Credit: Shutterstock photoSlumping corporate revenues are a big factor in the current merger boom, lifting stock prices that otherwise would reflect a downbeat reality. This is artificial stimulation, though, and cannot last. Nothing beats escalating revenue as a profit elixir.
Revenue declined 3.3% in the second quarter at Standard & Poor's 500 companies. This followed a revenue drop of 2.9% in the first quarter, according to research firm FactSet , the first consecutive quarters of revenue declines since 2009.
Much of the revenue decline stems from weakness in the materials and energy sectors and a strengthening dollar. There may be no better fundamental measure of the health of a company than revenue. Relative to almost all other reported statistics in financial statements, the top line (as it also is known) is a pure number that is hard to manipulate, particularly over multiple quarters. Two quarters of declining sales could be a red flag for stock investors.
Management teams are paid to create earnings growth. Declining sales makes this job particularly difficult. If sales are declining, the primary way to make profits rise is to reduce costs faster.
Corporate earnings are the difference between revenues and costs. You can measure this difference as a percentage, called net margin - which in its simplest for is net income divided by revenue. Last year, net margins reached their highest level in the past 10 years at about 10%. Companies are running at historically very high efficiency levels. There is not much room to expand margins through cutting fat from the budget or squeezing out more profitability from each dollar of revenue.
Given that corporate margins are near highs, revenue declines are likely to translate directly into earnings declines. In the second quarter, S&P 500 earnings declined by 1%. To deliver rising earnings to shareholders, management teams either have to become better salespeople with more exciting products or find new ways to increase margins.
One way to increase margin and sales growth is to acquire a similar company and eliminating duplicate cost functions like lawyers, accountants, administrators, mid-level management, buildings, etc. Acquirers gain the other companies revenues but without all the cost. The newly combined company now has a larger top line, improved margins and perhaps a better strategic position in its industry, which helps boost sales. This is called synergy.
It's no surprise that, in a market whose hallmarks are low growth, high cash balances, cheap debt and high stock valuations (and where executive pay is tied to rising earnings and stock prices), we are seeing a record level of mergers and acquisitions. M&A activity is on pace this year to reach $4.58 trillion, an all-time high.
Even master investor Warren Buffett and his holding company, Berkshire Hathaway ( BRK.B ), are actively involved in the M&A boom. His recently announced plan to acquire Precision Castparts ( PCP ) for $37.2 billion announced is his largest deal ever for Berkshire, and significantly larger than their $26 billion buy of Burlington Northern Santa Fe railroad in 2010.
Buffet may see long-term value in Precision Castparts - which makes parts and equipment for aircraft, oilfields and power plants - and Buffet is a buyer of what he believes to be undervalued assets. This is generally a bullish signal for the broader market. Whatever the motivation, high levels of M&A support stock prices. Rising merger activity is part of the reason the S&P 500 is flat on the year, rather than down, despite declining revenues and earnings.
Using M&A as an instrument of growth can sustain stock valuations for a while, but fundamentals eventually win out. For the stock market to advance meaningfully from current levels, we will need to see a resumption of revenue growth and organically derived earnings growth.
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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management,a registered investment advisory firmin San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your Risk. Additional market commentary andinvestment adviceis available via their websitesat www.deltaim.com and www.deltawealthaccelerator.com
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
