The Big Picture

Briefing.com Summary:

*Price hikes by Apple and Microsoft signal mounting gross margin pressure from rising memory and storage costs across the technology industry.

*Gross margins drive operating leverage, making their direction a critical leading indicator for future earnings and stock market performance.

*Earnings guidance in the Q2 reporting period will reveal whether companies can offset rising costs or face downward earnings estimate revisions.

Apple (AAPL) has a problem on its hands, but the problem it has is not its own.

Apple has been forced by the rapid increase and high costs for memory chips and storage to raise the prices for several of its products, namely its Macs, iPads, Vision Pro, and home devices. This round of price hikes did not include the iPhone, Apple Watch, or AirPods, yet Apple suggested those products may not be able to escape price increases either.

Soon after Apple announced its price hikes, Microsoft (MSFT) announced that it will be raising the price on its Xbox consoles by up to $150. It sounded regretful for doing so, knowing it had raised prices by $20-$70 in the U.S. last October, but Microsoft pointed out that, "Unfortunately, console storage and memory prices have increased by more than 2.5x and we expect another doubling by the fall of 2027."

These are some of the world's largest companies. If they are feeling the gross margin pressure, you can bet others are, too, and will be following course with price hike announcements of their own to try to protect their profit margins.

It is a delicate task, as companies run the risk of inviting demand destruction with their higher prices. That can lead to lower sales, which often leads to lower earnings unless companies find a way to offset the lower sales with cost cuts elsewhere. That gets hard to do, however, when the cost of goods sold remains elevated.

Gross margin pressure starts at the top of the income statement but has a way of working its way down to the bottom line in a troublesome manner.

The price hike announcements from Apple and Microsoft are important developments that leave the stock market, with all its optimism about earnings prospects, at a critical juncture as it makes the turn to the second half of the year.

Let's Talk about Something Gross

We need to talk about gross profit. It isn't gross as in "yucky." Rather, the gross profit is what is left for a company after it subtracts the costs of goods sold from its revenue. The gross margin is a measure of what the company keeps of every sales dollar, and it is determined by dividing the company's gross profit by its revenue.

For example, if a company has $1,000,000,000 in revenue and its cost of goods sold totals $600 million, its gross profit is $400 million. Its gross margin is 40% ($400 million/$1,000,000,000 x 100), which is to say the company keeps $0.40 of every $1.00 of sales before it pays operating expenses.

Companies with high gross margins typically have pricing power, efficient manufacturing, and/or valuable products and services. Those high gross margins also create more operating leverage, as there is more cash to fund things like marketing and advertising, personnel costs, and office operations.

Gross margins deteriorate when cost increases outpace a company's ability to raise prices or improve efficiency. That can have a knock-on effect further down the income statement since there is now less leverage to help offset operating expenses. The result would be a less profitable company if the company hadn't found a way to cut operating expenses enough to compensate for the drop in gross profit.

Such approaches might include cutting spending for a marketing campaign, closing a facility, or reducing staff that isn't directly involved in the production process.

Moves like that can have a macro impact if they are being pursued by a large assortment of companies, which is why it is important to keep tabs on gross margins. They get the ball rolling, so to speak, for a company's operating profit, which is the cornerstone for earnings growth.

Briefing.com Analyst Insight

We have discussed for some time how strong corporate earnings growth has been. It has been the basis for the stock market's outperformance, but even more so because the market expects the strong earnings growth to persist.

The chart below shows a clear connection between analysts' forward thinking about gross margins and earnings prospects. Both have continued to rise.

It is a pretty picture alright, but if gross margins deteriorate, the picture won't be as bright as it appears today—or, at least, market participants will have more reason to start questioning if the picture can remain as bright, leaving them less reluctant to pay up for every dollar of earnings.

To be fair, companies can compensate for a decline in gross profit by cutting expenses elsewhere, but that is apt to mean less business for another company and/or possibly job losses for employees, which can have its own domino effect on economic activity.

Apple and Microsoft are giant companies that have a lot of leverage. Still, to hear them both bemoan the higher costs they are having to pay for memory chips and storage demonstrates that they don't currently have the upper hand in some critical supply relationships. That could become problematic in the near term if customer demand weakens in the face of higher selling prices implemented to protect gross margins.

The stock market is off its highs as the first half of the year nears its completion. Earnings estimates, though, are as high as ever. That won't remain the case if gross margins deteriorate. Broad evidence of margin deterioration hasn't emerged yet, but the announcements from Apple and Microsoft were yucky and are an indication that component inflation is resurfacing for technology hardware companies, which have been an important engine of earnings growth.

Higher costs aren't unique to Apple and Microsoft. Many companies continue to face cost pressures, yet relatively few have publicly announced broad price increases specifically to offset higher component costs. That suggests some have found alternative ways to absorb or mitigate those pressures.

The upcoming Q2 earnings reporting period will provide some important answers, not just in the results but in the guidance. 

Companies can still manage to deliver strong EPS growth even if they see some pressure on their gross margins. There can be other offsets like share repurchases, productivity gains, and operating expense discipline. Still, what happens at the top of the income statement doesn't always stay at the top of the income statement.

Gross margins are one of the primary drivers of earnings growth. It is much better for the stock market when they aren't yucky.

--Patrick J. O'Hare, Briefing.com