Trader Talk: Alcoa Downgrade a Bad Earnings Omen?

Bob Pisani is off; this post was written by CNBC producer Robert Hum.

With the March jobs report now behind them, traders are beginning to turn their attention to the upcoming earnings season, which officially kicks off next Monday with Alcoa’s report after the close.

Traders are hoping the Deutsche Bank downgrade of Alcoa this morning isn’t an indication of broader earnings season headwinds.

As mentioned earlier, Deutsche Bank lowered its rating on the aluminum maker due to concerns that declining sheet sales and higher energy prices could be impediments to a strong Q1 earnings report. Consequently, it also slashed Alcoa’s full-year earnings outlook by 38 percent to $0.64 (also partly due to one-time EU fines) and cut its price target from $25 to $18.

Nonetheless, this report brings up a handful of potential headwinds companies may face headed into earnings season:

1) Rising costs may pressure margins. Many commodities are hitting their highest levels since summer/fall 2008 — threatening companies’ inherent cost levels. And the price gains amongst the energy and metal complexes have been momentous. Over the past year: crude oil up 65 percent, gasoline up 58 percent, copper up 82 percent, and aluminum up 58 percent.

That translates to higher metal costs for steelmakers, higher manufacturing costs for industrial firms, higher fuel costs for transportation companies, as well as higher packaging costs for consumer/food companies, etc. In many cases, the surge in input costs may likely outpace any top line growth, putting a squeeze on profit margins.

2) Will revenue growth be sustainable? A year ago, companies reported steep double-digit revenue declines — harsh evidence of the country being in the middle of the severe recession. As a result, many firms should post strong year-over-year revenue gains this quarter due to the easier comparisons.

But regardless of how big these gains might appear to be, traders will certainly eye a) how the top line strength compares to Street expectations and more importantly b) any indications on whether the growth can be sustained over the rest of the year – when top line comparisons get more difficult.

Bottom line: with potential costs skyrocketing recently, companies can no longer rely on the benefits of cost cuts and lower commodity prices that were realized in recent quarters to prop up earnings. Instead, it will be critical for earnings growth to be largely supported by improving revenues as the economy continues to recover.

3) Stock prices are no longer “cheap.” Over 20 percent of the S&P 500 and a large number of NYSE stocks are already trading at new 52-week highs, with stock valuations looking more pricey.

Take the S&P 500. The index is trading at 1,187 and analysts are currently expecting forward earnings of $77.64. Based on those numbers, the S&P is now already trading at over 15 times forward earnings (1,187/$77.64). That’s about inline with its historical average P/E ratio, but a far cry from when the S&P was “cheaper” — back in the fall of 2008 when it traded at just 9-10 times forward earnings.

Therefore, IF the market attempts to continue its rise, either a) earnings must grow enough to maintain the index’s current valuation, or b) the markets risk sustaining more expensive valuation levels. If the latter situation develops, the markets could inch closer to trading at a more lofty 20 times forward earnings (similar to the record high levels seen last decade).

Another potential threat to existing valuations: cautious corporate guidance during earnings season. Any uncertainty on the prospects for future earnings this year could prompt analysts to lower estimates (as Deutsche Bank did with Alcoa), which wouldn’t bode well for current stock valuations.

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