A variety of macro forces is raising the cost of doing business and thus putting severe downward pressure on corporate profit margins, Morgan Stanley warns in a recent report entitled "No Margin For Error." Among the stocks that Morgan Stanley believes are most vulnerable to steep price declines are Macy's Inc. (M), Apache Corp. (APA), Bed Bath & Beyond Inc. (BBBY), Brinker International Inc. (EAT), Cypress Semiconductor Corp. (CY), Abercrombie & Fitch Co. (ANF), C.H. Robinson Worldwide Inc. (CHRW) and Southwestern Energy Co. (SWN). "The market underappreciates margin downside" for these stocks, the report says. The table below presents Morgan Stanley's target prices for each stock, and the declines that they imply.
8 Stocks With Huge Downside Risk
|Stock||Target Price||Implied Decline|
|Abercrombie & Fitch||$14.00||(23.1%)|
|Bed Bath & Beyond||$13.00||(7.2%)|
Sources: Morgan Stanley for target prices; Investopedia for Oct. 16 opening prices on which implied declines are computed.
Significance For Investors
The major macro forces that the report cites as exerting downward pressure on profit margins include: a tight labor market, with rising wages; the fact that the prices of energy and other commodities typically surge late in an economic cycle; freight costs which are increasing at a double-digit pace; interest rates which are trending up, raising the cost of debt for corporations; risks from the escalating U.S.-China trade conflict "are not reflected in guidance and aren't adequately priced;" and slowing U.S. growth in 2019, which will lead to decreasing demand.
Commenting on the market as a whole, Morgan Stanley asserts, "estimates are optimistic because they reflect sanguine company guidance on topline growth and the ability to pass on costs." The bullet points below outline the key criteria that led Morgan Stanley's analysts to rate the 8 stocks listed above as underweight, and at particularly high risk of significant price declines.
How Margins Are Squeezing Stocks
- High sensitivity of these stocks to negative macro forces (rising costs of labor, commodities, other inputs and transport; rising tariffs and interest rates; slowing economic growth and demand).
- Deteriorating profit margins present a huge risk to stock valuations.
- The market is underestimating the downside risk to profit margins.
The 3 biggest anticipated declines are associated with Southwestern Energy, C.H. Robinson, and Abercrombie & Fitch. Morgan Stanley's commentary on each is summarized below.
Southwestern Energy. The company is a natural gas producer, and Morgan Stanley sees a more attractive risk-reward profile related to oil production, while turning bearish on gas. Also, Southwestern is richly-valued compared to competitors in the Permian Basin, across several metrics.
C.H. Robinson. This trucking company faces a near-term challenge to margins from the electronic log book (ELD) mandate, which will replace paper log books with electronic monitoring of drivers' hours on the road, which are limited by federal safety standards. Technological advances such as the "uberization" of freight, blockchain and autonomous trucks present longer-term challenges. Morgan Stanley also sees increasing competition in the shipping industry, which is giving shippers the leeway to push back on rates.
Abercrombie & Fitch. Specialty apparel retailers are experiencing declining store traffic, and A&F has recorded lower same store sales in 5 of the last 6 years. Reduced occupancy costs from closing stores is being offset by rising marketing costs, while lower promotional activity and decreased efforts to reduce inventory are hindering margin expansion. A positive is growing online sales, which have lower associated costs than in-store sales, but Morgan Stanley sees margins trending downward overall for A&F, projecting a 1.7% EBIT margin for 2019, versus the consensus estimate of 3.1%.
Investors should pay particular attention to profit margins and the factors that are likely to influence them going forward. A close look at third quarter results and corporate guidance may give an indication of how well margins are holding up, as well as their future direction. Meanwhile, Goldman Sachs has recommended stocks with high margins and pricing power as likely to hold up well in a challenging macro environment.