Barron's Cover

SATURDAY, AUGUST 17, 2013

Beware Falling Profit Estimates

By JACK HOUGH

This market is more richly valued than you think, but opportunities still exist. Five stocks that look attractive, three to avoid.

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Jonathan Carlson for Barron's
 

Despite high expectations for earnings growth at the start of the year, U.S. companies delivered only ho-hum results for the second quarter, and estimates for the current quarter are plummeting. Downward revisions of fourth-quarter estimates can't be far behind.

That's not to say that this market is going to crash, last week's 2% drop notwithstanding. But stocks aren't as cheap as they look, either.

It's a familiar Wall Street waltz. Analysts start out with rosy projections for distant quarters; companies gracefully guide expectations lower as the year unfolds; and both sides end up with easily beatable numbers come reporting time. In 29 of the past 37 years, estimates have started too high, according to Morgan Stanley. The Standard & Poor's 500 has handily racked up compounded yearly returns of more than 11% during that period.

The next round of estimate cutting may not go smoothly. Stock valuations have swelled, making the stakes higher for companies that fail to produce healthy growth.

Opportunities for easy earnings gains through cost-cutting have shrunk. There's evidence that more companies are falling back on a bad habit: using accounting adjustments to earnings to beat estimates. The numbers suggest that stocks, up 13% a year on average over the past four years, could slow from here. Cautious investors should avoid sectors that look particularly prone to near-term estimates cuts, like consumer discretionary and telecom, while favoring sectors on safer ground, like technology and health care. A search for promising companies yielded five stocks, including drug maker Pfizer (ticker: PFE), industrial manufacturer Danaher (DHR), and wireless chip maker Qualcomm (QCOM). Three to avoid are jeweler Tiffany (TIF), industrial gas producer Praxair (PX), and home builder Lennar (LEN).

During the second quarter, companies in the S&P 500 grew earnings by 2.1% on a 1.8% rise in revenues, compared with the second quarter of 2012, based on the 93% of companies that have reported results, according to FactSet. Meanwhile, rising demand for stocks has pushed the index 18% higher over the past year. That means shares have gotten more expensive relative to earnings.

The index trades at 14.2 times earnings forecasts for the next four quarters, up from 12.6 a year ago. That's on par with the 14.2 average of the past decade. But it's based on projections that look too ambitious.

The consensus estimate on Wall Street assumes that earnings growth will accelerate to 3.9% in the third quarter, and more than double, to 10.5%, in the fourth. The third-quarter estimate has already been slashed by more than a third since the end of June, but the fourth-quarter forecast has barely budged from 11.9%.

Recent earnings gains have come largely from revenue growth with only a smidgen of margin improvement. That suggests that after five years of aggressive cost-cutting, companies are finding it more difficult to squeeze extra earnings out of each sales dollar. Among nonfinancials in the S&P 500, operating profit margins are 13.6%, higher than the historical average of 12.1%, according to Bank of America Merrill Lynch. For the third quarter, companies are projected to increase their revenues by 2.8%, making a 3.9% earnings gain seem feasible, if not a sure thing.

 
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The fourth quarter is a different story. Sales are expected to grow only 0.6%, making a double-digit jump look suspiciously high.

"Where's that margin growth going to come from? More layoffs? Productivity gains? Most of us aren't exactly napping on the job as it is," says Howard Silverblatt, chief index analyst at S&P.

"Second-half forecasts look very optimistic. So does 2014." For the first two quarters of next year, published forecasts show continued strong earnings growth of 6.8% and 11.1%. Replace those numbers with more realistic assumptions, and the stock market appears pricier.

Assume, for example, that earnings growth will indeed quicken but will average 5% over the next four quarters. That would push the valuation of the S&P 500 to 15.3 times forward earnings, just about where it was when the market peaked in October 2007.

OTHER SIGNS DO LITTLE to suggest rising earnings momentum. As usual, most companies beat earnings forecasts in the second quarter, but the average size of the beat, 2.4%, was less than the four-year average of 7%, according to FactSet. Financials drove all of the earnings growth and then some during the quarter; ignore them and earnings were down about 3% from a year ago. Among 92 companies in the S&P 500 that have issued third-quarter guidance, 82% have guided lower, versus a five-year average of 62%. And companies that miss forecasts are seeing bigger declines in their shares than usual, according to BofA.

There's also the matter of just what constitutes earnings. Companies must report them based on generally accepted accounting principles, but they're free to also report non-GAAP earnings that exclude one-time expenses. Wall Street typically focuses its forecasts on these non-GAAP numbers.

Managers have some discretion is deciding whether, say, the cost to close a store or lay off some workers is one-time in nature or a regular part of business. They appear to be making such judgments opportunistically; companies are more likely to meet or beat earnings forecasts when their non-GAAP earnings exceed their GAAP ones, according to a paper published in July in the Journal of Accounting and Economics by Mark Soliman at the University of Southern California, Jeffrey Doyle at Utah State University, and Jared Jenning at Washington University in St. Louis.

THIS DOESN'T MEAN that the market's long bull run is over. Bond yields have picked up on hints the Federal Reserve will end its program of buying bonds to suppress interest rates, but they remain low by historical standards. The 10-year Treasury yields 2.8%, up more than a percentage point from the start of May, but well below its half-century average of 6.7%. Low bond yields make stocks more attractive by comparison. And cash-stuffed companies are devoting record sums to dividends and share repurchases. Add the two together and the result is a 4.6% payout to shareholders, higher than the yield on investment-grade corporate bonds, according to a recent analysis by JPMorgan.

Meanwhile, rising home and investment-account values bode well for consumer spending. Household debt and delinquencies are down. Even Europe is coming around. Gross domestic product in the 17-nation euro zone expanded at an annualized pace of 1.1% in the second quarter, according to data released this past week, ending six straight quarters of contraction.

As for already high profit margins, BofA thinks they are due less to a short-term economic upswing than a long-term decline in company borrowing costs and tax rates, as companies earn more overseas. Since those conditions won't soon change, margins should remain high, and perhaps push a touch higher, the firm says.

ONE WAY FOR INVESTORS to avoid having their portfolios hit by tumbling estimates is to favor sectors where earnings gains look reasonable relative to revenue growth. For example, technology firms are expected to increase their earnings by 6.3% in the fourth quarter on a 4.5% rise in revenues. That's achievable at a time when the shift to cloud-based computing is driving down costs, although the sector isn't immune to stumbles. Cisco Systems (CSCO) shares tumbled 7% on Thursday after the company edged past Wall Street forecasts but announced plans to lay off 5% of its workforce.

Health-care targets look relatively achievable, too, with earnings seen rising 5% in the fourth quarter on 2.7% revenue growth. But growth numbers alone don't always tell the whole story. Adam Parker, chief U.S. equity strategist at Morgan Stanley, favors technology and health care but also industrials, which are seen growing fourth-quarter earnings by a whopping 17.6% on a 2.6% rise in revenues.

The reason: A large portion of manufacturer costs are fixed in the form of plant and equipment. That gives them high incremental margins -- the ability to turn small revenue increases into large earnings gains as they operate closer to full capacity.

On the other hand, expectations for consumer-discretionary companies like department stores and restaurants; materials producers like steel makers; and telecoms seem too high.

For telecoms, fourth-quarter growth estimates are skewed higher by AT&T's (T) massive charge last year for pension costs and Hurricane Sandy damage. But Wall Street is predicting a strong start to next year, too -- 11.4% earnings growth in the first quarter. Yet subscriber growth for wireless carriers has stalled, except at T-Mobile, which is taking market share by undercutting on price. That's not a backdrop for a big rise in industry margins. Financials are a wild card. Their earnings-growth forecasts are off the charts but are also in keeping with recent reported growth, as banks rebound from a stretch of depressed profitability.

Stockpickers can reduce risk by holding companies with reasonable valuations. One of the best predictors of future returns is high free cash relative to a company's stock-market value, says Morgan Stanley's Parker. Free cash, a simple tally of the cash companies clear each quarter, rather than the paper profits they record, offers a side benefit for investors. It's less subject than non-GAAP earnings to those discretionary tweaks by managers.

An analysis performed for Barron's by Morgan Stanley scored companies by free cash yield as well as incremental margin analysis, a look at the likelihood of companies turning new revenues into projected earnings gains. It produced five good bets.

PFIZER REPORTED LOWER REVENUE and earnings last quarter due to generic competition for blockbuster drugs like Lipitor for cholesterol, but the worst of the company's patent expirations are over. As drugs in late-stage development come to market, earnings should rise an average of 7% a year through the end of the decade on 1% yearly revenue gains, predicts JPMorgan analyst Chris Schott. The company says it plans to split the fast-growth portion of its drug business from slower-growing ones in a restructuring. That could earn it a higher valuation, because at 12 times next year's earnings forecast, it now trades roughly in line with slow growers like Merck (MRK) rather than fast growers like Bristol-Myers Squibb (BMY), at 21 times earnings. Pfizer shares, which closed on Friday at $28.37, carry a dividend yield of 3.4%.

Danaher makes a wide range of machines and equipment for clinical research, packaging, water treatment, and more. Its playbook involves using free cash flow to make frequent acquisitions, and then applying lean manufacturing techniques to drive margins higher in the new businesses. Earnings per share are expected to rise 6% this year on a 4% increase in revenue. The company's reputation as a steady earner makes its shares popular; they go for 18 times next year's earnings, based on Friday's price of $66.73. But the earnings forecast understates the amount of cash the company is generating. Shares trade at less than 15 times next year's projected free cash.

Lear (LEA) makes seating and electrical systems for cars and light trucks. Car production has rebounded strongly in the U.S. but is only beginning to show improvement in Europe. Lear is growing faster than the market.

Last quarter, its revenue rose 12% on only a 3% increase in global production. The company appears to be gaining market share in seating, while increased computerization of cars means the electrical content is rising. At $70.88, the shares go for 10 times next year's earnings forecast.



Unlike the broad market, Oracle (ORCL) and Qualcomm have seen their earnings grow faster than their share prices of late. Both look attractively priced. Qualcomm is the dominant supplier of broadband wireless technology, particularly for high-end smartphones. Wall Street expects average selling prices for phones to fall slightly next year, but Qualcomm may benefit from an iPhone launch this fall and gains with fast-growing handset makers in emerging markets. At $66.90, shares go for under 14 times forward earnings. Oracle sells software and hardware to help companies manage data.

The industry is shifting from locally installed systems to cloud-based ones, and Oracle has rolled out its own cloud offerings. Its customers face high costs to switch vendors, which bodes well for keeping them.

Oracle recently signed deals with cloud rivals Microsoft (MSFT) and Salesforce.com (CRM), suggesting its systems remain an industry standard. Shares closed on Friday at $32.41. They trade at 11 times earnings.

ICONIC JEWELER Tiffany, meanwhile, has been enjoying fast growth overseas, but its shares look expensive at 20 times next year's earnings -- and that figure assumes its earnings growth rate will jump next year. Praxair is the world's third-largest industrial gas supplier. Wall Street expects its earnings growth to rise from 7% this year to 13% next year. Even with such a pickup, shares already trade at 18 times next year's earnings.

Home builder Lennar is just the kind of land-rich home builder to benefit from the housing recovery, and its recent results have been strong. But rising mortgage rates, home inventories, and labor and materials costs suggest the recovery may downshift into a slower phase. Lennar's earnings are currently projected to rocket 32% higher on similar revenue growth in its next fiscal year
 

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