by Greg Harrison.
The current N/P earnings guidance ratio of 11.4 for Q4 2013 is the most negative on record. Prior to this, 6.8 was the highest negative-to-positive ratio. Some broad reasons companies are giving for negative guidance are that consumers remain cautious about spending, and that October’s federal government shutdown reduced government spending.
Now that the majority of S&P 500 companies have reported their third-quarter earnings results, investors are looking ahead to the fourth-quarter earnings season. Currently, analysts expect earnings to grow 7.8% over the fourth quarter of 2013. This estimate is down from the 10.9% estimate at the beginning of the quarter. Given the 0.4% expected revenue growth, it may be difficult to achieve profit increases of the magnitude currently expected.
Companies have been expressing concerns about high fourth-quarter expectations in the form of earnings guidance. So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative-to-positive guidance ratio is the most negative on record by a wide margin. The highest N/P ratio prior to this quarter was 6.8 for Q1 2001.
Throughout the first three quarters of this year, company-issued guidance was more pessimistic than usual, resulting in downward estimate revisions on the part of analysts. Though estimates were frequently being cut in prior quarters, analysts and company management teams frequently left their full-year estimates intact under the assumption that profits would be made up in the latter part of the year. Now that the fourth quarter is upon us, earnings expectations are still very optimistic, resulting in negative guidance as companies adjust their internal projections based on the current environment.
In addition to generally optimistic estimates, companies have been citing broad themes as reasons for earnings guidance. Even as the economy recovers and the employment picture improves, consumers are still cautious about spending. Target Corporation (TGT.N) cited this factor as it estimated fourth-quarter profits of $1.28 per share, well below the $1.41 analyst consensus at the time. Kathee Tesija, EVP of Merchandising, discussed the consumer outlook during the earnings call. She stated, “As we survey our guests and monitor the overall consumer environment, we continue to see anxiety regarding the economy and the ability to stay within household budgets, particularly among lower- and middle-income consumers. We even heard from some guests that they were cutting trips for fear they would be tempted to spend too much, a behavior we first observed in the recession. In light of this environment, we are entering the holiday season with a cautious outlook for sales and a very liquid inventory position.”
NetApp, Inc. (NTAP.O) mentioned the government shutdown and associated effects as a reason for its negative guidance. During the earnings call, CEO Tom Georgens expressed his concerns about the effects of reduced government spending on NetApp and on other companies that sell to the government. He explained his unease regarding “companies like us that have a dependency upon that business—and we see it slow down, and perhaps for a protracted period of time, that has impacted on our spending. If other companies are acting like we are, then clearly the impact of the government is going to spill over into the commercial side of the house. We will see that going forward as well, and that is also reflected in our guidance to some degree.”
With guidance at an overwhelmingly negative level, analysts are starting to cut fourth-quarter estimates. However, the question is whether it has fallen far enough. Expected earnings growth has come down 3 percentage points since the beginning of the quarter, but analysts are still projecting solid earnings growth of nearly 8 percent. Should estimates remain near this level, we will have to wait until the fourth-quarter earnings season to find out if analysts are too optimistic or if management teams have been too pessimistic.