Last issue we discussed how revenue results for S&P 500 companies were not meeting or exceeding estimates nearly as much as earnings were. This raised concern despite the S&P 500 posting near record earnings in the third quarter of 2011 with fourth quarter expectations for record highs.
Now that more than 400 companies in the S&P 500 have reported earnings for the quarter we can get a better handle on results and better yet, profit margins. When earnings growth is stronger than revenue growth it means companies are slashing their costs to boost profit margins, this is not a positive and represents a short-term fix.
We saw a lot of this in 2008 as the economy tumbled into recession. However, that can only be done until the point of maximum cost efficiency, thus leading to revenue growth as the only option to build earnings.
The good news is despite not surpassing estimates as frequently as earnings, fourth quarter revenue growth exceeded that of earnings. S&P revenue grew by 11 percent while earnings were up 7 percent (Interestingly, excluding Apple growth was 10 percent and 3 percent, respectively).
What makes things convoluted is that profit margins contracted in the fourth quarter. In fact, every sector outside of technology saw a decline in profit margin. (See chart)
Confused yet? I am.
Granted, profit margins could have been squeezed from companies investing in their business, i.e. increased labor costs or inventory builds.
If business costs are going up due to investment that would be a positive for the U.S. economy and show confidence is coming back amongst corporate executives. However, if costs are rising due to higher input expenses than there may be cause for concern.
Interestingly enough, it looks like both items are true. Higher input costs in the fourth quarter were reported from clothing companies to packaged food makers. General Mills is a good example; in their last quarterly report the company said “gross margin as a percent of net sales was below year-ago levels due to higher input costs…”
At the same time, U.S. non-farm payrolls were strong late in 2011 and unemployment pushed lower. So increased labor costs most likely played in the mix for U.S. companies.
For the second quarter we need to keep an eye on revenue for growth that offsets rising costs. As for the costs, we need to pay mind to where the increases are coming from. Either way it looks like profit margins may be pressed further in the second quarter, good or bad.