What is common between DuPont (DD), UPS (UPS), 3M (MMM), Whirlpool (WHR) and United Technology (UTX)? They all reported results this morning, and the one thing common in those reports is what’s happening on the revenue lines in each case – revenue came short of expectations by varying degrees and was lower than in the same period last year.
The reason behind this widespread top-line weakness shouldn’t come as a surprise to anyone. After all, revenue growth is a function of (nominal) GDP growth. And as we all know, lack of economic growth has emerged as a worldwide phenomenon. The consensus expectation of 1.9% U.S. GDP growth in the third quarter (the report comes out this Friday) makes it at the top of the growth league tables among the world's developed economies.
This may not be much growth to brag about, but this is better than what’s happening in Europe and many other parts of the world, including the emerging markets (the ‘cleanest dirty shirt’ analogy for the U.S. economy may not be so off the mark). Companies with a predominantly domestic business orientation are overall doing somewhat better this earnings season. The stronger-looking numbers this morning from Whirlpool and Coach (COH) are mostly due to domestic strength.
But with about 40% of the average S&P 500 member company’s revenues coming from beyond the U.S. shores, the worldwide economic weakness is having a bearing. With sales growth difficult to come by given this weak global economic backdrop, the only other way companies can increase their profits is by expanding their margins, which basically means to 'squeeze' more profits from the same amount of sales. But that's hard to do at this stage as margins have already reached the prior cyclical peak and at best will remain stable.
We are seeing both of these trends at play in the 141 S&P 500 reports we have seen thus far (as of Tuesday morning, October 23rd). We have plenty of earnings reports still to come, but I will be surprised if the trend set by these 141 companies will materially change. Total earnings for these 141 companies are down 1.7% from the same period last year, while earnings for the remaining 359 companies are expected to show a decline of 2.3%.
But lack of growth aside, positive surprises are also at their lowest level in a while. Of the companies that have already reported results, only 55.3% have beaten earnings expectations. In the second quarter of 2012, which was by no means strong either, we had 66.7% of these same companies come out with positive earnings surprises, while the 'beat ratio' for these same companies has averaged 70.9% over the last four quarters. On the revenue side, only 33.3% of the companies have come ahead of expectations, which compares to a 38.1% 'beat ratio' for the same group in the second quarter.
The sub-par third quarter earnings performance is at odds with expectations for a strong earnings growth in the fourth quarter and beyond. Please note that earnings are expected to increase 7% in the fourth quarter and in excess of 11% in 2013. I have been of the view that consensus expectations of a turnaround in earnings in the fourth quarter and beyond were overly optimistic. I am getting more convinced of that view given how the third quarter reporting season has progressed thus far.
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