Earnings Update 2023: How Are Companies Making Money? Prices Up, Volumes Down = Higher Profits
Or why company earnings have been fine and why the stock market has held up alright despite, well, a rather hefty set of headwinds.
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Earlier this year, before the ongoing banking crisis took over both the headlines and the future direction of financial markets, we had argued that earnings were critical to watch in the first few quarters of the year.
Our argument was that, as inflation receded, other questions would gradually take over and one of the most important was:
Are companies still making profits?
This matters for the simple reason that if most companies could still make money then perhaps against expectations of most investors and prognosticators, the stock market could still rise.
You can find our old work here and a second update here.
Our conclusion was that, though likely uneven and volatile, in general companies would do alright. This wasn't a very popular opinion necessarily and to be fair, we were hardly gung-ho in our argument.
The reason for that skepticism was simple: during a time of high inflation, rising interest rates and (gently) slowing growth it would be very difficult for companies to sell as many goods and also protect their profit margins:
For the former, if consumers are experiencing high and consistent price inflation then they will be forced to buy less and make their dollar stretch further by making sacrifices somewhere.
For the latter, companies would likely see their profits eroded as, like everyone else, they had to contend with higher costs and buyers with stretched budgets.
Well, over the last few weeks we have had over 50% of the S&P 500's first quarter earnings and have learned a lot about how these businesses are doing, in aggregate and so far:
79% of companies have beaten their earnings-per-share estimates (above both the 5- and 10-year averages)
74% have beaten their revenue estimates (above both the 5- and 10-year averages)
Not bad!
Far more importantly than that, however, is the strategy that companies are embarking on that is delivering the above results.
You could shorten it to the pithy saying of: Price over Volume (but still pretty good volumes!).
By that we mean companies are effectively raising prices, often by quite a bit, and in doing so sacrificing some of their sales volume but they are still making more per unit and so they are, in effect, protecting or even increasing profit margins.
It is not just unexpected but also pretty impressive.
This isn't how it is supposed to go in theory or in practice. High inflation is supposed to directly eat into profit margins. That is the entire threat or it was historically. This time however, companies are finding that they can raise prices considerably while only sacrificing a small portion of their sales revenues.
Often these price increases over and above the rate of inflation. So, actually they are making MORE profit and on LESS volume than before inflation took hold. And, the stock market is, generally speaking, rewarding the companies for this which will only encourage them further.
The latter is not surprising but the overall trend is very important. Here are some company executives on recent earnings call speaking to this theme:
P&G CFO Andrew Schulten on their earnings call: "Moving to third quarter numbers; organic sales grew more than 7%. Pricing added 10 points to sales growth, and mix was a modest positive contributor for the quarter. Volume declined 3 points, including a 1-point headwind from portfolio reduction in Russia."
Or Jan Philipp Jenisch, chief executive of Holcim: “We are in that inflationary environment already for almost two years now…We have done the pricing in a very proactive way, so that our results aren’t suffering. On the contrary, they are improving the margins.”
Or Pepsi's CFO Hugh Johnston: "From a revenue standpoint, I think generally speaking, you see the consumer continuing to buy our products. Elasticities are still holding up quite well across most of the globe. And then despite the fact that we’re taking pricing driven by the inflation that we’re facing into."
There are various implications of this new trend:
The first and most important is that it suggests that inflation will remain sticky. Companies are raising prices and getting away with it, it would be highly unwise to expect them to stop.
The second is that this general trend speaks to the continuing strength of the American economy. Over the last few weeks, company after company have reported that the death of the American consumer has been greatly exaggerated. Add it all up and it seems that the mighty jobs market is keeping the American consumer spending and absorbing the higher prices.
Third, is that it may take a bit of time but this will quickly attract political attention and not necessarily just from the left. The image of large companies "ripping off" their customers is a very easy sell on both sides of the political aisle at the moment.
So, earnings have done well and the market has held its own. The question now becomes, how long can it last?
The problem is, of course, storms clouds are gathering. Namely:
If inflation stays elevated then it will keep eroding the value of customers' dollar and eventually it will lead to a dramatic fall in sales volumes.
Second, growth is slowing. It may not be collapsing but the US economy is grinding towards stall speed and that combination of high inflation and slowing growth is a tough one for most companies to overcome.
There are increasing alternatives to own, other than the stock market. We have made mention of short term US Treasuries multiple times in the past. That is still the case. On Friday, the US 6 month Treasury bill rate went back above 5% since before the bank crisis first took hold.
This fits with our year long bias to stick with "higher inflation, higher short term interest rates and higher economic growth" than many commentators and analysts expect. We will write about other "alternatives to stocks" in the coming weeks.
For now, add it all up and while we may have survived through the first quarter of the year there is no question that the macroeconomic back drop has worsened, not improved.
That suggests caution going forward. The stock market (like the economy) may not collapse but it is hard to see it doing THAT much better than it has so far. The S&P 500 is up over 8% for the year and the Nasdaq is up over 17%. Those are very solid returns and would be above the long term average returns for the year for both benchmarks.
We are likely around fair value. Be careful about getting greedy or hoping against hope for another big leg higher. Also be skeptical that the endless discussion of "cutting interest rates" will either a) happen or b) be positive for the stock market.
This isn't the only area where hope might be triumphing over experience either.
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