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March 29, 2012

Don’t Be Fooled! First Quarter Revenue Growth Doesn’t Always Mean Higher Profits

by Greg Harrison.

It’s no secret companies reacted to the financial crisis by laying off employees and cutting costs to the bone in order to improve their bottom line. While the unemployment rate spiked to levels last seen during the Great Depression, corporate income statements painted a rosier picture of the economy. But what worked for a while may no longer prove as reliable a strategy in the future: while companies still seem to be trying to operate as leanly as possible, it is going to be harder for them to translate whatever cost-cutting measures are still possible into profits that can surprise analysts and beat the latter’s earnings estimates. As a result, analysts expect first quarter earnings for the S&P 500 to grow by only 3.1%; if that prediction proves accurate, it will mark the weakest increase in corporate profits since the third quarter of 2009.

The fourth quarter of 2009 was the first quarter for which the 500 companies in the S&P index posted positive earnings growth – in aggregate. And that growth was remarkable: earnings soared 205.6%, an astonishing figure largely due to very low earnings in the previous fourth quarter, at the height of the crisis. But the results of cost cutting also were evident, as 86 of those S&P 500 companies managed to report higher earnings despite the fact that they had generated lower revenues. Since then, fewer companies have succeeded in pulling off this trick with every quarter that has passed. In the first quarter of 2012, only 41 companies in the S&P 500 are expected to have accomplished it.

As the number of companies reporting higher profit margins in the face of lower revenues has fallen, so the number that have posted lower earnings on higher revenues has risen. In fact, over the last several years, the two groups have shown a significant negative correlation of -.60. This indicates a general degradation of profit margins to the point where more than 20% of the companies in the S&P 500 index are expected to report lower earnings per share for the first quarter of 2012 even though their sales are increasing.

EXHIBIT 1. EARNINGS AND REVENUE GROWTH Q4 2009 – Q1 2012

Source: I/B/E/S estimates. Note : Q1 2012 data is an estimate.

The findings of this analysis closely parallel our data on earnings preannouncements. There, too, the news has been less-than-rosy; while 28 companies issued upbeat guidance, another 81 cautioned that they might not live up to analysts’ expectations for first-quarter earnings. In general, as we discussed previously on Alpha Now, companies are warning investors against expecting too much from them.

Overall, the reasons for this downbeat view of corporate profit margins and the negative guidance appear to fall into three categories:

1. Slower global economic growth in emerging markets and Europe
2. Less favorable exchange rates due to weakness in Europe
3. Higher energy prices, fuel and commodity costs

Although Proctor & Gamble Co. (PG.N) previously has lauded itself on its ability to pass on higher costs to its customers in the shape of higher prices, this quarter we expect the company to generate lower earnings than it did in the first quarter of last year, in spite of the fact that it managed to grow the top line. Jon Moeller, the company’s chief financial officer, emphasized these issues during its recent earnings conference call. “Historically, when foreign exchange rates have moved significantly in a negative direction, we have received a meaningful offset from declining commodity costs,” Moeller said. “This has not been the case this year.” As a result, the consumer manufacturing giant tightened its fiscal year sales guidance and reduced its earnings guidance.

Despite reporting a 30% jump in revenue, Carnival Corp. (CCL.N) reported a 205% decline in earnings during the quarter that ended February 2012 from the year-earlier quarter. During the earnings conference call, David Bernstein, Carnival’s chief financial officer, attributed the slump to a 30% jump in fuel prices during the quarter. That, he said, cost the cruise ship line an additional 18 cents per share of profits. (It reported a loss of 20 cents per share.)

Analysts polled by Refinitiv expect Southwest Airlines Co. (LUV.N) to post a dramatic 221% plunge in earnings in the first quarter, in spite of a 30% increase in revenue. It isn’t the only airline likely to see its profitability suffer as a result of higher-than-expected jet fuel costs. Based on the proprietary StarMine SmartEstimate score, Southwest Airlines also appears likely to post earnings for the first quarter of 2012 that are weaker than the current consensus estimate.

With headwinds like that, it’s little wonder that analysts have taken an increasingly bearish view of earnings expectations and have spent much of the first quarter revising downward their earnings estimates on many of the companies they cover. The estimated growth rate in earnings for the S&P 500 has fallen from 5.5% to 3.1% since the first quarter began, with analysts predicting earnings growth will turn negative in three of the S&P’s ten sectors, including Materials (-14.7%) and Telecommunications (-13.7%), although analysts expect nine of those sectors to report higher revenues, again signaling the discrepancy between earnings and revenue growth.

The fourth quarter of 2011 marked an end to what had been an impressive winning streak: eight straight quarters in which corporate profits grew at double-digit rates. If analysts’ forecasts prove accurate, however, the first quarter may see a dramatic reduction of nearly two-thirds, as the fourth quarter’s 9.2% earnings growth pace becomes a meager 3.1%. The outlook is actually even more bearish than this fact suggests, as a 3.1% gain is highly dependent on one company — Apple Inc. (AAPL.O) – delivering another impressive jump in earnings. Excluding Apple, the estimated growth rate for the S&P 500 drops to a mere 1.7%.

In this environment, investors may well want to find a way to identify those companies that are able to sustain their earnings and profit margins. Companies with pricing power can do this by passing on higher costs to their customers. Others that may be able to buck the trend include companies in the Technology and Financials sectors. Since they don’t have to devote a large portion of their budget to acquiring jet fuel or other vital commodities in large quantities, they have removed at least one potential source of trouble. Not surprisingly, companies in these sectors are those that appear likely to generate higher-than-expected earnings growth rates in the first quarter.

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