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What's More Important, Earnings Beats or Good Guidance?

The market would love to see companies both beat expectations and raise guidance. But if it has to pick one, it would rather see positive guidance than just an earnings beat.

Given how low expectations for the third quarter are, the proportion of companies coming ahead of expectations will likely be not much different from what we have been seeing in recent quarters. While less than half of the 31 companies that have reported results already (as of Wednesday, October 10th) have beat earnings expectations, we can reasonably assume that this ratio will go up to more than 60% by the time the third quarter reporting season comes to an end.

It is an altogether different matter how companies will guide towards the fourth quarter and beyond. And that is more than just an academic exercise, as the quality of management guidance will determine how much earnings estimates for the fourth quarter need to come down.

The weak guidance from Alcoa (AA), FedEx (FDX) and Nike (NKE) on their earnings calls and pre-announcements from Cummins (CMI) and Intel (INTC) are likely a preview of things to come in the following days and weeks. As such, the final verdict on the third quarter earnings season will depend not be so much by what proportion of companies beat earnings expectations, but whether they are able to provide improved visibility for the coming quarter(s).

Key Points
  • The third-quarter 2012  reporting season has started, with results from 31 companies in the S&P 500 already out. Total earnings  for these 31 companies are down 3.3% from the same period last year, with only 46.4% of the companies beating earnings expectations. This is weaker than what these same companies did in the previous quarter.    
  • Total earnings for the remaining 469 companies, or roughly 94% of the total, are expected to decline 3.9% in the quarter from the same period last year. This growth expectation reflects a 2.5% drop in total revenues and a 37-basis point contraction in net margins. Total earnings were up 4.4% in the second quarter.
  • Third quarter earnings would be even weaker had it not been for the 14.3% growth expected in the Finance sector, one of only two sectors to have double-digit positive earnings growth (construction is the other).
  • Excluding Finance, total S&P 500 earnings would be down 7% in the third quarter, which compares to ex-Finance growth of negative of 0.9% in the second quarter. Easy comps at AIG (AIG) and Goldman Sachs (GS) account for most of the Finance earnings growth.
  • Energy and Basic Materials have the weakest growth profiles, with Energy earnings expected to be down 22.4% and Basic Materials earnings down 26.8%. Both of these sectors were the weakest in the second quarter as well. The pre-announcement from Chevron (CVX) and the weak growth in Alcoa’s report confirms these sector level expectations.  
  • Tech sector earnings are expected to be flat from the same period last year (down 0.6%). This compares to growth rates of 5.1% in the second quarter and 16.8% in the first quarter of 2012. Excluding Apple (AAPL), Tech sector earnings are expected to be down 4.6% in the third quarter.
  • Unlike expectations for the third quarter, estimate for the following quarter remain quite strong, with total earnings expected to be up 7.1% in the fourth quarter. Of the 8 sectors that are projected to have negative year-over-year comparisons in the third quarter, 6 are expected to turn positive, with Basic Materials and Autos as the most prominent. Energy becomes far less of a drag in the fourth quarter.
  • Net margins are expected to be down in the third quarter, both year over year as well as sequentially. Ten of the 16 sectors are expected to see margins contract in the third quarter, including Tech. But margins are expected to improve back up in the fourth quarter.
  • Total earnings for the full years 2012 and 2013 are expected to be up 6.6% and 12% respectively. Revenues are expected to be essentially flat this year (up only 0.1%), but up 4% in 2013.
  • The bottom-up ‘EPS’ estimates for 2012 and 2013 -- reflecting projections of analysts at brokerage firms covering individual companies -- currently stand at $102.95 and $114.91, respectively. The top-down estimates -- reflecting the projections of strategists at brokerage firms -- currently stand at $101.96 and $109.06 for 2012 and 2013, respectively.
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