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Another brick in the recovery road: Revenue rebounds

January 28, 2013: 5:00 AM ET

The gap between sales and earnings growth is shrinking. That's a very good sign.

chart-sp500-earnings-revenue_blogFORTUNE -- It's not always all about the bottom line.

Analysts and investors are normally focused on corporate profits. But the most interesting sign of where the market and the economy are headed this earnings season could be coming from the top of corporate ledgers, rather than the bottom.

Of the 147 companies in the S&P 500 that reported their fourth quarter results through Thursday, 65% have beaten analysts sales expectations, according to data provider Thomson Reuters I/B/E/S. Beats are typical. Wall Street tends to low-ball. But that's not what had been happening lately. In the second and third quarters of 2012, just 40% of all companies had sales that were better than expectations, meaning 60% of all companies missed expectations. (UPDATE: As some readers have pointed out, some of those companies may have just met expectations, not all missed. I believe the rest of the story is correct.) That was a worrying sign.

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Earnings tend to roar back faster than revenue when the economy turns. But in this recovery the divergence between corporate profits and sales has been wider and gone on longer than usual. That's not sustainable. Companies can only boost their earnings through layoffs and other cost-cutting measures for so long. To keep the recovery going, people eventually have to begin spending money, and sales growth takes over. But that's not what was happening. Instead, sales fell 1% from a year before in the third quarter. That lead some strategists to argue we had hit an earnings peak.

So the rebound in revenues is a very good sign. What's more, sales growth is expected to account for roughly 85% of the increase in corporate profits last quarter, meaning more and more of the bottom line improvements are coming from economic growth, and not from cost-cutting or accounting gains.

Not everyone is convinced this is good news. Falling expectations can account for some portion of sales beats. What's more, the euro strengthened a bit in the fourth quarter, which can make sales expressed in U.S. dollars seem higher. And it's not like sales are taking off. The average company in the S&P 500 is estimated to have seen a 2.3% jump in revenue in the last three months of the year. Take away inflation, at 1.8%, and that's really not much. "These aren't great numbers," says market strategist Jim Bianco. "We've rebounded from a disaster to just average."

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Nonetheless, you have to start from somewhere. And there are a number of signs sales growth can continue. Citigroup strategist Tobias Levkovich says the longer than expected lag in sales growth was because of credit markets, which were still tight as recently as the end of 2011 thanks to European debt fears. But credit started finally easing in early 2012. When that happens, sales growth tends to follow 9 to 12 months later. That's what we have been seeing, says Levkovich. And with the Fed likely to keep borrowing rates low for some time, revenue growth should continue.

Levkovich adds that sales growth doesn't need to be as big as it once was to produce gains. Technological change means that companies have a lot more leverage to boost profits as the economy recovers. "I would hear people say that profits were incredibly high and just shake my head," says Levkovich. "The argument was faulty to begin with."

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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