The Importance Of Revenues And Revenue Growth

The following was originally published on Moneyball Economics. 

First quarter earnings are in the book. The second quarter has officially started.

I’m spending the next few weeks doing a deep-dive into what to expect from the economy this quarter. Regular readers know our Vice Index is the true way to gauge the real economy (you’ll receive the most recent Vice Index soon).

I’m also spending hundreds of hours looking into several companies for my Moneyball Trader readers. These readers get my top conviction ideas and have had the chance to make enormous gains (you can learn more here).

So today’s essay is to give you an insight into the true importance of revenues and revenue growth.

For example, here’s a chart of  Advanced Micro Devices, Inc. AMD stock price. 

I’ve added a few arrows that indicate when earnings were released. Notice that the stock price moves sharply after earnings releases. But not just any ordinary earnings release. AMD’s stock is moving when the revenue growth momentum is shifting.

If you lay the revenue growth over the stock price growth (NOTE: stock price growth, not stock price), they move in step.

Rule #1: The market likes revenue growth. The stock price will move accordingly.

Rule #2: The biggest stock price moves come at the pivot points in revenue momentum

For example, in 2013, AMD’s revenue growth went from -30 percent to +20 percent. A big shift in growth and it was accompanied by a stock price that also surged almost 100%.

The reason is straightforward: investors like winners.

The sign of a winner is expanding business and that is easily measured: growing revenues, expanding margins, growing earnings.

At the pivotal shifts, earnings magnify the effect of revenues. For example, when a business is shifting into an expansion period, their existing infrastructure cost is growing slower than the revenues. Simply put, an extra $10M in revenues does not pull along extra support costs. So the margins and earnings expand faster than revenues.

The opposite is true as well: as business slows, the infrastructure costs drag down earnings faster. From an investing standpoint, buying and selling the shifts in revenue momentum is the perfect way to maximize yield.
 

Reading The Charts Correctly 

Let’s look at that AMD chart again.

Revenue growth accelerates in late 2013 and then moderates into late 2014. The momentum grows and then slows.

The stock price doesn’t drop as the revenue growth slowed – it simply stopped rising.

However, when revenue growth turned negative, the stock price dropped.

So revenue growth is a pretty safe entry sign and an exit sign.

Here is a chart mapping that revenue growth (both historical and forecast).

I have added the Moneyball Economics forecast which maps my revenue forecast based on operational spending and hiring.

A few things to note:

Moneyball Economics signals a lag the turn up. Beginning 3Q 2016, revenue growth kicks in but the Opex growth accelerates 2 quarters later (in 4Q 2016). In other words, AMD’s revenues began to grow while their spending stayed flat. That’s normal: when a company is playing defense, they won’t hire or expand until business activity picks up consistently and in a sustained manner. The fact that spending has picked up is a powerfully positive sign. It’s a vote of confidence that AMD sees sustained growth

Actual growth is higher than Moneyball’s forecast. This is more about the AMD business. Semiconductor designers can ramp production without expanding their infrastructure costs. In 2H 2016, Microsoft Xbox orders grew 30% or ~6M consoles. Since AMD makes the processor for the Xbox, the Microsoft order turbo-charged AMD’s sales. With that done, they are returning to ~8% growth.

Key Takeaways 

The market loves growth and hates contraction.

• Playing this momentum is a tried-and-true approach.
• There is a way to use hiring and opex data to confirm and predict shifts in revenue momentum

For the past year, I have been using the hiring/opex data primarily to catch earnings day surprises—would a company be ahead of or behind expectations.
Going forward, I will also look for situations where revenue momentum looks set to shift, based on my hiring/opex data. This would be for longer term investing (90+ days)

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