The Downside of “Up” for Commodities

Eric Fry By Eric Fry
Macro Strategist

Commodities

There is a downside to being “up.” Today we’ll take a look at how the profit margins of certain companies go down when commodities prices go up.

Our first example comes from the agriculture sector, which includes commodities like corn, wheat and sugar. As a group, the prices of these commodities topped out in 2011 or 2012, and they’ve been falling for most of the last six years.

That’s why most investors left them for dead a long time ago. But over the last few months, they’ve been showing signs of reawakening. So if you’re looking for evidence of life after death, agriculture might be a good place to start…

Agriculture commodities prices have returned from the grave, and they are quickly having a negative impact on the profitability of numerous companies.

Tyson Foods (NYSE: TSN), which raises poultry and livestock, is a prime example.

According to Tyson, cornmeal and soybean meal represent more than two-thirds of the cost of raising a chicken. So when corn and soybean prices go up, Tyson’s profit margins go down, all else being equal.

The story is the same at Pilgrim’s Pride (Nasdaq: PPC) and Sanderson Farms (Nasdaq: SAFM).

In the first quarter of the year, for example, grain prices were about 10% higher than they were a year ago. These rising prices took a bite out of first quarter profit margins from Tyson Foods, Pilgrim’s Pride and Sanderson Farms. On average, the operating margins for these three companies tumbled 28% year over year.

Rising grain prices are not the only cause of share price declines, but they are an important part.

And investors are expecting profit margins to get worse before they get better…

A similar trend is unfolding in the industrial metals sector.

The price of aluminum is up 25% year over year, while the prices of steel and nickel have jumped more than 50%. So we shouldn’t be too surprised to see that the profit margins of metal-bending companies like Whirlpool (NYSE: WHR), United Technologies (NYSE: UTX), Ford Motor (NYSE: F) and Deere & Company (NYSE: DE) are all lower than they were one year ago.

To explain the cost pressures United Technologies is facing, CEO Greg Hayes simply stated, “Copper has gone up, aluminum has gone up, steel has gone up.”

Echoing this remark, Whirlpool CEO Marc Bitzer told analysts last month, “Over the last few months, raw material costs have risen substantially.”

Both CEOs predicted rising input costs would boost their expenses by hundreds of millions of dollars.

Unsurprisingly, the stocks of all four companies are showing losses so far this year, even though the S&P 500 is showing a slight gain.

For a third example, let’s look at energy prices.

The price of crude oil has rocketed more than 60% during the last year… meaning the price of jet fuel has too. And that’s no help whatsoever to energy-intensive companies like airlines.

Airline profitability and jet fuel prices are inversely correlated. In other words, when fuel prices zig higher, airline profitability zags lower – and vice versa…

Fuel prices have been trending higher for most of the last two years. And, as the chart above shows, airline profit margins have been dropping sharply during that time frame.

American Airlines, for example, blamed higher fuel prices for a 45% drop in its first quarter profits. The company also slashed its profit forecast for the rest of the year.

Clearly, rising commodity prices can wield a very potent influence over profitability, for better or for worse.

Companies like Tyson Foods, United Technologies and American Airlines have been relishing the upside of down-trending commodities prices these past few years…

But those days have come to an end.

Companies that rely heavily on commodities must now brace themselves for the downside of up-trending prices.

Investors, beware.

Good investing,

Eric