Jubak's Journal
Recent articles:
• 3 ways to profit from Europe's turmoil, 6/21/2005
• Higher oil prices? It's worse than you think, 6/17/2005
• 5 stocks for the continuing oil rally, 6/15/2005
More...
| | Jubak's Journal
5 potential positive earnings surprises
The second-quarter earnings season will produce few results that'll spur buyers to rush in. But some companies will stand out by easily surpassing expectations. Here's a likely list.
By Jim Jubak
On July 6, Alcoa (AA, news, msgs) is scheduled to report second-quarter earnings. That'll mark the beginning of another earnings season.
Not that you'd ever know that earnings season is just two weeks away. Worries over the price of oil, a potential housing bubble and projections for slower economic growth dominate financial market chatter. And since the Federal Reserve's Open Market Committee is scheduled to meet on the last two days of June, I don't expect that earnings have much chance of rising to the top of investors' minds until after everyone returns from a long July 4 weekend.
Which is too bad. This earnings season looks like it'll be critical for setting expectations for the next few months. Now, the Wall Street consensus increasingly expects a disappointing earnings season with a lot of misses and near misses and few positive surprises that get investors excited about a company's prospects.
I agree that positive earnings surprises will be in short supply in July, but that's likely to bring outsized gains for the stocks of companies that manage to produce them. For my picks this week on CNBC's "Morning Call," I've looked for stocks that produced an earnings surprise last quarter -- academic research has shown that a company that surprises once is likely to surprise again -- and where analysts have raised their earnings estimates over the last 90 days, which also correlates with future earnings surprises.
The findings
There aren't a lot of stocks out there that fit the bill, but I did find three: A.O. Smith (AOS, news, msgs), Oil States International (OIS, news, msgs) and Sunterra (SNRR, news, msgs). And in the energy sector, I found two exclusive picks for CNBC.com on MSN readers: Encana (ECA, news, msgs) and Marathon Oil (MRO, news, msgs).
So why is this likely to be such a tough earnings season for positive surprises?
The earnings growth trend this quarter is decidedly down. After recording earnings growth of 21% for the fourth quarter and 13% for the first quarter, Wall Street forecasts are calling for just 7% growth in operating earnings for the stocks in the Standard & Poor's 500 stock index for the second quarter.
And that forecast has been falling for much of the second quarter. The forecast called for 9% earnings growth on April 1 and 8% growth on May 1.
Now, normally, I'd say expectations that are this low are a good setup for positive surprises. Earnings almost always come in above expectations, usually by about two to four percentage points. So the modest nature of expectations for this quarter normally would leave a lot of room for positive surprises.
Taking a large bite
But not this quarter, I'm afraid. This time a stronger dollar and higher oil and raw materials prices are likely to take an unexpectedly large bite out of earnings at a large number of companies.
Take the stronger dollar, for example. A study by Merrill Lynch market strategist Richard Bernstein found that while a weak or falling dollar adds to earnings, a strong or rising dollar cuts reported earnings. Bernstein's research estimates that the falling dollar added 10 percentage points to S&P 500 earnings growth rate in 2003 and 14.5 percentage points to 2004 growth.
The dollar's rise this year, Bernstein estimates, will subtract 2.4 percentage points from earnings growth. And, I'd add, it's exceedingly difficult to figure out which companies will show the biggest dollar effects in any particular quarter.
Oil prices that have pushed up to near $60 a barrel will have the same effect. Higher-than-expected oil prices -- remember that earlier in the quarter it looked like oil was headed toward $40 a barrel -- will produce earnings disappointments this quarter.
Oil isn't the only commodity that has seen a price surge this quarter either. Yesterday, for example, copper prices hit a historic high.
Here are my picks:
Controlling costs
A.O. Smith finally got costs under control in the first quarter, and the result was a 45% earnings surprise. Since then analysts have raised their earnings estimates for the second quarter to 53 cents a share from 49 cents.
In the first quarter, the company increased operating profit margins in its water systems unit to 8.8% from 4.6% in the first quarter of 2004. But there are more manufacturing efficiencies to come in the water systems (49% of sales) and electrical products (51% of sales) units as the company continues to improve its North American plants and build new factories in China. Revenue growth, which fell short of expectations in the first quarter, will pick up on the strength of the residential construction market and increased sales in China. Our StockScouter rated the stock a 10 out of a possible 10 on June 22.
It's all about timing
Oil States International has made its most recent acquisitions at exactly the right time: before the price of the companies it acquired zoomed out of sight and just in time to catch the boom in energy production. The company expects the May acquisition of Stinger Wellhead Protection, which provides equipment and services to protect wellhead blow-out preventers from damage during fracturing, to add 13 cents to 17 cents a share to earnings this year. The June deal for Phillips Casing and Tubing will add about 5 cents a share to 2005 earnings, the company estimates.
That last deal should improve earnings before interest, taxes, depreciation and amortization in the company's lagging tubular services division, which grew by just 6% in the first quarter from the fourth quarter. "Lagging" is a relative term. Growth in the tubular services unit is only slow in comparison to the 51% quarter-to-quarter growth in well site services and the 59% growth in offshore products.
In the last 90 days analysts have raised their second-quarter estimates to 36 cents a share from 28 cents, and I think the company has a good shot at matching the 22% earnings surprise it reported last quarter. Our StockScouter rated the stock a 7 on June 22.
In the right place
Sunterra reported a 20% earnings surprise in its fiscal second quarter, which ended in March, and certainly the vacation resort timeshare market hasn't cooled since then. The earnings surprise was especially impressive since it came from all directions: sales grew, costs fell and profit margins improved. And, importantly for the second quarter, despite record sales, the company's pipeline of timeshare projects moving to sale grew.
With 50% of the company's finished units in the hot markets of Hawaii, Florida and California, fiscal third-quarter results could beat estimates even though analysts have raised their estimates to 29 cents from 27 cents during the last 90 days. Our StockScouter rated the stock a 9 on June 22.
Exclusive picks
My two exclusive picks are both from the energy sector. Here the trick is to find companies that might actually report higher growth than the 30%, 40%, 50% or more growth already expected by analysts. I think I've found two.
Marathon Oil is sitting in the sweet spot of the current oil market. As tight as global oil supply is, global refining capacity is even tighter, and that'll push refining margins in North America to a projected $6.65 a barrel this year, Morgan Stanley says. And the second quarter may be the peak in the cycle with refining margins in North America climbing to $9.60 a barrel, again according to Morgan Stanley, before new refining capacity starts to come on line and cuts into margins. (For comparison, the refining margin in the second quarter of 2003 was just $3.89 a barrel.)
That's enough to give Marathon a good chance of producing an earnings surprise in current quarter: Analysts have raised their estimates to $1.37 a share for the quarter from $1.02 90 days ago and that still may turn out to be low. Our StockScouter rated the stock a 9 on June 22.
Encana is proving that when the energy market is hot it's better to be a seller than a buyer. The company is busy selling its weakest assets at high prices. For example, it just sold its Gulf of Mexico fields for $2 billion, well above Wall Street's estimate of $1.5 billion.
When the dust settles, Encana will be a 100% North American producer, where low decline fields make up 75% of the company's energy portfolio (compared to a peer group average of 25%, according to TD Securities) and with a substantial backlog of undeveloped oil and gas. Great long term story, eh? Don't worry. Encana looks like it's got plenty of short-term momentum, too. In the last 90 days analysts have increased their earnings estimate for the second quarter to 66 cents a share from 57 cents. Our StockScouter rated the stock a 9 on June 22.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Encana. He doesn't own short positions in any stock mentioned in this column.
|
