US first-quarter earnings season kicked off this past week with Alcoa (AA) and Google (GOOG) delivering more than respectable results. But many are wondering whether this trend will play out for the rest of the earning season. If the recent past is any guide, the answer is yes. Despite the malaise elsewhere in the economy, corporate America is on a pretty impressive run. Deep cost cuts made during the recession, global footprints, and a rebound in demand in many industries have pushed profitability to very high levels.
There is no immediate sign that this trend is poised to dramatically turn around this quarter. We've had very few warnings from American management teams that previous guidance was wildly optimistic, and the first quarter's macroeconomic indicators seem to point to a continued expansion in the States. But even if the headline numbers remain robust, there could still be hints in earnings reports that the next few quarters may not be quite as rosy for investors. Here are five areas I'll be keeping a close eye on when examining the quarterly reports in the coming weeks.
Margins, Margins, Margins
The huge increase in profitability has been one of the biggest stories of the downturn. Firms took advantage of the recession to shed costs and emerge leaner. Underperforming divisions were unceremoniously shut down, unproductive workers let go, and other costs cut down. Saving cash wherever possible became paramount.
But these gains have now been realised. There just isn't that much more to cut. On the contrary, businesses are now finding that they have to invest more and bring more people on in order to keep growing. Fast-growing headcount might bode well for the employment numbers, but it isn't going to do much for profit margins. These workers may very well be necessary for sustainable growth, but they are going to depress margins to more normalised levels. How fast headcount and other overhead expenses are rising should indicate if margins are set to contract sooner rather than later.
Two-Speed Recovery
One of the truisms of the beginning of the recovery was that high-end consumers were outperforming lower-end consumers. This dynamic wasn't particularly surprising. Higher-end consumers have a much lower unemployment rate, saw their stock portfolios recover faster than many expected, and were less likely to experience financial shocks such as foreclosure or bankruptcy. We heard from management team after management team that affluent consumers were coming back with a vengeance but that others were nowhere to be seen.
That dynamic has been changing lately as the jobs picture has improved, and all consumers have felt more confident and started making bigger-ticket purchases, like new cars. But will average consumers continue to keep up their confidence levels? I'll be listening to management teams to see where they are seeing strength. Is the US in a two-speed recovery that is only being driven by a few consumers, or is there broad-based strength? Are middle-class consumers about to pull back into their shells? Broad-based strength is more comforting because if stock market volatility were to return and the wealthy pull back on spending, corporate results could turn around in a hurry.
Emerging Markets Performance
Emerging markets have to be one of the biggest question marks when it comes to the strength of the recovery. The economic data from these regions often paint an incomplete picture, and it is difficult to know how hard governments are pushing on the pedal to keep growth rates high.
One way to gauge what is really happening on the ground is to see how businesses that have a footprint in, say, China or Brazil are performing. I'll be carefully monitoring both the actual results from these regions but also management's comments about business conditions. Are they expecting results in emerging markets to meaningfully slow? How much are they actually investing there? Who is showing strength and weakness? These reports are invaluable in figuring out just how much we can depend on emerging-markets growth to help keep the global economy afloat.
Is Europe Dead?
The news out of Europe hasn't been pretty. All of the talk of austerity, the debt crisis, and emergency loans to banks from the European Central Bank has made it seem like the economy in Europe must be all but dead. True, important economies like Germany and even France have managed to keep their GDP growth above zero, but how much longer can that go on given the macro headwinds across the pond? What impact is the currency uncertainty having on corporate decision-making and consumer behavior? It can be hard to divine this from GDP statistics, therefore, seeing the results from the first part of this year should be very revealing. The US can likely survive a mild slowdown in Europe without too many ill effects, but if management teams are starting to prep for a much more severe contraction, it could spell trouble, which could have knock-on effects elsewhere.
Dividend Time
You rarely hear too much gloom and doom from CEOs. They are paid to be cheerleaders for their firms and to paint their results in the best way they can, even if privately they have concerns.
But one thing that is hard to fake is a dividend payout. Boards became very conservative during the downturn, opting at almost every turn to preserve cash and shore up balance sheets, even at the expense of dividend payouts. So if boards are truly confident about the future outlook for their firms, we should hear a lot more about how those companies are planning to return unneeded capital to shareholders. Dividend increases and share buybacks are a good indicator that corporations are happy with the current business conditions and don't see a big drop-off soon.
One of the most recent dividend increases we saw came from Proctor & Gamble (PG), which announced a 7% boost to its quarterly dividend on Friday evening. “The new annualized rate of $2.248 a share is a little less than the $2.28 I'd been looking for, but 7% dividend growth is still a solid showing for a stock that now yields a handsome 3.4%,” explains Morningstar’s Josh Peters, a CFA and editor of DividendInvestor, a U.S.-based Morningstar publication. “Even more impressive is P&G's long term record: 2012 will represent a 56th straight year of higher dividends,” he says.
This article was originally published April 2012 on Morningstar.com, a sister site to Morningstar.co.uk.
