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August 13, 2012

Earnings Roundup: Beware, Falling Earnings Guidance Ahead

by Greg Harrison.

Second-quarter earnings growth looks surprisingly strong – but this time around, it may be wise to heed some of the negative third-quarter guidance that companies are offering up along with their results for Q2.

Last week was another good one for corporate earnings, as the companies that announced their second-quarter results did well enough to push the blended growth rate in profits for companies in the S&P 500 index upwards by a full percentage point, to 8.4%. Even revenue growth – hard to come by during the quarter, it seems – edged higher, to 1.1% from 1% previously. True, that 8.4% figure is artificially high, inflated as it is by the results of Bank of America (which faced an extraordinarily easy comparison, thanks to the impact of a mortgage lawsuit settlement on its results for the same period in 2011) but even so, 68% of S&P 500 companies have posted results that were better than analysts had anticipated.

Of course, those analysts were downright bearish by the time the second quarter drew to a close, and corporate executives weren’t much more upbeat, cutting guidance three times as often as they provided positive guidance. And now that the reporting season is drawing to a close, and we begin to look forward to the third quarter, companies appear to be even more cautious than they were three months ago. So far, only 14 S&P 500 companies have published positive preannouncements, while 68 have issued some kind of warning. The negative-to-positive guidance ratio of 4.9 that results is more bearish than we witnessed during the heart of the financial crisis of 2008. Indeed, the last time, corporate executives were this downbeat goes all the way back to the third quarter of 2001 – a period which included the 9/11 terrorist attacks.

The question that needs to be addressed is whether investors should discount at least some of that negative guidance, given that in recent quarters, it has been followed by earnings announcements that are significantly stronger than investors had been led to believe. Perhaps companies have fallen into a pattern, providing negative guidance in a bid to set up their eventual earnings releases for a positive surprise. While there may be an element of that in the third-quarter guidance now being provided, there are some significant differences to which investors should pay heed.

First of all, there is the magnitude of that ratio of negative to positive preannouncements, and the fact that it has dramatically increased, as seen in the chart below. Moreover, it isn’t just corporate managers who are adopting a bearish stance – analysts have been cutting forecasts as well, and collectively are predicting that S&P 500 earnings will post a decline in the third quarter, for the first time since the third quarter of 2009. They’re warning investors about revenues, as well, predicting that these will rise only 0.2% in the third quarter; if true, that would be the most sluggish rate of growth recorded since the third quarter of 2009. Nor does the economic backdrop offer much room for optimism: the European economy continues to weaken, growth in the emerging markets is slackening. This time around, the negative guidance may reflect reality rather than being just an attempt to “game” estimates.

Fossil Inc. (FOSL.O) was among those companies that last week chose the release of their second-quarter results to warn investors that the stream of good news may not last long. The fashion accessories retailer had a solid quarter, with double-digit gains to both revenue and profits (a growing rarity, as we have discussed previously), thanks in part to its acquisition of Danish watchmaker, Skagen Designs. Nonetheless, the rise in the dollar against the euro and other currencies still hurt Fossil, and the company says it expects to take a hit of 14 cents a share to its earnings for the full year. “We are in effect revising our guidance slightly downward for the balance of the year,” Fossil CEO Kosta Kartsotis told listeners on the conference call. “Most of this is due to the U.S. dollar being much stronger. In addition to that there is a lot of uncertainty and lack of visibility in the global marketplace.”

Fossil isn’t the only company with exposure to Europe to provide investors with downbeat guidance. (PCLN.O) generates more than half of its revenue in Europe, and the company is exposed to further declines in the value of the euro against the dollar, as the company’s chief financial officer, Daniel Finnegan, explained during the conference call. The reduction in third-quarter guidance reflects the company’s assessment of macroeconomic conditions globally (and in particular in Europe) and also the impact of a stronger dollar, Finnegan added.

If these and other bearish managers are proven correct, we may be about to see corporate earnings growth rates turn negative for the first time during the current economic recovery. But even if earnings once again come in stronger than expected, and a decline is averted, without a strong catalyst it’s likely that profitability will – at best – start to stagnate.

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