Third-quarter earnings season will “officially” start next Thursday when Alcoa (AA) reports.
Overall corporate profit growth should be good. Standard & Poor’s predicts that per share operating earnings for the S&P 500 will rise 31% this quarter on a year-over-year basis. Thomson Reuters calculates the consensus growth estimate as being slightly more conservative at 24%. Either way, this should be the fourth consecutive quarter of profit growth.
Dirk van Dijk at Zacks.com is looking for a mid-single-digit increase in revenues. He also believes that widening net margins will have the biggest impact on profit growth. Van Dijk observes that financial companies should show the biggest year-over-year improvement in profitability, thanks to easy comparisons.
The summer’s economic speed bump will likely be reflected in these numbers, though it’s worth noting that there has been an increase in profit warnings. Thompson Reuters counted 77 S&P 500 companies that issued negative preannouncements (earnings should be below expectations) versus 34 that issued positive preannouncements (earnings should be above expectations). This negative/positive preannouncement ratio of 2.3 is nearly double the second quarter’s ratio of 1.2, but is roughly in line with the historical average of 2.1.
It’s not just whether a company exceeds or misses earnings that will matter, but also the factors that drove the bottom line. Taking a step back to look at the big picture reveals some of the items investors should pay attention to.
Revenues: The summer’s economic speed bump and extremely low levels of inflation made it difficult to increase sales. Thus, it is important not only to look at the percentage change in revenues, but also to understand what drove sales higher or lower. Did the company gain market share? Did overseas operations contribute a higher proportion of total revenues? Alternatively, did the company cut prices or otherwise engage in more aggressive marketing tactics to get the register to ring?
Cost-Cutting: Many companies continue to control costs. The question investors should ask is whether the tight controls on expenses are occurring at a detriment to long-term growth? The cash flow statement will show what the company is spending on new equipment and other fixed assets. The detail accompanying the income statement may list what the company is spending on research and development and its workforce. While you don’t want a company that spends with reckless abandon, you should ask questions if a company is cutting deeper than its peers.
Commodity Prices: Prices for several commodities rose during the third quarter, particularly for wheat and gold. Such increases are a negative for companies that buy commodities, but a positive for companies that extract them. As a general rule, the greater the sensitivity to fluctuations in commodity prices, the bigger the impact on profits and margins.
Interest Expense and Income: Many companies have been taking advantage of the strong bond markets to refinance debt. Though lower yields are a problem for income-oriented investors, they do help shareholders by contributing to higher profits. At the same time, companies with large cash balances are not earning very much on their cash balances, which hurts both profits and return on equity (ROE). If interest expense, or income, does have a significant impact, calculate what the change in profits would have been excluding the expense or income.
Guidance: Pay attention to both the earnings guidance provided by the company and, if the company is followed by analysts, the change in earnings estimates. More importantly, consider whether the guidance fits with your investment thesis for owning the stock. This is particularly the case if you invested in a company because of its historical growth or if you viewed it as a recovery play. One of the basic rules of investing is to sell a security when the reason you bought it no longer applies.
Finally, be sure to read through the earnings press release and SEC Form 10-K (available at www.sec.gov). The October issue of the AAII Journal, which we just sent to the printer on Wednesday, will include an article about what to look for in shareholder communications.
THE WEEK AHEAD
As stated above, Dow Jones industrial average component Alcoa (AA) will officially kick-off third-quarter earnings season with its report on Thursday afternoon. Joining AA in releasing results will be S&P 500 members Yum! Brands (YUM) on Tuesday; Constellation Brands (STZ), Costco Wholesale (COST), Marriott International (MAR) and Monsanto (MON) on Wednesday; and Micron Technology (MU) and PepsiCo (PEP) on Thursday.
(Alcoa’s report is symbolically viewed as the start of earnings season because AA has historically been the first large-cap company operating on a January-December fiscal year to report its quarterly results. And yes, I do see the irony of other large-cap companies reporting earlier in the week.)
The week’s economic schedule starts on Monday with August factory orders and August pending home sales. The September ISM services index will be published on Tuesday. Wednesday features the September ADP employment survey. The August Monster Employment Index will be issued on Thursday, followed by data on the Federal Reserve’s balance sheet in the afternoon. Friday features September jobs data, which includes the unemployment rate and the change in nonfarm payrolls. August wholesale trade numbers will also be released.
No Federal Reserve officials are currently scheduled to make public speeches.
Charles Rotblut, CFA is a Vice President with AAII and editor of the AAII Journal.
View original at: AAII Investor Update E-Newsletter
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