What's Missing in Earnings Reports: Revenue Growth

Profits are still down, and the economy is weak, but investors are celebrating second-quarter earnings season anyway. Some market watchers worry that the lack of revenue growth will make it harder for companies to boost earnings in the current quarter.

So far, second-quarter results have arrived from 83% of the Standard & Poor's 500-stock index companies, and earnings are down 28.4%, according to Thomson Reuters (TRI). Before earnings season officially began a month ago, analysts were expecting a drop of 35.6%. The S&P 500 is up about 13% since Alcoa (AA) kicked off the second-quarter earnings season on July 8 through Aug. 6.

This is the second earnings season in a row that coincided with a stock market rally. S&P 500 profits dropped 35.5% in the first quarter of 2009, but investors were apparently expecting much worse results. The market moved solidly higher in April and early May.

As a result of the recession, expectations have been very low for the last two quarters, says Uri Landesman of ING Investment Management (ING). "In each case, [results] came out a lot better than the worst people feared," he says.

Growing Optimism

Pushing stock prices higher this season weren't just better-than-expected profits, but a different tone from executives. "There were more companies seeing light at the end of the tunnel," says Peter Cardillo, chief market economist at Avalon Partners. For example, Cisco Systems (CSCO) Chairman and Chief Executive John Chambers said on Aug. 5 the economy might be at a "tipping point."

Jim Owens, Caterpillar (CAT) chairman and chief executive, said in a statement on July 21: "There is still a great deal of economic uncertainty in the world, but we are seeing signs of stabilization that we hope will set the foundation for an eventual recovery."

When reporting March quarter results, many management teams sounded as though they had "no idea what's going on," says Terry Morris, senior equity manager at National Penn Investors Trust. Now, "management is starting to be a little more optimistic—but still cautious."

Tempering the enthusiasm of both executives and investors was where better-than-expected earnings came from: layoffs and other cost-cutting measures. Companies produced profits by slashing spending, not by growing sales. While more than 70% of companies beat profit expectations, only about 35% beat analysts' revenue estimates, says Ashwani Kaul, global head of research at Thomson Reuters.

Beating Forecasts

Given the lack of sales growth, Michael Yoshikami, president and chief investment strategist at YCMNET Advisors, says: "I don't believe you can read too much into this earnings season." Without improvement in revenues, it's hard to extrapolate results out to future quarters.

The good news is, more companies beat revenue forecasts than in the first quarter. Last quarter, just 20% of companies beat revenue estimates, a sign of how weak the economy was.

Companies should be credited for cutting costs in this environment, Kaul says. "Corporations have adapted better than expected," agrees John Merrill, chief investment officer at Tanglewood Wealth Management. By cost-cutting now, companies should produce bigger profits when the economy recovers, he adds.

Many market watchers believe future earnings seasons will continue to push the stock market higher. But that depends on how high analyst and investor expectations get. If investors expect too much, they might be disappointed. "We still don't know what the slope of the recovery is going to be," ING's Landesman admits. Still, he's optimistic: "The worst is behind us. We're recovering."

Fourth-Quarter Hope

According to Thomson Reuters, analysts expect S&P 500 earnings to fall 21.9% in the third quarter, compared with the third quarter of 2008, but then to jump 183.5% year-over-year in the fourth quarter. The fourth quarter's predicted rebound is a reflection of how weak profits were in the last quarter of 2008, when S&P 500 earnings fell 67%. Despite the better-than-expected second quarter results, estimates for the third and fourth quarters have barely budged in the past month.

Merrill thinks earnings results could pleasantly surprise investors again in the third and fourth quarters, thanks to more noticeable improvements in the economy. But, he warns, companies still face large challenges in 2010. "There are just a lot of things that are unknowable right now," Merrill says. "What you can see ahead looks promising. But what you can't see after that is pretty uncertain."

Morris worries it could take a while before companies start growing sales again. "Until the consumer starts to feel a little better, we're probably not going to see the sales growth we're used to seeing."

And without a jump in revenues—driven by selling more goods in a growing economy—stocks may have some roadblocks ahead।

By Ben Steverman (businessweek.com)