With the S&P500 75% through Q3 earnings season, which has been generally disappointing despite another quarter of stellar earnings growth (EPS up 26% Y/Y) as investors have focused instead on lackluster revenue growth amid concerns about “peak earnings”, US companies have yet to report any shocks or major adverse impact to profitability from higher tariffs. Yet while US corporations say they have so far been successful in blunting the effects from escalating tariffs with China through price increases or changes to their supply chains, they warn that the picture will worsen next year.
This is not to say that tariffs have had no impact: they have slowed timber and grain shipments, raised the cost of clothes hangers and heavy-equipment materials, and compressed margins for chip- and toolmakers, among other effects the WSJ notes. “The negative impact is pretty widespread across the S&P 500,” said Binky Chadha, chief U.S. equity and global strategist at Deutsche Bank. Still, he added, the overall impact is rather modest so far.
There is a reason for that: in a note from Goldman’s chief equity strategist David Kostin, he writes that the actual impact of tariffs on 3Q results has been minimal because implementation of the 10% levy on $200 billion of imports from China only started on Sept 24. However, the tariff rate is slated to jump to 25% starting in January 2019 and an additional $267 billion of imports may be subjected to a 25% tariff.
In this context, and reminding Goldman clients that in his 3Q earnings preview, Kostin encouraged investors to focus on how firms would address three mounting margin pressures in 2019: (1) increased tariff rates, (2) a tight labor market, and (3) rising debt costs. Here is what firms have said in response to those 3 points:
Some executives insisted earnings of their firms would be largely unaffected by the tariffs.
- After assessing the “impact from the different sets of tariffs imposed by the US and China,” Qorvo (QRVO) reported that all existing tariffs were “immaterial on [their] business.”
- Similarly, eBay (EBAY) suggested that “most of the tariffs have been consumer goods and we haven’t seen very much.”
- Rollins (ROL) was “fortunate to be in an industry that is minimally impacted by trade talks or tariffs.”
Most managers expect to mitigate the effects of tariffs through price increases.
- Illinois Tool Works (ITW) commented that “for 2019, we estimate the impact of tariffs at around $60 million, which is based on all announced tariffs and tariff increases as well as any carry over from 2018. And we continue to expect that our pricing actions will continue to offset raw material cost inflation, including tariff impact on a dollar-for-dollar basis.”
- United Technologies (UTX) said “We have been able to more than offset the tariff impact through pricing this year. I would expect pricing will also have to increase next year if these tariffs remain in place.”
- Mohawk Industries (MHK) “continued to execute additional pricing across most product categories to offset ongoing price inflationary pressures.” Still, Mohawk CEO Jeffrey Lorberbaum urged patience and said in the short term that higher prices could drive customers to buy other products unaffected by the tariffs. “It won’t happen like a light switch,” Mr. Lorberbaum said.
- Other companies may alleviate the increased costs by shifting their supply chains. W.W. Grainger (GWW) noted that “With respect to quantifying the impact, product sourced directly from China represents about 20% of the US segment’s cost of good sold … Applying tariff rates of 25%, we estimate our cost will increase by about 2% for the US segment … we are confident that we can find alternative supply and/or price to cover the expected tariff increases.” The company indicated that production could shift “either to India, to Mexico, or to the US, depending on the nature of the product.”
- Along those same lines, C.H. Robinson (CHRW) found that “many shippers had existing strategies to migrate more of their sourcing to lower-cost regions,” such as Vietnam, India, or elsewhere in Asia.
Some companies acknowledge the tariffs are slowing demand for products shipped to China from the U.S.
- According to timber company Weyerhaeuser, log exports to China declined with the country’s 5% tariffs, imposed Sept. 24, despite solid construction activity there.
- Railroad giant Union Pacific said in October that the season’s typical grain-shipment increase hadn’t materialized, due in part to Chinese tariffs.
- Caterpillar said sales haven’t suffered, and its manufacturing operations in both countries reduce its need for imports. Still, additional material costs are running toward the lower end of the company’s earlier forecast of between $100 million and $200 million in the second half of this year, company officials said in September
- Micron Technology which sells computer memory and storage, said tariffs could reduce its first-quarter gross margin by 0.5 to 1 percentage point, contributing to projections for a year-over-year decline of at least 1.4 percentage points.
- Workplace uniform supplier Cintas said it is paying more for clothes hangers because of the tariffs, while other direct effects are limited. “It is something that’s starting to creep in,” Chief Financial Officer J. Michael Hansen told investors in September.
- Stanley Black & Decker said tariffs, with commodity-price and currency shifts, squeezed operating margins. Two-thirds of the toolmaker’s imports from China are subject to tariffs, primarily finished goods such as power-tool accessories, vacuums and some hand tools.
Meanwhile S&P 500 wage costs are being pressured by the tight labor market. Friday’s jobs report showed a gain of 250K, a steady unemployment rate of 3.7%, and a 3.1% year/year rise in average hourly earnings. In the most recent NFIB survey of small businesses, 30% of firms selected either Quality of Labor (22%) or Quantity of Labor (8%) as their single most important problem. As a result, more firms acknowledge increased competition for labor.
- Robert Half International (RHI) explained that “as the labor market tightens, it’s just logical that you have to pay more.”
- Darden Restaurants (DRI) observed that “Restaurant labor was unfavorable 70 basis points, despite continued productivity gains and sales leverage. The increase was driven by hourly wage inflation of approximately 5%.”
- J.B. Hunt Transport (JBHT) noted that “Probably in the last 12 to 18 months, our driver wages are up about 10% or a little bit more than that.” On the other hand, some firms minimized the risk of profit squeeze from labor inflation.
- Procter & Gamble (PG) plans to boost productivity using ”tools available today to us and others that offer unprecedented opportunities in terms of automation and digitization to improve cost both on the manufacturing and on the office floor.” Higher interest rates will also put pressure on margins. GS economics forecasts that 10-year rates will gradually climb to 3.4% by the end of 2019. Although net leverage has increased sharply in recent years and stands near its post-crisis high, interest coverage ratios have remained healthy due to the low level of interest rates. From a strategic perspective, we believe firms should consider reducing leverage in 2019.
Earnings transcripts also reveal managers are preparing for further tightening of financial conditions. Companies reported building financial strength and reducing risk through debt refinancing and maturity extensions.
- Ventas (VTR) reported that “aggressive efforts to reduce debt, extend and stagger maturity profile, and significantly reduce medium-term refinancing risk has already paid off.”
- Noble Energy (NBL) “paid down substantial debt, enhancing financial flexibility.”
- Firms across a variety of industries noted they were undertaking efforts to pay down debt. Examples include Zimmer Biomet Holdings (ZBH), Eastman Chemical (EMN), Digital Realty (DLR), and Alaska Air (ALK).
Finally, in an notable twist, a handful of companies say they have turned tariffs to their advantage. Costco accelerated some imports ahead of Jan. 1 and reduced commitments to buy other products. But the warehouse-store chain is also pitching customers merchandise such as nuts and pork, exports of which have slowed in the face of China’s retaliatory tariffs.
“Something like one third of the U.S. pork…is exported to China,” Costco CFO Richard Galanti told investors on an early October conference call. “That’s changed, and therefore pork prices are way down. There’s great savings. That’s creating some opportunities.”
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