Research note: August 2011

Q2 2011 Reporting Season

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Q2 2011 Reporting Season

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Q2 2011 Reporting Season

Earnings & Sales Performance OverviewAs more than 97% of S&P 500 companies have now reported their financial results for the second quarter of 2011, we take this opportunity to conduct our quarterly review of performance, trends and other various signals and patterns from this quarter and over time.

Index valuations based on earnings per share are significantly lower than those in the previous quarter; the overall S&P 500 index is currently trading at just 13.17 times trailing-twelve-months earnings, whereas the comparable ratio from the end

The S&P 500 is now valued at 13.2x trailing-twelve-months earnings, despite the fact that aggregate earnings increased by nearly 14% over the previous quarter.

1 97% of S&P 500 companies have now reported results for the second quarter of 2011.

1 Quarterly EPS increased by 13.7% on a year-on-year basis, with the highest-growth sectors being Basic Materials and Energy.

1 Revenues for the same period increased by 14.6%, with Energy companies seeing the largest rise.

1 75.6% of all companies’ earnings exceeded analysts expectations, far above any point prior to the third quarter in 2009.

1 70.2% of companies posted positive sales surprise, the highest level since 2004.

1 The difference between these two numbers converged, with the spread being the lowest since the onset of the financial crisis in mid-2008.

EPS Sales

Count Aggregate P/EAggregate QTR EPS

YoY%Aggregate

P/SalesAggregate QTR EPS

YoY%

S&P 500 500 13.17 13.73 1.18 14.58

Basic Materials 28 15.78 50.51 1.11 17.76

Communications 44 15.43 13.99 1.70 15.46

Consumer, cyclical 62 13.53 15.62 0.63 14.70

Consumer, non-cyclical 103 12.80 9.20 1.26 7.93

Energy 44 11.14 47.07 0.98 36.81

Financial 77 17.87 -24.86 1.41 7.40

Industrial 60 12.50 18.89 1.01 9.21

Technology 49 10.87 28.20 1.87 14.87

Utilities 32 12.61 -0.59 1.32 9.06

Table 1S&P 500 Earnings and Sales Growth by Sector

of the 1Q11 earnings season was 15.6x. As can be seen below, earnings per share on an aggregate level are still increasing (and, indeed, grew by nearly 14% over the same quarter of the previous year); a fall in the overall index value due to well-known, external factors accounts for the decline in valuation.

Repeating the performance seen last quarter, the various year-on-year earnings-growth rates of market sectors were quite widely distributed. Whilst Basic Materials and Energy companies chalked up impressive gains (of 50.5% and 47.1%

Source: FactSet

Q2 2011 Reporting Season

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respectively), consumer-focussed sectors showed somewhat more lacklustre growth and profits of Financial companies fell substantially – coming in nearly 25% lower than in the second quarter of 2010. The steep growth in Energy companies’ profits was almost certainly related to a significantly higher oil price due to ongoing unrest in the Middle East and the accompanying uncertainty about the continuity of supply – although oil prices have fallen significantly since April 2011 and thus future year-on-year comparisons may be difficult. Year-on-year earnings growth for Industrials companies was just a hair under 19% – significantly lower than the previous quarter’s YoY increase of 33.8%. This is likely related to the impact of the Fukushima earthquake in Japan on 11 March working its way through the various supply chains for the industry – as mentioned by several large Industrials companies in their earnings press releases.As in the previous quarter, dispersion in year-on-year revenue growth rates was more tightly clustered. Nevertheless, the Energy sector posted impressive gains of almost 37% – due again, at least in part, to the inflated oil price. In such an environment, both energy providers and their servicers benefit – and this occurrence is evident in the sector’s increased revenues. The Financial and Consumer, Non-Cyclical sectors posted much lower gains, but with both still increasing revenues by more than 7% year on year.

Earnings Growth Rates – Breakdown Per SectorIt is worth diving into a bit more detail about the earnings-growth trends across the various market sectors (as defined by GICS) comprising the S&P 500 index. As can be seen in the table below, there is a great deal of dispersion amongst EPS growth rates amongst the industry groups. A slowdown of growth in the Consumer Staples and Materials sectors is noteworthy as it shows that earnings in these two market segments, whist still greater than the same period a year ago, are increasing at a lower rate. This change is much

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more precipitous in the Telecommunications Services sector (three quarters ago, earnings were 171% greater year on year; most recently they only grew at 26%). Slightly more noteworthy, however, is the Financials sector, where 2Q11 earnings were more than 26 per cent smaller than those from 2Q10. The majority of declines in index earnings through 2008 and 2009 were also driven by this sector. Whether or not we are at a turning point remains to be seen, but these changes and those for all sectors will be watched closely over the ensuing quarters.

Earnings Sales “Surprise” – Trends & BreakdownsReversing slightly the recent trend, the number of companies in the index whose profits exceeded analysts’ expectations increased to 75.6%. This percentage is higher than almost all points over the past nine years, and also exceeds every quarter prior to 3Q09. Such a high proportion of companies surpassing expectations is more similar to the economic recovery in 2009 than to the recession of 2008.It is worthwhile pointing out that this metric does not indicate a company’s overall profitability; it merely tracks a company’s earnings performance relative to analysts’ expectations. Companies that lose money are still capable of generating positive earnings surprises and, indeed, those whose earnings grow but do not exceed forecasts can have negative earnings surprise. Nevertheless, it is clear to see that more companies’ profits are exceeding market expectations in 2Q11 than in any of the previous three quarters and that a mean-reversion trend (in which the quarterly percentage converges on a long-term average) might be a while off yet. This is reinforced by the fact that the most recent surprise-percentage of 75.6% is more than one standard deviation above the nine-year average.Interestingly, the number of companies whose sales numbers exceeded analysts’ expectations was a hair over 70% – the second-highest percentage on the chart below (with the highest value, 71.3%, being measured in 1Q04). Traditionally, and perhaps due to the differing ways in which the numbers

Consumer Discretionary

Consumer Staples Energy Financials Healthcare Industrials

Information Technology Materials

Telecomms Services Utilities

Quarterly EPS

2010 Q3 3.95 4.5 8.5 2.4 5.62 4.58 6.58 4 4.34 3.09

2010 Q4 4.54 5.96 9.03 3.44 5.26 4.71 7.76 2.83 1.11 2.07

2011 Q1 4.4 4.71 10.72 3.6 6.53 4.61 6.93 4.66 1.79 2.83

2011 Q2 5.1 5.11 12.53 2.53 7.08 5.36 7.25 5.06 1.71 3.14

YoY% Growth

2010 Q3 27.0 0.9 44.3 103.4 -16.5 53.4 53.4 66.0 171.3 -11.0

2010 Q4 19.8 39.3 45.9 -1374.1 -23.8 24.0 24.0 92.5 65.7 -49.8

2011 Q1 15.5 18.0 29.6 3.2 20.7 28.6 28.6 73.2 94.6 -6.9

2011 Q2 17.0 10.1 28.6 -26.5 14.7 24.4 24.4 56.2 25.7 10.6

Table 2Earnings Growth Rates – Breakdown Per Sector

Source: FactSet

Q2 2011 Reporting Season

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are derived, analysts tend to be better at forecasting revenues numbers; nevertheless, the percentage of companies exceeding revenues projections for the second quarter in 2011 was also outside one standard deviation of the nine-year average. Once again it bears mention that these numbers do not indicate a company’s overall performance or profitability; they simply indicate the broad-market’s financial state in relation to expectations. Even if a company is doing poorly, it might be doing less poorly than expected – in which case its surprise will be positive on the chart above. Given this, however, the increasing positive-surprise percentages of companies’ sales and earnings, coupled with the fact that both seem to be avoiding reversion to a long-term mean, could mean, among other things, that analysts are downbeat about the future but that more companies are proving them wrong than in the recent past.

Comparing the breakdown of positive-surprise companies by sector for both earnings and sales estimates – and how this number has changed from the previous quarter – shows us some interesting things. Although the Basic Materials and Energy sectors’ earnings grew the most out of all nine sectors (as shown in the first section above), their members’ positive surprise was among the lowest of all sectors. This is a very good example of the above-mentioned phenomenon whereby a company (or, indeed, an entire sector) may achieve significant positive earnings growth but, since this is entirely accurately predicted by analysts, the positive-surprise numbers are very low.

There are cases, however, when analysts’ predictions vary widely in their accuracy over time, as demonstrated in the table below:

EPS Sales 2Q11 Spread 2Q11 Spread

CountPositive Count

Negative Count % Positive

Positive Count

Negative Count % Positive

EPS – Sales EPS – Sales

S&P 500 500 366 118 75.6% 335 140 70.5% 5.1% 4.3%

Basic Materials 28 17 11 60.7% 22 6 78.6% -17.9% 23.1%

Communications 44 35 9 79.5% 30 14 68.2% 11.4% -18.2%

Consumer, cyclical 62 50 9 84.7% 44 16 73.3% 11.4% 7.9%

Consumer, non-cyclical 103 77 17 81.9% 68 26 72.3% 9.6% 5.9%

Energy 44 29 15 65.9% 28 13 68.3% -2.4% -0.1%

Financial 77 57 20 74.0% 51 21 70.8% 3.2% 0.6%

Industrial 60 40 18 69.0% 39 19 67.2% 1.7% -1.7%

Technology 49 41 6 87.2% 34 13 72.3% 14.9% 10.0%

Utilities 32 19 13 59.4% 18 12 60.0% -0.6% 29.4%

Chart 1Percentage of Positive EPS Purprises – S&P 500

Source: FactSet

Chart 2Percentage of Positive Sales Surprises – S&P 500

Source: FactSet

Table 3S&P 500 Earnings and Sales Surprise Proportions by Sector

Source: FactSet

Q2 2011 Reporting Season

The most interesting feature of the chart above is the change in spread values shown in the two rightmost columns. For instance, let us consider the story of the Basic Materials sector. In the first quarter of the year, far more companies surprised the market with their profits than their revenues (the spread is 23.1%). However, in the second quarter, the pendulum seems to have swung the other way: now the trend is reversed, with the spread between positive-earnings and positive revenues companies at -17.9% (meaning that analysts were now much more accurate with their earnings than with their sales forecasts). This shows the highly volatile nature of forecasting in general and could indicate that, after having been very wrong with their estimates of earnings in relation to sales in the first quarter (shown by the fact that so many more companies had positive earnings surprise than sales surprise), analysts covering Basic Materials companies might have overcompensated by ‘upping’ their earnings estimates relative to sales estimates quite significantly, thereby tipping the scales in the opposite direction. The exact opposite phenomenon can be seen with companies in the Communications sector: over-optimistic earnings estimates relative to revenues in the first quarter most likely led to far more companies surprising with their sales numbers than with profits (the spread is -18.2%); adjustment of earnings estimates accordingly for the most recent quarter led to a reversal of the phenomenon, where the spread is now 11.4%.

Earnings Sales Surprise – ComparisonThe following chart shows the proportions of companies beating earnings and sales expectations side by side – and shows how the difference between them (the red line) has changed over time. As in the previous quarter, the spread is still below the nine-year average, indicating increasing consistency between analysts’ earnings and sales estimates – at least compared to the past three years.The future of this spread will be interesting to observe. Will the period of 2008-2009 be remembered as an aberration in which

analysts’ forecasts proved much more accurate for revenues than for earnings – reflecting, perhaps, pessimism about companies’ ability to convert sales into profits? Or will future periods see as much inconsistency between estimated metrics as those during the last financial crisis?

ConclusionsAlthough profits and revenues grew for the S&P 500 index in aggregate, the increases were slightly less than those of the previous quarter. Once again, however, the growth rates were distributed quite widely amongst various industries, reflecting impacts of differing external forces on the companies within them. The percentage of companies exceeding forecasts increased – for profits and revenues – above both the previous quarter’s numbers and each respective long-term average. Additionally, the spread between number of companies exceeding sales and earnings expectations converged slightly this quarter, bringing the difference between the two numbers to pre-crisis levels.

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Chart 3Ratio of Positive EPS to Sales Surprises – S&P 500

Source: FactSet

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