Analysis: Lean firms squeeze profit growth out of skimpy sales
BOSTON (Reuters) - Investors breathed a sigh of relief this week as big U.S. companies topped Wall Street's profit forecasts with companies, including General Electric Co (GE.N), showing they could continue to grow in the face of Europe's economic woes.
Shares of companies including Honeywell International Inc (HON.N), Textron Inc (TXT.N), International Business Machines Corp (IBM.N), Mattel Inc (MAT.O) and Baker Hughes Inc (BHI.N) rallied this week after they reported better-than-expected second-quarter earnings.
Their strong profit growth in many cases outstripped increases in sales, showing that companies continue to find ways of improving productivity more than three years after the official end of a brutal recession that left them focused on cost cutting.
"We did expect slowing revenue growth, and we're seeing that, but I think many analysts and strategists overdid it with the lowering of expectations," said Oliver Pursche, president of Gary Goldberg Financial Services in Suffern, New York. "They had presumed there would be a very high correlation between lower revenues and lower profits and that is not what has happened."
That is not to say that Wall Street was awash in good corporate news: Verizon Communications Inc (VZ.N) fell due to weakness in its wired phone business; Morgan Stanley (MS.N) said it would cut its headcount by 7 percent from its level at the end of 2011 after a 24 percent drop in revenue, and Xerox Corp (XRX.N) slumped after cutting its full-year profit target.
Even Microsoft Corp (MSFT.O) reported its first loss as a public company, contributing to a mild selloff in U.S. stocks on Friday, which saw the broad Standard & Poor's 500 index .SPX decline a little less than 1 percent, giving up some of its rise of the past week.
EARNINGS BETTER THAN SALES
Of the 97 companies in the S&P 500 that have reported earnings so far this season, 65 percent have beat Wall Street's expectations. On average, their profit rose 29 percent in the quarter, according to Thomson Reuters I/B/E/S data.
The picture is not quite so bright on the revenue side, where 56 percent of reporting companies have missed analysts' forecasts and collectively grown sales by just 2.5 percent.
A variety of factors hurt their sales, including deteriorating demand in Europe, a strengthening dollar that ate into the value of U.S. companies' foreign sales, and turmoil in stock and bond markets that took a toll on the financial sector.
One factor that has helped companies manage the European downturn is that it has been so long in developing, giving chief executives' plenty of time to plan for it.
"Even back in the middle of last year, we all talked about how Europe was going to be tough for several years," GE Chief Financial Officer Keith Sherin said in an interview. "As a result we've been working on costs, we've been prepared for lower orders and revenue."
The largest U.S. conglomerate said it would split its big energy arm into three pieces, a move it estimates will save $200 million to $300 million a year once completed. GE shares rose on Friday after it reported a 2.5 percent rise in operating profit that was modestly ahead of Wall Street forecasts.
The beats, particularly in the tech and industrial sectors, have eased market fears of a broader downturn. Eleven of the 16 S&P 500 tech companies that reported results surpassed estimates on earnings, according to Thomson Reuters data.
"A lot of people were very concerned with what's going on in Europe ... and that's why you're seeing this reaction," said Daniel Morgan, who helps manage about $3.5 billion at Synovus Trust Company (SNV.N) in Atlanta. "It's kind of like wiping the sweat off your forehead."
Of the S&P sectors, technology has the highest sales exposure to Europe, at about 25 percent, according to a Bank of America/Merrill Lynch research note.
Even as they reported strong profit growth, CEOs remained wary of raising investors' expectations further, generally holding 2012 profit forecasts steady or raising them by roughly the amount they had beat second-quarter expectations.
IBM, the world's biggest technology services company, took the latter approach, hiking its profit forecast by 10 cents to "at least" $15.10 per share after topping Wall Street estimates by 8 cents.
Textron, the world's largest maker of corporate jets, played it even more conservatively, holding its full-year profit forecast steady after beating estimates by 14 cents per share. Chief Executive Scott Donnelly told analysts that reflected concern that demand for business aircraft was closely tied to corporate confidence.
"I worry about the back half of the year," said Donnelly. "I remain concerned we'll have too many people sitting on the sideline as opposed to guys willing to make significant capital investments."
The Providence, Rhode Island-based company has spent much of the past few years restructuring its Cessna jet arm, which saw demand drop precipitously after the 2008 financial crisis.
Donnelly was by no means alone in fretting about corporate confidence.
When BlackRock Inc (BLK.N) reported an 11 percent drop in second-quarter earnings -- which was less steep than analysts had feared -- CEO Laurence Fink said that uncertainty about the global economy seemed to have left executives wary of investing in new equipment or staff.
"This uncertain climate has shortened the horizons for decision-making," said Fink, who as head of the world's biggest money manager regularly meets with dozens of top executives and government officials. "This is a big change, from my perspective, from 2011. ... I do believe CEO behavior has changed much more this time than we have seen a year ago. I do believe CEOs have truncated their field of vision."
LIMITS TO PRODUCTIVITY GAINS
Investors warned there is a limit to how long corporate earnings growth can outpace revenue growth by as wide a margin as it has done this quarter, particularly since many CEOs have been looking for ways to cut costs since the start of the financial crisis in 2008.
Honeywell this week said it had spent about $800 million on restructuring since 2009, and that it was continuing to look for ways to lower cost, particularly in Europe.
"Productivity has to continue to grow or you're going to see unit labor costs rise unless you get some top-line growth," said Jim Rudd, CEO at Ferguson Wellman, a Portland, Oregon-based money manager. "At this point in time, it's hard to count too much on top-line growth."
That realization may be weighing on analysts' estimates for the rest of the year.
Over the past 30 days, analysts have cut their average 2012 earnings estimate on the companies in the Standard & Poor's 500 index .SPX by 1.2 percent, according to StarMine data. Analysts have cut estimates 2.5 times as often as they have raised them over that period.
Particularly in the face of weakening demand in Europe, as joblessness rises and governments adopt austerity spending programs, companies with a broad geographic reach are having the best luck growing revenue -- several reported solid growth in the United States and China.
When Coca-Cola Co (KO.N) earlier this week reported better-than-expected earnings and sales, it said that growing soda sales in emerging markets offset declines in Europe.
"We're naturally keenly aware of how turbulent the economic landscape is today," CEO Muhtar Kent told analysts on a conference call. "We've got a wonderful portfolio of geographic regions. Not all of them will ever do well all the time, but just like this past quarter, where we had very unseasonable weather in Europe, we had tremendous, again, negative consumer sentiment brewing in Europe, we still have delivered our results."
Investors seem convinced that the economy has not slowed quite as much as they feared it would earlier in the year.
"The pullback in stocks leading up to earnings season seems to have discounted everything that's being reported," said Goddard, of Capital Advisors. "Perhaps fear was worse than what's actually happening, even though the outlooks are pretty muted."
(Additional reporting by Nick Zieminski, Ernest Scheyder and Caroline Valetkevitch in New York and Aaron Pressman and Tim McLaughlin in Boston; Editing by Patricia Kranz and Leslie Gevirtz)
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