Earnings are coming in, and higher costs are weighing on profit margins

Early earnings returns from the first quarter are in, and there is a clear warning: higher wage costs, higher raw material costs, and higher transport costs are weighing on earnings.

There's good and bad news as we enter the heart of earnings season.

Good news: companies continue to report earnings well above expectations. It's the main story of this earnings season: analysts, fearing a global economic slowdown in 2019, dramatically cut earnings estimates in December of last year. A meltdown has not happened, and it's now obvious they cut too much.

The bad news: there's a very large discrepancy between earnings and revenues, and that is likely a sign that cost pressures are starting to show up in the system.

John Butters, who has been analyzing earnings trends for many years at FactSet, notes that the S&P 500 is expected to report a year-over-year decline in earnings while it is also expected to report year-over-year growth in revenues:

Q1 Earnings and Revenues

Earnings: down 1.8%

Revenues: up 4.9%

Source: Refinitiv

This disconnect is very unusual. Butters told me that, "This is where higher costs are likely coming into play."

Indeed, in a recent survey of 23 companies that have reported first quarter earnings, FactSet noted that a high percentage cited some form of higher costs:

Negative impacts on earnings/revenues (Q1, 23 companies reporting)

• Unfavorable foreign exchange 57%
• Higher wage and labor costs 43%
• Higher raw material costs 39%
• Higher transport costs 22%
• Weather 39%
• Europe 26%
• Tariff/Trade 26%

Source: FactSet

Listen in on the conference calls or read the earnings reports of the companies that have reported so far, and you can see plenty of references to the impact of higher costs on the bottom line. Trucker and logistics firm JB Hunt cited "increased driver wages and higher recruiting costs" as a negative impact on earnings, but there have been plenty others:

AutoZone, Feb. 26: "It still feels like to us...that there is more wage pressure than there has historically been."

Costco March 7: "[W]e're still facing the headwinds from the U.S. wage increases to our hourly employees that went into effect last June 11, 2018."

FedEx March 19: "FedEx Ground operating results were negatively impacted by the inflationary impact of the tight labor market on our purchase transportation rates and employee wages."

Lennar March 27: [T]he industry still faces the headwinds of the ongoing labor crisis, which puts pressure on labor costs along with material cost pressures that come from tariffs, factory labor shortages, stricter energy codes and all without the benefit of the lower lumber cost, which will materialize later in the year."

Where's all this going? Higher wages are certainly good news for the American worker, but that and other costs are clearly putting pressure on margins. Butters notes that the current profit margin for the S&P 500 in the first quarter, at 10.7%, is the lowest margin since the fourth quarter of 2017, when it was 10.5%.

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