Written by Brenda Nakalema

Earnings Season Might Mean Shrinking Profit Margin for Stocks

Second-quarter earnings season will be a true test of which companies are the strongest and which will be recession-proof. Just …

Second-quarter earnings season will be a true test of which companies are the strongest and which will be recession-proof. Just like their customers, companies are also affected by inflationary pressure, and their historically high corporate profit margins are at risk from rising costs this earnings season.

Within a high inflation environment, revenue growth isn’t difficult to guarantee. Prices are increasing everywhere, and businesses and consumers are bracing for a big shock. Companies can grow their profits by simply increasing their prices, without necessarily needing to sell more units.

However, input costs such as raw materials, transportation, wages, and others are on the rise as well. The companies most likely to survive are the ones that can increase their selling prices faster than suppliers increase theirs. That is the real definition of pricing power.

“With margins under attack, profitability will be increasingly important,” said a John Hancock Investment Management Co-Chief Investment Strategist, Matt Miskin.

Second-quarter results over the next month- covering April, May, and June period- will be quite telling. That period saw a massive increase in oil and other commodity prices, rising wages every month, a climb in interest rates, and continuing supply-chain bottlenecks that increase the cost and complexity of daily operations.

According to Credit Suisse’s head of U.S. equity strategy, Jonathan Golub, S&P 500 revenue is expected to increase 10.3% year over year in the second quarter. However, earnings per share is seen rising 5.5%, suggesting a meaningful decline in the index’s overall profit margin.

“It’s going to be hard for margins not to slip, but the revenue numbers are going to be growing by double digits,” Golub added on Tuesday. “Inflation is companies raising their prices. We’ll see some of that pricing power fall as inflation falls.”

The best margin growth from the previous year’s period is expected from cyclical companies, including many of the energy and commodity producers that are witnessing the market price of their products climb. The expectation is that S&P 500 cyclical will grow revenue by 23.0% and earnings per share by 51.7%, said Golub.

That contrasts with a 4.5% increase in revenue and a 1.1% decline in earnings per share expected from noncyclical companies in the S&P 500, which contains many technology, healthcare, and utility names.

Tech giants like Apple (ticker: AAPL), Microsoft (ticker: MSFT), Alphabet (ticker: GOOGL), Amazon.com (ticker: AMZN), Meta Platforms (ticker: META), and Nvidia (ticker: NVDA) are a few of the companies with margin concerns this earnings season. Revenue for these tech giants is expected to grow by 7.6% year over year, while earnings per share is seen dropping by 4.3%.

The heavyweight in the S&P 500 makes the expected contraction noteworthy for the index as a whole. Aside from those companies, S&P 500 sales are expected to increase by 10.9% and earnings per share to increase by 9.9%, according to Golub.

The remarks made by company CEOs and CFOs this earnings season regarding their expectations for margins in the second half of 2022 may have a greater impact on how their company stocks respond than the actual hard numbers they present for the second quarter. Analysts and investors might also predict the margin trend for the next six months in the reported period.

“We think company management teams will say that inflation is boosting their revenues and that the Fed’s tighter monetary policies in response to inflation aren’t depressing their unit sales so far,” said Yardeni Research president Ed Yardeni. “That would explain why analysts have been raising their revenue estimates. Analysts also have been raising both their earnings estimates and with their revenues estimates, implying that overall profit margins are holding strong and not getting squeezed by rapidly rising labour and material costs or by labour and parts shortages. So it will be intriguing to see whether that’s actually been the case during Q2.”

Currently, the S&P 500’s forward profit margin stands at around 13.3%, a near-record high and where it has been since the end of last year, according to Yardeni.