FYI | Nov 19 2010
By Greg Peel
I recently saw a re-run of the 1990s movie based on the book Barbarians At The Gate which took a “can you believe it?” approach to chronicling history's most famous leveraged buy-out, that of private equity firm KKR for tobacco/snack food producer RJR-Nabisco. The movie itself bordered on the satirical.
RJR's stock had been wallowing for a long period in the US$40s before the word “buyout” was mentioned, but by the time a battle between management, KKR and various investment banks had been won and lost, KKR ended up paying just over US$100 per share, leading the world to shake its head in disbelief. But in its first year post-buyout, RJR-Nabisco increased its earnings by 40%.
It did so by immediately putting a halt to all excessive spending. The most memorable scene in the movie has both the group CEO and the head of the RJR division jetting down to Florida having just thrown a lavish party to which all the banking fraternity came to watch the first Tyson fight, en route to the lavish RJR-N sponsored celebrity gold day. While both executives left the same party to fly to the same location, they each travelled in their own private jets, which flew side by side, conducting a “meeting” all the way down over their respective house brick mobile phones.
It was not hard to get the point.
The LBO/Savings& Loan collapse in the US and the fall of Japan in the early nineties brought to an end a period of excess in the US corporate market which was soon quickly replaced by another period of excess up to the dotcom crash which was soon replaced the period of excess which led up to the GFC. Following each event, those companies which survived knew they were now facing a period of much reduced revenues, but that earnings per share could be supported nonetheless by cutting the excess costs out of the business.
Aside from clamping down on unnecessary spending, the fat could also be trimmed from staff numbers and a broom swept through operations so to increase company productivity. It took a while for this to sink in, as evidenced by the meeting called in Washington in 2008 of all the heads of major investment banks to discuss the government's bail-out of all among them which were now ostensibly bankrupt. Each CEO flew the short distance from New York to Washington in their respective private jets, sparking a scathing rebuke from all quarters.
To a subsequent meeting they all drove down in family sedans.
Once it had sunk in, across the entire US corporate spectrum, the cost cutting began. The resultant increases in earnings per share in calendar 2009 were so impressive one could have been forgiven for thinking we were still in a raging bull market. The trend has continued into 2010, yet underlying revenue growth has only just began to very quietly resurface. Productivity increases have remained the driving force. Past quarters have seen net earnings increases of 20-30% but revenue increases struggling to make double digits.
RBS notes that with the 2010 September quarter result season now all but over, the net year-on-year earnings growth for the S&P 500 stands at 28% compared to the pre-season consensus forecast of 23.4%. Revenue growth has netted to 9%, which maintains the trend, but consensus forecasts had only 0.9%. Wall Street is no longer paying too much attention to earnings and has been concentrating on revenues. It has become used to, and wary off, earnings per share reflecting “slimming down” rather than growing, and more focused on whether or not people are actually “buying stuff”.
RBS sees evidence of this in the fact stocks which “beat” on revenues against forecasts were better rewarded than those which beat on earnings. Indeed, those which beat on earnings but fell short on revenues were mostly severely punished. Taking a “beat” to equate to a result at least 2.5% better than consensus, RBS notes 60% of the S&P 500 beat on earnings and 31% on revenues. That revenue “beat” is a big improvement on last year's equivalent comparisons.
But there are potentially two sides to cost-cutting. On the one hand, companies might sell off the private jets and trim down the workforce into a “lean, mean fighting machine”, or companies without such luxury may simply cut back on staff, stores, floor space, factories or whatever and perhaps sell off whole divisions cheaply just to keep the bank from the door.
In the former case, an economic recovery will translate squarely into improved earnings per share given the costs removed from the existing operation will ensure more joy on the bottom line. In the latter case, the economy might recover but it could be a long time before the company recovers given it has not cut back on its excess but cut back on its actual earnings capacity.
It is the former case companies which drive results of 28% earnings growth, and consensus forecasts for the December quarter currently have another 24.5% growth. Onward, ever upward.
However take out the financial sector – which was the most beaten down in the GFC and thus still offers the most recovery upside in percentage terms – and that earnings growth figure is only 10.2%. And the bulk of that, notes RBS, comes from the Energy and Materials sectors. The bulk of the forecast increases for those sectors comes from expectations of higher commodity prices.
There may be the long-running, underlying story of emerging market industrialisation and urbanisation underpinning those commodity price forecasts, but realistically increased forecasts owe just as much, if not more, to expectations for a weaker US dollar.
Those expectations are all about QE2.
So if the 10% of December quarter earnings growth is based on the dollar then it's not earnings growth at all, from the normal perspective of being demand-driven, but simple currency debasement. And all the world, pretty much, is assuming such currency debasement as a given.
Someone forgot to tell that to Ireland, obviously.
On this side of the Pacific, it is simply being taken for granted that commodity prices will rise into perpetuity due to Chinese and Indian demand, despite US dollar debasement driving an appreciating Aussie dollar, providing a return to surplus for the government by 2013.
The RBS analysts, on the other hand, expect the commodity price upswing to decelerate through 2011, such that they expect average US earnings growth to be only 13% in 2011 compared to all these 20-30% numbers of 2009-10.
It is a timely reminder that if everyone in the world expects the same thing to happen, it won't.
