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Revenues Down, Profits Up, Is This A Problem?
By: Dr. Charles Lieberman
Date: 7/27/2009
About 75% of all companies reporting second quarter earnings have exceeded market expectations, even as revenues declined year-over-year. Bulls focus on the higher profits, while bears key off the lower revenues. While both are important, especially in the long-term, it is the rise in profits that is most significant at this stage of the business cycle. A decline in revenues is hardly a surprise given the recession, especially since these comparisons are made against the second quarter 2008, before the economy weakened sharply. Sales growth should resume in the third quarter compared to the second quarter, as GDP turns up. It is the rise in profits that foreshadows an improving ability of firms to finance investment and hiring, which supports a rise in GDP in the near future.
Which factor is more significant, the unexpected rise in profits, or the ongoing decline in year-over-year revenues? The decline in revenues should be fully expected, given that earnings reports are for the second quarter when GDP declined significantly, at least year-over-year. Just to remind readers, GDP declined about 5% at an annual rate in the fourth and first quarters, and likely declined to a lesser degree in the second quarter. So it is premature for corporate revenues to increase, as yet. Revenues should rise (sequentially) in the third quarter, although not year over year, if GDP increases in the third quarter, as we expect. So, any revenue comparisons are largely backward looking and useful only in giving a reading on the latest state of the economy. Revenue comparisons are useless in forecasting the future state of the economy.
In contrast, the improvement in profitability is significant, because it demonstrates quite clearly that businesses have been very successful in lowering costs, mostly by laying off workers, to reduce operating expenses and adjust the size of their operations to the lower level of demand in the recession. The very fact that profits rose, despite the fall in sales, suggests that firms have gotten ahead of the recession and may have fired too many workers. If demand now increases at all, firms may need to resume hiring. Moreover, the rise in profits implies that firms have the means to finance capital investment to further enhance their productivity and profitability or to pay out more to shareholders by buying back shares or boosting dividends. Therefore, the rise in profitability has significant positive implications for the economy going forward, unlike the reported decline in sales, which is mostly just backward looking and simply confirms what we already know, namely that the economy went through a recession.
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