In previous articles, I have mentioned that wage inflation would have to grow faster to slow employment growth and push down profit margins. The chart below shows the correlation between unit labor costs and profit margins. When unit labor costs go up, margins fall. What I didn’t mention is unit labor costs can be higher than hourly wage growth if productivity growth is negative. I didn’t mention this point because productivity growth has historically been positive. However, in Q1 productivity fell 0.6%. This means the 2.4% hourly wage growth led to a 3.0% increase in unit labor costs. The slow wage growth in the past few years is directly correlated with weak productivity growth. It’s tough to pay workers more when they’re less productive. Margins have been able to improve because of cyclical reasons and because large technology firms have natural monopolies.
Apple is one of the technology firms with a monopoly as it earns almost all the profits on smartphones. I think Apple’s margins will come down because all consumer technology firms’ margins fall over time. Some margins collapse like GoPro’s and some take longer to decline, but the competition in this space is relentless. Apple’s software advantages and ecosystem of devices has allowed margins to stay elevated, but this trend of deteriorating margins has already started as you can see in the chart below. Both gross margins and operating margins have been falling for several quarters even as other products and services revenues have expanded as a percent of total revenues. This isn’t saying services don’t have high margins; it’s saying that margins on iPhones are coming down faster than can be made up by services. There’s rumors that Apple may be releasing a more expensive iPhone with more features. That can help margins, but margins have still been falling since the iPhone Plus model was introduced.
One of the trends I have been discussing in my past few articles is that Q1 earnings growth is going to be the peak of the year. Part of the reason for that is because this quarter is lapping the weakest quarter of the earnings recession. Another reason is that energy earnings have recovered mostly, which means there’s not much room to boost growth further. A third reason is margins have recovered mostly as they have increased from 8.75% in Q1 2016 to 10.06%. There’s little room for improvement, unless you think they will reach new record highs. Apple’s falling margins is a headwind to that achievement. Keep in mind that 2018 earnings estimates assume record margins. While I think it won’t happen, it is the mainstream perspective.
The chart below supports my point that Q1 earnings growth is the peak. As you can see, while the Q1 earnings reports have blown past estimates, the estimates for the rest of 2017 have declined. This chart is great because the charts which show total 2017 earnings miss this divergence in the changes to estimates. In Q2 2017, bottom up earnings will be very close to the 2014 peak. I see this level as a ceiling while the average analyst is modeling in accelerating earnings growth as if the economy is coming out of a recession. In fact, this is the third longest expansion ever and corporate leverage is at an all-time high.
In this article, I will be looking at the Q1 earnings reports and estimates using FactSet data because the S&P Dow Jones numbers haven’t been updated since May 4th. This is the last week where there will be any significant changes to the data because now over 90% of firms have reported earnings. The biggest trend in the reports in Q1 is the firms with international exposure did better than the domestically focused firms. Firms with over 50% of sales coming from abroad had over double the earnings growth of the firms with less than 50% of sales coming from abroad. The firms with international exposure were the ones which drove the margin expansion. As you can see, revenue growth for the multinational firms was only 2.3% faster than the domestic firms. This is consistent with my point that large tech firms are driving margins higher as Apple, Alphabet, and Microsoft all have a large percentage of their sales coming from abroad.
The chart below breaks down the earnings growth in each sector compared to expectations. It was a great quarter as earnings growth was 13.6%. Telecom services was the only sector to miss expectations. The sector which stands out to me in this chart is consumer discretionary. As you can see, the expectations were for a 1.9% drop, yet earnings grew 4.7%. This is in stark contrast to the headlines which blazed about the negative reports from JC Penny, Macy’s, Dillard’s, and Nordstrom which all had their stocks fall by over 15% in the past few trading days.
Part of the reason for this divergence in what we are seeing anecdotally and the blended results which show estimates and actual reports is that some of the retailers which are expected to report good results won’t report until this week. The chart below shows the firms which are reporting this week. Ross Stores and TJX are expected to show positive same store sales growth as the discount kings take share from the department stores. Home Depot will do well as it rides the trend in home improvement retail. That sector is doing well because it is resilient to online competition. It’s easier to buy plants and heavy materials for your backyard at the store opposed to online. Seeing paint in-person gives you a better feel for how it will look on your walls.
Conclusion
Earnings season is mostly over. This week’s reports won’t move the needle in terms of aggregate earnings growth, but they will give us more information on the health of the consumer. The biggest report of the week will be Wal-Mart on Thursday. As you can see in the chart above, same store sales growth is expected to be 1.3%. This report will give us the latest update in how it’s doing in its battle against Amazon. Wal-Mart acquired Jet.com last year to compete better online.
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