VERSACE: Look beneath surface of earnings growth

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ANALYSIS/OPINION:

The debate between corporate earnings growth and the economy raged this past week as companies such as FedEx Corp., Equinix Inc. and E.I. du Pont de Nemours & Co. delivered significant earnings growth year on year and compared with Wall Street’s expectations.

A notable characteristic of this earnings period thus far is the relatively low number of negative disappointments on the earnings front. The key phrase in that prior sentence is “thus far,” but more on this later. At face value, positive surprises when it comes to earnings are good, but as I have said many a time, we need to dig deeper, below the headlines, to understand what is really going on.

Upon closer examination, more than a few companies delivered better than expected performances for the June quarter on what we would call in-line or only slightly better than forecast revenues. Connecting the dots, this means we need to look at the cost side of the equation - raw materials, services and labor - that has improved for companies. Said another way, companies are reaping the benefits of productivity gains from not only technology but also squeezing incremental productivity from the existing work force.

By doing more with less, the concern about a jobless recovery remains, particularly following this week’s unemployment claims and the results of the Federal Reserve Beige Book report released this week. Fresh unemployment claims remained over 450,000, while 4.57 million people were still receiving benefits after an initial week of aid for the week that ended July 17, up 81,000 from the previous week.

Meanwhile, the Beige Book report found that the U.S. economy is growing but so are the risks. The survey data showed that the vast majority of the 12 regions tracked in the report had modest economic activity, with better growth in Cleveland and Kansas City offset by slowing in Atlanta and Chicago. The report identifies high unemployment, cautious consumers and businesses and an ailing housing market as keeping the recovery from gaining strength.

Not surprising for regular readers of this column or those who follow the economic data flow.

Despite these signs, Wall Street expectations for the S&P 500’s operating earnings have risen in recent weeks and now stand at $79.53 per share for 2010 and $92.19 for 2011. What strikes me most about the 2011 expectation is not that it suggests 16 percent year on year growth but rather that those expectations are the highest for S&P operating earnings for the past 10 years.

Overly optimistic?

I think so, especially when we factor in the notion that the vast majority of the domestic economy is fueled by the consumer and spending patterns. Consumer-related companies are one slice of corporate earnings reports that we have yet to really hear from, and hear from it we will in the next few weeks.

What we have heard so far, however, has been disconcerting to some but reinforces our notion of the trade-down effect associated with the cash-strapped consumer. When both the Colgate-Palmolive Co. and the Kellogg Co. reported their respective earnings, both cut their outlooks for the balance of the year. Consumers continuing to trade down to store-brand products fueled their reduced views. The concern is that both companies have been viewed by many investors to be safe ports in a storm because of their inelastic products such as soaps, oral care, cereals and convenience foods.

One has to wonder what the outlooks will be at more trendy, fashion-forward retail companies as well as higher-end retail and consumer-product companies when they update their respective views in the coming weeks. From my perch, this raises the risks associated with corporate earnings. Given the strong move in the S&P 500, up more than 5 percent month to date as I type this despite weakness late this past week, and aforementioned prospects for upcoming corporate earnings, odds are we will see at least a modest pullback from current levels in my opinion.

In prior columns, I’ve shared strategies for protecting profits as well as how to position oneself for a potential retrenchment in the stock market. The parting thought this week would be to examine companies like II-VI Inc. and others that are productivity plays for businesses as well as those for-profit education companies we dished on last week.

Good hunting.

• Chris Versace, the Thematic Investor, is the director of research at Think 20/20, an independent equity-research and corporate access firm located in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. At the time of publication Mr. Versace had no positions in companies mentioned. However, positions can change.

About the Author
Chris Versace

Chris Versace

Chris Versace, the “Thematic Investor,” is the director of research at Think 20/20, an independent equity research and corporate access firm located in the Washington, D.C. area. Before Think 20/20, Mr. Versace was the portfolio manager of Agile Capital Management (ACM), a thematically driven alternative investment fund. The groundwork for ACM was laid during Mr. Versace’s tenure as senior vice president of equity ...

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