Earnings Without Revenue, Bubbles Without Credit Growth


“With fame I become more and more stupid, which of course is a very common phenomenon.” 


Albert Einstein (1879 - 1955)


Watching the denouement of Q1 2013 corporate earnings, one is tempted to pinch both arms in an effort to regain consciousness and perhaps an accurate perspective.   Maybe pinch is not the right term.  The world of finance is a very strange place at present, in part because traditional indicators of future earnings, revenue and growth seem to be completely divorced from reality – especially when it comes to the prices accepted by the financial markets. Global economies are weak and forward corporate revenues mostly invisible.  But financial markets are riding to new highs carried on a tidal wave of fiat money care of the Federal Open Market Committee and Bank of Japan. 

Since the trough of 2009, S&P 500 operating earnings have risen almost 100% from about $65 to almost $115, while revenue has increased about 26% from just a little over $910 to a little shy of $1,150 per share, according to the latest chart book from Yardeni Research. That is a 4:1 ratio between earnings growth and the increase in underlying revenue.  Or put another way, in 2009 there was $14 in revenue underneath every dollar in earnings in the S&P 500 vs. about $10 today.  


Of the 102 companies that have reported earnings to date for Q1 2013, 72% reported earnings above the mean estimate and 45% reported revenues above the mean estimate, according to FactSet.  

“Pricing power has been nonexistent [and] sales volume increases have been very limited so the only route to profit has been cutting costs. That has pushed profit margins to all-time highs,” Gary Shilling tells Bloomberg News.Shilling called the present market course “unsustainable,” a profound insight if you consider that layoffs and capital releases are the two leading components of increased corporate efficiency ratios.  Yet most of the major market analytics providers remain bullish.  

“The Financials sector has the second highest earnings growth rate of any sector at 7.1%. This marks a slight drop in earnings growth for the sector from the 16.6% growth reported in Q4 2012 and the 11.7% growth reported in Q3 2012,” FactSet continues. “… However, the first quarter is expected to be a trough in earnings growth for the Financials sector. Earnings growth is projected to return to double-digit levels for the remainder of 2013, led by companies such as Bank of America and Citigroup.”


What is really interesting about the financials is that nearly 60% of the reporting companies came in with revenues below Street estimates, while almost 70% managed to beat earnings estimates on the upside.  FactSet notes that three of the bottom ten names in terms of percentage earnings misses were financials, including Bank of New York Mellon, BB&T and Bank America.   

The notion that financials can lead the way in terms of higher earnings in 2013 is more than a bit speculative, at least to this banking maven turned housing banker.  First and foremost, the US commercial banking sector has largely retraced lost ground in terms of regaining pre-crisis levels of operating income.  With ROEs in high single digits and little revenue growth, what mechanism will drive bank earnings in 2013?   And with a flat economy and so-so consumer spending activity, it seems a little exuberant to say that financials will continue to grow earnings as a multiple of flat revenue.  Indeed, volume growth is so poor in the banking sector that rising dividends are starting to actually result in negative retained earnings.

The chart below shows net operating income, dividends and retained earnings for all US banks at year end 2012, according to the FDIC.  Notice that banks are now paying out in dividends an amount that is in excess of NOI, resulting in negative retained earnings.  So much for all of that talk in Washington about higher bank capital levels.  If the largest banks are not able to grow revenues, then there is no way to build higher capital levels without radically shrinking the balance sheets of the banks.  

One of the biggest reasons that banks have been able to pay-out capital to shareholders via dividends is a general reduction in risk.  Risk weighted assets reported by the largest banks have been falling as have defaults and related loan loss reserves, resulting in higher capital levels – at least for now.  Off balance sheet leverage continues to run off with the non-agency mortgage sector.  The noxious combination of Basel III, Dodd-Frank and the state AG settlement also means that banks are providing much less credit to support the US economy.   You cannot have an asset bubble – or job growth -- in a classical sense without credit growth.  And bank lending volumes are actually falling.  Yes, falling.  Yet we have row upon row of Wall Street economists and analysts predicting near-double digit growth in bank earnings in 2013.  Hmmm.

These seemingly conflicting indicators, of rising earnings and flat to down revenues and credit volumes at banks, should be of concern to financial analysts and fiduciaries.  But since many of the prognosticators who contribute to industry earnings estimates are, in fact, economists, this is not a problem.   We can simply assume that bank earnings can continue to rise more quickly than bank revenues based upon cost cutting, layoffs and other short-term expedients.  Problem solved -- at least until the economist too joins the ranks of the “redunzl,” to recall composer Frank Zappa.  

Of course, with financials up double-digits for the year and the US economy showing signs of going into its now familiar fade after a strong Q1 performance, it is time to ask whether or not the gains should be taken from the table – with or without the Fed’s QE continuing.  Or imagine you have a 40% gain on an REO property you bought in 2009.  Do you take the cash off the table now or let it ride?

Since, as already noted, there is little or no net credit growth in the US economy, the efficacy of QE as a means for supporting higher GDP and job growth, and consumer activity and increased lending volumes, seems questionable. But of course even asking such a question is considered to be a sign of negative thinking.  Above all else we must be constructive.  After all, the first goal of FOMC policy is enhancing confidence rather than real economic activity. 

Indeed, to drive home the point about confidence, consider that one of the big drivers of performance in the financials in Q1 2013 was not the banks at all but rather non-bank financials.  The torrent of new issues for all sorts of non-bank strategies, many of these connected to the residential housing sector, has been the most interesting part of the financials complex for the past year or more.  And not all strategies are created the same.  

To that point, those selfless souls at Goldman Sachs wrote recently in a report on REO-to-Rent: “Rental yields on single-family homes, conditional on the current market prices, are compressed. Even among the 10 metro areas where our estimated 2013 rental yields are the highest, the average rental yield is only 5%.”  Goldman adds: “The REO rental yield assumes a 30% discount in acquisition price and $15,000 upfront repair costs.”   So nice to hear that caveat about expenses, especially compared with earlier GS tomes on the rent trade touting double digit returns without any mention of those pesky operating costs.

Of course, if you follow the US housing sector closely, you know that the “discount” in terms of pricing of REO vs. voluntary home sales has largely disappeared.   Like many of the opportunities for generating earnings and even revenue in the financials, the rally in home prices seems to be reaching a near-term peak – especially judging by the recent behavior of some of the shorter-duration professional strategies.  The fact of continued slack in the job market and in terms of consumer behavior also constrains the upside on housing.  The latest Case-Shiller data is more a function of short supply than a strong economic rebound, but does anyone care?    

When you look at some of the emerging alternative strategies and the agendas behind non-bank financials, you must ask yourself a question: Is an IPO for a firm that is primarily engaged in some aspect of owning and managing residential housing a bullish indicator?  Or rather is it an exit strategy for a savvy institutional investor?  More, if the total expenses on a given IPO reach well into double digits, is that a red flag from a risk management perspective? Does the prospect of a low single digit return on a hastily assembled rental strategy render a low double digit cost of capital problematic?  Hmmm

All of these questions and many others will be resolved in the fullness of time.  In the meantime, just remember that with the Fed and Bank of Japan buying nearly every government and agency security on the planet, even a completely rancid pile of bollocks might look and smell like a lovely red rose – at least until the rules of quantum mechanics are reinstated by our dutiful servants on the Federal Open Market Committee.  The tough part is discerning the median from the mean in this narrative, but that will have to wait until next time.