Over and over again I hear analysts say that the recent good (relatively speaking) earnings were due to cost cutting and that there is only so much cost cutting you can do.
The implication of this is that earnings related to cost cutting are temporary and unless top line revenue grows, the earnings will disappear. Now, I can't imagine that is what the analysts are actually saying, but, over and over again I hear that comment and I'm beginning to wonder if they can really believe it.
If you have a company with sales of say $1 billion dollars and make a profit of 10% or 10 million dollars and then find that because of an economic contraction you are losing sales, you either reduce cost or lose money. Now, getting rid of excess inventory, reducing staff and closing facilities can be painful, but suppose sales have shrunk to 850 mil from the billion. If you have reduce costs enough to generate the same 10% profit, you will have earnings of $8.5 million.
Now, that constitutes reverse growth of a sort, but the savings and earnings will not go away unless sales continue to decline or costs are reintroduced. Since I believe the economic contraction has ended, the reasonable expectation is that sales will increase or at least stay stable.
Now, if you are thinking about investing in this company, the stock price should be lower than what it was when earning were higher. Mostly they are. I would argue, you need to analyse the company based on what is going to happen, not on what used to be.
Does the new company have growth potential from where it is? The fact that a company that is now only 85% of what it was is simply an interesting tidbit. Does it have good growth potential? Does it pay stable dividends?
Lots of analysts came up during a period when constant growth was the goal and they seem unable to adjust to the fact that we have reversed about 10 years of growth in the current economy. Businesses seem to have adjusted and have set themselves up to be profitable. The analysts seem to be a lagging indicator.
Showing posts with label earnings. Show all posts
Showing posts with label earnings. Show all posts
Saturday, August 29, 2009
Tuesday, August 18, 2009
Earnings projections
In every industry, whether times are good or bad, some companies do better than others. The reason for this is most often better management although at times other factor play a part.
When one company in an industry reports results, and they are unfavorable, often they claim the problems are beyond their control and attribute them to a poor economy. When the companies that have done better report, they may also cite economic conditions and generally, try to be conservative in making predictions as to future results.
While human nature has a certain boastfulness to it, in business, the surest way to fail is to fail to produce the promised results. For a fair number of years I used to review bonus plans for companies. No employee likes to sign up to a performance objective that they don't feel confident about. At times management tries to impose stretch goals but these are resisted. So, when you are preparing projections, and put together estimates based upon inputs from various districts, regions, stores or whatever corporate structure you have, it is going to be understated since any manager knows that he better not promise more than he can deliver.
Clearly, there may be events that cause even fairly conservative estimates to fall short but in an economy that is reasonably stable or growing, most companies will exceed their estimates.
We saw that during the recent earnings season. Earnings generally exceeded projections despite the decrease in year over year revenue. Most companies were quite conservative in giving guidance about the rest of the year citing difficult economic conditions. However, the fact that they exceeded estimates for the most part is a tremendous indicator that conditions have achieved a reasonable level of predictability. This occurs when the economy is stable or growing, not when it is contracting.
The one lesson I believe you can take away from earning season is that the economy has clearly stabilized and is probably starting to grow slowly.
When one company in an industry reports results, and they are unfavorable, often they claim the problems are beyond their control and attribute them to a poor economy. When the companies that have done better report, they may also cite economic conditions and generally, try to be conservative in making predictions as to future results.
While human nature has a certain boastfulness to it, in business, the surest way to fail is to fail to produce the promised results. For a fair number of years I used to review bonus plans for companies. No employee likes to sign up to a performance objective that they don't feel confident about. At times management tries to impose stretch goals but these are resisted. So, when you are preparing projections, and put together estimates based upon inputs from various districts, regions, stores or whatever corporate structure you have, it is going to be understated since any manager knows that he better not promise more than he can deliver.
Clearly, there may be events that cause even fairly conservative estimates to fall short but in an economy that is reasonably stable or growing, most companies will exceed their estimates.
We saw that during the recent earnings season. Earnings generally exceeded projections despite the decrease in year over year revenue. Most companies were quite conservative in giving guidance about the rest of the year citing difficult economic conditions. However, the fact that they exceeded estimates for the most part is a tremendous indicator that conditions have achieved a reasonable level of predictability. This occurs when the economy is stable or growing, not when it is contracting.
The one lesson I believe you can take away from earning season is that the economy has clearly stabilized and is probably starting to grow slowly.
Thursday, July 9, 2009
Thoughts on earnings
Where is the stock market headed, or maybe a better question is what should the S&P 500 be trading at? Generally the level is closely related to earnings and as earnings for the 500 have dropped since last year so has the market valuation. However, we are now in earnings season and as companies make announcements, the S&P is going to react.
There are a number of historical charts on the relationship between the S&P level and earnings. Generally the price/earnings ratio needs to provide a yield that is better than what you can get in US Treasuries since realistically, why take a risk if you are going to get less money than you would for not taking a risk? Right now this would require returns of at least 5% but that isn't enough of a premium so generally I think 7-8% is a better gauge. At 7.5% you would trade at 13.3 times earnings. Generally $55 is the current estimate for 2009 so the S&P lower limit would be in the 730 range. Now if you are will to accept the 5% return with the hope of future growth, the P/E ratio changes to 20 and we get an S&P at 1100. A more normal P/E ratio tends to be about 17 so a reasonable estimate is 935.
Now of course the estimate for earnings and whether it should be earnings from operations or GAAP earnings, (includes all accounting write-offs and additions) is the starting point. I prefer earnings from operations, since if you start using gains and losses from asset valuations, and other accounting requirements, you add a lot of individual company variability. I think those things are important is assessing the long term well being of individual companies, but distort the overall comparisons too much. As an aside, all those asset write-offs due to property and inventory valuations, may now actually be hidden assets if the valuations have any upside.
However at a P/E of 17 the return is around 6% (5.88) and it is fairly safe to say that the market want to get at least the treasury rate of about 4% plus protection against inflation. So if you expect inflation to be 1% we are back to a P/E of 20, at 2% 17, at 3% 14 etc.
So level of earning with return on treasuries and inflation expectations can give you a good estimate of where the S&P should be.
Concerning earnings, while revenue is down for most of the S&P companies we have seen aggressive cost cutting and inventory reductions (look at unemployment and commodities). This is likely to show some earning improvement despite the fact that the level of activity is reduced. Two things should be considered. I think companies need to adjust to a reduce level of consumer spending. This doesn't mean they can't be profitable, simply that they need to be profitable at a lower level of sales.
Growth will return, but barring an unexpected surge in real estate prices, consumers simply don't have the ability to spend like they used to. We also know that ugly reality has hit the baby boomer generation and that the comfortable retirement they envisioned from the equity in their homes and the gains in the stock market have vanished. They are now saving more and spending less. I don't expect this to change. However, if GM for example can be profitable selling 2 million cars a year, is it a bad investment? It won't be as big as it once was, nor will it employ as many people, but it may still be a good investment.
So I expect that we will continue to see earnings beat expectations because of the cost reductions, not revenue growth. In fact I believe what we saw from Alcoa may not be far from the norm, where the aggressive cost cutting allowed them to beat expectations, admittedly still losing money, by 30%.
It may seem a bit contradictory, but the cyclical industries hardest hit by the recession have had the best opportunity to do drastic cost cutting.
How will the Market react? Initial reaction to the Alcoa earnings is positive. I would think that as earning continue to beat estimates we will see the S&P go to the 935 level and possibly approach 1000. However, the naysayers will talk about a sluggish recovery with little job growth and reduced consumer spending. True enough, but if we accept that the economy isn't going to return to 2007 levels, have we recalibrated sufficiently to grow from where we are?
There are a number of historical charts on the relationship between the S&P level and earnings. Generally the price/earnings ratio needs to provide a yield that is better than what you can get in US Treasuries since realistically, why take a risk if you are going to get less money than you would for not taking a risk? Right now this would require returns of at least 5% but that isn't enough of a premium so generally I think 7-8% is a better gauge. At 7.5% you would trade at 13.3 times earnings. Generally $55 is the current estimate for 2009 so the S&P lower limit would be in the 730 range. Now if you are will to accept the 5% return with the hope of future growth, the P/E ratio changes to 20 and we get an S&P at 1100. A more normal P/E ratio tends to be about 17 so a reasonable estimate is 935.
Now of course the estimate for earnings and whether it should be earnings from operations or GAAP earnings, (includes all accounting write-offs and additions) is the starting point. I prefer earnings from operations, since if you start using gains and losses from asset valuations, and other accounting requirements, you add a lot of individual company variability. I think those things are important is assessing the long term well being of individual companies, but distort the overall comparisons too much. As an aside, all those asset write-offs due to property and inventory valuations, may now actually be hidden assets if the valuations have any upside.
However at a P/E of 17 the return is around 6% (5.88) and it is fairly safe to say that the market want to get at least the treasury rate of about 4% plus protection against inflation. So if you expect inflation to be 1% we are back to a P/E of 20, at 2% 17, at 3% 14 etc.
So level of earning with return on treasuries and inflation expectations can give you a good estimate of where the S&P should be.
Concerning earnings, while revenue is down for most of the S&P companies we have seen aggressive cost cutting and inventory reductions (look at unemployment and commodities). This is likely to show some earning improvement despite the fact that the level of activity is reduced. Two things should be considered. I think companies need to adjust to a reduce level of consumer spending. This doesn't mean they can't be profitable, simply that they need to be profitable at a lower level of sales.
Growth will return, but barring an unexpected surge in real estate prices, consumers simply don't have the ability to spend like they used to. We also know that ugly reality has hit the baby boomer generation and that the comfortable retirement they envisioned from the equity in their homes and the gains in the stock market have vanished. They are now saving more and spending less. I don't expect this to change. However, if GM for example can be profitable selling 2 million cars a year, is it a bad investment? It won't be as big as it once was, nor will it employ as many people, but it may still be a good investment.
So I expect that we will continue to see earnings beat expectations because of the cost reductions, not revenue growth. In fact I believe what we saw from Alcoa may not be far from the norm, where the aggressive cost cutting allowed them to beat expectations, admittedly still losing money, by 30%.
It may seem a bit contradictory, but the cyclical industries hardest hit by the recession have had the best opportunity to do drastic cost cutting.
How will the Market react? Initial reaction to the Alcoa earnings is positive. I would think that as earning continue to beat estimates we will see the S&P go to the 935 level and possibly approach 1000. However, the naysayers will talk about a sluggish recovery with little job growth and reduced consumer spending. True enough, but if we accept that the economy isn't going to return to 2007 levels, have we recalibrated sufficiently to grow from where we are?
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