Andrew Gawith: Profit revival yet to face real test

The earnings revival is under way. Estimates of company profits that were slashed during the latter part of 2008 and into last year are now being revised up.

US market analysts now expect profits of S&P 500 companies to grow by more than 35 per cent this year and by a further 20 per cent next year. That is a pattern broadly repeated in other markets around the globe. Is this wishful thinking, or is there something of more substance going on?

Corporate earnings plunged last year and are now well below the peaks we saw in 2007. That profit collapse was due to a combination of sharply weaker sales, asset write-downs and rising funding costs. The credit crisis and the accompanying global recession hammered corporate bottom lines. Companies with high fixed costs and debt-heavy balance sheets fared the worst.

The earnings results could have been a lot worse. Fiscal and monetary stimuli have helped sustain consumer spending and support corporate revenues.

Companies have also been proactive in protecting their bottom lines by cutting their number one expense - employment.

That approach has been most prevalent in the US. Workers have either been laid off or have seen a reduction in the number of hours they've been able to work.

The aggressive cuts in employment have certainly helped firms soften the squeeze on their margins. By taking fixed costs out, operational leverage has been improved. Firms have also worked hard to conserve cash and lower debt levels by cutting back on capital expenditure and reducing payouts to shareholders. According to Standard & Poor's, US companies cut dividends by nearly US$60 billion ($87 billion) last year.

But how quickly can companies go back to their previous high levels of returns and profitability?

The forward-looking estimates by market analysts suggest that profits will be nudging towards their previous peaks by 2011. In the US, by the end of 2011 overall market earnings will be just 10 per cent shy of the level they were at in the middle of 2007.

That's a reasonably big bounce-back in the aftermath of a banking crisis and one of the severest recessions in 20 years.

While cost cutting is an important and quick way of getting businesses on to a competitive footing and improving earnings per share, it's not a long-term strategy for growth.

To achieve sustainable growth in profits, companies will look to lift revenues via increased volumes and/ or higher prices, or some solid and sustained productivity improvements.

The question is where that sales growth is going to come from and how robust it's going to be. Consumer and investment spending will need to step into the breach as government spending tails off.

The bounce-back in economic growth has been largely government (debt)-funded and unwinding all that easy money and high government spending is likely to cause some anxious moments for businesses. Without incentives such as the "Cash for Clunkers" scheme there might not be so many US consumers lining up to buy the latest Ford Fusion Hybrid.

Companies that mostly sell to the debt-laden US consumer are likely to continue to struggle, unless they have a particularly appealing new product or are managing to grab market share and savage their competitors without damaging their own product pricing in the process.

Those selling goods and services into the emerging economies such as in Asia should have an easier time. Most of these economies were in much better shape heading into the credit crisis and are moving back towards trend growth much more quickly than their developed-market counterparts. The growing middle class in the emerging economies and their spending capacity offer some significant sales opportunities for developed-economy businesses.

The financial sector is one area where earnings could come under pressure. The public has been demanding retribution for the injection of funding required to prop up the banks and the Obama Administration is in the process of delivering change. The latest proposal focuses on limiting the size and activities of the larger US banks. While that is far from being passed into law, it's a potential game-changer for the industry's business model and profits.

So far, the quarterly earnings season under way in the US is reassuring. While there have been one or two big names that have disappointed, in general bottom-line earnings are beating market expectations. Growth in sales has also been better than expected. Not by much, but it's a pleasant development and crucial if the market forecast for 35 per cent plus growth in aggregate profits is going to be met.

The crucial thing to bear in mind when looking at these confidence-building earnings figures is that they are being achieved in a highly stimulatory economic environment. The real test of the resilience of company earnings will come later this year as the stimuli are unwound.

* Andrew Gawith is a director of Gareth Morgan Investments www.garethmorgan.com