Earnings growth is bound
to slow after recent run-up

NEW YORK » With second-quarter earnings season just days away, it looks like the largest U.S. companies might break a notable winning streak -- 12 straight quarters of double-digit earnings growth.

So far, there have been twice as many companies in the Standard & Poor's 500 warning that they'll miss second-quarter earnings targets as there are companies saying they'll beat expectations.

That doesn't mean earnings will be a stream of disappointments and a harbinger of economic bad news. Analysts predict double-digit growth in the third and fourth quarters. And S&P predicts record earnings for 2005.

Still, torrid double-digit growth can't last.

"These are year-over-year growth percentages; you can't look at this as if it were dollar amounts," said David Dropsey, a research analyst at Thomson Financial. "Twenty percent growth is not going to be sustainable. We have to come back to a more normal level."

After the 2001-02 recession, earnings growth numbers looked great because they were compared to results from a weak economy.

"We were coming out of a fairly difficult recession," said Sandy Lincoln, chief market strategist at Wayne Hummer Asset Management. "People get lulled into seeing these growth numbers and forget the circumstances around those numbers."

Another reason growth rates were so steamy: Companies dramatically slashed spending, cutting jobs, discretionary spending and capital spending. Their expenses were so lean that when revenues picked up, they flowed straight to the bottom line, Lincoln said.

Even in June 2003, when the recovery was well under way, Hewlett-Packard Co.'s then-CEO Carly Fiorina told financial analysts the company would cut costs by $1 billion.

"We can control our own cost structure," she told an analysts' meeting. "We cannot control the economy."

But when the economy recovers, companies are forced to spend to keep up with demand. They hire workers and increase capacity -- which means higher expenses that chip away at earnings.

The consensus estimate is that earnings will grow 7.1 percent for this year's second quarter, compared to a stellar 25.3 percent in 2004's second quarter.

Growth expectations for the second quarter have also been tempered by the most negative earnings preannouncements in two years, said Zachary Karabell, chief economist at Fred Alger Management.

The preannouncements, also known as warnings, cross industries. International Paper Co. said earnings were hurt by weaker paper and packaging sales. Covenant Transport Inc. blamed low freight demand and high fuel costs. Teen retailer Hot Topic Inc. said its sales are down. Cardinal Health Inc. blamed research and development and infrastructure costs. Nucor Corp. steel blamed lower steel prices.

Despite the warnings, other factors make many on Wall Street optimistic.

Douglas Cote, senior portfolio manager at ING Investment Management, is cheered by how frequently earnings estimates are wrong. In eight of the last nine quarters, he found, Wall Street underestimated earnings, often missing by a dramatically wide mark.

Earnings growth for 2004 was expected to be 15 percent, for instance. Instead it was 20.9 percent, he wrote.

This "is very bullish for the stock market because the level of corporate profits is not fully priced into the market," he wrote. "It is arguably setting the stage for what happened in 2004 when the market increased 3.5 percent in the first half of the year, only to more than double that in the second half."

He's not the only one who expects companies to beat earnings estimates this quarter. In the first quarter, analysts were looking for growth of 7 percent or 8 percent, but the quarter ended with growth closer to 13.9 percent, Karabell said. "I'd anticipate the same trajectory now."

Dropsey, at Thomson Financial, said earnings estimates rise as companies begin reporting their results. That's partly because warnings are historically negative, with a 2-to-1 historical ratio of bad news to good news, he said. Despite the high number of warnings for the second quarter, companies remain quite close to that ratio.