(c) 2009 
Dow Jones & Company, Inc. Reproduced with permission of copyright owner. Further reproduction or distribution is prohibited without permission.A record number of U.S. companies beat earnings expectations in the third quarter, but a big portion of their profits came from cost-cutting, disappointing investors who were hoping for boosts in revenue.
With nearly all of the companies in the Standard & Poor's 500-stock index reporting their numbers, 80% did better than Wall Street analysts anticipated, according to Thomson Reuters. That's up from 73% last quarter, which tied the previous record.
Revenue is on track to fall 10%, but that is what analysts were expecting. The worry is that without a meaningful upturn in U.S. sales, cost-cutting can only boost profits so long.
"It goes to the heart of the question about the recovery," said David Kostin, equity market strategist at Goldman Sachs. "Are we going to get some end-demand picking up that is more than just inventory rebuilding?"
The good news is that companies are running so lean that should revenue pick up in coming months, operating margins would likely surge, giving a powerful boost to profits. Companies with a strong presence in emerging markets are particularly poised to benefit, because faster economic growth there could drive higher sales.
The falling dollar also could help profits rise. A weaker dollar, which raises the value of profits earned outside the U.S., has yet to be felt on corporate bottom lines.
No one doubts that profits will look good next quarter, if only because last year was so terrible. After nine straight quarters of earnings declines, analysts expect fourth-quarter earnings to more than triple.
Even without good news on the revenue front, the Dow Jones Industrial Average closed last week at 10270.47, just shy of a 13-month high, up from around 9725 in early October, when earnings season began.
Earnings news last week from Wal-Mart Stores encapsulated the good news-bad news tenor of the quarter. The company, which has benefited from bargain-hunting, topped profit expectations with record earnings.
However, Wal-Mart executives said increased productivity and inventory management drove earnings. Meanwhile, the company said it was seeing "ongoing deflation across our businesses."
Wal-Mart executives are wary. Sales are expected to be flat in the fourth quarter from a year ago, as "customers may be more cautious in their holiday spending."
With 93% of S&P 500 firms reporting, third-quarter operating profits are on pace to have fallen nearly 14% from the third quarter of 2008, just before the recession peaked. Analysts had expected profits to fall by 25%.
Some 370 of S&P 500 companies beat earnings estimates, the highest since Thomson Reuters began keeping track in 1994 and well above the 61% average in that time frame. Roughly five firms beat expectations for every one that disappointed.
"We've seen company after company come in reporting better-than-expected earnings. And it wasn't just 'We beat by a penny or two pennies,' " said Dirk Van Dijk, chief equity strategist at Zacks Investment Research. "We've seen some companies beating their estimates by 40% or 50%," he said, noting the median surprise was 7.1% above estimates.
Revenue growth doesn't compare. According to Goldman Sachs, 32% of the companies in the S&P 500, excluding financials and utilities, beat revenue estimates by a significant margin in the third quarter, below the long-term average of 40%. Goldman's Mr. Kostin called that overall performance "weak."
Also, Mr. Kostin noted that the positive revenue surprises were heavily concentrated among health-care and technology companies, and more broadly among "intermediary" companies that make products, such as semiconductors, rather than companies that sell finished goods. "Inventory restocking was definitely a big theme," Mr. Kostin said.
That's a potential problem for the market now that the price-to-earnings ratio on stocks in the S&P 500 stands at roughly 14.4 times expected earnings for the next 12 months, putting it just shy of long-term averages. In March, when the market bottomed, it was below 11.
"The path for the market will be dictated largely by earnings . . . which are a function of revenues and margins," Mr. Kostin said, adding that additional margin improvement is likely to be tough given the difficulty of raising prices. "That's why the focus is on revenues and they've been disappointing."
But Thomas Doerflinger, stock-market strategist at UBS, said he saw good news in third-quarter revenue. He was encouraged by what he called a "healthy" 3.8% rise in revenue when measured against the second quarter. That compares with an average quarter-on-quarter increase for the period of 0.8% between 2000 and 2008. "People have been unduly negative about the profit picture," he said.
Mr. Doerflinger said the productivity gains chalked up this year will set the stage for a robust 29% rise in S&P 500 operating earnings next year. (Some of the big gain in 2010 will be the result of "easy" comparisons to the depressed levels in early 2009). The consensus forecast is for a 26% increase in 2010, according to Thomson.
He argued that revenue will rise a solid 9% even if the U.S. economy continues to struggle. That's in part because S&P 500 companies get about 32% of their sales from outside the U.S. In addition, the S&P is more heavily tilted toward cyclical areas such as commodities and manufacturing than the broad U.S. economy, which is more driven by consumer spending.
Credit: By Tom Lauricella
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