While it is by now clear that despite a few headfakes, the economy largely sputtered in the second quarter, with the only positive data point coming from a major inventory build up that led to a better than expected manufacturing ISM, the question now is how did the global weakness over the past 3 months translate into corporate earnings. Next week we will start finding out as 4% of the S&P500 companies report, but the peak of reporting will hit in the 3 weeks following when 83% of all companies hits the tape. Oddly enough, while there has been a material number of downgrades, especially in the financials sector, preannouncements have once again been largely missing, especially in the industrials space. As Dylan Grice pointed out, the game whereby analysts lower EPS forecasts for companies only so hey can beat by about a cent has started in earnest. The biggest question is whether the "farce that is reporting season" will simply be a modest drop in EPS even as the government resumes its corprate friendly approach, or, with advance indicators now tumbling, is this the inflection point? Recall that corporate margins have now peaked: the only saving grace for the corporate sector will be if companies are once again laying off people in droves and cutting overhead (an event which should lead to massive layoffs at ADP for example). Anyway, here are some observations from JPM and Goldman on what to expect and how to fade the big banks' calls on what is coming.
JPM, naturally, comes out with optimistic guns blazing:
The reporting season that kicks off Monday should act as a positive catalyst for equity markets. The bottom-up consensus of $23.08 for the 2Q S&P500 EPS has fallen sharply by $1.34 since the end of June. Although half of this decline is due to BofA’s $8.5 billion charge to settle lawsuits related to mortgages, even an adjusted EPS figure of $23.75 represents a rather undemanding expectation. Over the past 22 years only once, in 2001, did 2Q S&P500 EPS come in lower than 1Q and only three times did 2Q rise by less than 3% from 1Q. The average 2Q/1Q sequential change over the past 22 years was 6.4%. Such an increase translates to an S&P500 EPS of $25 for 2Q. Even a 3% increase would create a positive surprise by pushing the 2Q EPS to $24.2.
Too bad JPM is only credible when it comes to dominating commodities warehousing and becoming a de facto storage monopoly, as well as in all dealing that involve being the Fed's right hand bank. Everything else can be ignored.
A far more detailed analysis comes from Goldman's David Kostin, who as usual provides this week's chartology packet.
2Q 2011 reporting season begins next week. Companies representing 4% of S&P 500 market cap will release earnings. Our conversations with clients have centered on the interplay of corporate profit growth and a sluggish US economy. The questions are (1) whether US firms were able to post another quarter of strong earnings growth despite a lackluster economy and (2) the tone of management guidance. If year/year profit growth is near our forecast of 14% and management forward-looking commentary is constructive the S&P 500 should continue its recent rally.
Our three-month price target of 1400 reflects a potential return of 3.7% and our year-end 2011 target of 1450 represents a potential return of 7.5% from the current level. With the S&P 500 up 7.6% YTD, if our year-end target is achieved it would mean a 15% full-year return and rank in the 67th percentile over the last 80 years. The 6.8% move higher during the past two weeks likely raises the bar somewhat for 2Q earnings.
We expect another quarter of below-trend GDP growth but solid EPS gains. The US economy expanded at a 1.8% annualized rate during 1Q 2011 (2.3% on a year/year basis) while S&P 500 profits rose 3.8% on a sequential rolling four quarter basis and 17% on a year/year basis.
Our US Economics research team forecasts 2Q 2011 annualized GDP growth of 2.0% representing year/year GDP growth of 2.4%. We expect S&P 500 operating EPS for 2Q 2011 will equal $23.75, 14% above 2Q 2010, and an increase of 3.3% on a sequential rolling four-quarter basis. Our quarterly EPS estimate is 2% below the bottom-up consensus forecast. See our 2Q earnings preview note for complete details and earnings calendar.
The historical seasonality of earnings suggests the S&P 500 is on-pace to deliver 2011 EPS of $93-95. Our estimate remains $96 and bottom-up consensus equals $98. Recent examples of 3Q 2011 earnings guidance suggest consensus quarterly estimates are near or above the high end of management expectations. Guidance midpoint for the following companies was 2%-8% below 3Q consensus EPS: Jabil Circuit (JBL), Carnival Corp. (CCL), ConAgra Foods (CAG), Bed Bath & Beyond (BBBY), Adobe (ADBE).
Our forecasts imply downside to full-year consensus EPS estimates of 2% and 8% for 2011 and 2012, respectively. The gap between our topdown estimates of $96 and $104 and bottom-up forecasts of $98 and $113 is largest in cyclical sectors (Consumer Discretionary, Materials, Industrials). Given that revenue forecasts are similar the source of the gap is margins.
We estimate 2Q net margins on a rolling four-quarter basis will equal 8.7%, unchanged versus last quarter. Our full-year 2011 margin forecast remains 8.9% and we expect margins will fall slightly in 2012 to 8.8%. Upside potential exists to our 2011 EPS estimates if margins continue to rise. Consensus forecasts margins will rise to 9.0% in 2011 and 9.6% in 2012.
Complicating the earnings season analysis are the $8.5 billion mortgage settlement by Bank America (BAC) and the surge in oil prices. BAC preannounced 2Q charges and non-recurring gains totaling approximately $1.20 per share. However, subsequent analyst estimate changes cut 2Q EPS for the S&P 500 by only $0.81, so the potential exists for further downward revisions. We expect S&P will classify the adjustment as non-operating activity, and exclude it from the operating EPS calculation.
The Energy sector should drive strong overall S&P 500 sales growth of 13% on a year/year basis. Brent crude prices averaged 47% higher in 2Q 2011 than a year ago ($118 vs. $80). Energy revenues should surge 27% compared with last year and account for 15% of overall S&P 500 sales in 2Q 2011. However, Brent ended June at $112 (11% below its 2011 high), adding another layer of uncertainty to the outlook for S&P 500 sales and earnings.
At the sector level we expect positive earnings surprises in Consumer Staples and negative surprises in Financials. Consumer Staples firms raised prices during 2Q in an effort to offset the impact of higher commodity input costs and protect margins. We expect earnings surprises for Consumer Staples 2Q 2011 EPS estimates, which have declined by 1% since April while sales estimates have risen by 2%.
Negative EPS revisions have been greatest in the Financials sector where 2Q estimates have been cut by 24% during the past two months. Estimates for Insurance companies, which represent about one-quarter of the sector’s EPS, fell by more than 20% in the past two months as a result of major catastrophe losses. Excluding revisions to BAC, Financials EPS estimates have been cut by 7% since April while estimates for Diversified Financials fell by 2%. Diversified Financials’ results may be weak but our analysts believe expectations have come down even if estimates have not.
Energy earnings estimates reflect higher crude oil prices as upward 2Q EPS revisions have totaled 5% since April. Integrated Oil & Gas firms such as Exxon (XOM) and Chevron (CVX) contributed most to Energy sector revisions. Energy accounts for 30% of our 2011 EPS growth estimate.
Companies representing 4% of S&P 500 market capitalization report 2Q earnings next week highlighted by: Alcoa (AA), Marriott Int’l (MAR), JP Morgan Chase (JPM), Google (GOOG), and YUM! Brands (YUM).
And the biggest earnings revisions: