Strong profits - but from lower costs, not higher sales

By Noel O Halloran , Tuesday, 4th August 2009 | 0 comments

Trends in corporate profit reports are helping stock markets.  But it's cost cutting that has improved profits, not better sales growth, and this has implications for the economic recovery.

Over the past month the second quarter profits reporting season has been very helpful for equity markets. Profits have been better than expected, with upside surprises comon across large US companies that have reported so far have beaten expectations.

The strong feature of the results has been upside surprises have been driven by cost cutting and not by better revenues. Operating margins are higher than expected and margins are holding up better than in the last recession. At a global level profitability will bottom at higher levels than during previous recessions reflecting those better margins. Sales are generally in line with expectations: quite anaemic and down considerably on a year on year basis. They are consistent with the recessionary environment that exists.
 
The better than expected profit margins are a result of companies adapting to the new environment by aggressively cutting their cost base. Unfortunately, this is leading to large scale job layoffs, which is feeding directly into the rapidly rising unemployment rate. This now stands at 9.5% in both the US and Europe and is very likely to rise still further in the coming months. As the outlook for a pick up in revenue growth remains uncertain, we expect that companies will continue to aggressively target costs.
 
The positive equity market reaction strongly suggests that investors see current profits as a trough for the cycle and that they will sequentially improve over coming quarters. In fact, some are arguing that we could get back to peak profits again by 2010, which to us looks far too optimistic. The strong focus on cost cutting is, however,  expected to put in place a springboard whereby even a small pickup in revenues can deliver more powerful profit growth due to the operating margin improvements companies have put in place. So, against the expected dull economic recovery, companies can deliver superior earnings growth.
 
The other side to the corporate costs cutting story is clearly that consumers incomes will be under pressure as a restul.  This poses an uncertainty for the shape of the likely economic recovery.
 
We expect that global GDP will improve from now on but we are somewhat sceptical that it will do so at the pace the market is now very rapidly moving to price in. During the reporting season, management teams have generally focused on their cost cutting initiatives and have been shy to give much guidance on expected revenue developments from here. They cite the continued “uncertain” macro environment but when pressed they are marginally less gloomy on the top line outlook for their business. Another smaller feature that is evident is that a couple of the larger and stronger players in certain industries have talked about the potential for them engaging in M&A activity from here, which in itself is a sign of increased confidence and different to the cash hoarding mentality of previous quarters

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