SERIOUS MONEY:It is difficult to see how low, single-digit sales growth will propel margins any higher than they already are
EQUITY INVESTORS have enjoyed a sustained advance in stock prices for several months, as expectations based upon the belief that policymakers are miracle-workers allowed the major market averages to move sharply higher. An overdue reality-check was sure to arrive at some point, and so it has, as corporate America’s most disappointing quarterly earnings season in many years reveals that “big business” is not immune to the troubling deterioration in global economic momentum.
The third-quarter reporting season is well under way at this stage, and the latest numbers reveal that corporate America is set to post a year-on-year decline in quarterly earnings-per-share (EPS) for the first time since the autumn of 2009. Consensus estimates forecast a 2 per cent drop in quarterly EPS, as a sharp slowdown in revenue growth alongside margin compression has sent corporate profitability into reverse.
Corporate America has enjoyed an extraordinary earnings boom over the past three years, as an intense focus on costs allowed margins to surge to record levels – more than three percentage points above their long-term mean, while a strong contribution from global operations more than offset tepid revenue growth in the US.
However, the ability to tap further cost efficiencies is largely exploited at this juncture, while the economic malaise in the euro zone, and a marked slowdown in the pace of economic growth in emerging markets including China, means that foreign operations are no longer bolstering bottom-line performance.
The recent trends are unsettling. FactSet reports that the percentage of companies reporting earnings above expectations thus far is in line with historical averages at close to 70 per cent, but the aggressive reduction in earnings estimates during the pre-reporting season means that this figure is not particularly impressive.
Further, the percentage of companies posting revenues above consensus estimates at about 35 per cent, is more than 20 percentage points below recent experience, and as low as the number seen in the first quarter of 2009, when the global economy was deep in the throes of the worst downturn in generations.
The top-line disappointment is almost exclusively an international affair, with a spate of companies including GE, Ingersoll Rand, and Microsoft attributing the shortfall in sales to weak economic conditions in Europe, and others including Caterpillar and Intel, citing soft activity in China. Currency issues were mentioned in a number of earnings reports, but this was just a minor irritation, with sluggish revenue growth stemming primarily from soft demand.
The fourth-quarter earnings season is unlikely to prove any kinder than the current reporting period, as more than three-quarters of the companies that issued forward guidance provided an earnings outlook below the Wall Street consensus. This was the highest number since FactSet began collating the data in 2006.
The negative guidance appears to have had little impact on the bottom-up analyst community, who forecast a resumption of earnings growth during the fourth quarter, with an 8 per cent increase in EPS pencilled in. The optimism continues for 2013, with a 4 per cent increase in revenues expected to lead to EPS growth of 10 per cent.
The numbers appear fanciful as the US economy continues to grow at subpar rates, the euro zone crisis is ongoing, while structural issues could well see growth rates in emerging markets such as Brazil, China, and India that are well below recent norms. Further, it is difficult to see how low, single-digit sales growth will propel margins any higher than they already are.
Corporate America’s good fortunes in recent years have been premised upon a concerted effort to control variable costs, with incremental revenue increases dropping straight to the bottom line. Costs have already been pared to the bone, which means further margin expansion is not feasible without robust top-line growth. Indeed, revenue increases in the 3-4 per cent range, at such an advanced stage of the earnings cycle, have typically been accompanied by margin contraction, not expansion.
In this regard, it is instructive to observe that current earnings have reached levels – relative to their 10-year average – that have rarely been exceeded during the past half century and typically followed by poor growth outcomes in subsequent years. Statistical analysis reveals that corporate earnings are roughly 25 per cent above trend, and given the soft global economic picture, it would be unduly optimistic to expect double-digit percentage point gains to continue.
The third-quarter reporting season has been notable for the sluggish revenue growth that has brought an end to corporate America’s winning streak. Wall Street remains bullish on the outlook for the remainder of this year and beyond, but a more constructive analysis suggests the boom in corporate profits is at an end.
