Threat Builds on the Margins
By JONATHAN CHENG
This earnings season has seen a much-welcomed return to revenue growth, giving investors another reason to push stocks to two-year highs.
But beneath the surface lurks a fresh worry: For many companies, the cost of raw materials is rising at a faster pace than revenue. Blame it on soaring prices of everything from cotton to copper and corn. That has squeezed profit margins more markedly than many analysts anticipated—and is serving as a worrying sign for future earnings.
Harvested corn is loaded onto a truck in Ines Indart, Agentina, on Monday, April 5, 2010. Before April 20, corn declined 14 percent this year on forecasts for production to rise in Brazil and Argentina, the biggest exporters behind the U.S. Photographer: Diego Giudice/Bloomberg
.Procter & Gamble, Ford Motor and Kraft Foods are among dozens of companies that reported lower profit margins for the fourth quarter of 2010 compared with the third quarter. Their stocks were punished by investors, even as the companies' profit and revenue exceeded analyst forecasts. The cool reception stood in contrast to the general optimism among investors that has helped the Dow Jones Industrial Average to gain about 6% this year.
About three-quarters of the companies in the Standard & Poor's 500-stock index have reported their earnings so far. Some 25% of those companies have posted lower margins in the latest quarter, according to Morgan Stanley. S&P says operating margins for S&P 500 companies in the latest quarter have come in at 8.69%, down from margins of 8.95% for the S&P 500 in the third quarter.
"I think this quarter was a wake-up call. We're seeing these stocks get hit on margins and sell off dramatically," said Erin Browne, director of global macro trading at Citigroup. "It's definitely picking up steam and becoming much more on the tops of investors' minds, and it's only going to continue as we move through 2011."
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.While some of these costs can be passed on to customers, many companies have been unable to increase their own prices. The economic recovery is just gaining steam, unemployment remains high, and consumers are keeping a tight rein on spending.
Some worry that many analysts aren't taking the lower margins into account and are overestimating future profit margins. Adam Parker, Morgan Stanley's chief U.S. equity strategist, says consensus earnings estimates for the rest of the year imply that analysts continue to see margins expanding. That leaves plenty of room for disappointment if rising commodity prices bite deeply into companies' margins.
"Some analysts may be guilty of 'over-extrapolating' the recent margin improvements into their forward outlooks," and companies that fail to meet these heightened expectations may find themselves punished by the market, Mr. Parker warned in a recent note to clients.
Kraft reported a 30% rise in revenue on Thursday. But the company said higher costs for meat, packaging and other raw materials sliced $500 million from net income, which the company reported at $540 million. The shares fell about 2% after the earnings were released. Procter & Gamble blamed higher commodity prices for crimping margins and said higher costs will lower annual earnings by about $1 billion. Since its earnings on Jan. 27, the shares are down 2.1%, compared with a gain in the S&P 500 of 2.5%. Ford shares are down 13% since Jan. 28, when the auto maker reported that rising costs of commodities such as steel and oil helped drag down its fourth-quarter profit.
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Ford Motor is among dozens of companies that reported lower profit margins for the fourth quarter of 2010.
.Companies that are dependent on raw materials to produce their goods are going to feel the biggest pinch, like Procter & Gamble and Ford, said Charles Blood, market strategist at Brown Brothers Harriman. But energy and materials companies are benefiting.
Citigroup's Ms. Browne recommends investors buy energy and agricultural stocks that benefit from higher commodity prices. Among her recommendations are Exxon Mobil, Peabody Energy and Monsanto. She says investors should avoid—or even bet against—consumer staples and consumer discretionary stocks that have to absorb or can't pass along these higher input costs in slack consumer times. On her list: General Mills, Kimberly-Clark and Kraft. Ms. Browne said that while the theme began to emerge in third-quarter earnings, "concern regarding input costs picked up materially during fourth-quarter earnings" as more and more companies reported lower margins.
The pinched margins put a damper on an earnings season that has finally delivered on revenues, which have come in much stronger than analysts have expected, in part because demand picked up faster than anticipated.
During the downturn, U.S. companies aggressively cut costs and improved productivity, allowing many of them to churn out profits even as the weak economy kept sales muted. But investors were worried that the cost-cutting would have its limits, and that longer-term growth could really only be sustained by revenue growth.
According to Brown Brothers Harriman, 71% of S&P 500 companies reporting so far have beaten revenue expectations this earnings season, compared with the usual rate of about 60%. Revenue has grown an average of 9.8% in the fourth quarter, significantly outpacing estimates of 3.8% growth.
"It tells me that end demand is stronger than what analysts had expected, and that's a very healthy sign that there's more to the profits recovery than just cost-cutting," says Priya Hariani, U.S. equity strategist with Bank of America Merrill Lynch. Ms. Hariani says she is unfazed by the shrinking margins, adding that worries are being stoked by "a handful of companies making headlines." She says current margins are sustainable. Interest rates are low, as are corporate borrowings and corporate-tax rates, she says.
While wages have started rising—up 0.4% in January, according to the Labor Department—they remain low, she notes. And large swaths of the S&P 500 are commodity producers, which benefit as commodity prices rise.
"There are some pockets of the S&P 500 that get pressured, including retailers and food-product companies, but net-net, S&P 500 commodity input costs are low," she says. "What I think this will do is, you won't see the same rapid pace of margin expansion, but it doesn't mean we'll see any meaningful margin contraction."
Goodyear Tire & Rubber still managed to please investors worried about profit margins. The tire-maker posted a loss, but saw its stock jump 14% after the company said it would ramp up production and is ready for 25% to 30% increases in raw-material costs, including for natural rubber.
"Higher raw-material prices are the most significant challenge facing our industry today," Goodyear Chief Executive Richard Kramer said. "Commodity prices that were already high continue to increase." While Goodyear sold the same number of tires in North America in the fourth quarter as in the year-earlier quarter, sales were up 17% as consumers continued to buy Goodyear's more expensive tires.
Write to Jonathan Cheng at firstname.lastname@example.org