April 27, 2018

Earnings Roundup: Are Margins In Trouble?

by David Aurelio

The busiest week of the 18Q1 earnings season saw a storm of earnings reports from 180 S&P 500 companies. Quarterly earnings are now expected to increase 24.6% from the prior year, up 4.4 percentage points from the April 20 estimate of 18.3%. Among the positive results, concerns of inflationary impacts on gross margin and the topic of peak earnings arose.

Exhibit 1: S&P 500 Quarterly Bottom Up EPS

Peak earnings debate

Year-on-year (YoY) earnings are expected to peak in 18Q1; however, analysts do not expect to see peak earnings in the foreseeable future.

Exhibit 2: S&P 500 Average Gross Margins

Rising inflation

This week, several companies commented on a rise in material and other inflationary related costs. This sparked concerns of margin compression. However, many of these companies are able to offset these costs with higher pricing, volume efficiencies, and other tactics. As a result analysts expect to see the average S&P 500 company expand gross margins.

Illinois Tool Works Inc. (ITW.N) was one company effected by the rise in steel and aluminum prices due to the recent tariffs. However, these increases were seen as manageable. Michael M. Larsen, Illinois Tool Works Inc. – Senior VP & CFO, said the following, ”We have incorporated what we currently know about the impact of Section 232 Steel and Aluminum Tariffs and the mitigating price actions into our business plan and company guidance. We’re currently assessing the impact of proposed tariffs under Section 301. Bottom line, as we sit here today, we believe that price/cost is manageable, and we expect to continue to recover material and freight cost inflation with price on a dollar-for-dollar basis as we go through the year.” He went on to say, “We’re well-positioned to deliver strong margin expansion.”

The ability to manage inflationary cost increases was echoed by Parker-Hannifin Corporation (PH.N). Lee C. Banks, Parker-Hannifin Corporation – President, COO & Director, said the following: “Pricing for us is more than just passing through input costs. I mean, we’ve got a very strong discipline in this company on how we do things when it comes to price. But we’re definitely in a period of inflationary costs throughout the supply chain. And it’s not the first time we’ve been here before. I mean, we’ve been through several cycles before in the past where this has happened. But I will tell you, first and foremost, this is not contributing to the North American margin incrementals. I mean, I think one way you can look at that is the nice margin accretion we had in International and in Aerospace is just some indication that price costs — our process is recovering price costs.”

Although inflation costs have risen, which could dampen available cash flow, CapEx still looks to be strong.

Exhibit 3: S&P 500 YoY CapEx

CapEx spending

Investors have been waiting to hear if tax reform and global growth would translate into increased CapEx spending. Analysts currently expect 18Q1 CapEx to increase 26.5% from the prior year. The information technology (60.3%) and energy (35.5%) sectors are expected to see the largest increases while the real estate (-28.1%) sector is expected to see the largest decline.

The industrial machinery sub-industry is expected to benefit from increased CapEx spending and increase YoY 18Q1 earnings by 22.5% and revenue by 11.6%. Both Illinois Tool Works and Parker-Hannifin had positive macro outlooks.

Lee C. Banks, Parker-Hannifin Corporation – President, COO & Director, said, “On the industrial side, I have to tell you, if I look at all our heat maps, it’s really hard to find an end market that’s not accelerating. We continue to find significant markets that have had year-over-year growth and continued to grow during the quarter. All the natural resource end markets continued to grow during the quarter. This includes agriculture, construction equipment, mining, oil and gas, to name some. And on the oil and gas, the land base is really backed very strong. And we’ve also seen, for the first time, some increased activity in offshore activity.”

Scott Santi, Illinois Tool Works Inc. – Chairman, President & CEO, said, “CapEx-related demand continues to strengthen in a number of our end markets, which is driving accelerated organic growth in our Test & Measurement and Electronics and Welding segments.”

As more companies report investors will look closely to see if inflationary costs are a threat to margins and if CapEx spending can continue to grow.

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