen better.
Next we change our focus to the expectations for the fourth quarter. The year over year growth rate for the S&P 500 (so far) is 14.92%. That is actually well above the 11.98% growth that those same 496 firms posted in the second quarter. However, the second quarter was distorted by some big hits to the financial sector, most notably Bank of America ([url=http://www.zacks.com/stock/quote/bac]BAC[/url]). This time it reported better than expected earnings and did not have the big “write off” it did in the second quarter. That resulted in a $12 billion swing in total net income between the second and third quarters.
If we exclude the Financials, the year-over-year growth rate is higher at 17.79%, but it represents a slowdown from the second quarter, when growth was 19.57%. At the beginning of earnings second quarter season, growth of 9.7% was expected; 12.2% ex-Financials. The total net income should be $241.0 billion, up from $209.7 billion a year ago.
However, as the expectations stand now, growth is expected to slow dramatically in the fourth quarter to just 5.18% in total and 3.79% ex-Financials. Sequentially, total net income is expected to actually fall; by 3.54% in total, and by 5.67% ex-Financials. Given that growth almost always comes in higher than expected, I’m sure that we will do better than that, but still, it will be a struggle to get to either double-digit growth year over year, or even to be flat on a sequential basis.
Both EPS & Revs Doing Better
Relative to expectations, both earnings and revenues are doing better than expected. Then again having far more companies report positive surprises than disappointments is entirely normal. The current ratio of 2.73% (for the 496) is marginally worse than the average experience of the last five years or so (around 3.0%). The median surprise is 2.78%, slightly below “normal” (about 3.0%). Still, it represents far more positive surprises than disappointments.
Surprise Ratio Slipping
Top-line surprises started off extremely strong, but have faded. The surprise ratio is now 1.42 for revenues with a 0.62% median surprise. Not bad, but not terrific either. Top-line growth is 11.25%, and 11.89% ex-Financials, on both counts actually a slight acceleration from the second quarter. At the start of earnings season, revenue growth of just 5.85% in total, and 6.04% was expected. Currently, the expected year-over-year revenue growth for the fourth quarter is just 2.59% in total and 2.45% ex-Financials.
Net Margins Keep Widening
Expanding net margins have been one of the keys to earnings growth. That is still the case, with reported net margins of 9.36% so far, up from 9.06% a year ago, and 9.12% in the second quarter (for those 496 firms). Excluding Financials, net margins have come in at 8.48% up from 8.05% a year ago, and equal to the level in the second quarter. That game might be coming to an end, though.
The expected net margin for the fourth quarter is 9.17 in total and 8.11% ex-Financials. However, that will still represent year-over-year growth from 8.94% in total and 8.01% ex-Financials in the fourth quarter of 2010. In relative terms, revenue surprised more to the upside than did earnings. Thus the actual net margins for the quarter were lower than the expected 9.67% in total and 8.56% ex-Financials at the start of earnings season.
On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.27% in 2009. They hit 8.51% in 2010 and are expected to continue climbing to 9.23% in 2011 and 9.64% in 2012. The pattern is a bit different, particularly during the recession, 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 8.12% in 2010. They are expected to rise to 8.75% in 2011 and 8.93% in 2012.
Total net income in 2010 rose to $788.7 billion in 2010, up from $538.4 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 $904.5 billion, or increases of 46.5% and 14.7%, respectively. The expectation is for 2012 to have total net income come close to $1 Trillion mark to $994.1, for growth of 9.9%. However, this is the first time since the bottom-up expectations were fully formed (i.e. we had estimates for all 500 firms for 2012) that the total has dipped below the $1 Trillion mark.
That will still put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $104.85. That is up from $56.78 for 2009, $83.19 for 2010 and $95.37 for 2011. In an environment where the 10-year T-note is yielding 2.05%, a P/E of 15.0x based on 2010 and 13.1x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.9x.
More Upward Revisions than Downward
Estimate revisions activity is well past its seasonal peak and is plunging (seasonally normal). We have seen a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year. There are more increases than cuts, with a 1.25 ratio, but by a margin that is right on the border line between bullish and neutral territory.
To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by a nickel, and the analysts don’t increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter. With almost three positive surprises for every disappointment, one should expect more upwards revisions than cuts. That suggests that on balance the guidance given in the earnings conference calls was negative.
There is no mechanical effect when it comes to the revisions for next year, and those remain in negative territory at just 0.90 (neutral). For this year, 10 of 16 sectors are seeing more positive than negative revisions. Slightly more firms (ratio of 1.08) have higher mean estimates than a month ago.
For next year, only five sectors have more cuts than increases, and more firms have falling rather than rising mean estimates (ratio of 0.79). Changes in the revisions ratio have somewhat less significance when total revisions activity is falling than rising, because it means that they are being driven more by old estimates falling out of the four-week moving total than new estimates being added.
As far as sectors are concerned, it looks like the clear winner this time around was Energy. It won gold by a healthy margin for both earnings and revenue surprise, as well as for revenue growth. It took home silver for earnings growth, edged out by Construction, which was coming off a very low base a year ago. There was no clear-cut loser for the quarter, but Utilities, Aerospace and Financials were all candidates for that dubious distinction.
All in all, another successful earnings season for the third quarter, and the bar is set very low for the fourth quarter.
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