Q3 Earnings Growth Expected To Be 5.9% (Up From 4.4% Last Week)

Earnings Season Forever Changed By Regulation FD

Earnings season is mostly done, so it’s fair to say this was a great reporting period. Usually I only have the stats on the percentage of firms beating estimates in the past 4 years. The chart below gives us more data to look at to further contextualize the beat rate. First, notice how since Regulation FD was passed, the beat rates have expanded. Before that set of rules, earnings season had misses and beats on the bottom line. Now it’s almost always beats. It’s amazing to see that even in 2008, more than half of firms beat results. It’s why you need to look at the historical trend of estimates to get a full picture of how firms are doing.

Regulation FD promotes fair disclosure so news comes out at the same time for everyone. Companies used to be able to meet with investors to discuss non-public information to get the investors to understand the narrative the company wants to promote. Now that it’s up to the marketplace to decide how the quarter was, firms try to make sure earnings beat estimates to make themselves look good. It’s not always that easy as the stocks of firms which beat estimates don’t always rise. There’s more to evaluating a business than just looking at if the EPS number beat expectations because they can be manipulated. Firms can utilize buybacks to boost EPS to report the number needed. They also get expectations lowered to make a bad result look good like putting lipstick on a pig.

The manipulation of estimates and the use of buybacks to get EPS to beat estimates doesn’t work well for revenues, making topline growth a better representation of the truth. As you can see from the chart below, the revenue results were more impacted by changes in the economy than EPS results. It’s not always sunny skies as recessions and moderate slowdowns have caused revenues to miss estimates. Now that I made the point about how earnings and revenue surprises work, look at the latest quarter’s results. As you can see from the chart above, the earnings beat rate was the 5th best this expansion as 74% of S&P 500 firms beat estimates. The revenue beat rate was 57% which is tied for the highest beat rate since Q1 2011.

Q4 Estimates Fall Much Less Than Usual

Now let’s look at some of the latest results from FactSet and S&P Dow Jones to get a more detailed look at the results. Because Q3 was affected by hurricanes, I went into the reporting period with the goal of understanding how Q4 would look. If the weakness in Q3 was caused by the weather, the estimates for Q4 wouldn’t be cut much. If the weakness was caused by the economy, Q4 estimates would be cut sharply. As you can see from the chart below, the Q4 estimates have been cut 0.8% which is tied for the lowest cut percentage since Q2 2014. 2017 is a repeat of 2014 which is great news because that was the previous peak in earnings. This chart shows that Q3 earnings would have been great like the past two quarters if it wasn’t for hurricane related weakness. Q4 earnings are expected to grow 10.4%. This validates the great stock performance we’ve seen in the past month as the S&P 500 is up 1.82% in that period.

According to FactSet, earnings growth in Q3 was expected to be 3.0% on September 30th and now it’s on pace to be 5.9%. That’s a big increase from last week which had the blended result at 4.4%. With 81% of firms reporting earnings, the surprise percentage is 4.8% which is above the 5 year average of 4.2%. The revenue surprise percentage is 1.2% which is above the 5 year average of 0.5%. The full year 2017 earnings expectations jumped to $131.58 because of these great results.

Looking at the S&P Dow Jones numbers, with 408 of 505 firms reporting results, operating margins are expected to be 10.25%. That’s 11 basis points above the record last quarter. While tech can boost margins in a secular fashion, I still think revenue growth is the main cog that will need to push earnings higher because margins are at their record. As a comparison to the FactSet results, S&P Dow Jones has 2017 bottom up operating earnings at $125.25 and as reported results at $114.32. That puts the current 2017 earnings multiple at 22.68 which isn’t extremely high, but is above the long term average.

Will This Growth Last Into 2018?

The two factors which will start to mitigate earnings growth in the second half of 2018 will be the tougher comparisons energy will have and the end of the currency tailwind. Q4 2017 and Q1 2018 will have the most favorable impact from the dollar, but after that the tailwind is less prominent. Energy had 20.06% growth in year over year sales in Q3. Q4 comparisons will be the last easy ones for the sector. As you can see, the currency impact and the energy comps are part of the reason why Q4 is looking so bright. However, reality isn’t as bright as these results will indicate just like it’s not as gloomy as the 5.9% growth in Q3 indicates. Also, keep in mind that my prognostication for the second half of 2018 can be completely wrong if the dollar furthers its decline and oil prices spike. In fact, oil had a 3.09% rally on Monday, so this isn’t out of the question. The price per barrel is now $57.34.

Conclusion

Even with Regulation FD making most earnings growth reports beat EPS estimates, this still was a great quarter as 75% of S&P 500 firms beat results. That’s above the average this cycle which is 69%. Furthermore, the growth in Q4 looks good as the estimates only fell 0.8%. The great results in Q4 will be driven by energy improvements, currency tailwinds, and the improving economy. The economy will be the only positive factor which is likely sustainable into the 2nd half of 2018.

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