Above the noise: EPS is like red lipstick,it creates a false glow

Before the present earnings season we highlighted several times that it was likely to produce disappointment, even more than conventional wisdom would have it on Wall Street. A few of our remarks ahead of earnings season are repeated below.

The risk picture looks gloomy for the rest of the year. We see four major events that could spark this correction in stocks, 1) the Spanish bailout, 2) debt restructuring in Greece, 3) disappointing earnings season, and 4) the US fiscal cliff...

Another factor that plays into our view of a disappointing earnings season and correction in stocks is the economic conditions in China. FedEx’s CEO Fred Smith is spot on when he says that analysts are completely underestimating the effects of the slower exports on the overall China economy. The continued slowdown in China’s exports (see figure 3) is worrisome and it will likely spill into the earnings season to many analysts’ surprise. (October 3, 2012 - Above the noise: Stock correction is imminent, perhaps up to 10%)

FedEx's comments adds to the earnings season risk picture. We know China has slowed, but FedEx emphasises that it will continue, and given their insight into global trade their word is more trustworthy than most other sources.

The slowdown is likely to impact the coming quarters negatively and we have thus become slightly more pessimistic on the coming earnings seasons. And no, it will not be an EPS disappointment as this figure always lags due to the accrual principles in accounting. Yet sales and cash flows, which management has less discretionary control over, may very well disappoint and that is the crucial part. (September 19, 2012 - Above the noise: What FedEx tells us about China - and vice versa)

Earnings per share: The emperor without clothes

As we have been saying, the Q3 earnings season would likely be disappointing measured on sales and especially cash flow due to the nature of accrual accounting which gives a certain lag to the earnings numbers. However despite the obvious flaws of focusing on earnings per share (EPS) if one's goal is to gauge the health of corporates, this is exactly what Wall Street does every earnings season with the help of the media of course. 

Before moving on let us shortly linger on one EPS flaw. If a company has made USD 90 million in net income compared to 100 million the year before most investors would take it as a sign of deteriorating business conditions. However if the company on the management's sole discretion has bought back 1 million shares so outstanding shares have fallen to 9 from 10 million then EPS is unchanged at USD 10 per share, sending a completely different signal about the business. What should be obvious here is that the tunnel vision of EPS is like red lipstick, creating a false glow about the underlying "business".

Earnings season: Cash flow is down 9 percent from a year ago

Coming back to the present earnings season, slightly below a third of the companies in the S&P 500 have reported earnings, and the quick facts are sales and EPS have surprised by 42 and 69 percent respectively. Not bad, but not uncork-the-champagne material either. As hinted above, the EPS figures are surprisingly strong despite the evident slowdown around the world.

Taking a look at the aggregate figures in the S&P 500. The sales figures stack up to a more or less unchanged level from a year ago, together with net income. The striking change is cash flow from operations that shows business conditions have deteriorated in sync with survey and hard figures for the last 3-4 months. The 8.7 percent change in cash flow from operations does not sound like much, but given sales and net income are unchanged, the change is likely driven by significant changes in net working capital, which may signal tightening credit conditions for global companies.

Sectors: Information technology sees declining sales, net income and margins

Turning our attention to aggregate numbers on sector level, some interesting signs emerge. In terms of sales, financials and materials have been hit the hardest which is not a surprise given their link to the business cycle. The previous growth engine in information technology has come to a halt, with an aggregate decline in sales. The best performing sectors on sales have been the defensive ones such as consumer staples, health care and telecommunications, not taking into account the energy sector (driven by higher energy prices) which is this season's winner so far on sales.

Measured by net income, materials and information technology are among the worst performers. Surprisingly enough, the energy sector has seen decline in profits, but given the small number of releases it might be due to some one-time items.

When looking at profit margins, the financial sector has seen the best improvement, with around 1.5 percentage point change in margin. Again information technology is among the worst performers, and margins in the sector are being squeezed.