Saturday, July 25, 2009

Digging Beyond "Better than Expected" Earnings

We are more than half way through earnings season, and I thought that it would be important to take the pulse of what many of the companies are individually telling us. In all sorts of market environments (bull and bear), it is important to know how a certain company has reached the results it reports. It is not enough to simply see the headline number and draw any conclusions from it. Many of these companies are massive organizations with dozens of different income streams and products. In a way, they are little economies in themselves.

When looking for economic recovery, it is important to know where to look. Many people, the media being the major culprit, make the mistake of labeling anything that looks a return to the conditions present in the prior expansion as a sign of impending recovery. But economies don't work that way.

Economic expansions are led by increases in capital expenditures, investment and the application of theretofore unproductive technologies. The prior contraction is the lead cause of these factors. Wages typically fall as quality employment becomes scarcer, thus making new investment more "productive." Additionally, consumers and businesses have a propensity to save more during economic contractions. These savings provide the capital needed, at a lower rate of interest, to make these investments possible.

As the expansion wears on, the excess profits then derived from the previous gains in productivity are used increasingly for consumption goods. The perceived benefit to making further investments at that time is typically nowhere near where it was years earlier. Wages will be higher, machinery more expensive, interest rates rising, etc. It becomes more "economic" to satisfy one's immediate wants.



The US economy can be seen riding this wave following the early 90's recession into the 2007 top. The blip in between ('01-'02) was the economy making the adjustment between this productivity driven economy to the consumption driven. How central bank and government policies interfere with this process, twisting certain parts, expanding and lengthening others, is not of importance to the bigger picture. What we are trying to determine here is which part of the cycle are we embarking on and thus, how to allocate our investments.

What we are looking for is not a return to the consumption driven economy. Going backward is not feasible. We are looking for signs that the contraction is morphing into a productivity driven expansion. This process is never going to be uniform. Certain sectors of the economy will lead, while others will lag behind. We can ascertain from history that technology and other capital intensive industries will be the first to show signs of making this transition. However, no two recoveries are the same. When not making the mistake of assuming the recovery will look like the previous consumption driven expansion, many make the mistake of assuming the productivity expansion will look the same as the previous one. The previous productivity expansion centered around telecommunications and information technology. It would be safe to say that this expansion will surround something else entirely.

I'll have more on what I think this will look like in a later post. For today, let us focus on some important notes by companies that can be seen as "leading edge" or "investment intensive" for the economy:

Dell Reviewing Alternative Sources of Capital

uly 14 (Bloomberg) -- Dell Inc., after cutting spending, raising money in the debt market and temporarily suspending its share-buyback program, says it is reviewing alternative sources of capital to bolster its unit that provides customer financing.

The world’s second-largest maker of personal computers has had to fund the unit internally and will likely need to provide more capital to the business later in the year, Chief Financial Officer Brian Gladden said today. The unit provides financing to customers who buy Dell products and services.
...
Dell is also working on a plan to save $4 billion in annual costs by fiscal year 2011. The company is adjusting to a slump in information-technology spending, which Goldman Sachs Group Inc. expects to drop 8 percent this year.

“In 2009, there’s been a deferral of spending -- a pretty significant deferral -- which we think sets up for a pretty large refresh in 2010,” Michael Dell said. “The refresh will come first in storage and servers” and then in PCs.

Intel Trumps Forecast; Bodes Well For PC Sector

SAN FRANCISCO (Reuters) - Intel Corp's quarterly results and outlook blew past Wall Street forecasts on better-than-expected consumer demand for PCs, especially in Asia, setting an auspicious tone for the technology sector.
...
Intel's strong showing came despite what it described as weak demand from the corporations that traditionally are big buyers of computer equipment, and comments by Intel executives that Microsoft's forthcoming Windows 7 operating system is unlikely to revive corporate spending this year.

"You have an $8 billion quarter with very little enterprise spending taking place," said Broadpoint Amtech analyst Doug Freedman. "The consumer is healthier than we expected."

Cost Cuts Help IBM Earnings Surge 18%

IBM's second-quarter earnings per share surged 18 per cent from a year earlier, exceeding Wall Street expectations of a 3 per cent improvement, as cuts in the workforce and other expenses more than made up for falling revenue.

Although total sales slid a more-than-expected 7 per cent after currency adjustments and hardware revenue dropped 22 per cent, every dollar that IBM did take in contributed more to the bottom line, the company said yesterday.

Cost cuts boosted the pre-tax profit margin more than 4 percentage points to 18.3 per cent, delivering $3.1bn of net income on sales of $23.3bn.
...
The company said it was still on track to save $2bn this year from "workforce rebalancing" - or cutting out employees in more expensive countries and adding back a smaller number elsewhere.

It previously said it would save a further $1bn by retooling its internal processes and support mechanisms, and Mr Loughridge said yesterday that the company could save another $500m that way.

Google Earnings Top Analysts' Expectations

Google Inc. said Thursday that its net profit for the second quarter hit $1.48 billion US, or $4.66 a share, as the company topped Wall Street's expectations.
..
Overall revenues grew year-over-year by only three per cent to $5.52 billion. That is the company's lowest growth rate since its stock started trading publicly five years ago. Prior to late 2008, Google's quarterly revenue growth had never fallen below a year-over-year rate of a 30 per cent.
...
"We remain focused on investing in technical innovation to drive growth in our core and new businesses."

Economy Hits Microsoft Earnings
A tough global economy has impacted technology sales in recent months, weakening Microsoft's (NASDAQ: MSFT) profits in the process.

This week, the company announced that its revenues declined 17 percent in the fourth quarter of 2008, with a total of $13.10 billion in revenues. Earnings per share fell 26 percent to 34 cents, while operating income was down 30 percent and net income was down 29 percent.

"Our business continued to be negatively impacted by weakness in the global PC and server markets. In light of that environment, it was an excellent achievement to deliver over $750 million of operational savings compared to the prior year quarter," said Chris Liddell, Microsoft CFO.

General Electric's Net Earnings Fall 47% Led By Finance Unit

General Electric reported a steep fall in second-quarter earnings on Friday, weighed down by the continuing struggles of its big finance business, falling orders for industrial equipment and declining advertising spending at its NBC television network and local stations.
...
Given its global reach across product lines as diverse as gas turbines, power plants and aircraft engines, G.E. provides a concentrated glimpse of the health of capital spending in the industrial economy as a whole.

On that score, the G.E. report showed continued weakness. The company’s revenue fell 17 percent, to $39.08 billion. After adjusting for a stronger dollar, which reduces the value of overseas sales, sales were down 12 percent from the previous year. G.E.’s quarterly revenue was about $3 billion less than the Wall Street forecast.

Capital equipment orders for G.E. fell sharply, especially transportation machinery like locomotives and health care equipment like medical-imaging machines. In a conference call with analysts, company executives said they expected industrial equipment orders to be off about 25 percent for the year.

“That’s a pretty significant decline, but it’s not unexpected in this economy,” said Richard Tortoriello, an analyst at Standard & Poor’s.

Still, analysts said, the fall in industrial orders disappointed investors, sending G.E.’s shares down 6.05 percent, to $11.65.
...
Analysts say two main concerns cloud the outlook for G.E. Its industrial side is a collection of capital-equipment businesses, and many customers will delay large purchases until genuine signs of economic recovery surface, they say.

The worry about the finance unit, analysts say, is the possibility that G.E. may not yet have seen the worst of losses and that it may have to set aside more money to cover them. But for a quarter at least, the trends looked encouraging.

The finance business was the biggest drag on G.E.’s results. Its operating profits fell 80 percent, to $590 million, down from $2.9 billion a year ago. And revenue in the finance unit, which includes home mortgages in Britain and private-label credit cards in the United States, declined 29 percent, to less than $12.8 billion, from nearly $18 billion.

G.E. has moved to strengthen the finance business. It said leverage, or the ratio of borrowings to equity, is down to 5.6 to 1, compared with 7 to 1 a year ago. And borrowing in the short-term commercial paper market is down to $50 billion, from $72 billion a year ago.
...
The impact of economic stimulus programs has not yet been evident, Mr. Immelt said. “We’ll see benefit from the global stimulus in the second half of the year,” he said.

United Technologies Profit Falls; Sales Forecast Cut

July 21 (Bloomberg) -- United Technologies Corp. posted a 23 percent drop in second-quarter profit as the recession slowed demand for aircraft parts and commercial construction, and said full-year sales will be less than it previously predicted.
...
Chief Executive Officer Louis Chenevert has been reducing costs to cope with a drop in revenue, which fell 17 percent to $13.2 billion in the quarter. He is cutting 18,000 jobs, or 8 percent of the global workforce, at the maker of Otis elevators, Carrier air conditioners and Pratt & Whitney jet engines by the end of the year. The company still sees profit growth next year.
...
United Technologies still expects to return to profit growth in 2010 based more on cost-cutting than revenue boosts, Chief Financial Officer Greg Hayes told investors on a conference call. So far, the company has spent more than $460 million of the $750 million targeted to reduce costs this year to cut 12,000 positions.

“We don’t expect to see a significant economic recovery in 2010,” Hayes said. “As we begin developing our detailed 2010 financial plan, business units are developing cost-led plans without much reliance on top-line recovery.”


United Technologies is also tightening costs through reduction in travel, furloughs and paring back expenses such as merit raises. The company doesn’t foresee any economic improvement in 2010 with the possible exception of China, where Otis and Carrier equipment orders declined 18 percent in the second quarter, an improvement over 40 percent in the first.

UPS Earnings Decline 49% As Downturn Saps Demand

United Parcel Service, the world’s largest package delivery company, said on Thursday that its second-quarter earnings fell 49 percent as the recession cut business demand. It forecast that its profit in the third quarter will be lower than analysts’ projections.
...
Package volume in the United States slid for a sixth consecutive quarter as the recession caused businesses to reduce orders amid the highest unemployment rate in 26 years. The company said shipments would remain “significantly below” those for last year. U.P.S. is considered an economic bellwether because it delivers a wide variety of items, including clothing, auto parts and financial documents.

“A lot of us got excited by those initial signs of stabilization, and now we’re realizing it’s going to be more of a 2010 event before we see real recovery,” said Nathan Brochmann, an analyst at William Blair & Company in Chicago.
...
“We are cautious, frankly,” the company’s chief financial officer Kurt Kuehn told analysts and investors on a conference call. “We don’t have any confidence that either demand or activity is going to pick up substantially” in the next several months.

Domestic volume fell 4.6 percent in the second quarter, the worst results since the company’s 1999 initial public offering. The measure will probably decline at a similar pace this quarter, Mr. Kuehn said. International volume tumbled 5.5 percent and will not improve this quarter, he said.

The number of hours U.P.S. airplanes were in operation declined 11 percent, saving 14 million gallons of fuel and contributing to a 54 percent drop in the company’s total fuel bill to $539 million as oil prices collapsed from a year earlier.

Burlington Northern's Earnings Up 15%; But Volumes Fall

Burlington Northern Santa Fe Corp.'s (BNI) second-quarter profit grew by 15% amid a prior-year charge, but fuel surcharges and volumes dropped.

The company's results were the latest sign that freight demand hasn't improved after rivals CSX Corp. (CSX) and Union Pacific Corp. (UNP) posted declining profits and volumes for the second quarter.

Still, executives from CSX and Union Pacific said the freight sector appeared to hit a bottom as the economy shows signs of recovery. On Thursday, Burlington Northern said volumes were beginning to stabilize in its more economy-sensitive businesses.
...
Total freight revenue dropped 26%, as volume, measured by rail car units, fell 19%.

Consumer and industrial products revenue each decreased 34%. Consumer products revenue fell on lower international and domestic intermodal and automotive volumes, while the decline in industrial products revenue was due to lower demand for construction and building products. Automotive revenue, counted in consumer goods, fell 43%.

As can be seen from doing a little digging in these earnings reports, there is little consensus of immediate or near term economic recovery. Many companies are benefiting from inventory buildups which had been decimated in the prior two quarters. Many are also showing increased revenues by cutting costs. Cutting costs, in most cases, refers to laying off workers, spending less on R&D, and sometimes eliminating businesses units altogether that have been losing money. Some are experiencing cost savings on falling fuel prices, which have experienced YoY price reductions.

It is in these sectors that we want to see companies going out and spending their cash reserves buying new units, hiring more workers and otherwise lengthening the productive cycle to add goods and services that increase the ability for others to attain their wants at lower costs than were previously possible.

Some may suggest that I am cherry picking by not focusing on the positive news in the financial space. But I will reiterate my above points. The recovery that eventually follows this period of contraction/liquidation/deleveraging will not be driven by easy credit and consumption. It will come from savings and capital investment. So focusing on either the financial services or consumer discretionary sectors is missing the boat entirely in my opinion.

But I will note that although the financials posted their best quarter in a long time, there is nothing in those results that tells me it was anything other than temporary. The bulk of the gains came from accounting changes and trading gains. To a lesser extent banks were beginning to make money on interest differentials. However, there was an aura of optimism in listening to conference calls - and it does not appear that the banks are taking seriously enough the coming impairments on Option ARM mortgages, commercial real estate loans nor consumer loans. My estimate is that they blew their "allowance" in one quarter, so they can attempt to raise capital at inflated prices. Next quarter, they will again require significant provisioning for loan losses, which will again hurt the bottom line.

Valuations

Operating earnings are expected to come in (combined actual numbers with estimates for the other half) somewhere around $14.22 for the quarter. This makes for trailing 12-month operating earnings of $40.20. As of Friday's close, this gives a current trailing P/E valuation of 24.35. Analysts are expecting earnings of $15, $16.09, $16.40, and $17.89 for the next 4 quarters respectively for a total of 65.38, giving a forward P/E valuation of 14.97.

There are two things wrong with these numbers in my opinion.

First, they are excessively optimistic. As I mentioned above, much of the improvements are due to more or less one time cost cutting measures that add EPS points. These obviously cannot continue to occur, lest the companies disintegrate entirely. This means that when it comes to meeting the analysts targets, an even larger proportion of earnings are going to be required from actual revenues, expanding profit margins, etc. With that in mind, those targets are lofty at best.

Second, those numbers are "operating" earnings. Unfortunately, a company cannot invest operating earnings. Nor can they be used to pay dividends. For those often overlooked reasons to purchase common stock (ie. growth and/or income), a company must use their "as reported" earnings - which are what counts according to GAAP. As reported earnings were typically the benchmark for determining value. However, in 2008 when financials especially were writing off hundreds of billions per quarter in bad loans and making loan/loss provisions for the future, these numbers went off the charts. Other factors that contribute to "as reported" earnings include:

- legal costs
- goodwill writedowns
- plant and property writedowns (value of office buildings, for example)
- charges incurred to refinance debt and much, much more.

Clearly, these are all issues that affect a company's ability to operate - even though they are not considered to be "operating" issues. It is quite normal for reported earnings to be marginally lower than operating earnings (anywhere from 5-15%) during times of expansion, and substantially lower (usually 40% or so) during recessions. However, there is something notably amiss in the analysts expectations for this "recovery" that they are all pricing into operating earnings: They are not forecasting reported earnings to recover much at all for the next four quarters. Even in comparison with the "top down" operating numbers, analysts are forecasting reported earnings to stay 30-40% below operating earnings over the next year. They are obviously forecasting a continuation in writedowns of various sorts.

So I would beware of the "mass consumption" valuation numbers being thrown around by the financial media. The analysts making these forecasts appear to be hedging their bets by talking down reported earnings. Below is a table of various metrics of P/E valuation applied to whatever multiple you choose. "Trough earnings" for bear markets consistently fall between 6-8x, while "peak earnings" for bull markets typically get as high as 24.



One of these forces will win out. They are currently miles apart. My money is on reported earnings, as that is what is tangible and what affects a company's ability to invest in projects for the future. It is now a waiting game. I think we will eventually start to see the evidence for these future impairments in credit delinquency reports. Knowing that this will cause another bout of deleveraging will create a similar atmosphere seen last autumn, where individuals begin to turn pessimistic on their job prospects and run for cover. There is, of course, room on the upside for the opposing force to continue its reign, but I believe the optimism trade is close to running its course.

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6 comments:

mannfm11 said...

One of these days I am going to sit down and write something new, but I am too busy reading the good stuff on the net. I agree at least 98% on what you put down here. There is a lot more than meets the eye though.

The biggest oddity is that INTC posted much better results than MSFT. There is something wrong with that picture, though I know INTC chips are going into Apple PC's now. Apple just isn't that big a player in the PC market.

The other thing is the shippers are saying that there is no recovery until 2010 at the earliest. Not good and it kind of concurs with the idea that maybe there is some cooking of numbers going on.

There is a lot more to stock valuations than PE's. I believe the first thing that has to occur is the dividend rates need to reach to levels near the interest on AAA bonds, at a minimum. The SPX is yielding about 3% at these prices and I venture we could actually see dividends decline over the next few years as companies struggle with capital. Historically, 3% has been a bottom or a minimum yield on the SPX, until the buy and hold forever game came out of academia, that holding stocks paid 9% every year forever so don't worry about dividends. Clearly at some time or another the SPX could have paid higher dividends, sans stock buybacks. but we would have probably seen the cap weighted SPX decline, as dividends do nothing to reduce the divisor, which buybacks do. One more cloud of smoke to come out of the recent bull runs.

My best guess is that once stocks pay a 6% dividend, we will have some kind of workable bottom in. The rate may go to 8%, but the downside will be limited at 6%. Then it will only be a case of who stays in business and who doesn't.

This time I am not sure your model works. I think the big thing about recoveries in the past has been that the downtrend exhausts itself, people get tired of old stuff and start ordering new stuff. I think that is the signal to invest in capital goods. Of course, the businesses have to have worked down their inventory and their debts. If the debts associated with their floorplans are stil present, they may have a real money problem

When this type of situation is reached, the big question is how much capital is collectable or real. Investment into banking comes out of the money supply and the money supply is needed to pay the debts owed the banks. This may merely be the current depositors taking their haircuts on their accounts, but bank capital doesn't have an account other than profit or loss. Taking money in this fashion shortcuts the usual trip through the economy to the debtor. People that owe money don't have money to spend through the economy so if it is used by those that have it to speculate, then the losses continue. That is why this time its different.

I believe Bernanke and some of the central bank bigwigs around the world have known for some time that the next recession was going to be a real bomb. We take it as the stock market causes this, but it is really the debt bubble that causes the stock market, money piling up into accounts that don't owe any money and the debts of others being perpetuated by more credit. Credit that this time came out of home equity.

What I fear is the total collapse of the paper due to the loss of faith in the issuer, the Fed and the US government. If their hands are forced, the government will raise taxes. I doubt the Obamaites are going to cut much spending. This will be highly deflationary, but not as deflationary as a collapse in the dollar. Those calling for such a collapse have little clue as to what this would do to world demand for products and commodities. You might pass some wooden nickels.

You are one of the best reads on the net in my opinion. Thanks for the good work. Barry

Henry said...

Matt: You mentioned before that sentiment is most important thing now.

You said that the next major correction will be when a famous investor like Warren Buffett comes out and tell people to buy stocks, but stock prices keep going down and everyone is selling.

It is funny that Warren Buffett just came out told people to buy stocks even though Dow Jones 30 hit 9000. If S&P500 continues to rise in the next few weeks after Warren Buffett's buy stock comment, is it likely that we will not see a fall correction and S&P500 may see new short term highs?

Your analysis has been great and I learned a lot from you.

Matt Stiles said...

Thanks for the comments guys. I learn a lot from the comments and feedback, which is why I continue to write.

The sentiment thing has been high on my list of important factors. Perhaps the highest. When Roubini was misinterpreted a couple weeks ago about being bullish the same week as Merideth Whitney put a buy on financials for a trade, I started seeing the first signs of sentiment shift. I heard Richard Russell turned bullish recently as well as Buffett. Soon it will be "common knowledge" that the worst is over. It would be nice to see a prominent magazine cover announce this to put the icing on the cake.

I still think it is possible we see either S&P 1000 or 1075. But my thoughts were that if that were to happen, the selloff in between would have needed to be deeper. It wasn't, and therefore I think we're very close to a top.

As always, we'll see.

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