Partner Article

Don’t be alarmed by the earnings drop

by James Butterfill, equity strategist at Coutts

With about 80% of the S&P 500 index (based on market capitalisation) having reported fourth-quarter earnings, aggregate results so far have shown a disappointing 12% quarter-on-quarter decline. While this is well below consensus estimates and the greatest quarterly decline since the third quarter of 2008, it still represents annual earnings growth of 9%.

This quarter has seen substantial share buybacks, which has distorted the earnings per share (EPS) figure, essentially increasing it by about $1/share due to fewer shares outstanding. Consequently, EPS for the S&P 500 has only fallen 5% quarter-on-quarter, so the 12% drop in net income is a more accurate measure.

Crucially, sales grew 1% in Q4 ’11 (as a comparison, they fell 1% in Q3 ’08), putting the decline in earnings down to a squeeze in profit margins. To put this into context, profit margins are down from an unusually high 8.5% to 7.5%, which remains well above the historic average of 6.1%, highlighting continued health in the corporate sector. It is also important to note that the figures vary widely depending on what accounting methodology is used. Our calculation is based on US Generally Accepted Accounting Principles, or GAAP, for the majority of the earnings results.

The utilities, healthcare, financials and consumer staples sectors have seen the most significant margin squeeze. The latter have been particularly exposed to recent strength in the dollar, which hurts competiveness versus overseas rivals. By contrast, the information technology and consumer discretionary sectors have benefitted from a continued rise in margins. Meanwhile, 68 of the 77 companies that have given guidance on future sales have a positive outlook.

Company statements have highlighted dollar strength and rising raw material costs as the primary drivers of the margin squeeze. Raw material prices, which tend to have a lagged impact on margins of about a year, have been rising for the last 12 months, so it shouldn’t come as a great shock that margins have fallen. But crucially, raw material costs typically have a limited impact on margins, with labour costs being the primary driver. While labour costs have risen, they are unlikely to have a large effect on margins while the US unemployment rate remains so high. Until unemployment falls to 7%, versus the current 8.3%, this is unlikely to have a significant impact on corporate profitability. This rise in labour costs in conjunction with the recent rise in corporate productivity should be seen as confirmation that businesses are beginning to hire new staff (as reflected in private payroll figures) and the economy is on a sounder footing.

This was posted in Bdaily's Members' News section by Ruth Mitchell .