ETN Eaton Corp New

Third quarter earnings results are pouring in.  So far I would characterize the season as good, but not great. We have 126, or 25.2%, of the S&P 500 firms reporting so far. That sort of understates things a bit, since those 25.2% of firms represent 39% of all expected earnings for the quarter (provided that the remaining 374 firms all report exactly in line with expectations).

The year-over-year growth rate for the S&P 500 is 12.13%. That is actually well above the 3.33% growth that those same 126 firms posted in the second quarter. However, the second quarter was distorted by some big hits to the financial sector, most notably Bank of America (BAC). This time it reported better-than-expected earnings and did not have the big “write off” it did in the second quarter. That resulted in a $12 billion swing in total net income between the second and third quarters.

If we exclude the financial sector, the year-over-year growth rate is just a bit higher at 13.51%, but it represents a far bigger slowdown from the second quarter, when growth was 22.71%. The remaining 374 stocks are expected to growth their earnings 12.33% over last year, down from 22.71% growth in the second quarter. If we exclude the financials, the remaining growth in the third quarter is expected to slow to 11.99% year over year from 17.99%. Then again, at the beginning of earnings second quarter season, growth of 9.7% was expected; 12.2% ex-financials.

We will need another season where positive earnings surprises far outpace disappointments if we are going to match the second quarter growth rate. If we combine the already reported results with the expectations, it now looks like the final growth will come in at 12.25%.

Better than Expected

Relative to expectations, both earnings and revenues are doing better than expected. Then again, having far more companies report positive surprises than disappointments is entirely normal. The current ratio of 2.65 (for the 126) is actually well below the average experience of the last five years or so. The median surprise is 2.78% and that is also below normal. Still, it is far more positive surprises than disappointments.

Top-line surprises started off extremely strong, but faded over the last week. The surprise ratio is now 2.00 for revenues with a 1.12 median surprise. Not bad, but not terrific either. Top line growth so far has been 8.37%, and 8.83% ex-financials. The remaining 374 firms are collectively expected to grow their top lines by 7.20%, or by 10.28% if we exclude the financials.

Expanding net margins have been one of the keys to earnings growth. That is still the case, with reported net margins of 13.40% so far, up from 12.95% a year ago, and 12.27% in the second quarter (for those 126 firms). However, the mix of firms that have reported so far is skewed towards higher-margin firms, and the BAC effect is very big as far as the increase relative to the second quarter is concerned. Excluding financials, net margins have come in at 9.99% up from 9.58% a year ago, but down from 10.45% in the second quarter.

Looking ahead, overall net margins are expected to be down only slightly from the second quarter at 7.97% versus 8.00% in the second quarter, but up from 7.61% a year ago. Excluding the financials, though, it looks like the expanding net margin party might be coming to an end, with only 7.17% expected, down from both the 7.94% level of the second quarter, and 7.59% a year ago.

On an annual basis, net margins continue to march northward.  In 2008, overall net margins were just 5.88%, rising to 6.33% in 2009. They hit 8.57% in 2010 and are expected to continue climbing to 9.28% in 2011 and 9.84% in 2012. The pattern is a bit different, particularly during the recession, if the financials are excluded, as margins fell from 7.78% in 2008 to 6.99% in 2009, but have started a robust recovery and rose to 8.18% in 2010. They are expected to rise to 8.82% in 2011 and 9.12% in 2012.

The expectations for the full year are very healthy, with total net income for 2010 rising to $793.6 billion in 2010, up from $543.4 billion in 2009.  In 2011, the total net income for the S&P 500 should be $907.0 billion, or increases of 46.0% and 14.3%, respectively. The expectation is for 2012 to have total net income passing the $1 Trillion mark to $1.015 Trillion, for growth of 11.9%.

S&P "EPS" to Surpass $100

That will also put the “EPS” for the S&P 500 over the $100 “per share” level for the first time at $106.43. That is up from $56.98 for 2009, $83.25 for 2010, and $95.10 for 2011. In an environment where the 10-year T-note is yielding 2.19%, a P/E of 14.6x based on 2010 and 12.8x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is just 11.4x.

Estimate revisions activity is starting to rise again. We have seen a little bit of a bounce in the ratio of upwards to downwards revisions, especially for this year, but it is still far from turning positive. To some extent, there is a mechanical reason for upwards revisions to this year. After all, the third quarter is part of the full year, so if a company beats by, say, a nickel, and the analysts don’t increase their estimates for the firms by at least that much, they are implicitly cutting their numbers for the fourth quarter. With more than five positive surprises for every disappointment, one should expect more upwards revisions than cuts.

Even so, the ratio is still deep in negative territory at just 0.61, although that figure still includes a lot of estimate changes that were made before the earnings reports came in (we track a four week moving total). There is no mechanical effect when it comes to the revisions for next year, and those remain even further in negative territory at just 0.36, or almost three cuts for every increase.

The net cuts are very widespread. For this year only five of 16 sectors are seeing more positive than negative revisions, and eight sectors have more than two cuts for every increase. For next year, every single sector has more cuts than increases, and cuts out number increases by more than three to one in nine sectors. As the principal argument in the bulls favor is the high level of corporate earnings, and the low valuations relative to them, this trend needs to reverse -- and soon.

I would look for those companies with solid dividends and for which the analysts are still raising their estimates for next year, and which are rated either #1 or #2 on the Zacks Rank.  Some of the names that meet those criteria are DuPont (DD), Eaton (ETN) and PPG Industries (PPG) and Phillip Morris (MO).
 
BANK OF AMER CP (BAC): Free Stock Analysis Report
 
DU PONT (EI) DE (DD): Free Stock Analysis Report
 
EATON CORP (ETN): Free Stock Analysis Report
 
PPG INDS INC (PPG): Free Stock Analysis Report
 
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