If you’ve ever hammered out an earnings model you know the concept of earnings leverage, defined as “the rate of change in corporate earnings is usually greater than the rate of change in revenues”.
If you’ve been spared this particular Wall Street rite of passage, here’s how this works:
- In any given quarter a company’s revenues will vary because of both macro (economic growth, competitive landscape, etc.) and micro (company-specific) factors.
- In contrast, a company’s cost structure is generally somewhat fixed and therefore more predictable than revenues. Cost of goods sold may vary with sales in a manufacturing company, for example, but selling, general and admin expenses should be relatively stable.
- When revenues rise by 10 percent, therefore, earnings should rise by more than that since the company’s fixed costs do not change. Conversely, when revenues decline by 10 percent earnings may well fall by more than that number unless management does a good job of cutting costs.
Since this is our Disruption section, you can probably guess where this is going: how much earnings leverage does Big Tech have going into Q4 2020 earnings season and 2021 as a whole? With Tesla’s inclusion in the S&P 500 and its steady rise since it was added, we now have six companies to consider. In aggregate, they are 23 percent of the index.
Here’s how each company looks on this count based on current Wall Street analysts’ earnings estimates. We’ve also included the dates of each earnings release for your reference.
Apple (January 27th):
- Expected Q4 EPS growth: 12.0 percent
- Expected Q4 revenue growth: 15.7 percent
- Expected 2021 EPS growth: 9.0 percent
- Expected 2021 revenue growth: 5.3 percent
Takeaway: analysts expect no earnings leverage in Apple’s calendar Q4 2020 (revenue growth>earning growth), but it returns to levels we’d call “normal” in 2021 (earnings growth about 2x revenue growth).
Microsoft (January 26th)
- Expected Q4 EPS growth: 8.6 percent
- Expected Q4 revenue growth: 8.9 percent
- Expected 2021 EPS growth: 10.5 percent
- Expected 2021 revenue growth: 10.9 percent
Takeaway: Microsoft is expected to show essentially no earnings leverage in either Q4 or all of 2021.
Amazon (February 4th)
- Expected Q4 EPS growth: 10.7 percent
- Expected Q4 revenue growth: 36.7 percent
- Expected 2021 EPS growth: 30.1 percent
- Expected 2021 revenue growth: 18.4 percent
Takeaway: higher operating costs around the Holidays likely crimped AMZN’s operating leverage in Q4, but 2021 looks like what you’d expect with roughly 2x earnings growth versus sales growth (similar to Apple, for example).
Google (February 1st)
- Expected Q4 EPS growth: 2.6 percent
- Expected Q4 revenue growth: 15.2 percent
- Expected 2021 earnings growth: 18.7 percent
- Expected 2021 revenue growth: 21.2 percent
Takeaway: of the 6 companies we’re reviewing today, Google has the worst (most negative) earnings leverage in Q4 2020 and only returns to zero leverage (still not great) in 2021.
Tesla (February 3rd)
- Expected Q4 EPS growth: 131.7 percent
- Expected Q4 revenue growth: 38.1 percent
- Expected 2021 EPS growth: 70.9 percent
- Expected 2021 revenue growth: 47.3 percent
Takeaway: as much as Tesla isn’t an “auto stock”, these wildly positive earnings leverage ratios (2-4x earnings growth/sales growth) are emblematic of a traditional manufacturing company as it ramps production.
Facebook (January 27th)
- Expected Q4 EPS growth: 24.6 percent
- Expected Q4 revenue growth: 24.7 percent
- Expected 2021 EPS growth: 12.3 percent
- Expected 2021 revenue growth: 23.9 percent
Takeaway: Q4 isn’t awful for Facebook in terms of earnings leverage (flat), but Wall Street is clearly unsure just how much – if any – earnings leverage this company really has in 2021.
Bottom line: excluding Tesla, there isn’t much in the way of earnings leverage at these companies for Q4 (at least as far as the analysts’ estimates go) and only Amazon and TSLA have much of a story to tell in 2021. That’s important, because earnings leverage is what creates upside earnings surprises. Make no mistake, however – these are all excellent companies with strong competitive positions and even stronger free cash flow in most cases. That’s why they have high multiples. But as far as a “gotta-buy-em-here” story, that’s a harder tale to tell for now.