With approximately 90% of the S&P 500 having reported calendar Q1 2013 results, first-quarter earnings season can be declared a success. We are not surprised the industry giants making up the S&P 500 continue to grow profits. After the hard lessons of the 2001 and 2008 recessions, every line item on the collective corporate P&L has been redesigned for maximum return. The leverage in this reworked earnings model is considerable and suggests that 3%-4% of global GDP growth in 2013 could yield 6%-9% of EPS growth. Even in a rising market, earnings growth has kept valuations from overheating. We do not expect this bull to top out until a) earnings growth stops, and b) valuations expand as stocks keep rising amid no growth.
Most investors are too busy to a do a line-by-line analysis of the P&L; that is left to the analysts. Investors tend to focus on the top line, then factor in some predictable multiple for operating leverage (i.e., 3% sales growth will produce 9% EPS growth). But such an analysis overlooks that some of the most earnings-positive developments have occurred below the operating income line.
Before we take a walk through the corporate P&L, it is worth considering how the down-cycles from past recessions have helped shape the modern corporation. The core lessons learned were to shepherd cash, made easier by low prevailing rates of interest, and to add flexibility and variability across the operating structure to reduce the drag of fixed costs in a downturn. The 2001 downturn was more moderate than the downturn in 2008. But the valuation excesses and crazy deals in the late 1990s prompted accounting changes -- such as the end of pooling-of-interest acquisitions and the end of goodwill depreciation -- that have introduced more rigor and due diligence into the M&A process. Corporate asset portfolios are more cohesive and symbiotic, simply because junky acquisitions are much less common. Any assets that are added via acquisition are more easily integrated, thanks to advances in ERP, CRM, and back-office software functions.
The 2008 recession was much harsher than the 2001 downturn. But with many of the same management teams intact from that earlier downturn, corporations were able to effectively deploy strategies and tactics that had been imperfectly deployed in 2001-02. Thus, in 2008 companies were quicker to downsize personnel, rein in travel and IT budgets, close or mothball facilities, double up production at remaining sites, and find countless economies right down to the branch-office level. Companies had learned that their workforces should balance permanent employees with consultants, part-timers, and seasonal workers -- all easier to "flex" out when times got tough -- and downsizing was first aimed at these groups.
Working capital discipline was particularly impressive amid and following the 2008 economic decline. Using software tools previously unavailable, companies cut inventories and managed/factored accounts receivable to reduce working capital -- which is additive to cash flow from operations. Battle-hardened by the 2001 downturn, companies went into the 2008 recession with an extra padding of cash on the balance sheet. Working capital management kept cash from eroding severely in the most recessionary quarters.
Now let's take that walk through the P&L to see how these lessons have played out and continue to play out in the current earnings environment. On the top line, experienced U.S. multinationals place dedicated sales and marketing resources in the largest nations and markets, while working with regional distributors to serve smaller markets. In all markets, these companies have learned to flex revenues by working with local partners, thus laying off risks from regional downturns.
On the cost of goods line, supply chain efficiencies, software-driven procurement, lean manufacturing, and six sigma all improve the manufacturing process. But the biggest margin contributor to efficiency is use of shared services, such as contract manufacturing. Once dedicated to technology manufacturing and consumer goods, contract manufacturers now derive up to one-third of revenue from mission-critical areas such as instrumentation, medical IT, automotive, capital equipment, automation and process, and aerospace-defense. OEMs in these industries can expand gross margins by competitively shopping their cost-of-goods to price-aggressive contract manufacturing partners.
Below the gross margin, the principal operating-cost line items are R&D and S&M. In R&D, the "means test" for future projects is ever more rigorous; processes to monetize blue-sky ideas have been formalized. Here, too, outside vendors contribute; contract research firm Quintiles (Q), which works in the pharmaceutical field, has been among the biggest IPOs in 2013.
No part of the organization is subject to as much headcount and compensation flexibility as the sales and marketing department. Direct sales teams are complemented by distribution partners, VARs, and other indirect partners. Sales and marketing payrolls are levered to variable compensation by being linked to performance metrics. Sales teams and R&D engineers are awarded stock as a rising percentage of total compensation, tying their personal performance tighter to the stock price. Companies have thus added efficiencies at every phase of operations. But the earnings drivers below the operating-cost line are equally powerful if less understood. The most important is the cost of debt service.
During the 1990s bull market, the Fed repeatedly hiked interest rates, resulting in a 6.5% discount rate when the market came crashing down in 2001. Since the turn of the millennium, the "sluice gates" of global trade have been opened. Fund flows have become much more global, causing U.S. interest rates to level out to global rates. At the same time, the U.S. Federal Reserve has become structurally more accommodative. In February 2008, six months before the crash, the fed funds rate was already below 3%. In fact, the fed funds rate -- which, along with LIBOR, helps set the rate at which companies price their bonds -- has averaged around 2.3% since the millennium turn. This means companies have been setting coupons on their corporate bonds at low rates for well over a decade.
Corporate debt as a percentage of GDP is declining, and that is also easing the debt-service burden. According to a Bloomberg report from October 2012, corporate debt (excluding the financial sector) has backed off from being equivalent to about 82% of GDP in 2009, to about 76% at present. The levers of this transformation include the use of working capital as an instrument of "leveling" cash flow from operations, and strong cash stewardship overall. According to financial information company Sageworks, debt service coverage (EBITDA relative to debt interest) is currently above 5x, after being at 4x in 2009.
Another non-operating line item is income taxes. As U.S. corporations go increasingly global, their "blended" tax rate tends to reflect the lower tax rates prevailing particularly in emerging economies. The more business you do in fast-growing emerging economies, the lower your tax rate goes. Finally, corporations use cash to repurchase their stock. There are many stated reasons for this, including as an antidilutive offset to share-based compensation as well as return of value to shareholders (we prefer dividends). Investors value stocks not on profits, but of profits per share. Reducing the denominator while the earnings numerator stays stable increases per-share earnings. Cash used to buy stock is not reflected on the income statement -- a bit of accounting sleight-of-hand, in our view. Nonetheless, this is another way in which activities below the operating line contribute to EPS growth as meaningfully as operating activities.
So where does all this flexibility, variability, and financial engineering get us? It gets us to ongoing earnings growth, even in a very mature bull market. We estimate that calendar first-quarter EPS grew in the low- to mid-single digits, based on an averaging of several inputs. It is difficult to get an accurate read on just how much EPS grew because companies have their own methodology.
Morgan Stanley quoted FactSet data to suggest Q1 2013 EPS grew 4.8% (which is 520 basis points better than Morgan Stanley's pre-reporting expectations). With about 90% of the S&P 500 having reported as of mid-May, Bloomberg estimates that first-quarter EPS for the S&P 500 components grew 2.7%. Bloomberg, by the way, uses S&P sectors but conducts its own analysis on the EPS data. Standard & Poor's published data suggests that S&P 500 earnings from continuing operations grew 7.1% year over year in Q1 2013, although we are not sure that data is fully up to date.
If we average out those three inputs, we get to 4.9% growth for Q1 2013. That is not spectacular, given EPS growth rates in prior first quarters in this bull market of 7.1% in Q1 2012, 16.4% in Q1 2011, and a whopping 91.7% in Q1 2010 (all based on S&P data). Nonetheless, 50-plus months into a bull market that has advanced over 140%, earnings are still growing. That is a testament to the lessons from past recessions and recoveries, and the fact that U.S. corporations have learned them well.