Q3 Earnings Season: It’ll Be Crappy, and Wall Street Won’t Care

by Dan Burrows | October 4, 2013 1:23 pm

Q3 Earnings Season: It’ll Be Crappy, and Wall Street Won’t Care

When it comes to earnings season, at some point you’d think the market would get wise to companies under-promising and over-delivering on their quarterly profits.

But it never does.

We play this game every earnings season and somehow it never gets old: A company sets the bar so low on its expected earnings that it could trip over it. And still the company gets applauded — and often receives a share-price pop — for “beating the Street.”

So here we are with third-quarter earnings season upon us, and — wouldn’t you know it — companies are issuing profit warnings like mad.

Again.

As of Oct. 1, 89 companies in the S&P 500 lowered their earnings outlooks for the third quarter, while just 19 raised guidance, according to data from FactSet.

That’s a new record, for both the high number of warnings and the low number of positive revisions. Mind you, the previous record didn’t stand for very long. Indeed, the last record of 88 warnings and 22 upward revisions was set about three months ago, when the second-quarter reporting season was about to kick off. And how did that work out?

Great! When all was said and done, a whopping 86% of S&P 500 companies beat Street profit estimates for the second quarter. On average, 78% of companies exceed analysts’ earnings estimates in any given quarter, so it’s fair to say companies really outdid themselves on the whole under-promise, over-deliver thing.

It worked last quarter (hey, it works every quarter), so why not try it again? Everyone knows companies low-ball their guidance — Apple (AAPL[1]) being the most famous example — and the market still rewards it. A company would be remiss if it didn’t tamp down expectations as much as possible.

And it’s not like analysts ignore these profit warnings. When a company issues a negative pre-announcement, Wall Street dutifully marks down its own earnings forecast. Just not by enough — not if 86% of companies still manage to “surprise” them on the upside.

This game is hardly new. Far from it. That average beat rate of 78% goes back to 2006.  It’s just that we’ve all sort of gotten carried away. Thomson Reuters has a much longer data series than FactSet, extending well past a decade, and by those numbers the long-term average beat rate is 63%. More recently, though, it’s up to 67%.

It’s like grade inflation. Whichever data series you use, historically a solid majority of companies always beats the Street. But that number has now crept up to where two-thirds to three-quarters of all earnings reports have to exceed analysts expectations or else fear the market’s wrath.

Some people say that a CEO’s most important job is managing investors’ expectations. If that’s true, then they’re certainly deserving of their oversized paychecks. In the aggregate, earnings growth is going to stink this quarter, just like it did last quarter[2] and the quarter before that. Yet despite all that, before the recent selloff, stocks have been marching to new all-time highs.

The S&P 500 is projected to report year-over-year profit growth of just 3.2% in the third-quarter earnings season, according to FactSet. True, that’s better than the 2.1% increase logged in Q2, but it could hardly be characterized as being robust.

Ultimately, stocks are supposed to be driven by earnings — and the market remains ever-optimistic that earnings are going to pick up. Share-price performance in the first half was pegged to expectations of earnings accelerating in the second half.

Well, this is the second half, and the third quarter hardly looks like it picked up steam. Fourth-quarter earnings are forecast to grow more than 10%, but how long will that prediction last? In three months, we’ll get another slew of profit warnings, and the expected growth rate will tumble once again.

The problem is that when stocks rise faster than earnings, they risk getting too pricey. The S&P 500′s forward price-to-earnings multiple has expanded to 14.4, well above the five-year average of 12.9 and the 10-year average of 14.

So as we enter this reporting season, don’t lose sight of the fact that Street-beating earnings are not the same thing as earnings growth. Heck, you can beat the Street with a narrower-than-expected loss.

And unless that elusive acceleration in profit growth comes to pass … well, it’s getting harder and harder to argue that stocks are a bargain.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. just like it did last quarter: http://investorplace.com/2013/07/earnings-season-set-to-be-another-stinker/

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