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

U.S. Economy Lesser Of Many Evils

When taking a look back at all of the economies around the world, you get a general sense 2011 was, well, really not all that bad in the U.S.  Granted the economy was somewhat soft but at least there was some growth.   Overall, we know things weren’t pretty for the global economy last year, especially the euro zone.

The U.S. economy saw Gross Domestic Product (GDP) grow 2 percent in Q3 2011 and expectations call for at least some Q4 growth (first estimate of Q4 GDP is due out next week).   Additionally, no one expects the U.S. economy to shrink in Q1 of 2012.  However, this is not the case in other nations.  The Office for Budget Responsibility (OBR) expects Q4 GDP shrank in the U.K. and that it will be followed by a marginal 0.1 percent gain in Q1 2012. 

   

Economic activity in the Asia Pacific region is now sputtering as well.  Singapore recently cut its 2012 GDP growth forecast to 1-3 percent, down from earlier estimates of 5 percent.  Japan is seeing additionally weakness as exports to the European Union hit a 32 year low back in October.

It’s worrisome how and when the continued deterioration in Europe will impact the U.S.   Looking at U.S. based multinational corporations may help gauge that and it lends into what I’d like to cover next; Q4 earnings season and expectations.

After seeing strong overall earnings results in the first three quarters of 2011, with many corporations posting quarterly record profits, the outlook has softened quite a bit for Q4.  In fact Q4 forecasts have recently been revised down to their lowest levels over the past 12 months.   In fact Q4 EPS expectations for the S&P 500 are below both Q3 and Q4 results as the following chart displays.

 

Additionally, overall margin estimates for S&P 500 companies have seen mixed forecasts, with some expecting a slight uptick in Q4 to 9.0 percent from 8.9 percent, while others are expecting a decline to 8.7 percent.

In the next couple weeks we will be able to delve further into the numbers and gauge results compared to estimates and prior quarters.  Nearly two-thirds of S&P 500 companies report Q4 earnings in the last two weeks of January.    

Is Confidence In The Consumer Waning

The Commerce Department released their second estimate of third quarter Gross Domestic Product (GDP) last week.  The number was revised down to 2 percent from the first estimate of 2.5 percent.   The result was weaker than the 2.3 percent economists had expected as average on average.

Digging further into the report, the Commerce Department tagged weaker inventory building by businesses as the main culprit.  According to the report, additional data from the private sector showed weaker restocking of inventory than seen in the first estimate.

As for the numbers, inventories fell by $8.5 billion in the third quarter, after rising $39.1 billion in the second quarter.

Basically this tells us that confidence in the American consumer by U.S. businesses is not high.  If businesses were expecting strong demand in the current quarter and those ahead, they would be more willing to stockpile inventory so that they have product on hand.  

Rather, by staying lean, business costs remain lower which can help the bottom line.  There are two ways to increase profits; generate more revenue or cut costs.  Lower stockpiles of goods fits in the latter.  Businesses are basically more confident that keeping costs low is a better bet than on consumers buying more.

What’s a bit troubling, consumer spending, which makes up two-third of GDP, came in at 2.3 percent for the quarter, down slightly from the first estimate of 2.4 percent.  So it’s not like spending is dead, it just looks like businesses are betting it is going to slowdown.

There is one caveat here, the tsunami in Japan.  Many tech companies struggled to get parts as a large chunk of semiconductor components are manufactured there.  So in that instance, lower inventory was not really a choice.  How much of an impact it had on the overall softening of inventory levels remains to be seen, we likely won’t know the full affect until the first quarter.

Additionally, the Commerce Department reported that Americans after tax incomes fell by the largest amount in two years, due to high unemployment and lower pay raises.  That being said, I guess we cannot be surprised businesses are slow to restock inventory.

Let’s revisit a point that has become a staple in this letter, year-over-year GDP.   As for the latest reading, third quarter year-over-year GDP growth now stands at 1.5 percent, following the 1.6 percent registered in the second quarter.   Remember, whenever this figures falls below 2 percent a recession follows.  We are now going on a second consecutive quarter of sub 2 percent year-over-year growth.

Please see the below chart for reference:

I don’t want to sound like a broken record, but if I see a data trend, I am going to play it till it breaks.  Yes, I expect the U.S. economy will fall into another recession in the near future; a double-dip is very likely.

When this occurs is up for debate, especially considering fourth quarter GDP estimates call for a rise from third quarter GDP.    However, we need to keep an eye on the year-over-year figure an that 2 percent threshold.

My portfolio is still in defensive mode; high yielding utility type stocks and gold related securities.

NOTE:  I will be traveling to Australia for a few weeks so there will likely be a delay between letters.  I apologize for the delay on this one.

Your waiting to see the final GDP reading analyst,

Mitch Jaworski

The Schizophrenic Economy

The current state of the U.S. economy can be defined by one word; paradox.   The definition of a paradox is a seemingly true statement that leads to a contradiction or a situation which seems to defy logic or intuition.

This seems to be the appropriate label for the economy after we analyze the economic data released last week, coupled with the consumer sentiment data.

The Commerce Department released retail sales figures last Friday for the month of September.  The 1.1 percent increase was much better than the 0.6 percent expected.  Excluding autos, sales were up 0.6 percent compared to an expected increase of 0.3 percent.  Both figures were ahead of growth rates from a month ago.

In addition to this data, last week the Labor Department reported a 0.2 percent increase in workers’ hourly earnings in September, compared to a 0.2 percent decrease the month prior.  Nonfarm payrolls showed a 103,000 increase (though the number did receive a boost from the 45,000 striking Verizon workers going back to work) so there were some positives there as well.

What totally throws me is if people or spending more money and making a little more money in addition to jobs being added; then why is consumer sentiment getting worse, especially in regard to employment outlook?

The Thomson/University of Michigan preliminary index of consumer sentiment for October showed a drop to 57.5 from 59.4 in September.  The result was a disappointment as economists expected an increase to 60.2 (which seems justifiable considering the data mentioned earlier).

According to the survey, the gauge for current economic conditions fell to 73.8 from 74.9.  Additionally, consumer expectations fell to its lowest level since May 1980, at 47 from 49.4.  What’s more is the expectations gauge has faded more than 20 points since the beginning of 2011. 

So my question becomes this; if consumer sentiment is falling in regard to the current state of the economy and their outlook is worsening as well, who exactly is spending more money?

In addition to that contradiction is the fact that 39 percent of consumers said that income declines were the reason for their finances worsened.  Recall, this report come out after a month showing an increase in average worker earnings. 

If you are confused about the outlook for the U.S. economy, don’t sweat it, because I am too!

The below chart muddles it up even more:

Do you see the trend starting around 2008, retail sales soaring and consumer confidence languishing?  Apparently the economic paradox has been going on for some time now.

I don’t want to discount the strengthening retail sales numbers of late, but a quick top level analysis may give us some clarity on why sentiment is not matching results.   A majority chunk of the sales growth came from autos and gas.  When looking further into those sales, data (produced by Goldman Sachs) shows roughly 70 percent of growth in vehicle sales have come from businesses, not consumers since the auto sector bottomed a couple years back.

Along with that bit of information, I plan to keep an eye on the September consumer credit number to see if it increased after Americans cut down on debt in August.  If spending received a bump from U.S. households taking on more debt, that would not be a positive.  Hopefully this will not be the case, the change in revolving credit (credit cards) in particular is what to watch.

Your anxiously waiting end of the month data analyst,

Mitch Jaworski