Custom Search

Monday, July 27, 2009

Watch The Divergence Between Earnings and Revenues

“The real theme is the divergence between earnings and revenues." -Steven Ricchuito, Mizuho Securities

FN: There is a dirty little secret to earnings season. In all the excitement over bottom line beats, nobody really noticed the top line misses.

Analysts, after being complete wrong all of 2007 and 2008 have finally collapsed their estimates, lowering the bar to the point where even a mortally wounded company can stumble over it. That was to be expected, and isn't really important. Most of the bottom line beats were the result of draconian cost cutting. Bonuses and merit raises first, big budget items second and finally people. Lots and lots of people. They all beat because they cut people faster than anybody expected. These kind of cuts can't be repeated and companies won't be able to pull the same miraculous bottom line beat next quarter.

Far more important and ominous are the top line misses. Revenues have collapsed and continue to do so. Big economic bellwethers all reported revenue declines of about 30%. Revenue at 143 companies fell on average of 10%. This is the true state of the economy and it is still in a 'controlled' free fall.

Something to really think about is the feedback loop. When companies attempt to shrink themselves to profitability on a grand scale, what do you suppose happens in the months afterwards? The former employees are faced with insurmountable problems. First, they cannot easily find a job precisely because companies in general are pursuing these massive cost cutting strategies. They are therefore unemployed for much longer periods of time than would otherwise be the case. Second, they cannot continue to live as they did before being let go. Drastic reductions in personal consumption must be made. This is particularly bad, and we've already seen the savings rate go parabolic to reflect this change in behavior, after a gigantic, prolonged credit bubble.

So if this were a turned based simulation with the following conditions:
- The economy employs 1000 workers.
- The mean income for each employee is 100 per round.
- The mean expenditure for each employee is 100 per turn, or 100%.

Round 1.
- There are 1000 workers employed, making $100 000, and spending $100 000, or 100%.

Round 2
- Companies fire 10% of the workers, or 100 workers.
- The economy employs 900 workers, making $90 000, and spending $90 000, or 100%.

Round 3
- Workers grow concerned over job security and decide to save money. They now spend only 90%.
- The economy employs 900 workers, making $90 000, and spending $81 000, or 90%.

Round 4
- Companies grow concerned over growth forecasts and decide to cut costs, firing another 100 workers.
- The economy employs 800 workers, making $80 000, and spending $72 000, or 90%.

Round 5
- Workers freak out! Dual income households are down to a single income. Everybody knows somebody that lost a job. Many are helping friends and family out. The savings rate increases again. Now only 80% of income is spent.
- The economy employs 800 workers, making $80 000, spending $64 000, 80%.

Round 6
- Companies freak out! They've been beating bottom line estimates by cutting jobs, but they can see their top lines getting hammered. With no end in sight, they cut another 100 people.
- The economy employs 700 workers, making $70 000, spending $56 000, or 80%.

Round 7
- Where and how this self fulfilling destructive cycle ends nobody can know for sure. It happened during The Great Depression and it was not pretty.

John Praveen at Prudential International Investments says, "Because of rising unemployment and rising household savings rate, the rebound will be anemic or weak."

In reality it is almost impossible to have a rebound with unemployment AND savings rising. In my example rising unemployment cut much deeper into consumer spending than you might expect. A 30% cut in jobs cut income by 30%, but spending by 44% or 46% more! Now imagine an model of an economy where spending was actually greater than 100% of income to start. Imagine and economy where consumers relied on home equity lines and rapidly appreciating assets to spend well beyond their means. Then imagine them going from being a net negative saver, to a saver.

You think maybe that's what's happening here today?

Sales Fail to Keep Pace With Profits as Economy Stays Sluggish: "Sales growth lagged behind profits as companies in the Standard & Poors’ 500 Index beat analysts’ estimates this week, a signal that economic recovery may be slow.

Second-quarter revenue at Caterpillar Inc. and Freeport- McMoRan Copper & Gold Inc. tumbled more than 30 percent from a year earlier, though earnings topped the average of analysts’ predictions. Inc.’s profit skidded and sales missed estimates. United Parcel Service Inc.’s sales slid 17 percent. Microsoft Corp. saw annual sales drop for the first time in 23 years as a public company.

“The economy is coming back but it is not going to come roaring back,” said Mark Zandi, chief economist at Moody’s Companies “are going to be reluctant to add investment and jobs until they get better sales.”

Revenue at 143 companies in the S&P 500 reporting this week, many of them bellwethers for the American economy, fell on average 10 percent from a year ago, according to Bloomberg data. Seventy managed to top the analysts’ consensus for sales, while 107 did so for earnings per share.

The economy probably declined 1.5 percent in the three months ended June 30, marking the fourth straight drop and the longest such streak since quarterly records started in 1947, according to the median of 66 economists in a Bloomberg survey."

blog comments powered by Disqus