Blue-chip America is bumping up against the limits to growth – and financial engineering.
International Business Machines Corp., McDonald's Corp. and Coca-Cola Co., three icons of U.S. business, all reported disappointing earnings this week and suffered painful hits to their share prices as a result.
The companies' biggest issue is their inability to expand revenues in a global economy that is only trudging ahead. But the slow-growth environment is also casting a harsh spotlight on the giants' addiction to cheap debt, a strategy that may be nearing its limits.
The three flagships of U.S. enterprise have helped to fuel their stock market gains in recent years by borrowing money and using it, among other things, to buy back shares. One advantage of this shift in the capital structure, from an investor's perspective, is that the same amount of overall earnings goes further when it is divided among fewer shares.
Share buybacks since 2007 have helped IBM and McDonald's, in particular, to achieve impressive gains in earnings per share even though their gains on the profit front have been considerably less spectacular. But swapping debt for equity has its limits and eventually even the best-known businesses have to find sources of true organic growth or risk seeing investors lose faith.
To be sure, not every U.S. giant faces that same dilemma. Apple, for instance, reported solid growth this quarter, as did Boeing.
But the disappointments at IBM, McDonald's and Coca-Cola should act as a signal to investors that one of the dominant financial-engineering strategies of recent years is growing long in the tooth. If that trend continues, the outlook for earnings is going to darken.
The problems are exacerbated by a strong U.S. dollar and a sluggish global economy that is not generating much in the way of increased demand. Coca-Cola, for instance, saw its sales volume dwindle 5 per cent in Europe this quarter, while IBM's revenues in the Asia-Pacific region tumbled 9 per cent. McDonald's encountered problems nearly everywhere, with third-quarter comparable sales dipping 3.3 per cent in the U.S., 1.4 per cent in Europe and 9.9 per cent in Asia and Africa.
However, the companies' issues aren't simply a result of the recent economic slowdown. All three have struggled to increase their revenue in recent years. Coca-Cola and McDonald's are both expected to post sales in the current fiscal year that will be essentially unchanged from 2011. IBM's forecast revenue for this year is below what it achieved in 2007.
Stagnant sales don't necessarily crush profits, so long as a business finds ways to extract more earnings from every dollar of revenue. But on that front, the three companies have had mixed results. Analysts surveyed by Bloomberg say that profit before extraordinary items at McDonald's and IBM will be roughly the same this year as in 2010, while Coca-Cola is expected to unveil results below what it achieved four years ago. For all the talk about strong corporate profits, these iconic U.S. businesses have been treading water in recent years.
They have, however, displayed an increasing fondness for borrowed money – prompted, no doubt, by the rock-bottom interest rates that have prevailed since the financial crisis. IBM's debt-to-equity ratio jumped from 124 per cent in pre-crisis 2007 to 173 per cent now. Coca-Cola's ratio shot from 42 per cent to 111 per cent, while McDonald's surged from 61 per cent to 88 per cent.
Loading up on debt makes sense at a time, like now, when interest rates are low and lenders are eager for high-quality places to put their money. But the corollary is that any move to higher rates will be painful for investors in these companies. Cheap debt and financial engineering can't substitute forever for real growth – and, for now, that looks to be in perilously low supply.
Ian McGugan