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Earnings results so far show companies are effectively navigating supply issues and rising costs


We are half way through the third quarter earnings season and we have two important catalysts. 

  1. The demand is high.
  2. Companies are learning how to deal with supply-chain and cost inflation, which are both major headwinds. 

Sometimes, disruptions in supply chains have caused serious damage. Tim Cook, Apple’s CEO, stated that supply chain problems had caused $6 billion in losses. This was due to chip shortages and manufacturing delays related to COVID.

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

So far, there’s a lot to be happy about in terms of earnings.  Here are some bright spots

In almost every sector, there is high demand.  

Michele Buck, Hershey’s CEO, says: “We will raise both sales and earnings guidance in 2021 to reflect increased consumer demand across all markets, an improved fiscal outlook, and optimized brand investments, which collectively are expected to exceed higher supply chain costs, inflation, and tax outlook.”

The same goes for 3M. It is closely monitored because its sales span many industries (industrial and transportation electronics), as well as being among the most diverse industrials in America (less than half the U.S. sales).

Mike Roman, CEO of MMM, summarized quarter for corporate America by saying, “End Market Demand remains strong and we have 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.”

Although profit margins may be lower than expected, they are not significantly less. 

Operating profit margins in the second quarter were at historic records: 13.5%.  At 13.0%, the previous (first) quarter saw the second-highest profit margins.

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.

This is what worries about earnings

Earnings growth continues to be strong but it isn’t as strong as last year.  Companies are less likely to beat estimates and, most important, they’re not beating as often as in the first half.

According to analysts, companies have outperformed estimates by 10%.  While this beats the historical average of about 5% but is still well below the 20% for the first quarter and the 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. 

According to Refinitiv, the earnings forecast for fourth quarter is now at 22.9%.  This is still a healthy estimate, however it’s not as high as the 21.7% analysts expected a month ago.

Strong demand growth led analysts to raise their forecasts in the third and fourth quarters.  However, although demand continues to be strong analysts aren’t rushing to revise their estimates as fast as they did earlier this year.

It seems that analysts are not as surprised by corporate America as they were in the first quarter of this year. Wall Street was shocked at the extent of the recovery’s strength.

This is what’s currently 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?

Can companies raise prices forever? 

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.   Why did they go up? 

Profit margins can be described as the earnings multiplied by revenue.  Margin growth is mainly due to the fact that profits have grown faster then revenues. 

While revenues have increased, costs haven’t gone up as significantly so higher revenues can be attributed to the bottom line. 

Silverblatt said that revenue is up due to both price and sales increases. Silverblatt said, “Companies have it both ways.”  While sales are rising, companies are raising their 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.”

At the moment, prices that are higher than expected aren’t being met with great resistance.  MMM’s CFO Monish Paolawala said that margins were at 20%, which is higher than the range of 19%-20% that was expected. He also stated that the company continued to increase prices.

Sherwin-Williams reported similar problems, but their margins did not improve due to higher raw material costs. They also had difficulty procuring the raw materials which resulted in lower sales. 

John G. Morikis, the CEO of Morikis, said that margins would rebound. “We continue price increases across our business to offset higher material costs and we are confident margins can recover once inflation headwinds 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. According to Nick Raich, Earnings Scout’s analyst, the impact of these disruptions will not be as severe or significant than anticipated.  Raich pointed out that the 2022 estimate had started rising which he considers a sign of a tightening supply chain.

Is the fourth quarter the tipping point for labor and supply chain worries?  

Supply chain problems include a shortage in semiconductors, high commodity prices, and congestion at ports.

These issues may be related, but they are all separate and each one has its own resolution timeline.

 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.”

Hatzius stated in a note addressed to clients that the September end of the emergency unemployment insurance will also help with the labor shortage.

 A third problem — the congestion at U.S. ports — may take longer to address.  Hatzius is of the opinion that the complete elimination of congestion may not occur until the second quarter of 2022.

Hatzius stated that “the slower resolution of supply constraint means that year on year inflation will be higher than we had expected in the immediate aftermath” of tapering.

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. These indices are now lower than their May peak, but we have reason to be optimistic.

Tim Cook, Apple’s CEO, also pointed out that they were distinct issues.  Cook stated that “The COVID-related manufacturing disruptions” have greatly improved, according to CNBC’s Josh Lipton.  “Chips shortages persist.”

Are tech problems a real 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.

The core of disappointment remains supply chain problems, which will likely abate. Webush analyst Dan Ives stated in a note shortly after Apple’s earnings that “It is not a demand problem but a supply problem that continues to remain the elephant in the Room for Apple and all other tech/consumer players heading into holiday season…We view this as temporary and does not impact our long-term bullish outlook.”