Q3 Earnings Season is coming along nicely, at least with respect to beating earnings per share (EPS) estimates. As of Nov. 13, 63 percent of S&P 500 companies have beaten earnings estimates. The problem is the topline; most companies are missing revenue estimates.
According to an analysis by JP Morgan, 63 percent of the 447 S&P 500 companies that have reported numbers for the third quarter missed revenue expectations. This begs the question whether companies are sacrificing long-term growth for short-term earnings. Many companies have slashed costs and laid off many workers to stay profitable in an increasingly competitive global market.
Cisco Beats Estimates but Profits Outpace Revenues
Cisco Systems, which reported earnings after hours Nov. 13, is an example of a company where this strategy has worked. “We delivered record results this quarter—with revenue growth of 6 percent and strong earnings per share growth—demonstrating our vision and strategy are working,” said Cisco CEO John Chambers in a press release.
The company reported an 18 percent increase in Q1 EPS year over year, generating net income of $2.1 billion. Cisco beat analyst expectations of 46 cents EPS by 2 cents and delivered 48 cents, sending the stock soaring. Cisco rose 4.8 percent, outperforming the Dow Jones, which dropped 1.45 percent.
However, the 18 percent gain in earnings was generated by revenues that only rose 6 percent over last year to $11.9 billion. Analysts had expected only $11.8 billion. If profits rise more than revenue, it usually means that the balance is taken out of the cost structure.
“Gross margin of 62.7 percent topped our estimates by 1.1 percentage points … on cost reductions, driving the EPS beat,” wrote Morgan Stanley in a note. Cisco cut 7,800 jobs during the last 12 months and shut down some unprofitable businesses.
“Once again, we delivered strong financial performance with continued execution on our long-term strategy of growing profits faster than revenue and driving long-term value to our shareholders,” said Chief Financial Officer Frank Calderoni.
Revenue Growth Needed for Sustainable Profits
While it is good for a company to stay lean and mean, there is only so much cost that can be cut. New orders need to keep coming in to sustain future profitability. Cisco’s order growth slowed to zero percent this quarter compared to 2 percent during last quarter.
Jim Kelleher of Argus Research, who has a buy rating on the stock, does not think Cisco will slash costs too much and jeopardize growth. “Cisco is more likely to seek to preserve margins by exiting low-return and consumer-exposed areas, where margins are not as good. Cisco could also de-emphasize its commitment to Europe, meaning reduce sales force, until Europe comes out of recession and starts acting like a better market,” he comments in an email.
Despite the widespread misses, JP Morgan still estimates that we are going to see a quarter with flat revenue growth overall for the S&P 500 and remains bullish on the direction of the stock market.
“Remember corporates have a lot of cash here. They are sitting on massive cash balances, record cash balances as of the third quarter, up 7 percent year over year. And they may be doing some buy-backs or M&A toward year end,” said chief equity strategist Tom Lee.
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