Revenue: key indicator that profit may not show

Revenue: key indicator that profit may not show

Investors are always told to focus on a company's profit, or bottom line. And sure enough, a big reason for the recent stock market surge is a spate of better-than-expected earnings reports.

Nearly three-quarters of the companies in the Standard & Poor’s 500 (S&P 500) that have already announced quarterly results have beaten analysts’ forecasts. That comes on the heels of a first quarter in which nearly two-thirds of the index companies surpassed expectations.

But on their own, profit upgrades may not paint an accurate portrait of the economy’s health. Sometimes, the way a company generated its profit is at least as important as the earnings themselves. And on that score, the recent record isn’t as impressive.

So far this year, nearly all of the earnings improvements have been achieved through major cost-cutting.

Overall selling and administrative costs among S&P 500 companies fell 5.7% in the second quarter versus the period a year earlier, according to a recent report by David J. Kostin, the chief US equity strategist at Goldman Sachs.

This represents far more drastic cuts than were undertaken in the recessions of 1991 and 2001.

Still, “you can only cut so much," said Howard Silverblatt, senior index analyst at S&P. “At some point, you need to start seeing the business actually grow. You need to see increased sales"—sometimes called “top line" growth.

That’s why Silverblatt says that revenue—not earnings—“will be the most important number for investors to watch."

Thus far, sales have been slow to rebound. While overall S&P 500 earnings are still falling on a year-over-year basis, for example, the rate of decline has begun to slow, according to figures compiled by Thomson Reuters.

By contrast, declines in S&P 500 sales are picking up speed, according to S&P. After slumping 14% in the fourth quarter of 2008 and nearly 17% in the first quarter this year, corporate revenue tumbled nearly 20% in the second quarter.

The revenue declines are even more staggering on a dollar basis. From June 2008 to June 2009, revenue of the 500 companies tumbled by a total of $1.15 trillion (Rs55.08 trillion). “That’s more than the entire fiscal stimulus," Silverblatt said.

To be sure, aggressive cutting of expenses will ultimately improve corporate profitability when revenue recovers. “Once sales kick in, this will have a leveraged effect on earnings," says Jack A. Ablin, chief investment officer at Harris Pvt. Bank in Chicago.

But Ablin does not expect a turnaround in corporate sales until at least the fourth quarter of this year or the first quarter of 2010.

And it could easily take more time than that. Historically, revenue is one of the last indicators to recover after an economic downturn.

A recent analysis by Ned Davis Research, the investment-consulting firm in Venice found that sales typically hit a trough three months after earnings do—or nine months after a recession ends. There is a reason for that: It is the cost-cutting that actually helps stem the slide in earnings within a recession. “Eventually, as the economy recovers, sales take the baton and earnings growth moves more in lock step with revenue growth," says Ed Clissold, a senior global analyst at Ned Davis. Assuming that the recession has just ended, this means S&P 500 sales might not start to recover until July.

Keep in mind that revenue doesn’t always heal exactly nine months after the economy does. A full year after the 2001 recession ended, sales among companies in the S&P 500—minus the financial sector—were still shrinking by around 6%.

Moreover, in the last big downturn, at the start of this decade, revenue declined for seven consecutive quarters. If the market were in store for a similar sales drought, revenue might not start expanding again until the start of the third quarter of next year.

Of course, not all economic sectors will be affected equally. Goldman Sachs analysts are forecasting that three segments of the economy are likely to see a quick recovery and significant sales growth in 2010. These are energy, where sales are expected to grow 17%; technology, 7%; and materials, 6%.

Those sectors also happen to be the three areas of the market that derive the highest percentage of sales overseas. In fact, all three generate at least half their revenue from foreign markets.

Besides looking abroad, companies are also scrambling to find other creative ways to build sales.

This could be a reason for the recent uptick in merger-and-acquisition activity.

“You can try to increase your sales organically, which can take some time," Silverblatt says. “Or you can buy sales growth." That seems to be the path that many companies are taking.

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