Are Earnings Cutbacks Just a 'Sheep in Wolf's Clothing'?

While big-name companies lowering their earnings outlooks might be interpreted as a negative sign, some analysts say the reductions could be temporary and signal better days are ahead.

Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.
Daniel Acker | Bloomberg | Getty Images
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.

A handful of firms in recent days have warned that the rest of the year could be difficult for growth and have thus cut back their profit expectations.

The short-term effect has been decreases in those stocks. But some analysts are looking at why bottom-lines are tightening and finding some hope amid what could be lower profits.

Investors have been waiting for companies to put the cash they've been hoarding back to work, and recent growth in software and equipment purchases indicate that is happening slowly.

"Investment changes your long term productivity as your firm generates profits," says Tom Higgins, chief economist at Payden & Rygel in Los Angeles. "So I think that's a positive if that does turn out to be the case."

Wall Street has enjoyed three straight robust earnings seasons, with more than 80 percent of companies on the Standard & Poor's 500 beating expectations.

But announcements in recent days indicate that may no longer be the case.

"We knew there was going to be a disappointment phase," Higgins says. "It does look like the recovery is sustainable. But once the government starts to scale back on stimulus, growth is going to close. The second half could slow considerably."

Economic bellwether FedEx is the latest company to foresee less profit than originally expected for the year ahead.

In a report Wednesday, the company said full-year earnings per share would range between $4.40 and $5, a shade below analyst expectations.

Shares immediately sold off for the package delivery company, losing about 6 percent immediately afterward but stabilizing in Thursday trading.

The lack of investor panic could be because of what Mike O'Rourke, chief market strategist at BTIG in New York, calls a "sheep in wolf's clothing" regarding FedEx earnings.

Digging deeper into FedEx expectations, he says, shows a company preparing for growth, not contraction, but one that could see the bottom line tighten as it starts spending some of its stored cash on compensation, restoration of 401k contributions and new equipment.

"As revenues have begun to return in the first half of 2010, the lean cost structure has helped margins and boosted profits," O'Rourke wrote in an analysis of the FedEx report. "As the recovery progresses, companies will need to begin hiring again, increase capital expenditures and reinvest in their respective businesses. In short, they cannot plan for future growth using an organization that has been cut to the bone."

FedEx has been joined by Best Buy , McDonald's and Nokia in warning about full-year outlook.

Yet investors haven't seemed to mind too much, bringing markets out of a correction phasebrought on by European debt concerns even as the warnings have commenced.

"A market that wants to keep going down is going to take any bit of negative news—in fact it's going to take good news and turn it into bad news," says Quincy Krosby, market strategist at Prudential Financial in Newark, N.J. "Yet the market was able to hold on."

The avoidance—for the moment, at least—of a full-blown bear market plungemay reflect investor sentiment that the economy will continue its trudge higher, with companies mirroring those slow steps forward with increased investment in their businesses. General Motors, for instance, said Thursday that it was forgoing a planned summer shutdownof its manufacturing plants.

"You should see signs here and there of positive activity. The underlying economy is looking pretty positive despite everything you hear," says Brian Gendreau, market strategist with Financial Network Investment in El Segundo, Calif. "If you look at underlying earnings they look pretty strong."

What investors are seeming to crave most these days is certainty—from Europe, from financial regulators and Congress, and from corporations—that employment will begin to show actual improvement in the face of weekly jobless claims numbers that don't seem to be going anywhere but sideways.

"If earnings aren't strong enough you're going to hear every excuse," Krosby says. "You're going to hear health care, you're going to hear volcanic ash, you're going to hear the euro. Companies have been given a full plate of potential excuses."

'Pressing the Pause Button'

Indeed, FedEx and a plethora of others have cited anticipation of higher health care costs as an additional burden for earnings.

In short, the environment promises uncertainty, something rarely good for sentiment.

"Uncertainty is not a positive for hiring, even if they are relatively comfortable about their own firms' prospects," says Zach Pandl, economist at Nomura Securities in New York. "It could be firms are just pressing the pause button for the moment due to heightened uncertainty over how the problems play out in Europe. I think it's a very sensible thing to do at this point."

"This is going to be a recovery that is slow and anemic that won't feel much like a recovery," adds Dirk Van Dijk, analyst at Zacks Investment Research.

He adds that earnings revisions higher are about equal to those lower, which is a stark turnaround from the previous two quarters when companies were looking higher by about a 2 to 1 ratio.

Various headwinds are likely to combine with companies' desire to start growing again to make a difficult investing environment.

"We're in for some volatility," Higgins says. "Once we get some clarity on the fiscal side in Europe...that would go a long way toward lowering volatility and letting the market start trending upwards again. I don't see that happening in the short term so volatility is going to be the order of the day for the next few months."

But O'Rourke says FedEx's earnings should be taken as a sign that businesses will continue to expand.

"If a company that serves as a barometer of the global economy is going to reduce its earnings guidance, this is the healthiest manner in which one could see them do it," he said. "Any investors sharing the belief that 2011 estimates are too high should not be surprised when we see them cut."