Feb 15, 2011
Earning Reveal Troubling Trend for 2011
By Andrew Mickey, Q1 Publishing
One of the big themes of 2011 is starting to be felt.
This earnings season has revealed margins are getting squeezed across a number of industries.
Rising food, oil, and metals prices are cutting into bottom line earnings. Some high-profile industry leaders are missing Wall Street’s low-balled expectations. And the costly trend, which could be the catalyst for the next correction, is only going to get worse.
But investors willing to realize it and make the right moves now are going to see it as an opportunity for a number of reasons.
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Margin Squeezing
Business costs can be divided into three main groups: goods, labor, and money.
The cost of goods includes raw materials, equipment, and everything needed to run a business.
The cost of labor includes salaries, bonuses, healthcare, training, etc. Even though high unemployment has kept a lid on wage increases, a lot of companies are still trying to do more with less. As a result, many are getting hit with unexpected overtime costs.
The cost of money is the borrowing costs. Now that we’re at the relative top of the long-term bond bubble, interest rates and borrowing costs are very low. Over the last few months that has changed for the worse. Mounting inflation pressures and bond bubble deflation have pushed long-term interest rates and borrowing costs up.
Meanwhile, as costs rise, the economy is stagnant and demand is still low for many goods and services. As a result, a time will come when these rising costs cannot be fully passed onto customers. This earnings season has shown that’s starting to happen.
The Canaries in the Marginal Coal Mine
This week a few leading companies served as perfect examples of what rising costs can and will do to share values:
Ingersoll Rand (NYSE:IR) –investors got a perfect example of how costly the margin squeeze can and will be when Ingersoll Rand reported earnings last week.
Ingersoll Rand is an industrial conglomerate with a big cooling systems business. It’s a huge consumer of raw materials including copper, aluminum, and other metals and is highly susceptible to margin squeezes from rising commodity prices.
When it reported its most recent results, the headline numbers were pretty solid overall. Sales were up 13%. Net earnings were up more than 50%.
Its margins, however, told a much different story. Its operating margin fell from 22.1% in the previous quarter to 17.9%.
The declining margins sent shareholders running for the exits. Ingersoll shares fell 6% immediately following the report.
Sara Lee (NYSE:SLE) – The maker of Jimmy Dean sausage and Ballpark Franks reported last week that food prices increases are starting to have a significant impact on its bottom line.
In its latest quarterly report, Sara Lee reported sales were basically flat compared to the same period last year at $2.35 billion for the quarter. It also said raw material costs increased by $127 million.
The increased costs turned a mediocre quarter into a bad one. The cost surge pushed net earnings (after one-time events) from 27 cents down to 24 cents per share in year-over-year terms.
The only reason Sara Lee shares didn’t slide (yet) is because management expressed confidence in their ability to pass on increased costs to customers. As consumers’ grocery store bills continue to climb though, we have to wonder whether price increases will be as easily absorbed as Sara Lee is predicting.
Cisco Systems (NASDAQ:CSCO) – the networking giant posted quarterly earnings last week and results were mixed once again.
Sales and profits were up and margins were squeezed.
Cisco’s gross margin, which incorporates all the costs of producing all the equipment that makes the Internet work, fell from 64.5% to 60.2%.
The declining margins were so significant Cisco management promised to form a “working group” to explore ways to improve margins.
The news sent Cisco shares down nearly 10% and cutting Cisco’s market value by more than $10 billion.
Clearly, there’s a big problem for companies going forward. Sales are increasing, costs are increasing faster, and margins are getting squeezed.
More importantly, these margin squeezes are indicative of a much bigger systemic problem – stagflation.
Sidestepping the Margin Squeezes
Margin squeezes can and will be costly to investors. Continuous cost increases will steadily drag down earnings. Share prices will follow.
With the exception of technology companies which have significant pricing power and can often pass on increased costs, now is the time to avoid companies that process raw materials into finished goods.
Their sales may be rising but their costs are rising even faster. This is a mix that rarely produces excess returns for investors.
However, one company’s margin squeeze is another company’s margin gain.
Over the coming year we’ll likely see elevated commodity prices and steadily rising earnings for commodity producers. Producers of timber, copper, and agriculture commodities have been posting earnings as big as they were in 2008 if not higher.
While margins get squeezed in some industries, others are going to be expanding.
Look to the expanding margins for where to put your investment dollars at work. For where margins are expanding, earnings, and investment returns usually follow.
Good investing,
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
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