Are We Finally Seeing Top Line Revenue Growth?

Although it’s still very early in the 2nd Quarter earnings season, a very encouraging pattern seems to be finally emerging among the companies that have reported thus far.  That pattern is that companies are finally beginning to see top line revenue growth again.  As you may recall from previous commentaries, ever since 2008 and the “Great Recession,” the general pattern for US companies has been to generate stronger earnings by either cutting costs and/or share repurchases.  While cost cutting can be good in that it necessitates that companies operate more efficiently, it is also a generally painful process to the broader economy as job cuts are typically the primary cost cutting mechanism that firm’s use, which obviously drives up unemployment numbers. 


Share repurchases are more of an accounting tool that firms have used recently.  In buying back their own shares, either with cash on hand or the issuance of debt, a company will have fewer shares outstanding.  Insofar as a primary measure of stock valuation is EPS (earnings per share), that ratio will be higher if the denominator (shares outstanding) is reduced.  So even though earnings might be flat, or even contracting, EPS could actually grow depending on how aggressively a firm might be buying back its own stock.


Now, at least based on the few earnings reports we’ve seen so far from the 2nd Quarter, top line revenue finally seems to be growing as well.  GE posted top line revenue growth of 3.2%, which is the first year over year revenue growth they have seen since 2008 without any special items.  Honeywell (another very important US manufacturer) posted 5.8% year over year top line revenue growth.  Equally important, that trend does not seem to be confined to just the manufacturing sector as we are seeing similar results from transportation companies (especially railroads), technology (Intel and Google thus far), and the banking sector as well.


At this point, less than 10% of the S&P 500 has reported 2nd quarter earnings, so it’s too early to declare a new general trend in top line revenue expansion.  However, if this trend continues, the value ramifications will be quite exciting.  In such an environment where firms operating costs are as lean as they have been in decades (thanks to all of the cost cutting mentioned above), to the extent firms can hold their operating costs relatively stable, this newfound revenue growth will simply fall to the bottom line in the form of dramatically higher earnings.  Indeed, if this pattern holds and firms can finally start to book broad, across-the-board, top line revenue growth, stock prices may prove to be considerably undervalued today.  In fact, with stocks trading around 16x 2014 earnings estimates, we would argue that stock prices have not factored in this possibility.


The point of this observation is that stocks could be entering a sort of “sweet spot” for the next 18 months or so.  With plenty of slack in the labor market (still too-high unemployment), interest rates will stay low even after the Fed has completed its wind down of its Quantitative Easing program.  Another benefit to companies, and by extension shareholders, of higher unemployment is relatively low wage inflation pressure.  If low interest rates and low wage inflation can prevail for a time, companies should be very successful in holding the majority of their operating costs down for a considerable period. 


However, the top-line revenue expansion was not completely a surprise.  Recall the observation that we, and many others, made after Q1 in respect to the very heavy impact the harsh 2014 winter had on the US economy at that time.  We are wary of the possibility that the top-line revenue strength we are seeing now may very well turn out to be Q1 production that was simply delayed into Q2 because of the bad weather.  Certainly if that turns out to be the case we would want to revert back to a fairly conservative discipline built around the assumption of slow GDP growth of around 2.0%. 


There are some indicators we are watching to help determine whether the economy is gaining the kind of momentum it would need to sustain 3.0-3.5% GDP growth, or simply pulling Q1 inventory forward.  The primary indicator for those companies that carry inventory is to simply watch their inventory levels.  If we see a company is simply meeting Q2 orders from its on-hand inventory and not really moving to replace that inventory, obviously that would suggest the top-line revenue story may be transitory.  However, if inventory levels remain generally constant from Q1 to Q2, or even expand, that could suggest a new found confidence on the part of those company’s management that order flows (and top-line revenue) may be accelerating.  Unfortunately, in a largely service-based economy like the US, inventory levels are not a particularly reliable indicator, as service companies simply do not carry inventory.  Therefore, the biggest thing we are watching are the management statements from the numerous companies we follow.  Many times, company management will make statements during their earnings calls about how their business is doing; how their customers and suppliers are behaving, whether they are expanding production, investing in new plant and equipment, etc.  To the extent we can glean a general trend from these calls in the aggregate, combined with inventory observations and other more macro economic observations, we should be able to draw some more concrete conclusions in the next few weeks as to whether to expand our GDP assumption for 2014.


At this point, we have not changed our GDP assumption for the year (our assumption is still in the 2.0-2.5% GDP range).  If we do, and you would like to know at the time if we make that determination, please give me a call or send me an email ( and I’ll be sure to share that information with you.    


As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us.  This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).


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Mark P. Culver

Managing Partner  


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