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TMFPostOfTheDay (< 20)

Separating Top from Bottom Line



October 25, 2012 – Comments (0)

Board: Macro Economics

Author: yodaorange

During the 2008 credit crash corporate profits took a swan dive, but recently they have come roaring back. Profits as a percentage of GDP are close to all time highs. All fine and good.

When I read an earnings report, the first data I search out is the “top line” aka revenues. Before the crash a typical earnings report would show X percent growth in the top line and ~ X percent growth in the “bottom line” aka earnings. This indicates that the net profit margin for the company was relatively unchanged. It made for a simple formula, increased sales lead to increased earnings.

That all changed after the crash. The typical earnings report had a disconnect between the top line and the bottom line. The top line might be flat to down, yet the bottom line showed impressive growth. Stated differently profit margins improved. Companies have a lot of levers they can push to change profit margins. One lever they used extensively post crash was to reduce payroll costs through layoffs and/or outsourcing. If your company can produce the same output of goods and services with less people it is called improved productivity. You can argue that this proves that companies were NOT at peak productivity before the crash. Stated differently they had a lot of things like “excess employees” that were NOT needed to maintain the top line sales.

Usually there is an asymptotic limit as to how much productivity improvement you can squeeze out of a company. In the end if you lay off all of the employees, you have no ability to produce the goods and services to sell for the top line. Of course, there are other methods of improving profit margins, like cutting salaries, 401k matching, other benefits, cost of office space, etc.

In the end game, you have to start GROWING the top line to grow the bottom line. Recently the news on top line growth has been discouraging. Factset reports that so far this earnings season 42% of companies have reported sales above estimates. [1]This is the lowest percentage since we were in the middle in the crash back in 2009.

However, only 42% of companies have reported sales above estimates. This percentage is well below the average of 55% recorded over the past four quarters. In fact, it is the lowest percentage of companies to report sales above estimates at this stage of the earnings season since Q1 2009 (35%).

This is NOT good news. Couple that with Q3 earnings looking like they will shrink by 2.3% and the picture is NOT optimistic. Understand that Wall Street is all about expectations. If they have a one foot high hurdle set and you clear it, you are a hero. If they have a 7 foot hurdle set and you jump 6 feet 11 inches, you are an idiot. Your stock will be trashed.

There is one other broad implication that is not widely discussed at this time. If companies are missing on the top line, they HAVE to cut costs to maintain their profit margin. If they want to grow earnings, they have to double cut costs. Unfortunately, the fastest and easiest way to do this is to layoff employees. US companies have evolved to a shoot first, aim later mentality. At the first sign of weakness they tend to layoff employees until waiting to see how long/deep the downtrend will be. If I was an employee of a company that missed the top line forecast, I would be very nervous about job security. . .

The investing thesis is not as clear cut. Poor top line results is proof positive that the Fed and Politicians need to do more to “get the economy going.” Some form of stimulus would normally be what the doctor ordered. In today’s climate with the election coming up plus the fiscal cliff looming, it looks like the Fed is the “only game in town” for a while longer. I wouldn’t be surprised if they announced a major new initiative the day after the election. Something like doubling the QE or announcing direct investments in securities might do the trick.

BOTTOM LINE is that we have to see corporate top line growth if we ever want to grow the economy, much less produce more US based jobs.

I recommend you take a look at the graph on the link. It is very insightful IMO.



[1] Factset “Lowest percentage of S&P 500 companies beating sales estimates since Q1 2009”

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