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Why some stocks are sinking despite big profits

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Aug. 11, 2012, 11:15 a.m. | World — by Associated Press

An investor reacts as she looks at the stock price monitor at a private securities company.
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Associated Press

Associated Press

NEW YORK — For investors, this restaurant chain is as hot as the red chili salsa on its menus. Maybe hotter. Maybe too hot.

The stock of Chipotle Mexican Grill has climbed four-fold in five years, and for good reason. Most quarters, the company would report surprisingly high earnings and investors would clamor to buy. But last month, the pattern broke. Chipotle posted blockbuster earnings, but investors sold.

The company's sin? It missed its target for revenues. The stock fell 21 percent, from $404 to $317, in a day.

Chipotle is not alone. Six in 10 big companies reporting second-quarter results have missed revenue targets, according to FactSet, a financial data provider. That is the worst showing since the recession.

Companies meeting expectations aren't doing so well, either. Overall, companies in the Standard & Poor's 500 are expected to have increased revenue 2 percent in the second quarter, according to S&P Capital IQ. That is the lowest growth, outside of a recession, in more than nine years.

"Demand is drying up," says Michael Thompson, managing director of S&P Capital IQ. "I'm worried. I'm very worried."

So are investors. On Wednesday, Priceline.com fell $117 to $562 after reporting revenue that was lower than analysts had expected. The story has been the same for dozens of companies across industries, from Coach, a luxury goods retailer, to Boston Scientific, which sells medical devices, to glass-container maker Owens-Illinois.

Revenue matters because it's a good path, though not the only one, to higher profits. If you sell more, you will often earn more. Companies in the S&P 500 index increased revenue 11 percent last year. That helped lift earnings 16 percent to a record high.

But now companies are having trouble getting people to buy more. The U.S. economy grew at an annual pace of just 1.5 percent in the April-June period. And growth abroad is faltering, too. Many of the 17 countries that use the euro are in recession. Brazil and China are slowing. On Friday, China reported that export growth slumped to 1 percent in July, down from 11 percent a month earlier.

For all the ominous news, most investors are still buying stocks. The S&P 500 is up 11 percent so far this year. That is because in the end, all that matters is earnings, not revenue. And earnings, after barely rising in the second and third quarters, are supposed to explode.

Wall Street analysts who advise investors on stocks expect earnings to rise 10 percent in the fourth quarter and 12 percent for all of 2013, according to S&P Capital IQ. But their expectations for revenues don't seem to jive with the optimistic profit picture. Revenues are expected to rise only 3 percent in the fourth quarter, then drop nearly 2 percent for all of 2013.

Economist Ed Yardeni, head of Yardeni Research, says he's hoping companies will post higher revenue, but he doesn't think that's likely.

"If anything, they will surprise on earnings," he says, meaning earnings will come in lower than expected.

Previously when revenue has faltered, companies were able to cut costs to compensate. They laid off workers, squeezed remaining staff and used technology to run more efficiently. And U.S. companies have been pros at doing this, as the millions of unemployed and all those people who do the work of two employees can attest.

The problem is, there's a limit to how much you can squeeze your workers and use technology to produce more. And U.S. companies are just about as lean as any time in history.

U.S. companies are pulling nearly 9 cents of net income out of every dollar of revenue versus a three decade average of 7 cents or so. Yet the consensus among analysts is that this profit margin will jump to a record 9.6 cents per dollar next year, according to Goldman Sachs.

In other words, companies will do even more with less.

Though that may seem unlikely, it is possible. Many economists did not expect U.S. companies could run so efficiently for so long. Typically in a recovery, profit margins snap back to their long-term average as companies spend more. But wages are barely growing. It also helps that interest rates are at record lows. That means companies have been able to keep borrowing costs low.

But lately the signs haven't been good. On Wednesday, the government reported U.S. companies squeezed more out of workers last quarter but less than average. Productivity, or output per hour worked, rose at an annual rate of 1.6 percent versus a 2.2 percent average since 1947. Larry Hatheway, chief economist at UBS, also notes that profit margins have been slipping lately, not rising as analysts expected.

Hatheway is one of the few economists who think margins can stay abnormally high. But even he's worried. His guess is that earnings will climb no higher than 5 percent next year, less than half what analysts expect.

"You won't be able to grow earnings much faster than revenue," he says. "Analysts will have to revise down their earnings."

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