Focus on Earnings
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Elliott Gue PFNewsletter .com |
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The next four weeks mark the heart of third quarter earnings season. Although economic reports will continue to move the market, investors’ focus will shift to corporate results and, in particular, signs of actual growth in demand.
As I’ve noted before, second quarter earnings season was largely better than expected, with an unusually large number of S&P 500 firms beating expectations. A steady stream of positive reports acted as an upside catalyst for stocks, snapping a midsummer correction and sending the S&P 500 to new highs.
Of course, all was not rosy in the second quarter. While most companies beat their earnings forecasts, few showed real year-over-year growth in profits. Even more important, few companies managed to beat their revenue forecasts heading into the quarter. In other words, higher-than-expected earnings results were largely driven by cost-cutting rather than actual sales growth.
For the third quarter, analysts expect S&P 500 companies to report their ninth straight year-over-year decline in profits. Revenue growth is also expected to remain negative for the quarter. The final turn in earnings is projected for the fourth quarter, when the S&P 500 as a whole is expected to show year-over-year earnings growth of more than 85 percent and revenue growth of nearly 5 percent.
Those year-over-year growth numbers are aided by easy comparisons. The fourth quarter of 2008 marked the height of the credit crunch and therefore fourth quarter 2009 profits are being compared to a low base number.
Nonetheless, an actual inflection in earnings and revenues for S&P 500 companies will be necessary to sustain the market’s strength into 2010. Investors will be scouring earnings releases and conference calls this quarter for any further evidence that companies are seeing a real turn in business conditions.
It’s far too early to draw any real conclusions about third quarter earnings because only 37 S&P companies have reported to date. So far, however, 32 of those firms have beaten analysts’ profit expectations by an average of 18 percent. And 26 of the 37 companies have also beaten expectations for sales, though the beat on the top line is far less impressive at just 0.12 percent on average.
Here’s a quick summary of two reports that have been released by companies I follow; I’ll provide more detailed analyses of these and other companies in upcoming issues of Personal Finance and The Energy Strategist.
CSX Corp (NYSE: CSX) is one of the largest freight railroad companies in the US. I watch results from railroads extremely carefully because they’re a great gauge for overall economic health; if traffic trends are positive, it indicates that economic activity is strengthening.
And because railroads break down their traffic and volume statistics by product type, we can also get a good idea of what sectors of the economy are growing and which are not.
Broadly speaking, CSX’s earnings were better than expected, and the stock traded higher after the numbers came out. That said, much of the beat was due to outstanding cost control, strong growth in pricing and efficiency improvements.
One of the reasons I like the railroads for the long term is that most of the majors have made huge strides in recent years reducing costs and increasing efficiency. The rails remain an excellent back-door energy efficiency play because transporting goods by rail is a great deal more fuel-efficient than by truck; the rails have been taking volumes from trucks in recent years, a trend I expect to continue. Consider that a railroad can move a ton of cargo for more than 430 miles on a single gallon of diesel fuel.
CSX reported a 23 percent decline in revenue for the quarter against the same quarter of 2008. That works out to around a $672 billion drop year-over-year. Roughly two-thirds is attributable to a decline in volumes of freight moved by CSX, while most of the remainder is due to fuel price surcharge declines.
The latter isn’t a huge concern and was a well-known headwind going into the quarter. CSX collects fuel surcharge fees based on average fuel costs, and oil and diesel fuel costs were higher in the third quarter of 2008 than in the same quarter this year.
Volume declines remain a headwind, though there are some tentative signs of improvement. For example, general merchandise volumes were down 17 percent in the third quarter compared to 23 percent in the first, while auto volumes were down more than 53 percent in the first quarter, 41 percent in the second and just 26 percent in the third.
Although a good deal of that improvement in autos was due to “Cash for Clunkers," volume trends were improving somewhat before that program went into effect. CSX also sees the volumes in autos continuing to pick up into the fourth quarter because dealer inventories remain tight and some manufacturing capacity has been restarted.
The one area of real weakness that CSX management spent considerable time discussing was coal. Coal inventories at US utilities remain near record levels at 76 days of supply compared to a more normal average of 50 to 70 days. CSX sees continued weakness in coal loadings well into 2010 as utilities seek to draw down their stockpiles to more normal levels.
On the other hand, CSX noted a favorable volume outlook in some of its agricultural markets, including grains and fertilizer, heading into the fourth quarter. The rail also noted an improvement in chemicals volumes.
All told, the CSX report is consistent with the US economy bottoming out over the summer, with volume trends gradually improving from extremely depressed levels earlier this year. Management did comment that the worst of the downturn appeared to be over from a freight volume perspective.
The rail noted that consumer demand is stabilizing and that weakness in global trade (intermodal volumes) is beginning to ease. There’s been some sequential improvement in volumes of some commodities transported; in other words, volumes have picked up from first and second quarter levels even though they continue to shrink year-over-year.
As for coal, in The Energy Strategist and Personal Finance I recommend investors focus their attention on mining firms levered to Australia rather than the US. Coal demand in Asia is picking up notably even as demand in the US remains weak, and Australia is the key coal export nation.
It should come as no surprise that Australia was the first G-20 nation to raise interest rates this cycle and is one of only a handful of countries where residential house prices are hitting new highs. The nation’s abundant natural resource wealth and export capacity will remain major tailwinds.
A major catalyst for US coal demand would be a jump in US natural gas prices; utilities have been substituting gas for coal in recent weeks due to ultra-cheap gas prices.
Technology has been among my favorite and highest weighted sectors in PF for most of 2009. Google’s (NSDQ: GOOG) report was better than expected in terms of both earnings and revenue, and the stock reacted favorably to the news. Google’s revenue rose 7 percent year-over-year and 8 percent over the second quarter.
Google’s report reflects a real upturn in online advertising spending, and management commented that the worst of the recession is behind the company. Google also noted a real improvement in click pricing--the amount advertisers pay when their Google ads are clicked--for the quarter.
Another positive trend is international revenues. While US revenues were up 4 percent year-over-year, international revenues soared 19 percent in constant currency terms. International revenue accounts for around 53 percent of Google’s total business, so this is a major positive for the company.
More broadly, earnings performance overseas has been consistently outpacing the US in recent quarters, and a rising percentage of US corporate earnings are coming from outside the US. If US companies are focusing more attention on international growth prospects, this suggests that US investors should also focus more attention on investing overseas and in US companies like Google that have significant leverage to international growth.
Elliott H. Gue is editor of Wall Street Winners the premier monthly growth newsletter designed to manage investor’s portfolio risk. Mr. Gue examines the market sector by sector to find the industries with big tailwinds and avoid investing pitfalls. Mr. Gue uses both top-down and bottom-up approaches to search the global stock and currency markets for strong intermediate-term trends, picking investment vehicles accordingly.
Mr. Gue is also editor of Trading Floor Pro and a research analyst for Personal Finance, where he specializes in global equity and debt markets and also has broad interests in technology and sector investing.
He has worked and lived in Europe for five years, where he completed a Master’s degree in Finance from the University of London, the highest-rated program in that field in the U.K. He also received his Bachelor’s of Science in Economics and Management degree from the University of London, graduating among the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that business school.