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The potential for a squeeze in corporate profitability is starting to loom larger for the investors and analysts who track USA Inc.
It’s not hard to see why. Mentions of “inflation” or “shortage” in S&P 500 earnings transcripts in the second quarter reached the highest level since at least 2010. Costs are rising, and supply chain disruptions have hit the supply of goods as demand for them increases.
Investors are concerned about how long companies will be able to turn such a high portion of their revenue into profits and what that means for stock markets that are at record levels. And the warnings are trickling in.
Brown-Forman, owner of Jack Daniel’s, said this week glass shortages, higher prices for Agave used to make tequila, tariffs and an assortment of supply chain issues contributed to a 70 basis point contraction in quarterly gross margins.
And it’s not the only one. Campbell Soup, Clorox, Colgate-Palmolive and others have flagged margin pressures as corporate America’s supply chain continues to be upended by a litany of issues.
Schedule reliability in ocean shipping is abysmal, with a 35 per cent chance a vessel arrives on time, compared with 80 per cent this time last year, according to global logistics company CH Robinson. Air freight demand has skyrocketed. Some larger terminals like Chicago are reporting delays of up to two weeks for cargo collection. And dire conditions on the trucking front have been severely exacerbated by Hurricane Ida.
Labour shortages are also part of the problem. Job openings remain at record levels. And then there’s sourcing. Pockets of Asia continue to be ravaged by the coronavirus pandemic. Vietnam has closed factories to arrest the spread of the virus. The country is the second-largest supplier of apparel, footwear and travel goods to the US.
These bottlenecks have driven up labour and input costs — a trend exacerbated by strong demand as Americans flush with cash continue to spend on goods and services.
The Institute for Supply Management’s August survey of US purchasing managers showed a backlog of orders that remains at historically elevated levels, signalling production is unable to keep up with continuing strong new orders. Businesses are telling customers to hit stores or websites early or risk losing out on holiday shipping.
“Think of it almost as peak season on top of peak season,” says Bob Biesterfeld, chief executive of CH Robinson. “There is strain everywhere in the system.”
US companies have thus far managed to protect their margins by reducing costs where they can and passing higher prices on to customers.
With the bulk of S&P 500 companies having reported results, the “blended” — a mix of actual and expected margins — net profit margin for the second quarter for them is 13.1 per cent, according to data provider FactSet. If that holds, it will be the highest on records going back to 2008.
That has helped propel a 90.8 per cent year-on-year EPS growth for the quarter. If that is sustained, it would mark the strongest quarterly growth since the end of 2009. Over the same quarter, revenues are on track for the strongest growth since 2008 with a 25.2 per cent increase.
Such a performance has helped the S&P 500 chalk up seven consecutive monthly gains that have left the blue-chip index up 20 per cent so far this year.
Analysts have currently pencilled in EPS and net profit growth of 28.1 per cent and 12.1 per cent respectively for the current quarter, and 42.6 per cent and 12.4 per cent respectively for the full year, according to FactSet.
The question now is how much the warnings on margins will affect stock performance. Other risks for the market include a drop in US consumer sentiment to its lowest level in almost a decade, fuelled by worries about the Delta variant and inflation, monetary policy changes as well as the threat of higher corporate taxes.
The key will be how well placed companies are to continue to pass on higher costs. Some, like McDonald’s and Chipotle, have been more able to do so.
“Margins are likely to contract, but not in a meaningful way,” argues Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. “If margins contract and look like they did pre-pandemic, that won’t have a huge negative impact on markets more broadly.”
But the ability to pass on costs may get harder if the economic cycle turns. “It isn’t until later in the cycle where we see revenues begin to decelerate, as we begin to head into a recession, that we see margins actually roll over in a meaningful way,” says Patrick Palfrey, senior equity strategist at Credit Suisse.
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