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Wednesday, November 23, 2022

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Revenue — aka the "top line" — doesn’t have to deteriorate by much for earnings to really suffer.

“[A]t the end of the day it's typically margins that do the heavy lifting to the downside in an earnings recession, not top line growth, because of the power of negative operating leverage,” Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote on Monday.

Operating leverage is the degree to which the change in revenue translates into operating earnings. For example, a company with 5% sales growth and 15% earnings growth has higher operating leverage than a company with 5% sales growth and 10% earnings growth. And it cuts both ways: A company with high operating leverage will see earnings fall faster as sales decline.

Companies with a lot of fixed costs relative to variable costs tend to experience high operating leverage.

Wilson offered a little more color on his current view on operating leverage in a Nov. 7 research note (emphasis added):

… our economists are not officially forecasting a recession for next year, but they assume we barely skirt one. As we have noted, from an earnings standpoint, that may be worse because it means companies are not reducing headcounts as they typically do when revenue growth slows. That will put even more pressure on margins as the rate of change on real growth and inflation – i.e., nominal GDP – fall sharply. In other words, the decline in the rate of change in revenue growth overwhelms the ability of companies to adjust fast enough to avoid the negative operating leverage that is driving our well-below consensus EPS forecasts for next year. The shortage of labor created by the lockdowns and de-globalization is reducing companies' willingness to let employees go for fear of never getting them back. This is a new dynamic that US equity investors haven't had to contemplate over the past 30 years when labor was much more fungible and cheap.

Labor represents a massive cost for companies. And so when demand cools, it would make sense for companies to lay off employees to lower costs as the amount of work that needs doing shrinks.

However, the past two years have come with persistent labor shortages as companies struggled to hire amid the rapid economic recovery. Because they didn’t have the capacity to keep up with demand, companies missed out on sales opportunities.