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First Quarter Earnings Preview: Why Profits Don’t Matter Most

It’s officially earnings season again. And you’d think shares of aluminum maker Alcoa (NYSE: AA) would have rallied today.

After all, the company put up its best quarterly profit in almost two years, earning $0.28 per share to beat expectations by a penny.

Instead, shares suffered a heavy bout of selling pressure. The $19 billion company lost 6% today.

So what gives? I’m convinced that this gives a clear indication of the overriding trend: profits don’t matter most in this quarter.

I know. That’s sounds heretical for someone that always says, Share prices ultimately follow earnings. But for this earnings season, an exception is in order.

Here’s why…

Profit Hunt

When it comes to increasing profits, companies have three ways to do it…

  1. By increasing sales.
  2. By expanding profit margins.
  3. Reducing the number of shares outstanding via stock repurchase programs.

On the heels of the recession and sluggish consumer demand, most companies relied heavily on option #2. They achieved this by slashing extraneous costs and cutting workers by the thousands in order to boost bottom line profitability.

It worked remarkably well, too. Case in point: Last year, profits for S&P 500 companies jumped 40%.

But that strategy won’t work forever. As Ed Clissold of Ned Davis Research says, “Most of the earnings gains from margin expansion are likely over.”

The data underscores the same truth…

The Equation is Simple…

The S&P 500’s profit margin currently stands at 8.2%, which is within spitting distance of the highest level in decades. So any further margin expansion is limited, especially with rising commodity costs and renewed hiring efforts. (Raw materials and employees are the two biggest expenses for most companies.)

And with regard to option #3, I’m afraid companies can’t rely solely on share repurchases to drive profit growth. Shareholders just won’t tolerate management burning through cash reserves, or worse, borrowing money to fund repurchases.

Ultimately, at this stage of the economic recovery, increasing bottom line profitability boils down to increasing top line sales. Period.

Against such a backdrop, Alcoa’s sell-off makes eminent sense…

Treat Alcoa as a Bellwether, Not an Anomaly

Although the company beat its earnings expectations, it came up short on the sales side. The company reported first quarter sales of $5.96 billion, compared to the expected $6.14 billion.

Management also noted three headwinds…

  1. A weaker dollar.
  2. Higher energy costs.
  3. Higher raw material costs.

So there’s no doubt that cutting costs to increase profits is no longer an option for the company.

Add it all up and the reason why investors are spooked becomes abundantly clear: If Alcoa struggles to increase sales in future quarters, it’s going to struggle to increase profits, too.

Hmm… I really haven’t contradicted my motto that share prices ultimately follow earnings, after all. It’s just that right now, revenue figures hold the key to earnings.

As more companies report their quarterly results this week, including Google (Nasdaq: GOOG), J.P. Morgan (NYSE: JPM) and Bank of America (NYSE: BAC), expect this trend to become more pronounced.

Companies reporting solid revenue growth – and predicting more to come – should rally. Meanwhile, those with weak sales growth, no matter how strong the profit growth, should stumble.

Ahead of the tape,

Louis Basenese