You Don't Necessarily Need Sales Growth to Grow Profits but be Wary

DuPont and Dow each achieved strong earnings growth last year, but analyzing their underlying performance reveals a concerning trend.

Feb 4, 2014 at 10:18AM

Investors suddenly seem concerned about the state of corporate profits. Actions taken by the Federal Reserve have set a fire in the market's belly. Add that to the sudden concerns over economic growth in the emerging markets, and it's not entirely a surprise why the Dow Jones Industrial Average and S&P 500 Index have sold off over the past couple of weeks.

At the same time, major chemicals companies including Dow Chemical (NYSE:DOW) and DuPont (NYSE:DD) have had almost nothing but great things to say in their most recent earnings reports. They're rising above the broad macroeconomic concerns and reporting strong profit growth. In case you may be asking yourself how this is possible, here's how they're able to do it.

Self-help is the key to growing profits
Chemicals producers Dow and DuPont are mostly achieving earnings growth through internal measures such as aggressive cost cuts, as well as share repurchases. These are helping to boost the bottom line through reduced expenses as well as resulting in fewer shares to divide profits among.

Actions such as cost cuts and share buybacks are boosting profits much more so than revenue growth, which should be a pivotal focus point for investors going forward. That's because cost cuts can only go so far to keep profits grinding higher. At some point strong revenue growth, the lifeblood of any business, needs to kick in.

Consider that Dow nearly doubled its adjusted earnings in the fourth quarter, and grew adjusted earnings by 31% in 2013. Meanwhile, DuPont's core operating profits jumped 52% in the fourth quarter, and rose 17% to $3.04 per share last year.

While their profit figures are impressive, their revenue growth isn't keeping up nearly to the same degree. It's worth noting that Dow and DuPont posted just 3% revenue growth each in 2013. It's clear that profit growth is being achieved largely through cost savings.

For example, Dow delivered more than $500 million in cost reductions along with another $850 million in proceeds from divestitures. DuPont increased margins through 5% higher volumes, but it also reaped considerable gains from its productivity initiatives.

Seed giant Monsanto (NYSE:MON) did a much better job of producing organic revenue growth in fiscal 2013. It grew sales by 10%, as it's clearly benefiting from the boom in global food demands. A longer-term view paints an even brighter picture: Monsanto's revenue is up 26% since fiscal 2011. The agriculture industry has a strong underlying tailwind, since rising worldwide populations place an unprecedented strain on food production.

Watch where the money goes
It's clear from how Dow's and DuPont's management teams are setting the stage for the upcoming year that neither company is expecting economic growth to accelerate in 2014. Instead of reinvesting significant portions of last year's profits into strategic growth initiatives, Dow and DuPont are simply funneling cash back to shareholders. This will be achieved by even greater share buybacks, as well as increased dividends.

Dow is sending money out to shareholders hand over fist. First, the company just increased its cash dividend by 15%. In addition, Dow added $3 billion to its existing share repurchase authorization, to a total of $4.5 billion, to be completed by the end of the year. For its part, DuPont declared a brand-new $5 billion share repurchase program, which replaces its existing buyback program. Of the $5 billion, the company expects to utilize $2 billion in the upcoming year.

Keep revenue in mind going forward

DuPont and Dow did a great job improving their bottom lines last year. In such an uncertain economic climate, it seems foolish to try to find fault with companies that are growing profits so strongly. However, there's a meaningful difference between profit growth obtained by cost cuts versus organic revenue growth. Cost reductions can only take a company so far; at some point, DuPont and Dow will have to start growing revenue for their outsized profit growth to continue.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

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That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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