We have reached the halfway point for the first quarter earnings reporting period and some things are abundantly clear:
- Analysts once again sufficiently low-balled their earnings per share estimates to allow 73% of companies to beat them
- Cost-cutting and/or special factors like a lower tax rate, the release of loan-loss reserves (in the case of the banks), and share buyback activity have driven a rash of positive EPS surprises.
- Demand in the first quarter was relatively weak
- Guidance has been generally cautious
- EPS growth estimates for Q3 and Q4 are too high; and
- Market participants have an abiding faith in central bank support
It has not been surprising at all to see the majority of companies surpass earnings estimates. Thomson Reuters informs us that 63% of companies on average, over the long term, have reported better-than-expected quarterly earnings. That average has climbed to 67% over the past four quarters.
The first quarter reporting period then is on track to be a blockbuster period considering 73% of companies reporting so far have beaten bottom-line estimates. The top-line results, however, have been an entirely different and more bothersome matter.
Thus far, only 43% of S&P 500 companies reporting revenue have topped analysts' expectations. The long-term average is 62%, according to Thomson Reuters, while the average over the past four quarters is 52%.
Missing revenue estimates isn't always as bad as it sounds at first blush. Some companies simply run up against analysts setting their revenue expectations too high.
Alarm bells don't necessarily have to ring when a company reports 10% revenue growth instead of the 10.2% growth the consensus was expecting. The bell begins to toll for investors, though, when a company reports an actual decline in revenue.
Revenue Growth Is Weak
Some revenue declines can be the result of selling a division or a certain product line. In instances such as that, it is important that apples are being compared to apples.
The latter point notwithstanding, we have seen an increasing number of minus signs popping up in the Yr/Yr Revenue Growth column on Briefing.com's Earnings Calendar page. The companies reporting revenue declines aren't little-known companies either. In fact, they are some of the most well-known and widely-held companies.
There are too many to list here, but for illustrative purposes, consider the following:
|Stock||Symbol||Sector||Yr/Yr Revenue (Q1)|
We purposely included the companies above to highlight that revenue declines have cut across economic sectors. Furthermore, most of the companies in the table are multinational companies, which goes to show that demand weakness has cut across geographies.
According to FactSet, the revenue growth rate for S&P 500 companies that have reported their first quarter results is negative 2.3%. In the same period a year ago, revenues increased 5.5%. The blended growth rate, which takes into account estimates for companies that have yet to report, is negative 0.5%.
ConocoPhillips (COP) alone subtracts 1.7 percentage points from the revenue growth rate, yet the company skews the overall measurement since its results for the year-ago period include Phillips 66 (PSX). On the flip side, Express Scripts (ESRX) adds 0.5 percentage points to the growth rate, yet that includes results from Medco which were not part of the year-ago report.
Even if ConocoPhillips and ExpressScripts are removed from the mix, the message remains that revenue growth is weak.
Earnings Growth Matters
Why so much fuss about weak revenue growth when 73% of companies are posting better-than-expected earnings results? Because, unless companies keep finding ways to cut costs, earnings can't grow without revenue growth.
An overall lack of earnings growth, in turn, typically leads to disappointing economic growth as companies work to maintain profitability, or to stem the flow of losses, by cutting back on capital expenditures, laying off staff, curtailing wage increases and benefits, slowing hiring, deferring orders, and/or pushing suppliers for price concessions.
Such a domino effect makes it plain to see that earnings growth -- or the lack thereof -- matters.
Company valuations are predicated on earnings. A company's stock won't be worth as much if the company's earnings are decelerating or in decline.
Fed policy, however, is providing some artificial support for stock prices as the low level of real interest rates is driving investors into higher-yielding assets. Accordingly, some investors are paying more in a number of instances than they have in the past to own higher-yielding stocks. That is apparent in the consumer staples, telecom services, utilities, and health care sectors, all of which are sporting forward 12-month P/E ratios that are higher than their 10-year average.
In that regard, policy risk looms large right now since it has propagated herd-like investing behavior driven by the P/QE ratio rather than the P/E ratio -- or so it seems.
What It All Means
We have said for some time now that analysts' earnings growth estimates for the back half of the year are too high. We haven't heard anything in the first quarter reporting period that would change our view.
While estimates for the third and fourth quarter have been coming down slowly, they still look pretty generous at 8.4% and 13.6%, respectively, according to figures compiled by FactSet. If first quarter demand issues persist, those estimates will likely fall much further since profit margins will come under pressure.
That may not register as much with the market if the Fed, and other central banks, stay on their current policy path.
One can only squeeze so much lemon juice out of a lemon, however. Price risk will build if the earnings trend moves in a way that suggests Fed policy has failed to make the real economic difference the stock market has taken for granted.
A decline in revenue growth is a step in that concerning direction.