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Why third-quarter earnings matter so much

In case you missed it, here's a piece I did analyzing third-quarter earnings so far in yesterday's dead-tree edition of The Post:

Halfway through what many analysts and traders are calling the most important earnings quarter in years, investors are eager for signs that America is back in business.

Aluminum giant Alcoa, as it traditionally does, kicked off earnings season, reporting the week before last that it had returned to profitability. But the real action started last week, with reports from big companies such as Johnson & Johnson and big banks such as Goldman Sachs. This week, we'll hear from tech giants Apple, Texas Instruments and Microsoft; economic bellwethers Caterpillar, 3M and Boeing; and more big banks, with Capital One and Wells Fargo checking in.

So even though we've had just a taste of third-quarter earnings, there's plenty to chew on. Let's start with the importance of this quarter, which in many ways will tell us whether we're back on track.

Google chief executive Eric Schmidt seems to think we are, and with good reason: The apparently invulnerable Internet search-and-advertising giant last week reported its highest quarterly profit ever -- $1.6 billion -- on nearly $6 billion in revenue, up 7 percent from the third quarter of last year. With no debt, the company is not bound to the health of credit markets.

"The worst of the recession is clearly behind us. And because of what we have seen, we now have the confidence to be optimistic about our future," a sunny Schmidt told analysts Thursday, saying his company will even begin hiring again.

But the outlook is not so bright for: (a) banks that are still choking on abandoned mortgages and delinquent credit card accounts; and (b) many companies that, unlike Google, are trying to sell products that require manufacture and shipping.

For most businesses, the fourth quarter of last year and the first quarter of this year were the Apocalypse Quarters -- the worst in U.S. business since the Great Depression, as unemployment shot up, confidence dove and the nation's most important banks required government aid to stay in business. Corporate earnings weren't even an issue. For those six months, it was about corporate survival.

The second quarter of this year -- from April through June -- was the Rally and Cost-Cutting Quarter. After bottoming on March 9, the stock market began its remarkable seven-month rally, which culminated last week with the Dow Jones industrial average passing 10,000 for the first time in a year. It was also a quarter that saw massive layoffs, as the businesses that survived the previous six months cut costs in Draconian fashion.

Now, we've just completed the Maybe We're Back to Business Quarter. Singed from the disaster, having trimmed their fat, companies have to prove that they can sell their products again. Could they achieve "top line" -- that is, revenue -- growth, or would profit continue to come from the "bottom line" only, meaning from cost-cutting?

In the second quarter, about 75 percent of reporting companies beat forecasts for profit. But only half beat revenue expectations. Because businesses cannot cost-cut their way to long-term profitability, revenue growth is a must.

Alcoa surprised Wall Street by beating estimates on both top- and bottom-line growth -- largely thanks to stepped-up demand in China -- and said it expects worldwide aluminum use to increase by double-digits in the second half of this year.

But if Alcoa gave the market a reason to say "Yay," Johnson & Johnson's earnings were received with more of an "Ooof."

If it were only a health-care company, J&J would be a fine defensive stock -- it makes stuff like Band-Aids that people use all the time, regardless of the economy. But it's more than that. Two-thirds of J&J's revenue comes from medical devices and pharmaceuticals, and the bad economy helped generic drugmakers, which ate into J&J's revenue. On Tuesday, the company announced that it missed revenue expectations, and that sent a warning to Wall Street: Corporate America is not out of the woods yet.

"J&J woke up the market," said Art Hogan, chief market strategist at Jefferies. "Companies will not be rewarded for beating only on the bottom line." Shares of J&J were down all week after its earnings report.

The third-quarter results of the big banks continue to illustrate the Wall Street/Main Street schism you've heard so much about and possibly even experienced, with the U.S. unemployment rate at 9.8 percent and rising.

The big banks are investment banks, such as Goldman Sachs; retail banks, such as Bank of America; or a hybrid of the two, such as J.P. Morgan Chase.

So far in this quarter, the further you stay from Main Street, the better your results will look.

Goldman, the lion of Wall Street, had its second straight home-run quarter, seeming to defy economic gravity with a $3.2 billion third-quarter profit report on Thursday. But a closer look shows why: Despite its official status as a bank holding company, Goldman has almost no exposure to the many bad things in the economy that plague other banks, such as mortgages in default, delinquent credit card accounts and bum loans. Goldman makes its money by commodity, bond and fixed-income trading and by advising on deals -- not by writing subprime home loans.

J.P Morgan hedges its bets. Even though it said in its third-quarter earnings report Wednesday that it had doubled the amount of money set aside to cover bad consumer loans, J.P. Morgan's investment banking business led it to a $3.6 billion profit.

At the other end of the spectrum are Citigroup and Bank of America. On Thursday, Citigroup said it eked out a $101 million third-quarter profit after losing nearly $3 billion in the third quarter of last year. That's the good news. The bad news is that Citigroup remains one of the world's largest subprime lenders and investors, and those toxic bets show on the bank's balance sheet. Bank of America, the largest U.S. consumer lender, reported a $1 billion third-quarter loss Friday, worse than analysts expected. If Goldman is Wall Street, then Citibank and Bank of America are squarely Main Street, suffering along with its out-of-work residents.

Perhaps it would be smarter to use the big regional banks, such as PNC, which reports next week, as a gauge of the economy. The regionals tended to hold more mortgages on their books, rather than selling them into securitization. But they also hold commercial real estate loans, which have soured. Also, they don't have big investment and trading businesses to prop them up, like Goldman and J.P Morgan.

But a better rubber-meets-the-road gauge on the health of the economy over the past three months will come in earnings due out next week from the big consumer companies: McDonalds, Amazon, eBay, Coca-Cola, Hershey, Starwood and Whirlpool are all scheduled to report. McDonald's -- which has thrived during this recession, benefiting from the "trade-down" factor as people stopped going to more expensive quick-serve restaurants -- said August same-store sales rose less than forecasters expected, a troubling sign.

The Reuters/University of Michigan index on Friday reported that consumer confidence pulled back sharply in October. The drop was bigger than economists had expected. Big banks and tech giants are important to track, but in an economy that is 70 percent based on spending, consumer companies form the front lines of any recovery. That's what we'll learn in the coming week.

By Frank Ahrens  |  October 19, 2009; 10:16 AM ET
Categories:  The Ticker  | Tags: Alcoa, Amazon, Bank of America, Citigroup, Coke, Goldman Sachs, J.P. Morgan Chase, Johson & Johnson, McDonald's, PNC, consumer confidence, earnings  
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