In a recent post (see Are Better-than-Expected Earnings Illusory?) I suggested that first quarter earnings came in better than expected largely because corporations undertook larger-than-expected cost cuts.

In response to economic malaise, it’s fairly typical for firms to try to reduce costs in an effort to stave off the deleterious consequences of decreased demand. There are several ways that a firm can do so: through layoffs, by rationalizing product lines, by trimming fat from operations, and/or by squeezing suppliers for lower input costs.

Nike provides a classic example of the illusory earnings effect that I described in that post. Take, for example, the following nonsensical headline from CNBC: Nike Posts Surprise Profit Increase, Tops Estimates. At first glance, one might think, “Wow, great news, Nike (a consumer products giant) did well. Maybe there are some green shoots in this economy after all.” But after digging a bit deeper, reality sets in:

The maker of athletic shoes and apparel said after markets closed Wednesday that it earned 99 cents a share in its fiscal fourth quarter, excluding one-time items. Nike reported revenue of $4.71 billion during the period. On a comparable basis a year ago, Nike turned a profit of 98 cents a share on a topline of $5.088 billion.

During the quarter, Nike reduced several layers of management and cut more than 1,750 jobs worldwide, or 5 percent of its global work force. About 500 of the jobs lost were at Nike’s world headquarters in Beaverton, Ore.The cuts come on top of other measures that the company has taken—including a hiring freeze and tight inventory controls—to improve its bottom line as the economic meltdown took a toll on its sales.

So, let’s take stock. Nike’s revenues were down 8% from last year. The reason it reported profits that beat estimates was because of layoffs and its success in squeezing its suppliers.

As I wrote in my previous post:

…cost cutting has systemic implications…Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

Squeezing suppliers generates the same effect. It reverberates up the supply chain by reducing supplier revenues leading to fewer jobs leading to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs. Again, wash, rinse, repeat.

I concluded that post by suggesting:

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

I concede that the economy is more stable now versus when Lehman collapsed and AIG nearly collapsed. We successfully averted the financial armageddon scenario. However, I believe that economic growth and corporate earnings are farther off than most think. Nike is fairly representative of the broad corporate earnings effect that I described in that prior post, and writ large, anemic corporate earnings coupled with cost cutting are likely to keep economic growth muted for quite some time.

So I ask: Where are those green shoots?

This entry was posted on Wednesday, June 24th, 2009 at 10:17 pm and is filed under Corporate Strategy, Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.