Back in July, investors eagerly anticipated Alcoa's (NYSE: AA) second quarter financial snapshot -- not for any particular interest in the aluminum sector, but simply because the Dow component happens to kickoff earnings season each quarter.
Fortunately, the company pleased the market by reporting a loss of $0.32 per share -- analysts were forecasting an even steeper shortfall of $0.38 per share.
But if you look past the estimate-topping headlines, Alcoa's sales figures tell a completely different story. Revenues slumped to $4.2 billion, nowhere near the $7.2 billion taken in during the second quarter of 2008.
Management has been able to make deep cuts to help offset weak sales. Procurement savings, for example, have totaled $1 billion so far this year. But those actions are like putting a band-aid on an open wound -- they won't do anything to heal a glutted market plagued with global overcapacity and anemic demand.
But it has also been a microcosm for the entire market lately.
Earnings among S&P 500 companies showed a decline of -14% last quarter from a year ago according to Thomson Reuters. Not great, but substantially stronger than the -25% drop that was feared. Four in every five companies posted better than expected earnings for the period.
But like Alcoa, most topped Wall Street's estimates because of aggressive cost-cutting initiatives, not improved business fundamentals. In fact, sales dropped -10% across the board in the third quarter. This type of growth just isn't sustainable -- there are only so many places to ring out future savings.
The real challenge for investors is to identify companies whose improvements on the bottom line are driven by real expansion at the top. (This is just one of several criteria I examine in my "catalyst rating system." Right now nearly 9 out of 10 stocks picked with this system are up -- generating gains of up to +565.1%. Visit this link to see how to get my next pick.)
Which Companies Have More Room to Run
The market hasn't been terribly discerning lately. Look at almost any random stock chart since March, and you'll probably see a sharp upward spike. Most of the low-hanging fruit has been plucked. At these high valuations, "less bad" just isn't going to cut it anymore.
Sooner or later, stock performance will have to square with what we're actually seeing on the ground. As they say, you can't save your way to prosperity.
Cost-cutting can be great, but I prefer those that are bringing more cash in the front door.
Cost-cutting is a temporary solution that always runs dry at some point. Plus, cuts to critical areas like research & development and marketing might actually do more harm than good in the long run. Finally, keep in mind that profits derived from true sales growth are far more indicative of where the company is really headed.
But growth isn't always created equal. These are the types of questions I'm asking when evaluating prospective investments right now:
- Where is the extra revenue coming from?
Don't just look at the raw numbers; it's far more instructive to see what's driving them. Is the company raising prices (often a sign of strength), moving more products, exploring new markets? Place any growth in proper context: A +15% increase might look good, but not if the overall industry was up +20%. Look for firms that are outpacing their peers.
- Is it sustainable?
Yesterday's sales are nice, but it's tomorrow's that matter most. Determine whether the factors underpinning recent growth are moderating or strengthening. And remember that internal growth counts for more than acquisition-inflated growth. There won't always be takeover targets.
- What is the impact on margins?
It's no secret that companies often slash prices to win customers and gain market share. But lower prices also mean slimmer margins, so this tactic is a calculated gamble. Be wary of firms with a growth-at-any-cost mindset that have rising volume but no profits to go with it.
- How scaleable is the company?
There's nothing wrong with a +10% gain in revenues that translates to an equal +10% hike in earnings, but it's always better when operating leverage can convert that same increase into a +15% or +20% jump in earnings.
With these points in mind, the standouts below (which are all outpacing their competitors by more than a 2-to-1 margin) are all worthy of additional research.
|Company (Ticker)||3-Yr. Rev. Growth||Peer Group Growth||YTD Rev. Growth||Recent Price||Fair Value||Possible Return|
|Neutral Tandem (Nasdaq: TNDM)||+97%||N/A||+16.8%||$20.26||$34||+68%|
|Research In Motion (Nasdaq: RIMM)||+124%||+14%||+1.8%||$61.79||$78||+26%|