Top Gun FP Client Note: Why Simmering Inflation Is Poised To Knock This Market Down
NOTE: Every week I write a Client Note for my clients. For a limited time, I am allowing non-clients to sign up and receive the Client Note. You can sign up at the top right hand corner of the website. I will also be posting the notes on my blog with a time delay from time to time.
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Gross margin decreased 190 basis points due to higher commodity costs. Higher year-on-year commodity cost reduced gross margin by 160 basis points. For perspective, on a weighted average basis, spot prices for our key materials and energy inputs are up more than 20% versus last year’s levels.– Jon Moeller, CFO, Procter & Gamble, Earnings Conference Call, January 27Accelerating and significant food cost inflation negatively impacted our customers’ purchasing budgets, contributed to increased gross margin pressure and meaningfully increased our selling expense.– Bill DeLaney, CEO, Sysco, February 7
Since the March ’09 bottom, the DJ-UBS Commodity Index – an index of 19 commodities – is up more than 60%. More than half of that gain has been in the last six months during the run up to and follow through from the Fed’s announcement of QE2.
One of the negative surprises from fourth quarter earnings has been the dent made by increased commodity costs.
Two Thursdays ago, Procter & Gamble’s stock sold off 3% when it announced a 2% decrease in gross margin in the fourth quarter compared to the year ago period as a result of higher commodity costs. On the conference call, CFO Jon Moeller said higher commodity costs will cost them $1 billion after-tax this fiscal year – $500 million more than they expected six months ago (Also see “P&G Profits Hurt By Rising Materials Costs”, The Wall Street Journal, January 28, B4).
Let’s look into this a little closer. P&G has about 3 billion diluted shares. $500 million works out to 17 cents a share. Analysts are forecasting $3.98 EPS for the fiscal year ending June 30, 2011. P&G earned $3.67 in fiscal 2010. 17 cents destroys more than half of their profit growth. This makes a difference when valuing a stock.
Yesterday morning (Monday), restaurant wholesaler Sysco (SYY) – a $16 billion, S&P 500 company – reported a similar problem. Gross margin declined 50 basis points on higher commodity costs. It might not seem like a lot but it knocked 5 cents (10%) off their after tax earnings (42 EPS excluding special items). Sysco shares dropped 6% on heavy volume yesterday
Based on reaction to these reports, it would seem that analysts have not factored rising commodity costs into their earnings estimates. Jack Ablin, Chief Investment Officer at Harris Private Bank, made this point yesterday on CNBC.
Last Thursday, The Wall Street Journal ran an important story on some companies that are stocking up on commodities to get ahead of what they expect to be higher prices in the future. For example, spice maker McCormick (MKC) – a $5 billion, S&P 500 company – and its customers are stocking up on spices (“Fearing Inflation, Firms Stocking Up”, The Wall Street Journal, February 3, C1).
In addition to rising commodity prices, interest rates are going up. On Friday, the 10-year treasury broke through resistance at 3.50% and is currently at 3.68%. Higher interest rates discourage individuals and companies from borrowing. It can also cause problems for overleveraged individuals and businesses.
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Positive economic sentiment has helped drive investor appetite for global equities to its highest level in 3 1/2 years, according to the BofA Merrill Lynch Survey of Fund Managers for January.A net 55 percent of asset allocators say that they are overweight global equities, the highest reading since July 2007. It represents a significant increase from December when a net 40 percent was overweight the asset class.
Behind this rise is growing confidence in the global economy and corporate profits. A net 55 percent of investors expect the world’s economy to strengthen in 2011 with 39 percent predicting “above trend” growth in the coming 12 months, the highest reading since the question was introduced in February 2008. A net 57 percent believes that corporate profits will rise 10 percent or more this year, up from 45 percent in December.
– BofA Merrill Lynch Fund Manager Survey Finds Surge In Support For Equities, January 18
The bullishness I wrote about in December has only increased in the last two months (“Top Gun FP Client Note: A Bullish Consensus For 2011”, Top Gun FP, December 27, 2010). According to the most recent BofA Merrill Lynch Fund Manager Survey, professionals are the most overweight global equities since July 2007.
I – along with many others – got faked out by the Egypt selloff two Fridays ago. I thought that was the beginning of an overdue correction (“Top Gun FP Client Note: Rebellion In The Land Of The Pharaohs”, Top Gun FP, January 31). As it turns out, the S&P is up 5 of the 6 trading days since then to new 2 1/2 year highs.
This has roused the bulls to further paroxysms of euphoria. After the S&P broke through 1300 last Tuesday, Cramer excoriated the bears. Yesterday on TechTicker, James Altucher said “the market is clearly going higher”.
The return of inflation could be the catalyst that pricks an overly bullish stock market consensus.
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