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Halftime report: Is fear of a weak 3Q overblown?

DANIEL WAGNER and CHRISTINA REXRODE, AP Business Writers
Friday, 26 Oct 2012 | 4:59 PM ET

WASHINGTON -- It's halftime for the season of corporate earnings reports, and investors are in desperate need of a locker-room pep talk.

Before Alcoa reported its third-quarter results Oct. 9, marking the unofficial start of earnings season, financial analysts were predicting that profit and revenue for companies in the Standard & Poor's 500 would be lower than the year before.

That would have been the first decline by either measure since the third quarter of 2009, just after the Great Recession ended.

But a funny thing happened on the way to the pity party: Some of the biggest and most important U.S. companies started reporting revenue growth and raising their guidance.

The quarter was no blockbuster, to be sure, but by midweek analysts were reassessing their grim predictions. Halfway through earnings season, both winning streaks _ profit and revenue _ are on track to survive another quarter.

There are still plenty of reasons to worry about corporate America.

Sales are hurting because of weaker demand from Europe, which faces a recession, and China, where economic growth has slowed. A stronger dollar means sales overseas translate into lower revenue on the books back in the United States.

Above all, analysts worry about weaker revenue. Net income grew for 11 straight quarters partly because so many companies cut costs, borrowed money more cheaply and employed other short-term strategies to boost their profit margins.

In the fourth quarter of 2010, for example, net income for the S&P 500 leapt 37 percent, but revenue increased only 10 percent, according to S&P Capital IQ, a research firm.

That gap can't survive, analysts say, and revenue growth is starting to weaken. Companies will need to beef up sales to keep increasing their earnings, and that takes stronger customer demand.

And yet: The winning streak appears likely to continue.

With stronger reports piling up at midweek, it appeared that S&P 500 earnings will increase 1.1 percent from last year, says Sam Stovall, chief equity strategist with S&P Capital IQ. Before earnings season started, his firm predicted a 2 percent decline.

At first, corporate reports appeared to be as bad as many feared.

Alcoa said China's economic slowdown was reducing demand for its aluminum. Energy and commodity companies were similarly downbeat. Dow Chemical CEO Andrew Liveris announced layoffs and spending cuts, saying weak sales in China and Europe are contributing to a "slow-growth and volatile world."

The Dow Jones industrial average plunged 243 points on Tuesday, its third-biggest decline of the year, after more comments about weak demand from DuPont, 3M, UPS and Xerox.

Then on Wednesday, Aflac, the life-insurance company known for its nasal-voiced spokesduck, posted higher net income on double-digit revenue growth. Boeing, among the biggest U.S. exporters, reported revenue growth and raised its expectations for the rest of the year. US Airways said net income and revenue rose during peak travel season.

"I think it's intriguing that everyone thinks earnings are falling off the cliff," Stovall says. He expects earnings and revenue to improve by the end of the year and into 2013. After this year's weakness, he says, companies will have an easier time showing improvement in next year's results.

Stock traders appeared to agree that earlier fears were overplayed. In the three days after Tuesday's plunge, the Dow barely budged, posting a net gain of just 4.7 points.

"All in all, I'm a tad encouraged by the earnings season, and the sense that we are seeing more people beat expectations," said David Brown, CEO and chief market strategist for Sabrient Systems, a research firm. As of this week, 62 percent of the companies had reported third-quarter earnings that were better than analysts' expectations, according to S&P Capital IQ. That's right in line with the 10-year average. That's another signal that this quarter, while weaker than the most recent few, isn't quite wreaking havoc on U.S. companies.

None of which means that corporate America is in the clear. There's a big difference between less terrible and good.

Strong performance by financial companies is boosting the average earnings growth. Many banks are benefiting from a temporary boom in mortgage refinancing. That can't last forever. Banks acknowledge that the number of qualified borrowers is already dwindling.

Companies that depend on global demand, like metals and energy companies, are reporting the weakest results.

"We're getting confirmation that the world is slowing through these earnings," says Stovall, who believes that U.S. companies can continue to grow modestly even in a period of weak economic growth.

Revenue will remain under pressure if current economic trends continue. The U.S. economy is growing at a sluggish 2 percent annual rate, the government said Friday. If growth remains slow, revenue gains will remain weak, analysts say.

The global economic slowdown, meanwhile, is threatening companies that rely on overseas markets. Businesses had relied on international sales to offset weak U.S. consumer demand. Europe's recessions and China's pullback are making that more difficult.

Last year, S&P 500 companies got 11.1 percent of their revenue from sales to European countries, according to data compiled by Howard Silverblatt, senior index analyst with S&P Dow Jones Indices.

The problem is not confined to Europe. In all, companies generated 46.1 percent of their revenue from sales outside the U.S. The data include 252 companies that include such information in their financial disclosures.

It's difficult to say definitively whether U.S. companies that sell only domestically are doing better than those that operate overseas. But analysts and companies say anecdotally that it's harder to make a sale in recession-wracked Europe than in the slow-growth U.S.

Another challenge for multinationals: the almighty dollar. As it strengthens against other currencies, sales overseas translate into fewer dollars of revenue back home.

Coca-Cola told analysts that currency exchange rates sliced its operating income by 7 percent and its net revenue by 5 percent in the quarter. McDonald's said exchange rates reduced its per-share earnings by 8 cents to $1.43 per share. Both companies expect the drag to continue in this quarter, which ends Dec. 31.

Some traders see foreign-exchange adjustments as yet another way for companies to game their numbers or explain away weak performance.

"You definitely didn't hear anything when the dollar was falling about how it was juicing returns then," said Tim Courtney, chief investment officer at Exencial Wealth Advisors in Oklahoma City.

Longer-term investors can take comfort that the pullback is part of the regular ebb and flow of the business cycle, says Bernard Schoenfeld, senior investment strategist at Bank of New York Mellon Wealth Management in New York.

"They're not losses, they're just less growth," Schoenfeld says of the recent reports. "It's not unusual to have a pause this far into a recovery period."

___

Rexrode reported from New York.

Daniel Wagner can be reached at www.twitter.com/wagnerreports.

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