My Take on US June-Quarter Earnings

The June quarter earnings report season is practically over.  Two things strike me as noteworthy:

1.  Most companies’ profit results handily beat analysts’ expectations.  This in itself is not so surprising, since earnings are difficult to estimate in uncertain times and because neither companies in their guidance to analysts, nor analysts in their reports, saw any advantage to be gained by putting out a number that might be too high.

What is noteworthy, though, is that the better than expected earnings were accompanied by worse than expected revenues.  This doesn’t usually happen.  Normally, surprisingly weak revenues produce really, really awful earnings.  The reason?  …operating leverage.  An illustration:

2008                           2009 (est.)

sales                             120                         100

direct costs                    90                           75

gross profit                              30                           25

overheads                                 20                           20

operating profit                              10                               5

In this simple example, I’ve divided costs into two types, the out-of-pocket expenses of making the product the company sells and indirect costs, like advertising, interest expense, depreciation, the chairman’s salary…  A 20% reduction in sales produces a 50% fall in profits.  That’s operating leverage, working in a downturn.

In a recession, the reality is probably worse than this.   I’ve assumed that the company can mark up its products by a third over its production costs, so that the reduction in revenues is due solely to a falloff in units sold.  But in bad times, customers pressure suppliers to lower their prices as well.  So the sales numbers for 2009 might really be 90 instead of 100.  If everything else remains the same, the company ends up with a loss of 5.

Where, then, did the surprisingly strong earnings come from?  I don’t think it’s all from deliberate low ball guidance and estimates.  I think the companies that could must have cut costs in a truly unprecedented way, enough to reverse the negatvie effect of operating leverage.

My point?  With costs pared to the bone, the positive effect on earnings when revenues and profit margins begin to expand again could be immense.

2.  Strong companies often make their greatest market share gains during recessions.  Why is this?  For one thing, customers are much more careful in bad times about how they spend their money.  And strong firms can use a combination of their superior technology, manufacturing skill and financial muscle to offer products that weaker rivals either can’t match or can’t match while still remaining profitable.

I see this phenomenon as a strong feature of the June quarter:  for every Samsung, there’s a Sony; for every Apple, there’s a Microsoft; for every Hyundai, there’s a GM; for every Activision, there’s an Electronic Arts.

In every possible pairing of this type, there’s an interesting investment judgment to be made.  Will the weaker rival benefit much more strongly in terms of percentage profit gains when the economy turns up again (i.e., are they going to be really good stocks) or will they be so damaged by the downturn that they just can’t recover.

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