Thursday, 25 October 2012

Are Earnings Coming Back to Earth?

By Jeremy Glaser

Morningstar – Sun, Oct 21, 2012

Corporate earnings have long been a bright spot during this recovery. Even when everything else in the economy looked bleak, corporations seem to keep delivering better-than-expected news quarter after quarter. But is that turning around? So far in this third-quarter earnings season, we've seen disappointing top-line numbers that could be a sign that the momentum in corporate earnings might be beginning to slow.
All things considered, most large firms handled the great recession fairly well. Faced with collapsing sales and an uncertain future, most managers became very defensive. They cut staffing to the bone, shut down unprofitable divisions, paid off debt, and raised additional capital if needed. These moves not only helped keep the lights on during the worst of the downturn, but they positioned firms well for the upturn. As the economy slowly began to come back, the leaner and more efficient companies were able to consistently boost their margins and surprise investors, even when revenue growth remained anemic. The charts below show just how high corporate profits have reached, and how profits have hit an all-time high as a percentage of gross domestic product. Shaded areas on these charts represent U.S. recessions.
US Corporate Profits After Tax data by YCharts
US Corporate Profits After Tax as % of GDP data by YCharts
But high levels of profitability can't go on forever. Eventually firms are going to have to hire more workers, invest in equipment, and face new competitors. Many (including GMO and others) have predicted that margins are due for a mean reversion and that regardless of the strength of the recovery, corporations are going to get squeezed. It's hard to extrapolate too much from the earnings we've seen during the last two weeks, but that squeeze could be starting.
Squeeze Play
To be sure, earnings have not been a disaster so far. According to data from FactSet, of the 98 members of the S&P 500 that have reported earnings so far, 70% have exceeded analyst expectations. But of those 98 firms, only 42% have beaten estimates for sales. During the last four years, an average of 59% of firms had beaten revenue estimates at this point in the reporting cycle. Some of those current misses are being driven by unrealistically high expectations and very strong currency headwinds, but some firms are starting to show signs of weakness. Given that most firms have already cut about as much as they can from their organizations, the drop in sales is likely to eventually lead to a drop in profit as it will be harder to cut deeper to keep profit growing.
One of the highest-profile misses this past week was Google(GOOG), which surprised the market not only with a premature earnings release but also with disappointing results. Revenues were below expectations, and operating costs rose quickly as the firm spent money to launch a new tablet and invest elsewhere in the business. Morningstar analyst Rick Summer thinks that as the firm continues to shift its revenue stream away from ads hosted on its sites toward ads on partner sites, content, and hardware it will become even hard to "gain operating leverage from the business" and increase margins at all. Google was hardly the only tech firm that reported a rough quarter. Microsoft(MSFT) and Intel(INTC) are feeling the impact of slowing PC sales ahead of the Windows 8 launch. International Business Machines(IBM) missed expectations as its revenues declined 5% (partially because of currency headwinds) as the firm launched its mainframe refresh.
Beyond tech, earnings misses could be found in plenty of other sectors. Sales at
McDonald's(MCD) and Chipotle Mexican Grill(CMG) both fell short of expectations. Profitability at the oil-services firms took a big hit this quarter, and
pressure pumping remained challenged. Baker Hughes(BHI) reported a North American margin of 10.5%, a nearly 300-basis-point sequential decline. This is more than Schlumberger's(SLB) 230-basis-point decline but less than
Halliburton's(HAL) 660-basis-point decline.
Sluggish global growth is causing some of these misses, and some are idiosyncratic based on product cycles or one-time issues. Certainly, some of the misses are driven by heightened expectations after such a long stretch of good earnings. But part of it is also that corporate earnings have reached very high levels, and firms are beginning to feel the force of mean reversion. The weak sales this quarter could be the canary in the coal mine that earnings are about to be pressured, too. Even if margins don't come all the way down to historical levels, the reduction in profitability could be a major headwind for investors in the coming years.

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