Dollar Toll on S&P 500 Profit Seen Overblown as Margins Grow

Companies in the Standard & Poor’s 500 Index are in the process of salvaging the first-quarter earnings season with an expansion in profit margins that analysts failed to foresee.

So says Jonathan Golub, the chief market strategist at RBC Capital Markets, and a handful of other Wall Street forecasters trying to explain why results have beaten estimates by so much even as sales fall short. According to Golub, S&P 500 companies are surpassing projections by enough that they may avoid their first quarterly drop in income since 2009.

The explanation is that too much pessimism was created among analysts by the rallying U.S. currency, which along with a 60 percent plunge in oil prices spurred the downward revision in quarterly profit forecasts. Instead, companies preserved profitability by lowering costs in overseas divisions and collecting sales in dollars, Golub said.

The overestimation of currency impact on earnings was a “real miscalculation,” Golub said by phone. “The upside for companies to push margins further than people anticipate is alive and well and it’s not going away anytime soon.”

The average net income margin, or profits as a percentage of revenue, for companies in the S&P 500 expanded from 3.2 percent in 2008 to 12 percent in 2014, according to Bloomberg data. Among the 203 companies in the index that reported earnings this quarter, the average margin is 12.3 percent.

Margin Improvement

Profitability enhancements have provided a 6.4 percent boost in S&P 500 earnings per share, Golub said. Utilities, energy companies and commodity producers led the way, beating forecasts by more than 15 percent, data compiled by RBC show.

Before earnings season began, analysts predicted that profits in the S&P 500 would contract by as much as 5.8 percent as the strongest dollar in 12 years crimped exporter sales. The forecast was reduced to a decline of 2.9 percent as of last week, data compiled by Bloomberg show.

At many firms, analysts underestimated the savings realized by companies that manufacture outside the U.S. but still sell their end products in dollars, according to Golub.

“International exposure and non-dollar exposure are not the same thing,” he said.

The S&P 500 slid 0.4 percent to 2,108.93 at 4 p.m. in New York, while the Dow Jones Industrial Average fell 0.2 percent.

About 63 percent of companies with higher foreign exposure have beaten consensus earnings estimates this quarter, compared to 50 percent for pure domestic stocks, wrote Savita Subramanian, chief U.S. equity strategist at Bank of America Corp.’s Merrill Lynch unit, in a client note.

Of the non-financial companies that have reported earnings so far, 65 percent have reported year-over-year net margin expansion, according to Morgan Stanley chief U.S. equity strategist Adam Parker. That’s “well above” the long-term average, he wrote today in a client note.

“The number of businesses that have higher margins, lower capital intensity and superior profit structures has dramatically grown,” said Parker. “Frankly, we wouldn’t be surprised to see productivity accelerate.”

Before it's here, it's on the Bloomberg Terminal.