Rising Costs Threaten Corporate Profits

Rising Costs Threaten Corporate Profits

January 25, 2011

Reuters – The rising cost of commodities ranging from oil to food is emerging as the main threat to an earnings recovery that has helped push U.S. stocks to their highest levels since the 2008 financial crisis.

Major U.S. companies across a spectrum of industries, from blue-chip manufacturing companies 3M Co (MMM.N) and DuPont Co (DD.N), to tissues and diapers maker Kimberly-Clark Corp (KMB.N) and fashion accessories house Coach (COH.N) cited rising costs as a risk to growth this year.

Concern about the effect of rising costs on profit margins prompted investors to push shares of 3M lower and barely reward an earnings report from DuPont that blew past Wall Street's expectations in Tuesday trading.

To counter the higher prices they are paying for food and materials, executives at top companies such as fast-food giant McDonald's Corp (MCD.N) are looking to raise their own selling prices this year. That could be a risky proposition at a time when the U.S. economy's recovery from a brutal downturn has been more evident on Wall Street than Main Street -- with stocks rising while unemployment remains stubbornly high.

The pinch of higher costs has not been evident in fourth quarter results reported so far -- earnings growth has outpaced revenue growth, showing that margins have held up. But the outlook for 2011 is a different matter.

'NO QUESTION' COSTS GOING UP

Investors in DuPont -- which reported quarterly profit of 50 cents per share, easily topping analysts' 32 cents consensus -- expressed concerns about how long the maker of chemicals, automobile paint and plastics could continue to push through price hikes.

"There's no question that costs are going to rise; The question is whether or not they'll be able to pass it through," said Mark Connelly, an analyst at CLSA who follows DuPont.

Prices of commodities of all kinds have risen over the past year, driven by recovering demand in emerging economies. U.S. oil futures this month reached $92.58 a barrel, their highest level since 2008, while copper hit a record high last week.

Beyond raising their selling prices, executives said they were looking for other ways to cut production costs. Coach said it would manufacture less in China as local wages rise, while Kimberly Clark said it would stop making its own pulp and cease offering some generic products that command lower margins than its Kleenex tissues and Huggies diapers.

REINING IN SPENDING DUE TO COSTS

3M, which makes products ranging from Post-It notes to films used in flat-panel televisions, saw margins deteriorate at its healthcare supply and optical equipment unit, and plans to rein in capital spending early this year as it copes with higher commodity prices as well as rising pension expenses and a higher expected tax rate.

"We will spend cautiously in the early part of this year, to see where things go," said 3M Chief Executive George Buckley on a conference call discussing the company's fourth-quarter results, which modestly topped analysts' expectations.

Kimberly-Clark said it could close five or six factories, including locations in Everett, Washington and Australia, and seek out lower-cost manufacturing locations as a way to boost its profit.

"It is something that probably was long overdue," said Edward Jones analyst Jack Russo, who has a "hold" rating on the stock. "They're trying to really clean up their business."

But in a sign there are no easy answers for companies seeking lower-cost manufacturing, Coach said it would move some purse and wallet production out of China after Beijing raised the minimum wage by 21 percent.

The company is "feeling inflationary pressures," CEO Lew Frankfort said, noting that the cost of leather has also risen sharply, adding to last year's near doubling of the price of cotton -- another key raw material for the garment industry.

3M shares were down 2.4 percent to $88.12, DuPont was up 10 cents at $48.99, Kimberly-Clark was up 3.4 percent to $66.14 and Coach was down 1.3 percent to $52.62. All four trade on the New York Stock Exchange.

Investors could get more detail on the risks that rising commodity prices post to corporate profits later this week, when major manufacturers including Boeing Co (BA.N), Caterpillar Inc (CAT.N) and United Technologies Corp (UTX.N) report their fourth-quarter results.

SMOKE WITHOUT FIRE

Adding to U.S. companies' worries is continued weak demand at home, where the unemployment rate has held above 9 percent, crimping consumer spending.

Like many top U.S. CEOs, 3M's Buckley said his company is counting on demand in China, India and other fast-growing emerging economies to drive revenue this year, since he regards U.S. demand as unlikely to pick up until employment rises.That, he said, leaves him worried about the strength of the overall global economic recovery.

"There is still a lot of smoke without fire, and we all should remain cautious," said Buckley, whose successor 3M plans to name later this year. "We should ensure that it is a dawn and not a forest fire coming our way."