2003 EARNINGS OUTLOOK > Will Profits Finally Bounce Back?
After three awful years, some signs point to yes. But don't jump for joy just yet. There are plenty of reasons to doubt how high the numbers can go.
FORTUNE
Monday, January 6, 2003
By Kimberly L. Allers
There's really nothing to say other than this: Phew! The year 2002 is as dead as the Wicked Witch, and none too soon. The S&P 500 finished down a wrenching 22%, capping a third consecutive year of losses-- something that hasn't happened in six decades.
No wonder investors appeared ready for an attitude change. How better to explain Jan. 2--the best first trading day of a new year since 1988-- when all three major indexes shot up more than 3%, the Dow rising 266 points? Of course, in addition to pure relief (and a bullish report on manufacturing activity and spending), traders might have been starting the new year off by betting with the odds. The last time we saw four straight down years was during the Great Depression. And as bad as things might feel, we're not queuing up in bread lines--yet. How could next year not be better?
However appealing blind faith might be, let's not lose sight of what got us into this mess: the collapse of corporate profits. Since the first quarter of 2000, when earnings per share for the S&P peaked at $16, quarterly profits have alternated between free fall and wheel spinning--mired in the $11 to $12 range. And until they come bouncing back up, the relentlessly forward-looking market is not going to recover. Plain and simple.
So, whispers that optimistic voice in your head, what about that rally on Jan. 2? Was that a harbinger of great numbers to come? Are profits finally primed for a pickup? In two words: not likely.
But first the upbeat news you've been waiting for. According to Thomson First Call, the latest consensus among presumably sobered (and certainly battered) Wall Street analysts calls for a cumulative 14.1% year-over-year gain for S&P 500 companies in 2003, or earnings of $55.03 per share. Spread that EPS out over four quarters, and you get an average of $13.76. Not bad. And if such profit predictions bear out, that would certainly stand as a stark--and welcome--contrast to the current malaise. Here, though, are a few things to consider before you break out the pompons.
First is the immediate past. We are just entering a period when companies will be reevaluating and restating earnings for the fourth quarter of 2002, and the early word is that even stalwart moneymakers are languishing. A day after the Jan. 2 rally, in fact, Home Depot, the world's second-largest retailer, said it expected to see a mammoth 10% drop in same-store sales instead of the 3% to 5% falloff it had forecast just weeks before. Discount retailer Target also hinted that same-store sales for December would be well below its goal of 3% to 5% growth--a factor that is sure to drag down fourth-quarter numbers.
The relatively rosy consensus outlook is suspect in a broader way as well. Beset by what seems to be a plague of revisionism, analysts have been slashing their profit estimates faster and by greater amounts than ever before. Six months ago the group collectively projected a 25.3% increase for the first quarter of 2003. By October that consensus estimate had been chopped to 17.4%; it now stands at 11.7%, according to First Call. Last year's consensus estimate is no more comforting. The 9% gain in earnings predicted by these seers for 2002 has shriveled to a likely gain of about 1.5%.
A closer look at analyst expectations reveals another concern, particularly in light of last year's predictions. "Estimates for 2003 are very back-end-loaded. Not much in the first half of the year, but big gains for the third and fourth quarter," says Charles Hill, director of research at First Call. That sounds eerily like a replay of 2002, when analysts called for heady 30% EPS gains in the latter half of the year. Compare that with reality: Third-quarter profit growth is looking more like 6.8%, and the estimates for the fourth quarter are hovering at 10%.
Yet another reason dampening optimism is that there's no obvious catalyst to drive sales. One potential drag on profits is, quite frankly, you. Yes, you, the consumer. Tobias Levkovich, chief investment strategist at Salomon Smith Barney, puts it succinctly: "Americans like stuff." Indeed, consumers like stuff so much they've continued buying it right through the recession (see This Tunnel Has an End). That kept things from getting worse but also means there's no pent-up demand--no throng of self-deprived shoppers waiting to set off a no-holds-barred spending spree and drive up company revenues along the way.
Meanwhile technology, the sector that led the last bull market and then brought it crashing down (and the sector that has led most of the recent bear-market rallies), has the potential to cause mischief in 2003. According to Levkovich, the current earnings forecasts have built in an "overly optimistic" 20% increase in profits for the beleaguered group. Considering the continued wariness over corporate IT spending, such an earnings spurt seems, well, premature. While tech bellwethers like Cisco, Microsoft, and IBM led the market's autumn rally, the upward move wasn't supported by a broad-based earnings recovery in the sector. In fact, in early November, Cisco CEO John Chambers warned that the networking company could see its first drop in sales in over a year.
To throw still more cold water on the current optimism about an earnings recovery, consider that the expected 11.7% improvement for the first quarter of 2003 is in relation to the same period in the previous year. Those quarterly profits, in the aftermath of Sept. 11, tanked 11.5%. What's more, even the current predictions for the start of '03 are lower than the last quarter of '02. So much for the mini-rally of sequential quarterly gains we've been seeing (1.4% in the second quarter of 2002, 6.8% in the third quarter, 12.9% projected for the fourth). That raises a critical question: "Are we really into a continued upward trend, or is the rally a false start?" asks Hill. "Was the recent upturn a blip in a downward trend, or will the expected pullback be the blip? Could we possibly head into a double dip?" (Okay, make that three critical questions.) No, the double dip isn't likely--at least according to all but the most negative of the bears. The other questions are dead-on.
But take heart. One reason for confusion over the profit outlook is a happy one: Amid all the negative economic indicators are signs of lessons learned--a development that in crashes past has produced healthier markets going forward. For instance, extensive cost-cutting measures have allowed companies to emerge from the recession leaner and in better fiscal shape, able now to make more money on less sales volume.
Then there's the fact that after two years of accounting scandals, the quality of corporate financial disclosure appears to be getting better. In May, Standard & Poor's announced that it would promote a more conservative measure of reported profits, called "core earnings," which includes the cost of stock options and penalizes profits for restructuring charges. While S&P chief strategist Sam Stovall can't yet forecast using this new model, he says GAAP earnings--based on a more rigid standard than the one analysts typically use--look to be trending upward. "It's a positive sign to see projected improvement using a technique that offers less freedom of accounting interpretation," says Stovall.
So what's the bottom line? The best guess is that this year will be a transitional period. Levkovich and other strategists think a 7% to 8% increase in profits is realistic, about half of the analysts' consensus. Sure, new scandals could arise, capital spending could evaporate, and we could have that four-peat of stock market losses everyone fears. But what are the odds of that?
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