why does Wall Street care about sales gains and not just earnings gains?

…after all, what ultimately matters is how much profit a company’s management is making for its shareholders, isn’t it?

Yes, and no.

two special cases

Let’s deal with two special cases before getting to the main topic.

–Investors who focus a lot of their attention on startups that are not yet making money will typically use sales growth as their major metric.  There are no profits yet.

–Value investors will be drawn to mature companies with lots of sales and little or no earnings because of their turnaround potential.  This is especially true if they can see other firms in the same industry who are comfortably profitable with similar levels of sales.

Neither is an example of the phenomenon we are now seeing as some companies report 3Q12 results.

strong earnings, weak sales

When earnings meet/beat the consensus estimates of brokerage house analysts–and sales don’t, the stock in question often goes down, sometimes by a lot.


it’s all about recurring earnings

1.  Investors typically look for recurring gains when they buy stocks, not one-off profits.

Consider this oversimplified example:

A company reports earnings per share of $1 for the current quarter.  If you know that this is all the profit the firm will ever make, then–assets (if any) aside–you won’t pay more than $1 for a share of stock.  (In fact, you’d probably pay less, since the $1 of profits is in the hands of management, not in yours.)

On the other hand, if you thought the company would earn $1/share every three months for the next ten years, you could be willing to pay up to $40 for a share of stock.

So there’s a huge difference between the value to investors of recurring and non-recurring profits.

2.  If a company reports higher earnings without what analysts consider an appropriate increase in sales, investors assume that the firm has achieved its profit target through cost-cutting of some type.  They argue, correctly in most cases, that the profit increase isn’t sustainable.

More than that, they view the slower sales increase as a leading indicator of slowing profit growth that will emerge in subsequent quarters.  They can see the train coming at them, as it were, so they don’t wait to get off the track.  They sell now.

Their picture is this:

Suppose the company has been spending $1 million a quarter on marketing up until now, but cuts the budget to $500,000 for the just-reported quarter.  That produces just enough extra margin that the company reports $1/share in earnings instead of $.90, thus meeting consensus eps expectations.

The worst case is that the reduced marketing is a mistake that will negatively affect sales and profits in coming quarters.  But even in the best case–that this is a true savings–the company can only cut marketing expense once.  

Yes, the company will also report an extra $.10 in eps for the next three quarters.  But that’s it.  This is really no longer a company earning $1 a share per quarter for as far as the eye can see.  It’s a company that’s earning $.90 a quarter + a non-recurring $.10 now and for the next three reports.

If you were previously willing to pay $40 for $1 a share in quarterly earnings, you should (at most) pay $36 for $.90 a quarter profits.  Add (at most) $.40 for the non-recurring earnings.

The main point is that cost-cutting has to end relatively quickly–and should not be mistaken for a permanent element of a company’s profitability.

3.  Some managements won’t be inclined to call attention to this information and will just show it somewhere in the financials (in the hope analysts won’t bother to read the fine print).  The cost-cutting could also be a bunch of little things, significant in the aggregate but not big enough individually to require disclosure.   If so, the slowdown in sales is the only clue to what’s really going on.

4.  For multi-line companies, the situation isn’t so simple. Sometimes, a firm may be phasing out a line of business where it earnings little or no profit, so it’s sales growth sags while profits advance smartly.  Here, “Shoot first, ask questions later,” may be the wrong strategy.  But it’s what short-term traders always do.  And, in my experience, “Shoot first…” is right more often than not.

US bond market environment, October 2012 (II)

Here’s the second installment of the Bond Market Environment letter to clients by Denis Jamison of Strategy Asset Managers.  The first appeared yesterday.

debt without cost

Federal government borrowing has spiraled since 2008.  Total public debt outstanding–an amount that includes the notional amount owed by the Federal government to the various government trust funds–was $15.2 trillion at the end of 2011 compared with $9.2 trillion four years earlier.  Now, that debt is probably a trillion higher and exceeds nominal Gross Domestic Product.

You would think that much borrowing would put a huge strain on the federal government’s budget.

Well, it hasn’t.

In fact, for the year ended December 31, 2011, the interest payments on the federal debt were just 5% higher than in 2007, despite a 65% increase in the debt outstanding.  Moreover, the interest on the federal debt last year was just 1.5% of GDP.  That’s less than the 3%-plus drain on the country’s earnings during the second half of the Eighties and through the Nineties.

two reasons for this happy situation:

–first, the growth miracle during the Clinton Presidency provided a huge expansion in GDP while temporarily reducing the actual level of federal government debt.  And,

–second, the Federal Reserve’s zero interest rate policies begun in 2008 that reduced the interest cost of that debt from about 4.5% to less than 3%.

The trend in the cost of the federal government’s debt is glacial.  It takes a while for old bonds to mature and be replaced by new ones.  So the federal government’s debt costs will remain manageable for the next few years.  Investors should be very aware that the higher level of  federal debt to GDP plus the extraordinary low level of current interest payments could provide a severe headwind to economic growth down the road.


Bond investors have every reason to be confused.  They have enjoyed thirty years of high rates of return caused by steadily declining interest rates.  For various reasons, we experienced a secular decline in inflation since 1985.  Meanwhile, monetary policy amplified the impact of that decline on bond prices by steadily reducing the real rate of return (the nominal yield less the inflation rate).  We may have gone as far as we can down this road.  Real yields of most US Treasury securities are negative.  That’s happened before–in the Seventies.  Then it was caused by high inflation against a backdrop of loose monetary policy.  The inflation cure involved tight money, sharply higher interest rates and back-to-back recessions in the first half of the Eighties.

While Fed Chairman Bernanke draws parallels between the economic problems of the Thirties with those of today, he might want to consider the legacy of the Burns and Miller policies of the Seventies.  After the 1.5% inflation rates of the Sixties, these Fed chairmen didn’t think future inflation would be a problem, either.  And low interest rates seemed a good idea in exchange for economic growth.

It is likely bond investors will suffer a bear market someday–we just don’t know when.  For the moment, the music is still playing, so you have to keep dancing.

The only way to earn a real return today is to accept greater risk–maturity (or call) risk, credit risk, currency risk, liquidity risk and a lot of other risks that you won’t know are risks until something bad happens.  While I can’t pick the next winners (or losers), I can see a sector by sector return pattern created by the various waves of Federal Reserve policy.

By pushing short-term interest rates to zero, the Fed caused a huge rally in the US Treasury securities.  The gains now are limited because the real yield from these securities has reached zero.  Next, mortgages rallied as they were seen as a low risk alternative to government debt.  Now they, too, are exhausted because, at current price levels, prepayment losses are wiping out most of their coupon income.  That leaves maturity risk and credit risk still on the table for most investors.

maturity risk

The yield spreads between ten and thirty-year bonds are still attractive.  In the US Treasury market, that spread is about 125 basis points.  But the price risk for any change in interest rates is very high.  For example, investors in the current US Treasury thirty-year bonds would lose 15% if rates increase from the  current 3% to 3.5% ove the next six months.

credit risk

Assuming maturity risk isn’t to your liking, maybe the answer is corporate bonds.  Of course, there’s a lot of supply here because companies are busy selling new bonds to pay off old ones.  Maybe all this supply is keeping yields relatively high.  The spread between AAA-rated corporate bonds to ten-year US Treasuries is about 160 basis points.  If you can stomach BBB-rated securities, you’ll earn a 300 basis point advantage over governments.

Investors face difficult choices.  Old strategies aren’t working well in the current investment environment.  Unfortunately, when you step out on a new path, you never know where it will lead.

US bond market environment, October 2012

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.


More tomorrow.

Intel’s 3Q12: softness continues


After the close of equity trading in New York yesterday, INTC reported its 3Q12 earnings results.

Revenues were flat, quarter on quarter, at $13.5 billion, during the typically seasonally stronger 3Q.  The same with operating expenses.

EPS came in at $.60 vs. $.57 for 2Q12, based largely on a lower than expected tax rate (implying to me that business was stronger than expected in emerging markets, weaker in the US and EU).

The numbers were considerably better than the downward revision to guidance that INTC announced in early September.  At that time INTC expected revenue of $13.2 billion and EPS (my estimate) of $.52-$.54 (see my post on the pre-announcement).

Year on year, results were down.  3Q11 revenues were $14.2 billion, EPS $.65.

The stock fell about 3% in the aftermarket Tuesday.  In the Wednesday premarket, it’s about the same, while S&P futures are flat.



Demand for PCs in the US, EU and China continues to be lackluster.  As a result, INTC’s customers, the machine manufacturers, continue to pare chip inventories.  This is typical behavior:  the buyer gets the sniffles, the component manufacturer gets pneumonia.   But INTC customers appear to be shrinking inventories to even lower levels than the company anticipated a month ago, implying their ability to read end-user buying intentions is especially low.

Business did pick up a bit in September in anticipation of Windows 8.

Demand for servers from corporations has also begun to slow down, as company cash flows flatten out due to the current deceleration in global economic growth.  This is a new element in the INTC story, although not a huge surprise.  No matter what anyone says–including the companies–corporations usually don’t borrow to fund capital expenditures.  Spending is a function of the cash flows that operations generate.

Cloud computing remains very strong.


Visibility is very low.

INTC appears to expect that 4Q12 will more or less mirror 3Q12.  The company normally keeps inventories of just over a month’s sales.  It now has 5%-10% too much.  It will slow down manufacturing a bit during 4Q12, as a result.  This won’t affect revenues.  But the company will shut some production lines and shift the machinery to new leading-edge uses.  This will mean lower capex during the quarter, as well as an unspecified amount of equipment writedowns.

During 1Q13, INTC will begin another of its bi-annual production upgrades–which will mean lower gross margins by a few percentage points for a quarter or two as the company gets the new lines up to speed.

earnings guesses

I’m pencilling in $.60 (excluding writedowns) for 4Q12, which would mean full-year EPS of $2.33.  I’m thinking that 2013 will bring a minimum of $2 a share, with $2.50+ likely if the global economy begins to reaccelerate.

the stock

Since the bottom for the S&P in June, the index is up about 14%.  Over the same time span, INTC is down by 14%.  Most of the damage has happened since mid-August, when the global slowdown became more apparent.

At $22 a share, INTC is trading at 9x trailing earnings and at, I think, at most 10x what it can earn in 2013. INTC shares now yield 4%, a full percentage point above the 30-year Treasury.

I’m surprised that the stock has performed as poorly as it has.  I’d thought INTC might give up some of its run to $29+, but I’d expected it to settle in around $25 or so.

That’s clearly been wrong.  And it’s always a danger signal when a stock doesn’t do what you expect.

As far as I can see, the current earnings weakness has revived all the old fears that INTC products have no place in a post-PC world dominated by tablets and smartphones.  And this, rather than business-cycle softness, is what’s causing the sharp underperformance of INTC shares.

It’s possible that the negative scenario will turn out to be true.  I continue to think, however, that INTC shares are now being priced as if that outcome were a certainty–that ultrabooks and INTC’s forays into tablets and smartphones won’t be successful.  So I’m continuing to take the contrary bet–noting, though, that there are risks in saying that everyone’s out of step but me.

Macau casino gaming, September 2012

September gambling results

Earlier this month, the Macau government’s Gaming Inspection and Coordination Bureau released its monthly report of gaming “win” for the SAR’s casino industry.  The figures are as follows:

* 1 HKD = 1.03MOP (Unit:MOP million )
Monthly Gross Revenue from Games of Fortune in 2012 and 2011
Monthly Gross Revenue Accumulated Gross Revenue
2012 2011 Variance 2012 2011 Variance
Jan 25,040 18,571 +34.8% 25,040 18,571 +34.8%
Feb 24,286 19,863 +22.3% 49,325 38,434 +28.3%
Mar 24,989 20,087 +24.4% 74,314 58,521 +27.0%
Apr 25,003 20,507 +21.9% 99,317 79,028 +25.7%
May 26,078 24,306 +7.3% 125,395 103,334 +21.3%
Jun 23,334 20,792 +12.2% 148,729 124,126 +19.8%
Jul 24,579 24,212 +1.5% 173,308 148,337 +16.8%
Aug 26,136 24,769 +5.5% 199,444 173,106 +15.2%
Sept 23,866 21,244 +12.3% 223,310 194,350 +14.9%

Source: Macau DICJ

Initially the Hong Kong stock market took the September figure of 23.9 billion patacas (US$3.1 billion) as disappointing.  For reasons best known to themselves, the consensus of Hong Kong gambling industry analysts had been that revenue should be up by 17% (I have no idea why they were so bullish).  As a result, on the day of the report the stocks all sold off.  But they rallied back the next day, as the market began to look at the accelerating pattern the year to year comparisons appear to be establishing over the past three months.

October as a key

October, which contains Golden Week–normally the period of the highest demand for gaming during the year–will be important to monitor.

October 2011 gaming win was 26.9 billion patacas, a 26% month on month increase over normally weak September.  I would take a gain of 15%+ for October this year as a signal that the market has already hit bottom and is on the mend.

an important time

In my view, the Macau gaming market is at a crucial juncture, one that participants in capital-intensive industries dread.  Casino capacity has expanded to the point where it, at least temporarily, outstrips demand.  How so?  A number of big new casino projects, started several years ago, have been coming on-line just as economic slowdown in China is putting a crimp on high rollers’ desire to gamble.

I think the casino operators and the Macau government have been reacting to the situation in an unusually sensible way.  New casino approvals have dried up.  Operators have been stretching out the timetables for already initiated projects–Sands China, for example, has already paid a penalty to the government so it can postpone by a year the opening of its latest Cotai expansion.  At the same time, casino companies have used the current period of extraordinarily low interest rates to lock in their project financing on favorable terms.

It seems to me, therefore, that intra-industry dynamics are not the big worry they would be in, say, the cement or paper or high-rise building construction.  The most important steps to stimulate global economic recovery are already being taken.  So holders of Macau casino stocks (like me) are simply waiting for evidence that will show the timing of the market’s rebound.

My thought has been that a significant pickup in demand will be a 2013 phenomenon, not a 2012 one.  I’m not yet willing to act, but the pattern of recent yoy market win comparisons suggests to me I may be being too pessimistic.

looking at corporate cash balances

AAPL as a model global company

Many publicly-traded US companies have huge cash balances relative to their stock market value.  AAPL is a good example.

The company had just short of $120 billion in cash plus marketable securities on its balance sheet as of June 25th.  That’s about 20% of the stock’s total value at last Friday’s close.  Let’s say 80% of that cash is held overseas in countries that levy little or no tax on corporate earnings.

Like many global companies, AAPL’s tax rate–25.3% during the first nine months of its current fiscal year–is substantially below the 35% statutory rate in the US.  (Yes, the US rate is much higher than in the rest of the world.  Yes, a good part of the reason for AAPL’s lower rate is that it earns money abroad that it declares to be permanently invested overseas and therefore doesn’t repatriate to the US.)

analytic issues

Today’s dominant stock market view is that cash is cash, no matter where it’s located, and that earnings are earnings, no matter how lightly they’re taxed.

In contrast, when I began working on Wall Street in 1978, attitudes about recognizing earnings in low-tax areas and about holding cash balances there were far different from what they are today.

Specifically, in those days, investors in the US mentally subtracted from cash balances the home country tax that would be due if the money were to be repatriated and used for shareholder dividends or domestic capital expenditure.

In the UK, brokerage house analysts went further than that.  They did that work for you. Their written recommendations commonly contained, in addition to actually reported earnings, the same numbers “normalized” as if the firm had repatriated all foreign earnings and paid a full tax rate.  Brokers gave their estimates the same dual treatment.

two views:  what’s the difference?


This is pretty straightforward.  For profits on business concluded by a US company in, say, Hong Kong, the corporate tax rate is zero.  If the firm wants to distribute this money as dividends, it first has to be sent to the US, where it is subject to the 35% Federal corporate tax–and possibly to state tax as well.  If this possibility is all an investor is concerned about–cash in his hands rather than in the company’s (a view the dividend discount model explicitly endorses/encourages), then foreign cash balances are worth substantially less than domestic ones.

Figuring out how much less is more difficult,  That’s because a company gets a credit against tax due to Uncle Sam for any tax paid to the foreign country.  To make a stab in the dark, AAPL’s cash pile is probably worth $20 billion less to our totally dividend oriented investor than its balance sheet carrying value.

On the other hand, if you have faith in company management to maximize the value of the corporation, you’re probably willing to believe that holding the cash balances abroad is the best use of the money.  Maybe the funds are being earmarked for reinvestment there, either through purchase of capital equipment or maybe an acquisition.

So you’re less worried about the fact that the money is in a foreign bank.  You’d also think it would be crazy to repatriate the cash, lose a large chunk to taxes, and the ship the funds back out of the US to pay for foreign expansion.

earnings per share

AAPL’s corporate tax rate for the first nine months of 2012 is 25.3%.  If its pretax total were subject to tax at 35%, eps for AAPL would be about 15% lower.

Another way of saying the same thing is that if we adjusted the AAPL PE multiple to reflect a full US corporate tax rate, it would be about two PE points higher.

why write about this?

As I mentioned above, conventional wisdom is that these distinctions don’t matter.  But this is an expression of investor preferences or “taste,” as academics might put it.  And these are subject to change.  After all, these preferences were substantially different a few decades ago.

My reason for writing is that I think preferences are starting to change again.

Maybe it’s the more subdued state of world economic growth.   Maybe it’s the aging of the Baby Boom and that cohort’s increasing interest in dividends.  Maybe I’m just wrong.  But I think that investors are beginning to become more aware of differences in taxation of profits and of the geographical location of corporate cash.


If so, companies sporting low corporate tax rates– predominantly ones with emerging markets exposure, in my view–may be subject to a lot more backing and filling than is commonly thought as the market discounts the possibility that they’re more expensive than they seem.