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Earnings Aren’t as Good as They Seem
04/29/2011 9:00 am EST
Companies are reporting stellar results. But drill down into the numbers and you find those companies benefiting from temporary tax breaks and facing climbing costs. Stock pickers need to be extra-choosy.
So far, it's been a troubling US earnings season.
Surprised I'd say that? You might well be—80% of the companies in the S&P 500 that have reported first-quarter 2011 earnings have come in above Wall Street projections. (That's on the heels of the 72% of companies in the fourth quarter of 2010, and the 76% in the third quarter.)
Many companies from all over the economy have not just beaten expectations, but blown them out of the water.
Cummins (CMI), a maker of truck engines, reported earnings 31 cents a share above Wall Street estimates. That's 22% above Wall Street projections. Apple (AAPL) beat projections by $1.03 a share, or 19%. Timken (TKR), a maker of ball bearings and other specialty steel products, beat projections by 31%.
So What's the Problem?
To see it, you have to look not just at the numbers for this quarter, but at how companies achieved those numbers. You have to study trends for things like the cost of goods sold. Let me demonstrate with some very concrete examples.
On April 27, Whirlpool (WHR), the world's biggest appliance maker, reported earnings of $2.17 a share. Wall Street analysts had expected just $1.16. So where did this 87% earnings surprise come from?
Not out of revenue. Revenue for the quarter climbed by just 3%.
Not out of operating income. Operating income actually declined to $221 million for the quarter, from $287 million in the first quarter of 2010.
How about out of the tax code?
The company received a net income tax benefit of $24 million in the first quarter of 2011, up from $3 million in the first quarter of 2010. The company received more in energy tax credits—renewed as part of the lame-duck Congress’ December budget deal—than it had expected.
For 2011, the company expects to receive from $300 million to $350 million in energy tax credits. That's up from the $300 million the company estimated in February.
But investors should be asking what happens after 2011, since the energy tax credit was extended only for a year in December 2010, and is proving considerably more expensive than Congress had initially projected. (Although maybe since it's a "tax benefit" rather than "spending," it will survive the budget cuts looming for fiscal 2012.)
Whirlpool, in fact, has had a negative effective income-tax rate for 2010, 2009, and 2008. In 2010, for example, the company reported a negative tax rate of 10.9% and a tax benefit of $64 million.
Nice money, if you can get it. And Whirlpool certainly isn't the only company to get it. For example, General Electric (GE) got a tax benefit of $3.2 billion in 2010, and recorded a profit of $14.2 billion.
NEXT: Tax Breaks Are Lifting Profits|pagebreak|
Tax Breaks Are Lifting Profits
But I'd argue that a tax-related boost to earnings isn't as valuable to investors as an increase in operating profit.
The boost from taxes is dependent on the hard work of lobbyists and the vagaries of Washington politics—and to the ups and downs of the business cycle. (Taxes go down when companies apply the losses from a recession to the profits made during the early part of a recovery.)
I've seen a lot of earnings reports so far this quarter that noted a lower-than-expected tax rate. Intel (INTC), to take another example, reported a tax rate of 27.7% in the first quarter, against a consensus projection of 29%.
I really don't want to depend on those lower rates for earnings growth through the rest of 2011, or in 2012.
The other problem that I'm seeing in this quarter's earnings comes from companies reporting that they expect higher energy and raw material costs in the rest of 2011.
Higher costs are nothing new this quarter—they've been going up for a while. But what I'm seeing in this quarter's earnings reports is new admissions that companies are going to have to start passing on these costs to customers, by raising prices.
And that introduces new uncertainty about how higher prices might lower sales growth.
Higher Prices Coming
For example, Coca-Cola (KO) missed Wall Street estimates of 87 cents a share by a penny when it reported on April 26. That's not bad, given the rising cost of commodities, such as sugar, that the company had seen during the quarter.
Coke ran a very smart hedging operation in the quarter, if I can judge from the earnings report, which produced a penny-a-share gain that will be included in future quarters.
The problem came in the conference call. The company admitted that, because of rising commodity prices, it probably wouldn't be able to hold the line on its beverage prices later this year. It said it would probably have to raise prices by 3% to 4% for some brands, while for others it would keep the same price but reduce bottle size.
McDonald's (MCD) said essentially the same thing in its April 21 conference call. In the first quarter, the US basket of goods that the company uses to track costs climbed by about 1%. That kind of moderate increase in prices won't last, though, McDonald's said.
For all of 2011, the company is expecting a cost increase of 4% to 4.5%, with greater pressure in the second and third quarters. The 4% to 4.5% range is an increase from the company's estimate of a 2% to 2.5% cost increase that McDonald’s issued in its December quarterly-earnings report.
One likely consequence, the company said, is an increase in prices. (I'm sure glad that Ben Bernanke and the Fed still think there's no inflation in the United States.)
Of course, the problem isn't limited to food companies. In its earnings report, Union Pacific (UNP) said higher fuel prices had cut 8 cents a share off of first-quarter earnings.
The company paid an average of $2.88 a gallon for diesel fuel in the period. That was up 33% from the first quarter of 2010.
Trucking company Arkansas Best (ABFS) reported a first-quarter 2011 loss of 51 cents a share. That was partly the result of fuel costs that rose so quickly in the last weeks of the quarter that the company's fuel surcharges couldn't keep up.
Do I need to tell you that shippers of all kinds are raising their fuel fees? There's no telling, however, whether those charges will be able to keep up with fuel prices, or whether they may convince some customers to slow their traffic.
NEXT: Just What We Need—More Uncertainty|pagebreak|
Just What We Need—More Uncertainty
I'd describe what I'm seeing in first-quarter earnings reports at many companies as an erosion of earnings quality and an increase in earnings uncertainty.
Not for all companies. If you look at the first-quarter earnings report for Cummins, the numbers are rock solid, and uncertainty actually has fallen from the fourth quarter of 2010. (For my take on Cummins' earnings report, see this post.)
The overall effect, however, is a narrowing of the number of companies that I see delivering better-than-expected earnings numbers and first-rate earnings quality.
Technical analysts look to various measures of market breadth to answer these questions about the health of a rally. For example, it's a sign of increasing strength if advancing stocks outnumber declining stocks. And it's an even better sign if the ratio of advancing stocks to declining stocks is climbing.
Or to take another instance, it's a good sign if the number of stocks hitting new 52-week highs exceeds the number hitting new 52-week lows. (Just for the record, the technical analysts I read report that the advance/decline line, which tracks the ratio of advancing to declining stocks, shows that the market still leans bullish.)
Caution: The Market Is Narrowing
What I'm describing in my take on first-quarter earnings is a kind of fundamental version of those breadth indicators. And right now what I'm seeing are signs that breadth is narrowing. That's probably the big story of the current first-quarter earnings season so far.
The narrowing of fundamental breadth isn't so rapid that it threatens the bullish momentum in the US market—at least not as long as the Federal Reserve can engineer historically low interest rates. But investors should pay attention to this narrowing, and it should guide your selection of individual stocks and sectors.
If you pay attention to the falling quality and rising uncertainty of this quarter's earnings numbers, you find fewer companies to invest in. But that isn't a bad thing at this point in the rally. It will increase the quality of your portfolio, lower your risk, and make you more cautious in general.
That's a good attitude to have as we head into the uncertainties of a summer that will see the Fed end its QE2 program of buying Treasuries, increasing prospects for slowing US growth, and greater worries over inflation.
Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Cummins and Timken as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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