analyzing sales rather than earnings (ii)

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.

 

Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.

 

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.

Why?

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.