The economic slowdown could be a nightmare for the company’s earnings in 2023

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Wednesday, November 23, 2022

today’s bulletin by Sam Rothe writer TKer.co. Follow him on Twitter at @SamRo. Read this and more market news on the go Yahoo Finance Application.

Income – aka “top line” – does not have to decline by much for earnings to really suffer.

“[A]At the end of the day it’s usually margins that bear the brunt of the decline in revenue recessions, not top-line growth, because of negative operating leverage,” Mike Wilson, chief US equity strategist at Morgan Stanley, wrote on Monday.

Sales may hold up during the downturn, but damage to margins ultimately drags down the earnings picture.  (Source: Morgan Stanley)

Sales may hold up during the downturn, but damage to margins ultimately drags down the earnings picture. (Source: Morgan Stanley)

Operating leverage is the degree to which changes in revenue are translated into operating income. For example, a company with 5% sales growth and 15% earnings growth has higher operating leverage than a company with 5% sales growth and 10% earnings growth. And it cuts both ways: A company with high operating leverage will see earnings fall as fast as sales decline.

Firms with high fixed costs relative to variable costs tend to experience high operating leverage.

Wilson offered more color on his current view of operating leverage in a Nov. 7 research note (emphasis added):

… our economists are not officially predicting a recession for the next year, but they think we are barely a skirt. As we have noted, from the point of view of earnings, it can be bad because of the meaning companies are not reducing headcounts as they typically do when revenue growth slows. That will put even more pressure on margins as the rate of change in real growth and inflation – ie, nominal GDP – falls sharply. In other words, the declining rate of change in revenue growth extends the company’s ability to adjust quickly enough to avoid negative operating leverage. which is driving our consensus EPS forecast lower for next year. The lack of labor created by lockdowns and de-globalization reduces the willingness of companies to let employees go for fear of not being able to return.. This is a new dynamic that US equity investors didn’t have to think about 30 years ago when labor was easier to use and cheaper.

Labor represents a massive cost for the company. And when demand cools, it makes sense for companies to lay off employees to lower costs because the amount of work to be done shrinks.

Anthony Harris stops traffic as he works with EZ Bel Construction along Fredericksburg Road during an extreme heat warning in San Antonio, Texas, U.S. July 19, 2022. REUTERS/Lisa Krantz

Anthony Harris stops traffic as he works with EZ Bel Construction along Fredericksburg Road during an extreme heat warning in San Antonio, Texas, U.S. July 19, 2022. REUTERS/Lisa Krantz

However, the past two years have come with persistent labor shortage as companies struggle to hire Amid rapid economic recovery. Because they don’t have the capacity to keep up with demand, companies miss out on sales opportunities.

This dynamic has led some economists to predict that companies will be incentivized to engage in “labor hoarding“Or hang on to workers even when demand is slowing. The idea is to make sure you have good staff when demand eventually recovers.

The downside is that labor costs don’t decrease as sales decline, putting significant pressure on earnings in the near term.

This is the negative operating leverage that Wilson talks about.

And that’s why he expects S&P 500 earnings per share (EPS) to drop to $195 in 2023 from around $219 this year. According to FactSetWall Street’s consensus estimate for earnings rose to $232.

The good news is that Wilson sees this decline in profits as a short-term problem.

“While we see 2023 as a very challenging year for earnings growth, 2024 should be the opposite – a year of rebound growth where positive operating leverage resumes – that is, the next boom,” he wrote.

With that boom, he estimates EPS to jump to $241 in 2024.

Editor’s note: There will be no Morning Release published on Thursday, November 24. We will return to our normal publishing schedule on Friday, November 25th.

What to Watch Today

economy

  • 7 a.m. ET: MBA mortgage applicationweek ended November 18 (2.7% over previous week)

  • 8:30 a.m. ET: Durable Goods OrdersEarly October (0.4% expected, 0.4% during the previous month)

  • 8:30 a.m. ET: Durables Excluding TransportationEarly October (0.0% expected, -0.5% during the previous month)

  • 8:30 a.m. ET: Initial Unemployment Claimweek ended November 19 (225,000 estimated, 222,000 during previous week)

  • 8:30 a.m. ET: Proceed with the Claimweek ended Nov 12 (1.520 million during previous week)

  • 9:45 a.m. ET: S&P Global US Manufacturing PMIearly November (50.0 expected, 50.4 during the previous month)

  • 9:45 a.m. ET: S&P Global Services US PMIearly November (48.0 expected, 47.8 during the previous month)

  • 10 a.m. ET: University of Michigan Consumer SentimentNovember final (55.0 expected, 54.7 previous)

  • 10 a.m. ET: New Home SalesOctober (570,000 expected, 603,000 during the previous month)

  • 10 a.m. ET: New Home Salesmonth-over-month, October (-5.5% expected, -10.9% during the previous month)

  • 2 p.m. ET: FOMC Meeting Minutes, November 1-2

Income

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