Earnings Peak

Last issue we discussed how revenue results for S&P 500 companies were not meeting or exceeding estimates nearly as much as earnings were. This raised concern despite the S&P 500 posting near record earnings in the third quarter of 2011 with fourth quarter expectations for record highs.

Now that more than 400 companies in the S&P 500 have reported earnings for the quarter we can get a better handle on results and better yet, profit margins. When earnings growth is stronger than revenue growth it means companies are slashing their costs to boost profit margins, this is not a positive and represents a short-term fix.  

We saw a lot of this in 2008 as the economy tumbled into recession. However, that can only be done until the point of maximum cost efficiency, thus leading to revenue growth as the only option to build earnings.

The good news is despite not surpassing estimates as frequently as earnings, fourth quarter revenue growth exceeded that of earnings. S&P revenue grew by 11 percent while earnings were up 7 percent (Interestingly, excluding Apple growth was 10 percent and 3 percent, respectively).

What makes things convoluted is that profit margins contracted in the fourth quarter. In fact, every sector outside of technology saw a decline in profit margin. (See chart)

Confused yet? I am.

Granted, profit margins could have been squeezed from companies investing in their business, i.e. increased labor costs or inventory builds.

If business costs are going up due to investment that would be a positive for the U.S. economy and show confidence is coming back amongst corporate executives. However, if costs are rising due to higher input expenses than there may be cause for concern.

Interestingly enough, it looks like both items are true. Higher input costs in the fourth quarter were reported from clothing companies to packaged food makers. General Mills is a good example; in their last quarterly report the company said “gross margin as a percent of net sales was below year-ago levels due to higher input costs…”

At the same time, U.S. non-farm payrolls were strong late in 2011 and unemployment pushed lower. So increased labor costs most likely played in the mix for U.S. companies.

For the second quarter we need to keep an eye on revenue for growth that offsets rising costs. As for the costs, we need to pay mind to where the increases are coming from. Either way it looks like profit margins may be pressed further in the second quarter, good or bad.

Where Is The Revenue

We ended our last letter discussing the upcoming barrage of fourth quarter earnings from S&P 500 companies. Now that a substantial number of reports have been released we can analyze the overall theme of results.

As of the end of January, 184 companies released earnings. 59 percent of those companies posted earnings that beat estimates, not bad at all you’d probably think. Unfortunately, it represents the weakest result since the fourth quarter of 2001, which I believe was at the tail end of the recession that year. (Do what you will with that last piece of information).

Earnings expectations grew sequentially in every quarter in 2011 until the fourth quarter (noted in chart last letter). Additionally, the lower earnings expectations have not been exceeded. So what gives?

(And yes, I realize Q4 GDP was better than expected and unemployment improved during the period, thus puzzling me further.)

The culprit looks to be revenue, specifically the lack of revenue growth. Remember, a company can increase earnings by growing revenue or cutting costs. It looks like the later is still in the driver’s seat.

Only 43 percent of companies have beat revenue estimates, down from 59 percent in the fourth quarter of 2010 and 52 percent in Q3 2011. Granted this isn’t rocket science but we can see the theme here; 59 percent of companies beat earnings estimates, but only 43 percent beat revenue estimates. A good chunk of that difference had to be made up somewhere; lower costs.

Considering 243,000 jobs were added to the economy in January and the unemployment rate dipped to 8.3 percent, its lowest level in a few years, we should keep an eye on how this translates into first quarter results. Assuming February and March also put up respectable employment growth; we will keep any eye on costs to see if companies are investing money into their business through additional labor or not.

A growing labor force due to expanding business is the real economic growth we need and would like to see in America. However, revenue growth is the key to that formula.

One last interesting fact about fourth quarter earnings thus far; Apple and AIG alone account for 10 percent of the rise in S&P 500 fourth quarter earnings compared to 2010. Without those earning are up 1.5 percent from a year ago, the weakest showing of 2011.

Your waiting for the revenue analyst,

Mitch Jaworski