The wholesale trade data for August continues to paint a picture of weakening consumption. While the latest report saw month-over-month uptick in sales (0.87%) this is the first positive advance after three straight months of declines. While sales are still lower than they were this past April - inventories have continued to build to their highest level on record. This data clearly lines up with the trends that we have seen in earnings and revenue for corporations. Our argument for quite some time has been that the profit margin expansions we have witnessed since the last recession are ephemeral as they have been driven by cost cutting and low employment.
We discussed this in our article "Corporate Profits Surge At Workers Expense" where in we stated: "'Given the enduring hard times, you might think that corporations have used up their cash since 2009. But real pretax corporate profits have soared, from less than $1.5 trillion in 2009 to $1.9 trillion in 2010 and almost $2 trillion in 2011, data from the Federal Bureau of Economic Analysis shows.'
There is a very interesting, albeit disturbing, contradiction in the statement above. The initial assumption would be that if companies are having a hard time putting cash to work, because there is less demand for products and services, this would infer lower revenues. The chart shows the change in reporting earnings and sales (top line revenue) for the S&P 500. Since the beginning of 2009 the total growth in sales per share has been 21% as compared to a 206% increase in reported earnings. This confirms our assumption that lower revenues and demand is behind the historically high levels of corporate 'cash hoarding.' However, if revenue growth is weak then how are real pretax corporate profits soaring? The answer comes down cost controls and productivity."
There is also another factor that goes into how companies are beating bottom line estimates - legalized manipulation. Two business professors, Ilia Dichev and Shiva Rajgopal at Emory and Duke, conducted a survey of 169 chief financial officers at publicly-traded companies in the U.S. revealed at least 20 percent of the publicly-traded companies that, as required by law, report earnings results on a quarterly basis are probably fudging the numbers. Furthermore, almost every single CFO surveyed agreed that this is the case.
Their study found that "CFOs estimate that in any given period, roughly 20% of firms misrepresent their economic performance by managing earnings." Further more "For such firms, the typical misrepresentation is about 10% of reported EPS."
The reasoning behind the fudging of earnings reflects the growing problems of stock based compensation practices. "A large majority of CFOs feel that earnings misrepresentation occurs most often in an attempt to influence stock price, because of outside and inside pressure to hit earnings benchmarks, and to avoid adverse compensation and career consequences for senior executives."
The table below, from the study, is why companies misrepresent earnings:
What does this all have to do with the wholesale trade data. If you really want to know what is happening with corporate businesses don't look at the bottom line where all the fudging occurs but at the topline where the sales happen. While earnings can be managed through accruals, write offs, liability recognition, etc. - topline sales are much more difficult to manipulate. What is clearly evident in the recent wholesale trade data is that sales are slowing as the consumer has come under pressure.
More importantly, the slowdown in sales (consumption) has led to an unwanted rise in inventories of 5.51% annually. Increases in inventories are troubling as ultimately producers will become more defensive by liquidating excesses, idling back production and reducing employment. This obviously does not bode well for either GDP growth, or employment, in the future. This data confirms the recent slate of manufacturing reports which have shown a decline in new orders and backlogs with increases in inventories.
The chart shows the annual change in sales, inventories and the inventory to sales ratio. With the inventory to sales ratio rising towards historical peaks (excluding the financial crisis), combined with the sharp slowdown in sales, we are likely going to see continued weakness in upcoming manufacturing reports. The bump in inventories in August confirms the increases we saw in some of the most recent manufacturing surveys. However, if sales continue to remain weak, it is likely that those bumps in the data are likely to be temporary.
While the evidence is clearly tilted toward economic weakness we are still not at recessionary levels just yet with respect to wholesale trade (inventories and sales annual change will go below 0%). However, with the current trends in the data clearly negative, the increasing levels of a global slowdown affecting exports as shown in the slide from Federal Express, and consumers under pressure from stagnant wage, a recession drag in the economy is not out of the realm of possibility in 2013.
Therefore, as we kick off earnings season for the third quarter, here are the "red flags" that the CFO's surveyed said you should be watching out for.
1) "GAAP earnings do not correlate with cash flows from operations; Weak cash flows; Earnings and cash flows from operations move in different direction for 6-8 quarters; Earnings strength with deteriorating cash flow"
2) "Deviations from industry (or economy, peers’) norms/experience (cash cycle, volatility, average profitability, revenue growth, audit fees, growth of investments, asset impairment, A/P, level of disclosure)"
3) "Lots of accruals; Large changes in accruals; Jump in accruals/Sudden changes in reserves; Insufficient explanation of such changes; Significant increase in capitalized expenditures; Changes in asset accruals, High accrued liabilities"
4) "Too smooth/too consistent of an earnings progression (relative to economy, market); Earnings and earnings growth are too consistent (irrespective of economic cycle and industry experience); Smooth earnings in a volatile industry"
5) "Large/frequent one-time or special items (restructuring charges, write-downs, unusual or complex transactions, Gains/Losses on asset sales)"
Expectations for the 3Q earnings season have been lowered dramatically in recent months putting the bar at relatively easy levels for corporations to beat on the bottom line. However, watch the top line carefully. As we showed in the first chart above there is a huge disparity in growth between the top and bottom lines of corporate income statements.
While the Central Planners are fully engaged in their various bond buying schemes all over the globe - the reality is that bond buying doesn't create job growth, increase incomes for the consumer or provide economic clarity for businesses to plan. Of course, this is why US corporations are currently sitting on the largest cash piles since WWII. However, what bond buying programs do accomplish is the creation of a divergence between stock prices and the underlying fundamentals. This is more commonly know as an "asset bubble" and these divergences typically do not end well.
Here is the full study:20-Percent of Companies Fudge Earnings