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How CEOs Play "Beat The Wall Street Estimate"
Submitted by Lance Roberts of Street Talk Live blog,
Recently, I wrote an article discussing the "Truth About Wall Street Analysts" and the inherent conflict between Wall Street and individual investors. There is also another group of individuals who are also just as conflicted - corporate executives. Today, more than ever, corporate executives are compensated by stock options, and other stock based compensation, which are tied to rising stock prices. There are billions at stake in many cases and the game of "beat the Wall Street estimate" is critical in keeping corporate stock prices elevated. Unfortunately, this leads to a wide variety of gimmicks to boost bottom line profitability which is not necessarily in the best interest of long term profitability or shareholders. Today we will discuss four tools that have been at the heart of the surge in profitability since 2009 and why such profitability has failed to boost the economy.
One of the primary debates that is currently raging is whether, or not, the economy is currently experiencing a "soft patch" of activity and is set to begin a longer sustained recovery. Such an economic recovery is critical to support the primary thesis of a new secular bull market beginning in the stock market. At the core of all of these arguments is corporate profitability. With the stock market hitting all-time highs in 2013 market valuations have increased considerably. The chart below shows the forward reported P/E ratio change from January of 2012 to present.
The problem is that the price/valuation increases have come at the expense of deteriorating corporate profitability. I discussed this issue earnings at length in my recent report on "Evaluating 3 Bullish Arguments" but importantly was the chart below which showed the deterioration in earnings.
Since 2009 the reported earnings per share of corporations, the bottom line of the income statement, have increased by a total of 175% which is the sharpest, post-recession, increase in reported EPS in history. However, at the same time, reported sales per share, which is what happens at the top line of the income statement, has only increased by a marginal 34% during the same period. This is shown in the chart below.
In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability. Furthermore, as I will discuss below, each have a negative impact on investors and/or the economy.
Stock Buybacks Create An Illusion Of Profitability
One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buy backs. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buy backs.
The problem with this, of course, is that stock buy backs create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding - reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.
Working For Two
Since the end of the financial crisis corporations have been able to markedly boost profitability has been through increases in productivity. In any business the highest single expense is the cost of labor. Therefore, increases in productivity can reduce the need for more employees. The first chart below shows
As productivity increases the need for employment is reduced. Automated answering systems have been used to replace receptionists, automated billing systems, outsourced help desks, etc. have allowed for lower headcounts for businesses while increasing output per person. Higher output, and lower costs, have led to the highest profit per employee in history as shown in the chart below.
What? You Want A Raise?
While increasing productivity will increase profitability - a large and available labor pool, which creates competition for existing jobs, keeps wages suppressed. Suppressed wage growth, combined with increases in productivity have created massive profitability for businesses. The chart below shows real compensation per hour since 2000.
The spike in 2012, see inset, is deceiving because the entirety of the increase came in the 4th quarter as corporations panicked prior to the "Fiscal Cliff." That one time effect is now past but higher tax rates are here to stay. Real compensation has now fallen back to levels previously seen at the beginning of 2012 but higher tax rates have reduced the purchasing power of individual workers. With profitability now under pressure it is unlikely that we will see any significant increases to compensation in the near term particularly as real unemployment remains elevated. This does not support the economic recovery story.
Sorry, We Aren't Hiring Full-Time
The reason that I state the real unemployment remains elevated is that despite increases in employment in recent months it has been a function of population growth rather than a improved outlooks by businesses. The issue of population growth is ignored by most analysts and economists when discussing employment. However, when businesses are geared for a certain level of demand, increases in population will incrementally increase demand requiring fractional increases in business productivity and output. However, in order to keep costs minimized businesses have resorted to temporary hires rather than full-time employment which incurs additional costs of benefits and healthcare. The expectation is that temporary workers will eventually become full-time employees, however, with the impending effects of higher healthcare costs due to the Affordable Care Act - temporary hires may be the new normal. The chart below shows full-time employment relative to the population.
With full-time employment still near the recessionary lows it shows that businesses remain focused on the cheapest cost of labor possible. The chart above also shows jobless claims which have been steadily falling since the peak of the crisis. This is due to "labor hoarding" where businesses have literally run out of employees to terminate or fire. However, just because fewer people are being terminated it does not mean that greater levels of full time employment are being created which is what is needed to create sustainable organic economic growth.
Profit Scraping May Have Reached Its Limit
There is no doubt that corporate profitability has surged from the recessionary lows. However, if I am correct in my assessment, then the recent downturn in corporate profitability may be more than just due to an economic "soft patch." The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. While Goldman Sachs expects profits to surge in the coming years ahead - history suggests something different.
I say this because of something my friend Cullen Roche recently pointed out:
"We’re in the backstretch of the recovery. We’re now into month 47 of the current economic recovery. The average expansion in the post-war period has lasted 63 months. That means we’re probably in the 6th inning of the current expansion so we’re about to pull our starter and make a call to the bullpen. The odds say we’re closer to the beginning of a recession than the beginning of the expansion. That puts the Fed in a really odd position and not likely one where they’re on the verge of tightening any time soon."
This is a very important point. While the Fed's ongoing interventions since 2009 have provided the necessary support to the current economic cycle it will not "repeal" the business cycle completely. The Fed's actions work to pull forward future consumption to support the current economy. This is turn has boosted corporate profitability as the effectiveness of corporate profitability tools were most effective.
However, such actions leave a void in the future that must be filled by organic economic growth. The problem comes when such growth doesn't appear. With the economy continuing to "struggle" at an anemic rate of growth the effects of businesses profitability tools have become much less effective.
This is not a "bearish" prediction of an impending economic crash but rather just a realization that all economic, and earnings, forecasts, are subject to the overall business cycle. The problem with earnings forecasts, such as Goldman Sachs above, or the CBO's 10 year economic growth forecast, is that they have failed to factor in the probability of normal economic recession. This is a mistake that eventually produces very negative outcomes for investors.
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When walmarts is going to do a massive buyback, you know things are fucked. They have minimal labor costs when compared to everybody else for Christ's sake. The BTFDers are out in force. The Bernanke is smiling, bastard. Still tick tock bitchez...
insert treasury yield here.
I wonder how many on here tried to, once again, short this beast and just had to cover.
People trying to short this should just cut out the middle man and write a check to the squid.
must. keep. music. playing.
"The Bernanke is smiling, bastard."
There is a special place in hell for him.
Damn it feels good to be a gangsta! This casino is absurd and is coming down soon! http://tinyurl.com/ke4p2uy
We had an NFP number beat consensus estimates by 8000.. while at the same time having last month revised down by 16000..
And the S&P is up over 1% with the Dow up almost 200 points?
WTF
The wtf is the part where Bernanke has trained the monkeys to buy every single dip. It took a while but he got it done.
It also appears they are able to blowtorch gold and silver prices at will. Real demand seems to mean fuck all.
I think more than a few trader-folks needed some cash after yesterday's weirdness. Where else to get money?
Why, from a "store of value", of course. Hence, the PM activity. Silver just goes along for the roller coaster ride since gold is buying the tickets. Makes sense to me. All that without a conspiratorial intervention by JPM and TPTB and all the others accused of manipulation.
Hey, I ain't saying that they don't do it.... just that this time it was "adjusted" for them by market exigencies.
That's now 4 hard bangs off the 50DMA so far this year.. with a roughly 7 week interval between them.. so that should mean we'll be due for the next flirtation with the 50DMA roughly mid-to-late July.. and between now and then? New highs!
After all, there's no risk anymore!
(Really hoping for a major downside reversal this afternoon, this absurdity needs cleared out in a bad way)
H/S? 12:45ish plunge?
Ahh.. one can hope.
....unlimited banana printing ability will do this...
It's called 'operational leverage', Lance. Profits can triple, with sales up 50%. Happens all the time with cyclical companies coming off the bottom of the cycle.
its called accounting fraud and was legalized by Obama in Feb, 2009. Corps now stash crap on their balance sheets. They'll eventually take the massive hits.....at a time the markets are tumbling. They're called "one time charges". Get used to that term. You'll be hearing a lot of that later this year and especially 2014.
Go back a bit further than that retard, "mark to fantasy" has been around a lot longer and Glass-Steagal was ended in the 90's. That whent the bullshit paper games really took off.
With gas prices, how can profits not be up, and with all those wonderful jobs created by a computer model all the peons should have no problem filling the tank. $4.49 for reg unleaded in Chicago, I think we see $5 by the 4 of july. Should be good for the leisure industry
A friend of mine, CTO at a company that helps small truckers do routing, developed a "heat map" of fuel prices across the country, so as to be able to re-direct routes for small truckers that don't just have a contract with the oil majors, and actually have to pay at the pump.
It has revealed numerous instances of price fixing around the country, and the excuses given are pretty lame (transport issues, when the high prices are in places near piplines and refineries would be one example).
Chicago shows up frequently bright red, to the point of his clients routing around it when possible, and buying fuel before they need to so as not to have to buy it there.
In SW VA - regular is 3.39, checked it yesterday. Not that I care with my solar charged electric car all that much, but I still do buy some for the tractor and truck...
Not sure who is pulling the strings there - maybe it's just the oil companies colluding, maybe .gov is involved. My friend just plots the data, and it's obvious when you watch it over time that something odd goes on.
Interesting point, but his map might also reflect the "cost of doing business" is higher in some areas than others....as in CA, for example.
We are all so impressed with your wisdom.
Tell us more about your electric car. You know, the part about how it takes a week to charge it under perfect conditions, and how it never charges during cloudy/rainy seasons. Then you get to drive it for an entire hour.
Or about how you spent $50k to save a few pennies.
Or about how your storage batteries last a couple of years before needing replacement. No cost there, I guess.
Excellent article, except for maybe this...
"Since the end of the financial crisis..."
Hmmm, I didn't know it ever ended!
Should read-
'Since the start of the age of propaganda which would make Goebbels blush took over'.
Ineed SheepDog-One. Good one.
Give me the whisper number and I'll best it by a penny....when your major reward is stock options, you do everything possible to keep your stock going north,which leads to channel stuffing, cutting equipment maintenance that should really be performed, etc.
Perhaps all those share buybacks and extra dividend payouts will come back to haunt corporate America. The lack of cap-ex and R&D spending will eventually rear its ugly head as corporations find much of the world has evolved past them.
"The lack of cap-ex and R&D spending"
It's all about dumping expenses for future growth for profits here and now.
Wall Street trained CEOs to think this way. Rip companies and business apart for bigger bonuses and jump ship before it sinks with a golden exit package.
Good luck cashing out on the illusion....first out wins.
Who writes this bullshit? In most heavy industry, labor comes isn't even close to the largest cost.
Stock buybacks are not accounting magic -- the author is clueless. Stock buybacks just leverage the company more than they would be otherwise. Higher leverage results in higher earnings per share. The market can decide if it wants to value the higher leveraged results with a lower multiple or higher multiple. No magic or chicanery going on here.
The purported reason for share buybacks is the reduction of outstanding shares, but it is never done for this reason. Buybacks are done to ramp share prices temporarily, as share price increases in excess of what would be justified by share number reduction can be achieved, especially for more illiquid or tightly owned shares. You can find companies ramping their share price by 100% with a 5% buyback reduction. Then after the buybacks it is always back to issuing shares at inflated prices, as hopefully a new round of moron investors can be fooled.
As a sidenote, the theoretical justification for buybacks not only assumes a permanent reduction in shares that never eventuates, but also profits and dividends. But the ramp from buybacks can be done for a company without profitable prospects.
Share buybacks are most definitely chicanery, they are temporary ramps performed for the benefit of insiders at the expense of buy-and-hold investors.
the squid is squirting ink from it's privates. disgusting
http://www.youtube.com/watch?v=LLqEWDo1VQk