Where is the Growth Coming From?

Majority of the S&P500 companies have declared their third quarter earnings. There is a general observation that earnings are rebounding (i.e. going into positives instead of negative). Most of the companies are showing signs of stability. I have included two charts below taken from Business Week magazine.

Chart 1 shows the overall operating earnings of the S&P index companies. It shows the operating earnings were negative in last quarter of 2008. Since then, the operating earnings are slowing coming back and increasing quarter over quarter.

Chart 1: S&P500 Operating Earnings Growth

Chart 1: S&P500 Operating Earnings Growth

Chart 2 shows the summary plot of percentage of companies beating the estimated earnings. This chart also shows improving trends. 80% of the companies beat estimated earnings.

Chart 2: S&P Companies Beating Estimates

Chart 2: S&P Companies Beating Estimates

Now these two charts will make you believe that company results are turning positive and hence the rise in markets are justified. We all like to see some greens in our portfolio.

No matter how much I like to see positives, I am still skeptical about the stability and continued growth. Beating own estimates does not mean company is doing good. All it means is estimates were wrong. Estimates were out of whack. Earnings need to be compared with company’s past record, and not to S&P’s estimates. So many times these analysts have been wrong. Sometimes I wonder what was the author trying to communicate.

Furthermore, we would tend to believe that growth in operating earnings shows companies earnings are growing. However, if we take a look at S&Ps data on actual operating earnings, the message seems to be different. A total of 478 companies have reported their third quarter earnings which represent 96.3% of the market. The observations are as follows

  • 137 companies show positive revenue growth, while 341 companies have negative revenue growth. Basically, most of them have reduced their revenue.
  • 227 companies have had positive growth in operating earnings, while 251 companies have had negative growth in operating earnings.

Let us take a look at two examples:

  • Sysco Corporation: Its revenue has been either flat or little reduction during 2009. It has had reduced earnings, but flat to increasing free cash flow. Overall, most of this is coming from reduced cost of goods, reduced payroll expenses, and lower incentive compensation, and other accounts of cost reduction. There is no growth in revenue, means it is not selling more to earn more.
  • Proctor and Gamble: Through 2009, it has seen continued reduction in its revenue. However, on account of reduced working capital, reduced manufacturing cost, reduced commodity cost, etc the earnings and free cash flow are improving.

In essence, revenue is decreasing but operating earnings are increasing. In short, while companies are not selling more, they are continuing to earn more on per share basis. Intriguing! In my view, these growth in operating earnings are nothing but cost reduction initiatives. Companies are reducing their expenses by reduced head count, weeding out in-efficiencies, etc. By citing SYS and PG, I am these are in trouble or bad shape. I am only attempting to show how the earnings are growing.

Every company should try to weed out in-efficiency and make cost reduction efforts. In my viewpoint, that is the hallmark of the good company that they are trying to adapt according to business environment. However, in the end there is only so much one can do with reducing operating expenses. These performances are temporary, and real growth should come from selling more product or services. Charts like these do not communicate the real underlying scenarios.

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