May 23, 2013

Report prepared by: Ryan Lewenza, CFA, CMT V.P., U.S. Equity Strategist

Q1/13 Earnings Recap Highlights

The S&P 500 Index (S&P 500) is up a stunning 17% year-to-date, largely due to multiple expansion. Over this period, the S&P 500 forward P/E has increased from 13.5x in December 2012 to its current 15.1x, while S&P 500 forward earnings expectations have remain largely unchanged. It is our view that the multiple expansion has been driven in part by the Federal Reserves aggressive quantitative easing (QE) policies. We suspect that similar to QE1 and QE2, when the current round of QE ends the market could pull back. However, provided key fundamentals such as corporate earnings remain strong, the markets should be able to withstand this potential short-term set-back. Overall we would give the Q1/13 earnings season a B- rating given: 1) the S&P 500 earnings growth rate of 5.9% Y/Y was better than expectations; 2) the earnings beat rate of S&P 500 companies was a respectable 71% and above its long-term average; and 3) margins expanded, reversing a recent trend of margin compression. The disappointment this quarter was on the top-line, where only 48% of companies within the S&P 500 exceeded revenue estimates. This was a steep decline from Q4/12, which saw 61% of S&P 500 constituents beat top-line estimates. Despite the better-than-expected earnings results, forward guidance provided by management remains fairly guarded with 68 companies within the S&P 500 providing negative guidance for upcoming Q2/13 results, while only 12 provided upbeat guidance for the next quarter. This results in a negative/positive (N/P) ratio of 5.67, which is above the previous quarter, and according to Thomson Reuters would mark the most negative N/P ratio since Q1/01. All told, we remain bullish on equities, however we see the potential for near-term weakness/consolidation, as the S&P 500 remains technically overbought in the short term.

This Document is for distribution to Canadian clients only. Please refer to Appendix A in this report for important information.

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Q1/13 Earnings Recap

The S&P 500 is up a stunning 17% year-to-date, largely due to multiple expansion. Over this period, the S&P 500 forward P/E has increased from 13.5x in December 2012 to its current 15.1x, while S&P 500 forward earnings expectations have remain largely unchanged (Exhibit 1). It is our view that the multiple expansion has been driven in part by the Federal Reserves aggressive quantitative easing (QE) policies, with the Fed buying $85 billion per month in mortgage backed securities and U.S. Treasuries. We suspect that similar to QE1 and QE2, when the current round of QE ends the market could pull back. However, provided key fundamentals such as corporate earnings remain strong, the markets should be able to withstand this potential short-term set-back. In this report we provide a recap of the Q1 earnings season, and highlight some key themes that stood out in the quarter. Overall we would give the Q1/13 earnings season a B- rating given: 1) the S&P 500 earnings growth rate of 5.9% Y/Y was better than expectations; 2) the earnings beat rate of S&P 500 companies was a respectable 71% and above its longterm average; and 3) margins expanded, reversing a recent trend of margin compression. Our reservations with the quarter, and why we graded it a B-, relate to the weaker revenue data and continued guarded forward guidance. With 94% of S&P 500 companies having reported results, Q1/13 EPS is likely to come in around $26.22, which would equate to Y/Y growth of 5.9% (Exhibit 1). Heading into the quarter the street was looking for earnings of $25.74, resulting in earnings coming in 2% above expectations. While well below the double-digit growth seen in 2011, the 5.9% earnings growth in Q1 is still decent, and points to a reacceleration in earnings growth following the slow down in the second and third quarters of 2012. Q2/13 and Q3/13 earnings estimates have been revised modestly lower over the last quarter, with consensus pointing to EPS of $26.68 and $27.88, respectively, representing earnings growth of 5.6% and 11.9%. Q4/13 estimates remain largely unchanged at $29.49, which equates to growth of 16.5% Y/Y. We continue to expect H2/13 estimates will be revised lower in the coming months. Our full-year S&P 500 earnings estimate remains at $104, which is 5.5% below current consensus estimates of $110.16. Despite this, we believe that corporate earnings remain strong and supportive of equities. Exhibit 1: S&P 500 Gains Have Been Driven By Multiple Expansion; Q1/13 Earnings Grew At a Decent 5.9% Y/Y
16 15 14 13 12 11 10 Jan-11

S&P 500 Forward P/E

20.0%
16.9% 19.6%

S&P 500 Quarterly Earnings Growth Y/Y

Consensus forecasts
11.9%

16.5%

15.0%

14.9%

10.0%
7.1%
S&P 500 forward P/E has increased from 13.5x in Dec 2012 to 15.1x currently. Earnings estimates have remain largely unchanged over this period.

7.8% 5.9% 5.6%

5.4%

5.0%
1.5% 0.4%

0.0%
Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13

Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 Q4/13
Source: Bloomberg Finance L.P. As of May 21, 2013

Source: Bloomberg Finance L.P. As of March 21, 2013

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As mentioned, 71% of companies within the S&P 500 beat analysts earnings estimates, with the consumer discretionary, health care and financials sectors posting the strongest beat rates (Exhibit 2). However, the disappointment this quarter was on the top-line, where only 48% of companies within the S&P 500 exceeded revenue estimates. This was a steep decline from Q4/12, which saw 61% of S&P 500 constituents beat top-line estimates. As seen in Exhibit 2, the materials and industrials sectors had the hardest time beating estimates, with beat rates of 23.3% and 29.3%, respectively. S&P 500 revenues are projected to be up 4% Y/Y in Q1/13, with utilities and health care posting the strongest revenue growth, while the energy sector experienced the weakest revenue growth at -14%. Exhibit 2: S&P 500 Revenues Beat Rate Disappointed; Sector Breakdown of Beat Rates
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Q1/10 Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13
Source: Bloomberg Finance L.P. As of May 21, 2013

S&P 500 Quarterly Sales Beat Rate

73% 66% 61% 56% 61% 48% 42% 40%

67% 60%

68% 63%

69%

Long-term Average = 62%

S&P 500 Energy Materials Industrials Consumer Disc Consumer Staples Health Care Financials Information Tech Telecom Utilities

Sales Beat Total Positive Positive % 470 / 500 225 48.2% 43 / 43 21 48.8% 30 / 30 7 23.3% 58 / 60 17 29.3% 66 / 81 38 58.5% 37 / 42 16 43.2% 52 / 53 18 34.6% 82 / 82 49 61.3% 64 / 70 36 56.3% 7/7 3 42.9% 31 / 31 20 64.5%

EPS Beat Positive Positive % 333 71.2% 32 74.4% 20 66.7% 35 60.3% 52 80.0% 24 64.9% 41 78.9% 63 77.8% 43 67.2% 5 71.4% 18 58.1%

Source: Bloomberg Finance L.P., PAIR. As of May 21, 2013

Other Observations from Q1 S&P 500 net profit margins increased 60 basis points (bps) to 9.6% in Q1/13. This expansion reverses a trend of declining margins that had been in place since Q1/12 (Exhibit 3). Margins were likely aided by lower commodity prices and continued low interest rates which have dramatically lowered interest expenses for most companies. Sales to Europe were particularly weak, which had a greater impact on the industrials and information technology sectors given their higher percentage of sales from the region. General Electric Co. (GE-N), McDonalds Corp. (MCD-N) and a number of other large multinationals specifically cited the challenges in Europe in their quarterly results. Despite the better-than-expected earnings results, forward guidance provided by management remains fairly guarded with 68 companies within the S&P 500 providing negative guidance for upcoming Q2/13 results, while only 12 provided upbeat guidance for the next quarter. This results in a negative/positive (N/P) ratio of 5.67, which is above the previous quarter, and according to Thomson Reuters would mark the most negative N/P ratio since Q1/01. This is one factor that supports our below consensus EPS estimate. Exhibit 3: Net Margins Expanded 60 Bps in the Quarter; Forward Guidance Remains Guarded
12% 10% 8%

S&P 500 Net Quarterly Profit Margin

7.8% Average Since 1998

6% 4% 2% 0% 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Source: Bloomberg Finance L.P. As of May 21, 2013

S&P 500 Pre announcements Positive In-Line Negative Total N/P Ratio

Q2/13 Total (#) Total (%) 12 14 7 8 68 78 87 5.67

Q1/13 Total (#) Total (%) 14 16 4 5 70 80 88 5

Net margins increased from 9% in Q4/12 to 9.6% in Q1/13.

Source: Thomson Reuters. As of May 10, 2013

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Conclusion Q1 earnings results were generally better-than-expected, but the top-line remains a challenge in a low economic growth environment. With margins near peak levels, we believe the top-line will need to improve in order to see sustained earnings growth in the coming quarters. Forward guidance by management supports our below consensus S&P 500 2013 EPS estimate, and we see analysts H2/13 estimates being revised lower in the coming months. Q4/13 estimates in particular look high at $29.49. Despite this, with S&P 500 earnings likely hitting new all-time highs in 2013, we believe corporate earnings remain highly supportive of stocks, while valuations remain fair. All told, we remain bullish on equities, however we see the potential for near-term weakness/consolidation, as the S&P 500 remains technically overbought in the short term.

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Appendix A Important Disclosures

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