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The potential for a decline in corporate profitability is growing for the investors and analysts tracking USA Inc.
It’s not hard to see why. The mention of “inflation” or “scarcity” in the S&P 500 profit transcripts this quarter was at its highest level since at least 2010. Costs are rising and the supply chain has been affected by supply chain disruptions due to rising demand.
Investors are concerned about how long companies can turn such a high percentage of their sales into profits, and what that means for stock markets that are at record highs. And the warnings penetrate.
Brown-Forman, owner of Jack Daniel’s, said glass shortages this week, higher prices for agave used to make tequila, tariffs and a number of supply chain issues contributed to a 70 basis point decline in quarterly gross margins.
And it’s not the only one. Campbell Soup, Clorox, Colgate-Palmolive and others have seen margin pressures as a number of issues continue to turn the American companies’ supply chain upside down.
Adherence to deadlines in maritime shipping is catastrophic. According to global logistics company CH Robinson, the chance that a ship will arrive on time is 35 percent, compared to 80 percent at this time last year. The demand for air freight has exploded. Some larger terminals, such as Chicago, report delays of up to two weeks in picking up cargo. And the dire conditions at the truck front were greatly exacerbated by Hurricane Ida.
Labor shortages are also part of the problem. The job offers remain at a record level. And then there is procurement. Parts of Asia continue to be hit by the coronavirus pandemic. Vietnam has closed factories to contain the spread of the virus. The country is the second largest supplier of clothing, shoes, and travel items to the United States.
These shortages have driven up labor and production costs – a trend compounded by strong demand as Americans, filled with cash, continue to spend on goods and services.
The Institute for Supply Management’s August survey of US purchasing managers found order backlogs at historically high levels, suggesting that manufacturing is unable to keep pace with ongoing strong orders. Businesses urge customers to get to stores or websites early, or risk losing on holiday mailings.
“Think of it almost as a high season in addition to the high season,” says Bob Biesterfeld, CEO of CH Robinson. “There is tension everywhere in the system.”
US companies have so far managed to protect their margins by cutting costs wherever possible and passing higher prices on to customers.
With the majority of the S&P 500 companies reporting results, the “mixed” – a mix of actual and expected margins – net profit margin for the second quarter is 13.1 percent, according to data provider FactSet. If so, it will be the highest record since 2008.
This helped spur 90.8 percent year-over-year EPS growth for the quarter. If this is sustainable, it would be the strongest quarterly growth since the end of 2009. In the same quarter, sales showed the strongest growth since 2008 with an increase of 25.2 percent.
Such performance has helped the S&P 500 make seven consecutive monthly gains that have risen the blue-chip index 20 percent so far this year.
According to FactSet, analysts currently expect EPS and net profit growth of 28.1 percent and 12.1 percent for the current quarter and 42.6 percent and 12.4 percent for the full year.
The question now is how much the margin warnings will affect stock performance. Further risks for the market include a decline in US consumer sentiment to its lowest level in almost a decade, fueled by concerns about the delta variant and inflation, monetary policy changes and the threat of higher corporate taxes.
The decisive factor will be how well the companies are positioned to continue to pass on the higher costs. Some, like McDonald’s and Chipotle, were better able to do this.
“Margins are likely to shrink, but not in a meaningful way,” argues Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. “If margins are shrinking and looking like they happened before the pandemic, it won’t have a major negative impact on markets in general.”
But the ability to pass on costs can become more difficult as the business cycle turns. “Only later in the cycle, when we see earnings slow as we slide into recession, do we see margins actually increase significantly,” says Patrick Palfrey, senior equity strategist at Credit Suisse.
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