Can Margins Remain Strong? - Ahead of Wall Street

Wednesday, May 14, 2014

A somewhat hotter than expected wholesale inflation reading and a couple of mixed earnings reports provide the backdrop for today's stock market action. The wholesale inflation report doesn't necessarily mean that the retail inflation number CPI coming out on Thursday will show similar spike, though some signs of inflationary pressures will not necessarily be bad. The bond market's tepid reaction to today's PPI report shows that it isn't overly concerned about the inflation situation, at least not yet.

On the earnings front, we got reports from Macy's M and Deere & Co DE this morning, while Cisco CSCO will report after the close. Deere's earnings and revenues were below the year-earlier level, though effective cost controls helped the farm-equipment giant beat top- and bottom-line estimates. Equipment sales were down -10% in Q1, with North American sales down -12% from the year-earlier period. Crucially, the company is guiding towards a bigger drop in equipment sales this year, with soft agricultural commodity prices weighing on equipment demand.

The Macy's report was similarly mixed, with the company beating on EPS but missing revenue estimates. Importantly, the company reiterated full-year guidance and raised quarterly dividend by 25%. Macy's has been a strong performer in the retail space, though the sector as a whole hasn't being doing that good on the earnings front. Total earnings for the 55% of the retail sector's total market capitalization that has reported Q1 results already are up +3.1% on +6.3% higher revenues, with only 39.1% of the companies coming ahead of EPS estimates.

The lack of earnings growth for the retail sector despite revenue gains spotlights the broadly promotional environment and the sector's margin challenge. Beyond retail, margins have held up strongly for the corporate sector as a whole, though today's wholesale inflation report points to challenges down the road. If companies can't pass on rising costs to consumers due to competitive pressures, it will eventually show up in contracting margins.

Corporate margins already remain in record territory, but consensus estimates expect them to steadily keep expanding, albeit at a slower pace in the coming periods. But margins have historically tended to revert to the mean and expecting them to continue expanding may not be reasonable. If we have to see earnings growth in the coming quarters, we will need to rely more on top-line gains and less on continued margin expansion.

Sheraz Mian
Director of Research