Corporate earnings are one of the main drivers of the stock market. But right now, there is one thing that could become a major drag on corporate profits: rising wages.
According to a recent report from Morgan Stanley, wages are eating away at corporate profits, a trend that has only accelerated after the pandemic.
“The record pace of economic recovery has been accompanied by very rapid wage growth,” writes the Wall Street giant. “If we are correct, monetary and fiscal policy will now create persistently tight labor markets, which means that the case for a structural upward trend in wages – and therefore the labor share in income – are strong.”
This does not bode well for corporate results.
“In our top-down economic model, full convergence of real wages with productivity implies that the economy-wide pre-tax profit margin declines to 10.7% from 17.8% today.”
That said, Morgan Stanley also identifies several companies with significant advantages and much less exposure to higher labor costs.
Here is an overview of three of them.
Sportswear and footwear giant Nike is a popular stock with investors. Over the past five years, stocks have soared more than 130%.
Management also returns cash to investors. Last quarter, Nike paid out $484 million in dividends to shareholders, up 12% from the year-ago period.
These dividends are backed by a profitable business. For the quarter, Nike made a profit of $1.4 billion. Meanwhile, its revenue grew 5% year-over-year to $10.9 billion.
Morgan analyst Kimberly Greenberger is confident in Nike’s ability to generate strong earnings despite rising US wages
“We expect Global Brands to be relatively insulated from wage inflation given the decline in store counts and strong revenue penetration in the wholesale and eComm channels,” writes- she. “Additionally, earnings exposure to international geographies could help ease wage inflation pressures in the United States.”
Greenberger has a price target of $192 on Nike, which is around 57% above the current share price.
Knight-Swift Transportation Holdings (KNX)
Knight-Swift is in the freight transportation business, providing multiple truckload transportation and logistics services throughout North America.
Having Knight-Swift on this list might seem counter-intuitive as pay raises are common in the transportation industry amid driver shortages. But Morgan analyst Ravi Shanker sees the company doing just fine.
“While TL driver wages have seen some of the largest increases in the past two years, KNX’s relatively low exposure to labor costs as a % of revenue and remarkable pricing power (evidenced by the growth of EBIT 2x the group average) should position them well to manage wage inflation,” he says.
“We believe scale and exposure may make this the primary beneficiary of any further upside in the cycle.”
Knight-Swift is already seeing rapid growth in this cycle. In the first quarter, consolidated revenue increased 45.4% year over year, while consolidated operating income jumped 83.7%.
The company hasn’t been an investor favorite of late, as shares are down about 19% year-to-date. But Shanker sees a rebound on the horizon. His price target of $85 implies 74% upside potential.
Rockwell Automation (ROK)
More and more companies are choosing to automate their processes in the face of rising labor costs. And that means a significant tailwind for Rockwell Automation, a global leader in industrial automation and digital transformation.
“We view Rockwell as the primary beneficiary of centuries-old investments driven by a host of converging catalysts (supply chain constraints, labor shortages, outsourcing) as technology improves and returns on investment are getting shorter,” writes analyst Josh Pokrzywinski.
He adds that because Rockwell can also increase automation in its own factories, the stock is “pretty insulated from higher wages.”
Rockwell shares are down 36% in 2022. But the company recently reported that in the March quarter, total orders were up 37% year-over-year.
Rockwell’s improvement should give contrarian investors food for thought. Pokrzywinski has a price target of $277 on Rockwell shares, 27% higher than current levels.
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