Profit margins may be starting to erode because of rising costs

Trader Talk

Rising costs and lower prices are beginning to eat into profit margins.

Analysts and strategists are puzzling over an unusual development: 2019 earnings estimates are dropping fast — they are down to a measly 0.5 percent for the first quarter, but revenue estimates are barely changed at 5.6 percent.

The likely explanation: a combination of higher costs and — in some cases — pricing pressure that is eroding profit margins. This is not trivial: Profit margins have been high (above 10 percent) for years, as corporations successfully cut costs and then as the economy expanded higher revenues also increased margins.

That may be beginning to change.

Margins can decline for several reasons: currency fluctuations, higher interest rates, or lower prices for goods that are sold, for example. But higher costs are often a prime suspect.

A good example: Church & Dwight, maker of Arm & Hammer banking soda, which said this week it had seen higher costs from commodities and transportation, as well as tariffs. Though the company had raised prices, it was not enough to offset margin erosion; the stock was down 8 percent. The company is hopeful it will be able to offset the higher costs with more productivity and higher prices.

One factor that can be ruled out: tax reform. David Aurelio, who watches earnings in the S&P 500 for Refinitiv, noted that earnings growth is flat even if you examine pretax profit: “Flat earnings growth in 19Q1 isn’t due to tax reform,” Aurelio told CNBC. “Based on what I can see, increased costs seem to be the driver.”

This makes sense: Already we have seen many companies cite increased costs as an issue, including Harley-Davidson, Caterpillar, Eastman Chemical, Fortune Brands Home and Ford, which cited higher costs from tariffs, increased commodity costs unrelated to tariffs, and an unfavorable exchange.

Lower prices due to competition are also an issue in some industries. Among the top 10 contributors to earnings drags so far reported, the majority are technology stocks, particularly semiconductor and semiconductor equipment companies like Micron, Nvidia and Applied Materials.

“The semiconductors are experiencing pricing pressures, which would explain the margin pressure and they may also be in an investment cycle, which would add additional pressure,” Aurelio said.

Other companies that have seen large drags on earnings are in the materials and energy space, such as Freeport McMoran, Exxon Mobil and Chevron. These, too, have suffered from declining prices in their respective industries.

Not surprisingly analysts have notably cut earnings estimates in all these sectors in the last few weeks, which is what has contributed to the precipitous decline in first-quarter estimates.

But have the earnings cuts gone too far? “The trauma of December and the fear of a global slowdown have made analysts much more aggressive in cutting estimates,” said Lindsey Bell, who tracks earnings for CFRA.

“We don’t appear to be going into a recession, and inflation is still sub-2 percent,” she said.

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