"Get Ready For Margin Collapse" Goes Mainstream
First it was "Get Ready For Higher Food Prices" going mainstream... Now, logically following, it is "Get Ready For Margin Collapse." As Zero Hedge has long been warning, the one immediate consequence of surging commodity prices as a result of endless liquidity, is a collapse in corporate margins. Now, about 6 months after we first broached the topic, it has finally hit the mainstream media. The WSJ highlights what is so obvious, it is no wonder no sellside "strategist" is willing to touch the topic with a ten foot pole: "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." But yes, aside from the painfully obvious collapse in margins, and thus plunge in net income (sorry, companies can't fire their skeleton crew workers any further) which will mean 2011 S&P 500 EPS will come far, far lower than prevailing consensus, everything is fine.. and don't forget to BTFD.
The WSJ - about half a year behind the curve:
rocter & 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.
Stunningly, the computers doing all the trading are shocked, shocked, to find out there have been unpassable price increases going on in here.
"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."
This is the token chart presented by the WSJ, which anyone who lived through 2008 could have seen coming from a mile away:
Even that permabull among bulls, Morgan Stanley is issuing warnings:
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.
Just who may Parker be envisioning? Why the pathological liars from Goldman Sachs of course, where displacing the truth by 179 degrees under the stern eye of Goebbels exhumated corpse has become a fetish.
Cue David Kostin:
Inflation is the initial topic raised by investors in every meeting. Discussion subsequently shifts in one of two directions: (a) the impact rising prices will have on profit margins and earnings; or (b) the impact higher inflation will have on bond yields and the implications for equity valuation. Both subjects are worthy topics for analysis and debate.
However, the initial premise that inflation is rising may be an incorrect assumption. Simply put, most indicators suggest inflation is falling, not rising. In 2011, the perceived risk to US equity prices from inflation vastly overestimates the actual risk, in our view. Investors should consider the historical evidence and our forecasts before finalizing portfolio decisions.
Unlike China where home prices continue to surge, most Americans would not use housing and inflation in the same sentence. Housing is critical to the consumer inflation outlook because it accounts for 41% of the basket of goods used to measure headline CPI and 49% of the core CPI. High unemployment means labor inflation pressures are also likely to remain low.
In fact, Goldman Sachs Economics forecasts most measures of inflation will decline in 2011 and 2012. We forecast Producer Price Index (PPI) for finished goods will fall on an annual basis from 4.3% in 2010 to 3.7% in 2011 and 1.3% in 2012. Core Consumer Price Index (CPI) will fall from 1.0% to 0.7% to 0.5% and the Personal Consumption Expenditures (PCE) Index willdecline from 1.7% in 2010 to 1.1% in 2011 to 0.9% in 2012.
It gets much, much worse:
Commodity prices have surged by an average of 40% during the last 12 months led by Agriculture (+60%), precious metals +50%), industrials metals (+24%) and energy (+14%). Cotton has stretched 142%, corn has popped nearly 90%, gold has rallied 23%, and Brent crude has risen 30%.
More importantly, Goldman Sachs Commodities Research forecasts prices for many commodities will fall over the next 3, 6, and 12 months. Cotton, sugar, coffee, cocoa, wheat and corn prices are all forecast to decline over the next 12 months along with aluminum, nickel and silver. However, gold, WTI crude, and soybean prices should rise (see Exhibit 3). Accelerating GDP growth, low inflation, and low interest rates will likely support a higher S&P 500.
But wait. there's more - the punchline(s):
We acknowledge many investors disagree with our forecast and believe commodities and other raw materials prices will increase in 2011. We analyzed changes in profit margins, P/E multiples, and equity returns during nine periods of rising PPI “crude materials” inflation since the mid-1970s. We focused our historical analysis on the PPI “crude materials” indicator, which is more related to commodities inflation than the PPI “finished goods” or headline or core CPI indicators.
The intuition of many portfolio managers is that inflationary pressures will likely weigh on margins. However, the historical evidence does not support this view. Operating margins actually expanded by an average of 13 bp during episodes of PPI “crude materials” inflation. Technology and Materials registered the greatest margin expansion while Energy margins experienced the sharpest margin contraction.
Hold on to your hats:
We forecast S&P 500 margins in aggregate will rise in 2011 and 2012 by 30 bp and 20 bp, respectively (from 8.5% to 8.8% in 2011 to 9.0% in 2012). Actual margin changes will differ by sector and by company. We expect margins this year will be 109% of the previous high reached in 2008 with Information Technology posting the strongest gains. We expect margins will expand in both 2011 and 2012 for all sectors except Consumer Staples where we forecast a slight 3 bp of compression during each year. We forecast 2011 sector margins will range from 62%-111% of previous highs.
Those who wish to subject themselves to the aneurism inducing masochism of reading David Kostin's complete weekly note, can do so here.
So going back from the never-never world of the Little Goldman Prince, here is what is happening in real life:
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.
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.
Luckily, the WSJ, where bonuses are not contingent on the size of the lie, has a slightly different view than Goldman:
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.
Bottom line - margins are collapsing, and whatever companies can pass them off (for now), are desperately trying to do so. Those that can't, see their stock prices plunge by 10-15% the day after earnings (see Cisco). And with the myth of recovery not really doing much for consumer purchasing behavior, contrary to repeated lies otherwise (mostly emanating from the very same Goldman Sachs) soon even Goldman will be forced to acknowledge what is an incontrvertible truth. We expect that Jan Hatzius will do so in April (with the lemming Kostin following suit shortly), just in time for the QE3 chorus to hit the 100+ dB level.
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