The Revenue Recession Of 2013

From Nicholas Colas of ConvergEx

The Revenue Recession Of 2013

If you’ve wondered what the next recession might bring in the way of U.S. corporate earnings, you don’t have long to wait for an answer.  Analysts expect the 30 companies of the Dow Jones Industrial Average to post a meager 0.7% top line growth for the upcoming Q2 2013 reporting season.  If recent history – think all the way back to Q1 2013 – is any guide, that means we’ll actually see a decline in revenues for the just completed quarter once all the numbers are out.  And with Q1 posting an average negative 0.6% top line comparison to last year, that will constitute a “Revenue recession” for these large and generally well-managed multinationals.  If that makes you question why U.S. stocks are still up 15% on the year, look to both corporate profits (still at record highs) and the anticipation for a better second half.  Hope may not be a strategy, as the old saying goes, but it certainly moves markets.

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What is the next U.S. recession going to look like?  That might sounds like a stupid – or worse yet, useless – question.  Everything’s getting better, right?  At the same time, it is worth considering for the following reasons:

  • The American economy is the only developed market in the world with some positive fundamentals.  Europe may be at a bottom, but it hardly seems anxious to get off the mat and back in the game.  Japan is at the start of an unprecedented experiment in monetary policy, with unpredictable outcomes yet to appear. 
  • While U.S. companies have certainly proven their ability to make money in a sluggish global economy, much of their sterling financial results have come with little incremental hiring.  Labor markets may be poking their head out of the foxhole here, but any signs of renewed trouble and they will likely do their best “Duck and cover” imitation, straight out of a 1950s newsreel.
  • The Federal Reserve has not proven its ability to execute monetary policy which fundamentally changes demographics (an aging and increasingly disengaged workforce) or stubbornly low consumer and business confidence.  How will they fight the next recession?  More bond buying? Meh – how’d that work last time around, unless you had a lot of capital on the sidelines at the bottom and went all-in for the ride back?
  • Then there is the sticky question of causes...  You can pick your poison here, with everything from recent tensions in the Middle East to the next Euro-crisis determining the fate of the U.S. economy.  Higher oil prices would ding consumer spending and confidence, perhaps for a year or longer in the case of greater tensions in Egypt or Libya.  While the U.S. banking system seems back on firmer footing, the same is not the case for the European financial system.
  • … And even definitions.  Look up “Recession” in the economist’s dictionary and you’ll get the classic “Two consecutive quarters of negative GDP growth”.  Fair enough, but try telling the 11.7 million unemployed or the 8.2 million underemployed workers in America that we’ve had a growing economy for several years.  Those 20 million people might have a quarrel with your definition of “Recession.”  As American president Harry Truman put it so well, “It’s a recession when your neighbor loses his job; it’s a depression when you lose yours.”

Here is a new phrase which expands the conversation: “Revenue recession”.  We’ll define it as when large, well run multinational companies fail to generate top line growth for two consecutive quarters.  Think we are far away from that, with record earnings reports in the offing for the upcoming financial reporting season?  After all, shouldn’t there be a little revenue growth compared to last year to help juice earnings per share?

There is an old saying: “Alcohol doesn’t solve problems, but if you think again, neither does milk.”  In the spirit of that sentiment, we need to “Think again” about where we are in the cycle for corporate revenue growth.  Here is our thought process:

  • Every month we review the expectations for year-over-year top line growth that the analysts for major Wall Street brokerage firms have in their financial models for the companies under their coverage.  We’ve included our spreadsheets and graphical summaries immediately after this note. 
  • Along with earnings per share, these numbers are the backbone of the quarterly “Expectations game” which pits corporate America against the Street’s voracious appetite for better-than-expected financial results.  For many years, EPS was the one-stop-shop to determine if a company beat the quarter.  Since the Financial Crisis, however, top line expectations have taken on more significance in judging the quality of the quarter.  Cost cutting to meet analyst expectations has a finite end, after all, where earnings growth driven by sales increases both proves competitive advantage and leverages fixed costs. 
  • Rather than take the S&P 500 or other index with hundreds of companies, we look at the 30 companies of the Dow Jones Industrial Average.  By the S&P Dow Jones Averages Committee’s own description, this group of publicly held enterprises collectively “Has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.”  The Average also excludes some very cyclical names – transports, for example, and slow growth industries such as utilities.  If these companies, with their global reach and competitive advantages, cannot grow revenues, you know things are tough all over. 

Our summary of this month’s analysis finds the following:

  • Wall Street analysts have continued to curb their enthusiasm about revenue growth for Q2 2013, now posting an average increase of just 0.7% for the 30 companies in the Dow.  Take out the financials, and the average drops to just 0.2%.  Yes, Alcoa may have “Beat” revenue expectations tonight, but the comparison to last year was still negative. 
  • Analysts have been trimming their numbers for almost a year – the average expected revenue growth for the Dow was a healthy 4% back in October 2012.  The current average estimate is the lowest level of expectations since the Street started posting quarterly estimates for the just-completed quarter.
  • The trend here is oddly reminiscent of Q1 2013, where analysts hacked away at their revenue forecasts but still managed to miss the inflection point through zero.  Actual results were negative 0.6%, with negative 0.1% for the non-financial names in the Average.
  • Wall Street is still more sanguine about the back half of the year – revenue growth expectations average 2.8-2.9% for the next two quarters.  Given the direction of Q2 estimates, however, it will not be a surprise to note that these numbers were 4-5% back in March 2013.
  • If the second quarter of 2013 follows the same cadence as the first, with final results negative versus very modest positive expectations now, we will have two quarters of negative revenue growth.  There, in an unwelcome nutshell, is your “Revenue recession”.

At the same time, literacy rates are reasonably high in America, especially if you have enough money to care about the stock market.  So let’s assume markets generally understand that, on average, some of the very best-run large companies on offer currently find it impossible to grow their business.  Does that merit a 15% year-to-date return?  Or a 15-16x earnings multiple? 

Let’s turn this frown upside down and see what the market is thinking.  I believe the bull argument goes something like this:

  • If I had a cheap car that could beat a new Ferrari around a racetrack despite needing a tune-up and a valve job, wouldn’t you want to buy it?  That’s the U.S. stock market – high corporate profits (record levels, really) with scarcely a whiff of macroeconomic tailwind.  We’re running on four cylinders when there are actually eight under the hood, and we’re still showing the Russian billionaire in his new 458 our tail lights on a back road in the French Riviera. 
  • If it weren’t for bad luck, the global economy over the last four years would have no luck at all.  As the joke goes, “There must be a pony in here somewhere.”  If you subscribe to this form of preternatural optimism, that equine opportunity doesn’t gallop towards bonds.  It runs to stocks.  What it does to fixed income is, well, unpleasant. 
  • In the end, what we have is a U.S. stock market which still sees the glass as distinctly half full, perhaps with a slice of lime and a rim of salt.  “Hope is not a strategy” is one investment aphorism that both traders and portfolio managers tend to respect.  It’s just not a particularly profitable perspective at the moment. Or, as Bob Dylan once put it, “When you ain’t got nothing, you got nothing to lose.”