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Expectations Are High for Continued and Impressive Earnings Growth

Expectations Are High for Continued and Impressive Earnings Growth

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Weekly Market Update 4-12-11
Weekly Market Update 4-12-11

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Published by: American Century Investments on Apr 13, 2011
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04/14/2011

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Execaions Ae High fo Coninuean Imessive Eanings Gowh
This week marks the start o “Earnings Season” or the rst quarter o the year. Thisis a quarterly ritual on Wall Street where companies report their actual nancialresults or the most recent quarter (earnings, sales, cash fow, costs, etc.), andanalysts use these actual results to update their longer-term orecasts or theprospects o companies, including their target share price and sell or buyrecommendations. Most observers expect to see a continuation o the impressiveearnings growth that began in early 2009 as the economy was still struggling toexit the Great Recession. This recovery o U.S. corporations rom the recessionhas been the one bright spot or our economy, which (otherwise) continues tostruggle with high unemployment, record government budget decits and aweak housing market.
Trends in Performance for the S&P 500
The Standard & Poor’s 500 Index is a composite measure o stock priceperormance or the 500 largest publicly-traded companies as measured bythe size o their market capitalization (i.e., the total market value o their equityas determined by their share price and number o shares outstanding). It is notan investible index but oten used as a barometer o how well U.S. companies(particularly large-cap companies) are doing.In addition to measuring composite trends in stock price, many analysts alsocombine other nancial aspects o all the companies in the S&P 500 Index asi to treat them as a single combined entity or mega-corporation. That meansthe income statements, balance sheets and statements o cash fow which eachcompany in the index releases quarterly (as part o the earnings season) arecombined into one income statement, balance sheet and cash fow statementprimarily or the purpose o conducting trend analysis using current and historicaldata. While the results are not specic to any one company, this analysis helpsillustrate how large businesses (generally) are perorming in the U.S. andglobal economies.
WEEkly MArkEt UpdAtE AprIl 12, 2011
Jim Finnegan, CFA
Investment Writer
 
WEEkly MArkEt UpdAtE2
The chart below plots our measures o perormance or the S&P 500 Indexcompanies rom the second quarter o 1998 to the ourth quarter o last year on atrailing our-quarter (12-month) basis. Each o these measures is based on a com-bined “per share” basis. Sales per share measures the combined reported revenueso the companies. Earnings per share is the net reported prots (ater tax). Free cashfow per share is a measure o the amount o cash the combined companies used(negative number) or generated (positive number) based on their operating activities(making and selling goods and services), investment activities (e.g., building plants,acquiring or selling businesses) and nancing activities (e.g., issuing equity, paying odebt). And EBITDA per share (where the acronym stands or earnings beore interest,taxes, depreciation or amortization) is a proxy or operating prot that can be com-pared among companies with diering capital structures (i.e., capital intensity, amounto leverage) because it measures prot beore the eects o debt (interest expense)or capital depreciation or amortization.The chart illustrates how sales per share and EBITDA per share have still notrecovered (as o the ourth quarter last year) to levels seen just prior to the GreatRecession. That’s understandable given the indebtedness o many households andthe high rates o unemployment which have both crimped consumer spending. Buton the other hand, earnings per share or the combined S&P 500 companies havenearly recovered to pre-recession levels (and will likely do so with the announcemento rst quarter earnings). And ree cash fow per share exceeds its pre-recessionlevels. These our trends refect how corporations have cut back substantially onemployment costs, overhead expense and investing activities in order to generateimpressive earnings and ree cash fow per share growth in an environment wheresales and operating prots (as measured by EBITDA per share) have struggledto recover.
WEEkly MArkEt UpdAtE
Sales per share andEBITDA per share havestill not recovered (as othe ourth quarter last year)to levels seen just prior tothe Great Recession. That’sunderstandable given theindebtedness o manyhouseholds and the highrates o unemploymentwhich have both crimpedconsumer spending. But onthe other hand, earnings pershare or the combinedS&P 500 companies havenearly recovered to pre-recession levels.
$0$50$100$150$200$250
Source: Bloomberg
Sales per Share (Trailing 4 Quarters)
Quarter/Year 
EBITDA, Earnings and Free Cash Flow Per Share(Trailing 4 Quarters)
On a Per Share Basis, Free Cash Flow Has Recovered Most DramaticallyRelative to Sales, Earnings or EBITDA for the S&P 500 Index
Trailing 4 Quarter Sales, EBITDA, Earnings and Free Cash Flow per Share2nd Quarter 1998 to 4th Quarter 2010
$200$400$600$800$1,000$1,200
Earnings per ShareFree Cash Flow per ShareEBITDA per ShareSales per Share
Q2 1999Q4 1999Q2 1998Q4 1998Q2 2000Q4 2000Q2 2001Q4 2001Q2 2002Q4 2002Q2 2003Q4 2003Q2 2004Q4 2004Q2 2005Q4 2005Q2 2006Q4 2006Q2 2007Q4 2007Q2 2008Q4 2008Q2 2009Q4 2009Q2 2010Q4 2010
 
WEEkly MArkEt UpdAtE3
Companies have also improved their earnings and ree cash fow by rapidly deleverag-ing—that is, reducing debt on their balance sheets which reduces interest expense.And at the same time, they have taken much o the ree cash fow generated and heldit on their balance sheets in the orm o liquid short-term investments (called cashand equivalents). As the chart below illustrates, cash and equivalents or the S&P 500companies as a percent o their total current liabilities was approximately 90% in theourth quarter o last year. Another way to express this is that there was $0.90 ocash and equivalents or every dollar o total current liabilities (which are short-termobligations that companies owe like vendor payables, wages due or taxes owedtypically in the coming 30 days). That is a record amount o short-term liquidity.These same companies have rapidly reduced their debt exposure, as shown by thetrend below in net debt to book value per share. Net debt is the amount owed aterany surplus short-term assets (like cash and equivalents) are netted against thisamount. And book value per share is the total amount o shareholder equity on anaccounting basis (consisting primarily o stock issued, paid-in-capital and retainedearnings). From 1998 to late 2007, this ratio fuctuated in a range o $1.75 to $2.00,but since the Great Recession, it has come down to approximately $1.00 per dollaro shareholder equity. One thing to keep in mind with this trend is that nancialcompanies such as banking institutions (a key part o the S&P 500) have beenresponsible or much o this drop in net debt to book value per share as they haveraised their shareholder equity with government support and substantially reducedthe leverage ratio on their lending and investing activities.While all these trends have cheered investors, there is one area o growing rustrationlinked in part to the large amounts o cash and equivalent short-term investmentsthe combined S&P 500 companies have on their balance sheets. Investors wantcompanies to reinvest earnings in a productive way that continues to generate (or
Source: Bloomberg
Cash and Equivalents as a % of Current Liabilities
Quarter/Year 
Ratio of Net Debt to Book Value per Share
Leverage and Liquidity Have Improved Substantially for the S&P 500 Index
Net Debt to Book Value per Share (leverage) and Cash plus Equivalents as a Percent of Current Liabilities (liquidity)2nd Quarter 1998 to 4th Quarter 2010
30%40%50%60%70%80%90%100%$0.50$0.75$1.00$1.25$1.50$1.75$2.00$2.25
Net Debt to BookValue per ShareCash plus Equivalents as aPercent of Current Liabilities
Q2 1999Q4 1999Q2 1998Q4 1998Q2 2000Q4 2000Q2 2001Q4 2001Q2 2002Q4 2002Q2 2003Q4 2003Q2 2004Q4 2004Q2 2005Q4 2005Q2 2006Q4 2006Q2 2007Q4 2007Q2 2008Q4 2008Q2 2009Q4 2009Q2 2010Q4 2010
Companies have alsoimproved their earningsand ree cash fow byrapidly deleveraging—thatis, reducing debt on theirbalance sheets whichreduces interest expense.And at the same time, theyhave taken much o theree cash fow generatedand held it on their balancesheets in the orm o liquidshort-term investments.

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