Zacks Earning Trends

Transcription

1 July 25, 2013 Zacks Earning Trends Sheraz Mian Weak Earnings Growth Outside Finance The Finance sector gave the 2013 Q2 earnings season a flying start, but the sector s momentum came as no surprise as estimate revisions activity in the run up to the reporting season indicated a strong showing from the sector. The sector s actual performance has turned out to be even better relative to pre-season expectations. The fact is that the strength in Finance sector results is helping hide broad earnings weakness elsewhere. Total earnings for the 240 S&P 500 companies that have reported Q2 results, as of Thursday July 25 th, are up +4.1% from the same period last year, with 65.8% beating earnings expectations with a median surprise of +2.6%. Total revenues for these companies are up +3.8%, with 45.4% beating revenue expectations with a median surprise of +0.4%. Not to make light of Finance s strength, but a big part of the bank earnings growth is due to loan loss reserve releases and not from loan growth. Reserve releases are a net positive as they reflect improving credit quality, but they don t constitute the sector s core earnings power. That said, the earnings growth picture outside of Finance is very weak. Expectations for the coming quarters represent a material acceleration in the total earnings growth pace, as the chart below shows. Source: Zacks Data

2 lot of the second-half growth is expected to come from sectors outside of Finance, as the chart below of ex-finance growth expectations shows. Source: Zacks Data My sense is that estimates need to come down in a big way. The market hasn t cared much in the recent past about negative revisions as aggregate earnings estimates have been coming down for over a year now. But if we are entering a post-qe world, as I believe we are, then it will likely be difficult to overlook negative earnings estimate revisions going forward. How the market responds to negative guidance and the resulting negative revisions will tell us a lot about what to expect going forward. Key Points» Total earnings for the 240 S&P 500 companies that have reported results are up +4.1%, with 65.8% beating earnings expectations. Revenues for these companies are up +3.8%, with a revenue beat ratio of 45.4%.» The earnings growth rate is better than what this same group of companies reported in recent quarters, the revenue growth rate is about in-line with recent history, while the beat ratios, particularly on the earnings side, is a bit weaker.» Finance results have been very strong, with total earnings for the companies that have reported results up an impressive +31.9%. Excluding Finance, total earnings for the remainder of S&P 500 companies that have reported would be down -2.8% from the year-earlier period. 2

3 » Finance reclaims its leadership role in the S&P 500, contributing more earnings to the index s total than Technology this year for the first time since the 2008 crisis. The sector is expected to account for 19.2% of total S&P 500 earnings in 2013 compared to Technology s 18%.» Technology earnings remain weak, with total earnings for the 78.5% of the sector s market cap that have reported results down -11.3% on +1.6% higher revenues.» The composite total earnings for Q2 (combining the results for the 240 companies with the 260 still to come) are expected to increase +2.3% on +0.5% higher revenues. Excluding the Finance, total earnings for the rest of the S&P 500 would be down -2.9% on +0.2% higher revenues.» Estimates for the second half of the year still reflect strong growth, with total earnings in the second half expected to increase by +7.4% after the +2.4% increase in the first half. Total earnings are expected to be up 6.1% in 2013 and +11.2% in 2014.» While there is not much growth, the overall level of total earnings is quite high. Total earnings in Q2 are on track to reach a new all-time record, surpassing the preceding quarter s record level. 3

4 Record Earnings in Q2, But No Growth The Finance sector gave the 2013 Q2 earnings season a flying start, but the sector s momentum came as no surprise as estimate revisions activity in the run up to the reporting season indicated a strong showing from the sector. The sector s actual performance has turned out to be even better relative to pre-season expectations. The fact is that the strength in Finance sector results is helping hide broad earnings weakness elsewhere. s of Thursday, July 25 th, we have Q2 earnings reports from 240 S&P 500 companies or 48% of the index s total membership that combined account for 56.6% of the index s total market capitalization. s such, we have a fairly representative sample of reports from which to start drawing conclusions about this earnings season. Total earnings for these 240 S&P 500 companies are up +4.1% from the same period last year, with 65.8% beating earnings expectations with a median surprise of +2.6%. Total revenues for these companies are up +3.8%, with 45.4% beating revenue expectations with a median surprise of +0.4%. Here is the Scorecard for the 240 S&P 500 companies that have reported already, with the first two columns of the table showing the ratio of each sector s total number of companies and total market capitalization that have already reported. 4

5 Scorecard % Reported Q2 Earnings Q2 Revenue Total Companies Total Market Cap Growth YoY Beat Ratio Median Surp. % Growth YoY Beat Ratio Median Surp. % Cons. Staples 47.1% 61.5% 2.2% 43.8% % 18.8% -0.5 Cons. Discretionary 35.5% 21.4% 13.3% 72.7% % 45.5% 0.0 Retail/Wholesale 39.6% 40.2% 8.7% 36.8% % 36.8% 0.0 Medical 51.1% 49.2% 1.9% 70.8% % 29.2% 0.0 utos 70.0% 82.3% 16.3% 100.0% % 42.9% 0.0 Basic Materials 60.9% 70.7% -8.4% 50.0% % 35.7% 0.0 Industrial Products 54.2% 54.9% -13.4% 69.2% % 46.2% 0.0 Construction 36.4% 38.2% 52.7% 50.0% % 25.0% 0.0 Conglomerates 75.0% 95.5% -1.5% 83.3% % 16.7% -0.8 Technology 54.4% 78.5% -11.3% 75.7% % 64.9% 0.7 erospace 100.0% 100.0% 12.4% 75.0% % 50.0% 1.1 Oil/Energy 38.1% 21.9% -14.5% 56.3% % 62.5% 0.0 Finance 53.8% 62.6% 31.9% 76.2% % 64.3% 0.9 Utilities 13.5% 43.7% 0% 40.0% % 20.0% 0.0 Transportation 80.0% 93.7% 3.6% 62.5% % 25.0% -0.4 Business Services 47.6% 58.0% 10.8% 70.0% % 30.0% -0.3 S&P % 56.6% 4.1% 65.8% % 45.4% 0.4 ex Finance 46.9% 55.3% -2.8% 63.6% N/ 4.6% 41.4% 0.0 Source: Zacks Investment Research, Inc. Data as of: 7/25/13 3:33 PM s you can see in the Scorecard, 10 of the 16 Zacks sectors have more than half of the sector s total market capitalization already reported results. The Q2 reporting season has ended for erospace (a small sector with only 8 companies), with 78.5% and 62.6% of the respective market capitalizations for even the Technology and Finance sectors in the already reported column. The sectors with most results still awaited are Consumer Discretionary, Retail, Energy, Utilities, and Construction. Finance s growth numbers have been better relative to pre-season expectations, with total earnings up +31.9% on +9.7% higher revenues. Not to make light of Finance s strength, but a big part of the bank earnings growth is due to loan loss reserve releases and not from loan growth. Reserve releases are a net positive as they reflect improving credit quality, but they don t constitute the sector s earnings power. But as the ex-finance line at the bottom of the Scorecard table shows, the growth picture outside of Finance is very different. 5

6 Technology, the other big sector within the index, tells the story of what is happening outside Finance. With results from sector leaders like pple, Google, Microsoft, Intel, IBM, Yahoo, Oracle and others already out, we know for sure that the sector s earnings picture is very poor. Total earnings for the 78.5% of the sector s market capitalization that have reported already are down -11.3% on +1.6% higher revenues. Corporate spending on Technology worldwide remains weak and the picture may not change materially going forward either if the global economic outlook doesn t improve. Unlike the Finance sector, which has a predominantly domestic orientation, Technology is a global phenomenon and corporate spending trends need to pick up worldwide to improve the sector s earnings prospects. Basic Materials and Industrials are other sectors heavily exposed to the negative crosscurrents in the global economy, particularly the emerging markets. Total earnings for the Basic Materials sector are down -8.4% on -2.1% lower revenues, with only 50% of the companies beating earnings expectation and 35.7% beating revenue estimates. Notwithstanding the extremely weak results from Caterpillar, results in the Industrials sector have been modestly better in terms of surprises compared to Basic Materials, but not by much. Total earnings for the sector, however, are down -13.4% on -3.3% lower revenues, with beat ratios of 69.2% for earnings and 46.2% for revenues. Q2 Results Compared The earnings growth rate from these 240 companies compares favorably with what we saw from these same companies in 2013 Q1 and the four-quarter average, while the revenue growth rate is roughly in-line with what we saw in recent quarters. But as the table below shows, a big driver of the positive earnings performance is Finance. Strip out Finance and the growth picture becomes weaker than what we saw in Q1. The table below compares the earnings and revenue growth performance for these 81 companies with what these same companies reported in Q1 and the average of the preceding four quarters. 6

7 Growth (YoY) Earnings Revenue % Reported 13 verage 13 verage Cons. Staples 47.1% 2.2% 4.6% 2.6% 1.8% 1.7% 1.2% Cons. Discretionary 35.5% 13.3% 33.7% 7.8% 2.5% 0.9% 2.1% Retail/Wholesale 39.6% 8.7% 8.9% 3.9% 7.5% 6.9% 6.7% Medical 51.1% 1.9% 3.0% 1.4% 4.1% 10.7% 4.3% utos 70.0% 16.3% -20.9% -16.4% 5.4% 1.8% 0.0% Basic Materials 60.9% -8.4% 0.0% -11.5% -2.1% -1.4% -3.5% Industrial Products 54.2% -13.4% -16.7% 1.2% -3.3% -5.0% 1.1% Construction 36.4% 52.7% 154.3% 114.4% 24.2% 22.1% 18.2% Conglomerates 75.0% -1.5% 5.7% 5.4% 1.7% 2.9% 2.7% Technology 54.4% -11.3% -4.8% 2.6% 1.6% 6.2% 8.0% erospace 100.0% 12.4% 16.3% 0.2% 1.9% -2.7% 1.7% Oil/Energy 38.1% -14.5% -4.7% -2.5% 2.7% -0.3% 4.2% Finance 53.8% 31.9% 8.8% 24.0% 9.7% 4.2% 3.9% Utilities 13.5% -0.1% 4.9% -30.1% 3.1% 1.9% 2.0% Transportation 80.0% 3.6% 3.4% 4.4% 2.2% 2.3% 2.2% Business Services 47.6% 10.8% 11.7% 10.8% 0.0% 3.8% 3.0% S&P % 4.1% 2.1% 3.6% 3.8% 3.4% 3.5% ex Finance 46.9% -2.8% 0.1% -0.3% 4.6% 3.3% 3.4% Source: Zacks Investment Research, Inc. Data as of: 7/25/13 3:44 PM The revenue beat ratio started off weak for the revenue side, but appears to have recovered a bit. The earnings beat ratio remains within long-term historical ranges, but is nevertheless a bit on the soft side, particularly outside Finance. 7

8 Beat Ratio Earnings Revenue % Reported 13 verage 13 verage Cons. Staples 47.1% 43.8% 81.3% 76.6% 18.8% 37.5% 42.2% Cons. Discretionary 35.5% 72.7% 90.9% 79.5% 45.5% 54.5% 43.2% Retail/Wholesale 39.6% 36.8% 57.9% 53.9% 36.8% 26.3% 31.6% Medical 51.1% 70.8% 58.3% 68.8% 29.2% 33.3% 45.8% utos 70.0% 100.0% 57.1% 57.1% 42.9% 57.1% 46.4% Basic Materials 60.9% 50.0% 71.4% 44.6% 35.7% 28.6% 32.1% Industrial Products 54.2% 69.2% 61.5% 71.2% 46.2% 7.7% 28.8% Construction 36.4% 50.0% 100.0% 93.8% 25.0% 50.0% 43.8% Conglomerates 75.0% 83.3% 33.3% 54.2% 16.7% 16.7% 25.0% Technology 54.4% 75.7% 67.6% 67.6% 64.9% 51.4% 54.7% erospace 100.0% 75.0% 100.0% 87.5% 50.0% 75.0% 59.4% Oil/Energy 38.1% 56.3% 56.3% 54.7% 62.5% 56.3% 56.3% Finance 53.8% 76.2% 76.2% 69.6% 64.3% 45.2% 56.0% Utilities 13.5% 40.0% 60.0% 55.0% 20.0% 60.0% 45.0% Transportation 80.0% 62.5% 87.5% 75.0% 25.0% 37.5% 37.5% Business Services 47.6% 70.0% 50.0% 67.5% 30.0% 40.0% 40.0% S&P % 65.8% 68.8% 66.6% 45.4% 41.7% 45.8% ex Finance 46.9% 63.6% 67.2% 65.9% 41.4% 40.9% 43.7% Source: Zacks Investment Research, Inc. Data as of: 7/25/13 3:47 PM The Composite Picture: Reported + Still To Come Table 1 below provides the composite or blended picture, combining results from 240 companies that have reported already with the 260 that have still to report numbers. The way to look at the composite growth rate for the quarter is that if the rest of the companies report as currently expected, then total earnings would be up +2.3% on +0.5% higher revenues and 27 basis points wider margins. 8

9 Year-over-Year Growth Earnings Revenue Margins Cons. Staples -0.5% 1.8% 1.9% -0.9% -0.52% -0.31% Cons. Discretionary 11.6% 14.0% 5.9% 4.6% -0.03% 0.76% Retail/Wholesale 5.7% 7.9% 4.3% 1.7% 0.32% 0.06% Medical -3.3% 4.3% 2.6% 13.2% -0.82% -1.86% utos 10.9% -20.6% 4.5% 0.3% 0.06% -1.57% Basic Materials -11.2% -1.8% -1.5% -2.1% 1.17% -1.78% Industrial Products -7.2% -7.7% -0.2% -0.5% -0.16% -0.16% Construction 48.5% 105.2% 9.5% 13.9% 0.40% 2.05% Conglomerates 0.5% 0.4% -0.5% 0.1% 0.52% 0.77% Technology -10.1% -4.3% 0.5% 3.0% -0.02% -1.97% erospace 12.4% 16.3% 1.9% -2.7% 0.66% 0.43% Oil/Energy -8.2% -1.0% -10.4% -6.3% -0.09% -0.87% Finance 28.9% 7.6% 1.9% -8.7% 2.46% 8.67% Utilities -0.6% 8.9% 4.1% 3.9% -1.53% -0.75% Transportation 3.6% 3.3% 2.9% 3.1% 1.09% 1.00% Business Services 6.6% 9.7% 1.0% 3.1% 0.50% 1.43% S&P % 2.5% 0.5% -0.2% 0.27% 0.45% ex Finance -2.9% 1.3% 0.2% 1.1% -0.04% -0.62% Source: Zacks Investment Research, Inc. Data as of: 7/25/13 3:56 PM Here are a couple of quick takeaways from looking at the data above. There is not much earnings growth outside of the Finance sector. Excluding Finance, total earnings are expected to be down -2.9%, with 7 of the 16 Zacks sectors showing negative earnings growth. Finance has had a solid Q2 earnings season thus far and the momentum is expected to carry through the rest of the sector s results in the coming days. Total composite earnings for the sector are expected to be up an impressive +28.9%, with all the key industries within the sector like major banks, insurance, and brokers/money managers generating strong growth. On current trends, the sector is on track to surpass its previous quarterly record of total earnings achieved in 2013 Q1. The Technology sector was weak last quarter and remains on track for an even weaker showing this time around, with total earnings for the sector expected to be down -10.1% on +0.5% higher revenues. Had Technology not been such a drag on growth, total earnings for the S&P 500 would be up +9.6% in Q2 and +4.6% in Q1. The sector s 9

10 weakness is broad-based, with modestly positive growth for the software industry (33% of the sector s total earnings) more than offset by weakness for the hardware makers (43% of the sector s total earnings) and semi-conductors (9% of the total). mong other growth laggards, Industrials (-7.2%) and Basic Materials (-11.2%) are joined by the Medical sector in Q2, with total earnings for the sector expected to be down -3.3%. Within the Medical sector, the weakness is primarily in the pharmaceutical industry which accounts for roughly two-thirds of the sector s total earnings. Tough comparisons at Pfizer, Merck, bbot and others tell the pharmaceutical industry s earnings growth challenge. The Context for Growth Expectations Let s take a look at how consensus earnings expectations for 2013 Q2 compare to what companies earned in the last few quarters and what they are expected to earn the rest of this year. Table 2 below presents the year over year earnings growth rates - expectations for Q2 and the final two quarters of the year. It also shows consensus earnings growth expectations for 2013 and Table 3 presents the same data for revenues. Table 2 Earnings Growth Context Earnings Growth (YoY) 14E 4Q 3Q 13 4Q 12 nnual 20 nnual 2014E Cons. Staples 5.4% 5.6% 2.3% -0.5% 1.8% 4.4% 6.4% 9.4% Cons. Discretionary 13.8% 16.2% 5.4% 11.6% 14.0% 2.1% 12.9% 15.9% Retail/Wholesale 22.9% -9.6% 16.7% 5.7% 7.9% 6.6% 9.4% 15.5% Medical 1.0% 1.2% -3.6% -3.3% 4.3% 3.0% -0.2% 8.8% utos 19.1% 25.0% 0.3% 10.9% -20.6% 5.2% 4.2% 21.2% Basic Materials 14.2% 14.9% 3.7% -11.2% -1.8% 13.2% 3.9% 19.6% Industrial Products 6.5% 22.0% 4.6% -7.2% -7.7% -8.4% 3.3% 12.4% Construction 18.4% 4.9% 22.7% 48.5% 105.2% 90.7% 39.5% 23.7% Conglomerates 0.0% 10.9% 4.7% 0.5% 0.4% 8.6% 5.4% 10.9% Technology 5.7% 4.0% 1.0% -10.1% -4.3% 1.9% 1.6% 11.5% erospace -5.1% 10.6% 0.6% 12.4% 16.3% -14.2% 9.1% 4.8% Oil/Energy 3.6% 0.2% 1.2% -8.2% -1.0% 5.8% -0.1% 9.5% Finance 4.1% 28.7% 7.4% 28.9% 7.6% 10.0% 15.6% 9.4% Utilities 5.5% 125.1% 5.1% -0.6% 8.9% -50.0% 4.9% 7.1% Transportation 14.5% 12.8% 11.2% 3.6% 3.3% -0.7% 10.4% 15.8% Business Services 17.5% 15.5% 10.7% 6.6% 9.7% 9.3% 12.1% 13.3% S&P % 11.0% 4.0% 2.3% 2.5% 2.5% 6.1% 11.2% ex Finance 7.4% 7.5% 3.2% -2.9% 1.3% 1.1% 4.0% 11.6% Source: Zacks Investment Research, Inc. 10

11 s is typically the case each quarter, estimates for 2013 Q2 came down in the run up to the start of the reporting season, but has started going back up as actual reports have through. Unlike Q2 estimates, expectations for the back half of the year have largely held up thus far, but will likely start trending down in the coming days in the coming days given the underwhelming Q3 guidance on Q2 earnings calls thus far. Table 3 Revenue Growth Context 14E 4Q Revenue Growth (YoY) 3Q 13 Cons. Staples -7.3% -7.1% -10.6% 1.9% -0.9% 4Q 12 nnual 20 nnual 2014E - 1.0% -7.7% 4.0% Cons. Discretionary 4.1% 6.1% 4.9% 5.9% 4.6% 0.0% 5.1% 5.5% Retail/Wholesale 11.8% -3.0% 5.3% 4.3% 1.7% 5.3% 3.3% 6.8% Medical 4.7% 1.6% 4.3% 2.6% 13.2% 0.0% 3.9% 5.0% utos 2.9% 2.5% 4.2% 4.5% 0.3% 0.0% 2.1% 5.4% Basic Materials -14.2% -1.5% 1.2% -1.5% -2.1% 0.0% 18.2% 4.5% Industrial Products -5.5% 6.9% 3.1% -0.2% -0.5% 0.0% 2.0% 4.4% Construction 10.7% 10.0% 10.8% 9.5% 13.9% 0.0% 11.3% 11.8% Conglomerates -44.2% 1.7% 0.0% -0.5% 0.1% 0.0% -0.2% 4.5% Technology 2.5% 2.5% 1.4% 0.5% 3.0% 0.0% 2.1% 5.4% erospace 3.6% -2.1% 0.2% 1.9% -2.7% 0.0% 3.6% 1.7% Oil/Energy -5.5% -9.6% -5.3% -10.4% -6.3% 0.0% -7.2% 1.2% Finance 4.2% -14.4% -6.0% 1.9% -8.7% 0.0% -16.9% 3.4% Utilities -4.5% 3.9% 5.5% 4.1% 3.9% 0.0% 5.1% 3.0% Transportation 5.7% 5.0% 4.6% 2.9% 3.1% 0.0% 4.2% 6.1% Business Services 3.8% 3.2% 1.0% 1.0% 3.1% 0.0% 2.4% 5.4% S&P % -3.1% 0.3% 0.5% -0.2% 0.9% -1.0% 4.5% ex Finance -0.2% -1.3% 1.2% 0.2% 1.1% 1.0% 1.3% 4.6% Source: Zacks Investment Research, Inc. The next two tables present the same data in a different format instead of year-overyear growth rates, we have the dollar level of total earnings and revenues for each of these quarters. What this tells us is that while quarterly earnings totals reached an all-time record in 2013 Q1 and remain on track to surpass that level in Q2, there hasn t been much earnings growth. But growth is expected to resume from the second quarter onwards, with a significant ramp-up in the back half of the year. 11

12 Table 4 Total Quarterly earnings Quarterly Earnings (billion dollars) 14E 4Q 3Q 13 4Q 12 3Q Q 11 Cons. Staples Cons. Discretionary Retail/Wholesale Medical utos Basic Materials Industrial Products Construction Conglomerates Technology erospace Oil/Energy Finance Utilities Transportation Business Services S&P ex Finance Source: Zacks Investment Research, Inc. Data as of: 7/25/13 4:05 PM

13 Table 5 Total Quarterly Revenues Quarterly Revenues (billion dollars) 14E 4Q 3Q 13 4Q 12 3Q Cons. Staples Cons. Discretionary Retail/Wholesale Medical utos Basic Materials Industrial Products Construction Conglomerates Technology erospace Oil/Energy Finance Utilities Transportation Business Services S&P ex Finance Source: Zacks Investment Research, Inc. 13

14 Table 6 Total nnual Earnings nnual Earnings (billion dollars) 2014 E 2013 E Cons. Staples Cons. Discretionary Retail/Wholesale Medical utos Basic Materials Industrial Products Construction Conglomerates Technology erospace Oil/Energy Finance Utilities Transportation Business Services S&P ex Finance Source: Zacks Investment Research, Inc. Data as of: 7/25/13 4:07 PM

15 Table 7 Total nnual Revenues nnual Revenues (billion dollars) 2014 E 2013 E Cons. Staples Cons. Discretionary Retail/Wholesale Medical utos Basic Materials Industrial Products Construction Conglomerates Technology erospace Oil/Energy Finance Utilities Transportation Business Services S&P ex Finance Source: Zacks Investment Research, Inc. Data as of: 7/25/13 4:08 PM It may be obvious, but it s still useful to explain what we mean by total earnings. This means the sum total of aggregate earnings for all the companies in the S&P 500. For historical periods through 2013 Q1, we have taken the total earnings (not EPS) for each company in the S&P 500 and added them up to arrive at the sector and index level totals (we do adjust reported GP earnings for non-recurring items). For the coming quarters, including Q2, we have taken the Zacks Consensus EPS for each company in the index, multiplied that by the corresponding share count to arrive at the total earnings for each company. nd then we aggregated them to arrive at the totals for each sector and the index as a whole. The lack of accuracy in real-time share count notwithstanding, this gives us a fairly accurate view of the total earnings picture. In plain language, what Table 4 tells us is that companies in the S&P 500 are on track to earn $256.4 billion in 2013 Q2 vs. $253.5 billion in Q1 and $250.5 billion in 2012 Q

16 Here are a couple of quick takeaways from Table 4. The overall level of total earnings is very high. In fact, the Q2 total is a new all-time quarterly record, surpassing the prior record achieved only in the preceding quarter (Q1). There hasn t been much growth in recent quarters, but the expectation is for a trend reversal going forward. Comparing the consensus expectations for the first half of 2013 with the actual results for the same period in 2012, we get a growth rate of 2.4%. But the same year-over-year comparison for the second half of the year shows a growth rate of +7.4%. nd as you can see from Table 4, the second-half 2013 growth ramp up is not simply due to easy comparisons total earnings in each of the last two quarters of the year represent new all-time records. This second-half growth recovery is then expected carry into 2014, resulting in further earnings growth of +11.2%. Where Is the Growth Coming From? Driving this optimistic growth outlook is the view that the forces that held down profitability over the last few quarters abate in the second half of the year and are replaced by strong growth. The U.S. economic outlook has certainly stabilized and consensus expectations are for GDP growth in the second half of the year to be better than what was achieved in the first half. But it s hard to envision the modest economic growth ramp up in the second half translate into this magnitude of earnings growth. Expectations for next year s GDP growth remain in the +3% to +3.5% range, even the Fed recently raised its estimate for 2014 GDP. The international economic growth picture looks a lot less impressive. But with almost 60% of total earnings coming from the home market, a material acceleration in U.S. GDP growth along the lines currently expected would provide a major boost to earnings. But will that be enough to give us the +11.2% earnings growth expected next year. The health of corporate earnings is closely tied to the health of the economy. fter all, earnings in the aggregate can grow only through two avenues revenue growth and/or margin expansion. Revenues for the S&P 500 grow in-line with nominal global GDP growth. If real or inflation-adjusted GDP growth next year is expected to grow at +3% rate and inflation is around +2%, then nominal GDP growth next year will be around +5%. Given these consensus GDP growth expectations, the +4.5% revenue growth expected next year doesn t seem so unreasonable. But in order to reach the expected +11.2% total earnings growth in 2014, we need a fair amount of margin gains to compliment the revenue growth. 16

17 Margins have come a long way from the 2009 bottom and by some measures have already peaked out. But it may not be so reasonable to expect margins to continue expanding. Just like trees don t grow to the skies, margins don t expand forever either. The Margins Picture Net margins are expected to be flat from the same period last year, with 8 of the 16 Zacks sectors showing lower net margins than the same quarter last year. Net margins are down modestly from the preceding quarter s level. Excluding Finance, net margins are expected to be down. Table 8 below shows the year-over-year and quarter-over-quarter changes for the current and preceding quarters, as well as the year-over-year changes for last year, this year, and next year. Table 8: Change in Net Margins E YoY QoQ YoY QoQ YoY YoY YoY Cons. Staples -0.52% 0.03% -0.31% 0.08% -0.23% 1.68% 0.65% Cons. Discretionary -0.03% 0.24% 0.76% 1.19% 0.05% 0.73% 1.04% Retail/Wholesale 0.32% -0.04% 0.06% 0.14% -0.07% 0.22% 0.31% Medical -0.82% 0.02% -1.86% -0.22% -0.94% -0.54% 0.47% utos 0.06% 0.01% -1.57% 0.82% -0.90% 0.08% 0.65% Basic Materials 1.17% -0.18% -1.78% -0.90% 0.29% -0.93% 0.98% Industrial Products -0.16% 0.25% -0.16% 0.95% -0.13% 0.11% 0.67% Construction 0.40% 0.09% 2.05% 1.07% 1.15% 0.97% 0.51% Conglomerates 0.52% -0.28% 0.77% 0.07% 0.54% 0.58% 0.67% Technology -0.02% 0.12% -1.97% -0.49% -0.50% -0.09% 0.95% erospace 0.66% 0.00% 0.43% -0.35% -0.26% 0.34% 0.21% Oil/Energy -0.09% 0.07% -0.87% -0.33% -0.98% 0.58% 0.67% Finance 2.46% -2.03% 8.67% 3.06% 1.43% 4.98% 1.04% Utilities -1.53% 0.80% -0.75% -1.06% 0.04% -0.01% 0.35% Transportation 1.09% 0.00% 1.00% 1.74% -0.09% 0.50% 0.81% Business Services 0.50% 0.15% 1.43% 0.45% 0.84% 1.25% 1.09% S&P % -0.09% 0.45% 0.27% -0.05% 0.67% 0.64% ex Finance -0.04% 0.06% -0.62% 0.03% -0.29% 0.23% 0.60% Source: Zacks Investment Research, Inc. Data as of: 7/25/13 4:13 PM

18 Table 9 below puts the net margin expectations for Q2 in the context of where they have been in the preceding five quarters and where they are expected to go in the coming quarters. s you can see, quarterly net margins are expected dip below the preceding quarter s level in Q2, but the expectation is for a nice jump from Q3 onwards. Table 9: Quarterly Net Margins 14E 4Q 3Q Cons. Staples 12.6% 12.8% 13.3% 11.2% 11.1% 11.1% 11.2% 11.7% 11.4% Cons. Discretionary 10.2% 11.1% 11.0% 10.9% 13 4Q 12 3Q % 9.5% 10.2% 11.0% 9.9% Retail/Wholesale 4.4% 3.6% 3.9% 3.8% 3.8% 3.7% 4.3% 3.5% 3.8% Medical 13.0% 12.6% 13.1% 13.3% 13.3% 13.5% 12.7% 14.2% 15.2% utos 4.8% 4.2% 4.7% 5.0% 5.0% 4.2% 3.4% 4.9% 6.5% Basic Materials 10.6% 6.5% 5.8% 6.9% 7.1% 8.0% 5.6% 5.7% 8.8% Industrial Products 8.4% 8.7% 9.3% 9.0% 8.8% 7.8% 7.3% 9.2% 8.9% Construction 4.4% 4.7% 5.4% 5.2% 5.1% 4.1% 4.9% 4.8% 3.1% Conglomerates 19.4% 11.5% 10.5% 10.6% 10.9% 10.8% 10.6% 10.1% 10.1% Technology 16.5% 17.9% 15.7% 15.7% 15.5% 16.0% 17.6% 15.7% 17.5% erospace 6.9% 6.6% 6.6% 7.2% 7.2% 7.6% 5.8% 6.5% 6.8% Oil/Energy 8.9% 8.7% 8.5% 7.9% 7.8% 8.1% 7.9% 8.0% 8.7% Finance 17.1% 15.8% 15.1% 15.8% 17.8% 14.8% 10.5% 13.3% 9.2% Utilities 10.1% 7.4% 10.4% 8.9% 8.1% 9.2% 3.4% 10.4% 8.8% Transportation 8.4% 9.1% 8.9% 9.5% 9.5% 7.8% 8.5% 8.4% 8.5% Business Services 14.9% 15.5% 14.5% 13.8% 13.6% 13.2% 13.8% 13.3% 12.2% S&P % 10.1% 9.8% 9.8% 9.9% 9.6% 8.9% 9.5% 9.4% ex Finance 9.6% 9.3% 9.1% 8.9% 8.8% 8.8% 8.7% 8.9% 9.4% Table 10 below of annual net margins provides the full context for margins since the start of the current earnings cycle in s you can see, aggregate net margins for the S&P 500 peaked in 2006 and are expected to get past that level in Given Finance s relatively flaky margins and the sector s outsized role in the index back then, it is even more instructive to look at the ex-finance net margins, which are basically the margins for everything else outside of Finance. s you can see, ex- Finance margins are already at peak levels. But consensus earnings expectations reflect even more gains this year and next. It may not be unreasonable to be skeptical of these margin growth expectations. 18

19 Table 10: nnual Net Margins nnual Margins 2014 E 2013 E Cons. Staples 13.3% 12.7% 11.0% 11.2% 11.6% 11.1% 10.8% 10.6% 11.9% Cons. Discretionary 11.6% 10.5% 9.8% 9.7% 9.4% 8.1% 8.2% 9.3% 9.1% Retail/Wholesale 4.2% 3.9% 3.6% 3.7% 3.7% 3.4% 3.4% 3.7% 3.8% Medical 13.5% 13.0% 13.6% 14.5% 14.2% 14.4% 14.7% 14.5% 15.4% utos 5.0% 4.3% 4.2% 5.1% 5.1% 0.3% -0.6% 1.7% 0.9% Basic Materials 7.8% 6.8% 7.7% 7.4% 8.8% 4.6% 6.2% 8.3% 8.1% Industrial Products 9.4% 8.7% 8.6% 8.7% 7.7% 6.1% 7.6% 8.2% 8.0% Construction 5.3% 4.8% 3.8% 2.7% 2.6% -0.1% -1.4% 2.0% 5.2% Conglomerates 11.5% 10.9% 10.3% 9.7% 9.3% 8.3% 9.2% 10.8% 10.8% Technology 17.4% 16.4% 16.5% 17.0% 16.4% 13.2% 12.2% 13.2% 13.4% erospace 7.0% 6.8% 6.4% 6.7% 6.3% 5.3% 6.9% 6.6% 5.6% Oil/Energy 8.9% 8.2% 7.6% 8.6% 6.8% 5.5% 9.3% 10.2% 10.3% Finance 18.7% 17.7% 12.7% 11.3% 11.1% 6.8% 0.3% 12.3% 15.1% Utilities 9.3% 8.9% 8.9% 8.9% 8.9% 8.8% 9.1% 9.0% 8.0% Transportation 9.6% 8.8% 8.3% 8.4% 7.8% 6.0% 7.3% 8.2% 8.4% Business Services 15.6% 14.5% 13.2% 12.4% 11.5% 10.4% 9.7% 10.1% 8.9% S&P % 10.0% 9.3% 9.4% 9.0% 7.2% 7.0% 9.2% 9.7% ex Finance 9.6% 9.0% 8.8% 9.1% 8.7% 7.3% 7.9% 8.7% 8.7% Source: Zacks Investment Research, Inc. Data as of: 7/25/13 4:14 PM 20% nnual Margins 16% 12% 8% 4% 0% E 2014 E Technology S&P 500 ex Finance 19

20 Margins follow a cyclical pattern. They expand as the economy comes out of a recession and companies use existing resources in labor and capital to drive business. But eventually capacity constraints kick in, forcing companies to spend more for incremental business. t that stage, margins start to contract again. We may not be at the contraction stage yet, but we do need to buy into fairly optimistic assumptions about productivity improvements for current consensus margin expansion expectations to pan out. Market Cap vs. Total Earnings The charts below show the share of total earnings for 2013 as well as the share of total market capitalization for each of the 16 Zacks sectors. Since the S&P 500 is a marketcap weighted index, each sector s market cap share is also its index weight. Finance is on track to regain its leadership position in the index in terms of earnings contribution this year, though it still remains significantly below its record 27% share of the index earnings in The sector is expected to edge out Technology as the largest earnings contributor this year. 20

21 Share of 2013 Income Consumer Discrt 4.0% Consumer Stapls 6.7% Transportation 1.6% Retail 7.5% Business Svcs 2.2% Medical 10.8% uto/tires/trks 1.8% Industrial Prod 2.5% Basic Materials 3.0% Construction 0.4% Conglomerates 3.4% Utilities 5.2% Computer & Tech 18.0% Finance 19.4% Oils/Energy 11.8% erospace 1.5% 21

22 % Share of Mkt Cap Consumer Discrt 5.0% Retail 9.6% Medical 11.4% Consumer Stapls 8.0% uto/tires/trks 1.5% Basic Materials 3.0% Transportation 1.8% Utilities 5.4% Business Svcs 3.0% Industrial Prod 2.5% Construction 0.6% Conglomerates 3.5% Finance 16.8% Computer & Tech 16.4% Oils/Energy 10.0% erospace 1.3% Want more information about this report or about Zacks Investment Research? Contact Terry Ruffolo at or at Visit the Zacks Media Room at zacks.com/media-room Disclosure: This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. ll information is current as of the date of herein and is subject to change without notice. ny views or opinions expressed may not reflect those of the firm as a whole. 22