Meet the market's next winners
The recent seesaw in commodities has brought predictable gainers and losers. If things settle down, a different force -- pricing power -- could drive the next winners.
By Jim Jubak
We know which stocks will win if commodity prices plunge. Just look at the winners during the sell-off in everything from oil to copper in July and August. When the price of crude oil fell on Aug. 22, Continental Airlines' (CAL, news, msgs) stock climbed 10.6% and shares of JB Hunt Transport Services (JBHT, news, msgs) rose 4.8%. Nothing like a drop in oil to make heavy fuel users such as airlines and truckers soar.
And we know which stocks will win if commodity prices resume their rocketlike trajectory of the first half of 2008. When the price of crude oil rallied on Aug. 20 and 21, Devon Energy (DVN, news, msgs) jumped 10.3% and Freeport McMoRan Copper & Gold (FCX, news, msgs) shares climbed 10.6%. Nothing like a jump in oil to make oil stocks pop, along with inflation hedges like copper and gold.
But what if, despite the market's nearly daily swings recently from commodity doom to commodity boom, the future belongs to neither of these either/or scenarios? What if we're looking at neither a commodity collapse nor a resumption of the commodity rocket but instead a period of slower, more moderate increases in commodity prices? In other words, a world where oil and iron ore prices climb 20% in a year instead of the 80% or so we saw from mid-2007 to mid-2008?
The power of pricing
Then I think we're looking at a very different group of winners -- one that's pretty much off everyone's radar right now. Which, of course, raises the possibility that these stocks could actually deliver a profit to investors over the next six to 12 months. That possibility is enough to get my attention. After all, there isn't much of anything going up now that the bear market looks like it's resumed its hold on stocks.
What are these stocks? The shares of those companies that have the power to raise prices because they are leaders in their sector, with products and brands that customers want even if they have to pay more for them. The same companies that fell behind because commodity prices climbed so quickly that they weren't able to raise their prices quickly enough. A slowdown in the rate of commodity price increases would give these companies a chance to see their price increases catch up with rising costs. And that would produce a jump in profit margins just when everybody is expecting margins to fall further.
The result? Positive earnings surprises at these companies at a time when nobody else is delivering better-than-expected earnings per share. That's not a guarantee of a climbing stock price in a bear market when investors can sell off both the good and the bad. But it is a chance to own fundamental good news in a stock market and economy in which good news has become increasingly rare.
Let me use the stocks of two companies -- Deere (DE, news, msgs) and Procter & Gamble (PG, news, msgs) -- to show you why companies with pricing power will come out as big winners if the increases in commodity prices slow. I'll finish the column with the names of three other pricing-power companies to research for yourself.
Continued: Tractors
Tractor traction
Deere, the big maker of farm equipment, is a poster child for the damage that soaring raw materials costs have done to company profit margins. On Aug. 13, the company announced third-quarter revenue of $7.7 billion, a 17% increase from revenue in the third quarter of 2007 -- good growth at a time when a slowing economy and a collapse in the housing market have eaten into Deere's sales of forestry and construction equipment. Sales in those lines fell 7% in the quarter. But boom times on the world's farms produced a 35% increase in sales in the company's agricultural-equipment business, more than enough to pick up the slack.
But the profit story wasn't nearly as positive. Net income climbed only 7% in the quarter from the same quarter in 2007. (Because the company repurchased shares, spreading net income across fewer shares outstanding, earnings per share climbed 12% from the third quarter of 2007.)
Why did net income grow so much more slowly than revenue? Costs due to higher prices for raw materials such as steel and rubber and for shipping outstripped the company's ability to raise prices. Higher prices for raw materials cost the company an extra $140 million in the quarter. You can see the effect on the company's flagship farm-equipment business in a measure called "incremental margin," which tracks how much of each new dollar of sales winds up as profit. At its high in the third quarter of 2007, Deere reported an incremental margin of 40%. That is, each new dollar of sales of tractors, harvesters and the like yielded 40 cents of new profit. That figure slumped to 25% earlier in 2008 and hit 17% in the just-reported third quarter. That's quite a swing -- from 40 cents on the dollar to 17.Business is so strong in Deere's farm lines that the company has been able to raise prices without hurting sales. About two percentage points of the third quarter's 18% growth in net sales came from price increases, the company said, at the same time as it upped its forecasts for growth in net sales to 21% for fiscal 2008 from an earlier forecast of 20% growth. And Wall Street analysts project that the company will increase prices at least once more in 2008.
But the problem for Deere is that price increases take a long time to go into effect. Orders booked six months ago go out the factory door at six-months-ago prices. But while the company does have long-term contracts for raw materials, such as steel, that reduce the speed with which some commodity costs hit Deere's bottom line, other costs, such as those for shipping, hit home very quickly. When raw-materials costs go up as fast as they have recently, Deere finds itself playing catch-up with any price increases to its customers. The company now projects an extra $500 million in costs from more-expensive raw materials and shipping in the fiscal year that ends in October. Wall Street doesn't expect price increases to restore margins until sometime in calendar 2009.
P&G's pessimism
But you don't have to be a seller of big-ticket, long-lead-time farm equipment to feel the profit crunch from rocketing commodity prices. When Procter & Gamble reported quarterly earnings on Aug. 5, the company told Wall Street to expect a big hit to profit margins in fiscal 2009 from rising commodity prices. Costs of raw materials at the company climbed by $1.5 billion in the fiscal year that ended in June 2008. In fiscal 2009, the company estimates, raw-materials costs will soar by $3 billion.
Continued: Pricing
You'd think that most of that could be recouped quickly if the company simply raised prices. Absolutely true -- if Procter & Gamble didn't mind losing market share to competitors that decided to eat the extra cost in order to grab the business of price-conscious consumers. So instead of price increases, which would take effect as soon as anyone used up a can of Gillette shaving cream or a bottle of Mr. Clean, Procter & Gamble has to take the longer route of productivity increases, structural changes in distribution systems that will save energy (and money) and reformulating products to reduce raw-materials costs. All of that means that Procter & Gamble, too, is projecting a reduction in gross profit margins in fiscal 2009 of 0.75 to 1.25 percentage points.
All projections go out the window when trends shift. Procter & Gamble was just being prudent when it projected that the increase in raw-materials costs in the fiscal 2009 year, which ends in June 2009, would be twice as high as the increase in fiscal 2008. After many commodities almost doubled in price in the 12 months to July 15, 2008, projecting another doubling doesn't seem especially alarmist. But that projection may indeed be based on a trend that has changed not in its direction -- commodity prices are still likely to climb in the rest of 2008 and in 2009 -- but in its speed.
For example, Goldman Sachs recently called for oil to hit $149 a barrel by the end of 2008. While that would be a whopping 30% increase from the $114 a barrel of late August, it would leave oil in December at just about the July 2008 high and showing a single-digit percentage increase in price for the last six months of the year. Other raw materials, such as copper, have shown similar patterns recently. Prices aren't collapsing; in fact, they look likely to finish the year near historical highs set in 2008. But even a recovery to historical highs would leave prices pretty much flat for the last six months of 2008.
Goldilocks stocks
And that could be a big deal come October's reports on the September quarter. Investors are likely to see companies such as Procter & Gamble and Deere -- and others, such as General Cable (BGC, news, msgs), current Jubak's Pick Middleby (MIDD, news, msgs) and Du Pont (DD, news, msgs) -- announcing new guidance. Costs will still increase in 2009, the companies will say, but not as quickly as expected, and profit margins won't take as big a hit as forecast earlier.
That sounds like a formula for earnings surprises, analyst upgrades and some decent stock appreciation come October. I don't think you have to rush out and buy these shares now. Wait until they've struggled through what could be a nasty September for the stock market, and then look to buy in during the first days of October if the price is right and commodity price increases still seem to be moderating.The latest forecasts for global economic growth call for neither boom nor disaster. The most recent economic forecast from the International Monetary Fund sees world economic growth slowing to 4.1% in 2008 from 5% in 2007. That's certainly a significant slowdown and enough to take some of the frenzy out of commodity markets, but it's sure a long way from the end of the world. Or from $65-a-barrel oil or $2.50-a-pound copper.
And that would be just about right -- not too hot and not too cold -- for the stocks I've named in this column.
Jim Jubak, the Web's most-read investing writer, posts a new Jubak's Journal every Tuesday and Friday.
