Citi: The Cost-Cutting Recovery Is Over, But Leverage Will Drive Us Forward

80% of companies beat expectations during the recent earnings season according to Citi Investment Research. This was higher than the 73% beating estimates in the second quarter of 2009, and 65% in the first.

Still, many skeptics say this performance isn't sustainable since much of the earnings strength came from corporate cost-cutting rather than actual growth in new business. As proof of this, note how operating margins didn't fall as much as they had during the early nineties:

citi

Yet Citi's Tobias Levkovich makes an interesting point on the growth prospects for 2010.

Basically, while the margin boost from cost-cutting may be coming to and end, operating leverage could support margins over the next few quarters. Essentially, small additions to revenue flow disproportionately grow profit when you maintain the same fixed costs, since revenue increase but without a concurrent increase in costs. This is known as operating leverage. Thus as many companies remain highly cost-conscious, even a small growth in revenue could deliver decent earnings growth in 2010.

Citi: While deep employment cuts clearly helped sustain corporate operating margins during the downturn, a reluctance to add people quickly and a turn in industrial production should keep the profitability machine running over the next several quarters. If history is any guide, analysts will under-estimate the potential for incremental returns given management guidance on fixed overhead cost structures that miss some key factors such as S,G&A and R&D expense that do not change much at cyclical turning points.

The 2010 challenge though will be in terms of expectations. Beating expectations isn't getting any easier after the 80% beat rate we just had.

(Via Cit Investment Research, 'Meaningful Margin Madness', Tobias Levkovich, 4 December 2009)

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