When Surprises Don't Surprise

7/16/2012


Worried that profit surprises have become the norm? Consider this: In every quarter since at least 2000, at least 51% of companies in the S&P 500 Index have topped consensus profit estimates.

In each of the four quarters from the second half of 2009 to the first half of 2010, more than 70% of S&P 500 companies exceeded the consensus. The number of companies posting profit surprises has declined since then, though the 66% beat rate for the March quarter still exceeded the average of 64% since 2000.

The table below highlights 14 serial surprisers, all A-rated stocks that have topped consensus profit estimates in four consecutive quarters. Of course, not all profit surprises are equal, as reflected by the spattering of price declines following earnings reports. Investors, conditioned by a company's history of big beats, can punish shares if the surprise falls short of heightened expectations. Revenue results and the company's outlook also drive price action.

Management's communication with shareholders prior to the quarterly report can have a substantial effect on stock prices as well. Thomson Reuters looked at 972 guidance announcements for S&P 500 companies over the past eight quarters. Those that guided higher and then beat the consensus averaged returns 0.4% above the broader market on the first trading day following the earnings report. Companies that guided in line with the consensus, then exceeded the target, saw excess returns of 1.9%. And those that warned and then topped the lower bar topped the market by just 0.2%, on average.

EARNINGS SURPRISES FOR S&P 1500 INDUSTRIES
In the March quarter, 61% of S&P 1500 Index stocks topped the consensus estimate. Percentages vary greatly from industry to industry.
% Of Cos. Exceeding
EPS Consensus
Avg. 3-Mo. Est.
--- EPS Revision ---
Avg. Est.
---- EPS Growth ----
Industry (No. Of Companies)
March
2012
Qtr.
(%)
Dec.
2011
Qtr.
(%)
Curr.
Qtr.
(%)
Curr.
Year
(%)
Curr.
Qtr.
(%)
Curr.
Year
(%)
Automobiles & Components (12)
33
58
(1.3)
0.2
3.6
5.1
Banks (83)
49
58
3.0
3.2
11.5
13.1
Capital Goods (142)
67
66
(2.8)
0.3
10.2
13.3
Commercial & Prof. Svcs. (50)
66
74
(4.6)
(2.3)
4.5
13.4
Cons. Durables & Apparel (57)
65
59
(0.7)
2.9
(0.9)
16.2
Consumer Services (60)
71
67
(2.4)
0.5
9.0
9.3
Diversified Financials (51)
44
59
(3.8)
(3.1)
(4.8)
8.3
Energy (91)
56
57
(12.1)
(10.0)
(3.5)
6.7
Food & Staples Retailing (15)
80
60
(2.1)
(0.6)
3.6
6.5
Food Beverage & Tobacco (50)
60
49
(3.3)
(0.9)
5.5
10.8
Health Care Equip. & Svcs. (104)
59
67
(3.3)
(1.2)
2.3
8.0
Household & Pers. Products (13)
58
42
(11.7)
(4.3)
3.6
5.5
Insurance (55)
69
57
(2.6)
2.2
10.8
17.3
Materials (96)
53
61
(7.3)
(2.1)
4.4
10.9
Media (30)
86
57
(2.7)
(0.8)
6.1
9.5
Drugs, Biotech & Life Sci. (51)
65
71
(3.4)
(2.2)
2.3
7.8
Real Estate (75)
64
52
(4.2)
0.0
9.7
10.5
Retailing (92)
67
65
(3.5)
(0.2)
7.9
14.2
Semiconductors & Equipment (63)
69
55
1.4
0.1
(17.3)
(10.3)
Software & Services (111)
57
69
(2.7)
0.9
8.7
10.6
Tech Hardware & Equip. (89)
69
58
(6.7)
(5.5)
(5.2)
0.0
Telecommunication Services (18)
22
24
2.2
(1.7)
(6.5)
(0.3)
Transportation (27)
56
70
(3.3)
2.2
16.9
19.4
Utilities (65)
45
65
(0.3)
(1.4)
(2.7)
0.6
S&P 1500 
61
61
(3.4)
(1.1)
3.9
9.0

In short, if management has already guided higher or lower, investors widely anticipate the companies will beat expectations; it comes as more of a surprise to investors when companies beat in-line guidance.

As we enter the June-quarter earnings season, a skittish economy could still undermine modest expectations. Procter & Gamble ($62; PG) and Bed Bath & Beyond ($61; BBBY) are among 94 companies in the S&P 500 that have issued profit warnings for the second quarter, up from 82 at this time in the first quarter. Just 26 companies have raised their guidance for the second quarter, so negative preannouncements outnumber the positive at a rate of 3.6-to-1 — the highest ratio since the September 2001 quarter. Total S&P 500 Index earnings are expected to show 6% year-to-year growth for the June quarter, down from projected growth of 9% at the beginning of April and 10% at the start of 2012. Eroding expectations for the financials, energy, and materials sectors account for much of the decline.

The latest round of warnings could add fuel to suspicions that more and more companies are lowering expectations so they can achieve the coveted beat come earnings time. That strategy appears more effective than missing the consensus after issuing in-line guidance. S&P 500 companies that warned, then beat the lower target, averaged a return 1.1% below that of the market. That return considers two days of trading — the days after the guidance and earnings announcements. In contrast, companies that guided in line, then missed the consensus, lagged by an average of 3.1%.

After 10 straight quarters of growth, S&P 500 companies' profit growth will likely slow unless a new catalyst emerges — whether it comes from the U.S. labor market, Europe's financial crisis, or elsewhere. Below we review three stocks with favorable growth outlooks and a history of topping profit estimates.

Alliance Data Systems ($135; ADS) has topped consensus profit estimates in five consecutive quarters. Shares rallied after each of those earnings reports. Revenue has also exceeded the consensus in nine of the past 10 quarters. Up 31% so far this year, the shares hover within 2% of their all-time high set earlier this month. Alliance offers direct-marketing services, customer-loyalty programs and private-label credit cards.

Analysts target earnings per share of $1.90 per share in the June quarter, implying 9% growth and contributing to a projected 12% profit gain for the full year. Results will be announced July 19. Favorable trends in the private-label credit-card business (46% of sales in the 12 months ended March, 63% of operating income) could lead to more upside in coming quarters. In the first five months of 2012, the balance for average receivables rose 12% from year-earlier levels, versus management expectations for high single-digit growth. At the same time, net-charge offs continue to dwindle. Scoring above 80 in both of our sector-specific ranks, Alliance is a Focus List Buy and a Long-Term Buy.


EMC ($24; EMC) shares have dipped 15% since the end of April, hurt by profit warnings from rivals and concerns that businesses are tightening their purse strings. But EMC's 2012 consensus profit estimate has held up so far, and the company has a track record for managing expectations, topping the consensus in 15 of the last 16 quarters. EMC has registered double-digit sales growth for nine consecutive quarters. A maker of data-storage products, EMC is leveraged to the shift toward cloud computing.

Free cash flow surged 52% to $5.43 billion in the 12 months ended March. Net of debt, EMC holds cash of $4.72 billion, or $2.14 per share, more than double the balance a year earlier. Although management says it will eventually add a dividend, for now EMC focuses on niche acquisitions and share buybacks. It may be an opportunistic time for buybacks, considering shares trade at 15 times trailing earnings, a 37% discount to their five-year average. EMC, scheduled to post results July 24, is a Buy and a Long-Term Buy.


UnitedHealth Group's ($56; UNH) annual sales have risen between 5% and 8% in each of the last five years. Consensus estimates project 8% revenue growth this year and next year. The insurer's steady growth is supported by exposure to long-term favorable demographic trends and a string of contract wins, most recently a new Kansas Medicaid award. Split evenly among the three bidders, the Kansas contract covers 340,000 members and is worth about $2.6 billion annually over at least two years.

UnitedHealth has exceeded consensus profit estimates by more than 4% in four straight quarters, as medical utilization rates lingered near historic lows. Utilization trends remained "moderate" in the March quarter, said UnitedHealth, unlike some rivals that experienced an uptick. Analysts are ratcheting up 2013 sales and earnings-per-share targets, and the stock earns a Quadrix Earnings Estimates score of 90. As for the June quarter (results expected July 19), Wall Street targets 8% higher revenue and 3% growth in per-share earnings. With both sector-specific ranks exceeding 95, UnitedHealth is a Buy and a Long-Term Buy.


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