What To Expect From Third Quarter Earnings

Next week the third quarter earnings reports will start in earnest, as Alcoa (AA), kicks it off on Wednesday. Before we focus on Q3, let us quickly recall the Q1 and Q2 results.

The first quarter was all about very low expectations as the "sell-siders" and corporate CFOs have really reigned in their forecasts and it took just a small marginal improvement from a horrendous Q408, to beat the numbers. The Q2 was a bit more challenging, as both investor expectations and market dynamics have changed. Investors were looking to see a bit more than just 'small beats' we saw in April. The skeptics among us in July (myself including), were prepared for at least weak guidance, if not outright missed estimates. We were once again proven wrong. Well, not really wrong - most reports came above still pretty conservative earnings projections, but many companies did miss the topline expectations.

Now we wait with anticipation for what the third quarter results will bring. So if the Q1 was all about earnings and Q2 was all about future guidance, than what should we be looking for in Q3? In one word - topline growth.

Topline, also known as revenue or sales, is what the companies lacked during the last several quarters and investors gave them a pass. Now we expect a lot more. We want to see still strong margins that resulted from almost twelve months of aggressive purging of any excess expenses(bonuses and salary cuts, delaying maintenance and equipment upgrades, personnel, T&A, productivity improvements etc, etc, etc). This was how they made Q1 and Q2 numbers. Now, we expect to see the businesses to show an ability to generate sales. Those that did, will have not only see their revenues expand, but the leverage in the business models should deliver very strong operating results.

Is this even a possibility? I think so. Not for all companies of course. But lets take a look at a few places where we might see some surprises.

I think apparel manufacturers can do well, for example. Like everyone else they had a very difficult year, but the retailers are beginning to place orders again. Department stores have reduced their inventories by 12% YoY. Many retailers are beginning to sell full price items again, and not only sale items. The apparel manufacturers will not only enjoy savings from becoming mean and lean over the past several quarters by getting better sourcing from their own suppliers, cheaper cost of raw materials, etc, but potentially stronger orders from retailers. And I don't really want to hear that consumer is not shopping. After almost a year of being very prudent, we are clearly seeing traffic improve and shoppers are coming back. Maybe not the 10% that are now unemployed, but the other 90% that are still working, like yours truly.

Another example - semiconductors. The overcapacity in the industry has hurt many of the semi and semi cap companies. Many have rationalized their production and many have merged or just out of business. At the same time, we are nearing the upgrade cycle for many PC and laptops. Many are still running on 1 GB or 2GB of RAM. With $400-$500 machines that can have 3x as much power and hard disk space, we should see stronger consumers demand not only in US, but also in emerging markets. And don't forget Windows 7, that comes out at the end of the month. How about other electronics that now require more and better and faster chips? Even printers are now wireless. What about Netbooks and digital picture frames? Soon we will have chips in our new set of kitchen knives.

One of my favorite industries is Oil and Gas. This one is a bit trickier to call. I think we may see a mixed bag of results. Generally, I would expect to see production cuts to continue to pressure results. Having said that, I am looking for those that were able to hedge their production at higher prices, paid down their debt (reducing interest expense) and Capex (capital expenditure). As the prices of Oil and Nat Gas continue to recover, we should see them beat results, as most analysts and investors are basing their forecasts on $60-65 oil and $3.50 natty. This will not last much longer, as I am a firm believer that these prices are much closer to the bottom than to the top.

Lastly, a few select Chinese companies should have decent top- and bottom-line results. Chinese economy has really led the global recovery. Their domestic consumption is at levels that exceed 2007. They have access to cheap labor, tons of government subsidies, and cheap and abundant access to loans (this door is now getting somewhat closed, as Chinese govt decided to limit lending, and cool things off a bit as well as to prevent bad debt from becoming a real problem). At the same time, the several hundred Chinese companies listed in US, can still access fairly cheap equity capital. And lets not forget the $586 billion in government stimulus, which was not wasted on transfer payments or bailouts. It was focused on key strategic industries and had a much better impact than the ones in US or European Union. Expect to see much better topline and bottom line results from some of these companies. I have done a lot of work on some of them, and would urge you to do the same before investing. Emerging markets are not for lazy or complacent investors.

Finally, I would look for US multinationals that have a large part of their revenues coming from Europe or China. A combination of a weak US currency and demand coming from still growing Chinese economy could really help these companies deliver solid Q3 results.