falling sales, rising profits…

…are usually a recipe for disaster on Wall Street.  Yet, in the current earnings reporting season, a raft of companies are reporting this presumably deadly combination   …and being celebrated for it, not having their stocks go down in flames.

What’s happening?

the usual situation

First, why falling sales and rising profits don’t usually generate a positive investor response.

To start, let’s assume that a company reporting this way is maintaining a stable mix of businesses, that it’s not like Amazon.  There, investor interest is focused almost solely on its Web Services business, which is small but fast growing, and with very high margins.  AWS is so valuable that what happens in the rest of the company almost doesn’t matter.

Instead, let’s assume that what we see is what we get, that falling sales, rising profits are signs of a mature company slowly running out of economic steam.

So, where does the earnings growth come from?

Case 1–a one-time event.  Maybe the firm sold its corporate art collection and that added $.50 a share to earnings.  Maybe it sold property, or got an insurance settlement or won a tax case with the IRS.

All of these are one-and-done things. How much should an investor pay for the “extra” $.50 in earnings?  At most, $.50.  There’s no reason to make any upward adjustment in the price-earnings multiple, because the earnings boost isn’t going to recur.

Similarly,

Case 2–a multi-year cost-cutting campaign.  AIG, for example, has just announced that it is laying off 20% of its senior staff.  Let’s say this happens over three years, and that the eliminations will have no negative effect on sales, but will raise profits by $1 a year for the next three years.

How much should we pay for these “extra” $3 in earnings?  Again, the answer is that the earnings boost is transitory and should have no positive effect on the PE multiple.  So the move is worth, at most, $3 on the stock price.

Actually, my experience is that in either of these cases, the PE can easily contract on the earnings announcement.  Investors focus in on the falling sales.  They figure that falling earnings are just around the corner, and that on, say, a stock selling for $60 a share, the non-recurring $.50 or $1 in earnings is the equivalent of a random fluctuation in the daily stock price.  So they dismiss the gain completely.

why is today different?

I don’t know.  Although early in my career I believed that earnings are earnings and the source doesn’t matter, I’m now deeply in the only-pay-for-recurring-gains camp.

I can think of two possibilities, though:

–Suppose Wall Street is coming to believe (rightly or wrongly) that we’re mired in a slow growth environment that will last for a long time.  If so, maybe we can’t be as dismissive as we were in the past of the “wrong kind” of earnings growth.  Maybe company managements that are able to deliver earnings gains of any sort are more valuable than in past days.  Maybe they’re on the cutting edge of where growth is going to be coming from in the future–and therefore deserve a high multiple.

–I’m a firm believer that most mature companies formed in the years immediately following WWII are wildly overstaffed.  I also think that even if a CEO were willing to modernize in a thoroughgoing way–and I think most would prefer not to try–it’s immensely difficult to change the status quo.  Employees will simply refuse to do what the CEO wants.  As a result, this makes companies showing falling sales prime targets for Warren Buffett’s money and G-3 Capital’s cost-cutting expertise.  In other words, such companies become takeover targets, and that’s why their stock prices are firm.

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