United States

Are higher costs hampering corporate profits?

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Source: FactSet, as of 5/5/2021

Investors are closely watching first quarter earnings to gauge the extent to which corporate profits are being impacted by supply chain issues, rising raw materials costs, and labor shortages. The S&P 500 Index has already posted 25 record highs this year, suggesting investors are unconcerned that higher input costs and labor shortages will materially impact profits. However, the number of firms that have mentioned inflation on earnings calls this quarter has risen versus the same period last year. That hasn’t happened since 2018. Prices did subsequently rise, but by less than what earnings calls suggested and by less than the year prior1.

Looking at the 75% of S&P 500 firms that have reported first quarter earnings thus far, data show that companies in aggregate have been able to increase profit margins on the back of sharply rising revenues. Pent-up demand from consumers, who have extra money in the bank thanks to massive fiscal stimulus, is helping firms regain sales momentum. And for S&P 500 companies, their large size often enables economies of scale, which means incremental sales translate to incrementally higher profits. As the chart illustrates, sales rose modestly more than expenses; however, operating margins2 expanded a full percent to 16.2% from the 15.2% seen in the fourth quarter of 2020, leading to a 38.3% spike in operating income.

We expect price increases at the retail level to become more evident in the coming quarters. Many firms — including Proctor & Gamble, Kimberly Clark, Berkshire Hathaway, and others — noted that they have, or intend to, pass along higher input costs to consumers. However, price increases would reflect in part a bounce back from the deflationary trends seen in the first half of 2020. Further, while inflation may ramp up in the near term, we see little evidence at this point to suggest runaway (structural) inflation is likely.

1U.S. Bureau of Labor Statistics
2We use earnings before interest and taxes (EBIT) to measure operating margin, compared to net income, as we believe it is a better measure of recurring earnings power.

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