Since the second quarter of 2009, roughly 60% of companies have managed to deliver quarterly results that exceeded consensus profit forecasts. This has helped underpin a multi-year rally that leaves the major indexes back at levels not seen since early 2008. But signs are emerging that the era of upside surprises may be winding down.
In the most recent quarter, only 55% of companies in the S&P 500 topped profit estimates, the lowest level in nearly two years. Perhaps of greater concern to investors, only 49% of companies topped sales forecasts, down from the 61% average of the previous seven quarters.
Earnings season is still underway, but analysts are already planning for more tepid sales and profit growth in the quarter to come. And this should have investors paying attention.
Analysts at Merrill Lynch, for instance, now say profits for companies in the S&P 500 will rise just 6% this year, well below the double-digit pace seen in 2010 and 2011. This is just a natural phase of the economic cycle, since companies step up spending on growth initiatives, crimping profit margins in the process. Yet even as most companies are likely to simply muddle through 2012, a select group of firms are still pounding out huge profit gains.
The table below shows another group of companies that delivered major upside since then, as each of these firms beat the consensus forecast by at least 30% (with earnings per share (EPS) of at least $0.30). To narrow the list, I focused only on stocks trading for less than 15 times projected 2012 profits.
I've written a fair amount about Delta Airlines (NYSE: DAL) in the past six months, but United Continental (NUSE: UAL) holds very similar appeal. Both carriers acquired a large rival, which can often prove very tricky in the airline industry, since disparate fleets of planes and overlapping labor forces need to be reconciled, all while the customer barely notices.
These firms sought to get bigger in hopes of operating more extensive and rational route structures while taking an aggressive whack at the cost structure. In the case of United Continental, you can see how this plan paid off. The two companies joined forces in the middle of 2010, and you can see gains when comparing annual results. Despite markedly higher jet fuel prices in 2011, EBITDA still grew from $2.1 billion in 2010 to $3.4 billion. Were it not for the hike in jet fuel prices, that metric would have risen almost 100%.
The fact this stock trades for less than five times earnings -- even after a solid upward move in January -- reflects concerns that the industry will soon exit its "Goldilocks" phase. Either fuel prices will rise higher or demand for air travel will weaken, altering the current "not too hot, not too cold" conditions that the airline industry has been experiencing. Analysts say these concerns are overblown and see United Continental's EPS rising another 20% in 2012 to $6.16, implying a forward multiple below 4. As is the case with Delta, this is a company that continues to be overlooked by value investors -- and is worthy of your attention.
BP is back
It's curious to see this energy giant back on the upswing just a few years after the disastrous oil spill in the Gulf of Mexico. Shares had plunged from almost $60 in early 2010 to below $30 by the middle of June of that year. On June 4, 2010, I wrote that shares would rebound back to $50 when investors eventually came to see that this energy giant would go on to produce $8 billion in annual free cash flow. Shares are indeed back up near $50, but that cash flow forecast needs updating.
BP was able to boost net income sharply in 2011, from a $3.7 billion loss in 2010 to a $25.7 billion profit in 2011. That's the highest level of net income in the company's history. Management decided to capitalize on the company's high level of profits to pour a lot of funds into new energy fields. So my $8 billion free cash flow forecast was far off the mark: BP generated just $237 million in free cash flow in 2011, thanks to a hefty $17.8 billion in capital spending.
The current year figures to bring more of the same. BP intends to spend a whopping $22 billion in 2012 to acquire more acreage and step up production of existing energy fields. "Exploration, particularly in deepwater, has historically been a key strength of BP and now management appears to be decisively playing towards it," Merrill Lynch notes.
As BP's investments wind down, free cash flow should finally take off. Analysts at Citigroup predict free cash flow will rebound to $9.5 billion this year and $12.6 billion in 2013. Meanwhile, shares still trade a wide discount to rivals because the Gulf of Mexico-related litigation has still not yet ended. Merrill Lynch analysts figures the "discount remains too wide given the ongoing reduction of uncertainties regarding (the) Macondo (oil well disaster)." They predict shares will likely trade up to $54, which would still leave them at a 20% discount to peers such as ExxonMobil (NYSE: XOM) and Total (NYSE: TOT).
Risks to Consider: Though these companies just handily topped quarterly profit forecasts, the bar has been raised. Continued outperformance is no sure thing. Check in on quarterly trends for any stock you are researching from this group to ensure that the profit-boosting factors remain in place.
Action to Take --> Oil prices will have a huge effect on these two companies. Falling prices would push BP's shares back down, while rising fuel prices would hurt United Continental's profits. Perhaps it's wisest to own both of these undervalued stocks in tandem in order to mitigate that fuel price risk.
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