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Second-Quarter Profits: Grief or Relief?

The coming blizzard of earnings reports has Wall Street on edge, but it’s not all bad news ahead. Here’s what to expect.

by Ben Steverman

With just a few days left in the second quarter, Wall Street is preparing for yet another disappointing round of corporate earnings reports.

According to Thomson Reuters (TRI), analysts expect the earnings of the S&P 500 to fall 10.2% this quarter, a number that keeps getting worse as pessimism deepens about the financial sector. It would be the fourth straight quarter of falling earnings, the first such losing streak since 2001-02.

Recent bad news from big banks—such as KeyCorp (KEY), which warned it is seeing credit quality deteriorate, and Fifth Third Bancorp (FITB), which was forced to slash its dividend and raise $2 billion in capital—only deepened the gloom that has hung over financial stocks since the start of the credit crisis almost a year ago. And some brand-name nonfinancial companies, such as FedEx (FDX), have also joined the chorus of woe.

Another unsatisfying earnings season would fit the mood on Wall Street, as investors fret over credit market turmoil, higher inflation, and the weak housing market. Suspicions are that the U.S. is facing, or already in, a nasty recession.

Bright Spots
A close look at earnings expectations, however, shows that, despite all the focus on gloom and doom, there are bright spots.

Outside of financials, for example, companies are doing much better than one might expect during an economic slowdown.

Oracle (ORCL) on June 25 reported earnings of 47¢ a share, beating expectations for the software giant’s fourth quarter by 2¢. Revenue hit $7.24 billion, up from $5.83 billion a year ago.

“You’re seeing good growth out of many sectors,” says David Dropsey, an analyst at Thomson Reuters. Excluding the financial sector, S&P 500 earnings are expected to rise 8.2%.

“You have to divide the world into financials and nonfinancials,” says Brian Reynolds, chief market strategist at M.S. Howells & Co.

Even Worse Than Expected
True, within the financial sector, damage from the credit crisis is worse than almost anyone expected. Analysts estimate earnings for the S&P 500 financial sector will drop by more than half from the year before, according to Thomson Reuters. But the last few quarters have shown how difficult it is to predict financial earnings, Dropsey says. Quarter after quarter in the past year, analysts have underestimated the impact of credit difficulties on the bottom lines of banks and other financial firms.

Wall Street keeps expecting the big financial losses to stop or at least slow, but Reynolds believes it could take until 2009 for industry players to write off all the losses due to credit troubles this year. “These things always tend to drag out,” he says.

Another problem area is the consumer discretionary sector, where earnings are expected to fall 15%. American consumers clearly are cutting back their spending amid record gas prices.

A Recovery for Builders?
But even in this sector are glimmers of hope. Much of the drop from last year’s profits is expected to come from automakers. The slow housing market is still taking a toll on homebuilders, but their earnings are expected to recover somewhat from last year, which was disastrous for the residential construction industry.

If you can ignore financials and consumer discretionary names–a big if–the mood brightens quite a bit. “It’s those sectors that are dragging everything down,” says William Rutherford, president of Rutherford Investment Management.

Many companies are lucky the U.S. dollar is weak, because it gives a boost to earnings reported from overseas, Dropsey says. Oracle says 51% of its sales come from Asia, Europe, the Middle East, and Africa.

The best sector by far is expected to be energy, where high oil prices should help boost sector profits 23%, Thomson Reuters says.

Information technology companies are expected to increase their profits 16%. Other sectors are also expecting modestly positive quarter, a sign that some parts of the U.S. economy continue to hold their own.

One worry remains record fuel prices. High energy costs don’t just dampen consumer spending; they can also hurt a corporation’s bottom line. Such outfits as FedEx, United Parcel Service (UPS), and Carnival (CCL) recently warned that fuel costs could be a drag on profits later this year.

The financial crisis, particularly turbulence in credit markets, will hog the spotlight during second-quarter earnings season, according to Reynolds.

Still, corporate profits outside the financial sector could be a good test of the overall strength of the broader U.S. economy. Investors will be watching closely as traditional early-bird Alcoa (AA) kicks second-quarter earnings season into gear on July 8.

Steverman is a reporter for BusinessWeek’s Investing channel.