Companies will often take credit when revenue growth outperforms economic growth, using sentences beginning with "Despite the current situation, we...". But these same companies will be quick to blame the economy in the face of lower than expected results (e.g. "The economic crisis caused..."). Therefore, the investor needs to be able to determine whether management is indeed outperforming.
Despite the general economic malaise currently gripping the global economy, it is still possible to find companies experiencing record sales and profits. But some companies may be beneficiaries of circumstance. These companies could be in industries with positive long-term trends (e.g. health, education), they could be in industries that aren't much affected by recessions (e.g. producers of consumer staples), or they could be operating in niche segments that for whatever reason are experiencing temporary bouts of strong demand or little in the way of competition. To avoid overpaying for such a company, it's important for investors to be able to identify whether external factors (which may be temporary) are benefitting a company.
If a company is earning record profits in a recession, but is simply in a cyclical industry, it is likely attracting competition. When a company generates high returns on capital, it attracts competition looking to replicate those same returns. For most companies, this results in returns returning to normal levels, as the competition drives down margins. For some industries, this process can take years (e.g. high oil prices encourage drilling and innovation resulting in higher oil supplies, but this takes a long time), while in others it can be a matter of weeks.
Consider Kewaunee Scientific (KEQU), maker of laboratory furniture. A combination of favourable factors for demand along with low competition resulted in strong revenues for this company in 2009. But it's important to have kept those numbers in perspective. Assuming that those revenue and profit levels would continue for the foreseeable future would have resulted in an investor's overvaluation of its stock. In other words, it was easy to have gotten sucked into believing that those numbers would only improve, considering that we were in a recession.
Indeed, management's comments at that time suggested the company was resilient in the face of recession:
"Our programs and strategies over the past few years to make Kewaunee a stronger and more competitive company were put to the test. Despite [economic] and other challenges, year-over-year increases in sales and net earnings were achieved for each quarter of the year..."
As we've often discussed, however, investors must look at several years worth of data to determine if a company's current operating profits are indeed sustainable. If a company does not have a competitive advantage, high margins will simply encourage competition that drives margins back down to normal levels. A look at KEQU's revenue and margins over the last business cycle shows that last year it was operating as well as it ever has:
Not long ago, however, the company suffered from low demand resulting in margin erosion. In 2005, revenues and earnings dropped sharply. Did the company blame itself, in what was otherwise a strong economic period? Not likely, as it issued the following commentary:
"We accomplished much in realizing cost reductions and improving our products, but were not able to overcome the unfavorable marketplace and declining sales...Uncertainties surrounding the November presidential election, significant increases in construction costs, and fewer state funds available for projects, all combined to reduce the number of laboratory projects..."
To determine whether current revenues and margins are sustainable, investors must consider the underlying business. Does the company have a competitive advantage which should allow it to hold onto its record profits, or is demand cyclical and/or will competition reduce profitability to more normal levels? Rather than accept the biased explanation of managements, investors must use their own judgement, and not only rely on current earnings (which may be abnormally high) in valuing a company.
Indeed, this type of analysis suggested the company's 2009 margins and revenue growth were not sustainable, and that turned out to be the case. In the latest quarter, the company saw sharply lower revenue and margins, and of course blamed "a soft market for small laboratory furniture projects, and unusually bad weather". This management behaviour of "take credit when things go well, blame others when things go badly" is nothing new and is not limited to this one company; rather, it is common business practice. As such, as investors it's our job to think beyond what we hear from the managers.
About the author:
Saj Karsan founded an investment and research firm that is based on the principles of value investing. He has an MBA from the Richard Ivey School of Business, and an undergraduate engineering degree from McGill University.
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