Post This! MMM Comes Unglued and Raises The Threat of Peak Earnings

On Friday, 3M (MMM) pre-announced that they would miss earnings estimates which caused both MMM and the market to become unglued.  Before you flip over to the Montly Fool, which is no doubtly encouraging you to load up on the stock because Mr. Market has overreacted to this $0.02 earnings miss, let’s first try to figure out why the Market and the stock reacted so negatively to the warning.  Then we can decide whether it’s a buying opportunity or a sign of things to come. 

First, and most obviously, this has been a relatively benign earnings pre-announcement season.  Therefore, the MMM and AMD warnings are a bit of a shock to the market, which had probably assumed that everything would be OK on the earnings front.  Now, investors and traders have to worry about the Fed, Korea, Iran AND earnings, which might be a bit too much too handle.

Second, MMM blamed their shortfall on the lower demand for flat panel displays.  Combined with AMD’s pre-announcement and INTC’s woes, investors are now convinced that the technology spending cycle is turning down.

Finally, and more subtly, I think MMM’s warning is causing investors to worry that companies have reached "peak earnings."  Peak earnings simply refers to the time in the economic cycle when profitability is going to be as "good as it’s going to get".  Rising commodity prices, increasing competition for skilled labor, higher interest rates and difficulty in passing on price increases could all be reasons that corporations have already reached the height of profitability. 

To understand "peak earnings", think about a full economic cycle.  At the bottom of the economic cycle, companies are unprofitable and begin cutting costs and overhead.  This occurred in the US during 2001 and 2002.  When the economy improves, companies show rapid expansion of operating and net income margins. This occurred in 2003, 2004 and 2005. But as the economic cycle matures and revenue growth slows, companies find that costs and overhead have increased, driven by the desire to continue growing.  Combined with higher interest rates, the increased expenses cause net income margins to begin declining.  And, therefore, companies begin cutting costs and the cycle starts all over again.  That could be occurring now.

MMM’s announcement indicates that industrial companies might have reached the point at which it’s "as good as it gets" in terms of profitability.  MMM has achieved record operating and net income margins over the past three years.  It’s record of expanding margins is impressive for such a large organization.  The following graph shows that MMM has expanded net income margins from below 10% at the bottom of the economic cycle in 2002, to over 15% last quarter.  This is much higher than the historical median net income margin of 12.1%. 

Source: Baseline

Is it possible for MMM to continue expanding margins?  It’s possible, and MMM is an excellent company, so I wouldn’t put it past them.  But I’m not sure it’s probable.  And thus, it’s probably not worth betting on.  I am, therefore, not backing up the truck on this earnings disappointment from MMM.

The same can be said of the entire market.  If we examine the net income margin for the 100 largest companies in the S&P 500 (the S&P 100 or OEX), it shows a similar picture to MMM.  The following chart shows that net income margins for the OEX bottomed out at 7.2% in 2002 and now have almost reached 10%.  But the median net income margin for the OEX over the past 10 years has been 8.7%.  So margins are trending well above the median right now and have already been coming down. 

Source: Baseline

This theory that companies are experiencing "peak earnings" could explain why 3M’s stock looks so cheap compared to its 20 year history.  The market is certainly not giving MMM much credit for its record earnings because the stock is currently trading at a 16x P/E multiple – a 10 year low, and below the 19.9x median valuation. Investors could already be discounting the upcoming compression of the net income margins.  In other words, investors don’t believe in MMM’s earnings forecast and are already expecting a much more dramatic fall in earnings. 

Source: Baseline

Again, the same can be said of the broader market.  That’s why many analysts are currently arguing that stocks are cheap right now. The market certainly LOOKS cheap at 14x earnings, which is the lowest P/E the OEX has traded at in 20 years.  And if you believe that margins and revenue growth will remain strong, then the market IS cheap. 

Source: Baseline

However, if like MMM, earnings growth is slowing and net income margins are falling, then the low P/E multiples are simply an illusion.  The market is in fact already discounting an earnings growth slowdown.  As that slowdown becomes more apparent, the P/E multiple will increase and make the market look more fairly valued. 

In analyzing P/E ratios and earnings growth, it’s key to remember that the market is a discounting mechanism and is always looking into the future.  Given the market’s reaction to MMM, the market is telling me that it thinks the economic cycle has peaked and earnings growth will slow for all industrial companies. 

Of course, the market could be wrong.  As it’s commonly stated, the market has discounted nine of the last five recessions.   As investors look at the earnings announcements pouring in over the next few weeks, margins will become a key focal point.  Not only will investors focus on whether or not a company has hit it’s earnings estimates, they will examine operating and net income margins for signs that they have peaked.  And this will give investors the clues as to where we stand in this economic cycle.   

Right now, I am siding with the market.  I think that margins will disappoint investors and that despite the fact that stocks LOOK cheap, they might not actually BE cheap.  However, it’s very likely that this slowdown will simply be a minor dip in the growth rate, not an all out recession.  Therefore, if stocks continue lower through the Fall, I believe they will represent a compelling buying opportunity.  The market has already begun to discount lower earnings.  Once it starts becoming apparent to all that companies are actually seeing a slowdown, the market will truly be cheap enough to buy.