Halfway through third-quarter earnings season, and there are two key catalysts:
Demand is strong. Cost inflation and supply-chain issues are the main headwind, but companies are learning to navigate through them.
In some cases, supply chain disruption has taken a serious toll. Apple CEO Tim Cook said supply chain issues had cost the company $6 billion, driven by chip shortages and COVID-related manufacturing disruptions in Southeast Asia.
The major issues debated among investors watching earnings: Are supply chain and cost inflation issues peaking, and how long can corporate America keep raising prices?
Earnings: the good, the bad, and the ugly
There’s much to like in earnings so far. The bright spots:
Demand is strong in almost all sectors.
Here is Hershey’s CEO Michele Buck: “We are raising both sales and earnings guidance for 2021 to reflect elevated consumer demand across markets, an improved tax outlook and optimized brand investment, which, collectively, are expected to more than offset higher supply chain costs and inflation.”
It’s the same story at 3M, which is closely watched because it sells across many industries (industrial, transportation, electronics, health care, office supply) and is among the most geographically diverse industrials (less than half of sales in the U.S.).
MMM CEO Mike Roman summarized the quarter for most of corporate America when he said, “End market demand remains strong, and we navigated supply chain disruptions.”
The September Institute for Supply Management report noted that sentiment among manufacturers was “optimistic” due to the high level of demand for goods: new orders increased, inventories remained at low levels, and the backlog of orders stayed “at a very high level.”
Profit margins are lower, but not dramatically so.
Operating profit margins in the second quarter were at historic records: 13.5%. The second highest profit margins ever recorded were in the prior (first) quarter, at 13.0%.
Right now, third quarter blended profit margins for the S&P 500 is at 12.5%.
“That is a lower number than the prior quarter, but it is still close to historic highs,” said Howard Silverblatt, senior index analyst for S&P Dow Jones Indices.
Here’s what’s worrying about earnings
While earnings growth remains strong, it is not nearly as strong as the first half of the year. Fewer companies are beating estimates, and most importantly they are not beating by as wide a margin as they have in the first half.
For example, the companies that have reported so far have beaten analyst estimates by about 10%. This is above the historic norm of about 5%, but well short of the roughly 20% beat for the first and second quarter.
More worrisome is the fact that estimates for the quarter we are in now — the fourth quarter — are not being raised nearly as much as had been in the prior quarters.
The earnings estimate for the fourth quarter now stands at 22.9%, according to Refinitiv. That is still healthy, but not much above the 21.7% that analysts were anticipating a month ago.
In the first and second quarter, analysts were raising estimates much more aggressively in the forward quarter due to strong demand growth. While demand is still strong, analysts are not rushing to raise their estimates as aggressively as they had earlier in the year.
This suggests that corporate America is not surprising analysts nearly as much as they had in the first half of the year, when many on Wall Street were taken aback by the strength of the economic recovery.
Here’s what’s being debated
Three issues are being debated on Wall Street: how long can companies keep raising prices, when will the supply chain/labor issues abate, and is tech a specific problem?
How long can companies keep raising prices?
S&P profit margins of 13% and higher are significantly higher than the historic average, which is 8.1% since 1993, according to S&P Dow Jones Indices. S&P profit margins began to move over 10% in 2017. What moved them up?
Think of profit margins as earnings divided by revenues. The main factor behind the margin rise: profits have grown faster than revenues.
Revenues have increased, but because costs have not gone up as much those higher revenues have gone straight to the bottom line.
“Revenues are up because both sales and prices have gone up,” said Silverblatt. “Companies are having it both ways. Sales are up, but companies are also raising prices.”
There is a limit to how far this game can go, he tells me: “These high margins cannot last, because eventually you will get resistance to higher prices, and you’ll have to invest more in the company.”
For the moment, higher prices are not being met with much resistance. For example, MMM CFO Monish Patolawala noted that margins came in at 20%, versus a range of 19%-20% expected, and that the company was continuing to raise prices.
Sherwin Williams reported similar issues, though their margins did deteriorate because of higher raw material costs and difficulty procuring those raw materials, which led to lower sales.
Still, CEO John G. Morikis said margins would bounce back: “We continue to implement price increases to offset higher raw material costs across the business and are confident margins will recover as inflation headwinds eventually subside.”
Put it all together and corporate America has Wall Street convinced that margin erosion will be modest, or that it will bounce back in 2022.
“In our opinion, we believe many investors are anticipating the supply chain disruptions and inflation will be transitory. Or, at the very least their impact(s) will be less severe than expected,” Nick Raich at the Earnings Scout said in a note to clients. Raich noted that 2022 estimates had begun rising, which he believes is an early sign supply chain and inflation worries may be moderating.
Will the fourth quarter be the peak for supply chain and labor worries?
The supply chain problem encompasses several issues, including a semiconductor shortage, higher commodity costs, a shortage of workers, and port congestion.
Each of these issues are related but independent, and may have their own timeline for resolution.
Goldman Sachs’ Jan Hatzius believes that one major supply chain issue–a shortage of semiconductors –will begin improving this quarter as many factories restart and others expand capacity next year.
This was bolstered by Ford, which said in its press release: “Semiconductor availability remains a challenge, but markedly improved from the second quarter, propelling sequential increases in wholesale shipments and revenue of 32% and 33%, respectively.”
On the shortage of labor, the September expiration of emergency unemployment insurance should also bring more people back into the workforce this quarter, Hatzius said in a note to clients.
A third problem — the congestion at U.S. ports — may take longer to address. Hatzius believes a full wind-down of the congestion will not be accomplished until the second half of 2022.
“This slower resolution of supply constraints means that year-on-year inflation will be higher in the immediate aftermath of tapering than we had previously expected,” Hatzius said.
Andrew Obin at Bank of America Securities examined the ISM Manufacturing Index data and concluded that while there are still significant shipping delays, they may be past the peak: “The number of respondents seeing lead times and input prices increase remains well above historical norms. However, we see reasons for optimism considering that these indices have fallen from the May peak.”
Apple’s Tim Cook also noted that these were separate issues. “The COVID related manufacturing disruptions have improved greatly,” Cook told CNBC’s Josh Lipton. “The chip shortages linger on.”
Is tech a problem?
Many big tech names have disappointed this earnings season: Apple, Amazon, IBM, Intel, and SNAP among them. Others have not: Alphabet, Microsoft, and Shopify all reported strong numbers.
Still, the core of most of the disappointment has remained supply chain issues which are likely to abate, as Webush analyst Dan Ives said in a note immediately following Apple’s earnings: “It’s not a demand issue but a supply issue that continues to be the elephant in the room for Apple and every other tech/consumer player heading into holiday season…we view this as transitory and in no way impacts our long term bullish view.”