A New Worry for Earnings Season?

SMITH BRAIN TRUST – For corporations and stock analysts, there’s plenty to fret about these days.

There are rising labor costs from a notably tight job market. There is sputtering growth in Europe and Asia. And there’s that disquieting U.S.-China trade war. And all of those factors are conspiring to weigh on earnings per share.

But on the minds of some analysts as second-quarter earnings season gets under way is a different worry: The potential for contracting profit margins.

“It’s tense,” says David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business. “Profit margins are a leading indicator – a canary in the coal mine.”

The metric most talked about and most worried about during earnings season is earnings per share – not profit margins. But a squeeze in the profit margin can reveal a lot – a deceleration in the growth of corporate profits, or perhaps portending a decline.

“Profit margins are very important to analysts,” says Kass. “They look to profit margins to determine whether a company is becoming more efficient or less efficient in producing whatever it is that it sells.”

“It all boils down to that simple equation – revenue minus costs equals profit.”

Lately, companies have been warning the second quarter was less than ideal. More than 80 companies in the S&P 500 have cautioned that Q2 financials may fall short of initial forecasts.

As an example, Apple is expected to reveal a 14.7% drop in second-quarter profit margins when it posts its earnings on July 30.

“The bottom line – so to speak – is that you want to see a company increase its profits and free cash flow over time. And the profit margin does show how efficient a company is in achieving that goal,” Kass says. “Of course when it starts going the other way, as may be the case in the current situation, that indicates increasing cost pressures and shrinking margins, which may lead to a reduction in profits over time.”

Profits may still be increasing, even when a profit margin slims down – for example, when there is an increase in sales.

“I am not expecting a recession,” Kass interjects. “I’m not expecting corporate earnings to fall off a cliff, as they might in a recession.”

The rate of growth might be slowing, he says. There might even be a decline from one year to the next in a given quarter, But I don’t think it necessarily implies that the expansion is over.”

He notes that the Federal Reserve Board is expected to inject monetary policy stimulus into the economy, if it trims interest rates as expected by 25 basis points at the end of July. “That should offset at least part of the projected slowing in the economy.”

If it doesn’t, if profit margins continue to contract, and if the economy expands at an even slower rate, he says, further rate cuts could follow. But that’s for another day.

For now, Kass says, he wants to add one more point.

“Every recession that the United States has experienced since World War II was preceded by the Federal Reserve raising interest rates too far, too fast, from much higher levels than the current levels,” he says. “The Great Recession of 2007-9 was also caused by too much debt in the housing sector. It’s possible for a recession to start for other reasons. However, I believe that is unlikely in the near future.