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April 21, 2009, 12:01AM EST

Earnings: Good News or Bad News? If trends continue, first-quarter profits might beat expectations?barely?for the first time in several quarters

By Ben Steverman

Amid a deepening recession and credit crisis, investors have gotten used to companies’ earnings going from bad to worse. Now, based on the first of a wave of first-quarter results, earnings might be going from worse back to just bad.

But that’s small comfort. While the first two weeks of the current earnings season, which kicked off with Alcoa’s ( AA) release on Apr. 7, do not confirm the pessimists’ worst fears, the tidings are still pretty grim. Based on analyst predictions and the first 58 companies to report in the first quarter, Standard & Poor’s estimates that the 500 in the broad S&P 500 should see operating earnings drop 26% from a year ago.

Reflecting the serious concerns embedded in such a drop in profits, stocks sold off on Apr. 20. The S&P 500 fell 3.5% despite from financial giant Bank of America ( BAC). (Of course, a gloomy forecast on BofA’s future loan losses might have had something to do with the market’s malaise.)

But, after a six-week market rally, the S&P 500 remains 22% above its early-March lows.

Above the Water Line

One reason is the first quarter’s projected operating earnings on the S&P 500 index of $12.29 per share, which are a marked improvement from the disastrous last quarter of 2008, when operating earnings were actually a negative 9¢ per share.

“It’s miles apart from the fourth quarter of last year,” when “we really hit bottom,” says Ashwani Kaul, Thomson Reuters (TRI ) director of research.

After last quarter, Robert W. Baird Chief Investment Strategist Bruce Bittles predicted that “expectations were so low that most of the surprises would come on the upside.”

So far, that has been true. Yes, 27 of the 58 companies didn’t meet expectations, S&P says?but 30 companies did beat analysts’ estimates.

And the biggest good news came from the financial sector, where Wells Fargo ( WFC), Goldman Sachs ( GS), and Bank of America have exceeded expectations.

Financial Upside

Overall, actual results are 15.9% better than analyst estimates, S&P index analyst says. (S&P, like BusinessWeek is a unit of The McGraw-Hill Companies.)

Thomson Reuters’ Kaul says almost all the upside surprise in earnings has come from the financial sector. “All the other sectors have been flat or a little down,” says Kaul. According to Thomson Reuters, financials were expected to decline 40% from a year ago, but now, based on actual results, are expected to drop 25%. (Thomson Reuters and S&P use slightly different methodology to compute earnings.)

The bulls’ emphasis on financial, and especially banking, profits worries some. “I do question the quality of the bank earnings,” says William Rutherford, president of Rutherford Investment Management. Banks seem to be relying on a one-time accounting rule change to boost earnings, he says.

Thomas Nyheim, portfolio manager at Christiana Bank & Trust, agrees, attributing the banks’ good news to “an accounting change.” “The problems are still there,” he says.

Moreover, banks tend to report early in the earnings season, while insurance companies?also included in the financial sector?report later. Kaul doubts insurance firms, which also face serious problems, will do as well as banks.

So, the first quarter is almost certain to beat the previous quarter’s results. But beating investor expectations?and lifting the market in the process?is hardly guaranteed. A key test is the huge wave of earnings news arriving in the next two weeks. From Apr. 20 to May 1, 286 companies, or more than half the S&P 500, turn in results.

“What we’ve seen is slightly encouraging,” Nyheim says. “But this week is the heart of earnings.” Financial giants have already turned in results, so the spotlight will switch to nonfinancial earnings. Investors wonder how much the recession is affecting profits for retailers and firms in health care, technology, and other sectors.

Thomson Reuters calculates that on Apr. 17, analysts were expecting consumer discretionary earnings to fall 113% from a year ago, with energy profits dropping 60%, materials earnings down 81%, industrials off 41%, and technology down 30%. Health care could be the best-performing sector, with a year-over-year decline of just 2%. Not one sector is expected to post higher profits.

Such scary numbers may not deter investors if they remain convinced that the decline in U.S. profits has finally stopped and better days are ahead.


Rutherford is cautious. “I see stabilization,” he says, “but it’s still not clear to me whether this is a pause on the way down, or a pause that will lead to a turnaround.”

Executives’ forecasts for the rest of the year will be closely watched, Bittles says. Expectations might have been low for this quarter, but many analysts and investors already are predicting a rebound for earnings and the economy by the end of the year.

Even stellar-first quarter earnings won’t lift investors’ spirits if company brass dash hopes by warning of deeper problems ahead. It looks as if companies’ earnings conference calls will be required listening for investors in the weeks ahead.

Steverman is a reporter for BusinessWeek’s Investing channel.