Mosaic Global Perspectives

Fundamental and Technical Analysis, but Mostly Judgment

Will S&P 500 Profits Get Squeezed in 2011?

Date: 2/21/2011
S&P 500 Operating Margin
12% 95
10% 80
8%
65
6%
50
4%
35
2%
0% 20
Source:Standard & Poor’s and Institute for Supply Management
-2% 5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

S&P 500 Operating Margin (LHS) ISM Mfg. Prices Paid, Rolling 3-Month Avg. (RHS)

The debate is getting louder about whether profit margins can expand from 8.5 percent in 2010 to the Standard & Poor’s
estimate of 9.0 percent in 2011. The wake-up call seemed to gain momentum after last week’s report that the January ISM
Manufacturing Prices-Paid component surged to 81.5, the highest level since July 2008. This week’s disappointing earnings
report from Kraft followed earlier reports from Proctor and Gamble as well as Colgate-Palmolive that rising input costs would
continue to weigh on profits. For 2011, the gap between expected earnings growth of 15 percent and revenue growth of 7
percent implies a sharp rise in operating margins. Those who view the current forward P/E of 13.9X as reasonable should be
cognizant of this built-in margin forecast. This matters, since a 50 basis point change in margins is thought to produce a $4
change in EPS. Let’s review the primary factors that influence margins.

Labor costs are much more significant to the bottom line for most companies than changes in commodity prices. Lower
payrolls and other cost-cutting measures have been a powerful lever for boosting profit margins. Case in point, the fourth
quarter ECI showed that wages and salaries rose by a very anemic 1.7 percent on a year-on-year basis, while the 2.6 percent
rise in productivity led to a 0.6 percent drop in unit labor costs. We believe that companies will incrementally start to increase
payrolls and wage growth as the economy continues to grow. This would obviously serve to offset continued gains in
productivity and limit margin expansion. That said, it’s not a bad sign for a company to add employees in order to meet a
sustainable increase in demand for their products.

The market is punishing those companies that are most dependent on raw materials in order to produce their goods. The
consumer staples sector is thought to be the most vulnerable to margin contraction, and comprises 10 percent of the S&P
500. The consumer cyclical sector is likely to face headwinds as well, and makes up 11 percent of the index. However, the 16
percent weighting of the financial sector is expected to be the dominant driver of the margin expansion story in 2011, as banks
reduce their allowances for bad debts. Also, the technology and energy sector have recently had earnings for 2100 revised
higher to 22 percent and 16 percent respectively. These two sectors represent 31 percent of the index.

M o s a i c M a r k e t R e s e a r c h , L L C
K e v i n A . L e n o x , C F A
W e b s i t e : M o s a i c m a r k e t r e s e a r c h . c o m
E Mosaicmarketresearch@gmail.com
m a i l : K l e n o x @ M o s a i c m a r k e t rFundamental
e s e a r cand
h .technical
c o m analysis, but mostly judgment 1
 Profit Margins, Continued
Many companies have reduced their interest expense by either reducing or refinancing debt. Also,
lower corporate taxes, and additional share count reductions from share buybacks and M&A can also serve to support
margins.
Our assessment is that there will be a margin squeeze within certain sectors, but it will not be pervasive.
Hence, the collapsing margins thesis appears overstated. However, we find the current 9.0 percent margin forecast to overly
optimistic, and think that margins are more likely to settle between 8.3 and 8.5 percent. In that case, EPS increases by only 6
or 7 percent, not 15 percent. It also takes the forward P/E from 13.9X to 14.9X. Of course, stronger top-line growth would help
relieve some of the pressure on margins.

Sources
http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p-us-l–
http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942&token=22448&userID=

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