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April 22, 2013

Earnings Surprise Rate Jumps, but Revenue Disappoints

by Greg Harrison.

The rate at which companies are posting better-than-expected earnings may look impressive, but looking behind the headlines reveals an underlying problem: the fact that revenue growth just isn’t keeping pace.

When analysts cut their earnings estimates for S&P 500 companies in the weeks that led up to the first quarter’s earnings season, they created opportunities for companies to outperform and post positive surprises, even though their actual gains in profitability might be minimal. Now that about a fifth of those S&P 500 companies have reported their earnings, that appears to be what is taking place. Companies have posted positive surprises more often than not, with 67% of them beating their earnings estimates. This has caused the blended first-quarter earnings growth rate to climb to 2.2% at the beginning of this week from the 1.1% estimate as of a week earlier.

The revenue picture has been rather different, however. The blended revenue growth estimate provides an even lower hurdle, with companies needing only to report growth of 0.7% to better the forecast for S&P 500 companies as a whole. Unfortunately, even that appears to be too aggressive for the companies that have reported so far, as only 44% have manage to beat their revenue estimates and the remainder — a majority — have fallen short of those forecasts. If this pattern — a divergence between earnings and revenue growth rates — sounds familiar, well, that’s because we witnessed roughly the same phenomenon in both the second and third quarters of last year. Only in the fourth quarter did the revenue beat rate return to normal, as analysts apparently adjusted their forecasts to reflect this pattern of slow revenue growth. Now it seems as if analysts are being overly bullish on revenue growth — or certainly more bullish than is typical — given the fact that most companies have reported negative surprises when announcing their revenues.


Revenue shortfalls aren’t the only problem we are seeing with first-quarter earnings results. While most companies have beaten analysts’ earnings estimates, the quality of these surprises are suspect in many cases. As seen in Exhibit 1,above, of those companies that have beaten earnings estimates, 58% of them have simultaneously missed revenue estimates. This suggests that companies have somehow improved their margins above the level predicted by analysts. Given the revenue shortfalls and the fact that revenue is expected to climb a mere 0.8% for the quarter, the margin improvement clearly isn’t likely to be due to improved pricing power. Cost cutting appears to be a more probable explanation.

It is still early in the earnings reporting season, but this trend of companies beating earnings estimates while missing revenue forecasts should cause investors who are impressed by the high percentage of companies posting positive surprises to pause and take stock. In the ten years that we have tracked and studied this metric, this quarter is on track to go on record as having the highest rate of these “low-quality” earnings beat, assuming that the current trend holds through to the end of earnings season.

The flip side of the coin is that less than half (42%) of the companies that so far have beaten earnings estimates also have reported higher-than-expected revenues. When looking at of all the companies that have reported to this point, that rate falls to 30%. While the importance of earnings per share results is self evident, the fact that such a small percentage of companies have posted strong surprises on both the top and bottom lines paints a significantly different picture than the one received by those who may study earnings surprises in isolation.

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