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Monday, August 14, 2006

Reflecting on Earnings & What To Expect Going Further In Terms of Earnings Trends

By Yaser Anwar, CSC of Equity Investment Advisors

For the 2nd Q of 2006, S&P 500 companies enjoyed record profits, which climbed by more than 10% for the 12th consecutive quarter - matching the longest streak since 1950.

The MidEast conflict, volatile energy prices, and choppy jobs and retail sales reports, weaker than expected GDP growth and higher than expected inflation numbers have investors biting their nails and holding their cash. In short as the “E” has been moving up, the PE has been moving down, leaving the “P” basically unchanged

Earnings for American firms shot up by an average of 19% on the back of energy producers, which, "bolstered by record oil prices, regained their standing as the fastest-growing industry group."

I'm seeing sub-par growth from both tech & consumer discretionary. Investors should note that Consumer Staples, a safe haven in cyclical downturns, comes in last in terms of median earnings growth. However, the sector has started to show some upward momentum in its estimate revisions. We wouldn’t expect he group to leap to the head of the growth charts anytime soon, but the news is not all dismal in the sector.

"Oil and gas companies reported a 45% increase on average, the largest among the index's 10 main industry groups," the news service reported. "Earnings at Marathon Oil Corp., the fourth-largest U.S. energy company, and Valero Energy Corp., the country's biggest refiner, more than doubled. Crude-oil futures averaged $70.72 a barrel in the quarter, 33% higher than a year earlier." That marked Valero's largest quarterly profit ever, annihilating Wall Street's predictions.

The AP reported that "San Antonio-based Valero said today its net income after paying preferred dividends grew to $1.9 billion, or $2.98 per share, for the three months ended June 30 from $843 million, or $1.53 per share, a year ago."

Valero's CEO Bill Klesse said in a statement that slower growth in refining capacity - coupled with more exacting fuel specifications and continued demand growth - should ensure a tight supply-and-demand balance for the foreseeable future.

"The company said third-quarter earnings will come in above latest-quarter results and 'substantially higher' than the current average analyst estimate of $2.44 per share."

As the energy juggernaut rakes in record profits, that success may be taking its toll on other industries.

The differential between the earnings yield of the S&P 500 and the yield on the U.S. Ten-year Treasury Note is high enough that private equity investors will privatize publicly traded companies which is good news for mid-cap stocks. Corporate balance sheets continue to maintain record amounts of cash and many large companies are actively pursuing stock buybacks effectively boosting earnings per share by reducing the shares outstanding.

"The consumer discretionary group, which includes retailers, homebuilders and automakers, had the worst performance in the S&P 500. Earnings rose 4.3% on average, with about 71% of 86 companies reporting."

The median firm in the S&P SmallCap 600 index should report year over year earnings growth of 9.1% in the second quarter of 2006. The median firm in the S&P 500 is currently only expected to report 8.1% year over year earnings growth in the second quarter.

Although small-cap stocks are no longer trading at a discount to large-cap stocks based on forward PE multiples, small-cap stocks continue to grow earnings at a faster rate and on a growth adjusted basis small-cap stocks remain more attractive than large-cap stocks.

On balance, analysts are continuing to raise earnings estimates. Over the last month, a total of 648 estimates for fiscal year 2006 were raised and only 520 were cut (a ratio of 1.25). For fiscal year 2007, 538 estimates were raised versus 447 cuts (a ratio of 1.20). These ratios are a bullish sign for the market.

As one analyst tells the news service, the higher oil prices and continued rising interest rates "both have been a broad and regressive tax on consumers.''

Profit margins as a % of GDP should come back down as the economy go through mid-cycle slowdowns. Historically, corporate profits have been one of the first variables of adjustments in economic cycles.

Sources: Zacks, Bloomberg & AP

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