Summary:
- Net income growth was strong in 2013.
- Alternative measures of growth were much weaker.
- This could be bad news for business investment.
Net income growth looks strong
There is more than one way to measure growth in corporate America. The preferred measure is net income, which is informally referred to as the bottom line.
"At first look growth in US net income last year looks remarkably good," wrote Societe Generale's Andrew Lapthorne. "With nearly all S&P 500 names having reported year-end figures, net income grew 14% last year or 12.8% on an ex- financial basis. This is fairly impressive growth given the lacklustre economic backdrop."
If you haven't already sensed from his tone, Lapthorne is about to get a whole lot more skeptical.
Alternative measures of growth are much weaker
"So should we be celebrating?" he asked rhetorically. "Well we’re not so sure, as the source of this growth is not a robust improvement in operating cash flow but to be found in the large goodwill write-downs of 2012."
Before we get to what he's talking about, we need to talk about some accounting matters.
Net income is not without its issues. For example, net income could get distorted by a variety of nonrecurring or one-time items that aren't part of an company's ongoing business. These items include asset write-down, gains on asset sales, or restructuring charges.
This is why analysts look to other measures of growth. Here are a few:
Proforma net income: This is sometimes referred to as adjusted net income. It's net income excluding nonrecurring items like those mentioned above. It arguably captures a company's underlying earnings growth.
Earnings before interest and tax (EBIT): Interest and tax expenses largely reflect a company's capital structure and ability to take advantage of tax codes, both domestic and foreign. While they reveal things very important to a company's financial performance, they don't say a whole lot about operating performance. This is why analysts look at EBIT, which is sometimes referred to as operating earnings.
Cash flow: Net income is reported on a company's income statement, which utilizes a many accounting smoothing tricks, which are intended to reduce noise between reporting periods. Cash flow, which appears on the cash flow statement, is the actual money moving in and out of a company when it moves in and out of a company. Cash flow is not too dissimilar from income. In theory, cash flows and income (or loss) will equal each other in the long-run.
Sales: Some companies, particularly younger growth companies, are losing money. This is not because they are doomed for bankruptcy. Rather, new companies just tend to lose money as their sales are still reaching a level where the scale offsets costs and expenses. Because there is no net income to look at, analysts will often look to sales.
In a new note to clients, Lapthorne lines up growth in net income, proforma net income, EBIT, cash flow, and sales. As you can see in the chart below, one is not like the others.
"Reported net income is quite clearly the outlier, with other measures registering growth of between 2-4%."
What's behind that big jump in net income?
"Looking behind these headline numbers we see that the biggest increase in reported net income in 2013 came from Hewlett Packard," noted Lapthorne. "This improvement was courtesy of the large 2012 $19bn goodwill write-down (from the EDS and Autonomy acquisitions) dropping out of the 2013 figures. Indeed if we compare the biggest positive contributors to reported net income the list is very much different to the pro-forma net income figures. The top 10 biggest positive net income contributions are dominated by companies affected by write-downs in 2012."
In short, net income growth in 2013 was mostly noise.
A bad sign for business investment
So what's the upshot of all this?
"In our view this disappointing growth will have economic consequences, especially versus a consensus that signals that corporates are seeing a meaningful improvement in earnings," wrote Lapthorne. "As we have explained in prior reports, the knee jerk reaction to disappointing cash flow growth is to rein in expenditure; as we show below this now appears to be the case."
This is troubling as many of the more bullish economists are basing their forecasts for GDP growth on the assumption capital expenditure activity accelerates.
