Will the Third Quarter Live Up to Expectations?

• By Jeremy Glaser
• On 7:00 am EDT, Tuesday October 6, 2009

Third-quarter earning season kicks off in earnest this week as the first wave of companies report results. After steadily rising stock prices throughout the quarter and improving macro-economic trends, expectations are high. But can this quarter live up to the positive surprises investors saw in the second quarter?

The outperformance in the second quarter was likely caused by multiple factors. The first is simply that the economy improved much faster than anyone had expected. After the doom-and-gloom predications of the previous six months, it was difficult to even imagine what an economy that was in the process of bottoming out instead of in free-fall would look like. As the possibility of the second Great Depression ebbed, inventory levels proved to be unsustainable low and consumers finally began to buy again. This produced an unexpected jolt of demand.

Secondly, because management teams didn't know when the economy was going to stabilize, many cut costs to the bone. These sharp reductions boosted second-quarter profitability despite generally anemic revenue numbers. Finally, it seems that many management teams low-balled guidance as they were unsure how sustainable the budding recovery would be. There was little upside to raising guidance, only to have the economy collapse again.

So how is the third quarter stacking up? The broader economy did better in the third quarter than in the second. Looking at manufacturing, housing, and jobs data, it appears that the recession ended in the last three months. By no means was there evidence of robust growth, but the painful contraction seems to be behind us.

However, unlike the second quarter, these improvements were mostly anticipated by the market and have mostly been priced into shares. In fact, our team of equity analysts currently believes that the market as a whole is almost exactly fairly valued.

Cost-cutting may also not be as big of a boost this quarter. Although almost all businesses are still keenly focused on costs, there is only so much that can be cut without destroying the company. We'd expect fewer bottom line surprises in the quarter.

Finally, management teams have been relatively bullish. Several firms, including tech stalwart Intel (NasdaqGS:INTC - News), have raised guidance for the third quarter, and others have been more bullish from the start.

Given these higher expectations, it is unlikely we will see the kind of upside surprises that marked second-quarter earnings. There will undoubtedly be firms that smash expectations, but it seems just as likely we'll see many firms miss. Given the runup in stocks, we wouldn't be shocked to see the market take a turn down if earnings don't back up the thesis that the recovery has a solid footing. Management's expectation for the fourth quarter and 2010 could also play an important role. Are firms generally expecting a robust recovery, or we are looking at an extended period of sluggish growth?

Earnings on Tap
Tuesday, Oct. 6
We're expecting weak top-line results from restaurant operator YUM Brands (NYSE:YUM - News), but easing commodity prices and other cost controls should drive solid profitability.

Wednesday, Oct. 7
Stabilizing aluminum prices and the addition of a low-cost bauxite mine should narrow third-quarter losses for Alcoa (NYSE:AA - News), which reports after the market closes.

Family Dollar (NYSE:FDO - News) saw same-store sales increase 1% in the quarter as the firm lapped strong comps. Still, the company is stealing share away from full-price retail outlets.

Near-term Roundup-related worries will probably continue to dominate Monsanto's (NYSE:MON - News) earnings.

Thursday, Oct. 8
We'll get a glimpse into the strength of consumer leisure spending as both International Speedway (NasdaqGS:ISCA - News) and Marriott International (NYSE:MAR - News) report results.

PepsiCo's (NYSE:PEP - News) snack business could have received a boost from at-home consumption in the third quarter.

Click here for our complete earnings calendar.

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