Three Things to Watch for in Second-Quarter Earnings

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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Dorsey: Certainly. So, there is this double-edged sword. You had a very high wage inflation, especially in Southern China and that impacted the labor cost of a lot of retailers, clothing companies, which are now moving production to places like Malaysia and Vietnam. Of course, if China slows, China consumes over 40% of the world's iron ore, 40% of the world's copper, you're going to see commodity prices probably ease back a little bit, probably more on the hard commodities--the metals--than on the soft commodities. That could help, say, the impact of commodity prices in future quarters, but that would take time to ripple through the system. In the meantime, anything directly tied to those commodities would get taken out to the woodshed and shot.

Stipp: So Pat, I want to turn the discussion and look again at balance sheets, corporate balance sheets here. A lot of cash has been building up on balance sheets for a number of different reasons. We have seen some activity, some use of that cash happening over the first half.

What should you be looking for about how companies are going to spend that money or if they're going to spend that money?

Dorsey: I think this is something to be paying attention to now perhaps more than ever, because you know, cash on corporate balance sheets is really at record levels now. And it's not always deployed in the most effective fashion. So I think as an investor it's something to pay close attention to. Obviously, if a company is generating more cash than it can reinvest profitably, a dividend is always a nice thing to see--giving some of that cash back to shareholders.

Buybacks are fine at current valuation levels. It's kind of a company-by-company decision as to whether that's value additive or value destructive. What I am worried about most is the M&A cycle heating up even more, and companies having dollars burning holes in their pockets, and saying, "Well gosh, we need to go out and buy us some growth"--especially given that so much of that cash you just referred to is held overseas, and companies don't want to bring it back and pay taxes on it. Well, that cash can't be used for dividends and repurchases. So companies will often use it for a foreign acquisition.

I would argue that if it's a good deal, fine, but, I would rather have the cash sitting on the balance sheet earning essentially nothing than being used for an acquisition that has to get written down in a couple of years.

Stipp: You mentioned it before, you have to ask why are they doing this now? Why is the market so much better now when everybody is trying to make these acquisitions than maybe it was couple of years ago.

Dorsey: Exactly right. I think that will be one question to ask if a company announces an acquisition. Another one is: Acquisition is a learned skill, and so some companies, you think when ITW or Danaher--they've built businesses over long periods of time and have gotten very good at doing acquisitions. They understand how to evaluate them, when to step in, when to step back. But then when you see companies that have a history of more organic growth, suddenly saying "we're going to get more aggressive," that to me is a big red flag.

Caterpillar's purchase of Bucyrus recently is something I think the analysts at Morningstar flagged and that I think was a huge mistake probably near the top of a commodity cycle. Caterpillar is not a company that has a history of doing acquisitions. They have done a few smaller ones, but not that repeated [acquisition] expertise that really gives you confidence they can get a good ROI.

Stipp: So the market has been cheering some acquisitions lately, but it's important to definitely dig beneath the surface if you are a shareholder in those companies?

Dorsey: Exactly. I would say track record is one thing to look at and also just check your own gut. If it looks expensive, probably is.

Stipp: So, last thing I wanted to ask you about, Pat, actually does involve whether something looks expensive or cheap: It's the overall valuation of the market. I think the market has gotten used to pretty good earnings seasons, as we mentioned before, pretty good profitability. As you're looking at how the market overall is priced today, do you think that the market is expecting another good earning season? Could we be setting ourselves up for some disappointment or at least some rockiness if results don't quite meet those expectations?

Dorsey: It certainly seems like that's the expectation, because, estimates have been coming up. They really haven't been coming down very much. The small sell-off we had a few weeks ago, we kind of recovered ground pretty nicely. So I would think if we get a lot of earnings disappointments, there is the possibility for some rockiness.

You had the Japanese earthquake in the second quarter, which disrupted a lot of global supply chains. You had the usual seasonal shutdown for U.S. auto manufacturers moved from July, which is the third quarter, to June, which is the second quarter--that could impact some things.

So, I think what will be interesting to watch is over this week, we didn't get any warnings. We haven't had any earnings warnings really at all, and perhaps that indicates that it will be smooth sailing again.

Stipp: All right, Pat, thanks for setting the stage for second-quarter earnings season and for joining me today.

Dorsey: Always happy to be here, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.