Profits Prove Positive

Story Highlights:

• US Q4 2010 corporate profits were hugely positive—the eighth quarter in a row firms overall logged quarterly profit gains.
• As firms continue to post profits, some are increasingly putting their cash to work—via stock buybacks, M&As, and increasing dividends.
• S&P 500 companies will be reporting Q1 2011 earnings this week, with positive expectations overall.
• While expectations for Q1 earnings are positive, it’s important to note corporate profits now have a higher benchmark to beat than in previous quarters.

File this under "good news we largely expected." For Q4 2010, US companies reported a $39.5 billion increase in profits over Q3—making it the eighth straight quarter corporations overall logged quarterly profit gains. What’s more, corporate profits grew 29.2% in 2010 overall (the fastest annual growth in over 60 years) and by 61.5% from the cyclical bottom in Q4 2008. And with that, real after-tax profits have reached a new all-time high. So much for the idea, popular in 2009 and much of 2010, that we’d entered a new era of below-average US growth and tepid profits.

We’ve also frequently commented here that, thanks to huge profits, firms are sitting on a historic mountain of cash. We're beginning to see firms tapping that cash to invest in M&A, increase dividends, and buy back their own stocks. For example, announced M&As in Q1 2011 totaled more than $260 billion—the most since September 2008. All these actions, done right, reduce share supply (not to mention reward stockholders), which helps potentially attract more investors. Firms may also choose to spend surplus cash on capital investment—which is another source of demand driving future corporate profitability—and may also spend on expanding labor forces, especially if demand is stretching current production capacities. What’s more, expenditures so far have barely made a dent in the cash mountain, and ongoing profits help keep coffers filled. That cash is just more pent-up demand waiting to be satisfied.

All of this is very positive, and 29.2% profit growth sounds massive. Keep in mind, corporate profits now will be compared to not-so-depressed levels. Plus, analyst sentiment may finally be coming around to reality. Analysts predict a 14% Q1 2011 earnings growth rate over the same period last year for S&P 500 companies, with 8 out of 10 sectors expected to see an increase in comparative earnings.* That seems fair—but we won’t be surprised if earnings growth doesn’t beat expectations as soundly as it has in past quarters. The wide gap we’ve seen between expectation and reality was just one factor that helped propel stocks in 2009 and 2010. Strong ongoing US corporate profitability will likely underpin economic growth this year—but likely won't deliver the "holy cow" factor for equities it did for the last two years. This, however, is fairly normal. Corporate profits normally see a big pop just after a recession and cool off a bit after the period of easy comparisons is past.

The US reports first and fastest on corporate profits, but the same story is likely globally: Overall fine profit growth lacking the big oomph of the last two years that doesn't beat expectations so widely.

* Thomson Reuters