[“3 Things” is a weekly publication of ideas, usually contrarian, to provoke thoughtful discussions and decision-making processes. As a portfolio strategist, I am sharing things that I am considering with respect to current investment models and portfolio allocations. Please feel free to tweet me with your comments and ideas.]
Small Business Not Optimistic About Spending
The perennial hopes of a strong retail shopping season are once again upon us. As always, the National Retail Federation (NRF) is kicking of the season with their always cheerful holiday forecast. To wit:
“The National Retail Federation announced today it expects sales in November and December (excluding autos, gas and restaurant sales) to increase a solid 3.7 percent to $630.5 billion — significantly higher than the 10-year average of 2.5 percent. Holiday sales in 2015 are expected to represent approximately 19 percent of the retail industry’s annual sales of $3.2 trillion. Additionally, NRF is forecasting online sales to increase between 6 and 8 percent to as much as $105 billion.”
To no great surprise, since the NRF is an industry trade group, their forecasts are generally much more optimistic than reality eventually turns out to be.
For a more “realistic” expectation of retail sales over the next couple of months, we might want to look at data from actual retail businesses. The National Federation of Independent Business Small Business Survey shows a substantially different outlook from retailers.
As shown, the percent of businesses surveyed expecting higher sales over the next three months is declined sharply from the beginning of the year. Not surprisingly, when forward expectations decline so do actual nominal sales.
Furthermore, if we look at “control purchases,” which also excludes gas, food and autos, we see that actual activity in the economy is at levels more normally associated with recessionary environments.
Given the current deflationary backdrop, the sharp decline in imports and weak wage growth, it is quite likely that actual retail sales will likely disappoint the NRF’s forecast of a “shopping season significantly above the 10-year average.”
Regardless, I do suspect that consumers will once again be breaking out the credit cards and maxing out the remaining limits. The “shopping party” of chasing deals over a 36-48 hour “shopping day” has become a holiday tradition. Unfortunately, it is the “hangover” that hurts when the bills come due.
But it is truly important to remember that for retailers all #BlackFridaysMatter
Debt Funded Buybacks Failing To Boost Performance
I have written many times in the past about the use of debt-funded share buybacks as a method to boost bottom line earnings reports even as top-line revenue remains weak. Since 2009, the reported earnings per share of corporations has increased by a total of 190%. This is the sharpest post-recession rise in reported EPS in history. The issue is that the sharp increase in earnings did not come from a similar surge in revenue that is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 23% during the same period. To wit:
“For profitability to surge, despite rather weak revenue growth, corporations have resorted have resorted to using debt to accelerate share buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.”
“The reality is that share buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created; no more product was sold, it is simply accounting magic.”
This point was further made by Mike Bird via Business Insider in a discussion of a recent report from Goldman Sachs:
“US corporations have loaded up on a lot of debt since the financial crisis. In fact, America’s corporations have doubled their total debt levels, according to a note Tuesday from analysts at Goldman Sachs. The debt has been raised by American firms to fund mergers and acquisitions and to buy back their own shares.”
Over the last several years, corporations have been extremely effective at slashing costs to boost bottom line earnings. However, as I have stated many times, the benefits of cost-cutting, wage suppression and artificially manipulating bottom line earnings through share repurchases, are finite. Eventually, weak top-line growth will be reflected in bottom line earnings.
As reality begins to catch up with “earnings fantasy,” the performance of the “buyback index” is showing relative underperformance in recent months as compared to the index as a whole. (Note: that chart below is a total return calculation to put both indices on an equal scale.)
As Goldman notes:
“Following the crisis, imbalances of all types have been created. Chief among them, in our view, is the re-leveraging of America and the quiet growth of goodwill, as a percentage of assets on balance sheets. While neither poses an immediate terminal risk to the health of corporate America the changing nature of corporate balance sheets does raise the question, again, about the lack of organic growth and reinvestment post the crisis. Taken a step further, the spectre of rising rates, potential global disinflation (dare we say “deflation”?), declining operating profits and wider credit spreads continues to create near-term consternation for weak balance sheet stocks.”
That brings me to EBITDA.
EBITDA Is A Trap
I have written in the past about the fallacy of using EBITDA (Earnings Before Interest Taxes Depreciation and Amoritization) due to the ability to fudge/manipulate the number. To wit:
“As shown in the table, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures. For fundamental investors this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.”
Ramy Elitzur, via The Account Art Of War, recently expounded on the problems of using EBITDA.
“Being a CPA and having an MBA, in my arrogance I thought that I am well beyond such materials. I stood corrected, whatever I thought I knew about accounting was turned on its head. One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”
The article is worth reading and chocked full of good information, however, here are the four-crucial points:
- EBITDA is not a good surrogate to cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading, as I illustrated above, to a false sense of liquidity.
- Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
- Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
- EBITDA just like net income is very sensitive to accounting manipulations.
The last point is the most critical. The tricks to manipulate earnings are well-known. A difficult quarter can be made easier by releasing reserves set aside for a rainy day, recognizing revenues before sales are made, slashing costs, buying back shares, etc. More importantly, these “accounting gimmicks” can account for as much as 10% of the reported earnings per share numbers. So, before you jump off the “EBITDA Bridge”, you may want to take a much closer look at the real underlying picture.
Just something to think about.