Weekly Wisdom – August 10, 2023

By Hightower Great Lakes on August 10, 2023

Management Teams are Actively Protecting Margins

This S&P 500 earnings season is nearly complete with 444 out of 500 companies having reported. 79% of S&P 500 companies have beaten earnings expectations while 16% have missed expectations, and the remaining companies reported in-line results. In the run-up to earnings, the dominant theme was the artificial intelligence (AI) mania that led to soaring valuation multiples for most mega-cap technology names in the index.

Separate from AI, an increasingly visible theme this reporting season is inflation costs’ impact on pricing and volume. Input costs such as raw materials and labor have forced many S&P constituents to raise prices, which in turn are passed on to the consumer.

This trend is not new, but it’s clear that elevated input costs are eating into some company net margins, which are on track to decrease by -11.4% in Q2. Similarly, earnings are on track to decline -7% y/y in Q2, the largest drop in earnings since the second quarter of 2020.^[1]

Despite the cost pressure, select companies have been able to offset both inflationary inputs with higher prices and lower volumes with improved productivity. In fact, United States productivity was a positive surprise, increasing +1.3% y/y. This positive surprise resulted in unit labor costs increasing less-than-expected, +2.4% y/y.

Chart 1: U.S. Productivity, a Positive for Unit Labor Costs[2]

Price Impact on Volumes Depends Strongly on Brand Loyalty

The macroeconomic environment has kept prices high for consumers and companies alike. With the rise of input costs such as commodities, supply chains and labor costs, companies have had their own burden of higher prices to pay.

Companies have reacted by pushing costs onto consumers, seeking to protect earnings and margins. But there is a balancing act to this strategy – companies want to keep purchase volumes stable even as prices rise. Some are better than others at executing this strategy, as can be seen below in Chart 2.

A few consumer staples companies have had no trouble passing costs off to consumers. Companies like PepsiCo (PEP), Mondelez (MDLZ), Coca-Cola (KO) and Clorox (CLX) have been able to raise prices over double digits this year, while keeping volumes in check. This is not only a testament to the brand strength these staples have, but also, we view it as a testament to U.S. consumer strength and brand loyalty.

Some other companies have not been able to reap the same benefits as the stalwarts mentioned above. There are a few companies in Chart 2 below that have experienced lower purchase volumes as they raise prices.

Companies like Conagra (CAG), Lamb Weston (LW) and Kellogg’s (K) have seen volumes tumble over 7%, which makes investors wonder if they raised prices too quickly – or maybe consumers are less willing to pay up for these brands. We are keeping these questions in mind as we look for compelling ideas in the market.

While looking for ideas, we tend to favor companies with operating leverage. Thus, the companies that are able to raise prices should, in theory, also see higher operating income, which produces higher earnings for selling a similar amount of goods.

Chart 2: Consumer Pricing vs. Volume[3]

Materials is another sector in which the price-cost relationship is evident. Specifically, a global provider of water, hygiene and infection prevention solutions called Ecolab (ECL) was able to successfully raise prices +13% in the first quarter. Historically the company only raises prices about 1-2%.[4]

These price increases in the first quarter showed through in the second quarter as well, with volume excluding Europe growing +1% sequentially, operating margin growing +11% y/y and earnings growing +13% y/y. The company also said it will continue to take prices above its historical average range going forward.

Industrials Adjusting to Higher Raw Material Costs

Industrial companies are facing higher material costs which bleed into their manufacturing costs. Chart 3 below displays Bloomberg’s Commodity Index, which tracks the composite price movement in world commodity prices. This year’s commodity prices remain well-above the pre-Covid average.

Chart 3: Bloomberg Commodity Index[5]

Caterpillar (CAT), a company that is exposed to raw material prices, posted +22% y/y revenue growth. Pricing accounted for 45% percent of the revenue increase in the face of higher manufacturing and material costs. The company’s adjusted operating profit increased +88% y/y, and adjusted operating margin increased to 21.3%, up both sequentially and y/y.

The ability to outprice the market allowed the company to guide operating profit margins to the high end of its previously stated range. Caterpillar deals largely with products used in construction. Another company with exposure to construction materials that is seeing sequential pricing improvements is 3M (MMM).

During its most recent earnings call, 3M noted how it was able to more than offset lower sales volumes and inflation through improved productivity, restructuring benefits, strong spending discipline and selling prices.[6]

As a result, adjusted operating margins improved +140 bps and added $0.15 to earnings per share. Specific to construction materials, the company’s Safety and Industrial segment was able to increase adjusted operating margins by +70 bps y/y and 200 bps sequentially.

Despite the expectation that sales will be lower throughout the year due to weakness in the consumer markets, management noted it expects operating margin to end the year between 19.5% and 20%, 100 bps higher than originally anticipated. While many industrial companies face intense raw material inflation, others are dealing with labor inflation.

The United Parcel Service (UPS) presents a special situation because of its widely publicized labor disputes over the last seven months. UPS and the Teamsters Union currently have a handshake agreement that would increase labor costs by a 3.3% CAGR over the life of the five-year contract.[7]

The agreement resembles a barbell, in that it is front-end and back-end loaded, with years two, three and four representing the smallest increases. Clearly, higher labor costs represent a challenge to the bottom-line, however, the 3.3% CAGR is materially lower than many were anticipating. UPS revenue declined -7% y/y, where volume fell -10%, and was partially offset by a +3.3% increase in average revenue per package.

UPS is taking a multipronged approach to tackling the higher cost of labor. UPS’s Network Planning Tools (NPT) is an artificial intelligence model that quickly adjusts loading, planning and scheduling of flows across its network. These technologies resulted in a 10% decrease in hours worked in the quarter, in line with a 10% volume decrease and a large component of the $889M decrease in total expense y/y, the largest cost reduction in company history.

Durability of Price Increases

While reading this, you may ask: how long can companies continue to raise prices? The answer to this question relies on both the strength of the consumer and the actions of the Federal Reserve. As seen in the case of UPS, a strong labor market empowers employees to demand higher wages.

However, it simultaneously increases the ability for companies to increase price given that consumers have the income to pay the higher prices.

The independent variable in this equation is the Federal Reserve’s ability to crimp spending through interest rate increases, shrinking the supply of money, and therefore consumers’ power to spend. We continue to diligently watch these variables and make investment decisions based on all the factors mentioned.

Click here to read last week’s Weekly Wisdom (8/2).

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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[1] Source: The Wall Street Journal. As of August 1, 2023.

[2] Source: FactSet (chart). As of August 8, 2023.

[3] Source: Hightower Investment Solutions and Company Data (chart). As of August 8, 2023.

[4] Source: Morningstar. As of May 18, 2023.

[5] Source: Bloomberg (chart). As of August 8, 2023.

[6] Source: Morningstar. As of July 26, 2023.

[7] Source: Reuters. As of August 8, 2023.