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By Jason Stipp | 07-06-2011 01:49 PM

Three Things to Watch for in Second-Quarter Earnings

Investors should be on the lookout for moderating profitability, signs of a China slowdown, and capital allocation red flags, says Sanibel Captiva Trust's Pat Dorsey.

Jason Stipp: I'm Jason Stipp for Morningstar. Second-quarter earnings season will be heating up, just like the weather, over the next few weeks. What should investors be expecting? What should they look for?

Here with me to offer some tips is Pat Dorsey. Pat is director of research at Sanibel Captiva Trust and Morningstar's former director of equity research.

Thanks for joining me, Pat.

Pat Dorsey: Always happy to be here, Jason.

Stipp: So earnings season will be rolling out in a few weeks. I think one of the big things that investors will be looking for is that bottom line. What should we expect on the profitability front? It has looked pretty good in recent quarters. Can companies keep it up?

Dorsey: That's a real big question. Generally speaking, of course, it's hard to generalize about several thousand companies at once. Top-line growth has been somewhat tepid throughout this recovery, offset by some really, really nice margin improvement, stemming from cost-cutting during the great recession, companies rationalizing three plants into two, and that sort of thing.

What's going to be interesting to see is to what extent that might either moderate or even reverse, because we have both increased wage pressures in some parts of the economy. Certainly, if you're a carpenter, you're not going to get a raise anytime soon, but ... especially with the big tech companies in hot areas, where there was a lot of competition from startups, you are seeing some wage pressure. So that could be an issue. Then, of course, commodity cost inflation. The price of cotton has gone up quite a bit. That's been pressuring a lot of clothing companies. And commodities, foods, in general, have gone up, and that's hurting a lot of the big consumer product companies.

Stipp: So, we know one of the areas where we have seen some wage inflation and just generally causing inflation overall is China. Obviously, a big picture situation in the global economy. What are some things that we should think about when we're looking at China and the effect of China on U.S. companies?

Dorsey: I think it's an important thing. People sort of look at China, and they think, well ... maybe it affects iron ore prices, but otherwise it doesn't really affect my investments very much. But the thing to remember is that, even though China is only about, I think, 12%-13% of global GDP, it's a much bigger portion of marginal GDP growth globally.

China has accounted for about 20% of all the GDP added in the world over the past decade. So if they slow, it's going to hurt a little bit. You've had rates being raised in China to try and slow down inflation there. You've seen orders for construction machinery tail off a little bit. So I think that any U.S. company, Caterpillar or Emerson, that are very involved in infrastructure build outs. Yum Brands would give you a good window into the Chinese consumer, given how strong the KFC chains have been over there.

I think those data points are going to be very valuable, especially because they are a little bit more robust and granular, and, frankly, believable than a lot of the Chinese macro data that comes out, since the Chinese government's macro statistics are not known for their probity.

Stipp: So there are some countervailing forces here, though. If we do see China slow down a little bit, we might also see commodities ease up just a little bit and that could actually have a positive effect, at least for consumer spending here in the U.S.

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