Earnings Aren't What They Used to Be, Part II
They just don’t make earnings like they used to. In many industries, the quality of earnings has deteriorated in recent quarters.
Banks are among the worst offenders. On the downside of the biggest credit cycle in history, many banks are slowing the pace at which they’re provisioning for credit losses. Some banks are even reversing their loan-loss reserves and adding these accounting adjustments to their net profits.
These accounting games produce shams, not profits.
Banks need loan-loss reserves because they know that many of their loans will go sour…especially on the downside of the biggest credit cycle in history. So if it turns out that we’re not, in fact, past the peak of credit losses in the banking system, many banks will have to once again rebuild loss reserves, which would reduce – or completely wipe out – the earnings they would report in future quarters.
Bullish banking analysts are certain we’ve seen the worst of earnings performance in the banking system. But these are the same analysts who believed the bubble environment of 2005-2007 was normal, and that bank earnings would continue to grow indefinitely.
Another area to look for lower-quality earnings is any company with plant, equipment, and inventories. Lately, many of these companies have been reducing their capital expenditures to levels far below depreciation and amortization expense. This tactic temporarily boosts free cash flow, but does so at the expense of future earnings. Companies with shrinking asset bases eventually deliver shrinking earnings power, while also risking the erosion of their competitive position. As asset bases shrink, depreciation and amortization expense will also shrink, which temporarily boosts pretax income. I’ve seen several examples of this phenomenon in recent earnings reports.
Sharp swings in inventory can also push earnings up and down. Overbuilding of inventory sows the seeds of future earnings disappointment. During the late 2008/early 2009 liquidation of excess inventories, many companies suffered a squeeze in gross margins in a fire sale environment.
This phenomenon changed by the middle of 2009. Many companies had taken inventory liquidation too far. After the worst of the financial panic had passed, bottlenecks started clogging up the supply chain. This trend became very noticeable in the tech sector late last year. By late 2009, shortages in printer components had become so acute that companies like Lexmark (NYSE:LXK) were able to increase their pricing power. Since then, however, the tech supply chain has rebuilt inventories – in many cases, at a rate that exceeds sales growth. And Lexmark’s pricing power has declined.
Fred Hickey noted this phenomenon in the Aug. 4 issue of his newsletter, The High-Tech Strategist. Hickey suspects that inventories are overbuilt in many areas of the technology supply chain. After panicking about not having enough inventories when components were in shortage, many companies appear to have overdone it:
I think you can see how this could all go wrong quickly. Component suppliers are ramping capacities. Distributors are building inventories. Contract manufacturers are scrambling to increase inventories. The product suppliers themselves are adding to their inventories. Then, as has been intimated several times above, end product demand begins to ease (from Europe, from US consumers, etc.). Then all [heck] breaks loose, up and down the supply chain.
“Days sales in inventory” – or “inventory days” – measures the number of days required to sell the inventory balance at the end of the accounting period. A falling trend indicates shortages, while a rising trend indicates the possibility of gluts.
Recently, inventory days in many technology supply companies are on the rise. And I suspect that inventory days will rise again for most of these companies in the third quarter, because with the leading economic indicators turning down sharply in recent weeks, sales will likely grow more slowly than inventories.
In fact, inventory days for the entire US economy, as compiled by the US Census Bureau, is also on the rise. These trends highlight the folly of government stimulus programs. The programs send phony signals up and down the supply chain for manufactured goods. It’s a fool’s errand to try to restore the economic conditions we saw during the 2004-07 credit bubble.
The government squandered hundreds of billions of dollars propping up zombie banks that could have easily been recapitalized by cutting away the claims of shareholders and junior creditors in bankruptcy, and setting up a legal framework to tame and wind down over-the-counter derivatives – all without a penny of public funds. Policymakers had the entire spring and summer of 2008 to prepare such a plan in the months after Bear Stearns blew up in March 2008. Instead, US taxpayers got “TARPed” in order to bail out reckless bank shareholders and bondholders.
The banks are still standing…but they are mostly standing still. The big banks are still more interested in repairing their balance sheets than they are in lending to businesses. Meanwhile, those few corporations that possess sizeable amounts of cash are also standing still. They are sitting on their cash because they don’t know what else to do.
All of this standing around adds up to sluggish economic growth…and no real earnings growth.
Thus, the stock market is expensive if you adjust for the widespread accounting gimmickry we’ve seen in recent quarters. So the next time you hear that the market is “cheap” – and you’ll hear it frequently in the mainstream financial press – remain skeptical about the quality of earnings in the P/E ratio.
The market isn’t cheap unless you believe that accounting games produce real wealth.