The #1 Thing Investors Will Be Watching This Earnings Season

Earnings season begins today! Tradition first-out-of-the-gater Alcoa reports earnings after the close.

The #1 thing investors will be watching? Margins. There’s no question that input costs have been rising faster than end consumer costs, a fact that has been born out in just about every regional Fed and ISM survey for months now.

The big fears is that it finally takes its toll on the bottom line, stopping earnings growth dead in its tracks.

In a note out today, UBS gives a guide of what to look for:

In Q4 2010 the rising cost of energy, metals, and food, as well as rising wages in China and increasing regulatory pressure, cut the margins of many companies. Cost of Goods Sold / Revenue rose 200 bps sequentially. We expect this trend to continue in Q1, because input costs rose even faster in Q1 2011 than Q4 2010. The ISM Manufacturing Prices Paid Index rose 11.8 points in Q1 2011 versus 7.8 points in Q4 2010. The CRB Index rose 6.4% in Q4 and 10.7% in Q1.

As we have detailed in other reports, today margins of many firms are more vulnerable than usual to rising input costs, because these costs are not soaring (as they usually do) toward the end of the business cycle when capacity utilization is high and companies have pricing power. Instead, we are fairly early in the cycle when utilization is low and unemployment is high. Of the 109 months since 1948 that the ISM Prices Paid index has been over 80, January 2011 was the month with the lowest level of manufacturing capacity utilization. (See Rising Costs, Low Utilization, March 7, 2011.) For companies, high unemployment is positive in that it relieves wage pressure, but it is negative because consumers are more likely to resist price increases than when jobs are plentiful and consumer confidence is high.

But it’s not necessarily bad overall. Rising commodity prices do benefit many industries. What we may see is more margin-related profit warnings, and yet a fairly steady level of aggregate earnings:

While companies that purchase commodity inputs see margins squeezed, commodity producers obviously benefit from higher prices, as do their many suppliers of equipment and services. For example, when UBS recently raised the WTI crude price forecast $10 to $95 for 2011, oil and gas companies’ 2011 EPS forecasts were raised enough to add $2.65 to S&P 500 EPS. While it is difficult to quantify, we doubt that more than 100% of this benefit to earnings will be offset by earnings reductions by energy users. So rising commodity prices are probably positive or at worst neutral to profits. Historically, S&P 500 margins have climbed when the CRB index rises.

From a top-down perspective, rising energy prices are positive for earnings because they shift income from consumers to corporations—which is why rising gasoline prices are so unpopular with the general public. Conversely, profits tend to be weak during periods of commodity deflation and healthy real GDP growth.. (For example, in 1985, 1986 and 1998, real GDP growth averaged 4% but S&P EPS declined 1.3% on average). Quite simply, S&P profits (which are global and nominal) do not always track GDP (which is domestic and real).

Meanwhile, here’s a look at the historical level of positive vs. negative surprisers. It’s very high, but coming off its peak.