Refuting The Biggest "Recovery" Lies In Four Simple Charts
"US profits are growing, companies have underinvested and have no choice but to spend more on CapEx, and corporations have much less debt than they did during the crisis thanks to a massive cash build up."
These are the generic go to explanations by soundbity talking heads for why the US recovery is gaining traction with US corporations, if not so much Joe Sixpack, and why companies are still cheap. There is one problem: they are all wrong.
As SocGen's Andrew Lapthorne shows conclusively, "US profits are not growing, companies are over not underinvesting (they may in fact have overinvested), and corporates are carrying more (not less) net debt than they were in 2009. It would appear that many believe the opposite to be true, yet corporate report and accounts data seems to say otherwise." But hey- stocks are at record highs, right, and the market is never wrong (except when it is), so who cares. Indeed "Thank goodness equities went up in 2013, otherwise it might have been a rather depressing year."
Here is what else SocGen uncovered:
- When it comes to having a market view there are typically (at least) two sides to every argument. When it comes down to the state of US quoted sector profits and balance sheets there should be little argument, but even here there is a great debate, and several viewpoints with which we do not entirely agree.
- First is the notion that profits growth accelerated in the US last year. Yes, the pro-forma figures from popular providers such as I/B/E/S show EPS growth of around 6-7%, but pro-forma figures are whatever you wish them to be. Reported earnings growth slowed to almost zero in 2013 and EBIT is largely where it stood at the beginning of 2012.
- Capital expenditure growth, the great hope for 2014, slowed throughout 2013 as did cash flow growth and sales growth. However, capex as a proportion of sales is at elevated (not depressed) levels. Why would a company step up investment when faced with contracting margins and lacklustre demand? Surely sales and profit growth recoveries lead investment and not the other way around?
- US corporates do indeed hold lots of cash, which is currently at record levels, but they also hold record levels of debt. Net debt (so discounting those massive cash piles) is 15% above the levels seen in 2008/09. The idea that corporates are paying down debt is simply not seen in the numbers. What is true is that deleveraging has occurred through the usual mechanism of higher asset prices (no doubt an aim of central bank policy). This is the painless form of deleveraging. It is also the most temporary, for a simple pull-back in equities and rise in volatility will put the problem back on centre stage
US profits growth stalled in 2013
When looking at profit growth most people tend to quote pro-forma earnings numbers from the likes of Bloomberg and I/B/E/S which show 12 month forward or trailing EPS to have grown by around 7% over the past year, consistent with the figures you see in our Global Market Arithmetic product, which are based on I/B/E/S supplied data.
However, a better profit series comes from MSCI, which has earnings data going back to 1970 for most major indices. This definition of earnings is not as harsh as the S&P earnings definition incorporated into the likes of Robert Shiller’s CAPE, but neither is it as overly generous as the pro-forma numbers supplied by I/B/E/S. To give you an example of the difference, during the 2009 profit slump S&P core earnings fell peak-to-trough by 92%, MSCI defined earnings fell by 55% and I/B/E/S pro-forma earnings fell by 36%.
As we show above, not only are MSCI reported profits barely growing but the gap in the growth rate between these numbers and the pro-forma numbers is widening, with the proforma number considerably more optimistic. This is a phenomenon that often precedes a more significant profit slump. It is also an indication that the quality of earnings is deteriorating. Based on MSCI reported figures, earnings are no longer growing.
Of course even these MSCI figures have been flattered by a reduction in the share count plus lower interest rates and tax charges. If we look at overall growth in earnings before interest and tax, or indeed gross cash flow, we find that neither has really moved for the last couple of years. It would appear then, that at an aggregate level, most profit growth is the result of astute financial engineering rather than improving cash flow – yet another sign of a tired, long in the tooth, profit cycle.
Corporates are overspending relative to sales
Another, perhaps surprising conclusion also to be seen from US report and accounts data is that US corporates are not underspending when it comes to capital expenditure and, in fact, relative to sales they may be overspending! The following chart shows overall capex to sales ratios for the US ex-financials. Rather than being depressed, what we see is that capex levels versus sales are relatively elevated. If anything it would appear from this data that capex levels are too high – not too low – as many are saying.
Indeed, if we look at the evolution of capital expenditure and cash flow growth, we see that we have already been through a long period of substantial capex growth and capex growth has exceeded cash flow growth for some time. Importantly, just as cash flow growth is slowing so too is capex growth and, in the absence of a pick-up in demand, it may continue to do so in an effort to preserve those precious high margins and profitability.
So why are corporates complaining about the lack of investment opportunities and opting largely to engage in share buybacks instead? As has been the case in Japan, we’d argue that the problem is not a lack of desire to invest, but anemic demand reflected in very low sales growth. After all, corporates did step up capital expenditure post the financial crisis only to then be confronted with a lackluster economic recovery. If the demand isn’t there why invest? And, of course, with credit abundant there are easier ways to boost asset prices, so why not pursue those instead?
US companies are carrying far more net debt than in 2007
Another curiosity is this notion that US companies have substantially reduced their debt pile and are therefore cash rich. The latter is indeed true. Cash and equivalents are at historically high levels, but rarely do those who mention the mountains of corporate cash also discuss the massive increase in debt seen over the last couple of years. In fact, debt levels have been growing to such an extent that net debt (i.e. excluding the massive cash pile) is 15% higher than it was prior to the financial crisis.
In summary: 2013 was a year of weakening cash flow growth, lower profit growth, deteriorating earnings quality, and corporates pilling on the debt – again! Well at least equities were up strongly last year, otherwise you might be feeling rather bearish.
So several counterfactual points: US corporates saw profit growth slow to almost zero last year and on an EBIT basis it has been flat for some time now. Earnings quality, rather than improving is actually deteriorating, as indicated by the increasing gap between official and pro-forma EPS numbers. As a consequence, following a long period of overspending and in the absence of a strong pick-up in demand, corporates will have to spend less and not more. Finally, as a consequence of such anemic growth, corporates have been gearing up their balance sheets in an effort to sustain EPS momentum via the continuing use of share buybacks. With markets up substantially in 2013 executing those share buybacks has become increasingly expensive. Little wonder companies have to borrow so much to continue executing them. So as the Q4 numbers roll in we’ll be looking for evidence of increasing earnings manipulation, greater leverage and for signs that the capex cycle might be improving.
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