Bubbling earnings growth likely to lose its fizz

Here's the good news: 73% of the companies in the S&P 500 reported second-quarter earnings that beat analysts' estimates, and 80% beat the estimates in the third quarter. Those recent earnings, by the way, helped fuel the largest back-to-back quarterly gains for the S&P since 1935. Here's the bad news: Companies may have run out of ways to produce earnings growth unless the economy recovers and top-line revenue growth resumes. With unemployment at a 23-year high and climbing, it's only logical to assume that consumers won't be holding up their traditional 70% share of the U.S. economy over the next several quarters. That begs the question of where will top-line growth will come from. Wall Street has some answers, which we'll get to in a minute, but look for earnings to be an iffy prognosticator. Some market watchers and money managers shrug off Wall Street's recent off-target consensus estimates, saying that errors are to be expected in the jostling between companies wanting to look good and analysts wanting to look smart. “It's a little game that is played,” said Paul Larson, an analyst with Morningstar Inc. “Companies like to sandbag, and analysts are people too, so they sometimes make mistakes.” Gamesmanship we understand, even if it's going on among America's largest companies, not thinly traded micro-cap stocks. But two quarters of off-base forecasts? Instead of making analysts more reticent, being twice burned is likely to embolden them. “Analysts realized they were overly cautious, and I think this means future expectations are going to go up,” said Uri Landesman, head of global growth at ING Investment Management Americas. So far, extreme expense cuts — most notably in labor costs — have been the route to earnings growth. Consider the third-quarter report by Automatic Data Processing Inc. (ADP), which showed a 3.6% drop in revenue and a 1.4% increase in operating income. Another example is Amgen Inc. (AMGN), which saw revenue fall by 5.6% but operating income increase by 3.3%. But without top-line growth, there are only a few ways to wring out more profitability. Those in the bullish camp are choosing to look at things like the weak U.S. dollar and inventory restocking cycles as near-term drivers of revenues and profits. Jay Feeney, chief investment officer at Robeco Investment Management, is betting that the economic activity generated by inventory restocking will create enough operating leverage to keep profit margins at attractive levels at least for a few more quarters. “The skeptics are questioning the strength of a top-line rebound without a rebound in end demand,” he said. “But there has been so much aggressive cost cutting that it has built up operating leverage to the point where it won't take a lot of end demand to increase profits.” The operating-leverage argument posits that once a company has cut costs to the bone, revenue tends to move more directly to the bottom line in the form of profits. The lean, mean operating mode also translates into booming productivity among those workers lucky enough to be employed. According to the Bureau of Labor Statistics, employee productivity in the third quarter reached its highest level since 2003. “In a different environment, if a company cut your pay and benefits, you might go look for a better job,” said Mr. Larson. “But right now, the negotiating position of employees is somewhere between bad and horrible.” That's great for corporate earnings in the short run, although the widespread cuts in pay and benefits could be a drag on earnings when companies have to raise compensation levels to compete for labor. Ultimately, once you get beyond inventory restocking, government stimulus and whatever benefits can be derived from a weak U.S. dollar, the earnings story comes right back to the U.S. consumer. “There's just not a lot of evidence of top-line growth, and you can't cost-cut your way to greatness,” Mr. Feeney said.
“We don't think consumers are in a place right now to support a continued economic expansion,” said Brian Wright, head trader and portfolio manager with Advanced Equities Asset Management. “Without the consumer, you don't get revenue,” he added. “And without revenue, it's not a jobless recovery; it's a jobless economy.” Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.