Why Pepsi can rebound but GM can't

By Jim Jubak

Buckle your seat belts. Earnings season is going to be a bumpy ride.

Thanks to soaring prices for commodities from iron ore to corn, the second-quarter earnings season that kicks off with Alcoa's (AA, news, msgs) report on July 8 is going to be a volatile one. Lots of companies are going to meet Wall Street expectations for revenue, but miss -- and miss badly -- on net income as higher prices for raw materials savage profit margins.

In the current anxious sell-first, think-later market, I think any miss could quickly take 3% to 10% out of the price of a stock.

Which stocks are most at risk and which least? Let me try to sketch in a few rules for telling the most exposed from the least exposed. After that, I'll suggest where to look for post-earnings-season bargains.

More sales, less profit

Take a look at what's happening at Deere (DE, news, msgs) to see the effect of higher costs on profit margins. When the company reported results May 14 for the second quarter of its fiscal year, management raised projected revenue growth for fiscal 2008 to 20% from the previous forecast of 17%. But the company didn't raise earnings projections at all.

When can a company grow revenue but not grow earnings? When costs are climbing so that each dollar of sales results in less profit. That's exactly what's going on in Deere's case. At the end of fiscal 2007 the company had projected that raw material and freight costs would climb $140 million in fiscal 2008 from 2007. But now the company is projecting costs in those categories to climb by $300 million to $400 million. That comes right out of net income.

Eventually, Deere will be able to recoup those higher costs. Because its customers in the world's farming regions are seeing record prices for their crops, Deere will be able to charge more without seeing a drop-off in sales. But there's always a lag between the moment raw materials go up and the time when higher prices bring enough extra revenue in the door to make up for higher costs. In Deere's case, that lag is about six months, because the orders the company took in the first half of 2008 for delivery in the second half of 2008 were protected against price increases. Any price increase the company put into effect today wouldn't take effect until 2009.

This is why the price of Deere shares has been in a steady decline since its pre-earnings report high of $90.19 on May 13. As of June 27, the stock was down 20.9% from that level.

Deere isn't alone. Any company that uses steel faces the same cost pressures. For example, in May Deutsche Bank added $400 million in additional raw materials costs through 2009 to its forecast for Ford Motor (F, news, msgs). That same month the investment bank also estimated that rising steel costs will eventually add $2 billion to the cost structure at General Motors (GM, news, msgs) once the car company's current steel contracts reset. And steel price increases aren't done, either. After Rio Tinto (RTP, news, msgs) announced that it had negotiated a 97% increase in iron ore prices with Chinese steel makers on June 23, Posco (PKX, news, msgs), the Korean company that's the world's third-largest steelmaker, announced a 21% increase in steel prices.

And a company doesn't have to be a consumer of metals or energy to feel the full force of increases in the cost of raw materials. For example, PepsiCo (PEP, news, msgs) has raised its estimate of inflation in the cost of raw materials from 6% to as much as 10% for calendar 2008. The biggest culprit here is the record cost of corn, which PepsiCo uses in corn-based snacks such as Fritos and, more importantly to the bottom line, in its soft drinks as the sweetener corn syrup. After beating analyst expectations for the first, second and third quarters of 2007 by 4.8%, 5.6% and 3.1%, respectively, the company has reported results for the fourth quarter of 2007 and the first quarter of 2008 that just met Wall Street forecasts. The stock has fallen 18% from its 2008 high of $79.57 on Jan. 10 to a closing price of $63.93 on June 27.

Continued: Raw materials more expensive

 1 | 2 | next >