Signs that inflation is cooling may be good news for consumers contending with record prices, but for select stocks it could bring noticeable risk.
The October consumer price index rose 7.7% year over year, missing estimates and slowing from a pace of above 8% in recent months. Persistent high prices themselves have likely cut into demand, while the Federal Reserve’s interest-rate increases may be helping pull inflation back from a 40-year high.
Unfortunately, lower inflation could also be a drag for companies said to be “overearning.”
As higher prices boosted sales and profit margins, some companies saw their earnings rocket higher this year—jumping even faster than inflation. That dynamic could get dialed back now if the Fed’s inflation fight continues to make progress.
“As inflation peaks, companies where earnings were supported by rapid margin expansion are potentially at risk,” wrote 22V Research’s Dennis DeBusschere.
His team screened for companies that fit a few criteria: It looked for firms that have seen a large increase in gross margins versus prepandemic years and whose median sales grew more rapidly than the pace of inflation. The list excludes energy names.
One classic example on the list is
Lennar
(ticker: LEN). The home construction company benefited from the housing market boom just after Covid-19 set in. People were moving to the suburbs and mortgage rates were low as the Fed initially lowered rates.
Analysts expect Lennar’s sales this year to total about $33 billion, up from $22.2 billion in 2019. With home prices rising, the company’s gross margin is expected to hit about 26% from about 19% in 2019. Full-year 2022 earnings are expected at $15.80 a share, roughly triple the result in 2019.
But these robust earnings could become a thing of a past if consumer prices continue to fall. Analysts are even expecting Lennar’s selling prices to fall in 2023.
“You’re already seeing commentary from the home builders that people are backing away from decisions to buy a house,” said Michael Sheldon, chief investment officer of RDM Financial Group. “Demand is slowing.”
If earnings disappoint in coming quarters, the stock could come under further pressure. Shares of Lennar have slid 20% this year, compared with an 16% drop for the
S&P 500.
The good news is the market already understands much of the housing market challenge heading into 2023. Mortgage rates have soared this year, and analysts have lowered 2023 earnings estimates for Lennar to $11.93 a share from a peak projection of $17.91 in the first half of this year, according to FactSet.
Another stock on the list is
United Rentals
(URI). The company rents equipment to manufacturers, construction companies, and homeowners, so its sales are sensitive to changes in economic demand. Sales this year are expected to hit $11.6 billion versus $9.4 billion in 2019. Gross margin is expected to increase to 42.6% from 39.2% in 2019. Analysts see 2022 per-share earnings coming in at $32.59, versus $19.52 in 2019.
Risk to earnings in 2023 remains present. Sales and EPS are expected to grow in 2023—and estimates for the coming year have only risen. The stock is up a bit for the year, while the S&P 500 is down by double digits in percentage terms. The risk is that estimates for next year are too optimistic.
Finally, there is
Darden Restaurants
(DRI). Sales for this year are expected at about $10 billion, versus $8 billion in 2019. The gross margin should hit just over 31% in 2022 versus 19.6% in 2019, driving EPS up to $7.57 from $4.24 in 2019. The company has had to lift prices to protect margins against rising wage and food costs. Now, the risk is that it won’t be able to raise prices as aggressively as demand wanes.
There is one caveat, though. The Darden is known for having great ability within the restaurant business to lift prices. RBC analyst David Palmer said earlier in the year that the company was enacting “unheard of pricing,” so maybe it will have an easier time than its competitors going forward.
One positive for Darden is that analysts’ 2023 earnings estimates have already come down from their peak this year and stabilized in the past few months.
There is, of course, some risk. Shares are now only down 5% for the year. Any disappointments on earnings will dent the stock.
It may not be a bad idea to buy some of these stocks. Just don’t gorge on the shares—risk to earnings remains.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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