Disappointing 1Q Revenues Signal Trouble Under the Surface

With earnings season entering its final leg, don’t be fooled by record-breaking earnings per share -- revenue has been a huge disappointment.

Average S&P 500 EPS as of Monday was a record-breaking $26.66, above the previous all-time high of $26.36 from the fourth quarter of 2012, according to data from S&P Capital IQ.

Of the 408 companies that have reported for the first quarter, 279 have bested bottom-line Wall Street expectations, marking a beat rate of 68%, higher than the 10-year average of 62%, the data show.

While much of that can be attributed to ongoing streamlining that includes closing unprofitable businesses and slicing workforces, it is also yet another reflection of upper management’s ability to massage the bottom line amid top-line troubles.

“I think the disparity between earnings and revenues lies in the fact that the global economy is still weak, an issue that can’t be hidden in revenue results, but can be easily manipulated in EPS reports,” said Christine Short, associated director of S&P Global Markets Intelligence.

Since EPS is a function of shares outstanding, BTIG chief global strategist Dan Greenhaus notes C-Suite execs are able to more easily manage the bottom line through share buybacks and axing costs, including decreasing top-level bonuses, stock rewards and salaries. Reducing the number of shares outstanding through repurchase programs can inflate each share’s value, making them appear more valuable than they are when backed by flat or even weaker revenues.

“It’s very easy to manipulate EPS figures by introducing special non-recurring items,” Short said. “There still seems to be a fair share of cost-management plans in play out there, artificially inflating the bottom line, with no real growth at the top line.”

Of the companies that exceeded their earnings estimates, half missed their revenue target, far worse than the 31% that miss on average in a typical quarter. In total, 54.6% of companies this earnings season have reported revenue below the Street.

“It’s a bit of a mystery how companies are able to generate relatively decent earnings growth with what seems like relatively weak revenue growth,” said Ed Yardeni, chief investment strategist of Yardeni Research. “It boggles my mind companies would still have that much wiggle room to cut costs.”

Instead, Yardeni points to the likelihood that companies are investing in businesses with higher profit-margin potential, or those that are both cost efficient and financially attractive, while lowering internal costs and buying back shares. Another factor is technology, which he says has allowed companies to enhance their operations, making business functions more efficient from the supply chain to the point of sale, though not necessarily contributing to higher sales.

As for weak revenues, Yardeni says firms on the S&P 500 are highly linked with so-called U.S. nominal exports, which were in a volatile flat trend the first two months of the first quarter.

There's no denying global economic and fiscal uncertainty have weighed heavily on revenues across varying segments, a sign that sentiment remains low. Of the companies that missed last quarter, many blamed woes in Europe, while others pointed to unusual weather and the sluggish economy. The latter two causes have been cited for weaker-than-expected retail sales, which contracted in March for the second time in three months. April sales have not yet been released.

The EPS/revenue disparity can be seen across the broader indices and through a wide range of sectors. For example, MasterCard (NYSE:MA) posted a 12.3% profit increase last week but missed revenue forecasts after warning that both sales and earnings growth could be below its three-year target set last year.

Even the next-generation tech giants had top-line troubles, with both LinkedIn (NASDAQ:LNKD) and Facebook (NASDAQ:FB) reporting stronger earnings but disappointing sales in the first quarter.

Without fueling top-line growth, though, companies will eventually hit a cost-cutting wall, finding they can't possibly inflate EPS further without a real improvement in sales.

At the same time, the economic outlook has been anything but stellar. While many companies in 2012 were optimistic Europe’s problems would have fizzled by now, it now remains unclear exactly when the continent will shake its debt troubles. Several corporations have even cut their outlooks for the current year.

“Last year it was believed 2013 would be the year Europe recovered, however, we haven’t seen that yet,” Short said. “Thus far, we’ve seen several corporations comment on the continued weakness out of Europe, they believe will seep into the second quarter as well.”

If one needs more evidence, take a look at the number of companies that are beating revenue estimates. A paltry 45% have beat on the top line so far, sharply below the 62% that usually post surprisingly strong sales, according to Thomson Reuters data.

The Dow Jones Industrial Average has nevertheless ticked up 2.86% over the last 30 days, while the S&P 500 has climbed 4.25%.

Perhaps wrapping up the first-quarter earnings season best is Greenhaus, who in a note to clients on Sunday put it this way: "It was not good, but ‘not as bad as feared.’”