us earnings rise- real or imaginary?

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    2-interesting reads below , make of it what you will;

    US reporting earnings higher than forecast

    Hmmm, there’s something odd going on… The top-down data are suggesting that corporate America should have struggled in the March quarter, yet firms are actually reporting earnings significantly higher than forecast. Last week saw a weaker-than-expected GDP report for the quarter – although from a corporate perspective the important number is nominal, not real, growth, and that wasn’t as far from forecasts because prices rose faster than expected.

    But the bigger (negative) surprise was overnight: a much faster-than-expected rise in employment costs. Using GDP as a proxy for sales, top-line growth was roughly 4¼% at an annual rate in the quarter (1½% real plus a 2½% price rise), but labour costs increased by 5% (5½% rise in hourly labour costs partly offset by a ½% fall in hours worked). As labour is easily corporate America’s largest cost, this suggests that operating margins probably fell in the quarter. So how do we reconcile that top-down fact with the good bottom-up earnings?

    The first point to note is that the quarter-to-quarter correlation between the top-down numbers and earnings is not a 100% tight. This isn’t, however, a major concern: over time the correlations are strong, and in any case the top-down data have been saying that margins were falling through most of last year anyway (the December quarter was the exception). The second way to reconcile the two results is to remember that the bottom-up numbers have been affected by accounting changes – the new rules regarding good-will have probably boosted the IBES earnings base by 10% through the past year.

    In other words, earnings on a consistently-defined base have probably barely grown at all over the past year. Thirdly, the IBES data continue to over-state earnings because they are based on companies’ pro-forma numbers – that is, earnings excluding what-ever-the-company-damn-well-wants-to-exclude. Typically pro-forma earnings exclude restructuring charges and there is the on-going problem with misleading accounting of pension costs. In contrast, the labour cost data reported overnight seem to have been boosted by redundancy and pension charges – as they should be.

    Fourth, the top-down numbers are pre-tax; reported after-tax earnings will grow faster than pre-tax earnings this year as last year’s inflated depreciation charges fall. All these factors suggests that the reported bottom-up earnings aren’t actually that flash: if not for accounting changes, exclusions, mis-accounting for pension costs, and favourable tax changes, earnings are probably falling – which is what the top-down data hint at. Oh, and there’s one final reason why companies may be beating expectations: analysts took too big a knife to their estimates late last year.

    This is similar to what happened after 11 September, leading analysts (unusually) to go through an upgrade phase in early 2002. We could see a similar thing now, but it says more about the over-reaction of analysts rather than any major improvement in corporate America’s fundamentals. I’m marketing in NZ for the next couple of days. Kieran will do the note and I’ll be back on Monday.
    Who needed the war to end?

    Who needed the war to end? Wall Street is rallying on the back of what has become an excellent March quarter reporting season. Through the past week the proportion of companies reporting surprises has comfortably exceeded the usual reporting season average – and, as importantly, there have been far fewer lemons than usual: according to First Call, only 4% of companies have reported earnings 5% or more below forecasts, compared to the usual 10%.

    The bottom line is that by the end of last week, the earnings of the 329 S&P500 companies that had reported were running 6.8% above forecast, compared to the usual surprise margin of 2.7%. Three sectors have led the way with surprises: technology (earnings are running 16% above year ago levels, compared to 10% expected at the start of the month – a 6% surprise); consumer cyclicals (18% up on year ago levels, a 9% surprise); and materials (2% up on year ago, a 9% surprise).

    In other words, it has been the cyclically-sensitive sectors that have surprised – something all the more unexpected given last week’s disappointing March quarter GDP report. What can we make of all this? The first point is wait to see how the rest of the reporting season goes: in particular, this week sees most of the major retailers report, and that could take the edge off the aggregate figures.

    As First Call’s Chuck Hill wryly noted, despite the strength in the housing sector, it’s not clear what new home-owners are putting in their homes given the downgrades from all the major appliance makers (Whirlpool, Maytag and Electrolux). Secondly, it seems that a weaker US$ was a major help to companies with offshore-sourced earnings, particularly European earnings. That was evident last night with stronger-than-expected earnings from McDonald’s and Procter & Gamble: without the dollar’s fall McDonald’s sales would have risen by 1%, rather than 5.6% reported; Procter & Gamble’s sales would have been up 5% rather than the 8% actually reported.

    Thirdly, as the name suggests, the cyclical sectors have benefited from the improvement in sales evident compared to the very tough year-before period. Sales growth for the technology sector is now 2% yoy – weak, but well above the 13% sales decline reported in the year to March 2002. That 15% acceleration was bested only by materials (a 12% sales rise in the latest quarter compared to an 8% decline a year earlier) and the energy sector.

    Finally, corporate America is benefiting from cost cuts: topline growth is expected to be 5.3%, versus a likely earnings improvement of 11.7% or so. But remember a few things about all this. Firstly, much of the reported earnings improvement is fudge: the changed accounting treatment of goodwill, as well as reduced reported depreciation. Secondly, if consumer spending weakens it is likely to be in areas particularly detrimental to the cyclical sectors. Finally, costs are unlikely to be as controllable in coming quarters as productivity growth slows. In short, we don’t expect the goods trends to last.

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