April 15, 2024

Fundamentally: Beyond the Surge in Corporate Profits

EARNINGS season got under way last week, and at first glance it seemed as if nothing had changed.

As was the case throughout 2010, a vast majority of companies that reported their results beat Wall Street’s estimates — and companies in commodity-oriented sectors like energy posted some gaudy numbers. And for the sixth quarter in a row, profits among companies in the Standard Poor’s 500 index are on track to post double-digit growth.

But that’s about where the similarities end.

For starters, “the easy comparisons are over,” said John Butters, senior earnings analyst at FactSet. He noted that earnings growth exceeded 30 percent for five consecutive quarters partly because profits had sunk so low in the miserable years that preceded them.

Today, “earnings are pretty much back to where they were before the financial crisis,” Mr. Butters said. S. P., in fact, now estimates that S. P. 500 operating profits will likely grow to a record $96.59 a share, up from the previous peak of $87.72 in 2006. Because there have already been such big gains, first-quarter profits are expected to have risen by a more modest 15 percent.

Moreover, many of the tail winds that drove earnings growth in 2010 — like disinflation, low interest rates and aggressive cost-cutting that reduced jobs and bolstered productivity — are either gone or nearing an end.

That’s why market strategists say investors should look past the still fairly rosy profit expectations and focus instead on several important trends.

Start with revenue growth. This was a big concern last year, when analysts feared that much profit growth was a result of layoffs and other cost-cutting, instead of robust growth in demand.

Today, many strategists are looking at revenue in a different light. Global demand for goods and services has been strong, but a new fear has arisen. Many economists worry that increasing inflationary pressures — particularly in energy and food costs — might soon start to cut into consumer purchases.

“I’ll be looking at revenue to see if there’s any evidence of demand destruction caused by oil and other rising costs,” said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago.

He noted that with the recent increase in fuel prices, gas purchases have jumped to nearly 12 percent of total retail sales. “The last time that figure was persistently over 10 percent was in December 2007, near the beginning of the downturn,” he said. “So that’s a concern.”

Since retail sales are crucial, Jeffrey N. Kleintop, chief market strategist at LPL Financial in Boston, wrote recently that he is monitoring whether commodity prices are hurting sales at businesses driven by consumer spending.

Already, revenue among consumer companies is expected to grow at around 5 to 6 percent, slower than the 8 percent forecast for the broad market, according to Thomson Reuters. If those numbers ratchet down even further, it could be a sign that rising food and gas costs are weighing down consumers.

Of course, if inflation is truly seeping into the economy, it won’t affect only demand. It can also raise expenses, because rising energy and commodity prices would also increase the costs of raw materials for manufacturers.

So investors should also pay attention to trends in corporate profit margins. Mr. Ablin noted that gross margins for the S. P. 500 have declined to 43.7 percent from 44.9 percent last August, about the time oil prices started to climb higher. Any signs of a further squeeze in margins could start to drive down profit forecasts for later in the year.

FINALLY, strategists say, it makes sense to pay close attention to the fortunes of technology companies during this earnings season.

Why? S. P. 500 profits have recently been bolstered by fast-growing overseas sales. And tech companies derive a greater share of their sales from overseas than companies in other sectors.

The weakening dollar, which has lowered the price of goods sold abroad, has helped to improve those numbers. But much of that can be attributed to robust economic growth in emerging economies like China, strategists say.

Yet central banks in many emerging markets have begun to raise interest rates in an attempt to slow that growth and keep a lid on inflation. So if investors worry about how that might affect foreign demand, the tech sector may be the canary in the coal mine.

There’s another reason to focus on tech: the effect of Japan’s earthquake and tsunami on global sales and the supply chain. Because Japan is so important as both a buyer of tech products and a supplier of tech components, tech earnings could be affected first.

The software maker Adobe, for instance, was one of the first companies to cite Japan as a factor in its quarterly report. It lowered its guidance for second-quarter revenue by $50 million — reducing its forecast for Japanese sales by one-third after citing disruptions in that important market.

For the broader market, Japan’s problems alone aren’t likely to threaten the earnings outlook. But add them to rising consumer prices that might crimp global demand, and profit growth could slow further. And stocks may not respond well to that kind of change.  

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=fc2f9d150785958e3bcc224f7a87ef91

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