Is This ‘The Calm Before The Profit Storm?’
"Forecasting is challenging," SocGen's Andrew Lapthorne wrote, in his latest. "Some would say impossible."
He's right on the first point. On the second point, I'm one of the "some." If what we're forecasting has anything to do with markets or macroeconomics, it's impossible -- the forecasting.
The reason it's impossible is simple: We're dealing with human behavior, and humans are a volatile, mercurial bunch. Today, everything's great. Tomorrow, the world's ending. That's humans for you. Oscill
Revenue = Price times volume for each product or service a firm sells, summed for all products. The variable cost of each of those products is the cost per unit of each product’s inputs times the quantity of those inputs. That means there are essentially only four strategies a firm may employ to manage its gross margin which is the net revenue that is available to cover all the firm’s fixed costs. The firm may 1) Increase selling prices, 2) Increase the volume of a product sold, 3) Lower unit costs, and 4) Decrease the quantity of inputs per unit. That’s it. And these four components of profit are not entirely independent. If a firm attempts to rely on component 1), the likely result is inflation. Increasing volume, cet par, is very difficult for any legacy firm without lowering prices to try to take advantage of favorable elasticity. The result of using 2) as a strategy will require the firm to increase capacity or at least some fixed costs, negating much of the favorable effect of the price decline. Cost management (items #3 and #4) is the preferred method to increase profits because its easier but there are limits to that approach as well. How many of you have pushed your hand down on your car hood lately? The steel is so thin it’s almost transparent now (that’s item #4 above). And so forth. The upshot of this perhaps tedious recitation is that 10-12% increases in profits are a fantasy unless the firm engages in some form of financial engineering. Real growth (item #2 above) is lucky to breach 2% for most US industrial legacy firms. So we create inflation (Pepsi, General Mills, etc) or cut costs until we no longer can. Cutting prices may increase volume slightly if one is a monopolist (and then it would be silly to choose) and if a firm is part of an oligopoly, which includes the whole S&P 500, then the only result is a profit decline because all one’s competitors will follow. So count me in the bear camp for 10-12% profit increases this year. Having this happen for seven firms isn’t enough.
That is the old school approach. Modern “innovations” like stock-based compensation and ignoring other non-cash charges (EBITDA), massive stock buybacks and focusing on non-GAAP EPS rather than margins, help mightily to achieve that 10-12% “growth.”