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This Earnings Season, Watch Sales

William Hester, CFA
October 2009
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Earnings season moves into full swing during the next two weeks, when more than half of the companies in the S&P 500 will announce third-quarter results. The extent to which profits come in above or below expectations is typically a feature that has the spotlight to itself during the reporting season. That will change this quarter when investors' attention will also be focus on how frequently companies are meeting analyst's top-line sales estimates.

There are a few points on the topic of sales and surprises that investors may want to consider as the reporting season progresses. The first two points have received a fair amount of attention (and may not warrant it) and a third point that has received less attention (and might merit closer attention).

The current focus on revenues relative to expectations can be explained by the disappointing results of the last few quarters. Typically, a similar number of companies beat both sales and earnings expectations. The graph below shows the "beat rate" of both sales and earnings projections during the last few years, according to Bloomberg data. While earnings relative to expectations have come in at about the same beat rate as pre-recession quarters, the sales beat rate dropped by more than 20 percentage points during recent quarters. Even a year into the recession, analysts were caught thinking that this would be a typical slowdown where sales would basically hit a plateau, rather than contract. As for bottom-line earnings estimates, even though profits experienced their worst declines in 80 years, analysts were able to stay out in front of the declines, and ultimately lowered expectations prior to each reporting season, by enough for companies to maintain the typical earnings beat rate.

So the focus on third-quarter results will likely be shared between earnings surprises and sales surprises. The early results have been greeted well by investors, but the tendency for sales results to fall short of earnings is unchanged. Of the 40 S&P 500 companies that have reported earnings this month, 34 have delivered positive earnings surprises but only 27 have reported favorable sales surprises.

All of the attention focused on the surprises of either earnings or sales may be misplaced. And certainly investors should not become sanguine about the market just because the earnings beat rate is somewhat better. Though the beat rate has some effect on very short-term returns, there's not much correlation between earnings beat rates and stock-market performance, especially during the last few years. The graph below shows the earnings beat rate during the last few quarters along with the performance of the S&P 500.

When the S&P 500 was at 1500 and higher, the earnings beat rate was at the mid-60 percent level. When the S&P 500 fell to 800 and below, the earnings beat rate was at the mid-60 percent level. And if broader economic concerns resurface in the form of another leg down for the housing market, further unemployment pressures, or heightened credit concerns, it's unlikely that positive earnings surprises will provide support to the market at current levels of valuation.

The Decoupling of S&P 500 Earnings Expectations from US GDP

A number of my recent articles have focused on the aggressive expectations for earnings growth over the next couple of years in relation to expectations for economic growth. One argument that would help explain this projected divergence - and one that is gaining in popularity among investors - is that the companies in the S&P 500 have become more global in their businesses, and this exposure to foreign markets will boost earnings growth even in an anemic U.S. recovery. This explanation would alleviate the concern that earnings expectations were too high, and that markets were overvalued even on forward earnings (see: Forward Earnings Imply a Return To Near-Record Profit Margins ).

To judge the merits of this argument we need to estimate the sales and earnings that would be generated from countries that are expected to grow more quickly than the US. Based on consensus forecasts for worldwide growth, the number of those countries is small. The US economy may grow 2.4 percent in 2010 and by 2.8 percent in 2011 at a real rate, according to a Bloomberg survey. The Euro Area will grow by about 1 percent in 2010, according to economists. The European Commission expects the Euro area to grow at less than one half of one percent next year. Japan's economy is likely to expand at 1 percent in both 2010 and 2011. The UK economy may expand at 1.25 percent next year and 1.95 percent in 2011. Most of the large developed economies in the world are expected to grow more slowly during the next couple of years relative to the US economy.

Forecasts for developed markets offer more optimism. China is projected to grow 9.5 percent next year and by 9 percent in 2011. Brazil may grow at about 4 percent a year over the next two years in real terms. Indonesia may grow at 5.5 percent over that same period. So what role will revenues from developing markets play in boosting the revenues of companies in the S&P 500 Index?

Before proceeding, I need to stress that any figure for international sales should be considered an estimate. There are few conventions in how sales from outside the US are reported. Some companies disclose sales by region, some by continent, and some by country. The index group at S&P publishes a report each year with their estimate of international sales. They discard half of the companies in the index because the disclosure in these companies isn't sufficiently detailed. So, until reporting standards for global revenues are agreed upon, some amount of estimation is necessary to calculate international sales.

For S&P 500 companies taken together, about 28 percent of sales come from outside the US. That's up from about 24 percent three years ago (the 50 percent figure often quoted in the press is from S&P's smaller sample of companies that specifically represents large global companies, and therefore likely skews the number higher). It's important to keep in mind that the bulk of these international sales originate from developed markets. Only about 5 percent of total revenues come from developing markets, including most of Asia, Brazil, India, and from those areas that are reported broadly as 'Emerging' or 'Developing'.

This number likely doesn't capture the entire sensitivity to areas that are likely to grow faster than the US. There are sales that are not included in this number because of insufficient disclosure. Also, there are second-order effects - US companies may sell products to companies in other developed economies, which are used in the production of final goods that are sold to developing markets. A generous estimate might double the portion of sales that are sensitive to fast-growing countries, to 10 percent. This may be an overestimate, but it picks up the trend of S&P 500 earnings becoming more global and sensitive to developing economies.

Next year the S&P 500 revenue per share is expected to be $975 a share, with earnings of $75 a share. We'll apply an above-average profit margin of 8 percent the developing-market sales, because the technology group is somewhat over represented among these companies. This gives us $7.80 a share in earnings that are sensitive to developing economies ($975 * 10% * 8%) and would be subject to the benefits of potentially higher growth in those regions.

Now, $7.80 out of a total $75 of earnings is not immaterial, and it's a percentage that is likely to grow when the global economy eventually heals. But it turns out that the estimate of profit margins may end up playing a much more material role in whether S&P earnings meet or surpass expectations. Analysts are forecasting 7.6 percent profit margins next year, compared with a long-term average of less than 6 percent. If profit margins turn out to be a point lower, just 6.6 percent instead of 7.6 percent, then estimated earnings are almost $11 a share too high - $3 more than our estimate of the entire contribution of developing markets earnings. If profit margins come in at the long-term average, then forecasted operating earnings will be $16 a share too high, at least twice the entire contribution of developing markets to earnings. If we observe a tepid recovery of developed markets over the next couple of years, trends in profit margins will likely have the greatest influence in whether earnings reality meets expectations.

International Sales and Stock Performance

This doesn't make the role of international sales unimportant in the near term. Actually, the portion of sales that companies earn abroad has become an important 'theme' in the market. The graph below shows the ratio of the relative performance of two portfolios of stocks. The first portfolio (which represents the numerator in the ratio) is made up of the 50 stocks with the largest exposure to global markets. The second portfolio (which represents the denominator of the ratio) is a portfolio of stocks of companies with the highest share of domestic sales. A rising line implies the outperformance of stocks with a large percentage of global sales.

As the graph shows, companies with a large portion of global sales versus those with primarily domestic sales have outperformed impressively. This is partly being influenced by the rally in technology stocks, which make up an important share of the companies with the greatest global exposure. But it's also interpreted to mean that prospects are better elsewhere in the world.

That interpretation may be incorrect. The exchange value of the U.S. dollar is also playing an important role in the preference shown by investors for global companies. Even though currency translations tend to affect earnings by a very small amount at an index level, investors have responded strongly to currency fluctuations by rewarding or punishing companies with significant international sales. The correlation of dollar fluctuations and the relative performance of companies with a large portion of international sales isn't always as tight as it has been in recent years, but it tends to be the highest when the dollar is volatile, versus when it's trending.

As investing themes mature on Wall Street, they typically narrow. In the late 1990's, investors were first encouraged to own technology stocks, then internet stocks, then only those few dozen companies that were building out the infrastructure for the internet, until finally, investors were encouraged to buy just 4 stocks (A.K.A. The 4 Horsemen ). Although the theme of buying stocks based on rosier outlooks elsewhere may still be in its early days, it is narrowing. The graph below is again the ratio of the performance of two portfolios. The stocks in both of these portfolios all have a large percentage of sales that originate internationally. The first portfolio (which represents the numerator in the ratio) contains companies that have large exposure to developing countries. The second portfolio (which represents the denominator in the ratio) contains companies with a large portion of sales coming from developed European economies (which we'll use as a proxy for non-US developed economies). A rising line implies that companies with international sales coming from developing economies are outperforming those companies with international sales derived from developed economies.

The important indicators to watch this earnings season may not be the fundamentals, but rather the price action of companies with a large share of global sales. Beat rates - whether they are on the top or bottom lines - probably won't offer investors many clues to the inherent weakness or strength of the market. And favorable beat rates are unlikely to provide much support if larger concerns about the health of the financial sector or the consumer resurface. The portion of US companies' sales that come from faster growing regions of the world is still small, and subtle shifts in this portion are unlikely to make a material difference to index-level earnings.

Companies with a large share of global sales have outperformed other groups of stocks this year based on the uncertain prospects for the US economy, U.S. dollar weakness, and high hopes for a global economic recovery, spurred by developing economies. If investors begin to question the recovery, it will probably show up first in the performance of those stocks whose businesses are closely tied to fast growing areas. The price action of this group could provide more guidance to the risks in the market than near-term company fundamentals.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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