Productivity, Profits and Margins

The 4th quarter earnings season is almost done. We now have 419 or 83.8% of the S&P 500 reports in. However, the early reporting firms tend to be a bit bigger and more profitable than the stragglers, and those 419 firms actually represent 89.1% of the total expected net income.

That, of course, presupposes that all the remaining firms report exactly as expected, which is unlikely. But it shouldn’t be too far off, as those 419 firms also represented 90.0% of all the net income a year ago.

Strong Earnings Season

The earnings season has been a strong one, with total net income for reported firms having risen 27.5% over a year ago. The median surprise of 3.75% is also fairly strong, although the ratio of positive-to-negative surprises is only somewhat above normal at just 3.20. The total net income growth of the reporting firms is a slight slowdown from the 28.6% year-over-year growth those same firms posted in the third quarter.

Based on the expectations for the 81 S&P 500 firms yet to report, the final growth rate should be a bit higher than what we have seen so far, but there really are not enough of them (and the remaining firms are not big enough) to really move the needle. The expectations are that the remaining 81 firms will post total net income that is 41.8% than a year ago. That is a big acceleration from the year-over-year growth of the third quarter of 2.5%.

It now looks like the final year-over-year growth will be 28.9%, up from the implied level of 28.4% as of last week. Given that positive earnings surprises almost always outnumber disappointments, that number implies that the remaining firms would have a median surprise of 0.00 and a surprise ratio of 1.00, which is highly unlikely. Thus growth could be close to 30% when all is said and done for the quarter. At the very start of earnings season, the expected growth was under 20%.

Revenue Growth to Slow

Revenue growth though is expected to slow down significantly — rising 4.98%, down from positive growth of 6.17% those 81 firms reported in the third quarter. On the other hand, revenue growth among those that have reported is very healthy at 8.66%, actually higher than the 8.59% growth those 419 firms reported in the third quarter.

Looking ahead to the first quarter, though, those firms are expected to post year-over-year revenue growth of just 4.08%, while the yet-to-report firms are expected to see revenue growth of 4.11% in the first quarter. If the Financials are excluded, reported revenue growth is 9.16%, up from 8.90% in the third quarter, and slowing to 4.28% in the first quarter.

Tougher year-over-year comparisons are a bigger part of the story. However, as I mentioned above, revenue surprises have been quite strong so far, with a median revenue surprise of 1.33%.

Net Margins at the Heart of the Story

Thus, the stellar earnings growth is mostly due to the continued expansion of net margins. Much of the year-over-year margin expansion is due to the Financials, where the whole concept of revenues is a bit different from most companies, and thus the concept of net margins is also a bit different.

Much of the earnings growth in the Financials has come from firms setting aside less for bad debts than they did last year. One should be a bit on the doubtful side about the quality of those earnings, particularly in the absence of mark-to-market accounting.

Among those that have reported, net margins are 9.60%, or 8.61% if one excludes the Financials, up from 8.18% (7.82% excluding Financials) a year ago, but down from 9.85% (8.75% excluding Financials) in the third quarter.  The expected net margin for the remainder is 5.63% (5.41% excluding Financials) up from 3.73% (5.28% ex-Financials) last year. Retailers, which tend to be a low-margin group, are heavily over-represented in the yet-to-report group, as many of them have January fiscal year ends.

Net margins continue to march northward on a yearly basis. In 2008, overall net margins were just 5.88%, rising to 6.42% in 2009. They are expected to hit 8.64% in 2010 and continue climbing to 9.51% in 2011 and 10.09% in 2012. The pattern is a bit different, particularly during the recession if the Financials are excluded, as margins fell from 7.78% in 2008 to 7.12% in 2009, but have started a robust recovery and are expected to be 8.17% in 2010, 8.79% in 2011 and 9.31% in 2012.

Full-Year Expectations

The expectations for the full year are very healthy, with total net income for 2010 expected to rise to $784.8 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $903.6 billion, or increases of 43.7% and 15.1%, respectively. The early expectation is for 2012 to have total net income passing the $1 Trillion mark to 1.012 Trillion.

That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $106.67. That is up from $57.60 for 2009, $82.75 for 2010, and $95.29 for 2011. In an environment where the 10-year T-note is yielding 3.57%, a P/E of 16.2x based on 2010 and 14.1x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 12.6x.  Perhaps not as compelling as a few months ago, but still pretty attractive.

With more than three 2011 estimates being raised for every two being cut (revisions ratio of 1.55), one has to feel confident that the current expectations for 2011 will be hit, and more likely exceeded. Analysts are raising their 2012 projections at an even higher rate, with a revisions ratio of 1.78.

While a lot can happen between now and the time the 2012 earnings are all in, upward estimate momentum means that the current 2012 earnings are more likely to be exceeded than for them to fall short. This provides a strong fundamental backing for the market to continue to move higher.

The bullish argument is further boosted by such historical factors such as being in the third year of the presidential cycle (almost always the best of the four) and having a Democrat in the White House and the GOP at least partially in charge at the other end of Pennsylvania Ave. While there is not a huge sample size of years with that political alignment, those that exist were very good ones for the stock market. Just having a Democrat in the White House has historically meant good things for the stock market. Few, if any, binomial variables have as much statistical significance.

Sunny Outlook with Some Clouds

Overall, things are looking very good, but that does not mean that all is smooth sailing ahead. While the debt ceiling will eventually get raised — not doing so would be catastrophic — there will probably be some political theatre around it that could unnerve the markets. A government shutdown would not be good for either the market or the economy.

The economy does seem to have made a slow turn towards recovery. However, job creation remains very sluggish. That is particularly true if one goes by the establishment survey, which has shown only 157,000 jobs created over the last two months. The household survey has been much more upbeat, showing growth of 414,000 jobs over the same period, and the largest two month drop in the unemployment rate since 1958.

Most of the real growth in the economy has come from higher productivity, not more hours being worked. Those productivity gains are accruing to capital (higher profits, not labor; flat wages, slow hiring). In the fourth quarter, productivity rose at 2.6% while unit labor costs dropped 0.6%. This is a major reason behind the rising net margins, and resulting strong earnings growth.

Companies have been able so far to absorb higher commodity prices, and not pass them along to consumers (year over year core CPI is just 1.0%) due to those productivity gains. If earnings growth does weaken, I suspect it will be from a slower rise in net margins than currently expected, but there is no evidence of any margin slowdown so far.

Remember that net margins are after taxes, which makes businesses complaints about corporate taxes being too high ring a bit hollow. Clearly the analytical community is not expecting the economy to turn south again anytime soon.

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